Mergers and Acquisitions: Market Update First Half of 2014

Our acquisition finance course this October in Amsterdam features a detailed look at the current European merger market.  Today's post contains some hightlights from the first half of 2014.

The global M&A market finally recovered from the crisis. M&A is at a 7 year high of $1.7T for the first half up from just over $1T for the same period last year. The U.S. represents about 40% of the total and is somewhat more active than Europe. This probably represents the stronger U.S. economic and stock market recovery compared to Europe. Interestingly, private equity related transactions represent only about 7% of the market compared to an average of 15%, and down from the pre-crisis 25% high. The reason for this, despite high levels of dry powder and substantial new fund raising, is the return of the corporate strategic acquirer (CSA). CSA have “crowed-out” private equity and offered record prices for large transactions. U.S. PPX are at recorded level levels of 15X+ compared to the pre-crisis of 12X and the post crisis low of just 6X. The number of deals greater than $10B for the half was 19 compared to 9 last year for the half.

The drivers underlying the return of CSA are as follows:

1)     Excess Cash: firms have large and increasing cash balances with limited deployment opportunities. Stock repurchases are difficult to justify given the 35%+ increase in the S&P over the past year.

2)     Rates: low rates and spreads translate into enhanced debt capacity and “cheap” funding.

3)     Pent-up demand (AKA mean reversion): the immediate post crisis blues appears to have past. Firms are returning to targets that had been tabled by the crisis.

4)     Positive Market Responses: ordinarily the stock market reacts negatively toward the buyer when an acquisition is announced - with average drops of 2-3%+. The current market reaction to announcements has, however, been positive with increases of 3%+ upon announcement. This reflects that the deals have strong strategic rationales - as is usually the case early in the M&A cycle.

5)     Return of Hostile Transactions: either you develop growth options or you become one. Hostiles now represent 20%+ of total M&A.

6)     Increased Confidence: rise in buyer stock prices has increased managerial confidence. Also, it provides an alternative funding currency - the buyer’s stock. The level of all cash deals has dropped to the lowest level since 2001.

Improving investor risk appetite promises to support continued robust M&A. Note the drop in CCC (lowest rated-highest risk bonds) from 3500BP in 2010 to around 600BP now which is close to the pre-crisis low of 500BP. Expect more aggressive transactions with higher debt levels as the cycle progresses. Also, expect the return of PE as the dry powder urge to buy becomes too much to resist. Of course, beware of potential geo-political risks and other black swans.

J

Beam Me Up: Jim Beam to be sold to Suntory

Today's  Wall Street Journal reports interesting details of the proposed Jim Beam acquisition by Suntory:  a $13.6 billion dollar deal, ($16 billion, including debt), the deal is all cash and represents a 25% premia over Jim Beam's recent closing stock price.  Will this deal be successful for Suntory?  It is too soon to tell, but there are many elements of this deal that make it interesting for students of mergers.

A deal creates value when the present value of future cash flows exceeds the costs.  Three big elements of cash flows and costs are:

Bid Premia- 25% is the cost, plus all of the integration fees.  While this is in the range of typical bid premia, a much more detailed analysis is needed to determine if it is excessive. At about 20 times EBITDA, it seems pricey.  Moreover, if the market price had already anticipated the bid, the real premia could be higher.

Synergies -   should be present in the increased market power of Suntory (jumping from 15th to 3rd in market share), and from Suntory's ability to expand distribution of Jim Beam internationally.

Projected cash flows - could benefit from an increased worldwide demand for Bourbon.  A separate journal article notes that as we grow older our appreciation of more complex tastes increases.  This bodes well for the sale of bourbon and the synergies mentioned above.

It is also of interest to note the importance of ownership structure in acquisitions

The Role of Activists- Bill Ackerman's Pershing Square Hedge fund was reportedly instrumental in getting Fortune Brands to spin off Jim Beam.  Ackerman should now earn a sizeable return as the fund reportedly owns about 12% of the stock.  According to a report in The Guardian, the successful sale of Jim Beam will result in a return of 106% since the time of the spinoff.

 Ownership structure - Jim Bean isn't family controlled and is publicly listed. Both facts facilitate acquisition.  This is in contrast to Brown-Forman and others with concentrated family ownership. Concentrated ownership works to block acquisitions when the block (say, a family) is against a sale, or to facilitate acquisition when the block is in favor of the sale (presumably Pershing Square).

However, an element of caution is in order when one considers

Suntory's buying spree- Suntory has made several acquisitions in the past year.  A more careful analysis of the motives of Suntory is needed before drawing conclusions.  The spree could represent a carefully planned expansion or an attempt to increase size without adequate consideration of integration and value.  The companies acquired, however, do play to Suntory's strength in soft drinks, energy drinks, and alcoholic beverages.

