Monday, June 29, 2015

Sale Leasebacks: Fact and Fiction

SALE LEASEBACKs (SLB) allow the separation of ownership from control in the use of real estate reflecting the comparative advantages of owners and operators. It has a long history in the hotel industry where the hotel groups manage the hotels which are owned by investors such as REIT. SLBs are undergoing renewed popularity in the challenged retail and restaurant industries by firms with substantial real estate assets including Macy’s, Sears and Darden. This is due, in part, to the recovery in real estate values since the bottom of the Great Recession in 2009. For example, Sears is using SLBs to fund continued operating losses to hopefully stabilize the firm. Darden transferred restaurants like Olive Garden to a REIT, and plans to use the proceeds to reduce its debt (probably not the wisest use of funds). Activists are pushing Macy’s to lever up by selling assets to a mall operator and leasing them back to fund a share repurchase.

There are many reasons, some real - others bogus, for using SLBs. Bottom line, SLBs are just another form of financing. Their value to the seller/lessee depends of the sale price, lease terms and ultimately on the use of the proceeds. Some bogus reasons include:

1)     Improve Balance Sheets by Reducing Assets:  need to distinguish accounting from real effects. In any event, accountants have gotten tougher about removing such assets from the balance sheet. Even if they do remove them they are disclosed in footnotes allowing analysts to adding them back.
2)     Improve Debt Ratios: again unlikely as the rent obligations disclosed in footnotes are easy to add back. Most analysts focus on EBITDAR (earnings before interest taxes depreciation amortization and rent) over funded debt plus lease debt.
3)     Monetize Equity: This may, however, trigger possible capital gains taxes. You can structure the transaction to avoid true sale treatment to avoid taxes. This usually complicates achieving off balance sheet treatment for accounting purposes. Finally any book gain realized will be given back in the new higher lease terms.
4)     Increased Debt Capacity: giving up residual ownership and flexibility.
5)     Improved Focus: this may have some merit if the buyer/lessor has a comparative advantage in managing/owning the real estate AND is willing to share some of that with the seller. There may be a benefit in expressly charging an explicit rent to better reflect true operating performance.

As long as the sale price and lease terms are fair, which you would expect in a large relatively efficient real estate financing market involving sophisticated parties, there is unlikely to be any value created. You need to compare SLB against alternative functionally equivalent secured real estate financing (e.g. mortgage) to determine if market conditions may favor a SLB over a mortgage.

The second step is to review the use of the proceeds raised by a SLB. These include:

1)     Capital Structure Change: use to reduce debt in a potentially over leveraged situation like Darden. This was not well received by shareholders (possibly reflecting a decrease in Darden’s tax shield and reduced debt discipline). Alternatively, increase leverage in an under leveraged situation by repurchasing shares as activists are suggesting for Macy’s.
2)     Fund Operating Losses as in Sears
3)     Finance an Acquisition/LBO using an Opco-Propco structure as reflected below:

Be careful of free lunch arguments when evaluating SLB pitches from investment bankers (e.g. Mesirow ). Focus on how the transaction impacts firm cash flows and risk to determine the value impact and not the accounting. Finally, no matter how good the SLB, the key is the use of the proceeds.


Thursday, June 25, 2015

A Quick Overview of Acquisition Finance

 As readers of our blog know, Joe and I teach an Acquisition Finance Course in Amsterdam every year.  The current offering is scheduled for December 9-11, 2015.  Information can be obtained here.

Acquisition finance involves structuring a deal to best obtain the objectives of the various parties involved.  There are numerous considerations in this process and we spend quite a bit of time in the course analyzing and illustrating best practices.  In today’s post, I’ll just outline a few of the basics.

Finding the optimal financial structure for a deal leads one inevitably to the topic of capital structure – the best mix of debt, equity and hybrid securities for a particular situation.  At the heart of this is the desire to minimize the cost of capital, while also being cognizant of risk, flexibility and requirements (and personal desires) of buyers, sellers, regulators and suppliers of funds.

