Thursday, January 29, 2015

One Sided Activism? A Note on the Symmetry of Market Problems and the Asymmetries of Activists

There are a couple of really interesting articles about activists in the last two Wall Street Journals.  The first is yesterday's "Activists Are On A  Roll With More to Come", which documents the power and success of activists, noting the growth in the number of campaigns and in the number of assets under control.  The article also notes the increased success rate of proxy campaigns.  

The second article, entitled A Radical Idea for Activist Investors presents a provocative question.  If Actists are so smart, why are they one sided in their attacks? As the article notes:

"The vast majority are making similar demands of their targets, delivered with what now feels like a dull percussion: Raise the dividend, buy back shares, cut these costs, spin off that division, sell the company."

Wouldn't we expect a similar pressure by activists encouraging at least some firms to invest more?  Shouldn't we expect at least some activists campaigns to push firms to be less conservative, to invest more, to pursue heretofore missed opportunities?  

The article suggests three reasons for the one-sided attacks.  First, CEOs can be driven by ego and are motivated to expand not contract.  Second, such an attack requires a longer term investment to reap rewards.  Activists tend to be more short term.  Third, it could cause destabilizing investor turnover as one type of investor replaced another.  (I confess to not fully understanding the latter idea.  How does this ever stop value creation?  Don't takeover attempts do the same thing?)

But I'd like to offer a fourth reason that activists are not prone to pushing firms to invest differently and it is simply this:  Activists are not by nature, build it, type individuals.  Also, the expertise it takes to recognize over investment is likely to be more plentiful than the type of expertise it takes to build something.  I'm not saying one of these skills is more valuable than the other, just that it is not surprising that activists don't possess these skills.  Also as the article notes:

"These are the very opportunities that private-equity firms exploit, capitalizing on the market’s impatience for such undertakings."

So from my perspective, there is nothing unusual about specific types of investors being adept at different approaches.  Both articles offer a lot of food for thought and are well worth reading.  

All the best,


Monday, January 26, 2015

Dollar Tree Family Dollar Acquisition: A Rare Win-Win

DG began acquisition discussions with its smaller competitor, FDO, last summer. Another smaller rival, DLTR, emerged with an $8.7B mix of stock and cash offer-representing a 22% premium to its 7/25/14 price. DG responded with a $9.1B all cash offer. Ordinarily, a higher all cash offer would prevail as its value is clear. Nonetheless, DG’s offer contained a substantial risk of not closing due to real antitrust concerns.

DG was the largest of the three major players in the “dollar” retail industry at $4.7B in revenues and 11,700 stores compared to DLTR’s $2.1B and 5200 stores and FDO’s $2.6B and 8100 stores. Whenever the #1 buys the #2 in the same industry- antitrust issues become a real concern. It was estimated DG needed to jettison over 1500+ stores to may be satisfy the FTC; while DLTR with less overlap would close less than 500 stores. Recognizing this- DG offered a $300 mln+ breakup fee. Perhaps, DG wanted to remain the dominant industry participant and prevent the formation of a larger rival.

Last week, FDO shareholders  accepted the lower priced DLTR offer given its greater chance to close. Interestingly, the market was positive for all three firms. The stock price increase for DLTR and FDO is somewhat understandable. It signals belief in the synergy benefits of the combination and removal of uncertainty for FDO’s shareholders. Additionally, DLTR appears to have a better chance of turning around the struggling FDO which had suffered a 47% drop in earnings for the 11/14 quarter end.

Looking at the 3.7% increase in DG’s stock rise one can conjecture the following reasons:

1)     The price was too high relative to the possible benefits it could extract. Another way of saying it is DLTR is the better owner.

2)     Closing 1500+ stores given the premium offered makes you wonder what’s in it for DG’s shareholders. That is a lot to give up relative to DLTR.

3)     DG foregoes the possibility of paying a $300 mln breakup fee if the deal failed to obtain antitrust approval.

