Monday, September 29, 2014

No-This Time is Not Different

Leverage is increasing. YTD 50% of LBOs have FDX (funded debt multiples - Funded Debt/EBITDA) greater than 6X - 15% have FDX greater than 7. Additionally, creditor structural protections like financial covenants are disappearing. The driver is the increase in PPX (purchase price multiples - purchase price/EBITDA). Current LBO PPXs have increased two full turns to 11.5X since 2013. This reflects the increased pressure from competing strategic acquirers, a strong stock market and a recovering M&A market. PPX always increase to absorb any rise in debt capacity. Just as the Cash Burn Rate is important for venture capitalists so is the PPX for private equity sponsors - it represents a LBO burn through of value.

Some believe this time is different and the increasing debt levels are affordable. They believe an improving economy, low rates and low spreads translate into strong interest expense coverage and low default rates. They do, but this is a cyclical business and these pleasant facts can quickly change as we saw during the financial crisis when defaulted or restricted loans rose to double digit levels.
FDX greater than 6X mean you cannot retire principal during the original term of the loan. This means the ultimate repayment source is either a refinancing or trade sale of the company. These depend on markets remaining open and liquid - which is clearly not always the case. We have moved in Minsky terms from a hedged phase (2009-2013) in which debt principal and interest can be serviced from internal cash flow to a speculative phase. During this phase only interest can be covered from internal cash flow. The final Minsky phase before a correction is the Ponzi stage in which neither interest nor principal can be internally covered. Instead they must both be refinanced as was the case the last Ponzi stage of 2007. We are, hopefully, a few years away from this, but no one knows for sure when markets will turn. All we do know is they can and do turn violently when the refinancing wall is hit.

This situation has been noticed by banking regulators. They have strongly signaled that transactions with greater than 6X FD ratios will be subject to greater review. Last year they criticized over 40% of the large syndicated loans, known as shared national credits or SNC, which are heavily weighted towards leveraged transactions. Recently, they have signaled out Credit Suisse for underwriting loans exceeding the 6X guideline. This is understandable as CS is a major LBO loan sponsor with a 13% market share and generating over $400mln in loan fees this year alone. CS will push to defend its market position. Regulators may require CS to hold more capital and criticize banks participating in their loan syndicates via the SNC review. Ultimately, this will push more of origination effort to non banks just as most of the ultimate holders of leveraged loans are now non bank CLOs.

This will not end well. As Hemingway stated about bankruptcy - first it happens slowly, then suddenly. It is difficult for banks like CS to resist getting dragged into the fray. How can you choose not to play the game on the field especially when your competitors are doing so?  Citi’s Chuck Prince noted, as long as the music is playing you have to keep dancing. The regulators are trying to turn down the music. Whether they succeed this time is questionable.


Thursday, September 25, 2014

Common Errors in Valuation

The heart of merger analysis is valuation.  We spend considerable time in our acquisition finance course stressing best practices in valuation.  We've noted many times that value is estimated while price is paid.  Hence, errors in valuation can be crucial to deal success.  In this spirit, we note the article entitled 119 Common Errors in Company Valuations".  The abstract is below.  The complete article can be downloaded here.  

119 Common Errors in Company Valuations

Pablo Fernandez 

University of Navarra - IESE Business School

Andrada Bilan 

University of Navarra - IESE Business School 

This document contains a collection and classification of 119 errors seen in company valuations performed by financial analysts, investment banks and financial consultants. The author had access to most of the valuations referred to in this chapter in his capacity as a consultant in company acquisitions, sales, mergers, and arbitrage processes. We classify the errors in six main categories: 1) Errors in the discount rate calculation and concerning the riskiness of the company; 2) Errors when calculating or forecasting the expected cash flows; 3) Errors in the calculation of the residual value; 4) Inconsistencies and conceptual errors; 5) Errors when interpreting the valuation; and 6) Organizational errors."

All the best,


Monday, September 22, 2014

Blackstone’s Hilton Deal: The Best LBO Ever?

A recent Business Week article proclaimed Hilton the best LBO ever. This was based on the size, $12B, of Blackstone’s unrealized gain. Some details are as follows:

1)     Investment Size: Blackstone’s initial fall 2007 equity investment was $5.6B. This represented Blackstone’s largest single equity investment. It contributed another $820MLN as part of a 2010 restructuring. Blackstone had written off 70% of its investment in 2009 reflecting poor performance as the financial crisis impacted hotel occupancy.

