Keep It Simple Stupid: The New York Community Bank Astoria Financial Acquisition

New York Community Bank (NYCM) announced on October 29 the $2B acquisition of Astoria Financial (AF). The market reaction was brutal with NYCB dropping 8% (around $500 Mln) and AF losing 6%.  Perhaps, the AF drops reflects the depreciating value of the NYCB stock it is receiving. It is unusual for both the buyer and seller to drop. It is an in-market deal which should lead to cost saves. The price is full, but on its face does not seem excessive at 15% premium (over stock which may have run up in anticipation of a bid), 1.6X tangible book (1.2X book) and 30X AF earnings (high, but may reflect AF weak earnings?).

So what happened? Well it seems plenty happened beneath the surface including:

1)     Regulatory: the acquisition pushes NYCB past the $50B regulatory threshold. This means it will be subject to more intense regulation. Some estimate the incremental costs at $10 Mln+ p.a.  for items like compliance. Not necessarily bad if part of a higher value strategy. Nonetheless, it needs to be explained to investors so they can evaluate.

2)     Charge: NYCB is changing its capital structure by repaying existing debt. This triggers a $615 Mln charge represents 4X estimated first year cost savings and 30% of the purchase price. The cost plus premium starts to make this look like an expensive deal. The reduced debt lowers the interest tax shield and further lowers NYCB’s value. May be a preemptive regulatory action to ensure the deal’s approval?

3)     Equity Issuance: NYCB is diluting existing shareholders by a) issuing $600 Mln+ in new equity to cover the charge listed above and b) equity consideration for 80% of the purchase price. This is a sizeable surprise.

4)     Dividend Cut: NYCB is cutting its dividend by 35%. NYCB had been a high dividend yielding stock and attracted a dividend seeking clientele. To be fair this may be due to regulatory concerns to ensure the deal’s approval.

 This deal is a net negative and a real turkey (sorry for the pun given the season). The deal may be strategic, but the price and the financial policy changes make it a loser. When acquiring it is best to keep things simple and to explain clearly your actions to your shareholders.

J

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,

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

Capital Structure and the Fictional World of Miller-Modigliani

Capital structure is a key element in any acquisition.  How should a deal be financed?  How much debt can an acquisition support?  What are the resulting shifts in ownership structure?   What debt rating will result from a deal?  These are just a few of the key questions related to capital structure.

In previous posts, we've discussed some basic theories of capital structure (for just two examples see High Leverage Deals, Capital Structure and Common Sense and How Much Debt is Right for your Deal?).  The theoretical foundation for understanding capital structure starts with the classic work by Miller and Modigliani published way back in 1958.  That enormously influential work, showed that the level of debt doesn't matter in a hypothetical world where: taxes don't exist, bankruptcy costs are zero and there are no informational asymmetries (all parties have complete information).

Many of our readers will recall discussing this work in their MBA programs, but for many practitioners the idea of starting with such a hypothetical, completely fictional world seems insane. Wouldn't we all like to live in a world without taxes, bankruptcy costs or informational blockages! But the analysis is not  insane.  Rather it is the starting point for understanding all that matters in capital structure today.

The starting point of Miller and Modigliani can be likened to the scientist who analyzes the properties of some item in a complete vacuum.   He/she starts the analysis in a vacuum, not because it represents the real world, but because if we can't understand how things work in that idealized experiment, we can't hope to understand how things work in our complex environment.

Rather than objecting to the assumptions as ivory tower irrelevancies, consider these assumptions as the starting point for a very important experiment.  For indeed, under these assumptions, the level of debt does not matter.  So ------ if the amount of debt matters --- (and we live in the real world and we know the level of debt matters) --- it matters precisely because of the effects of these assumptions.  Rather than being irrelevant, when we relax the assumptions, debt does indeed affect firm value - and it does so because of the existence of taxes, bankruptcy costs and information.  In future posts we'll explore each of these assumptions and their implications for capital structure in a bit more detail.

All the best,

Ralph

M&A Red Flags

It may be useful to review some M&A red flags as the M&A market continues to improve. These signals are frequently ignored once the deal process starts. My on-going list is as follows:

1)    Do you believe in magic? Aggressive revenue based synergies are always questionable. Failure to consider competitor response to revenue gains renders the estimates useless.

2)    It is a great target: It may be, but it is still a bad acquisition if you overpay. For me, premiums greater than 40% over the pre bid target stock price are delusional.

3)    Trust me: New CEOs still in their honeymoon period can get some strange deals approved.

4)    Trying to get my mo-jo back: Underperforming firms seeking to regain their old growth status usually violate the first law of holes-when you are in a hole-stop digging. Such firms are not the best owner of the target’s assets and make the acquisition for the wrong reasons i.e. weak strategic rationale.

5)    Bid’em up: Revising upward your pre bid walk away price once the bidding begins. Frequently based on some newly discovered synergy, but always fatal.

6)    Don’t worry about it: Large transformational trophy deals with high levels of shareholder value at risk (SVAR). SVAR is the premium expressed as a % of the acquirer’s pre bid market value. Sometimes known as the “bet your company” acquisition strategy.

7)    What- me worry?  Coupling a large high business risk acquisition with a highly leveraged capital structure is questionable. Flexibility is needed to successfully implement the acquisition and withstand possible competitor responses.

8)    All the other kids have one: Late cycle acquisitions to catch up with peers.

9)    It has to work: Vague existential integration plans.

10)  Don’t confuse me with the facts: Weak or ignored due diligence.

11)  Tunnel vision: Ignoring alternatives such as doing nothing or selling out.

12)  We can trust them: Dealing with sellers who have questionable motives is always dangerous. Make sure you listen to your lawyers by including risk mitigation clauses in your documentation. If the seller objects-ask why.

The presence of any one of the above should be a cause of concern for investors and directors. Two or more should be enough to reject the transaction.

Good hunting, but be careful-it is dangerous out there.

J