High Leverage Deals, Capital Structure and Common Sense

Capital structure theory is too complex for a single blog post, but here are a few intuitive concepts blended with a little common sense.

Many of the practitioners I talk with  proscribe what is called the tradeoff theory of capital structure.  In short, as the proportion of debt in a firm’s capital structure increases, two countervailing forces interact.  First, firm value increases because of the value created by increased debt shields.  However, increased leverage also increases risk and the cost of financial distress also rises with the level of debt.  At some point, the advantage of the debt shields is offset by increased costs of financial distress.  Thus, firm value increases with the proportion of debt in the capital structure, but only to a point.  The chart below shows the basic idea.  The Value of a firm with debt  increases as debt is added to the capital structure but it only increases until we reach maximum value indicated by the top of the curve.  This peak signifies the optimal capital structure for the firm.   Beyond this point value declines as the costs of financial distress more than offset the value added by the tax shields.

 

The exact point of this optimal structure varies with the nature of the firm’s business, the tangibility of assets and other factors.  For some firms and deals, a mix of 30% debt and 70% equity might be optimal.  It other situations these proportions could be reversed.

The factors that go into these decisions are numerous and beyond the scope of a single blog.  In practice, we often use ratios as a guide to optimal leverage.  For example, we might ask if the ratio of EBIT to interest (the times interest earned ratio) is excessive, etc. 

One other thing to keep in mind in highly leveraged deals is that there is much that we don’t know.  Many of the theoretical assumptions behind capital structure, for example, assume a linear relation between factors with tax shields and financial distress increasing linearly with debt.  A bit of thought will suggest practical limitations: tax shields are only valuable if you are making a profit and certainly financial distress is unlikely to keep increasing linearly beyond some point.  Beyond some tipping point, financial distress costs increase exponentially. 

And so lets conclude with a little bit of common sense.  Joe and I are about to return to Amsterdam to teach Acquisition Finance again (see the link at the right hand side). A few years ago (before the crisis) as we were teaching we noted our concerns about deal fever and extreme leverage along with the admonition:  “Be cautious, we just don’t have a lot of empirical evidence regarding high leverage deals and financial default.”  Unfortunately, we have a lot more evidence now.  And while  understanding the intricacies of capital structure is indeed complex, I’m reminded of a comment my colleague Joe Rizzi made before the crisis, “It doesn’t take a rocket scientist to realize that if you are levered 20 to one, a five percent swing in asset value wipes you out!”

Understand the forces that drive acquisition finance but use common sense as well - and remember leverage is a double edged sword that magnifies outcomes.

Ralph

The Interrelated Nature of Deal Design

Point 3 of our 14 keys to acquisition success states:

3.     Negotiate the deal on all aspects (price, form of payment, contingencies, etc.)

In a previous post, we commented that any deal is a bad deal at some price.  But a deal is so much more than price.  If we think about just a few of the decisions made in an acquisition it is clear that any deal involves a busy menu of detailed choices.  One of the things we discuss in the acquisition finance class is the interrelated nature of these choices.  Each deal is a system and each of the choices we make and negotiate has the potential to influence the others.  Wise negotiators consider the whole deal and bargain on multiple fronts.

Let's take just a few factors: price, form of payment, accounting choices, ownership structure, risks to the acquiring and biding firm and the length of the deal.  The price or bid premium over market is known to be related to form of payment.  Premia are known to be higher in cash deals, ostensibly to compensate for the immediate tax effects to the seller - and tax obviously affects the 'real' premia that target shareholders receive.  But form of payment also determines the accounting choices we make and even the form of organization.  And, of course, price and form of payment are related to financing.

A choice of stock as a form of payment affects the resulting ownership structure of the combined firm.  It also affects risk to all parties.  If the stock of the acquiring firm or the target change before the deal is closed the price that is paid and received is different from that originally negotiated.  (One way around this is the use of collars, but more on that in another blog.)  And remember, in terms of risk, who bears the risk ultimately affects the returns of the parties.

The choices we've just described also affect the length of time until a deal closes.  Cash offers tend to be faster (which is why hostile offers favor cash bids); stock bids involve more regulation and tend to take longer and so on.

We begin to see the complications and interdependencies from just the factors we've considered and we haven't even talked about social terms of the deal: where will the firm be headquartered?  What will it be called?  How many directors from the target firm shift to the acquiring firm's board.  Nor have we talked about target management: will they stay with the firm? etc.  etc.

The point is to take a whole deal approach, to recognize the myriad of interrelated choices and to bargain on multiple fronts.  Structuring the most effective deal requires no less.

