Private Equity Capital Structures

Private Equity (PE) transactions are primarily debt financed. They represent up to 25% of the total M&A. Unlike corporate-strategic buyers (CSB) - they involve temporary capital structures and temporary ownership. They unlikely go to their legal final maturity of 7-10 years. They are either refinanced or sold if they perform well or are restructured if they do not. They reason is their high cost and limited flexibility based on their high debt levels. They typically have non investment grade debt ratings in the BB-B range versus CSB investment grade ratings. This is due to their inverted capital structures which are 30% equity-70% debt. CSB capital structures are usually investment grade-in the BBB-A range with 70% equity-30% debt.

PE firms consider the following when selecting an initial transaction capital structure:

1)     Their financial preferences concerning cost, risk and flexibility. Lower rated firms face higher financing costs and lower flexibility reflected in covenants and amortization schedules. For example, currently a BB+ leveraged loan has a prorate spread of LIBOR+ 165B, while a B+ spread is in the LIBOR+ 265BP range.

2)     Financing need: large needs argue for higher ratings/lower debt levels. The “B” market is smaller and less liquid than the “BB” segment.

3)     Firm specific characteristics concerning leverage levels, cash flow and size. For example, BB+ firms have revenues around $3B and debt to EBITDA of 3X while B firm’s revenues are closer to $1.5B with leverage in the 4.5X+ range.

4)     Market conditions: the non investment debt market is very volatile. The market virtually shut down during the financial crisis. This causes a real risk when attempting to fund a transaction with a capital structure designed for a market which has changed. Unlike CSBs- market, not firm factors are the most important determinants of PE capital structures.

Once they have chosen their rating which reflects their preference they can then determine their debt capacity as reflected in rating agency publications. A sample is reflected below:

So for a B+ target and $100 of EBITDA debt capacity is around $500.This would be fined tuned with cash flow projections to develop the debt amortization schedule. Of course, the level changes based on market conditions.

PE prices transactions off of debt capacity compared to CSB which price off synergies as reflected below:

Assuming an acquisition where the Target’s EBITDA is $100-the maximum that could be paid with a 25% level of equity injection and 4.5X funded debt leverage is $600 for 6X PPX. Currently purchase price multiples are 8+ leaving a significant gap. The PE firm’s options include:

1)     Decline the deal: PE firms are, however, under pressure by LPs to invest. Either you invest the LP’s commitment within an allotted time, usually 5 years, or it expires and with it the PE firm’s fees and carried interest.

2)     Increase the equity %: this reduces the deal’s IRR.  Deal IRRs below target levels reduce the PE firm’s carried interest. Additionally, low overall fund returns complicate future PE firm fund raising efforts. Remember, the deal IRR is the entry equity investment less the exit entry process upon future sale. Assuming the entry PPX equals the exit PPX and no interim dividends-then IRR will fall given increased initial equity unless the target’s EBITDA performance is increased.

3)     Reduce the PPX: unlikely in a competitive bid situation.

4)     Increase leverage by expanding debt capacity: this is achieved thru financial engineering with products that reduce debt service via reduced cash interest (PIK) or extended maturities (bullet maturities). Options include the following:

The availability and cost of the different debt options is subject to market conditions. The key points are that debt capacity is based on only two sets of factors- (1) the debtor’s internal operating cash earnings, EBITDA, and asset collateral values and (2) market conditions which influence debt service-cash interest expense and debt amortization reflected as (where the( I +1/n) term is the funded debt multiple (FDX)):
Debt Capacity= EBITDA/ (i + 1/n) 
        where i is the average interest rate and n is the average debt duration.

PE firms, like real estate developers are driven more by the second part of the equation than the first. This has some interesting implications:

1) PE target demand is driven by financing not price. Demand can actually increase as PPXs increase provided FDXs increase.

2)     Both the financing market and target market are volatile, highly pro-cyclical and amplify each other.

3)     PE fund returns tend to fall for later stage acquisitions. They continue to over pay and buy late in the cycle, provided funding availability, and suffer the return consequences later.

4)     Capital markets have accommodated PE firms by development a suite of debt capacity enhancing products.

5)     PE capital structures are non risk adjusted IRR driven.

