Listening to Markets and Hearing Government

Readers of this blog know that Joe and I are strong advocates of listening to the market - being aware of current conditions and opportunities.  Certainly, in structuring a deal we must contend with economic reality; a situation suitable under one set of economic conditions may be far from optimal in another.

Many analogies and cliches apply - e.g., play the cards you are dealt.  The best quarterbacks in American football learn to read the defenses and take the best opportunities.  So too should we read the market and find the best solutions.

In the best of situations, markets reflect the economic equilibria of competitive forces.  But alas, they also reflect governmental restraints.  The Wall Street Journal recently published a very interesting article showing the impact of government activity on deal flow.  The article, entitled, "Buyout Firms Feel Pinch From Lending Crackdown" suggests that regulatory guidelines favored by the government are impeding deal activity and deal design.  In particular, the author notes that regulators urged banks to avoid putting debt greater than 6 X EBITDA in most industries.  Further, "So far this year, 21% of U.S. private-equity deals have been financed with leverage at or above levels regulators generally consider risky..." down from 35% last year.  The chart below (from the WSJ article) captures some of these dynamics.

The merits of this regulatory guidance is a subject for another debate, although regular readers can guess where our feelings lie on the subjects of free markets, free choice and the law of unintended consequences.  To be fair, Joe and I have both warned of the dangers of highly leveraged deals and over-excited markets, but we prefer to take things on their merits and consider things in context to all of the other factors that go into structuring the deal.  One size rarely fits all.    But like it or not, the regulators are part of the world we mentioned and hence, their impact must be factored into our decisions.

All the best,

Ralph

Staples, Office Depot and the New Competitive Landscape

Nearly 20 years ago, Staples tried to acquire Office Depot to find the deal rejected by regulators.  Fast forward to today and we see the two largest office supply stores again seeking to combine.  What has changed and will the deal still be anti-competitive in the eyes of regulators?   How does the market see the prospects of the deal? What are the lessons to be learned?

To answer the last question first, there are many elements that make this an interesting story.  First is the role of activists (hedge fund Starboard Value).  Second, we have noted that a wave of consolidation in an industry is often sparked by some catalyst.  Note the Office Depot and Office Max combination of two years ago reduced the number of main stream office suppliers to two.  This merger would reduce that number to one.  Ironically, although the catalysts here are multifaceted, they led by a string of new competitors with competition for Staples and Office Depot ranging from the big box stores (Walmart and Target) to online behemoth Amazon. 

So will the deal be seen as anti-competitive?  That depends on how regulators view the market for Staples and Office Depot.  To be sure, there is considerable overlap in the geographic location of stores and the closing of duplicate stores is undoubtedly a central factor in any synergies from the deal.  But the question of market is much more complex.  For example a sizable component of the sales of the two firms comes from large quantity orders from businesses.  In addition, we have the big box and online competitors to consider.

Regulators measure anti-competitive behavior by a number of factors, including the 4-firm concentration ratio and the Hirfindahl index.  As we have noted before, the key to determining concentration is defining the market and in today's landscape, that market is widespread but the jury is out on how the regulators will view the world.

As for the market, it seems to be expressing skepticism over completion of the deal.  Office Depot closed yesterday at $9.49 a significant gap below the deal value of $10.91.  That is a quite sizable speculation spread.

(See also Comcast, Time Warner and the Myth of the Cable Industry, Concentration Ratios, the Case of Anheuser Busch and Modelo, and Speculation Spreads and the Market Pricing of Proposed Acquisitions)

All the best,

Ralph

Comcast, Time Warner and the Myth of the Cable Industry

Last week Comcast (CMCSA) announced a $45 million dollar acquisition of Time Warner Cable (TWC).   The announcement sent shock waves through financial markets and raised numerous questions.    

For companies that compete in the same market, there are obvious concerns about future strategies.  Charter Communications (CHTR) for example, wanted to buy Time Warner and bid low.  There is some speculation that they would attempt to revise their bid, but it is not clear that Charter could (or would choose to) handle the increased debt that would come with such a revision. 

