Warren Buffett's Criteria for Acquisitions - Thoughts for Selling Firms

In last week's post, I commented on Business Risk, Financial Risk and Attractive LBO Candidates.  Today, I just want to note the correspondance of many  of these items with those stated by Berkshire Hathaway.  The items noted on their website are quite similar (with the exception of concentrating on large companies).  From their website:

"BERKSHIRE HATHAWAY INC.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

1. Large purchases (at least $50 million of before-tax earnings),
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations), 
3. Businesses earning good returns on equity while employing little or no debt, 
4. Management in place (we can't supply it),
5. Simple businesses (if there's lots of technology, we won't understand it),
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)."

These criteria tie in very nicely with what we noted in last week's post: Strong stable companies with good management and predictable cash flows make excellent targets for leveraged finance.  

Buffett concludes with his typical humor:

"Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."

See our previous post on Buffett's advice to acquiring firms as well!

(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

All the best,

Ralph

Business Risk, Financial Risk and Attractive LBO Candidates

As the time grows closer to our Acquisition Finance course in Amsterdam, I find myself thinking of the relation between business risk and financial risk.  Business risk, of course, is the volatility in a firms pretax cash flows. Simply put, some firms have more stable business environments over time - without even considering how the firm is financed. Business risk is often measured as the variability of EBIT or EBITDA, although I've also seen the variability of sales used as a measure.  A utility like Trans Canada Corporate (TRP), for example, has much lower business risk than say, Dunkin Donuts (DNKN).

One of the basic concepts of capital structure is that business risk and financial risk should be inversely related.  A company with less business risk can afford (tolerate) more financial risk.  This concept for business should not surprise us - the same holds for individuals.  Imagine you and I are otherwise identical, making the same average income, etc  The only difference is that I earn my income by commission while yours is fixed.  It is not hard to see who can tolerate the most debt.

All of this relates nicely to LBOs.  When considering candidates we look for strong, stable companies with predictable cash flows to cover the increased leverage we will add to the capital structure.  In more detail, we would consider the balance sheet, the income statement, the company itself, the business cycle of the industry and any synergies.  For an LBO, it is also important to consider the exit strategy.

Let's consider these in just a bit more detail.  First, the balance sheet.  Good LBO candidates are those with low debt but high debt capacity and possibly non-essential assets or divisions than be divested to free up cash.

Now - the income statement.  Steady, predictable cash flows are important (i.e., the low business risk).   In addition, investors in LBOs such as KKR are interested in strong management teams.  This is important since private equity investors typically don't want to run the company's themselves.   They do want a strong managerial team that they can motivate with a carrot (high personal equity) and stick (high personal debt to buy the equity) approach.  Companies with low capital requirements and strong strategic positions in their industry are also desirable.

Possibilities for synergies are always desirable.  In an LBO this typically this includes paring expenses, or combining various firms (i.e., rollups) to create economies of scale.

The exit strategy is also important. A typical time horizon is 5-7 years.  Without a good exit plan, a relatively short term and lucrative investment can quickly turn into a less desirable or even disastrous investment.

A concept related to many of these items is the stage of business cycle for the industry.  One problem to avoid is the 'catch a falling knife' syndrome which occurs when investors purchase a company with declining cash flows.

Other considerations are important as well, but these are top of the line (or should I say bottom line) items.  We'll have more to say in Amsterdam and in future posts.

All the best,

Ralph

Choose Wisely: Selecting a Capital Structure

The funding requirements for larger merger transactions frequently have important capital structure implications. The portion of debt to equity used is more important for strategic acquirers than private equity firms. Private equity acquisitions usually involve temporary capital structures utilizing the maximum level of debt with rapid debt repayment. Strategic buyers focus on longer term “permanent” capital structures, and are the focus of this post.

Capital structure decisions are usually expressed as credit ratings targets. The ratings are based on industry, firm size, debt-to-capital, and funded debt to EBITDA ratios among other factors. Selection of the appropriate ratings target is based on the following matching process:

                  Financing Need = product market opportunities + operating performance & strategy

                  Capital Structure = capital market conditions + financial preferences

It is important to get this right. Insufficient debt reflected in high investment grade ratings can result in excess taxes, higher agency costs and increased shareholder activism. Excessive debt expressed in non investment grade ratings can reduce flexibility and increase financial distress costs.

Some of the factors affecting the decision process are as follows:

1)    Taxes: are the debt related tax shield benefits important? Can the firm generate sufficient taxable income to utilize the interest deductions? Firms with limited existing or volatile taxable income due to rapid growth, high investment requirements, cyclicality, rapidly changing regulation and technology tend rely on higher equity levels compared to stable cash generating mature firms.

