Warren Buffett's Criteria for Acquisitions - Thoughts for Selling Firms

In last week's post, I commented on Business Risk, Financial Risk and Attractive LBO Candidates.  Today, I just want to note the correspondance of many  of these items with those stated by Berkshire Hathaway.  The items noted on their website are quite similar (with the exception of concentrating on large companies).  From their website:

"BERKSHIRE HATHAWAY INC.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

1. Large purchases (at least $50 million of before-tax earnings),
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations), 
3. Businesses earning good returns on equity while employing little or no debt, 
4. Management in place (we can't supply it),
5. Simple businesses (if there's lots of technology, we won't understand it),
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)."

These criteria tie in very nicely with what we noted in last week's post: Strong stable companies with good management and predictable cash flows make excellent targets for leveraged finance.  

Buffett concludes with his typical humor:

"Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."

See our previous post on Buffett's advice to acquiring firms as well!

(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

All the best,

Ralph

Business Risk, Financial Risk and Attractive LBO Candidates

As the time grows closer to our Acquisition Finance course in Amsterdam, I find myself thinking of the relation between business risk and financial risk.  Business risk, of course, is the volatility in a firms pretax cash flows. Simply put, some firms have more stable business environments over time - without even considering how the firm is financed. Business risk is often measured as the variability of EBIT or EBITDA, although I've also seen the variability of sales used as a measure.  A utility like Trans Canada Corporate (TRP), for example, has much lower business risk than say, Dunkin Donuts (DNKN).

One of the basic concepts of capital structure is that business risk and financial risk should be inversely related.  A company with less business risk can afford (tolerate) more financial risk.  This concept for business should not surprise us - the same holds for individuals.  Imagine you and I are otherwise identical, making the same average income, etc  The only difference is that I earn my income by commission while yours is fixed.  It is not hard to see who can tolerate the most debt.

All of this relates nicely to LBOs.  When considering candidates we look for strong, stable companies with predictable cash flows to cover the increased leverage we will add to the capital structure.  In more detail, we would consider the balance sheet, the income statement, the company itself, the business cycle of the industry and any synergies.  For an LBO, it is also important to consider the exit strategy.

Let's consider these in just a bit more detail.  First, the balance sheet.  Good LBO candidates are those with low debt but high debt capacity and possibly non-essential assets or divisions than be divested to free up cash.

Now - the income statement.  Steady, predictable cash flows are important (i.e., the low business risk).   In addition, investors in LBOs such as KKR are interested in strong management teams.  This is important since private equity investors typically don't want to run the company's themselves.   They do want a strong managerial team that they can motivate with a carrot (high personal equity) and stick (high personal debt to buy the equity) approach.  Companies with low capital requirements and strong strategic positions in their industry are also desirable.

Possibilities for synergies are always desirable.  In an LBO this typically this includes paring expenses, or combining various firms (i.e., rollups) to create economies of scale.

The exit strategy is also important. A typical time horizon is 5-7 years.  Without a good exit plan, a relatively short term and lucrative investment can quickly turn into a less desirable or even disastrous investment.

A concept related to many of these items is the stage of business cycle for the industry.  One problem to avoid is the 'catch a falling knife' syndrome which occurs when investors purchase a company with declining cash flows.

Other considerations are important as well, but these are top of the line (or should I say bottom line) items.  We'll have more to say in Amsterdam and in future posts.

All the best,

Ralph

Due Diligence in M&A: HP, Quaker, BMW, Daimler, Mattel, etc.

In our last post, Joe commented that there were No Do Over's in M&A.  Indeed!  Why do disasters occur?  We've discussed many reasons in this blog, from Any Deal is a Bad Deal at Some Price, to The Winner's Curse, and many others.  And we've noted that Value is Estimated, Price is Paid.  But in many cases, errors in estimated value should be caught in the due diligence process.  Due Diligence is a crucial step in verifying assumptions and representations, assessing risks and beginning the integration process.  Too often it is fraught with errors.   Firmex provides the following list of the top ten due diligence disasters in M&A.  Quite an interesting list.

All the best,

Ralph

[Via: Firmex: Virtual Data Rooms]

Not Sold on the Best Buy LBO

Best Buy, the troubled electronics retailer, is rumored to be a LBO candidate. A group led by its founder Richard Schulze is expected to bid soon. If successful, it will be a $10B+ deal, the largest since the financial crisis began over 5 years ago. Increasing capital market investor risk appetite should be sufficient to fund a transaction of this size.

On the surface the basic financial metrics appear reasonable. The estimated equity purchase price based on current price and a premium would be in the $8B range which appears cheap compared to the $3B+ EBITDA. The purchase price should, however, be judged relative to what you receive in return. That is difficult to estimate given the expected 15%+ EBITDA, 2%+ sales and 3-5% same store sales declines expected over the next 5 years.

Typical required equity levels in the current market are around 35% or $3.5B of the $10B price, which includes the refunding of around $2B of existing debt. This is a large number even after Schulze’s rollover equity. Thus, multiple private equity sponsors may be needed. The $6.5B balance could be funded with loans of $4-4.5B(60%) and high yield bonds for the balance.