6)     The initial projected IRR range( based on varying exit EBITDA, PPX and year of exit) is calculated as:

a)     IRR: (Entry Equity) + Exit Equity Yr t/ (1+IRR) ^t=0. The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive-exit equity proceeds- and negative-entry equity investment) from a particular investment equal to zero.

b)     Entry Equity=EBITDA Yr0 X PPX Yr0 - FDX Yr0 X EBITDA Yr0. The initial equity investment outflow is equal to the purchase price defined as trailing EBITDA times the PPX less the amount of debt funding defined as trailing EBITDA times FDX all at the time of close.

c)     Exit Equity=EBITDA Yr t x PPX Yr t- FD outstanding Yr t (think of Exit Equity value as terminal value in a traditional DCF analysis). Expected net equity proceeds upon sale in year t are the enterprise value purchase price-exit year EBITDA times PPX-less any remaining outstanding debt.

7)     Viewed in this light PE firms can create value in later cycle acquisitions with high PPX by:

Increasing EBITDA in year t-this is difficult for later stage deals where EBITDA margins are already high

Assuming a higher exit sale PPX or earlier exit

Decreased entry equity from higher initial FDX-the usual choice

                 

PE firms are not stupid or crazy. Rather they have different incentives than CSBs. Hence they have different capital structures.

j

Mergers and Taxes, A Follow Up on "Inversions"

Last week we commented on the increased number of "inversions" where a US firm is merged into a foreign firm to become domiciled in a more tax friendly country.  (See Politics, Taxes and Economic Reality.) Our argument was for recognition of the economic reality of the marketplace and the need for companies and countries to remain competitive.  Countries with unfavorable tax environments will lose business.  An unproductive tendency, we warned, is for countries to try to set up roadblocks inhibiting the laws of economics.  These attempts are generally unproductive and can create unintended consequences that only exacerbate the situation.

Indeed, an interesting blog from the Deal Lawyer, points out that the Treasury department has already implemented steps to prevent or slow down these inversions.  According to the article, current law states that the existing shareholders of the US firm must end up owning no more than 80% of the new company to create an inversion.  The law is being changed, however, to require existing shareholders to own less than 50% after the deal is complete.  Obviously, acquiring companies are not going to be anxious to give up such control.

The end result will be a rush to complete these deals before the new laws take place at the end of this year.  A better long term strategy for the United States or any country is to recognize the economic reality faced by business and understand motivations for the inversions.  Imprisoning business with uncompetitive laws may work in the short run.  It will never work in the long run.

All the best,

Ralph

How Do I Pay: Stock, Cash or Combination?

The selection of the acquisition payment currency has important implications for both the seller and buyer. So far in this century about 55% of deals are cash, 23% combination and 22% stock. The proportion of cash and combination deals has increased since the elimination of Pooling of Interests accounting in 2001. Like all M&A items, the selection is negotiated and depends on the relative points of views of the buyer and seller regarding whether the risks and rewards of the acquisition should be shared. The simplest approach is use cash, but sometimes that is not always possible.

Buyer considerations regarding the use of stock in whole or part include the following:

1)   Valuation: consider not only the seller’s valuation, but also that of the buyer’s post transaction value to gauge the exchange ratio impact. The buyer should never use its shares if it believes them to be undervalued; whereas, it should use its shares if it believes them to be over-valued and the seller will accept them. An extreme example of this is AOL’s purchase of Time Warner.

2)   Synergy Risk: use cash if synergy risk is deemed low to keep the upside and stock if high to share the risk. Facebook’s recent high priced acquisitions are primary stock transactions. This helps cushion the downside should the early stage technology targets fail to work out as planned.

3)   Market Risk: if shares are used then you need to decide who bears the market risk of the shares changing price after the offer is made but pre close. The options include a fixed price deal where the buyer assumes the risk, a fixed share arrangement where the seller takes the risks or using collars and caps to share the risk. (See our post Acquisition Risk, Collars, and the Comast Time Warner Deal.)