Two major techniques for finding the best financing solution for a deal are the cash flow and asset based approaches.  Let’s take the latter first.  When we complete a deal, it is the assets that we are financing.  As we all know, Assets must equal Liabilities plus Equity.  Thus, the left hand side of the balance sheet (assets) must equal the right hand side (Liabilities plus Equity).  A given set of assets suggests particular opportunities with regard to risk, liquidity and the use of collateral. 

It is important to note that when we structure a deal, the securities we use (debt, equity and hybrids) are merely claims against the assets and against the cash flows generated by those assets.  That is, the securities are merely contracts promising particular provisions for the future.  And – while there are standard contracts for debt and equity, a contract is merely an agreement – it can be crafted, altered and structured in any way the parties can agree upon.  Thus, ultimately some deals are completed with more creative (non-standard) structures such as earn outs and other contingent payments.

The cash flow approach to acquisition finance is easy to understand.  Returns to the suppliers of capital will ultimately be generated from the cash flows of the business.  These include ordinary cash flows from running the business as well as one-time cash flows from spinoffs and asset sales.  A given cash flow projection suggests the level of risk inherent in the deal.  Generally, the returns (payments) promised will be compared with the funds projected to cover these payments.  Ratios like Times Interest Earned and Fixed Charges Coverage and tools like simulations are used to help assess deal risk. 

The paragraphs above provide just a sketch of the myriad considerations in structuring a deal.   One thing that is missing – and that we always emphasize in our class - is the analysis of markets.  That is, the paragraphs above outline some of the important items related to the parties involved and the deal itself.  But capital is raised in dynamic capital markets and different markets suggest different opportunities.  We’ll continue with an elaboration of these and other factors in subsequent posts.

All the best,


Monday, June 22, 2015

Investment Banking: The Dark Side of Corporate Finance

Investment banker valuation and securities pricing are heavily used inter alia in IPOs (e.g. offering pricing ranges) and M&A (e.g. fairness opinion). They involve translating a firm’s expected operating performance into a price in markets subject to asymmetric information. The price estimates are often more influenced by momentum than fundamentals. Thus, they can diverge from intrinsic value based discounted cash flow measures-sometimes intentionally.

Investment bankers can help bridge the gap between price and value among buyers and sellers of capital and firms. They do so by posting their reputation (the value of which varies considerably) as a signal, for a fee, to give the parties comfort that the offered price is fair based on their due diligence and technical analysis. The analysis is based on well know business tools like discounted cash flow and risk adjusted returns-at least on the surface.

The techniques used, however, are frequently a fig leaf behind which many other factors (sometimes conflicting) are taking place. These include:

1)     Objectives: What price (value) is the investment banker seeking to justify for his client or himself?
2)     Inputs: How were the inputs selected based on the firm, industry and market considerations? There is a great deal of (black?)“art” (subjectivity) in selecting key estimates for sales growth, operating profit margins, taxes, working capital, CAPEX,  and WACC.
3)     Who does the Investment Represent? For example, with IPOs, although representing the issuer, the investment banker is frequently more concerned with maintaining good investor relations as the source of his long term franchise value. Therefore he is inclined to under price the offering.
4)     Reverse Engineering: Is the valuation really independent or reverse engineered to justify a desired result? Remember, Investment Bankers do not get paid unless the deal closes. As Warren Buffet notes -fees too often lead to transactions rather than transactions leading to fees. This why his 2014 annual report contains so many Investment Banking “slams”.

In theory, there should be no difference between practice and theory, but in reality there is a big difference. Surveys showing an alignment of academic valuation approaches and investment banking practice (see valuation from the field which references once such survey) should be taken with more than the customary grain of salt. Investment Bankers herd and like to hide behind “best practices” (i.e. “me-too-ism”) to look smart and reduce legal liability. No one wants to admit they are using “primitive” earnings multiples unadjusted for risk or the time value of money in their analysis.

