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

Excess Cash, Leftover Wine, and Acquisitions

Quiz:

When a company has excess cash, what is the optimal thing to do?

a) return the cash to shareholders via dividends or repurchases

b) make acquisitions

c) return cash to shareholders only when they have a better use of the funds than the company

d) retire debt

e) save the cash, rainy days are ahead

(f) increased CAPEX.

With some explanation, the only correct answer is (a).

First, let's look at (e) and (c) and (f) which could be the best answers if we hadn't specified  the phrase 'exess cash'.  By definition, 'excess cash' occurs after consideration of the safety and usage reasons for holding cash.  The term 'excess' also implies that management has already taken all positive NPV projects which would seem to rule out any reason for management to keep cash for safety reasons (e) or as in (b) make acquisitions.  If there were good acquisitions to make, the cash would not be 'excess'. The same is true of increased CAPEX. 

Retiring debt (d) might make sense if a firm was over-leveraged and/or interest rates were high, but in general only makes sense if the cost of debt is less than the return shareholders can earn on their funds at risks typical to those of this firm. Typically, this is the cost of equity for the firm which exceeds the cost of debt and especially the after tax cost of debt.  Rule out (d).  

Now lets give greater credence to (b).  Sometimes it is argued that when a firm's stock price is inflated, it makes sense to use that over-priced currency to acquire hard assets.  When the firm's stock price adjusts to reality, the firm will still have acquired the hard assets at inexpensive prices.  This argument may explain why the number and dollar volume of mergers is strongly correlated with the stock market.   When stock prices are high, more deals get done.  The problem with this argument is that the target's stock price is also  likely to be high so the acquiring firm could be purchasing overpriced assets.  

Thus, when a firm truly has 'excess cash' the only correct answer is (a). Nevertheless, when faced with a decision to relinquish cash or build the empire, many managements choose the later. 

And it is well known that deals increase with stock prices.  

Currently stock prices are at or near record highs.  

So are the number of deals being completed.  This graph from Jesse Solomon in  CNN Money reveals that the number of deals completed in the first half of this year outpaces the total number of recent years and is on pace to surpass the all time highs of 2007.  

Why?  Certainly some deals make sense - and the conditions in many industries are demanding consolidation, but for many firms, one can suspect that excess cash, like excess wine is just not that apparent when it is in your hand.  

All the best,

Ralph

Do Bad Bidders Become Good Targets?

We all have our favorites, from food to songs and so it is with titles to academic articles.  Today’s post features one of my favorites, “Do Bad Bidders Become Good Targets?”  The answer, in a very interesting article by Mark Mitchell and Ken Lehn, is yes. 

We’ve argued before that the best takeover defense is to not leave money on the table.  The analysis of this article follows this logic.  Companies that lose money through bad acquisitions are wasting shareholder value and are likely to be targets themselves.  The complete article can be downloaded here.  The abstract is shown below.

“Do Bad Bidders Become Good Targets?”

by Mark Mitchell and Ken Lehn

This paper empirically examines one motive for takeovers: to change control of firms that make acquisitions that diminish the value of their equity. Firms that subsequently become takeover targets make acquisitions that significantly reduce their equity value, and firms that do not become takeover targets make acquisitions that raise their equity value. Within the sample of acquisitions by targets, the acquisitions that reduce equity value the most are those that are later divested either in bust-up takeovers or restructuring programs to thwart the takeover. This evidence is consistent with theories advanced by Robin Marris (1963), Henry G. Manne (1965), and Michael C. Jensen (1986) concerning the disciplinary role played by takeovers. 

All the best,

Ralph

Merger Wave in the Publishing Industry

We've written quite a bit in these posts about the motives for merger and merger waves.  In general, some catalyst shakes up an industry and creates opportunities for some firms and solutions to problems for others.  We have specifically mentioned shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology, (see our post Catalysts for Merger).   It is self evident to readers of this or any blog, that change has been afoot in the publishing industry.

 I read an interesting article today by Jeremy Greenfield in Forbes.com that makes these points very well for the publishing industry and I thought I would share the link.  The author argues, and I agree, that the publishing industry is currently in a merger wave.  He discusses the specific catalysts that are involved in the publishing wave and gives examples of each.  I hope you enjoy it.  See "Get Ready For More Mergers and Acquisition in Book Publishing".

