Private Equity (PE) Is From Mars - Corporate Strategic Buyers (CSB) Are From Venus

I have previously touched on the differences in Valuation and Capital Structure between PE and CSB. The differences go beyond these two factors and distort M&A averages. They reflect the differing incentives and objectives of the two groups of acquirers.

CSB have permanent capital and take a longer term strategic acquisition viewpoint. PE is transactional orientated with an intermediate investment horizon of 5-7 years. This reflects the temporary nature of their capital - 10 years per fund with a 5 year investment period. This distinction is critical. As Warren Buffett likes to say there are no called strikes in CSB M&A - you can wait for your pitch. In PE, the clock is ticking - there are called strikes. This difference raises the risk of forced errors for PE. I am not suggesting CSA does not error. Rather, I am suggesting PE errors have a different basis from CSB.

Some of style differences are as follows:

1)     Valuation:

a)     CSB use a WACC based DCF and perpetuity based terminal value.

b)     PE uses a cost of equity bases RETURNS TO EQUITY model with a 5 year exit multiple usually tied to the purchase price multiple.

2)     Debt Capacity

a)     CSB employ a permanent capital structure with an investment grade focus that is company determined. Additionally, they use simple funding instruments - straight debt and common equity.

b)     PE uses temporary capital structure focused on maximizing debt capacity. This means their capital structures are non investment and market not company determined. Also, they use complex structures with multiple debt layers.

3)     Value Added

a)     CSB value added is synergy related.

b)     PE value comes from financial engineering and exit multiple expansion.

4)     Affordability Constraint

a)     CSB EPS dilution from any required equity issuance serves as the main constraint. Typically prefer a dilution earn back of 2-4 years.

b)     PE maximum debt capacity and the IRR on the required equity (usually 35% of the price) serve as the main constraints.

5)     Holding Period

a)     CSB infinite

b)     PE 5 - 7 years with an outside limit equal to the fund’s life-usually 10years.

6)     Integration Risk Concerns

a)     CSB high as the acquisition is usually merged into the acquirer’s existing operations.

b)     PE low the target is usually treated on a standalone basis.

7)     Search Process

a)     CSB strategic focus

b)     PE opportunistic

8)     Incentives/Performance Evaluation

a)     CSB corporate level

b)     PE at the transaction and find level

Understanding the differences between PE and CSB allows a better understanding of their styles and allows improved recommendations.

J

Fantasy Finance: Funding the Fully Priced Deal

Private equity firms are facing increasing deal multiples. EBITDA purchase price multiples now exceed 9X-almost equal to the pre crisis 2007 level of 9.5X. Some factors underlying the increase include:

1)   Return of strategic buyers: corporate buyers have returned with M&A volumes continuing to climb.

2)   Rich IPO prices: sellers can point to higher IPO prices as a credible alternative to a buyout, which buyers must match.

3)   Dry powder: PE firms have raised $95B in 1Q14.This is the highest amount since the heady pre-crisis days. Consequently, the fund raising tail will once again wag the PE dog as the money needs to be invested.

4)   Recaps: sellers can obtain interim liquidity thru a recap in the wide open debt markets.

5)   Strong stock market: sellers feel they can wait. This reduces the current availability of targets.

Not surprisingly, debt markets have responded with increased appetite for leverage to support increased buyer funding needs. Debt multiples have risen to over 5.6X EBITDA. This compares to the pre-crisis peak of 6.1X. Perhaps more important, the percentage of deals with funded debt multiples greater than 6X is 40% versus pre-crisis 50% level. This is important as U.S banking regulators have expressed concern over the growth of highly leveraged transactions exceeding 6X leverage. This could damper further bank funded leverage increases.

The current back-of-the- envelope funding gap, PPX of 9 less a debt capacity multiple of 6, now exceeds 3X EBITDA. As the London subway signs state-mind the gap. PE funds are attempting to mind the gap in the following ways:

1)   Operating improvements to increase EBITDA: there are credibility issues on size of improvements. There has to be some strategic basis to the expertise the PE firm brings other than just money. Pay particular attention to pro-forma deals which translate into EBITDA without the bad stuff.

2)   Asset sales: these can be tricky. The market can dry up. Thus, a bridge facility is needed. Also, the sale EBITDA X must be greater than the deal’s PPX. Otherwise, the EBITDA stream will be diluted and remaining debt capacity will decrease.

3)   Assuming your takeout multiple will exceed the purchase multiple. This is questionable given today’s high PPXs. Typically you need to fundamentally improve the target to justify a higher exit multiple, which gets back to point 1 above.

4)   Increase debt capacity thru financial engineering - but we may be reaching a limit at least for banking regulators.

We are approaching the fantasy finance stage in deal pricing as reflected below:

PE funds will continue to be funded by yield hungry investors into the stupid state. Nonetheless, just because you can do something does not mean you should. These types of situations usually do not end well for LPs as reflected in my wheel of misfortunate:

We appear to be in the “capital chasing deals” stage. Like riding a tiger, it is difficult to get off. As noted before in MergerProf the single biggest inhibitor of PE fund returns is overpaying for portfolio investments. This means paying a premium of 40%+ over the target’s pre-bid price. Compensating with an aggressive capital structure from an accommodating debt market further reduces the chances of success.

j

2013 M&A Observations

2013 was an interesting year. The stock and credit markets boomed as investor risk appetite increased. M&A, at least in the U.S., continued to improve (see Thompson). Some of my not so profound observations on 2013 are as follows:

1)     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. The difference is also reflected in pricing with U.S. EBITDA multiples and bid premiums of 12.8 X and 40% respective compared to Euro stats of 10.8 X and 28%. The U.S. market benefits from an accommodating Fed, leading to easy financing and an increased confidence from a booming stock market, which also provides buyers with an attractive acquisition currency.

2)     Shareholder Activism: It seems that activism has become the 21^st Century hostile takeover. Additionally, activists are acting as M&A headwind (see Activists). They are focusing more on return of capital through repurchase than M&A. Watch for shifts in this area to spur activity.

3)     The M&A Paradox: Bidder M&A share performance are problematic at best. Yet M&A continues. Is management stupid or unaware of this fact? Recent research by Ralph highlights that the problem may have more to do with faulty methodology than faulty management (see Ralph). Failure to include the anticipation effect negatively skews M&A performance.

4)     Recent Shareholder M&A Response: Even without making the anticipation adjustments, recent shareholder response to M&A announcement has been positive. This reflects investors rewarding smart M&A. Of course, managers failing to deliver the promised returns will have to pay the piper.

5)     Beware the Aging Acquirer: Aging acquirers seeking to regain their growth are likely to make bad acquirers. We are seeing this is the tech industry where firms like Yahoo and others are acquiring to cover over business model problems. This is unlikely to work as these types of firms are rarely the best owners of the acquired firms.

Predictions are always tricky-especially when about the future. Nonetheless, often wrong, but never in doubt, here are a few:

1)     The market will continue to improve in 2014-both in the U.S. and to a less extent in Europe. Economic and political uncertainty seems to be declining. Additionally, large amounts of private equity dry powder, some from heavy fund raising, will provide heightened acquisition demand. This will put upward pressure on acquisition prices.

2)     Possible concerns are the traditional “black swans” of overheating financial markets, major unexpected defaults, and Asian and Middle Eastern geopolitical uncertainty.

Happy New Year

J