New Book for Acquisition Finance

This October we are using a new book for our Amsterdam course: Acquisition Finance - Structuring the Deal.  The book is Investment Banking by Joshua Rosenbaum and Joshua Pearl.  The book offers a step by step 'nuts and bolts' guide to valuing and structuring the deal.  The first three chapters review valuation by comparable companies, precedent transactions and discounted cash flow.  Chapters 4 & 5 cover LBOS and the last two chapters view M&A from the sell side and buy side.  It should be fun.  Of course, we will continue to use additional applied cases of actual deals to supplement the text.

A unique feature of our approach is Joe's experience and my academic background.  This produces a combination of sound theory and empirical evidence with lessons from the field.  The book is well suited for this approach.  If the material interests you, we hope to see you there.

All the best,

Ralph

Exit Strategies for Private Equity: US and European Evidence

Last week we outlined exit strategies for private equity investments.  One strategy that we didn't feature is a 'write-off'.  Obviously, write-offs can represent a failed investment and are (generally) undesirable. However, the ability to cut losses early is a healthy trait in any investment strategy.  The article below highlights exit strategies for US and European buyouts over the 1990-2005 period, revealing many interesting aspects of the exit process.  The importance of market sentiment is also noted, making it imperative to ascertain current and projected market conditions in any analysis.

 Exit Strategies of Buyout Investments – An Empirical Analysis 

Daniel Schmidt Sascha Steffen Franziska Szabó 

June 1, 2009 

(Abstract) 

"We analyze the three main exit routes for exiting buyout investments, initial public offerings (IPO), sales and write-offs on, using a unique data set for US and European buyout transactions for the 1990 to 2005 period. We examine the determinants influencing the choice of an exit channel employing a multinomial logit model. The results strongly support the view that private equity investors write-off investments that turn out to be non-performing early, showing their ability to filter out good from bad investments. We further find evidence that exits of buyout investments tend to be driven by market sentiment. We further analyze as to how the internal rate of return (IRR) influences which exit route is chosen. We find supporting results that only the most profitable ventures are taken public. Our results have implications for exiting buyout investments during the current financial crisis. "

The complete paper can be downloaded here.

All the best,

Ralph

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Acquisition Finance - Training in Amsterdam!

We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.   I thought I'd show last year's program to give an idea of our coverage.  This year's program will change to reflect current market conditions.  (One of the principal concepts we address in the program is the need to understand current market conditions.)  The basic content will remain the same, however, as will our approach: a highly interactive program combining theory and practice taught by an active researcher and an active practitioner.  We hope to see you there.

Joe and Ralph

Acquisition Finance - Overview of the Program

Day 1

Introduction to M&A Deal Design and Acquisition Finance

• M&A strategy
• Components of an M&A deal – where finance fits in optimizing M&A deal design
• Current conditions and trends in acquisition finance

Valuing the Highly Levered Transaction

• Techniques of valuing the target firm
• How financing creates – or destroys – value

Non-investment Grade Leveraged Financing

Private Equity Requirements

Framework for Analysis: the "Whole Deal" Approach

Case Analyses: Participants analyze and structure deals to better understand the interplay of capital structure, cost of capital, market products and deal design

Day 2

Designing the Capital Structure

• Identifying the range of financing alternatives
• Choosing the right mix of financing
• How lenders and investors look at the mix of debt and equity

Structuring the Financing

• Designing the terms of financing instruments
• Pricing the instruments
• The syndicated loan market
  -  Covenant late
  -  Second lien

• Developing the term sheet
• Risk analysis

Fixing the Broken Deal

• Decreasing senior debt
• Adding a back ended T/L C held by the originating bank
• Additional covenants
• Increased pricing

Additional Case Analyses of the Dynamics of Acquisition Finance

Day 3

Acquisition Financing in the Context of Negotiations and Auctions

• Acquisitions as bargaining outcomes; Behavioral finance
• Varieties of auctions and the incentives they create
• Hostile takeovers as settings for negotiations and auctions

How Financing Can Influence Outcomes in Negotiations and Auctions

Negotiating the Deal

• Understanding the needs of the other party
• The inter-related elements of deal design
• Bargaining on many fronts
• The ‘whole deal’ approach

Dealing with Risk in Acquisition Finance

• Earnouts – a great technique for closing the deal
• Toeholds
• Collars
• Termination Fees

Additional Case Analyses

Concluding Case in Deal Design

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

Acquisition Finance: Creating Value

Joe and I will be teaching our Acquisition Finance Course in Amsterdam in less than two months.  One of the things we start with in the course is identifying ways in which Acquisition Finance creates value.  I can't cover all of these in a short blog post but I'll try to outline some of the concepts and ideas.