Other companies that compete in the same space (note I didn't say 'Cable Industry') have to wonder if further consolidations help them achieve their own potential.  Some have suggested CableVision could be a target or even that privately held firms like Cox Communications would be involved in acquisitions.

As investors, we also wonder about the market reactions to rivals of targeted companies and what it means for future acquisitions.  In our research, when a bid like this occurs, the prices of target firms react in direct proportion to the probability that they will become targets themselves. (See Abnormal Returns to Rivals of Acquisition Targets.)  

There has also been much talk about the regulatory issues such a combination would raise.  For regulators the concerns will be whether the merger is a restraint of competition resulting in predatory pricing of consumers.  We have noted in a previous post that one of the main tools for such an analysis is the Hirfindahl Index or the related Concentration Ratio. (See Concentration Ratios: The Case of Anheuser Busch and Modelo.)  

But in that post, we also note that to create a measure of concentration in an industry, one must first define the industry.  And that brings us to the myth of the cable industry.  In a very interesting article entitled, The Comcast-Time Warner Merger Is Not a Sign of Strength, Larry Downes makes a convincing argument that fears of market dominance here are overrated.  To quote, 

"There is no cable industry.  Cable is just a technology, increasingly one of many, for transmitting information, whether video, voice or data.

Where cable was once the only technology used to distribute television programming—a vast improvement in speed, quality, and quantity over antennas—it now competes with fiber, copper, satellite, and mobile broadband, each with their own pluses and minuses, and each promoted by companies large and small, who together continue to spend heavily to upgrade their assets."

Indeed, the story is so much more than a merger of cable companies, even well known companies.  It is another event in the evolving battle for the vast market for entertainment.

Stay tuned.

Ralph 

Deals of the Year for 2013

Deal activity was much higher this year than last, but not at the pace we expected.  See Joe's recent post 'Something is happening here, what it is ain't exactly clear.'  Still, the years is over and we can look back at the highlights.

Investor Place gives a nice tally of the ten biggest deals of the year.  There's an interesting set of stories here, from bankruptcy and regulatory issues (US Air/American Airlines),  private equity (Silverlake and Dell)  Warren Buffett (H. J. Heinz), industry consolidations (Publicis Groupe/Omnicom Group and Applied Materials/Tokyo Electron) and size - the third largest transaction of all time (Verizon and Vodaphone).  See the complete list and more detail here.

All the best,

Ralph

When Say on Pay Becomes Binding: Australia's Two Strike Rule

Hello from Perth, Australia.  As some of you know, I am on sabbatical, currently touring Australia.  Last night I had the honor of talking to a local CPA society on Corporate Governance.  The question of Australia's two strike rule came up during the discussion.

The two strike rule is an interesting, if controversial rule in corporate governance.  If a board receives a 25%, no-vote on its compensation policy for two consecutive years, shareholders vote to decide if the the entire board must stand for re-election.  The rule, implemented in Australia in 2011, gives teeth to the previously advisory Say on Pay.

See this interesting article in The Sydney Herald.

One can imagine the pluses and minuses of such a system.  First, if directors are not responsive to shareholders a second year in a row, the shareholders get additional power to alter that situation.  It is reminiscent of the provisions in some preferred stocks, where if a firm misses dividends for say three years, the stock acquires voting rights.)

On the other hand, 25% might be a low threshold, and less than a majority could hold a firm hostage. Or, as directors often fear during a Say on Pay vote,  a low vote may be the result of something quite different from problems with compensation.  

David Trebeck, the Chairman of Penrice Soda, which recently survived a close call on the two strike rule, commented, ‘‘I think directors generally are more than capable of identifying and responding to prevailing shareholder sentiment without needing a legislative sledgehammer to do it for them."

