The Acquisition Paradox

Acquisitions remain popular despite overwhelming evidence that they rarely create value for the acquirer’s shareholders. Yes, acquisitions fall in and out of fashion on a cyclical basis. Acquisition volume or waves seem tied to managerial risk aversion amplified by leverage. Relatively high acquirer share prices increase management confidence. The confidence, whether misplaced or not, is increased by cheap and plentiful financing, and the actions of acquiring peers.  This leads to the perverse results of buying high as acquirers chase returns, but frequently end up with bubbles. The deals are always justified by the “you do not understand” defense. Other defenses include “our deal is different” and ”everyone is doing it”. Such actions are usually supported by elaborate investment banking financial discounted cash flow models, fairness opinions and consultants reports.

Certain types of acquirers and managers are more easily influenced by such factors. These include:

1)     Industry Followers: industry laggards trying to keep pace with what larger peers are doing. An example is Lloyds bank purchase of HBOS to keep pace with an industry consolidation.

2)     Sweet Bird of Youth: firms suffering from declining core operations and growth are prone to climbing back up the growth curve through transformational strategic acquisitions. Hewlett Packard stands out as the poster boy of this acquirer type.

3)     Weak Governance: firms with powerful charismatic CEO/Board Chairman (AKA overconfident-hubris) can push thru their boards highly questionable deals. Fred Goodwin at RBS obtained board approval for arguably one of the worst acquisitions of all time-the disastrous ABNAMRO acquisition that ended up bankrupting RBS, Fortis and ABNAMRO).

4)     New Outside CEO: new outside the firm CEOs are especially subject to “acquisition fever”. They are keen to make their mark, achieve a quick win and enjoy their honeymoon period with their boards. M Meyer at Yahoo is a current example of this type of acquirer with acquisitions like Tumblr.

5)     Over Valued Firms: overvalued firms are likely to capitalize on their perceived overvaluation by funding questionable acquisitions using their stock. The classic case was the AOL acquisition of Time Warner.

That is my humble attempt at acquisition psychopath profiling. Other than hiring company psychologists and maintaining adequate supplies Prozac-we probably will continue to suffer from these acquisition psychoses.

J

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

Leveraged Acquisition Loans: Fasten Your Seatbelts

The leveraged acquisition (non investment grade) market is heating up again. It is being driven by loan investors, both bank and non bank CLOs (Collaterized Loan Obligation funds). The investors are chasing yield in a low rate environment in which the forward calendar of new transactions remains tight. The low rates increase the affordability of higher debt levels by moderating debt service requirements. The rates are usually locked-in on a substantial portion of the debt through fixed rate bonds and interest rate swaps.

Deal structures follow market movements. Note the following (Source S&P Capital IQ):

Funded Debt/EBITDA (FD/EBITDA) up from the 2009 low of 4X to 5.5X, but still below the 6.2X 2007 peak.

Equity % contribution down from the 2009 high of 45% to 30%, which matches the 2007 peak.

The more aggressive capital structures improve the affordability of private equity sponsor based acquisitions. This is usually translated into higher purchase multiples as will now be illustrated:

1)   Assume the target has $100 EBITDA. A 4.5X FD/EDITDA multiple combined with a 30% equity contribution can support a $640 price or a 6.4X purchase price multiple (PPX).

2)    An increase in the debt multiple to 5.5X with the same equity contribution can support a $780 transaction with a 7.8X purchase price multiple.

This fact is reflected in the recent increase in PPX from 7.7X 2007 lows to current 8.5X levels. This is still, however, below the 2008 9.7 PPX peak.

These facts have not gone unnoticed by banking regulators. A recent Shared National Credit (SNC) report authored by the Federal Reserve, FDIC and OCC highlighted the widespread weakness in large syndicated leveraged loans exceeding $20Mln shared by three or more institutions. They especially noted:

1)     Excessive leverage

2)     Inability to amortize debt

3)     Weak covenants

4)     Minimal equity

This will have a significant impact on the bank loan syndication market.

Markets can be fickle. Just because you can do something does not mean you should. Acquisitions based on cheap plentiful credit frequently end up badly. The results of the class of 2007 private equity funds and transactions are evidence of this fact.