Yes, DG is smaller than it would be if the acquisition proceeded, but its shareholders are richer- better off. Yes, DG faces a new and larger combined DLTR-FDO competitor. The new DLTR, however, faces real integration and turn around issues. Furthermore, it will be saddled with a heavy debt load comprised of $5.4B in term debt plus another $2.8B in new senior unsecured notes. Well- in any event the market has spoken. My gut tells me DG’s shareholders dodged a bullet on this one and should thank the FDO shareholders for rejecting their offer and thereby preventing a forced DG managerial error.


Thursday, January 22, 2015

Earnings Dilution - A Real or Imagined Problem?

A good deal is one that is expected to produce a positive net present value.  That is, it is worth more than it costs.  But what about a deal that has a positive net present value and results in earnings dilution next year?  Is this possible?  If so, is this still a good deal?  Are there any ways to avoid dilution?  In a share for share exchange, how can we tell the maximum number of shares that an acquirer could issue without causing dilution?

Can a deal with a positive net present value cause immediate dilution of earnings?  Absolutely.  If we issue enough shares to acquire a target and the shares are not offset by an appropriate increase in next year's earnings, dilution will occur.  By NPV terms, the deal is still a good one if the expected net present value is positive.  It is just that the value and cash flows appear later in time.  Nevertheless, the dilution in eps creates a very real perception that the firm is declining.  Shareholders without privy to the stream of expected cash flows or NPV calculations can assume that the acquiring firm is in a downward trend.  Hence, dilution creates a very real problem.

How to avoid it?  A first solution is not satisfying: don't acquire targets where dilution would occur.  This results in missing great opportunities if the deal is indeed a positive NPV.  A better approach is to structure the deal so that dilution does not occur.  This is done by issuing fewer shares and substituting cash or debt to complete the payment.  Deferred or contingent payouts can also help in this regard.  

How can we know if dilution will occur?

  1.  Estimate projected eps without the deal
  2.  Estimate projected total earnings with the deal
  3. Divide the projected total earnings by projected eps in step 1.  This tells you the maximum number of shares you can have outstanding without dilution
  4. From this maximum number of shares, subtract the current shares outstanding of the acquiring firm.  This tells you the maximum number of shares you could give the target without dilution.
  5. Divide the number in item 4 by the number of target shares currently outstanding.  This gives you the maximum exchange ratio without dilution.  
As an advanced concept, you could expand this maximum using free cash flow generated by the target in the first year after acquisition although you'd be giving away some value.  To do this:

6. Calculate how many shares of the acquiring firm you could acquire using the target's first year free cash flow.  Add this to the maximum number in item 4 and recalculate item 5.

All the best,


Monday, January 19, 2015

How Private Equity Creates Value: A Look Back

Carlyle purchased the industrial fastening and packaging firm Signode from ITW in 1H14. The purchase price was 9X EBITDA. They contributed $885 mln in equity representing around 25% of the transaction. The leverage multiple was 4.5X FLD (loans) and 6.5X total with a B/B2 rating. So how did it workout for Carlyle?

There are four levers PE can use to create value:

1)     Buy Right (i.e. cheap): this is increasingly difficult in the competitive domestic PE market. Here, Carlyle appeared to pay about market as it was competing against other PE firms for Signode. Signode was attractive given its established customer base and low cyclicality. Result-neutral.

2)     Financial Engineering (i.e. leverage): Carlyle capitalized on aggressive debt market conditions to obtain a relatively full leverage level with loose loan terms (i.e. covenant lite). Carlyle’s reputation and large dollar amount of equity contribution probably helped creditors get comfortable with financing. The large leverage level illustrates that PE firms really do not care about risk adjusted returns. All that counts for them is nominal returns, which of course are amplified by leverage. Result-positive.

3)     Improved Operations: an initial move was to improve working capital efficiency by increasing accounts payable to 60+ days, which freed up millions. Remember free cash flow= EBIT X (1-t) + D&A- (CAPEX + Working Capital Increases). Additional efficiency improvements and cost cuts were also planned. These were possible as Signode was no longer a division of ITW, but now a motivated highly indebted LBO. Result-positive.

4)     Sell High (i.e. multiple expansion): Carlyle signaled that they planned a liquidity event in 2016/2017. So far they are benefiting from an increase in PPX from the 9X paid last year to the current 10.5X. This combined with improved operations should provide multiple exit opportunities including a trade sale, dividend recap or IPO. Of course Carlyle cannot control market developments, but they can capitalize on them. Things can change before their planned value monetarization, but right now things look promising. Result-positive.