All the best,

Ralph

PE Magic

One of the merger motives touted during the 1960's was PE Magic.  The concept was simple: you have Firm A with a PE of 20 acquiring Firm B for cash with a PE of 10.  Suppose both firms have an EPS of 1 and 10 shares outstanding.  The market price and market value of firm A is 20 and 200, respectively.  The corresponding values for Firm B are 10 and 100.  So without synergy, if the firms joined, the market value should be 300.  

Here is where PE magic comes in.  According to PE magic, when firm A acquires firm B the market attributes Firm A's superior PE of 20 to the combined EPS of 2.  Hence the market value of the merged firm is 40 and the total market value is 400.  Voila!  100 of market value by PE magic!

This concept was used to explain the conglomerate merger wave of the 1960s.  You know, when a cement company acquired an ice cream manufacturer - not much synergy there unless you can use the cement trucks to mix the ice cream!

Ahem.  There are obvious problems with PE magic.  There are reasons that firms trade for various PEs.  The PE of firm B is only 10 for reasons related to risk, managerial talent, growth and all the factors that relate to future projected cash flows and the variability of those cash flows.  Unless Firm A is able to alter those factors there is absolutely no reason to believe the PE of the combined firm will not settle somewhere in between 10 and 20 to reflect the realities of the new firm.  If nothing  changed after merger, the combined market value would be 300, the combined EPS would be 2 and the PE would be 15.  If you adjust for the costs of integration, the PE and market values would be reduced.

Now, Firm A may  be able to alter the characteristics of the cash flow stream - but that is synergy, not magic.  The moral of the story is to beware of any explanation for merger that implies something for nothing.   See our related posts on merger motives, synergies and the power of subtraction.

All the best,

Ralph

Utility Mergers, Synergy or Collusion?

Mergers of utilities face increased scrutiny by governmental regulators seeking to avoid collusion and monopolistic pricing.  Traditional research on mergers often neglect this industry due to it's unique characteristics.  In an article published in the Journal of Financial and Quantitative Analysis  we test for the existence and source of gains in utility mergers and distinguish between collusion and synergy as motives for mergers in this industry.  The abstract is below.  The complete article can be downloaded here.

Sources of Gains in Corporate Mergers: Refined Tests from a Neglected Industry

David A. Becher
Drexel University - Department of Finance 

J. Harold Mulherin

University of Georgia - Department of Banking and Finance 

Ralph A. Walkling

Drexel University - Lebow College of Business

Journal of Financial and Quantitative Analysis (JFQA), Forthcoming

Abstract:      

Our work provides refined tests of the existence and source of merger gains in a neglected industry: utilities. While excluded from traditional analyses, utilities offer fertile ground for a detailed analysis of the traditional theories of synergy, collusion, hubris and anticipation. The analysis of utilities provides methodological advantages and is important for public policy reasons. We find that utility mergers create wealth for the combined bidder and target. These positive wealth effects are consistent with both the synergy hypothesis and the collusion hypothesis. To distinguish between the hypotheses, we study the stock price returns to industry rivals across several dimensions specifically related to collusion: deregulation, horizontal mergers, geography, and withdrawn deals. We also examine the impact of mergers on consumer prices. The results are consistent with synergy and inconsistent with collusion. Analysis of industry rivals that subsequently become targets also rejects the collusion hypothesis and is consistent with the anticipation hypothesis.

The Google Waze Acquisition

The proposed Google, Waze acquisition illustrates many of the themes we've developed in previous posts.  First would be motives for acquisition.  In this case, we have acquiring technology, increasing market share and staying relevant - all consistent with increasing shareholder value (see Catalysts for Merger and  Motives for Merger).  But then we also have Merging defensively - (to prevent a competitor from doing the deal and getting an advantage) and the motive of 'eliminating the competition - by acquiring them'.   Now this may also increase shareholder value, but is, of course, frowned upon by the FTC, which is precisely why the FTC is now investigating the issue.  What criteria will the FTC use in deciding whether the deal is in restraint of trade?  See our post concerning the Herfindahl index.  

As the Wall Street Journal reports, 

"The FTC is expected to focus on whether Waze would have become a head-to-head competitor with Google, whose Google Maps software is the dominant digital mapping and navigation service around the world, or whether there is any evidence, such as emails, that show that Google wanted to acquire the company only to keep it out of the hands of rivals."

The complete WSJ article can be downloaded here.  

All the best,

Ralph

Catalysts for Merger

We've talked before of motives for merger.  This time let's talk about what causes an entire industry to suddenly be the target of acquisition attempts or similarly why an industry suddenly starts making bids for other firms.

