Cross Border Acquisitions

One of the most comprehensive analyses of cross border published in the Journal of Finance and analyzing deals from 1990 to 2007 notes:

"The vast majority of cross-border mergers involve private firms outside of the United States. We analyze a sample of 56,978 cross-border mergers between 1990 and 2007. We find that geography, the quality of accounting disclosure, and bilateral trade increase the likelihood of mergers between two countries. Valuation appears to play a role in motivating mergers: firms in countries whose stock market has increased in value, whose currency has recently appreciated, and that have a relatively high market-to-book value tend to be purchasers, while firms from weaker-performing economies tend to be targets."

"Determinants of Cross-Border Mergers and Acquisitions", Isil Erel, Rose Liao and Michael Weisbach  The Journal of Finance, June 2012

A lot has changed since 2007 but we still see the importance of many of these same factors.  A recent Wall Street Journal notes how the dollars strength is causing a resurgence of foreign deals.  (Of particular interest to our Acquisition Finance Course coming up in Amsterdam this December, the article notes that "FedEx cited the stronger dollar in its pending $4.8 billion takeover of Dutch carrier TNT Express N V").  Notice the graph below.  U.S. takeovers of foreign companies are on track to top even last year's record volume.  

Another major factor mentioned in the article is the opportunity to save on taxes by incorporating in more tax friendly countries.  See our blog post Politics, Taxes and Economic Reality.

All the best,

Ralph

Corporate CFOs Are From Venus and Private Equity GPs Are From Mars Part II

General Partners (GPs) in private equity (PE) firms behave differently than corporate chief financial officers (CFOs) concerning investment and capital structure decisions. CFOs tend to follow more textbook approaches; GPs, however, deviate from the textbook in several respects. This has gone largely unnoticed by academics until recently.

I have noted before how PE capital structure decisions differ from corporations. An interesting paper expands on the differences as follows:

1)     Corporations follow the textbook ratings based static trade-off approach when making capital decisions.

2)     PE firms do not follow the textbook. Rather, they use as much debt as they can get given existing market conditions. Thus, they use more debt in bull markets when debt is both easily available and inexpensive. This is consistent with my experiences when dealing with PE. As one GP stated it-“where I come from more debt and less equity is always better!”

3)     Higher debt levels allow PE to bid higher for investments. This in turn depresses returns on late cycle acquisitions leading to booms and busts.

PE also acts differently from corporations when making investment decisions.

1)     CFOs tend to follow the textbook or best practices valuation approaches. This means they use discounted cash flow based net present value models to evaluate investment opportunities. Furthermore, they use risk adjusted discount rates utilizing CAPM methodology.

2)     A survey of PE GPs reveals GPs do not follow textbook prescriptions regarding investments. First, they do not use net present value discounted cash flow methods. Instead they use MOIC (money over invested capital) multiples, which ignore the time value of money. Second they do not use risk adjusted hurdle rates or CAPM. Rather, they use flat 20-25% hurdle rates.

3)     This makes sense-why use complicated methods to evaluate projects when the driving force is debt based affordability based on market conditions? It is also consistent with my private equity experience. The investment committee never paid much attention to DCF or risk adjusted capital measures. All that mattered was the expected MOIC.

The obvious question is why does PE ignore the textbook and engage in primitive and value destroying methods compared to corporate CFOs? For me it comes down to incentives-people do what they are paid to do and not what they are told to do. The incentive arrangements in PE partnership agreements include:

1)     Limited investment period of 5 years. Either GPs use the LP’s commitments within that period or they expire and the fees and profits to GPs expire with them.

2)     The carried interest is an option. Option values increase as risk increases. Hence GP become risk seeking thru higher risk investments or increased leverage.

Thus, there are real agency conflicts from the misalignment of GP and LP interests. The next obvious question then becomes why do LPs put up with this? Consider there are similar agency conflicts between LP’s and their beneficiaries. The LP’s and their consultants are evaluated (i.e. compensated) based on nominal not risk adjusted returns. Furthermore, most LPs cannot lever their investments. Investing in PE allows them to gain implicit leverage which they are willing to pay for by accepting the agency costs.

In any event institutional factors can drive financial behavior as is apparent with GPs.

J

Drexel's 8th Academic Conference on Corporate Governance

As I mentioned before, last month we hosted our 8th Academic Conference on Corporate Governance at Drexel.  I say academic, because we also host specific practicioner events including our Director's Dialogue.  I'll recap that in a subsequent post.

This year's conference featured five top papers from over sixty submissions.  Many good papers didn't make the cut.  The audience features top researchers in Corporate Governance from around the world.