Having practiced the black art for many years, I can assure you that Investment Bankers are in the sales business. Therefore, the real motivation behind the various valuation estimates must be considered when reading their presentation booklets. Cash flow matters, but the question is whose cash flow are we discussing-the client or the banker’s? The Salomon Brothers quote from Liar's Poker  says it best-“do you want to be a winner or the client?” Bottom line-do your own analysis and come to your own conclusions. Academic finance as practiced by Investment Bankers can be dangerous to your wealth.

Joe- a hopefully reformed ex-Investment Banker.

Thursday, June 18, 2015

The Merger Fund

I've been an investor in the Merger Fund for a long time both for the risk adjusted returns it produces and for the wonderful discussions about merger activity in the most recent quarter.

The Merger Fund engages in merger arbitrage - betting on the outcome of deals.  Sound risky?  Not so fast.  The Merger Fund, like most arbs in mergers, hedges its bets, trying to lock in returns while minimizing risk.  The strategies that can be employed to do this can be complex, but let's just consider a simple example:

A target is trading for 30 euros and a bidder offers a stock deal suggesting a 40 euro bid price.  Right after the deal announcement, the price of the target rises to 38 euros, while the price of the acquiring firm settles at 60 euros.

We've talked elsewhere about the fact that the information above implies that, under simplifying assumptions, the probability of the deal being completed at 40 euros can be estimated to be about 80 percent.  But that is beside the point here.  A simple arbitrage strategy would be to short the appropriate amount of the bidder's stock and go long the target.  Assuming both stocks face similar market risks, this effectively hedges against market movements.

The hedge described is quite simple and not foolproof.  If the bid is abandoned and the target price returns to 30, the investor faces a substantial loss.  (There are other ways to hedge this, but we'll keep things simple here.)  More than likely, if this bidder loses, another bidder completes the deal at a higher price producing an even larger gain on the target than the 2 euro spread.  The original bidder would probably also experience price adjustments, perhaps gaining a bit and producing a slight loss for the investor.

But consider the returns if the deal is completed in, say,  two months: a 2 euro gain with little investment - in just a two month period.  

Now to be sure, many risks remain, but you get the idea. If you study the Merger Fund, you'll note that while its historical performance is below the S&P 500, so is it's volatility (and Beta).  It's Sharpe ratio is high.

Regardless, I offer the Merger Fund to you for the interesting commentary on deals.  See, in particular, The Quarterly Review.

All the best,


Monday, June 15, 2015

Mergers and Acquisitions: The Elusive Search for Growth

Firms have largely recovered from their near death 2008 Great Recession experience with margins and stock prices exceeding pre crisis highs. Revenue growth, however, remains disappointing. A low growth, low interest rate environment is partly responsible. Consequently, many firms have focused on cost cutting efficiency improvement and curtailed organic growth related CAPEX and working capital investments. Thus, free cash flow (EBIT [1-t) +DA-[CAPEX+WCI]) has grown resulting in excess cash. Firms have responded with massive dividend and share repurchases which could exceed $1T this year.

This development appears to have run its course. Repurchases are becoming difficult to justify at current price levels. Thus, investors are now seeking firms who grow their operations, not just increase shareholder near term distributions. Of course, not all firms can achieve such growth. 
Organic growth still remains tough. Therefore, firms are increasingly turning to acquisitions to achieve growth objectives. This is reflected in near record M&A volumes. As previously mentioned this comes with increased risk. The Q ratio, a quasi -market to book ratio indicates stock prices are fully priced. The “q” is at its highest levels since the 2000 tech boom peak and well above its historical mean. Adding the usual 30-40% M&A premium means you need to improve the targets’ contribution by 60-80% to cover the premium and yield a “home run”-sounds tough because it is.

