Risk Appetite: Eating Well or Sleeping Well

Ralph and enjoyed teaching the December 4-6 Acquisition Finance Course at the Amsterdam Institute of Finance-despite enduring the worst storm in over 60 years while in Amsterdam. The attendees raised some interesting questions, which I will attempt to address in this and upcoming posts.

Readers of MergerProf will note one of the reoccurring themes is how changes in investor risk appetite trigger changes in buyout volume, capital structure, financing instruments and structuring. The attendees inquired about what causes risk appetite changes. This is an important issue for trying to understand markets.

Risk appetite is based on Keynes’ notion of Animal Spirits and included in behavioral finace. My understanding of risk appetite is as follows:

1)   Risk Appetite is driven by changes in investor wealth. When wealth increases it encourage investors to risk their winnings on more adventurous activities. When wealth decreases, in a downturn or market crash, it make us more cautious. This is especially true when the wealth decreases are large enough to cause solvency and liquidity problems which breach our budget constraints.

2)   Risk appetite changes, both up and down, are amplified by leverage and liquidity. Leverage allows us to invest more thereby lifting asset prices and collateral values. This creates a virtuous circle or positive feedback loop. As we all know, when this reverses, the downward price movement can be unpleasant.

3)   Liquidity is driven by rising asset prices and increased credit. It tends to be ephemeral and is never there when you need it as investors learned during the credit crisis. Hence the need to hold negative return assets like cash and treasuries as an insurance policy.

4)   Liquidity shifts as asset correlations change. All asset correlations, except for cash and treasury insurance policy assets, go to one in a crisis. Diversification evaporates just when you need it the most. As prices decline, we tend to liquidate our most liquid assets first, to make margin calls, to minimize capital losses. This triggers a vicious circle further reducing prices, credit and liquidity.

Currently, central bank Quantitative Easing efforts with their massive liquidity injections and falling yields have spurred investor risk appetite-more so in the United States than Europe given the improved domestic economy. Thus, U.S. buyout volume is strong, fueled by investor demand for higher yielding high risk instruments like “CCC” rated debt, high yield bonds, second lien loans, and covenant lite loans used to fund more aggressive higher priced buyouts. Interestingly, we are also seeing more PE sponsored IPO exits like Blackstone’s Hilton Offering. This is a reflection of an exuberant stock market compared to a more subdued M&A-trade sale exit.

We all know how this will end. We just do not know when it will end. We need to structure transactions able to withstand abrupt market changes. Of course, this comes at a cost.

j

An Inch by Any Other Name Is Still 25 Millimeters

Banks post the 2008 financial crisis, have been priced primarily upon a book or tangible book basis instead of the pre crisis earnings basis Metrics. This was largely due to a lack of earnings and uncertainty over asset quality. A common pricing metric used is P/B (price-to-book) =ROE-growth (g)/Ke (cost of equity)-g.

Asset quality and earnings issues have been largely resolved as banks have recovered. Thus, Price-Earnings (P/E) ratios have returned. Some mistakenly believe that using P/Es will lead to higher M&A  pricing than P/B ratios. Higher pricing may occur, but not because of a switch in pricing metrics. The higher pricing reflects improved fundamentals.

A bank is worth what someone will pay for it. What someone will pay for it is driven by the underlying fundamentals-how much cash is produced, for what period of time and how sure we are about our estimates. The different metrics-P/E and P/B must be equivalent just like an inch must be 25mm (rounding error excepted). Consider:

1)     P/B= ROE-g/Ke-g

2)     P/E=P/B divided by ROE

Thus, for a bank with a 12% ROE, 2% growth and 10% Ke the P/B is 1.25X and its P/E is 1.25/12% is 10.4X. An improving bank with a 15% ROE, 3% growth and 10Ke will generate a P/B of 1.7X and a P/E of 11.3X.Of course there can be divergences of opinion regarding future operating performance especially concerning expected synergies. Nonetheless, large differences need to be reconciled against more detailed discounted cash flow analysis.

For me, the biggest issues in bank M&A pricing is not P/B or P/E, but rather the premium over the pre-bid target trading price. Premiums less than 20% have a much greater chance of adding value for the buyer’s shareholders than those exceeding 40%. If you over pay relative to the cash flow acquired, regardless if expressed in P/E or P/B terms, your shareholders lose.

Ralph and I are on our way to Amsterdam to hold our annual acquisition financing class. Thus, posts next week may be suspended. I always learn something new from the interchange with the attendees, and will share those insights with you.

I hope everyone had a great Thanksgiving Day holiday. As usual, I over ate and watched too much football.

J

European Deal Activity - An Update

Next week, we are offering our Acquisition Finance Course in Amsterdam again.  December is such a festive time to visit Amsterdam - they take the holidays seriously and it seems to be reflected everywhere you look from the Central Station to the Leidsiplein to the Canals to the small villages just outside the city.  I really look forward to being there.

Some of the things we'll be analyzing in detail next include understanding current market activity.  As part of this we'll take a look at trends over time.  The slide below shows the Countries most active as Acquirers and as Targets over the past five years.  The UK heads the list in Deal Value and Number of Deals.  

Leveraged Finance: Best of Times?