The five papers this year addressed issues in executive compensation (CEOs getting bonuses when corporate pensions are frozen and curious firm behavior in contract years) , Norway's gender quotas on boards (suggesting previous work was mistaken);  the role of passive institutional investors (hint, they aren't passive in terms of governance), and takeover defenses (what works, what doesn't).

The complete program along with links to the papers is available here.

All the best,

Ralph

Game or Illusion: Unicorn Valuations

I have been puzzled by seemingly irrational venture capital implied valuations. The number of unicorns (start-ups with implied values greater than $1B) just keeps growing-The Economist estimates over 100 worldwide. Some possible explanations include:

1)     New Paradigm: AKA this time is different-it never is. If something cannot go on forever then it ends (Stein’s Law). The “this time is different” explanation was the justification mistakenly used during the late 20^th century dot com bubble.

2)     Investor Irrationality: not so sure about this-just seems too easy an excuse. Usually reflects we just do not fully understand the economics underlying the set of facts.

3)     Pseudo Pricing/Valuation: price comparisons are difficult as unreflected /underpriced terms (e.g. downside liquidation preferences) are involved. As Ralph likes to remind me you can name the price if he can name the terms and he will win every time (yes-Ralph is tricky). Further complicated by inefficient markets without short selling to correct optimistic momentum based investors.

4)     Manipulation: interesting Fenwick & West report suggesting later round implied value prices are manipulated. The reasoning - reaching Unicorn status is an important badge of accomplishment for young firms. The increased credibility that comes with it conveys advantages in attracting employees, customers and additional financing. Thus, “wanabe” unicorns will work with investors to structure the terms specifically to reach the unicorn threshold. The report offers some interesting stats:

a)     The average price increase in the unicorn financing round is 100% higher than in the prior financing round.

b)     The unicorn financing round is led 75% of the time by nontraditional (not venture capitalists) investors.

An obvious implication is (a) later round financings led by nontraditional investors, (b) in which the price is substantially (e.g. 100%) higher than the previous financing round price and (c) the implied post money value magically reaches unicorn status are rigged. This manipulation hypothesis gets my vote for what is happening-combined with too much VC capital chasing too few deals (VC fund raising is at its highest level since the dot com crash). Remember, there is no SEC to worry about as these are private offerings-sometimes characterized as private IPOs (inter alia-limited due diligence and disclosure). Someone can sue if harmed, but caveat emptor may bar their claim-no one forced them to buy. Do not think courts should protect those who do not know what they do. Everyone should know the base rate success for venture capital is very low (i.e. most such investments fail). Thus, they should take the implied values with more than one grain of salt.

Provided investors realize it is all a game like fantasy football, and not real, things will remain benign. Unfortunately people can sometimes get confused and start to believe the prices/values are real (e.g. noise traders). Then, trouble occurs when everyone realizes there was gambling going on and they have been had.

J

The Evolution of Takeover Defenses and Managerial Entrenchment

In the wake of the DuPont - Trian outcome (DuPont retaining all 12 board seats), it is interesting to examine the impact of takeover defenses and outcomes in general.  Here is an interesting article examining the subject.  The article, refers to takeover attempts instead of activist proxy fights but is nonetheless interesting.

Have changing takeover defense rules and strategies entrenched

management and damaged shareholders? The case of defeated

takeover bids

by

Michael Ryngaert , Ralph Scholten 

"Using the Delaware Supreme Court's Time-Warner decision of July 1989 as a focal point,we study

defeated takeover bids before and after July 1989 to assess the direct effects of stronger takeover

impediments on takeover defense tactics used to defeat bids and the resulting shareholder wealth

outcomes and managerial turnover. We find that firms that defeated takeover bids after July 1989

shifted away from the use of active takeover defenses (repurchases, special dividends, greenmail,

and leverage increases). Nevertheless, shareholders of firms that defeat a takeover experienced

slightly better wealth outcomes in the 1990s than in the 1980s.We also find increased managerial

turnover rates after defeating a takeover bid post Time-Warner, suggesting that managers

that defeat hostile takeover bids did not become more entrenched due to greater takeover

impediments relative to prior years."

The complete article can be downloaded here.

All the best,

Ralph

Private Equity: Aging Cyclical Business Model?

Private equity is a mature asset class that is enjoying an excellent fund raising cycle. According to Prequin, 1Q15 fund raising topped $104B just $7B shy of a very robust 1Q14. Continued strong equity and IPO markets allowed PE funds to liquidate portfolio holdings at attractive prices and return substantial capital to their limited partner investors. These investors may be chasing yield based on past performance by reinvesting in new funds. For example, they committed $17B to Blacksone's latest fund in just 7 months, among others.