4)   Dilution: this includes both ownership and earnings dilution. Whenever new shares are issued the relative ownership positions of existing shareholders declines. This can be an important control issue for middle market firms and argue for a cash deal. Buyer earnings and earnings per share (EPS) always increase in a debt financed cash transaction provided the target’s earning exceed the incremental after tax interest cost on the debt. In stock transactions the new shares issued can cause a decline (dilution) in EPS if the seller’s price-earnings ratio exceeds that of the buyer. Over time, the EPS dilution should decline as earnings grow. Usually, buyers prefer a breakeven dilution of 2-3 years.

5)   Taxes: the buyer prefers a taxable transaction involving all or a substantial portion of the price to be in cash. This allows the write-up of the assets acquired by the buyer and higher future tax deductions. Other considerations include changing tax domicile to lower tax rates as in the Pfizer-AstraZeneca  bid.

6)   Credit Rating: debt financed cash transactions impact the buyer’s target debt rating.

Seller considerations include:

1)   Valuation: the seller needs to value the buyer’s shares on a post acquisition basis to determine what if any premium it actually receives. This means doing due diligence on the buyer. These valuation issues explain why targets in hostile takeovers prefer cash over stock as AstraZeneca is now demanding from Pfizer. Remember the old joke - daddy I sold my bike for $20,000- I traded it for 2 $10,000 marbles. The value of marbles, like the buyer’s shares, is an opinion. Cash, however is a fact.

2)   Taxes: sellers can defer capital gains taxes if the transaction is structured as a tax free share exchange. Unfortunately, this has negative tax implications for the buyer which will probably be reflected in the offer price.

3)   Liquidity: the focus is on the float of the shares to be received, lock-ups and registration rights.

Bottom line for me is the KISS principle (keep it simple stupid). It is usually cheaper for the buyer to pay in cash. This may reflect Warren Buffett’s apparent preference for cash purchases. Sellers will have an easier task of evaluating the offer and less risk in cash deals. Thus, being a simple guy, I recommend cash transactions whenever possible. If not using cash, be sure you are at least as smart as the other side.

J

Politics, Taxes and Economic Reality

I don't know anyone who enjoys paying more in taxes than is required but taxes are important and vital to our country.  So is the necessity of creating an environment where business can compete and win.  The Wall Street Journal noted that Pfizer is changing its headquarters from the US to enjoy a considerably lower tax rate abroad.  The article goes on to note that these inversions, as they are called, are created by merging into a company in a different country and are becoming more plentiful.

Many things remain the same for Pfizer.  It will still use New York as its operational headquarters, for example, and still widely market its products in the US.  One thing that will change is the lower tax revenue the United States will receive.

The article notes that Pfizer is fully complying with all laws and will continue to pay taxes as required in the United States.  Nevertheless, I fully expect we will hear more from politicians about Pfizer and other companies initiating these moves.  In other circumstances, politicians have created laws forbidding actions 'undesirable to the state' or heavily taxing 'undesirable' actions.  Indeed, such laws are one of the motivations for Pfizer's shift: the move will permit more tax favorable flexibility in utilizing off-shore funds rather than face hefty US taxes under current law.  It has long been argued that more reasonable and creative laws for the use of off shore funds would aid companies and increase tax revenue for the US, but changes have not been forthcoming.  

Many politicians seem to believe that the laws of economics can be ignored or worse, that their own laws are superior in creating  a more desirable world.  In the worst cases, laws are created by politicians without full analysis of the details or even recognition of possible unintended consequences.

In the end, the laws of economics prevail and the countries of those who ignore these laws suffer the consequences.  Instead of creating barriers or lamenting loss of business, energy would be better spent in working to make the business environment of our country more competitive.   That includes a hard look at the tax codes and the economic reality of the world.

All the best,

Ralph 

Build or Buy: Deconstructing the Big Pharma Value Chain Thru M&A

Industry changes drive M&A. Currently, we are seeing a plethora of deals in the big pharma industry. Traditionally, the industry utilized a Vertically Integrated business model. The model combines the various links in the Value Chain within each firm including early stage R&D, sales and marketing, manufacturing, and distribution. Early stage R&D is high risk and expensive (more than 15% of annual revenues in some firms). The search for blockbuster drugs to justify such investment has become difficult given many former winners going off patent and weak development pipelines. Consequently, big pharma margins have suffered.