Acquisition finance involves some change in the capitalization of a company.  That is, some change in the way it is financed.  It can occur as a result of a sale of the company to new owners or a recapitalization of the company under the existing owners.  In the case of an LBO or MBO, management is often part of the buyout team.  It is also common for the new financial structure to involve high amounts of leverage, hence the term LBO or HLT (highly levered transactions).

In an earlier post, we discuss 5 Ways that Acquisition Finance Creates Value, including

1. Improving incentives
2. Improving efficiency
3. Improving governance
4. Reducing regulatory requirements
5. Creating tax shields

As we have also noted, highly leveraged transactions increase risk (see Six Disadvantages of Highly Levered Firms).  And see Joe's recent column where he notes that just because you can do something, doesn't mean you should!  (See Leveraged Acquisition Loans: Fasten Your Seat Belts.) The art of the deal is finding the right balance, measuring the rewards of acquisition finance against the risks.  The following slide conveys the idea, considering just one of the advantages of high leverage, tax shields.

Increased leverage increases a firm's interest expense.  Since interest is deductible for tax purposes, this results in an annual tax savings.  The capitalized value of this tax savings increases a firm's market value, a positive.   But increased leverage also increases risk - a negative in terms of firm value.  And so the net impact must be carefully considered.  In future blogs, and certainly in our course, we'll discuss more of the specifics:  with tax shields this includes how to evaluate the level of risk, how to capitalize the value of the tax shields, how increased leverage directly impacts a firm's beta coefficient (and hence the required rate of return) and why discount rates are likely to change over time in the typical HLT.

All the best,

Ralph

Tick-Tick-Tick

M&A volume is on a tear at double the level for the same period last year for the first two months of 2013. There are a variety of reasons underlying that development including an improving economy and favorable financing conditions. Another largely unnoticed factor will further support the increase. Private equity firms raised record commitments for new funds formed in the 2006/2008 boom period prior to the financial crisis. Of the $700B+ raised during that period only half is invested, leaving a large amount of dry powder. The crisis caused funding to dry up and sponsors curtailed their activity during the 2009/2011 period. Most funds contain a provision limiting the time of the fund to invest to 5 years. Many of these sponsors are now facing the end of their 5 year investment period over the next 6-18 months. Commitments not invested by the end of that period expire - use it or loss it. It is estimated that almost 100B of this dry powder will expire this year alone. The loss of the commitments reduces their fee income. This can be problematic for the continued operation of many funds.

A further complication is the same difficult financing market conditions that limited their investment activities also depressed their ability to exit prior investments. Consequently, the average age of their portfolio investments now exceeds a record 5+ years. Unlike fine wine and cheese, portfolio investments do not age well. Their advancing age means investment returns (IRRs) are falling. Some large funds sponsored by well-known firms raised during the boom period register IRRs below 3%.

This complicates covering the requirement in most funds that a preferred return or hurdle rate, usually around 8%, be achieved before the fund general partners can receive their carried interest. Carried interest is the share of the gain, usually 20%, the general partners receive of any gains once an investment is sold. Thus, general partners are more reliant on fees on funds invested than carried interest.

This background suggests private equity firms will leave no stone unturned as they search for investments to make sure they fully deploy all commitments prior to the end of their investment period. This creates a potential conflict between the general partner fund managers and their limited partner investors. Therefore, we can expect to see an increase in questionable deals, especially in two areas.

The first is sponsor-to sponsor or secondary buyouts. These involve firms purchased by one PE firm and subsequently sold to another. Secondary buyouts, sometimes known as pass-the–parcel deals, now exceed the value of first time buyouts for the first time. These transactions are deemed lower quality for two reasons. First, it is difficult to squeeze additional improvements from firms that have already gone through the LBO process. Next, they raise the issue of collusion between PE firms to manufacture exits and create IRRs: buy my deals at favorable prices and I’ll buy yours. Next, mega deals, like Dell and Heinz, will become more popular to deploy funds quickly - perhaps too quickly.