2)     Deal: the deal was concluded at the height of the pre crisis LBO boom. It was overpriced, double digit purchase price multiple, and over leveraged with just 20% equity and a double digit funded debt multiple. The $20B in debt, was primarily Covenant-Lite loans.

3)     Restructuring: lack of financial covenants allowed Blackstone to control the restructuring process. In 2010, they contributed additional equity, got lenders to reduce billons in debt (AKA forgive) and extend loan maturities.

4)     Winter 2013 IPO: a partial $2.4B IPO was completed which gave Blackstone’s Hilton equity interest an implied gain of $10B. The stock price has improved. The implied gain now stands at $12B the largest single transaction gain for a LBO which represents a 2X multiple of investment (MOI).

I question whether this is the best LBO ever-particularly from the limited partners’ (LPs) viewpoint.  Consider the following:

1)     Unrealized Paper Profit: Blackstone and its LPs still have received no cash. They are feeling better than in 2009 with a gain instead of an unrealized 70% loss for sure. The PE model is based on the precept that there is no exit until cash is returned. Some will argue that it is smart to hold on to the stock because it is appreciating. Remember, that Blackstone gets 20% of any stock appreciation. It would be better for LPs to get the cash and buy Hilton on their own to keep 100% of any gains.

2)     Not Risk Adjusted: This investment is volatile and represents a huge concentrated bet of LP capital. Wonder if LPs are happy with the returns given the IRRs-especially what they could have received on an alternative high risk assets. Consider an equally leveraged $26B equity portfolio in 2007 would have also yielded a $12B gain.

3)     So-So IRRs: IRRs are mediocre even based on the implied values. The December, 2013 implied IRR was in the mid teens, while the current IRR is in the low teens. I am sure these are below what was initially projected when the investment was proposed.

4)     Over Betting: You can always manufacture high dollar returns by investing large amounts. This does not mean, however, you have created value. As the Kelly Criterion shows, beyond a certain point, taking more exposure becomes suboptimal due to a higher risk of ruin in bad states-i.e. you crap out of the game too early.

I am not taking anything away from them - I am glad things worked out. Sometimes, it is better to be lucky than smart. The Business Week story mistakenly assumes the current positive outcome flows from the original decision. The Hilton gains, however,  come from a lender value transfer who accepted a large discount on their loans and leverage - not from the investment target selection.  The deal does show, however, how PE, Wall Street and apparently some journalists think. Despite what you learn in business school, they do not care about risk or the time value of money. The key metric for them is MOI. Additionally, it demonstrates the value of covenant - lite loans for borrowers, which comes at the expense of lenders.


Thursday, September 18, 2014

Deal Making in the Beer Industry

The recent merger activity in the beer industry illustrates several interesting items that we typically cover in our upcoming Acquisition Finance course.  Given that the class is held in Amsterdam which is the home of Heineken only accentuates the interest.  

To recap:  Heineken rejected overtures from SABMiller to consolidate.  Meanwhile Anheuser-Busch InBev is reportedly raising a financing package of over $100 million purportedly to acquire SABMiller.  What can we learn from this activity?

Mergers occur in waves within the economy.  Merger activity is known to correlate positively with the stock market and has for more than a century.  It is not surprising that we are seeing increased activity near market peaks.

Mergers occur in waves within industries.  This phenomena is more interesting.   Industry merger waves occur because some catalyst makes deals attractive.  Typical catalysts include changes in consumer tastes, new technologies, new markets, changes in regulations and overcapacity within an industry.   Each creates opportunities (or needs) to merge.

As internal growth declines, companies seek deals.  This can be value enhancing or merely a ploy to avoid the realities of the marketplace.  Growth at Anheuser-Busch InBev is now projected to be much lower than in the past.  According to the Wall Street Journal, SAB generates 70% of its earnings from emerging markets which could nicely complement the market positions of Anheuser-Busch InBev.

Mergers occurring early in a deal cycle tend to generate higher returns.  This makes sense as companies enjoy the lower hanging fruit first.  Companies with the greatest opportunities for improvement or synergies are typically acquired first.  

Mergers can be a defensive move.  This could have been a reason SAB was courting Heineken, although from geographic diversification point of view the Heineken combination also makes sense.

Ownership structure plays a crucial role in mergers.  According to the WSJ, Atria and the Santo Domingo family control about 42% of SAB.  Such large positions are likely associated with increased monitoring and avoidance of bad deals.  When ownership structures are family dominated, hostile deals are quite unlikely.  Heineken Holding N.V. owns just over 50% and the family controls that firm.  