Bottom line, the transaction looks very promising despite Carlyle having paid a then full price. 
Most of the gains come from an old fashion carry trade (borrow and pay interest to acquire an asset with a higher cash yield) which appears to have worked out. Investors could have replicated the results by employing similar leverage to acquire stock in a comparable firm that would have also benefited from a rising stock market. Market timing is everything as other deals, richly priced at the wrong point of the cycle, like TXU and Caesars, have experienced trouble.


Thursday, January 15, 2015

Offense and Defense - The Evolution of Takeover Strategy and Defense

One of the hot topics of today's acquisition climate is the role of activists.  While activism has been a hot topic before the situation today is a  bit different, with many boards actively listening to activists.  It is another step in the give and take of corporate acquisitions between bidders and targets.  In fact, the recent history of acquisitions reveals the continually evolving offensive and defensive strategies.   Consider just a bit of the historical give and take (not in exact order but close):

  • Hostile takeovers were big in the 80's.  
  • Poison Pills are invented by Marty Lipton (Enstar 1982)
  • Acquiring firms started using junk bonds to finance deals.  Even large companies were vulnerable
  • States enacted anti-takeover statutes to slow down hostile deals.  
  • Courts strike down many of these statutes.
  • States revise anti-takeover statutes to be in conformity with the law 
  • Poison pills become a bit more popular
  • Poison pills are challenged in the courts (Household International)
  • Courts uphold poison pills (November 1985)
  • Poison Pills become widespread. 
  • Hostile deals decline
  • Shareholder activism picks up but doesn't capture great momentum (Mid - 90's)
  • Governance Scandals rock the corporate world (Enron, Worldcom)
  • Sarbanes Oxley is passed
  • Boards become independent in response to the law
  • Shareholder advisory services gain influence (Institutional Shareholder Services)
  • The financial crisis occurs
  • Dodd Frank is passed
  • Shareholder activism picks up speed - boards start to work with activists
Stay tuned.  It's a rapidly changing world.

All the best,


Monday, January 12, 2015

Tragedy of the Commons in M&A

Attached is a piece on the tragedy of the commons in banking. It refers to a chain reaction (AKA herding?) in which the action of one bank triggers reactions from other banks leading to a dangerous race to the bottom in risk standards. It underlies the boom and bust cycles in many deal markets including M&A. As Ralph has noted in his anticipation article, once one competitor starts buying firms, others in the industry react. Early buyers tend to get better prices than late in the cycle buyers. Nonetheless, late in the cycle buyers are under pressure to “do something” so as not to be left behind. Hence they make over priced acquisitions. The key takeaway is firms do not operate in a vacuum and are influenced, sometimes negatively, to respond to competitor actions.


Thursday, January 8, 2015

Managerial Indiscretions: Sex, Lies and Firm Value

Together with coauthors Brandon Cline and Adam Yore, we have completed a revision of our paper,  "Managerial Indiscretions: Sex, Lies and Firm Value".  By the time ethical problems are noticed in the boardroom, substantial shareholder wealth has been lost.  However, many executives are accused of ethical lapses in their personal lives - alleged indiscretions removed from the financial or operational aspects of business.  Are there firms impacted?  Are there signals of future corporate indiscretions?  Those are questions posed by our analysis.

From the abstract:

"Managerial indiscretions such as arrests, fabrications, and extramarital affairs are personal to the executive and separate from the business activities of the firm. We examine whether disclosure of these personal indiscretions are related to changes in firm value and subsequent malfeasance. Companies of accused executives experience significant short- and long-term wealth losses, reduced operating performance, and an increased probability of shareholder-initiated lawsuits, DOJ/SEC investigations, and managed earnings. Approximately sixty-five percent of accused CEOs retain their positions even among repeat offenders. Indiscretions are more likely in poorly governed firms where disciplinary turnover is also less likely."

The complete paper may be downloaded here.

All the best,


P.S. Our friend Wes Gray runs a terrific blog called Alpha Architect. Wes also recently posted about our paper.  Check out his site!