The amount of dry powder, combined with the current leverage level of 30-40% equity, can support a huge amount of LBO transactions.  Consequently, we can expected the level of LBOs as a percentage of total M&A to increase from their current 10% level to pre-crisis 30% levels. Unfortunately, given the incentives, many of these deals may have a difficult ending. The noise of the ticking investment period clock may adversely influence the judgment of many PE firms.

J

The Dell Stock Repurchases Program - Hmmmmmmmmmmm

Ralph and I have an on-going debate on the merits (Ralph) and demerits (me) of share repurchases. My point is not all repurchases are the same. Some may be value enhancing. Others, however, are not. They can be used by executives to manipulate earnings per share (EPS) to improve their option values.

Floyd Norris' January 18,2013 New York Times article on the misuse of repurchases at Dell provides a cautionary tale for shareholders. He analyzed Dell's long running approximately $ 40 B program. He concludes over priced repurchases benefited corporate executives at the expense of long term shareholders. Michael Dell, Dell’s founder and largest shareholder, was a substantial option recipient. His gain is estimated at over $650 MM. Executives would profit if Dell stock price increased following a decline in the number of outstanding shares post repurchase compared to a dividend. This encouraged repurchases to offset potential stock price weakening by increasing EPS as operations began to mature. This occurred despite the negative impact on long-term non-tendering shareholders. This occurred because the repurchases, being over priced, transferred value from remaining shareholders to those tendering. Michael Dell's losses were offset by his option gains, which were unavailable to non-executive shareholders, plus the gain on any shares he tendered. Dell paid an average repurchase price over the years of $ 19 per share compared to the current price of $ 12. A general observation is firms facing a challenging operating environment who have stock option programs may be prone to questionable repurchases.

The current low share price due to concerns over the firm's business model has increased the interest in taking Dell private. Michael Dell is rumored to contribute his shares into the potential LBO. This raises conflict issues as to who he represents-the firm's shareholders or himself in the buyout negotiations. Given his record on the repurchase program we can only guess hmmmmmmmm.

I promise this will be the last post on repurchases for a while. There will be more posts on Dell as the story develops.

j

Gin Rummy LBO Screening: The Case of Dell

My previous Best Buy post highlighted why I considered it to be a poor LBO candidate. Best Buy's big box retail model was rapidly losing out to on line firms like Amazon. Firms suffering from declining operations due to industry structural changes, which put their existing business into question, involve too much business risk. They have poor prospects of turning themselves around in a highly leveraged state.

Now another structurally challenged firm, Dell, is considering an LBO. Dell's shares declined 30% last year despite an overall rise in the stock market. Its core direct order PC business has fallen prey to retail stores and new products like smart phones and tablets. The result is that sales declined 19% and profits fell 47% last year. They have been trying to offset the decline by repositioning the firm through almost $13B in new initiatives (including acquisitions) for some time.

Dell's market value exceeds $20 B. Applying a reasonable premium suggests a transaction price around $24B. A 40% equity requirement generates a $9.5B equity need.  Assuming the rollover of Michael Dell's ownership reduces the new equity need to $6B. This is a large amount and would probably be split among multiple private equity sponsors as had occurred during the 2003/2007 LBO boom. Shared deals like this can be tricky if something goes wrong as it is difficult to know who is in charge.

Debt in excess of $13B would be needed. Dell has a sizable cash position. Unfortunately, it is largely overseas, and probably subject to substantial taxes if returned to the U.S. to support the proposed LBO. The key impediment to the debt levels is Dell's declining core earnings and market share-despite years of continued turnaround efforts by Michael Dell. How can you build a realistic capital structure if you are unsure about your cash flow?

Michael Dell is likely to continue in a senior role in the LBO. Thus, it is difficult to see what new turnaround efforts he will employ in a highly leveraged firm that will be more successful than past efforts. It is difficult to reinvent and implement a new business model in a leveraged firm. There is little room for delay or error. The fact that this project can even be seriously considered is a testament the current highly receptive bank and capital markets.

