Setting/negotiating the Bid Premia in Acquisitions

It is easy to set the likely minimum and maximum prices that should be paid for a target firm.  It is more difficult to adhere to these values in practice.  Without such boundaries, however, we don't have a chance for a disciplined bid.  As we've said many times, there is not better time to create or destroy value than when paying for the deal.  Value is created (destroyed) as we underpay (overpay) for a particular company.

From the bidder's point of view, the maximum that should ever be paid for a target is the NPV of the acquisition to the bidder.  That is, calculate the incremental value expected to be obtained from a deal.  This is the maximum dollar bid premium.  But if you pay this amount, you will break even and no value will be created for your shareholders.

From the target's point of view the minimum that would likely be accepted in a deal is the current market price.  Although one can create scenarios in which a target would take less because of liquidity issues, such scenarios are rare.  In practice, the mimimun for which a firm can be acquired is its current market price and as more shares of the target are sought, higher premia must be paid.

The actual price paid generally falls between these two boundaries and is a function of the bargaining power of each party.

Factors increasing the bargaining power of the bidder include the existence of unique synergies available only to this bidder, a toehold in the bidder, and the ability to pay cash to facilitate a speedy transaction.

Factors favoring the target include multiple bidders (usually a function of synergies available to many), a high level of target managerial ownership and the necessity of target management for continued success of the venture.

The actual price paid will be a function of the various estimations implied by these concepts and the negotiating ability of each party.  It takes a disciplined bidder to not overpay.  It takes a disciplined target to know which deals to reject.  Understanding one's boundary points is the start to this discipline.

All the best,

Ralph

Unique Synergies and the Tyson Foods/Hillshire Merger

The Tyson Foods/Hillshire merger provides an excellent illustration of Joe's Blog regarding the gains to merger (see Chance Favors the Prepared Mind).  Joe wrote that:

 Net Value Added to Acquiring Firm = (Unique Synergies + Common Synergies) -  (Market Cycle Premium/Discount + Common Synergies)  = Unique Synergies - Market   Cycle Premium/Discount

The basic idea behind this equation is simple.  Value added is the difference between what you get and what you pay.  The amount you pay is the premium over the pre-market value of the target.  This premium is driven by the competitive position of the bidder/target and also the competitive pressure of other bidders.  Hence the winning bidder will pay at least the common synergies.  

Now normally, we don't know what the unique synergies are in a merger.  But in this case there were multiple bidders for Hillshire and we know that the second highest bidder ( Pilgrim's Pride) offered $55./share.  Tyson "won" the contest by offering $63. per share.  

In this case, we can estimate the common synergies as the difference between the final bid price of the losing bidder (i.e., the $55 offered by Pilgrim) and Hillshire's $37.  stock price on May 9, the day before the merger activity began.  Thus, the common synergies of $18. (= 55 - 37) are included in the price paid by the "winning" bidder (Tyson).  Tyson paid $8. per share more than the common synergies to acquire Hillshire offering a final bid price of $63. 

 So how much must Tyson earn in unique synergies for the contest to be worthwhile?  Enough so the net value added exceed zero. 

Thus, for Tyson to succeed the deal must ultimately be worth over $8. per share in unique synergies.

Net Value Added to Acquiring Firm 

= (Unique Synergies + Common Synergies) -  (Market Cycle Premium/Discount + Common Synergies)  

= (      ?                      +       18          ) -  (                  8                           +          18          )

Which implies Unique Synergies must be at least $8.  to succeed.

But that's not all.  To succeed, Tyson must earn greater than the $8. premium and  successfully earn the common synergies of $18.  

Also note, we estimate the market cycle premium or discount as the difference between the highest and second highest bids.  The actual value is more complex than this and depends in part on whether the target's pre-market value was already over or under inflated.  That is, we are assuming here that Hillshire's pre-merger value of $37. per share was a fair value of the company as a stand alone.

The bids for Hillshire illustrate many important points about mergers and acquisitions:

• When multiple bidders compete, target shareholders win.
• Multiple bidders will emerge when there are common synergies, available to multiple parties.
• Bidders are likely to earn higher returns in cases without common synergies and in cases where the combination of this bidder/target produces unique gains unattainable by other bidders.
• Bidders face a tension between paying too little and losing the deal, and overpaying and reducing their rate of return.
• Unique synergies can also include precluding a rival (like Pilgrim) from establishing a competitive position.  That is, one motivation for Tyson's purchase is likely to be preventing Pilgrim from occupying the same space.
• Synergies that look good on paper may fail to materialize because of misestimation or problems of integration.  
• The Winner's Curse is a distinct possibility.

All the best,

Ralph

Six Disadvantages of Highly Levered Firms

In a recent blog I talked about the ways Acquisition Finance creates value.  To be sure, I believe that private equity firms and free enterprise in general have been greatly misunderstood and unfairly criticized in the popular press and in political ads during this election year.  To be fair, however,  I focus this blog on some of the disadvantages of the high leverage often associated with acquisition finance.  Six disadvantages are listed below:

• ·      Leverage is a double-edged sword
• ·      Increased risk of default
• ·      Overpaying
• ·      Political risks
• ·      Less access to capital markets
• ·      The need to cash-out

Put simply, leverage is a double edged sword.  It will magnify owner returns in good times and diminish them in bad times.  It is a sword that cuts both ways.  In general, we have two ways to finance a business: debt or equity.  In a physical sense, debt (leverage) magnifies our ability to lift an object.  Here, that object is the equity rate of return.  In good times, we pay off the fixed cost of debt (interest) and divide the profit pie among fewer shares producing a greater rate of return.  But in bad times, the reverse is true – we must pay the fixed interest charge regardless of profits.  Equity rate of return declines. 

In the U.K., leverage is known as gearing.  Similarly, one can imagine how using the proper or improper gearing on a bicycle could help – or hinder performance.  Correspondingly, increased leverage brings an increased probability of default.

Easy access to debt facilitates overpaying, which is probably the key factor responsible for less than adequate acquisition returns  (the other candidate is lack of proper integration).

Political risks arise as leveraged deals face adverse commentary in the financial press.  The result can be increased costs through higher levels of governmental regulation.

If a highly levered firm is also going private, there is generally less access to capital markets.

Finally, the typical private equity model assumes a five to seven year cycle.  The private equity firm doesn’t want to be a long term owner, but it does want to work its magic (see the blog on the ways acquisition finance creates value) and then cash out.  But cashing out at a desirable price may not be possible for many reasons.  First, anticipated increases in value may not materialize.  Second, the cyclical nature of industry or financial markets may work against a timely sale.  Third, in spite of best efforts, a suitable buyer may not materialize or may disagree on the value of the firm to be acquired. 

All of these factors produce problems for deals involving acquisition finance.  In later blogs, we will talk about ways acquiring and selling firms can a) have more confidence they are using the proper amount of leverage and b) protect themselves against the risks commonly associated with mergers and acquisitions.

All the best,

Ralph