2)    Financial Distress Costs: the major financial distress cost is not bankruptcy, but the impact of higher leverage on the firm’s operations. This includes inability to fund the firm’s strategic plan, and the impact of higher leverage on the firm’s suppliers, customers, employees, competitors, and capital market access. High leverage can scare suppliers, customers, and employees.

3)     Peers: compare target structure against competitors. An overly aggressive debt level relative to peers can encourage adverse competitor responses. We saw this in HP’s comments about Dell’s LBO. HP stated they intended to remind Dell’s P/C customers that HP was investment grade while Dell would be highly leveraged.

4)     Discipline: leverage can motive management to be more efficient to meet debt service requirements. Also, lender covenant restrictions and excess cash flow sweeps requirements in noninvestment grade financings can minimize management prerequisites and empire building which is often at shareholder expense.

5)     Ownership and Control: firms worried about these issues tend to favor debt over equity.

6)     Dividends: higher leverage can pressure dividends. The impact depends on the firm’s shareholder base. Shareholders preferring a steady dividend may favor a more conservative capital structure despite potential ownership and EPS dilution.

7)     Relative Pricing: the Fed’s QEs have altered the relative pricing of debt compared to equity. Excess liquidity and low rates have lowered the cost of debt. The equity risk premium, however, has remained elevated making equity a more expensive funding source (see Cookbook WACC Estimates: Wrong Recipies?).

Many acquirers will undoubtedly use the same pre transaction rating target when setting their funding mix. Nonetheless, it can be useful to revisit the capital structure decision as part of the M&A discussion.

So chose wisely.

J

P.S. Readers of this post may also find many of our other capital structure posts of interest including: How Much Debt is Right for Your Deal and High Leveraged Deals, Capital Structure, and Common Sense.

Due Diligence in M&A: HP, Quaker, BMW, Daimler, Mattel, etc.

In our last post, Joe commented that there were No Do Over's in M&A.  Indeed!  Why do disasters occur?  We've discussed many reasons in this blog, from Any Deal is a Bad Deal at Some Price, to The Winner's Curse, and many others.  And we've noted that Value is Estimated, Price is Paid.  But in many cases, errors in estimated value should be caught in the due diligence process.  Due Diligence is a crucial step in verifying assumptions and representations, assessing risks and beginning the integration process.  Too often it is fraught with errors.   Firmex provides the following list of the top ten due diligence disasters in M&A.  Quite an interesting list.

All the best,

Ralph

[Via: Firmex: Virtual Data Rooms]

Back to the Future Again: The Beginning of a New Debt Bubble?

You cannot blame investors reaching for yield given the current near zero interest rate environment. This has depressed credit spreads and increased the market appetite for higher risk transactions. Plentiful cheap credit has proved to be too much of a temptation for many firms to ignore.  An unintended consequence of this development has been an increase in corporate leverage for both investment grade and noninvestment grade corporate issuers. Much of this increase for investment grade firms is related to shareholder distributions such as debt financed dividends and share repurchases.  Issuers like Costco and others have been issuing new debt to fund these distributions. True, some of this is related to the expected increase 2013 tax changes. Nonetheless,  the net result is investment grade corporate leverage multiples are creeping up to 2X EBITDA.  Just like in the pre-crisis era, firms are scolded for lazy balance sheets with low debt levels and high cash balances. The rise in leverage levels for the noninvestment grade LBO is even more dramatic. Leverage as a multiple of EBITDA has increased to over 5.5X while equity levels have fallen below 35%. These levels are approaching their pre-crisis highpoints.

This is reminiscent of the 'optimizing balance sheets by leveraging up' themes prior to the crisis. The problem with leverage is the benefits are visible while the costs are hidden. This is because risk is difficult to measure. The key benefits are control, usually reflect in share accretion, taxes (because interest expense is tax deductible) and higher equity returns. The tax benefit associated with leverage comes from a value transfer from the IRS by reducing their take in the firm’s cash flows. This benefit was reexamined and revised  downward from the statutory tax rate times the level of debt by Merton Miller in 1977 once the impact of personal taxes are considered.