I understand Dell's frustration given the market's response to their existing turnaround efforts. Nevertheless, an ill-advised LBO is not the best alternative choice of action. Absent a strategic buyer, a more realistic option is to manage the firm for cash, and return the cash to shareholders. Part of the disappointing stock market performance may be due to shareholder concerns that Dell is over investing in low return activities, or overpaying for acquisitions.

The high financial risk in LBOs requires a stable operating environment with predictable cash flows. It is difficult at best to try a high-wire business turnaround in leveraged firm. A concern is banks and other investors in search for high returns will proceed with the transaction despite its size and risk. Wilbur Ross gives the proposal a 50% chance of proceeding. Investors should beware of LBO candidates representing weak discarded cards as in gin rummy.

J

5 Ways that Acquisition Finance Creates Value

Acquisition Finance typically involves a change in the ownership structure of a company, often accompanied by increased leverage.  The terms MBO, LBO and leveraged recapitalization are typical.  The entire process is often misunderstood and sometimes vilified.  At it's core, however, are changes that increase value through improvements in financing, incentives, strategy and operations to better meet the needs of customers.

Five interrelated ways that acquisition finance creates value include:

1. Improving incentives
2. Improving efficiency
3. Improving governance
4. Reducing regulatory requirements
5. Creating tax shields

Incentives are at the heart of acquisition finance.  Typical ways incentives are improved include revising compensation structures as well as capital structure changes.  Compensation structures can be revised to better align pay and performance, focusing on the strategic levers that create value for a particular company.  Capital structure changes involve shifts in managerial ownership levels as well as shifts in debt levels.  These changes can provide  powerful carrot and stick incentives.  In many transactions, managerial stakes are increased which results in more 'skin in the game'.  At the same time, personal and company leverage provide powerful motives to meet regular interest payments.  At the personal level, leverage motivates executives concerned about personal default.  At the business level, the requirement to meet debt payments reduces cash at hand and hence the ability to build the empire using owner's (shareholder's) money.  Executives that want to grow the company must face a market test of raising capital rather than using cash at hand from retained earnings.  

With revised incentives comes a need and a desire to take a fresh look at the strategic and operating position of a company, with a goal of increased efficiency.  While these changes can dramatically improve a company's ability to meet customer needs, they can also be painful.  Change can be difficult and one should not minimize the impact of these events on employees of the company.  We must keep in mind, however, that the marketplace is highly competitive.  It is a cruel and harsh truth but companies (and employees) that fail to adapt ultimately face the realities of a competitive world.  In many cases, painful changes associated with acquisitions would have happened anyway.  

In some cases, acquisition finance involves taking a firm private through a leveraged buyout or a management buyout.  Improved governance is often the result.  Incentives are also at the heart of governance.  A streamlined board of directors, higher levels of managerial ownership and increased focus on the sustainable competitive advantage of a company are just some of the ways that governance can improve value.

Related to this are the reduced regulatory requirements that can be associated with private firms.  Directors of publicly traded companies often tell me of the increased amount of time spent complying with Federally mandated regulations.  They loathe the 'check-box' mentality associated with a 'one-size fits all', requirements.  Directors of privately traded companies (which generally face fewer regulatory requirements) talk about increased time for strategic thinking on behalf of the company.

In addition to the incentive effects mentioned above, increased leverage creates tax shields.  In the current tax code (for the US and many countries), interest is tax deductible.  Increasing the leverage of a firm reduces its tax burden in the same way that individuals 'write-off'' mortgage interest deductions.  The capitalized value of these tax shields can add significantly to the value of a firm.  However, increased leverage brings increased risk.  The challenge is to recognize the optimal level of debt that can be associated with the firm's assets.  More detail on techniques for matching both sides of the balance sheet will be coming in a future blog.

One notes that some of the items mentioned above could be accomplished within the firm, without outside intervention.  Being aware of how acquisition finance can create value should help management and boards better understand ways to keep their companies thriving in a competitive marketplace.  Failure to remain competitive leaves opportunities for improvement and incentives for outside forces to take action.  In this regard, the best takeover defense is to maximize value, but that important concept is also worthy of additional discussion in a later blog.

Ralph