(Source:  http://www.smh.com.au/business/axe-twostrikes-rule-penrice-directors-say-20130125-2dbam.html#ixzz2hJu9p5li)

The two strike rule isn't the case in the US but, by the way, Australia had Say on Pay, well before the United States.  It makes sense to keep track of what is happening in other venues and use that knowledge to improve practice.  This is NOT to say, I'm endorsing this idea, but it bears watching the empirical results.  

See our related post on Swiss Say on Pay.

All the best,

Ralp;h

Bank M&A: A Wake Up Call-Finally?

Bank M&A, like M&A in general, has been depressed since the 2007 financial crisis. Deal volume for 1H13 was below 2012 anemic levels with just 76 deals. The deals done were primarily small fill-in transactions involving motivated (i.e. troubled) sellers. Low pricing multiples reflected the buyers’ market nature of the environment. A variety of factors were responsible for the depressed volume. These include:

1)     Post crisis malaise: confidence fell following the crisis. Banks were focused on surviving and resolving asset quality issues than growth. Investors also supported a cautious view regarding acquisitions-buyer share prices would fall for the few deals that were announced.

2)     Weak stock prices: buyers were reluctant to incur significant dilution by funding acquisitions with under valued stock. Sellers were unlikely to sell at depressed prices unless forced to do so by regulators.

3)     Regulatory uncertainty: regulators were likely to encourage banks to solve their own capital problems before approving significant acquisitions.

4)     Purchase accounting: the adoption of purchase accounting in June 2001 had a larger than anticipated negative impact on bank M&A. Any goodwill created reduced a key regulatory ratio concerning tangible book value (TBV) to assets. This pressured acquirers to consider larger equity issues to offset TBV reductions. Combined with depressed stock prices this would produce larger levels of earnings dilution. Dilution is dismissed as an accounting measure. Nonetheless, it serves as a useful buyer pricing constraint.

Despite the above, the case for M&A has been growing for years ( see M&A May be Best Path Available to Profit Growth). Stock prices for both buyers and sellers have risen substantially this year. Buyer confidence has returned as operating performance has recovered. Investors have signaled greater openness towards acquisitions that make strategic sense and are appropriately priced. Added to this is the growing frustration of many banks regarding weak loan demand (reflected in low loan to deposit ratios) and rising cost levels as a percentage of revenues.

In July, two large transactions were announced. The first was a July 15 $680MM deal involving MB Financial’s ($9.B assets-MB) acquisition of Cole Taylor Bank ($5.9B assets-TAYL) in suburban Chicago MB Taylor. The price was relatively full at 1.8X TBV (to book value) -sufficient enough to entice the seller to accept. The following week PacWest ($5.3B assets-PACW) announced the largest banking deal of year with a $2.3B deal PACW CSE to acquire Capital Source ($9.2B assets-CSE) an industrial loan company. The CSE price was 1.66X TBV. The market response to the less well covered Taylor transaction was muted with MB’s price falling 3% on announcement. Some investors have expressed concern regarding the price given Taylor’s mortgage reliance in a rising rate market. PACW’s price jumped 7% on its planned acquisition. This reflects the tighter pricing relative to expected synergies.

The transactions share some common features as follow:

1)    The driving force was strategic: the buyers had substantial low cost deposit bases and depressed loan to deposit ratios highlighting their difficulty in making loans. The sellers were 'demand deposit constrained' but had national asset origination capabilities in asset based finance, equipment leasing and mortgages reflected in high loan to deposit ratios. The buyers hoped to utilize the sellers’ national origination platforms to distribute credit products funded by their excess low cost deposits.

2)    Substantial identified cost savings.

3)    Tax free transaction involving use of the buyers’ appreciated stock limited TBV and EPS dilution. MB was trading near its 52 week high of $29 p/s as was PACW compared to its 52 week high of 33. Thus, fewer new shares needed to be issued.

4)    Relatively large transformational acquisitions involving significant integration risk. This  is offset by the experienced teams at MB and PACW. The business profile and risk of both acquirers will be altered by the transactions. How this impacts their pricing multiples is yet to be determined.