However, just because something can be done does not mean it should be done. A deeper review shows the following concerns:

1.                 The large equity need and problematic exit may depress expected private equity returns. The large amount of private equity dry powder may reduce the hurdle rate as PE firms look to invest capital vs. returning it to their investors.
2.                 Leases represent a large off balance sheet liability at Best Buy. Using the standard rule of thumb of 8X annual rental to calculate lease liabilities yield $9B+. Thus, Total debt will exceed $15B. Compared to EBITDAR (EBITDA + Rent) of around $4.5B this still seems reasonable. Nonetheless, the debt multiple will exceed the current equity multiple. This tends to make new creditors nervous.
3.                 Industry conditions are brutal with on-line competitors like Amazon and discounters like Wal-Mart stealing share and crushing margins. Best Buy’s largest competitor went bankrupt a few years ago. Both Best Buy and its competitor Radio Shack are suffering continued same store sales declines.
4.                 Expected core EBITDA(R) is difficult to gauge as Best Buy’s sales and margins are falling. Their entire business model is being questioned given declining sales per store, same store sales and market share deterioration. Best Buy’s high cost structure compared to Amazon and Wal-Mart make it difficult for Best Buy to compete. A major business model change is probable. Absent a reliable core EBITDA(R) it is difficult to build a realistic capital structure.
5.                 All retailers are experiencing macro head winds from an uncertain economy. This could further pressure sales and margins.
6.                 The fact that the management team is yet to be decided is a big issue. Look at the sales collapse at JC Penny when a new CEO implemented a substantial high-risk business model change.
7.                 Vendor impact is yet to be gauged. The substantial losses at Circuit City may cause vendor concern of an LBO. Remember, the senior secured bank debt places vendor inventory shipments into another creditor’s collateral pool. They could respond by curtailing shipment, reducing creditor or shipping “hot” high demand items first to Best Buy’s competitors.
8.                 Competitor response needs to be considered. They could initiate price wars and talent raids to take share from a highly indebted Best Buy.
9.                 Retailers need to maintain fresh stores. This requires substantial capital expenditures (CAPEX). Best Buy annual CAPEX is around $750MM.This serves to reduce its debt servicing capacity.
10.                 Best Buy is already perceived as near noninvestment grade. Its probable post close debt rating would be in the “B” range.  The B market window is currently open. It is, however, subject to unpredictable closures. This could adversely impact  Best Buy’s liquidity should unexpected needs develop.

Bottom line, troubled retailers and high debt do not mix well – there is simply too much business risk. Successful retail LBOs involve firms with strong category positions like Staples who can continue to grow. I believe Best Buy does not make a good LBO candidate - others disagree. Nonetheless, as Warren Buffett notes,  deals may fail in practice, but they never fail in projections. Thus, beware receiving a slick-offering memorandum that proves a Best Buy buyout works. Keep a skeptical eye and question everything.

This will be a developing story. So more to follow.  See Fitch 11-8-12 report entitled “Best Buy LBO Significant Hurdles Remain” for additional details.

Joe

How Much Debt is Right for Your Deal?

An important decision in any transaction is how it should be financed. This gets down to the mix between debt and equity. The right amount of debt can optimize the capital structure and create value. Conversely, too much debt reduces flexibility, destroys value and can lead to bankruptcy. Frequently, the decision is framed as do you want to eat well (high leverage) or sleep well (low leverage)?

This post focuses upon determining debt capacity and how much debt the deal can support in noninvestment grade buyout transactions. A critical point is that debt capacity is dynamic. It depends on the interplay of the transaction cash flows with market conditions.  Debt capacity fell from its pre-crisis highs, but is currently staging a recovery in the U.S.. This is largely due to increasing investor risk appetite reflecting the low interest rate environment.

   

Business risk reflects on the variability of operating cash flow - usually defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, smaller firms operating in cyclical industries usually have greater EBITDA variance than larger firms in stable industries. Financial risk relates to the level of cash flow to principal and interest debt service requirements coverage and to the equity cushion built into the transaction. Structural risk focuses on creditor priority of claims on the deal’s cash flows and assets as reflected in seniority and security arrangements. It also includes control features like covenants.

A deal’s internal debt capacity, exclusive of asset sales and re financings, is based on two factors. The first is cash flow generation based on EBITDA. The other is structure reflected in cash interest and debt amortization. You can “increase” debt capacity by improving projected EBITDA but beware unrealistic “hockey stick” type assumptions.  You can decrease cash interest payments thru non cash paying payment-in-kind debt and extending out amortization. Market related funded debt (interest bearing debt to EBITDA) and interest coverage (EBITDA to projected interest expense) requirements are determined from the interplay of these factors.   Future posts will focus on how to use special structuring products to expand debt capacity.

In practice debt capacity is heavily influenced by the choice of rating targets for your deal. Ratings are critical to access investors to fund your transaction. They are keys to open market doors needed to fund any deal of size. The process first involves selecting a ratings target -usually in the BB or B range for most buyouts - although during the pre-crisis boom period CCC rated deals could also get funded. The ratings choice impacts risk, cost and market depth considerations. The singe B segment is less deep, subject to abrupt closures and more costly than the BB market segment. Next, the financial requirements of the ratings target and the deal’s financial characteristics are compared. A HIGHLY simplified example illustrates the approach:

               

(A) Ratings choice: BB

            (B) Required interest coverage ratio for BB: 3

            (C) Deal EBITDA: $300

            (D) Blended interest rate for BB rated debt: 10%

            (E) Debt Capacity=(C/B) divided by D= 1000

Of course there many other factors involved, but this illustrates the point. Future posts will further develop and apply debt capacity concepts.

Joe

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.


All the best,

Ralph