Corporate Funding Process

The basic goals of corporate finance are (A) fund the firm’s strategic plan and (B) provide enough liquidity to satisfy the firm’s obligations as they come due. This involves a process incorporating strategy, operations, capital structure, and capital markets timing. This is the stuff of the practice v theory of finance-cash flow budgeting not models usually not covered in detail in textbooks.

The following diagram highlights the process:

The steps in the process are as follows:

1)     Investment Opportunities/Requirements: matching product market opportunities with the strategic plan gives rises to the investment budget. I find it useful to use Porter’s Five Forces model to gauge investment opportunities. Your strategy determines how fast you plan to grow and investment needs-CAPEX, working capital investment (WCI) and operating expenses like headcount and R&D.

2)     Financing Need: based on cash flow available for debt service (CFADS) = Net Income ( after interest and taxes) +DA-(CAPEX+WCI) +/- (AS-AA + CND) with DA being depreciation and amortization; AS-AA representing asset sales or acquisitions; CND being changes in net debt. Mature firms with excess CFADS focus on shareholder distributions (sometimes prefunded debt financed share repurchases i.e. recapitalizations) while growth firms with negative CFADS need to raise cash.

3)     Funding Sources: selection of instruments depends upon market conditions and financing preferences.

a)     Capital market conditions: influenced by macro factors such as rates and economic growth. Just like ordering lobster -prices and availability are subject to market conditions. We saw an extreme example of this during the market crisis years of 2009-2012 when markets shut.  Some key factors include market depth, cost, terms, access, and disclosure. You can only take what the market gives.

b)     Financial strategy: the objective is to match sometimes conflicting financial preferences with market conditions in a cost effective manner to assure certainty of funding. Key factors include

Control-closely held firm will be reluctant to fund with equity if it upsets control positions

Dilution-equity financing impacts dilution and can be an impediment

Flexibility-growing firms need flexibility hence avoid debt with covenants and prepayment restrictions

Ratings-rating targets influence the debt versus equity choice and debt capacity

Cost-both absolute and relative cost among instruments

Public or Private-firms seeking confidentiality balance depth of public markets with disclosure requirements

Dividend Policy-high dividend policy constrains debt capacity

Investor Base-banks, private equity, hedge funds, etc.

Liquidity Needs-financial slack is valuable especially for growth firms as s#$% happens

Speed-how soon you need the funds determines which sources you seek

Currency Preferences-USD or others

Nature of Funding Need-one-off or on-going; if on-going focus on relationship type investors

Hedging Policy-for financial exposures like rates and currencies

Accounting Policy (on/off balance sheet)

Taxes

Maturity Structure

4)     Instruments: the funding instruments choice usually becomes apparent once you go thru the above process. The key is to customize the instruments to capitalize on investor segments to achieve the best terms. Most firms utilize a Pecking Order approach to minimize information asymmetry costs reflecting the following order:

Debt

Hybrids-convertibles and warrants

Equity-preferred and common

5)     Repeat Step 2 once the cash flow implications of the choices are determined. Reflect plan in cash flow budgets and use scenario analysis to ensure it works with a sufficient margin for error.

The funding decision is like playing with a Rubik's Cube trying to match up sometimes conflicting goals under time constraints in an uncertain dynamic capital market environment. Compromises are needed to ensure adequate funding under all states of nature-not just the current state. As a general rule- raise funds when you can and not when you must as many capital challenged firms learned the hard way during the great recession.

J

How Do I Pay: Stock, Cash or Combination?

The selection of the acquisition payment currency has important implications for both the seller and buyer. So far in this century about 55% of deals are cash, 23% combination and 22% stock. The proportion of cash and combination deals has increased since the elimination of Pooling of Interests accounting in 2001. Like all M&A items, the selection is negotiated and depends on the relative points of views of the buyer and seller regarding whether the risks and rewards of the acquisition should be shared. The simplest approach is use cash, but sometimes that is not always possible.

Buyer considerations regarding the use of stock in whole or part include the following:

1)   Valuation: consider not only the seller’s valuation, but also that of the buyer’s post transaction value to gauge the exchange ratio impact. The buyer should never use its shares if it believes them to be undervalued; whereas, it should use its shares if it believes them to be over-valued and the seller will accept them. An extreme example of this is AOL’s purchase of Time Warner.

2)   Synergy Risk: use cash if synergy risk is deemed low to keep the upside and stock if high to share the risk. Facebook’s recent high priced acquisitions are primary stock transactions. This helps cushion the downside should the early stage technology targets fail to work out as planned.

3)   Market Risk: if shares are used then you need to decide who bears the market risk of the shares changing price after the offer is made but pre close. The options include a fixed price deal where the buyer assumes the risk, a fixed share arrangement where the seller takes the risks or using collars and caps to share the risk. (See our post Acquisition Risk, Collars, and the Comast Time Warner Deal.)