Regulators are concerned with the state of credit markets, in general, and the leveraged loan (LL) market, in particular (see Regulators). Market states are driven by changes in investor risk appetite. Rising wealth from the post crisis bull market is fueling increased risk appetite. This, combined with a search for yield in a low interest rate environment, underlies the resurgence of leveraged financing.

This is especially notable in the return of the collateralized loan obligation CLO market. This market shut down during the crisis due to unexpected losses from step market price declines. The activity returned in 2012. CLO investors are the major LL investor base. Their return underlies the spike in 2013 leveraged activity. Note the following:

1)        LBO activity has ballooned this year.

2)        Funded debt multiples of EBITDA have returned to near pre-crisis levels 5.5X v 6.2X.

3)        Purchase price multiples are increasing.

4)        Percentage of contributed equity in LBOs is falling to 32% - near the pre-crisis low.

5)        Financing structures have changed. Balloon based term loan B’s have replaced amortizing term loan A’s.

6)        Loan spreads have fallen to pre-crisis levels. They fell 100BP alone from 2012 levels.

7)        Return of aggressive pre-crisis instruments like Payment-in-Kind-Toggle PIK-T and covenant-lite   loans Cov-lite. In fact, cov-lite now represents a record 52% of LL  issuance.

8)        Surge in higher risk transactions including Public-to-Private (PTP) and Leveraged Recapitalizations (LevR). PTP is at its highest level since the pre-crisis 2007 peak, while LevR have reached record levels.

9)        CLOs issuance for 9 months 2013 is  $57B v $30B for same period 2013.

For issuers it is the return of the good times in terms of funding availability, structure and flexibility. Just because you can do something, however, does not mean you should do it. We are likely to see to higher priced and over leveraged transactions going forward. Yield chasing investors are likely to suffer disappointing pro forma returns once risk appetite peaks and market liquidity falls. We cannot predict when this correction occurs. We can, however, predict that it is closer than where it was at the beginning of 2013.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up. Hope to see you in Amsterdam - one of our favorite cities!

Exit Strategies for Private Equity: US and European Evidence

Last week we outlined exit strategies for private equity investments.  One strategy that we didn't feature is a 'write-off'.  Obviously, write-offs can represent a failed investment and are (generally) undesirable. However, the ability to cut losses early is a healthy trait in any investment strategy.  The article below highlights exit strategies for US and European buyouts over the 1990-2005 period, revealing many interesting aspects of the exit process.  The importance of market sentiment is also noted, making it imperative to ascertain current and projected market conditions in any analysis.

 Exit Strategies of Buyout Investments – An Empirical Analysis 

Daniel Schmidt Sascha Steffen Franziska Szabó 

June 1, 2009 

(Abstract) 

"We analyze the three main exit routes for exiting buyout investments, initial public offerings (IPO), sales and write-offs on, using a unique data set for US and European buyout transactions for the 1990 to 2005 period. We examine the determinants influencing the choice of an exit channel employing a multinomial logit model. The results strongly support the view that private equity investors write-off investments that turn out to be non-performing early, showing their ability to filter out good from bad investments. We further find evidence that exits of buyout investments tend to be driven by market sentiment. We further analyze as to how the internal rate of return (IRR) influences which exit route is chosen. We find supporting results that only the most profitable ventures are taken public. Our results have implications for exiting buyout investments during the current financial crisis. "

The complete paper can be downloaded here.

All the best,

Ralph

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Goodwill Hunting Revisited

An earlier Post focused on goodwill Impairments as a measure of M&A value destruction. Duff & Phelps has released a new Study which contains some interesting results:

1)   Goodwill impairment surged 76% from the prior year to $51B.They still remain below the peak 2008 crisis related levels which were centered in the financial services industry.

2)   Buyers paid the lowest premiums in nearly 20 years, less than 20% v a historical 30%+.

3)   Impairments were concentrated in industries and firms undergoing structural change. IT was the industry experiencing the largest share of impairments. Two firms in that industry, Hewlett Packard (HP) and Microsoft (MS) had the largest impairments at $13.7B and $6.2B respectively representing nearly 40% of total annual impairments. HP’s impairment concerned its Autonomy acquisition while MS’s related to aQuantive.

The biggest source of M&A value destruction is overpaying. No matter how good the fit, how good the target, how flawless the integration, or the amount of due diligence, if you overpay, reflected in the amount of goodwill created or earnings and book value dilution, your shareholders will suffer.

Conceptually, the target’s pre bid share price plus the premium equals price paid. The value received is the target’s standalone value (reflected in the pre bid price) plus any synergies. Thus, the acquirer’s net value received is synergies less the premium. Premiums are, however, a fact while synergies are an opinion subject to behavioral bias.

As a rule of thumb, premiums exceeding 40% are prima facie evidence of overpayment. Think about it, a 40%+ premiums means you have to improve the target’s performance by over 40% just to breakeven. Unless, the target was grossly mismanaged, this will be difficult in a low growth highly competitive market.

The HP and MS acquisitions were grossly overpriced with premiums of 64% and 85% respectively. Such actions reflect desperate buyers gambling for redemption (AKA Hail Mary pass). Both HP and MS are former growth stars experiencing slumping sales growth and eroding margins. Their management teams, both of which have or will be replaced following their disastrous acquisitions, believed large transformational acquisitions would serve as a growth elixir. Unfortunately their shareholders were forced to drink from the poisoned chalice of value destruction.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.