Keep It Simple Stupid: The New York Community Bank Astoria Financial Acquisition

New York Community Bank (NYCM) announced on October 29 the $2B acquisition of Astoria Financial (AF). The market reaction was brutal with NYCB dropping 8% (around $500 Mln) and AF losing 6%.  Perhaps, the AF drops reflects the depreciating value of the NYCB stock it is receiving. It is unusual for both the buyer and seller to drop. It is an in-market deal which should lead to cost saves. The price is full, but on its face does not seem excessive at 15% premium (over stock which may have run up in anticipation of a bid), 1.6X tangible book (1.2X book) and 30X AF earnings (high, but may reflect AF weak earnings?).

So what happened? Well it seems plenty happened beneath the surface including:

1)     Regulatory: the acquisition pushes NYCB past the $50B regulatory threshold. This means it will be subject to more intense regulation. Some estimate the incremental costs at $10 Mln+ p.a.  for items like compliance. Not necessarily bad if part of a higher value strategy. Nonetheless, it needs to be explained to investors so they can evaluate.

2)     Charge: NYCB is changing its capital structure by repaying existing debt. This triggers a $615 Mln charge represents 4X estimated first year cost savings and 30% of the purchase price. The cost plus premium starts to make this look like an expensive deal. The reduced debt lowers the interest tax shield and further lowers NYCB’s value. May be a preemptive regulatory action to ensure the deal’s approval?

3)     Equity Issuance: NYCB is diluting existing shareholders by a) issuing $600 Mln+ in new equity to cover the charge listed above and b) equity consideration for 80% of the purchase price. This is a sizeable surprise.

4)     Dividend Cut: NYCB is cutting its dividend by 35%. NYCB had been a high dividend yielding stock and attracted a dividend seeking clientele. To be fair this may be due to regulatory concerns to ensure the deal’s approval.

 This deal is a net negative and a real turkey (sorry for the pun given the season). The deal may be strategic, but the price and the financial policy changes make it a loser. When acquiring it is best to keep things simple and to explain clearly your actions to your shareholders.

J

Another One Bites The Dust: The Perils of Debt Syndication

I previously highlighted the perils of leveraged debt syndications. Another recent failed transaction is Veritas-the seventh broken Euro high yield deal this year. Veritas is a large complex cross border transaction. At $8B it is the largest LBO in 2015. Carlyle and GIC (Singapore’s sovereign wealth fund) agreed to purchase Veitas, Symantec’s data storage unit, in August. The deal takes place in a year in which private equity has faced high purchase prices due to competition from strategic acquirers. Thus, Carlyle likely paid a full price for Veritas.

Some details of the deal are as follows:

1)     Debt Underwriters: Bank of America, Morgan Stanley, Goldman Sachs, UBS, Jefferies, Barclays, Citi, and Credit Suisse.

2)     Original Financing Package: $2.45B term loan, Euro 760MM term loan, $500MM secured notes, and $1.775B unsecured notes. Both term loans were covenant-lite.

3)     Revised Financing Proposal (because the original failed): $1.5B term loan, Euro 760MM term loan, $700MM secured notes, and$700MM retained by the underwriters-never a good sign of the deal’s strength. Both term loans are covenant-lite.

4)     Leverage: giving full credit to pro forma EBITDA improvements yields leverage of 4.5X for the senior and 6.5X total debt. The trailing unadjusted EBITDA leverage is higher. Even at 6.5X pro forma, the level will raise regulatory concerns as it exceeds their 6X threshold. The issuer is rated B/B2.

Investor concerns include:

1)     Size: largest deal of the year.

2)     Business Risk: data storage and cloud uncertainty suggest high business risk.

3)     Leverage: see above.

4)     Difficult to Analyze: divisional buyouts are always hard to evaluate. You are concerned with historical parent cost allocations, and whether the standalone unit can operate as an independent business. Usually underwriters require a forensic accounting review, which is shared with potential investors to give them comfort regarding historical performance. The review reconstructs the historical financial statements. For some reason that was not required here. No wonder investors are reluctant to commit. How can you build reliable reliable debt service models off of unaudited divisional financial statements?