Early stage R&D relied on a big firm’s ability to fund the needed large expenditures. This has become more problematic given the weak governance and incentive structures in large bureaucratic firms. Consequently, firms have been considering alternative funding arrangements. Instead of developing drugs internally, they buy the new drugs from better suited smaller entities thru licensing, joint ventures or acquisitions. These early stage Incubator type firms would be funded by Venture Capital, Private Equity or Hedge Funds. This would allow big pharma to focus on its core competencies. Thus, the question or bet is what is the most efficient structure to undertake early R&D- in house or buy?

This question is at the heart of the recently announced $40B+ Valeant-Pershing Square  hostile joint venture buy-in for Allergan. Valeant's business model is based on buying versus developing new drugs-primarily thru acquisitions with Allergan being the largest by far. Valeant’s R&D expenses to revenues ratio is only 3%. Their stock price has increased 9 fold since the current CEO arrived in 2008 and embarked upon a serial acquisition program. The current bid despite being over 20X EBITDA promises to be minimally dilutive based on the large amount of R&D and SG&A cost savings planned.

Allergan uses the traditional integrated model. Its R&D to revenues ratio is 17% (almost $1B LTM). It also has a top heavy $2B+ SG&A cost structure characteristic of vertically integrated firms. Its stock had stagnated over the past years. The Valeant bid equals a price Allergan has not seen since 2008. It reflects the large strategic value gap inherent in Allergan based on its current strategy and asset combinations.

Allergan is expected to resist the offer. It has a Poison Pill, and is expected to seek possible white knights like Johnson and Johnson. If those fail, then it may embark an acquisition campaign of its own to make itself too big and ugly to buy like Jos A Bank tried. Valeant and Pershing established a significant 9.7% Toehold to cover the downside of losing he bid. How they accomplished this is an interesting application of good Lawyering.

Industry disruptors like Valeant are employing new business models to rapidly reconfigure industries undergoing structural change. They accept the change while targets resist change. Ultimately, history is on the side of change not resistance. Early stage drug R&D will continue. The questions is how and who will perform it.

 J

Costs, Benefits, Taxes and Culture

Mergers are once again filling the headlines of our financial papers and as one who writes a merger blog, there are plenty of things we could discuss.  The Omnicom Publicis merger appears in danger, reportedly due to the resulting tax structure of the deal (although one can suspect other issues as well).  

Taxes also figure in the the $46 billion dollar offer of Valeant for Allergan.  According to an article in the Wall Street Journal, Valeant changed its domicile to Canada after its 2010 merger with Biovail.  As a result, it's tax rate is below 5%, offering a huge competitive advantage over companies in the United States.  Allergan is headquartered in California, so one strategy would be to move the business to Canada.  

But the Valeant Allergan deal is also newsworthy because of the differing cultures of the two companies.  Allergan is more focused on research and development, while Valeant is focused on sales.  Indeed, the planned strategy of Valeant is to reap savings by slashing the R & D spending of Allergan.  Certainly there can be value in R & D and that brings us to the nexus of the items we've talked about.

Consider three aspects of the Valeant, Allergan deal: taxes, culture and strategy.  There are three major claimants on EBITA - bondholders, debt holders and the government.  Reducing taxes increases funds available to the other claimants and can result in significant gains for equity.  

Merging companies with clashing cultures, however, is fraught with problems and can dramatically increase integration costs.  In this case, however, it is clear that Valeant is well aware of the culture/strategy issues and not afraid to confront them.  

So lets consider the pieces: taxes, culture, costs, benefits and strategy.  The value of a company and the value of any deal always come down to the basics - cash flows and risks.  We estimate value by discounting expected cash flows at a rate commensurate with the risks.

And cash flows can be increased in two major ways - growing the revenue or reducing the costs.  Both can be viable strategies and the success of any deal will hinge on the correct estimation of the costs and benefits and implementation of the specific tactics to bring them to fruition.  Both companies have been successful following different paths.  The question here is whether it makes sense for the paths to converge.

The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant.  Valeant's stock price rose dramatically as well.  It will be interesting to follow this deal.  

All the best,

Ralph