Thursday, October 29, 2015

Pfizer and Allergan: Viagra Meets Boxtox

I can't wait to hear the late night talk show hosts talk about a merger between the makers of Viagra and Botox!  But we'll confine ourselves here to the more technical aspects of this deal.  There are many interesting aspects to this one including the size of the deal, the continuation of industry trends, the creation of a giant in Pharmaceuticals, the current price movements of the bidder, target and competitors, the possibility of an inversion, and the social terms of the deal.

First, this deal could be the largest deal of the year as Allergan has a market cap of $112.5 Billion and Pfizer has a market cap of $219 Billion - this year is on pace to be the biggest year yet in M&A.  Second, it continues the consolidation trends we have seen in the pharmaceuticals industry.  Third, it creates the world's largest drugmaker.  The combination would surpass Johnson and Johnson (currently valued at $278 Billion).

The deal would be an inversion, as Allergan is headquartered in Ireland with a far lower tax rate than Pfizer faces in the US.  Expect the US government to seek to impose restrictions on the move putting the tax benefits of an inversion in question.  See our posts about inversions (here, here and here) and the folly of governmental attempts to restrict inversions rather than addressing the root issue and making domicile in the US more attractive.

The price movements at the announcement were typical for the bidder and somewhat abnormal for the target.  The bidder lost a few percent while the target shares rose only 8%. Typical price jumps for the target would be in the 20% - 40% range.   

We've noted many times in these pages about the impact of mergers on rivals.  In particular, our research has shown how the rivals of bidders and targets react to deals involving a competitor.  In today's case, the Guardian reports that the prices of two competitors (GlaxoSmithKline and Shire) declined in value as there was some anticipation that they would be Pfizer's target instead of Allergan.  This illustrates both the anticipation effects embedded in a firm's stock price and the reaction when those anticipated effects are put into question.  Many social terms of the deal remain to be determined, including what happens to Allergan's CEO and how many layoffs might occur as part of the deal.  

One senses that in this market, there is more to come.  There will be a lot to talk about during our December course in Amsterdam.

All the best,


Monday, October 26, 2015

Fear the Walking (Dead) Unicorn

I posted several notes here, here and here trying to make sense of inflated late round technology valuations. My conclusion was the valuations were illusory rationalizations used to justify inflated prices. The private market valuation of these firms suffered from being unregulated, questionable accounting, lack of comparability due to differing provisions (e.g. liquidation preferences), and lack of short selling. The result is momentum based pricing driven by the optimism of the last investor. The number of previously rare unicorns (private firms with values exceeding $1B) increased to 124 in July of this year. Eventually, however, you run out of optimism when an event occurs causing investors to re-examine their assumptions and reduce their risk appetite leading to lower pricing. That something was the August correction.

You only really accurately value a private firm when you make the initial investment, and then when you exit. Exits had been delayed for many later stage tech firms. Only 14% of 2015 IPOs were tech related. The reasons (excuses?) given for the lack of tech IPOs was twofold. First, the founders did not want the hassle of public market scrutiny. Second, they did not need an IPO liquidity event because they could always do a “private IPO” (oxymoron?) by accessing private investor cash in subsequent financing rounds (at assumed higher valuation levels). Both reasons are nonsense.
In reality they wanted to avoid the evaluation of numerous hard-nosed investors both at the time of the IPO and the on-going trading-including short selling. You need a public market to get liquid; it is hard to access public markets at sky high prices.

Many tech founders and investors who confused bull market valuations for liquidity are now discovering the difference between paper and real liquidity. Over 40% of 2015 tech IPOs like Novo Cure are being priced near or below their last private financing round valuation. This fact has not gone unnoticed by private investors. They are balking at high implied valuations in later financing rounds forcing firms to accept lower values. For example, Blackrock which lead a prior $350M financing round for Dropbox has marked down its investment by 24%.

Pricing represents a short term belief in expected operating performance. Investors should gauge the gap between expectations and reality. This means not falling in love with stories about market growth and technology without considering how those factors translate into revenues and ultimately cash. 

This involves understanding the following:

1)     Market Characteristics: some markets have difficult characteristics making it difficult to yield superior returns. Use Porter's 5 forces framework as a starting point.
2)     Business Model: who will the firm achieve and maintain market share and pricing power when facing competitors, new entrants and substitutes?
3)     Execution: inept managers can negate attractive markets and credible business models.

If you claim this is hard because of profound uncertainty then recognize you are not investing. Rather you are speculating based on what you hope someone else will pay for the firm. This someone else can and does change his mind leading to wild price swings like those experienced this August. This in turn can turn your hoped for unicorns into unicorpses.