Leverage costs are reflected by the product of the probability of distress times the cost of distress. The probability of distress is a combination of business risk from factors including cyclicality, regulation, competitors , and others as outline in my previous  November 14, 2012 post "How Much Debt is Right for Your Deal?".  The second component-cost in the event of distress -is much more amorphous and frequently understated if not ignored all together. These included heighten risk of competitor attacks, negative relationship impact on suppliers, customers and employees, and ultimately risk of default and failure. Leveraged firms have simply less room for error. Many firms discovered this fact during the 2008/2009 period.

These firms lost financial market access, were unable to rollover maturing debt, had to curtail investments and dividends, and some ultimately failed. As James Grant has noted all lessons in finance are cyclical and not cumulative. They are continually being rediscovered. What is surprising is how quickly many of the crisis lessons have been forgotten again. They may be painfully rediscovered again.

Financial markets still face considerable macro headwinds which could result in their closure to some firms. This could severely impact their strategic investment programs - their main source of shareholder wealth creation - and especially the flexibility to capitalize on market disorder by profiting from competitor weakness. That is why capital structure decisions must be tied to overall strategy. Also, they must be consistent with an appropriate debt rating and liquidity levels.

Less leverage and more liquidity are not mere redundancies or insurance. Rather, they represent opportunistic investments. Firms sometimes under estimate their liquidity and capital needs during bullish markets. Apart from tax shields (which may be overstated) leverage does not create value-it only magnifies short term results.  In addition, offsetting costs of financial distress are difficult to estimate. See Nassim Taleb’s recent book “Antifragile -Things That Gain from Disorder” (Random House, 2012) for a more philosophical approach to this topic.

Cautious Joe

p.s. Best Buy (original post November 19, 2012 “Not Sold on Best Buy LBO") update: The firm has granted its largest shareholder and founder an extension to next February to make a bid. This another sign of the difficulties associated with the planned buyout. As the saying goes, good deals get done right away, while bad deals don’t.


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We won't post next week, but will return Jan 4.  We wish all of you a wonderful holiday season and a fantastic 2013!

Joe and Ralph

How Much Debt is Right for Your Deal?

An important decision in any transaction is how it should be financed. This gets down to the mix between debt and equity. The right amount of debt can optimize the capital structure and create value. Conversely, too much debt reduces flexibility, destroys value and can lead to bankruptcy. Frequently, the decision is framed as do you want to eat well (high leverage) or sleep well (low leverage)?

This post focuses upon determining debt capacity and how much debt the deal can support in noninvestment grade buyout transactions. A critical point is that debt capacity is dynamic. It depends on the interplay of the transaction cash flows with market conditions.  Debt capacity fell from its pre-crisis highs, but is currently staging a recovery in the U.S.. This is largely due to increasing investor risk appetite reflecting the low interest rate environment.

   

Business risk reflects on the variability of operating cash flow - usually defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, smaller firms operating in cyclical industries usually have greater EBITDA variance than larger firms in stable industries. Financial risk relates to the level of cash flow to principal and interest debt service requirements coverage and to the equity cushion built into the transaction. Structural risk focuses on creditor priority of claims on the deal’s cash flows and assets as reflected in seniority and security arrangements. It also includes control features like covenants.

A deal’s internal debt capacity, exclusive of asset sales and re financings, is based on two factors. The first is cash flow generation based on EBITDA. The other is structure reflected in cash interest and debt amortization. You can “increase” debt capacity by improving projected EBITDA but beware unrealistic “hockey stick” type assumptions.  You can decrease cash interest payments thru non cash paying payment-in-kind debt and extending out amortization. Market related funded debt (interest bearing debt to EBITDA) and interest coverage (EBITDA to projected interest expense) requirements are determined from the interplay of these factors.   Future posts will focus on how to use special structuring products to expand debt capacity.

In practice debt capacity is heavily influenced by the choice of rating targets for your deal. Ratings are critical to access investors to fund your transaction. They are keys to open market doors needed to fund any deal of size. The process first involves selecting a ratings target -usually in the BB or B range for most buyouts - although during the pre-crisis boom period CCC rated deals could also get funded. The ratings choice impacts risk, cost and market depth considerations. The singe B segment is less deep, subject to abrupt closures and more costly than the BB market segment. Next, the financial requirements of the ratings target and the deal’s financial characteristics are compared. A HIGHLY simplified example illustrates the approach:

               

(A) Ratings choice: BB

            (B) Required interest coverage ratio for BB: 3

            (C) Deal EBITDA: $300

            (D) Blended interest rate for BB rated debt: 10%

            (E) Debt Capacity=(C/B) divided by D= 1000

Of course there many other factors involved, but this illustrates the point. Future posts will further develop and apply debt capacity concepts.

Joe

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.


All the best,

Ralph