So what is the market saying about the prospects of the deal being completed?

Speculation spread- after a deal is announced, the market price jumps to something closer to the bid price.  How close?  This depends on the probability the deal will be completed and the probability of deal revision.  We call the percentage difference between the market price after the deal (P1) and the bid price (BP) the speculation spread.  In this case the market price rose Monday to $83.42 just slightly below the bid price of $83.50.  The resulting speculation spread is 0.1% which is much less than the typical spread of 2%.  The Jim Beam spread is signalling a successfully completed deal.  It also suggests that the deal is less likely to be revised by Suntory or other bidders.  (See our post on Speculation Spreads.)

Two reasons for this are:

Antitrust issues- according to the journal the four biggest spirits companies only control 9% of the global market.  This is in contrast to the beer industry where the four largest companies control 49% of the market.  Antitrust issues should not be a major factor here.  
Termination fees- the termination fee of $425 million represents 3% of the deal.  While not unusual, it could still  represent an obstacle for other bidders.

Will this deal, create value for Suntory?  As we mentioned, it is too early to tell.  The positive signs are certainly the potential synergies from distribution, the improved market power of Suntory, and the demographic trends suggesting increased demand for bourbon in the future.  Whether this is enough to offset a 25% premia is still to be seen.  As for now, however, I'd drink to this one.

All the best,

Ralph

European Mergers in 2013

Joe and I have recently been commenting about merger activity or lack thereof.   In his most recent post (viewed here) Joe notes, "Overall Volume is a Tale of Two Continents: U.S. volume is up over 11% over 2012 to over $1T-a post crisis high.  Europe, however, continues to lag, reflecting its structural problems." In the post before that (viewed here) I discussed deals of the year for 2013.  Combining these two streams, today's post deals with European Mergers in 2013, drawing on the note, Cross Market Commentary: European Merger Activity Falls in 2013.  

While aggregate deal activity was down in Europe in 2013, an analysis of quarterly activity reveals interesting and juxtaposed trends: the dollar volume of activity increased each quarter while the number of deals decreased each quarter.  Obviously, the average deal size was increasing by quarter as well.  The largest European Merger deal of the year was the 19 million dollar deal by Brazilian telecommunications firm Oi SA to acquire Portugal Teleccom SGPS S.A.  

Some of the Trends noted in the European Report are also borne out by Thompson Reuters.  Here we find that US merger activity accounted for the largest percentage of world activity since 2001 while European Activity hit a ten year low.  This reflects Joe's comment about the tale of two continents.

Regardless of the trends it is certain that mergers will continue to be important in the US, in Europe and in the World.  Why?  Because The forces that drive mergers will continue to be dominant in all of these markets, specifically changes in: technology, consumer tastes, regulation, competition, and factors of production.  The size and volume of activity will ebb and flow, but the fundamental factors driving deals are ever present.  More detail is contained in our post on Catalysts for Merger.

All the best,

Ralph

Microsoft and Noikia

Joe's recent post on Schumpeter and HP inspired a few thoughts, especially when I read about Microsoft and Noikia merging.   

The Microsoft/Noikia deal had been rumored and had died a few times before the recent announcement of the deal. (See That Microsoft-Nokia merger you've been predicting? It's no go.)

But now the deal is on.  Really?   Is this another case of lost margins chasing growth through ill conceived merger? Harry McCracken's Nine Thoughts about the Microsoft -  Noika deal is quite on point - and also consistent with what Joe noted about creative destruction and ill conceived deals.  Read the McCracken post here.

Of course, Microsoft is no stranger to acquisitions, having completed more than 150 deals since 1987.  It is, of course, easy to make acquisitions when times are relatively good and one is awash with capital. It is more difficult to integrate these firms and continue to use them to generate growth at acceptable margins.  

Ralph

Merger Activity in the First Six Months of 2013

In February it looked like the year was off to an upswing in merger activity, sparked by Berkshire and 3g's $28 Billion acquisition of Heinz and Dell's $24 Billion LBO.  Six months out finds the Heinz deal closed and the Dell LBO awaiting a shareholder vote.  Meanwhile overall merger activity is down for the year.  As the headline of Tuesday's New York Times States, Merger Activity Was Down But Not Out, in the first half of 2013.

It is interesting that many factors are in place that are associated with greater deal activity. Interest rates are low facilitating demand.  Stock prices are high and historically the number of deals has been strongly correlated with the general level of stock prices.  In addition, companies are sitting on record amounts of cash.  All of these factors should signal a strong robust market.  Why haven't they?