 Making acquisitions in such a market becomes tricky unless managers can clearly distinguish between good and bad growth. Good growth occurs when returns on assets (ROA) exceed their cost of capital (WACC). Acquisitions earning more than cost yield such growth and increase shareholder value. The levers management can pull to achieve such results is to control how much they pay and make sure they execute to achieve the required synergies to earn out the purchase price premium. The higher the premium the more difficult this becomes. Failure to achieve ROA>WACC results in bad growth. Revenues may increase, but shareholder value suffers. This is usually a time lag before this result becomes clear, and by then the damage is done.

A checklist I use to help me sort thru these issues is:

I hope managers are not acquiring out of desperation over what to do with their excess cash. It is always better to return the cash to shareholders than making poorly advised acquisitions.

Monday, June 8, 2015

Leveraged Finance Market Developments

Leveraged finance involves an ecosystem of parties funding leveraged buyouts and acquisitions resulting in noninvestment entities. It includes originators like private equity firms. Also includes financial sources such as bank arrangers like JP Morgan Chase, Collateralized Loan Obligation (CLO) Funds, the end takers of bank arranged leveraged loans (they hold > 2/3rds of the term loans), and high yield bonds. The market is highly cyclical. Thus, it expected to benefit from the sharp surge in deal activity.

Leveraged finance activity so far, however, has been disappointing. The crowding out of PE by strategic acquirers has been previously discussed.  Leveraged activity is down almost 50% from prior year. Additionally, regulatory developments impacting banks (e.g. GECC) and CLOs has made traditional participant reluctant to bring new deals to market. Some of the major changes include the following:

1)     Basel III: new higher capital requirements for higher risk transactions may “spook” some capital sensitive banks like Deutsche.
2)     U.S. Regulatory Guidelines: joint agencies directive frowns upon transaction leveraged more than 6X FD/EBITDA. This concern is understandable given banks are using subsidized government guaranteed short term deposits to fund long term highly leveraged borrowers. Leverage levels seem to be behaving by hovering around the 6X limit. This makes it difficult to match the high price bids by strategic acquirers.
3)     CLOs: the Dodd Frank Act retained interest rules (effectively requiring more capital) are forcing CLO to restructure and possibly raise new capital.

Hard to tell how this all is going to play out. It is a work in process and it is still on-going. Nonetheless, some preliminary observations are:

1)     High Yield Bonds (HYB): HYBs are substituting for bank loans in the capital structure. Issuers can swap back from fixed to floating. HYBs are, however, less flexible than loans on matters such as early repayment.
2)     New Non Bank Lenders (AKA Shadow Banks): include brokerage firms like Jefferies, which is in the top 10 of leveraged loan arrangers. Jefferies is less leveraged than a bank. Additionally, it is much smaller than the major bank arrangers. Finally, it has suffered some setbacks like the Rue21 transaction. So the jury is still out.
3)     Business Development Corporations (BDC): another specialized non bank lender. BDCs have special tax and leverage traits which may limit their application for large deals. Traditionally, they focused on smaller higher risk middle markets deals where they can get the extra spread needed to compensate for their lower leverage. The irony is both brokerage houses like Jefferies and BDC are funded by banks via warehouse lines. So the banks may still be exposed to highly leverage deals.

Some serious unresolved issues:
1)     Revolving Credit Facilities: banks are needed to provide revolvers. Less desirable alternatives include prefunding a liquidity reserve (expensive) and bank revolver carve-outs (messy inter-creditor issues).
2)     Securitization: still going to need warehouse facilities probably funded by banks.
3)     Non Banks: need larger participants to achieve scale to fund larger deals. May need to return to Drexel  (the firm not the school) style Highly Confident Letter  in lieu of firm bank type underwritings
4)     PE Accept Lower leverage: impact their bidding ability to compete against strategic acquirers.

These changes represent the third act of leveraged finance. The first being the entry of large arrangers like Bankers Trust in the 1980s. The second being the shift towards capital market style instruments to facilitate the entry of non bank investors. The current regulatory induce changes will take time and result in new winners and losers as this dynamic market continues to change.