Think of an industry where no firm has been targeted for acquisition and imagine that this situation has prevailed for some time, say at least a year.  Metaphorically, the waters are still, the pond is flat, with no acquisition activity causing disruption.  The first bid for a firm in this industry is going to cause waves, possibly large waves, in this industry - like a rock thrown in the middle of the pond.

What causes this sudden activity?  Presumably some managerial team has decided that the assets of the target firm are worth more to this team than their current market value.  Hence a bid takes place.  Will this signal other bids in the industry?  Perhaps.  In another post we'll talk about merger waves.  For now, let's assume that the first firm to be targeted does indeed signal the possibility of other bids.  What are the reasons for this sudden activity?

The reasons are that something has occurred to cause the value of the target firm to increase in the view of the bidder.  What causes this shift?  In terms of the present value equation some catalyst must have caused an increase in the estimated cash flows or a decrease in the discount rate.  Either (or both) of these will increase value.   

As one example, there were a multitude of oil mergers in the 1980s.  One reason is that exploration and development became a value-losing proposition.  Why did this occur?  Because the price of oil (a fundamental component of cash flows) dropped from over $40 a barrel to $10 a barrel and simultaneously, interest rates rose from single digits to double digits.  As a consequence, the present value changed from a positive cash flow to a loss for each barrel discovered.  For Gulf Oil, the present value impact was about $50. per share.  A popular Harvard case makes these points and others in explaining how Gulf Oil could be trading for $38 today and receive a bid of $80. per share tomorrow.  

So what are these shocks, these catalysts?  Common catalysts include: shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology.

Shifts in regulation cause firms to adjust their behavior.  New regulation increases the costs of operating a firm.  Reduced regulation creates new opportunities.  Both types of shifts can make it more profitable for firms to combine.  In some cases firms reduce costs through economies of scale.  In other cases, firms are able to exploit synergies in situations previously blocked by regulation.  A good example is the banking industry where regulations prohibited growth in a (new) state unless a bank already had a presence in that state.  One way to establish a presence was merger with an existing bank.  

When consumer tastes shift, so do the estimates of future cash flows.  Investments that previously seemed unattractive (or attractive) are reversed.   As as result, targets find it beneficial to merge with other firms to exploit new synergies or merge as an attempt to reduce over-capacity in the industry. Firms that fail to adjust to shifts in tastes (e.g. Chrysler) are forced to merge to avoid bankruptcy (General Motors).  In addition to an industry example like automobile manufacturing, one can think of company specific examples like Dell or Hewlett Packard or Yahoo.  All were dominate within their industry until they failed to keep up with changing times.  

Changes in the factor of production can include changes in the cost of supplies, or changes in the cost of wages, or changes in other elements used in producing or delivering products and services. As one example, some products depend more heavily on oil in their manufacture.  As the price of oil changes, so do the costs of these products.   In many cases, mergers occur to capitalize on these changes.  Vertical mergers will occur as bidders seek to control supply, reducing uncertainties and costs in the process.  Horizontal mergers will occur to erase overcapacity and develop economies of scale

Competition from unexpected sources occurs as new competitors enter what was once a protected business environment.  This could be accompanied by a shift in regulation like increased interstate banking or from the entry of foreign companies into what was primarily a domestic market.  It also happens when products are suddenly put to additional uses that infringe on new territory.  For examples, think of how the various applications for the cell phone have eroded traditional markets.  Garmin once profited by selling stand alone GPS units, now a smart phone application does the same thing.  

Changes in technology cause firms to adapt or become obsolete.  Polaroid and Kodak are good examples.  Banking is facing overcapacity with the advent of the internet.  I sometimes challenge executives to think of the new products and services that have existed only in their lifetime.  They mention Personal Computers, the Internet, Digital Cameras, and even things like Rock and Roll and Viagra!  Each new product and each new technology is a catalyst for change and a potential force for mergers in a particular industry.  (See our related posts on Do Unto Yourself and Anticipation, Acquisitions and Bidder Returns as well as posts on Dell and HP.)

Obviously, many of these catalysts are interrelated.  New smartphone applications that reveal calorie counts on specific food items can lead to shifts in consumer tastes.  Similarly, scanners on smart phones may lead customers to buy online, a new source of competition.

Any of these or other catalysts can lead to merger either for a particular firm or for an entire industry.  We'll follow up down the road with a related post on merger waves.  

All the best,

Ralph