I don’t think the market is losing faith in leveraged debt. Rather this appears to be a poorly structured deal agreed to before the mid August correction by aggressive underwriters trying to win a prestige assignment. Sometimes you have to be careful about what you wish for as may just get it. The underwriters are now getting it.

J

Private Equity: Between a Dog and a Fire Hydrant?

S&P Capital IQ-LCD published a report on the largest LBO transactions of 2015. Some interesting observations include:

1)     Purchase Prices (as multiple of EBITDA): increased a full turn in the LTM from 10.25X to 11.24X. This is a new high eclipsing the pre-crisis 2007 record.

2)     Funded Debt (as multiple of EBITDA): relative flat at around 6.5X. Regulatory security has depressed leverage levels.

3)     Equity Levels (as percentage of capitalization): increased to 35% to compensate for higher prices and constrained leverage.

4)     Deal Size: unlike corporate acquirers were the large deals (over $10B) have reached record levels, current LBOs are smaller in size. The largest deal PetSmart is $8.9B. This is partly due to the absence of larger Public-to-Private deals.

This presents a problem for PE. High prices, stagnate leverage and high equity will hamper the IRR performance for current deals. PE is forced to compete against not only corporate strategic acquirers, but also thousands of PE firms flush with newly raised funds. The current level of PE dry powder is $540B and growing. PE firms are being forced to deploy their capital into more expensive deals.

Leverage levels, unlike in previous cycles, are unlikely to loosen anytime soon. Regulators are still concerned with leveraged loan debt levels exceeding 6X EBITDA. The 2015 Shared National Credit report indicates a majority of the special mention credits (i.e. criticized) involve leveraged loans. Specifically concerning to regulators is poor underwriting represented by weak covenants, back-ended repayment terms, reliance on refinancing, and inadequate collateral. It is understandable that banks driven by shrinking net interest rate margins are attracted to higher risk leveraged loans with their higher nominal returns. Underwriting such loans this late in the credit cycle means credit losses are likely to increase-especially in energy and leveraged loans.

All of this leads to lower expected fund returns. You can see this reflected in lower stock prices of public PE firms like KKR and Carlyle. The August and November market corrections could slow corporate strategic acquirers relative to PE. The tightening credit markets, however, will complicate financing terms, pricing and availability. So, as the saying goes, PE may find itself caught between the proverbial dog and a fire hydrant, which means things, can get a little wet.

J

IPOs: The Unicorns Moment of Truth

It has been said that in finance things take longer to happen than you would expect, but then unfold faster than you would have thought. This fact seems to be occurring in the mythical land of unicorns. I am fascinated with unicorns because their purported valuations seem to violate basic economic logic. Values not dependent on cash flow, risk and time would upset how we approach mergers and acquisitions. Rest easy as it appears unicorns do not violate the first principles of finance. Rather, their financing round based implied valuations are worse than theoretical (the usual compliant against discounted cash flow models)-they are just fanciful.

Some many unicorns are getting long in the tooth at 5-7 years of age (tech firms age in dog years). Investors are pressing for liquidity AKA an IPO. The IPO process or test is exposing some of the inconvenient facts I have previously highlighted about unicorn implied valuations. A stark example is provided by the pricing range assigned to the pending Square IPO. Last year Square was valued at over $6B based on its last financing round. Fast forward to the present and the IPO values Square in the $4B range. So what the!@#$ happened?

Something could have dimmed the prospects for Square such as the loss of Startbucks next year and continued large operating losses. Also, IPO market conditions have softened somewhat following the August correction. Worse yet is the possibly that Square was never was worth $6B. It seems that investors in the 2014 financing round did not receive ordinary shares. Rather, they received “super shares” providing them with protection against an IPO priced below their financing round value. Basically, they get more shares at bargain prices to make them whole if the IPO is priced at less than their investment. Thus, unicorn values may be inflated and exposed during the IPO process. No wonder many unicorns are trying to postpone going public for as long as they can. It will get even more interesting after they are public when they face scrutiny of real market disciple. Perhaps, things may not be so different for unicorn valuation after all.

J

Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J