Ralph

Do Unto Yourself

Ralph’s suggestion to leave nothing on the table to reduce hostile takeover risk is a wise one. Hostile bids are a struggle by competing management groups over the control of corporate assets and strategies. Firms compete in two different markets. The first is the product market for customers and revenues. The second is in the capital markets for capital. Product market changes, such as new regulation, impact firm performance. It requires management and strategic adjustments. However, organizational inertia keeps management from changing strategies that have previously  been  successful. The delayed adjustment depresses returns on equity and equity values relative to underlying asset values. Furthermore, management continues to invest despite the unattractive returns believing the poor operating situation is only temporary, which worsens the problem. The depressed returns and weakening stock price attract bidders who believe they operate the firm more efficiently.

The key characteristics of takeover risk include

•  Fundamental structural change as opposed to cyclical industry change
•  ROE less than cost of equity
•  Sum of the parts exceeds the firm’s market value

Firms operating with these characteristics have two choices. Either adapt yourself or someone else will do it for you. A good example of this was provided by the 2007 takeover of ABN AMRO by a banking consortium of Royal Bank of Scotland (RBS), Banco Stantander (BST) and Fortis (FT). The trigger was an on-going war of words initiated by TCI (The Children’s Investment Fund) a UK hedge fund. TCI had been complaining of ABN’s subpar returns Also, TCI demanded in February, 2007, that bank management should consider a break up the bank as the sum of its parts was worth more that the bank’s current market value. TCI deemed ABN’s response as unsatisfactory and threatened action. TCI lacked the capacity to take over a bank of ABN’s size.They hoped other strategic bidders would join, and they did.

ABN’s suffered for years. It was an unfocused global conglomerate with little synergy among the countries in which it operated. Management was aware of the problem and making some incremental progress. They could not, however, make the difficult psychological choice to break up the bank. 

The consortium was a novel approach to handle the size and complexity of ABN’s business. RBS essentially took the international network (with the exception of Brazil and Italy which went to BST). The Benelux business went to FT. ABN tried to bring in Barclays as a white knight and sold their regional Bank, LaSalle, to B of A as a crown jewel defense to defeat the consortium. It failed and ABN was sold in October 2007 at a substantial premium to its pre TCI price.

One could argue that RBS and FT over paid and conducted inadequate due diligence. The market timing was also unfortunate as the transaction closed shortly before the great financial crisis of 2008 and both RBS and FT failed. Nonetheless, ABN’s sale released billions in trapped shareholder value. Additionally, the consortium did in the end what ABN managers should have done in the beginning-namely break up the bank. This illustrates the principle of doing onto yourself before others do unto you.

Joe

The Best Takeover Defense - Don't Leave Money on the Table

Publicly traded firms can be targets for acquisition bids.  Sometimes the bids are welcome and target managements try to understand how to maximize the bid price.  Other times bids are unwelcome and target management seeks to avoid a hostile acquisition.  In both of these cases, target management has a better chance of achieving its objectives if it will follow a simple rule:  maximize value.  In particular, don't leave easy money on the table. Maximize firm value by every means possible.  If target management does seek to sell the firm, this strategy will raise the floor from which premia are added.  If the target firm is trying to avoid takeover, this takes the easy money off the table and makes the firm a less attractive target.

Acquiring firms launch takeover bids for numerous reasons, but most, if not all, reasons can be classified into two broad areas: shareholder welfare and managerial welfare.  The latter set of motives deal with empire building, with overbidding due to hubris and other problems often associated with corporate governance.  We'll have more to say about that in another blog.

In terms of shareholder welfare, one firm bids for another when they believe it is in the best interest of their own shareholders.  In short, the expected net present value from completing the deal is expected to be positive.  Just as there are numerous motives for mergers, there are numerous ways a deal can create value.  For example, gains could accrue because of greater market share and the power associated with that market share or because of synergies that exist between the combined firms.

When the potential acquirer thinks about a bid, they envision the value of the firm under their control.  They also imagine the least amount they could offer for the target to acquire control.  For publicly traded firms, this minimum amount is  the current stock price.  Absent extreme liquidity concerns, rational shareholders would not sell their shares for less than they could get on the open market.  Thus, that market price becomes the floor from which bidders begin their pricing.  If the anticipated gains are insufficient to warrant the risks of the deal, a bid will not materialize.

Maximizing value won't prevent an acquisition bid, but it will put management in the strongest possible position should a bid materialize and in terms of hostile bids, it will discourage bidders looking for easy money left on the table.  Bids that do materialize are more likely to occur because of the synergistic potential of the combination rather than a failure of target management to follow the best value maximizing strategies.  In this regard, one should not disregard the disciplinary force of the takeover market.  In numerous situations, target management faced with a bid decided to implement changes similar to those that would have followed a 'takeover'.  These changes include things like focusing the firm, eliminating redundant assets, spinning off a division that doesn't fit the strategic mission and finding ways to reduce overhead costs.  In other words, taking the easy money off the table.  But it is better to be proactive than reactive.   Don't wait for a hostile bid to force value increasing change.