One explanation is that firms have been restructuring themselves rather than acquire other firms.  There has been some increase in share repurchases - companies essentially buying themselves.  Plus, this year's merger numbers may be a bit distorted, as there was increased activity in the 4th quarter of 2012 as companies rushed to avoid the fiscal cliff.  I think a bigger factor is general uncertainty about the state of our economy.  It is difficult to plan in the face of great uncertainty and there is much to be uncertain about.  Not in any order of priority, let's consider a few reasons for reduced activity.  

First is the increased regulatory environment.  We haven't witnessed such an environment in recent history.  What is worse is that so many of the regulations coming down the pike are unknown.  Over two thirds of the Dodd Frank Act remains to be written.  Bank M&A still lags largely due to regulatory approval uncertainity.The deals being done are very small.  We can adapt and adjust to most any set of rules but when the rules change in the middle of the game it is hard to plot your strategy.  The same could be said for the new health care laws, etc.  

Second, is the economy itself.  The Fed and Quantitative Easing have increased uncertainty.  The recent 80 basis point increase in the 10 year t-bill (140bp+ on BB credits) will curtail the level and types of deals (e.g. covenant lite and PIK) funding. This is a big thing and will require big adjustments. During the interim it is sure to depress deal activity.  Government intervention in markets means ‘artificial’  and that is not a word associated with market equilibrium. See point one.  

Third is the political uncertainty in the world.  European deals have really suffered.   Of the three points mentioned, this is the one that feels most like something we've seen before.  But even here we see technology shaping political unrest and revolution in ways that couldn't have been imagined a few years ago.  At the same time, we are increasingly aware of the technology used by our governments and by businesses themselves to track our movements.  This could turn out to be necessary, even beneficial, but it is unsettling.

My colleague, Joe Rizzi, also mentions a possible behavioral angle.  Managers who experienced the recent crisis have become ‘depression babies’ and may have a reduced appetite for M&A risk.

Those are just four items leading to a feeling of unease and increased risk.  There are signs of optimism for dealmakers, but it may take positive thinking to see them.  Risk means opportunity and deals are being completed, particularly in certain sectors of the economy.  Well-conceived and well-executed mergers create value and as we've noted before, regulatory, economic and political shocks are often catalysts for increased merger activity.  Let's see what the second half of 2013 brings.

Happy 4th of July, America!

Ralph

May the Odds Be With You

This blog has highlighted the difficulty for acquirers to create value for their shareholders. This is due to a variety of factors ranging from behavioral biases to governance breakdowns. This does not mean that all M&A is bad as some do succeed. Those success stories share some common characteristics. A key is the establishment of an appropriate process with effective procedural safeguards.

This process incorporates many of the following steps (my Ten Commandments) :

1)     Avoidance of large transformational transactions-especially when proposed by a new CEO seeking to make a reputation for himself. He usually succeeds in making the reputation-unfortunately, not the one he intended. HP’s Leo Apotheker stands out as the poster boy example with the disastrous Autonomy acquisition.

2)     Actively engage the board in the process from the beginning rather than just asking them to approve a fully cooked deal under a tight deadline.

3)     The board should establish a subcommittee chaired by a knowledgeable outside director to challenge management concerning, inter alia, pricing, valuation, synergies, and alternatives.

4)     Establish a firm up front walk away price before the negotiations begin. Beware having to adjust your price to “win”-AKA the winners curse. This reservation price should reflect your best alternative to a negotiated agreement (BANTA). This protects against accepting an unfavorable agreement compared to a better alternative outside of the negotiations. To paraphrase Warren Buffett-there are no called third strikes in M&A. There is always another opportunity.

5)     Carefully consider the “whole deal” and not just price. Remember, you can name the price if I can name the terms, and I will win every time.

6)     Ask yourself if you are honestly the best owner of the target. This means you can extract the highest value through an optimal mix of strategy and execution. If not, then you are unlikely to extract the premium paid in a competitive bidding situation. As my favorite Chicago mayor Richard Daley Sr. eloquently stated-“don’t play no games you can’t win”.

7)     Make sure you get what you thought you were buying through extensive hands on due diligence(DD). DD is not glamourous and is frequently out sourced to consultants by executives who do not want to get their hands dirty. This leads to failure like those at HP in their failed acquisitions program. The seller enjoys an informational advantage over the buyer. Since they are unlikely to tell, it is up to the buyer to find out. A useful supplement to DD is using the reps and warranties in the sales and purchase (merger agreement) to flesh out matters you should explore more deeply.

8)     Develop a detailed integration plan updated by DD results covering the first 100 days after the closing. You need quick victories and must consider the complex social issues.

9)     Tie management’s incentive compensation to the target’s post close performance.

10)  Conduct a post mortem a year after closing to uncover lessons to be learned.

Of course, there are no guarantees, but the odds for success can be increased through an appropriate process.

Good luck

j