Market Swings and Mergers: Protecting the Deal and Arb Opportunities

The recent market swings and declines impact mergers in many ways.  Let's consider two.  First, we have the parties involved in making a deal.  These are numerous, but for convenience let's just focus on the firm to be acquired (target) and firm doing the acquiring (bidder).

If cash is the form of payment and a fixed price is set, target shareholders are in a fairly secure position.  I say fairly, because extreme swings can threaten any deal (e.g. Dow Chemical's Acquisition of Rolm and Hass right after the 2008 market crash).  The bidder may nevertheless squirm as market shakeups impact the value of the target and the related projection of future cash flows.

In stock deals, things get more interesting.  Suppose, for example, a deal is set with a one to one stock swap.  If the price of the target changes relative to the price of the bidder, the value received and paid can be quite different than originally envisioned.

One way to mitigate this risk is the use of collars - essentially boundaries framing a range of values in which a deal will take place, depending on the price of the shares at closing.  This can offer upside protection to a bidder (a maximum payment or ceiling) and downside protection to a target (a minimum payment or floor).  For more detail on this, see our previous post Acquisition Risk, Collars, and the Time Warner Deal.

Another group active in mergers and affected by market swings are merger arbs, essentially trying to buy at one price, sell at another and minimize the risks.  For example, the Beta of The Merger Fund (MERFX) is 0.08 - taking close to zero market risk.  Again, see our related post Speculation Spreads and the Market Pricing of Proposed Acquisitions.

However, volatility and market dips can widen spreads and make arbitrage opportunities more attractive.  This works particularly well if, as mentioned, the arbs can appropriately hedge market (and where possible, deal) risk.  An interesting example of this comes from The Deal's post Stock Market Volatility Creates Opportunities for Merger Arbs.

All the best,

Ralph

Common Errors in Valuation

The heart of merger analysis is valuation.  We spend considerable time in our acquisition finance course stressing best practices in valuation.  We've noted many times that value is estimated while price is paid.  Hence, errors in valuation can be crucial to deal success.  In this spirit, we note the article entitled 119 Common Errors in Company Valuations".  The abstract is below.  The complete article can be downloaded here.  

119 Common Errors in Company Valuations

Pablo Fernandez 

University of Navarra - IESE Business School

Andrada Bilan 

University of Navarra - IESE Business School 
This document contains a collection and classification of 119 errors seen in company valuations performed by financial analysts, investment banks and financial consultants. The author had access to most of the valuations referred to in this chapter in his capacity as a consultant in company acquisitions, sales, mergers, and arbitrage processes. We classify the errors in six main categories: 1) Errors in the discount rate calculation and concerning the riskiness of the company; 2) Errors when calculating or forecasting the expected cash flows; 3) Errors in the calculation of the residual value; 4) Inconsistencies and conceptual errors; 5) Errors when interpreting the valuation; and 6) Organizational errors."

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1025424

All the best,

Ralph

Mitigating Common Deal Risks in Acquisitions

Last week we reviewed some common deal risks in acquisitions.  Today's posts deals with ways to handle these risks.  The original post is copied below along with thoughts on mitigating the risks.  We've written in more detail on many of these items in other posts but provide an overview here.

       One of the topics that draws considerable interest in our Amsterdam, acquisition finance course is mitigating deal risk in acquisitions.  In shortened version, here are some of the major risks involved in acquisitions.   

       1. The deal takes too long to settle (increasing the risk of material changes). The longer it takes to work through a deal the less likely it will be completed.  

     Some of the ways to handle this problem involve using cash (as it is faster than stock due to approvals, etc.).  Of course, deadlines help as well.  Material adverse clauses won't solve this problem but are certainly important in mitigating some consequences of lengthy transactions.

2. The cash flows don’t play out as expected.  We acquire firms assuming a set of cash flows for the future.  In many cases these cash flows don't play out.  It is also common for the seller to have more optimistic expectations about the future than the buyer.  It is necessary to bridge the gap between these expectations to complete the deal. 

       One solution to this problem is the use of contingent payouts.  Earnouts can bridge the gap between seller and buyer expectations and help in completing a deal. But earnouts are also associated with other problems and should be handled with care - especially for sellers who may be giving up control of operations and hence influence on the payouts.  

3. One party abandons the transaction.  This is particularly problematic.  For sellers, it can mean a lost opportunity to cash out.  For bidders, it can mean the loss of time, money and opportunity spent courting a target firm.  

        Termination fees are often used to reduce the pain associated with this problem.  

4. Another bidder acquires the firm.  Similar to the above, this can be problematic for bidders not only because of lost time, money and opportunity but because a rival bidder (likely a competitor) has won and is now stronger. 

       Termination fees are also useful here.  Another solution involves the use of toeholds.  If another party acquires the company, the original bidder gains on the appreciation of shares.