J

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

Carl Icahn’s Apple Tweet and Shareholder Activists

Carl Icahn’s short Tweet about his 9/30/13 dinner meeting with Apple’s CEO Tim Cook seems to have triggered some angry reaction by some commentators (see Tweet). In his Tweet, Icahn stated Apple should consider using its $ 150B+ cash hoard to buy back its undervalued stock. Some commentators are incensed that, although he is a major shareholder, he could call into question the use of Apple’s cash, or worse yet, demand its return to shareholders. I guess they believe that shareholders, like children, should be seen, but not heard.

Earlier this year Apple, prodded by another activist - David Einhorn, agreed to a major debt financed stock repurchase and dividend program (see Dividend). Nevertheless, Apple’s cash continues to grow. Apple, however, appears to be transitioning from a rapidly growing technology firm to a maturing consumer electronics company. This change is difficult for Apple’s senior management and many commentators to accept.

Companies experiencing life cycle changes find it difficult to accept change and cling to the hope they can regain their mojo. After-all, didn’t Steve Jobs accomplish this very feat 15 years ago? Unfortunately, the supply of Steve Jobs’ may be limited.

Activist investors like Icahn and Einhorn are concerned with the value destructive impact of firms failing to adapt. They are aware of Schumpeter’s creative destruction whereby firms are only king for a day (see Creative Destruction). Furthermore, they are especially concerned with Jensen’s free cash flow (see Warning). Jensen highlighted the excess cash flow leads to empire building. Consequently, financial policies like maintaining large cash balances that may have been appropriate for the younger Apple may no longer be appropriate. Evidence indicates that activist shareholders, bringing up inconvenient truths, have a positive impact on maturing firms by forcing them to disgorge cash instead of wasting it on misguided growth.

Companies like Apple should consider aggressive changes in their financial policy including increased dividends and debt financed share repurchases at the right price. Managers may dislike shrinking their kingdom even though such action makes their citizen shareholders richer. They, along with populist commentators, want a return to the past instead of realistically facing the future. They frequently allege the activists are destroying a great franchise. What they miss, however, is the return cash can be invested by investors in new Apples rather than trapped in the old lemons.

The capital markets are not museums to preserve once great companies - well at least for everyone but the French. The capital markets are complex adaptive systems in which firms are born, grow and are replaced. That is the key for a dynamic economy, and the efficient allocation of capital.

We may not like what the activists say or how they say it, but they provide a valuable catalytic function. Sorry for the rant.

J

PS Less than 2 months to Acquisition Finance in Amsterdam.  See the link here.

Selecting the Form of Payment: Signaling and Overvaluaton

Selecting the form of payment in an acquisition is a function of many factors.  What post-acquisition ownership structure is desired?  What are the tax consequences?  How much cash does the acquiring firm have?  Is the acquiring/target firm stock overvalued?  What are the legal ramifications for this form of payment? What does the target desire?

These are but a few of the payment related factors to consider in selecting form of payment.  We'll discuss just one aspect here - the concept of signaling and overvaluation.  Firm's that use stock to acquire other firms tend to experience a small drop in the market value of their shares.  Similar results are found for firms issuing equity.  

What explains the loss of market value?  The evidence is consistent with  the Signaling Hypothesis, which suggests that the use of stock is because the acquiring firm's managers believing that their stock is overvalued.  

Consider the following scenario - you are CEO of a firm whose shares are trading at $30.  You believe, however, that the shares are worth $20.  Thus, the shares are overvalued by 50%.  Now eventually, the market may 'wise up' and revalue your shares.  As a way to create value for existing shareholders you consider exchanging the overvalued equity for hard assets of another firm.  In this way you 'lock - in ' the excess value even if shareholders recognize your current overvaluation.

Now consider using shares for acquisitions.  Would you do so if you thought the shares were undervalued?  Probably not, you'd be giving away value.  Thus the prevailing wisdom is that firms using stock don't think it is undervalued.

Empirical evidence, showing stock drops on the order of 3% at the announcement of a stock deal, are consistent with this idea.

We'll discuss these and other ideas in great detail in Amsterdam, just over two months from now(see side note or click here)

All the best,

Ralph