Of course, all this is best contemplated while trying the products mentioned.  I look forward to having a Heineken in Amsterdam while overlooking the Amstel river.

All the best,


Monday, September 15, 2014

Private Equity (PE) Is From Mars - Corporate Strategic Buyers (CSB) Are From Venus

I have previously touched on the differences in Valuation and Capital Structure between PE and CSB. The differences go beyond these two factors and distort M&A averages. They reflect the differing incentives and objectives of the two groups of acquirers.
CSB have permanent capital and take a longer term strategic acquisition viewpoint. PE is transactional orientated with an intermediate investment horizon of 5-7 years. This reflects the temporary nature of their capital - 10 years per fund with a 5 year investment period. This distinction is critical. As Warren Buffett likes to say there are no called strikes in CSB M&A - you can wait for your pitch. In PE, the clock is ticking - there are called strikes. This difference raises the risk of forced errors for PE. I am not suggesting CSA does not error. Rather, I am suggesting PE errors have a different basis from CSB.

Some of style differences are as follows:

1)     Valuation:
a)     CSB use a WACC based DCF and perpetuity based terminal value.
b)     PE uses a cost of equity bases RETURNS TO EQUITY model with a 5 year exit multiple usually tied to the purchase price multiple.

2)     Debt Capacity
a)     CSB employ a permanent capital structure with an investment grade focus that is company determined. Additionally, they use simple funding instruments - straight debt and common equity.
b)     PE uses temporary capital structure focused on maximizing debt capacity. This means their capital structures are non investment and market not company determined. Also, they use complex structures with multiple debt layers.

3)     Value Added
a)     CSB value added is synergy related.
b)     PE value comes from financial engineering and exit multiple expansion.

4)     Affordability Constraint
a)     CSB EPS dilution from any required equity issuance serves as the main constraint. Typically prefer a dilution earn back of 2-4 years.
b)     PE maximum debt capacity and the IRR on the required equity (usually 35% of the price) serve as the main constraints.

5)     Holding Period
a)     CSB infinite
b)     PE 5 - 7 years with an outside limit equal to the fund’s life-usually 10years.

6)     Integration Risk Concerns
a)     CSB high as the acquisition is usually merged into the acquirer’s existing operations.
b)     PE low the target is usually treated on a standalone basis.

7)     Search Process
a)     CSB strategic focus
b)     PE opportunistic

8)     Incentives/Performance Evaluation
a)     CSB corporate level
b)     PE at the transaction and find level

Understanding the differences between PE and CSB allows a better understanding of their styles and allows improved recommendations.


Thursday, September 11, 2014

Rejecting the Top Dollar

We’ve seen numerous multi-bidder deals this year.  (See, for example, Unique Synergies and theTyson Foods/Hillshire Merger.)  One of the more interesting is the current deal involving Family Dollar Stores.  Two bidders, Dollar General and Dollar Tree are seeking to own Family Dollar.  One of the bids (Dollar General) is clearly superior, yet management of Family Dollar favors the lessor bid of Dollar Tree.  One can wonder why.  (See Miriam Gottfried’s article in yesterday’s Wall Street Journal for additional details.)

 The Dollar Tree bid is valued at $74.50 a share.  The Dollar General bid is $80.   Advantage to shareholders: Dollar General.

Dollar Tree’s bid is 80% cash and 20% stock.  Dollar General’s bid is all cash.  Advantage to shareholders: Dollar General.

There is a breakup fee on Dollar Tree’s bid of $305 million agreed to by Family Dollar.  Dollar General said it would pay this.  Advantage to shareholders: Neutral.

Yet management of Family Dollar favors the Dollar Tree bid citing anti-trust concerns.  Are these valid?  True Dollar General and Family Dollar have similar business models, but there are other dominant competitors to the firms, namely Wal-Mart.  In addition, Dollar General has agreed to divest as many as 1500 stores in an attempt to head off any anti-trust issues. 

We have shown in our research that opposition by target management is the single biggest factor determining whether a deal goes through. So the opposition by Family Dollar clearly gives an advantage to Dollar Tree. The Dollar General bid is clearly superior from a shareholder’s point of view.  Management is supposed to represent the shareholders.  Management opposes the Dollar General bid.  Hmmm.  In view of the clearly superior bid by Dollar General, one must wonder at management’s own incentives and how (and why) they factor into the decision.