4)   Dilution: this includes both ownership and earnings dilution. Whenever new shares are issued the relative ownership positions of existing shareholders declines. This can be an important control issue for middle market firms and argue for a cash deal. Buyer earnings and earnings per share (EPS) always increase in a debt financed cash transaction provided the target’s earning exceed the incremental after tax interest cost on the debt. In stock transactions the new shares issued can cause a decline (dilution) in EPS if the seller’s price-earnings ratio exceeds that of the buyer. Over time, the EPS dilution should decline as earnings grow. Usually, buyers prefer a breakeven dilution of 2-3 years.

5)   Taxes: the buyer prefers a taxable transaction involving all or a substantial portion of the price to be in cash. This allows the write-up of the assets acquired by the buyer and higher future tax deductions. Other considerations include changing tax domicile to lower tax rates as in the Pfizer-AstraZeneca  bid.

6)   Credit Rating: debt financed cash transactions impact the buyer’s target debt rating.

Seller considerations include:

1)   Valuation: the seller needs to value the buyer’s shares on a post acquisition basis to determine what if any premium it actually receives. This means doing due diligence on the buyer. These valuation issues explain why targets in hostile takeovers prefer cash over stock as AstraZeneca is now demanding from Pfizer. Remember the old joke - daddy I sold my bike for $20,000- I traded it for 2 $10,000 marbles. The value of marbles, like the buyer’s shares, is an opinion. Cash, however is a fact.

2)   Taxes: sellers can defer capital gains taxes if the transaction is structured as a tax free share exchange. Unfortunately, this has negative tax implications for the buyer which will probably be reflected in the offer price.

3)   Liquidity: the focus is on the float of the shares to be received, lock-ups and registration rights.

Bottom line for me is the KISS principle (keep it simple stupid). It is usually cheaper for the buyer to pay in cash. This may reflect Warren Buffett’s apparent preference for cash purchases. Sellers will have an easier task of evaluating the offer and less risk in cash deals. Thus, being a simple guy, I recommend cash transactions whenever possible. If not using cash, be sure you are at least as smart as the other side.

J

No Do-Over's in M&A

Both Ralph and I have highlighted the perils of bad acquisitions and bad governance. Bad acquisitions share common characteristics including:

1)     Over Priced: reflected in high purchase price premiums and substantial goodwill and earnings per share (EPS) dilution. This is especially true for winning bidders in an auction (AKA the winner’s curse).

2)     Large Transformational Transactions: trophy deals driven by delusional CEOs with weak Board oversight.

3)     Serial Acquisition Program: some initial success breeds hubris. Eventually a “bump-in-the-road” exposes the real risk.

4)     Stock Used to Fund the Transaction

5)     Occurs Later in the M&A Cycle

A near perfect example of bad acquisitions is First Niagara (FN) an acquisitive rapidly growing Buffalo, NY community bank. They replaced their CEO, Koelmel, in mid March. He had embarked upon a serial acquisition program including 4 acquisitions in 3 years upon becoming CEO in 2006. FN grew from $10B to over $35B in assets during his tenure. Unfortunately, his growth for growth’s sake strategy proved disastrous for shareholders. The stock peaked at $15 per share in February, 2011 before falling to its current $8.50 level. During this same period the KBW Bank index rose by over 30%.You know it is bad when your stock increases 4% upon your CEO’s resignation. The stock is trading at 67% of its book value with an equally depressed price-to-earnings ratio.

Koelmels’s first few smaller acquisitions were moderately successful. They occurred during the peak of the 2008/2009 crisis and were attractively priced. Confusing luck with skill, he met his Waterloo with the mid 2011 $1B+ purchase of HSBC’s $10B+ in deposits with 195 branches up state NY franchise. The premium paid for the deposits was 6.67% compared to the expected 3.5-4 % range. Koelmel felt the premium was required to beat the much larger $85B in asset rival Key Bank who was also a bidder. The premium created significant goodwill and depleted FN’s regulatory capital.

Subsequently, FN sold 37 branches to Key Bank to satisfy antitrust concerns. Key paid only a 4.5% premium and turned out to be the real winner. As luck would have it, the market worsened after the announcement due to the beginning of the Euro crisis during the summer of 2011.This caused a substantial decline in operating performance. FN failed to obtain committed financing and decided to postpone a needed equity raise until May, 2012 when the deal eventually closed. Its stock price collapsed during that period resulting in a highly dilutive $467MM common stock raise at a 30% discount to the prior year price. They additionally raised $350MM in preferred stock with an 8.625 dividend rate compared to an expected 6-7% rate.

Integration problems compounded weak operating performance resulting in losses. Their dividend was cut for the first time.Koelmel’s credibility with investors and the Board was shattered and he had to go. He walked away with a $5MM+ severance package after nearly destroying FN in his vain attempt to become the 21^st century version of Hugh McColl who created the modern Bank of America through acquisitions in the late 20^th century.

Unfortunately for shareholders there are no “do-over” in M&A.Thus, it is critical that Boards have the strength to say “no-do” to strong CEOs before they embark on ill-fated acquisitions.

j