Incidentally, managements often complain that they are forced to behave in myopic ways to meet quarterly earnings estimates.  But myopic behavior implies overemphasizing the short run and hence producing lower firm value.  Rather than discouraging acquisition, this type of behavior is likely to do the opposite.  Failing to run the firm optimally leaves easy money on the table, inviting acquisition by a management with the proper long term perspective.

Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price

We promised to return to the post entitled "14 Keys to Acquisition Success" and elaborate on one of the keys each week.  Today we look at Key 2:

2.     Any deal is a bad deal at some price; not every deal is a good deal at some price.

The first part of the statement is pure math.  Acquisitions are capital budgeting decisions.  We estimate the cash flows we think we can receive from a potential target and discount those cash flows to the present.  The sum total of these discounted cash flows is our estimate of what the deal is worth.  If we can acquire the firm for less than this our estimated net present value is positive and the deal looks good - it increases our value. When the costs exceed the benefit, the NPV is negative and should be avoided.  

We've written earlier about two behavioral problems with this math.  First, the present value amounts are estimated and can be subject to conscious or unconscious adjustments to justify an acquisition.  Second, even if the value is estimated correctly, potential acquirers can get caught up in bidding wars that escalate the price beyond what it is worth until the firm is acquired - at a loss to the bidding firm's shareholders.

The last part of the phrase is not as obvious.  Doesn't it follow that every deal becomes a good deal at some price?  No.  The reason for this is that the estimated cash flows from a deal can actually be negative once all the costs of integration are considered.  Thus - even a zero price could produce a loss.  (This assumes, of course that one cannot buy the firm and flip it to another buyer at a higher price - in that case, the estimated cash flows would be positive).  Note, it is not hard to find examples of deals that are examples of the principal or at least come close.  Think Sprint/Nextel or AOL/Time Warner or Quaker Oats/Snapple.  In the latter case, Quaker bought Snapple in 1994 for 1.7 billion and was forced to sell it a little over two years later for 300 million.  

Of course, there is much to be said about how cash flows are estimated in the first place.  We'll just note four points for now.  First is the importance of starting with a strategic question: is the acquisition a good fit?  Second is adequate consideration of all of the components that go into cash flow.  On the negative side this includes integration costs (part of which is an allowance for disruption in management during the transition).  On the plus side it means recognizing that cash flows could extend beyond those of the particular deal to new opportunities the project creates.  These are the 'real options' associated with the acquisition.  For example, acquiring a firm in Singapore may look like a zero net present value venture.  But if that venture is successful, it could give you access to the entire South East Asia Market which could be quite profitable.  (Note: be very careful with real options.  They can be quite important, but can easily be manipulated to justify deals.)  Third is the importance of justifying any synergistic cash flows - understanding the source of these synergies and the reasons these synergies accrue to your firm and are not bid away by competition.  This frank analysis will help, but not prevent, your overestimating cash flows.  Fourth is the need to use the proper discount rate - one commensurate with the risk.   

There is much more to the estimation process, but this covers some of the basics.  The point is: any deal is a bad deal at some price but not every deal is a good deal - even if the price were zero.

Ralph

Doing Deals in Tough Markets - It is the Best of Times - It is the Worst of Times

There are plenty of motivated sellers-especially private equity firms seeking to liquefy their portfolios. Debt financing is plentiful-at least in the U.S.  The domestic stock market is rising- at least for now. The financial markets are, however, driven by central bank liquidity injections, and not fundamentals.  Many buyers are hesitant given the troubled world economy. Consequently, M&A volumes are at their lowest levels since late 2009.  Recent goodwill write offs on prior acquisitions and lackluster growth support this hesitancy.  Nonetheless, good deals are often done in tough markets. The key is to employ a cautious policy utilizing a bear deal market menu of options. Unlike the bull market menu which focuses on winning the deal and financial engineering, the bear market menu is more risk management focused.

The key components of this menu include:

•  smaller fill-in transactions
•  low leverage with limited amortization during the initial years
•  limited covenants
•  seller notes
•  loss sharing provisions employing contingent consideration to bridge pricing  gaps
•  strong due diligence
•  strong lock-up provisions to minimizing losing the deal to competitors
•  expense reimbursement for legal and due diligence if the seller pulls the deal post letter of intent
•  detailed integration plans to achieve immediate cost cuts
•  strong closing conditions allowing you to walk from the deals should conditions worsen.

Beware ordering off the wrong bull market menu to minimize getting indigestion. Many potential sellers may resist some of these buyer-orientated provisions. Prospective buyers need the discipline to terminate discussions and not get carried away.  Discretion is the better part of valor in this market.

Joe

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.


All the best,

Ralph