The transactions offer insight into possible future deals. First, buyers are unlikely to be big banks ($250B+ assets) due to regulatory concerns regarding too- big- to- fail. Rather, buyers will likely be in the $5-10B asset size institutions looking to achieve scale and national lending platforms. Banks with assets exceeding $10B appear to have economies of scale reflected in higher ROEs compared to smaller institutions. Targets will likely either be lower priced smaller (less than $1B assets) deals, or larger fully priced $5B+ assets institutions. There are a limited number of the larger targets which offer scale. Hence, a scarcity value for these banks may exist.  The thousands of banks below $1B assets are likely facing a more difficult selling process. Non bank finance companies may also become more popular bank targets.

These two transactions could serve as a wake-up call to other banks which have been reluctant to consider acquisitions. This will be driven by investors growing frustration with low bank ROEs due rising costs and weak loan demand. My guess is we will see the formation of more regional ($10-20B assets) and super regional ($20-50B assets) combinations. Keep in mind that of the 7000+ domestic banks there are only 100+ with assets above $10B. Going forward,  small banks will need to get bigger, while the too-big-to-fail will need to shrink. The keys to implementing this strategy will be the patience to wait for the right target, discipline to avoid over paying and the ability to execute.

J

p.s. disclosure-I am a PACW shareholder.

Merger Activity in the First Six Months of 2013

In February it looked like the year was off to an upswing in merger activity, sparked by Berkshire and 3g's $28 Billion acquisition of Heinz and Dell's $24 Billion LBO.  Six months out finds the Heinz deal closed and the Dell LBO awaiting a shareholder vote.  Meanwhile overall merger activity is down for the year.  As the headline of Tuesday's New York Times States, Merger Activity Was Down But Not Out, in the first half of 2013.

It is interesting that many factors are in place that are associated with greater deal activity. Interest rates are low facilitating demand.  Stock prices are high and historically the number of deals has been strongly correlated with the general level of stock prices.  In addition, companies are sitting on record amounts of cash.  All of these factors should signal a strong robust market.  Why haven't they?

One explanation is that firms have been restructuring themselves rather than acquire other firms.  There has been some increase in share repurchases - companies essentially buying themselves.  Plus, this year's merger numbers may be a bit distorted, as there was increased activity in the 4th quarter of 2012 as companies rushed to avoid the fiscal cliff.  I think a bigger factor is general uncertainty about the state of our economy.  It is difficult to plan in the face of great uncertainty and there is much to be uncertain about.  Not in any order of priority, let's consider a few reasons for reduced activity.  

First is the increased regulatory environment.  We haven't witnessed such an environment in recent history.  What is worse is that so many of the regulations coming down the pike are unknown.  Over two thirds of the Dodd Frank Act remains to be written.  Bank M&A still lags largely due to regulatory approval uncertainity.The deals being done are very small.  We can adapt and adjust to most any set of rules but when the rules change in the middle of the game it is hard to plot your strategy.  The same could be said for the new health care laws, etc.  

Second, is the economy itself.  The Fed and Quantitative Easing have increased uncertainty.  The recent 80 basis point increase in the 10 year t-bill (140bp+ on BB credits) will curtail the level and types of deals (e.g. covenant lite and PIK) funding. This is a big thing and will require big adjustments. During the interim it is sure to depress deal activity.  Government intervention in markets means ‘artificial’  and that is not a word associated with market equilibrium. See point one.  

Third is the political uncertainty in the world.  European deals have really suffered.   Of the three points mentioned, this is the one that feels most like something we've seen before.  But even here we see technology shaping political unrest and revolution in ways that couldn't have been imagined a few years ago.  At the same time, we are increasingly aware of the technology used by our governments and by businesses themselves to track our movements.  This could turn out to be necessary, even beneficial, but it is unsettling.

My colleague, Joe Rizzi, also mentions a possible behavioral angle.  Managers who experienced the recent crisis have become ‘depression babies’ and may have a reduced appetite for M&A risk.