Thursday, October 22, 2015

A Few Working Papers on Mergers (and Finance)

I just attended the Financial Management Association International meetings in Orlando, Florida.  The FMA also holds European, Asian and other meetings, but the one in North America is the annual one and draws a large crowd.  The FMA itself consists of over 7000 academics and practitioners interested in best practices in finance.  The way we find 'best practices' is typically through analyzing empirical data - often samples of thousands of observations to find out what is increasing value and what is not increasing value.  Topics analyzed range from all the aspects of mergers one can imagine to capital structure, dividend policy, agency theory, option pricing, investments, banking, regulation, working capital and much more.

 The working papers presented at this conference are just that - works in progress that will improve from the careful criticism of peers.  Ultimately, academics hope their working papers are published in leading academic journal and influence theory and practice.  Indeed, what we teach in the business schools is designed to be cutting edge practice and is (or should be) heavily influenced by current research and conditions.  Textbooks are three to five years out of date by the time they are published.

Rather than comment on individual papers, I am adding the link to the complete program which itself has links to individual papers.  This way readers can note the breadth of topics covered and choose those of interest.  Of course, you can find papers on any specific topic (i.e, mergers) with the search function (control + f on my computer).  Not all of these papers are at the stage where they are informative of 'best practices'.  Some of them are.  I sift through research carefully before presenting in executive education sessions but our next session in Amsterdam is in early December and my Drexel EMBAs in early January.  Many of my practitioner colleagues find scanning even the topics to be a way to stay current and get new ideas and in the best scenarios, get ahead of the competition.

All the best,


Monday, October 19, 2015

Dell EMC Merger: Return of the Master

Michael Dell’s deal skills are second to none-including the Great Donald (Trump that is-the current presidential contender and author of “The Art of the Deal”). Michael took Dell PC (Dell) private at a very attractive price in 2013 utilizing clever vendor financing and high yield bonds. Now he is capitalizing on an activist motivated seller to make a beautifully structured acquisition of EMC, which will be the subject of numerous cases studies.

Both EMC and Dell are suffering serious business risk issues reflected in their declining revenues. EMC’s data storage business is moving towards the cloud, while PCs face a shift to alternative devices. Also, putting together the firms to create a technology conglomerate runs counter to others in the industry like Hewlett Packard that are spinning off divisions to achieve more focus.

Let’s consider the following:

1)     Deal Type: the deal is structured more like a LBO than a corporate acquisition with its high leverage, break-up fees and go shop clauses especially given the rumored shopping of the PC business for sale post close. The possible sale would also lower integration risk.
2)     Purchase Price: the purchase price multiple is around 11X EMC’s EBITDA-more in line with LBO multiples than higher priced corporate deals. The premium over the pre bid stock price is 20%. This is probably inflated given the use question value of the tracking stock being offer as partial payment. Adjusting for the post announcement fall in EMC’s price means the actual premium is closer to 13%. Dell appears to be getting a fair firm at a great price. EMC’s management is under attack by activist Elliott Management, and appears to be a very willing seller not necessarily acting in the best interests of EMC shareholders. Interestingly, Elliot sought the partial break-up of EMC by spinning off a majority owned subsidiary (VMware). Lawsuits will surely follow. The $2.5B break-up fee due Dell if EMC walks may mean EMC’s shareholders are stuck. Dell receives a substantial break-up fee should a competing bid arise during the go-shop period.
3)     Funding: this is where it gets really interesting. Dell, Silver Lake (partner in the original Dell LBO), et al are contributing around $4B in equity (not all cash?). The hard to value tracking stock representing a currently majority owned EMC subsidiary (VMware) supposedly represents $13B of the “equity” consideration. My take is the tracking stock is actually seller financing to close the funding gap facing Dell. The balance is $10B committed bank debt (plus a $3B revolver) and $40B in bonds. $5.5B of EMC’s existing formerly investment grade bonds do not need to be re-financed because they lacked covenant protection. Based on the combined EBITDA the funded debt multiple is around 5.5X EBITDA-modest by LBO standards and within banking regulator guidelines; hence the ability to secure the up-front bank group commitment. The bond financing portion is huge and market conditions remain unsettled. Nonetheless, Dell must feel comfortable based on the advice of his advisors because he is offering EMC $4B if he fails to obtain the financing.

Bottom line, Dell gets a modestly priced $67B firm with only $4B in equity and regains public market access. Hats off to Michael Dell if he can pull this off. It becomes even better if he can quickly reduce the debt thru the unloading of the PC business. The deal is not without risks, but my money is on Michael Dell.


Thursday, October 15, 2015

AB InBev and SABMiller: Negotiating the Deal

Negotiating the deal is crucial to bidder success and target shareholder welfare.  From the bidder’s side, increasing the bid premium reduces the ultimate rate of return on investment, but paying a premium too low could result in a failed offer.  Target shareholders generally want the maximum price they can obtain, but other factors also come into play including timing of the deal, ownership after the deal, seats on the combined firm board, etc.