5. The stock price of one of the parties changes before closing.  Particularly problematic in stock deals.  You think you have a deal arranged but at the time of closing find that the share exchange ratio you agreed upon now produces less than optimal terms.  For example, a one for one deal looked fine when the bidder''s stock price was $40, but doesn't look so good at closing when that price has dropped to $30.  

       Collars are useful in protecting against this problem and can give more price assurance to both bidders and sellers.  A typical collar places a ceiling (maximum) and floor (minimum) on the price that will be paid.

         

       All the best,

       Ralph

Common Deal Risks in Acquisitions

       One of the topics that draws considerable interest in our Amsterdam, acquisition finance course is mitigating deal risk in acquisitions.  In shortened version, here are some of the major risks involved in acquisitions.  We outline some of the major problems today.  Next Thursday we'll discuss some simple ways to handle these problems.  

       1. The deal takes too long to settle (increasing the risk of material changes). The longer it takes to work through a deal the less likely it will be completed.

2. The cash flows don’t play out as expected.  We acquire firms assuming a set of cash flows for the future.  In many cases these cash flows don't play out.  It is also common for the seller to have more optimistic expectations about the future than the buyer.  It is necessary to bridge the gap between these expectations to complete the deal.

3. One party abandons the transaction.  This is particularly problematic.  For sellers, it can mean a lost opportunity to cash out.  For bidders, it can mean the loss of time, money and opportunity spent courting a target firm

4. Another bidder acquires the firm.  Similar to the above, this can be problematic for bidders not only because of lost time, money and opportunity but because a rival bidder (likely a competitor) has won and is now stronger.

5. The stock price of one of the parties changes before closing.  Particularly problematic in stock deals.  You think you have a deal arranged but at the time of closing find that the share exchange ratio you agreed upon now produces less than optimal terms.  For example, a one for one deal looked fine when the bidder''s stock price was $40, but doesn't look so good at closing when that price has dropped to $30.  

         Fortunately, there are excellent ways to mitigate these risks.  We'll provide some solutions in next Thursday's post.  

All the best,

Ralph

Acquisition Risk, Collars and the Comcast Time Warner Deal

An article in yesterday’s Wall Street Journal illustrates one of the risks in stock swap acquisitions – by the time the deal closes the stock price of either target or bidder could change, sometimes dramatically.  What once looked like a good deal could now fall apart.  In this case, the article notes that Comcast’s stock price has dropped nearly 10% since the deal was announced, reducing the value to Time Warner shareholders from $159 per share to $144 per share.  The deal is set to close in the summer.   By that time Comcast’s price could recover – or it could drop further.  Meanwhile Charter Communications waits in the wings with threats to renew its own bids for Time Warner.

One of the topics that always draws considerable interest in our Acquisition Course in Amsterdam is how to mitigate risk in acquisitions.  In the case of the Comcast – Time Warner deal, the risk associated with the change in stock prices could be mitigated through the use of collars.   A collar, comes in various forms, but basically outlines how the value of an offer must change with variations in stock price at deal completion.

The two basic forms of a collar are illustrated below in a chart from an article by Micah Officer.   The formal names of Fixed Exchange Collar and Fixed Price Collar are illustrated graphically by the diagrams and humorously by Micah’s nicknames of Travolta’s and Egyptian’s, respectively.  (Presumably, one can imagine John Travolta striking a similar pose as panel A in Saturday Night Fever.)

Panel A shows the fixed exchange-ratio collar.  This is the most basic collar, setting a minimum and maximum share price at which a deal would be completed.  Imagine striking a deal somewhere in the middle of the chart on the sloped portion of the payoff line.  Small deviations in the bidders stock price produce deviations in the value received (paid) by target (bidding) shareholders at deal completion.  Both sets of shareholders receive some protection from extreme swings in stock price, however. If the bidder’s stock price has increased at deal completion, target shareholders gain and bidding shareholders pay more, but only up to a pre-determined threshold.  Beyond that threshold, the maximum price is reached, illustrated by the upper, horizontal line.   

Conversely, a drop in the bidder’s stock price at deal completion results in target shareholders receiving less and bidding shareholders paying less, but again, only to the point of a pre-determined threshold.  In this case, the lower barrier identifies the minimum value that target shareholders would receive.  Thus, bidders are protected on the upside and target shareholders are protected on the downside.

Perhaps more difficult to understand is the fixed price collar.  In this case the amount received and paid is fixed within a given middle range but varies at the extremes.  Thus, target and bidder are certain of the deal price in some (perhaps plausible) range.   Beyond the thresholds, however, target and bidding stockholders share upside gains and downside losses in response to changes in the bidder’s stock price at closing.   (Still, it is hard to imagine target shareholders suffering extreme losses on the downside without at least trying to walk away from the deal.)

In the case of Time Warner shareholders, there is currently no collar in place.  It will be interesting to watch the vote for approval in the summer if Comcast’s stock price remains low.

All the best,

Ralph