Those are just four items leading to a feeling of unease and increased risk.  There are signs of optimism for dealmakers, but it may take positive thinking to see them.  Risk means opportunity and deals are being completed, particularly in certain sectors of the economy.  Well-conceived and well-executed mergers create value and as we've noted before, regulatory, economic and political shocks are often catalysts for increased merger activity.  Let's see what the second half of 2013 brings.

Happy 4th of July, America!

Ralph

The Implications of Dodd Frank for Private Equity

In this very thoughtful video, Richard Jaffe (partner at Duane Morris) discusses the implications of Dodd Frank for Private Equity.  While the law applies in the US, Richard also discusses the European and US models related to management fees, current trends,  and the pressure on the industry in general.  

Incidentally, Richard has chaired the advisory board of Drexel's Governance Center since 2007.  While this video is unrelated to the Center, it is consistent with our mission of advocating excellence in Corporate Governance, which certainly includes a thoughtful consideration of the impacts and unintended consequences of regulation.

The video and transcript are available here.

All the best,

Ralph

Say on Pay in the US: The Early Evidence

Joe and I have been debating the merits of the new Swiss Say on Pay regulation.   (See Mad as Hell and I'm Not Going to Take This and Swiss Say on Pay - The Dangers. 

The US now has it's own, non-binding Say on Pay legislation, but it is a relatively new development.  A few years ago, my colleague Jay Cai and I performed the first empirical analysis of Say on Pay in the United States in the academic literature.

The starting point for our analysis was April 20, 2007, when underdog Presidential Candidate Barack Obama introduced the legislation into the Senate.  It had just passed the house on the same day.  Thinking about the impact of this legislation on shareholder wealth you can immediately envision three possible impacts.

First, it could be beneficial, prodding boards to rein in excessive pay and to be more careful in the compensation packages they offer.  In this case, the share price of firms would increase with the bill.

Second, such a law could be detrimental to shareholders.  Boards are responsible for executive compensation and can always hire additional expertise to advise them as needed.  Outside pressures from shareholders, some of whom may have narrow agendas, could produce unnecessary complications within the boardroom which could reduce shareholder wealth.

Finally, we might find that the mere introduction of the bill in the Senate (and it's passage in the house) have no impact on shareholder wealth.  After all, we are talking about the introduction of a bill, not its passage.  Moreover, even if it passed the Senate, then-President Bush said he would veto it.  Besides, it is an advisory vote - boards don't have to do anything even if a majority of shareholders disagree with the level of executive compensation.  (In this regard, I note that previous evidence on advisory votes finds them to have little impact on shareholder wealth.)  So in my mind, the probabilities were stacked towards no impact.  

What did we find?  Some interesting results.

First, we find that one size doesn't fit all with this legislation.  Our results indicate that situations where the law appears beneficial and situations where shareholder votes are likely to be seriously considered are associated with increases in shareholder wealth.  In other situations, the bill would appear to reduce shareholder wealth.  

So where was it beneficial?  In firms with high, abnormal CEO compensation, those with low pay for performance sensitivity and for those firms that had been responsive to shareholder votes in the past.  The latter result is in line with the fact that firms don't have to implement changes, even if a majority of shareholders disagree with pay packages.  

But Say on Pay could have been voluntarily implemented by boards if they deemed it beneficial.  They didn't need legislation to do this.  Moreover, shareholders themselves could have proposed Say on Pay to their boards.  In fact, this did happen.  We found numerous cases where activists (primarily unions) had sponsored Say on Pay proposals.  Unfortunately, they appeared to target the wrong firms.  The firms they targeted were large firms that, on average, appeared to have reasonable performance, governance and pay characteristics. As a result, the share price dropped for firms targeted in this way.  Our research suggests that say-on-pay creates value for companies with inefficient compensation, but can destroy value for others. 

The complete paper can be downloaded here: Shareholders’ Say on Pay: Does It Create Value?