Both sides are concerned about deal structure and we’ve said many times that it is important to bargain on many fronts.  In addition to the bid premium we must consider form of payment, structure of the deal, timing, taxation, residual ownership, warranties and representations, employee and stakeholder welfare, regulatory concerns and numerous other factors. 

The maximum price a bidding firm should pay is the estimated net present value of the target under their control.  But paying this amount produces a NPV of zero, with no room for error.  The minimum price a public target will accept is generally the pre-offer market price.  Where the final deal settles in this range is determined by the relative bargaining power of the two sides.  Numerous factors go into bargaining power including ownership structure (concentrated or dispersed, toeholds owned by the bidding firm, the percentage of shares controlled by management, etc). 

Bargaining power is also impacted by how important the deal is to each side and this is related to the alternatives available to bidder and target. Is this bidder the only firm that can purchase this target?  Advantage – Bidder. 

Are many bidders vying for the target?  Are obvious synergies available to many parties?  Advantage target..  Is the target management really anxious to cash out?  Is the timing of the deal crucial to the bidder, etc.

There is considerable empirical evidence on negotiating tactics and shareholder welfare.  An overriding finding is that target shareholder value is maximized by management that forcefully negotiates, but does not ultimately block the deal.

A good illustration of these elements is the AB InBev acquisition of SABMiller.  According to the Wall Street Journal, both sides stood to gain from the deal but SABMiller’s chairman was convinced that AB InBev wanted the deal more.  His resistance and negotiation led to a sweetened offer – a 50% premium over the pre-offer (and rumor) market price and a $3 billion breakup fee if the deal doesn’t go through.  Other aspects of the deal including the social terms (who stays on the board, the name of the combined firm, etc.  are yet to be disclosed.  Also unclear is the degree to which regulatory authorities will oppose the deal or force concessions. 

SABMiller’s ability to negotiate these terms is even more interesting given that Altria Group, Inc which owns about 27% of the target signaled they would back a lower bid.  But SAB’s chairman Jan du Plessis was also active in courting large shareholders, getting Colombia’s Santo Domingo family on his side.  The family controls about 14% of the company and is the second largest shareholder.

The skill of SAB’s chairman, comes in part, from experience.  According to the WSJ he was chairman of Rio Tino PLC when it fended off a takeover bid from Glencore PLC. 

All the best,


Monday, October 12, 2015

The Changing Investor Menus of Acquisition Finance

Low interest rates have encouraged investors to increase their risk appetite in search of yield. Issuers and arrangers have accommodated them with aggressive deals and financing structures; thereby supporting growing M&A volume. These usually work out until something happens. The August correction is one of those things. Investors, post correction, have paused to reassess their marked down portfolios, and have reduced their risk appetites. This presents problems for unfunded deals structured in the pre correction 1H15, but are only now coming to investors for financing. We previously examined this problem in 2013 with Rue21 in which the loan underwriters incurred large losses.

A current example of the same problem is FULLBEAUTY BRANDS (Beauty). Beauty is an on-line plus sized clothing retailer owned by PE firms Charles and Webster Capital since 2013. In March this year Beauty levered up to pay its owners $215 Mln via a special dividend, and announced plans for a summer $250 Mln IPO. The IPO window was wide open at that time. It subsequently closed late summer resulting in its owners switching to plan B-the sale of the firm. Apax, the same PE firm as in Rue21, agreed to acquire (secondary buyout) Beauty for undisclosed amount funded in part by $1.650B in loans underwritten by JP Morgan Chase, Goldman, Jefferies, and Deutsche.  JP Morgan Chase and Jefferies were also involved in Rue21.

Some details are as follows:

1)     Loan Facilities:
$820 Mln First Lien Term Loan -7 year term at LIBOR+450 BPS
$345 Mln Second Lien Term Loan -8 year term at LIBOR+850 BPS
2)     Leverage
First Lien-4.7X EBITDA
Second Lien (total)-6.7X
3)     Rating “B-“

The loan underwriters are experiencing sluggish demand for the loans based on several factors. First, increased concern over a slowing economy is dragging down retailer prospects. Next, the deal is highly levered at 6.7X, which exceeds bank regulatory guidelines and reduces the potential investor base. Non bank loan investors (CLOs) usually fill the gap, but have suffered portfolio losses during the summer correction. They are becoming more credit quality sensitive-especially toward higher risk second lien loans.

The Beauty loan syndication is still a work in process. The underwriters’ options, absent a rebound in investor risk appetite, are somewhat limited. Attempts to increase loan pricing or reduce leverage are unlikely to be received well by Apax, absent bear market pricing or structural flex provisions. More likely, they will be forced to offer deeper discounts at their expense (loss) and hold larger than planned portions on the loans.

Like war, most of the time acquisition finance is calm and boring. It is, however punctuated by brief moments of terror when investors risk preferences changes.