Strong fund raising combined with weak investing prospects have raised the level of PE dry powder to over $1.2T (that is in trillion not billion). PE investments both in number and dollars (excluding the hybrid 3G-Berkshire Hathaway Heinz-Kraft $40B deal) have fallen to their lowest level since the crisis year 0f 2009. PE is being out-bid by strategic acquirers in a buoyant M&A market. Thomson Reuters  reports that domestic M&A is up by over 30% 1Q15 to over $415B-heavily skewed towards larger $5B+ deals. Furthermore average purchase price multiples top 12.5X EBITDA with premiums in excess of 37% in an already frothy stock market.

Remember, PE adds value in one of 4 ways:

1)     Buying Right (i.e. not over paying): this is difficult when strategic acquirers are offering such high premiums.

2)     Financial Engineering (i.e. high leverage): complicated by bank regulator guidance frowning upon FD/EBITDA leverage levels above 6X. Current new deal leverage is stuck at around 6X. The PE math (not risk adjusted) is difficult when you pay 12X and can only leverage lever up 6X.

3)     Multiple Expansion (i.e. sell high): little room for multiple arbitrage (buying cheap in the public market and subsequently selling higher in the M&A takeout market) at current price levels.

4)     Operating Improvements (i.e. grow EBITDA): the easy stuff has already been done; the big payoff requires some special strategic sauce like 3G is doing with Kraft-combining it 3G’s prior Heinz acquisition. This is both difficult and rare for PE.

PE is a mature asset class experiencing a cyclical recovery. GPs will have a difficult time profitably investing. Make no mistake, however, invest it they will (otherwise they forgo substantial fees) leading to some unhappy returns for current LPs. This is just the nature of the pro cyclical boom and bust PE cycle. There is just too much capital to deliver superior risk adjusted performance across the market cycles thru differentiated strategies. The former persistence of superior returns in certain top tier funds has disappeared suggesting just competitive the market has become. LPs should beware of investing at this point of the fund raising cycle.

J

DuPont, Trian and Shareholder Votes

Yesterdays Wall Street Journal had a very interesting article related to Dupont's impending election, noting the importance of small shareholders in the voting process.  The vote will be to elect DuPont's 12 directors.  Trian has nominated an alternative slate containing eight of DuPonts nominees and four of their own, including Trian boss Nelson Peltz.  A decade or so ago, institutions typically sided with management.  Today's institutions appear to take a more nuanced look at the issues and directors upon which they vote.  Still, the typical shareholder is likely to be apathetic with regard to voting, assuming that their small holdings do not count.  

To understand the typical voting distribution, take a look at the chart below from our Journal of Finance paper, Electing Directors.  The typical director gets well over 90% support.

The chart is derived from an analysis of about 2500 director elections (for more detail, see Electing Directors).   However, only four of those were contested.  In the DuPont case, the 12 directors receiving the largest number of votes will be elected.  It will be interesting to see how this one turns out and if Trian is successful, what changes in DuPont's structure and what changes in share value follow.

All the best,

Ralph

Venture Capital Prices: Real or Make Believe?

Market efficiency and discounted cash flow analysis are important M&A concepts and tools. Their usefulness is questionable in the sometimes surreal realm of venture capital. Current venture capital valuation based on financing rounds keeps rising with the number of unicorns (private early stage firms with implied $1B+ values) at record levels. Reverse engineering the operating performance needed to justify such lofty values leads to some hard to believe let alone justify sales and margin estimates.

A possible explanation is the prices reflect the value of special downside protection features like liquidation preferences available to venture fund investors. The extra value for those features does not seem large enough to explain the huge current price run up.

This leads to another explanation; namely, the prices and implied values are an illusion. Unlike public shares you cannot short sell private investments if you believe they are overvalued. Absent short sales or some other mechanism prices take on a life of their own. All that is needed for a self fulfilling momentum based pricing cascade are optimistic investors and liquidity. The uptick in prices draws additional investors and the beat goes on. Disbelieving investors are unable to bet against the “excessive” prices. Thus, an apparent arbitrage opportunity goes unanswered.

It appears venture capital markets are inefficient-their prices do not reflect available information and views. Instead, they resemble lotteries-relatively low ticket prices for negative expected value investments with a large positively skewed payoff distribution. Venture funds and other investors are pressured to participate even at higher prices. They fear missing out in getting a winning ticket, and suffering a relative performance drop, which impacts their fund raising efforts. These types of one way markets can remain inefficient for long periods until some event occurs causing a revaluation. Optimistic momentum venture investors with sufficient liquidity will keep bidding up implied finding round valuations.

Interesting to see what values, if any, are realized once surviving start-ups are taken public and begin trading in a market where short sales are possible. I predict IPO investors will be in for a wild ride. Optimists will keep setting venture values until we run out of optimists. Sounds like a game of musical chairs-you do not want to be the last one standing when the music stops.

J