GM, Product Risk and Corporate Governance

We've written many times of the importance of corporate governance.  It becomes readily apparent when something like the GM ignition switch crisis occurs.  The product problem relates to a faulty switch which would turn the engine off with a slight nudge of the knee or when heavy objects (other keys?)  dangled from the keychain.  The company problem is much more complex.  The company links 13 deaths to the problem.  Plaintiffs attorneys suggest a figure considerably higher.  Even one known injury is too many.

The obvious questions to be asked are ones without any suitable answers: Who knew what when?  Top management?  The board?  If they did know, what actions were taken?  If they didn't know why not?  The board states that they were not aware of the problem, yet numerous customer complaints began pouring into the firm as early as 2005.  Press reports assert that some engineers knew of the problem in 2001.  Why wasn't management aware of these problems?  Why wasn't the board informed?  At the time of this writing, GM has recalled over 2.6 million cars costing more than $1.7 billion dollars. This doesn't begin to measure the cost of liabilities facing the firm, nor can it ever measure the human loss.  Why did it take so long to begin the recall?

It apparently would have cost about fifty seven cents to improve the switch.  Instead of doing so, the company tried makeshift solutions, shipping modified key inserts and writing to customers to be aware of hanging heavy objects from their keys.  When the part was finally improved, the company kept the same part number, providing further confusion.

The other solution the company took when at least some managers were made aware of the problem is to form two committees - not committees of the board - but committees of employees - and the board was never made aware of the situation.

To be fair, the current board is largely new, but it is not enough to say 'We weren't there.'  The board needs to understand if this is a systemic governance problem within the company.  They must assure themselves, as well as investors and customers that something like this could not happen again.  Those steps must begin with a thorough analysis of the process of risk management and the process by which the board is informed of problems.  

A dramatic audit of the firms governance structures is needed.  What governance structures led to this situation?  How must they be improved?  What was/is the process by which the board monitors product risk?   What whistleblower functions are in place and more importantly, what is the corporate culture with regards to reporting and addressing problems - even if they appear costly.

Moreover, it is not sufficient to make changes that could have prevented known problems.  The board needs to have a process for anticipating and eliminating future problems.  Again, this begins with having the right processes in place, and monitoring the corporate culture.  It begins with management developing the right tone for the firm and with the board continually probing and asking leading and open ended questions.  Board experience in working with other problems of risk management at other firms is essential, especially in pointing to weaknesses in current processes and in anticipating the unexpected.  

We'll know more about what happened soon as the firm has hired Anton Valukas to provide a detailed report on the situation.  Valukas was also the person who provided an analysis of the Lehman Brothers bankruptcy.  It should present a good start for reform and for recognition that safety of the customer has to be the highest priority.  Lack of safety is not an option.

All the best,

Ralph

Fantasy Finance: Funding the Fully Priced Deal

Private equity firms are facing increasing deal multiples. EBITDA purchase price multiples now exceed 9X-almost equal to the pre crisis 2007 level of 9.5X. Some factors underlying the increase include:

1)   Return of strategic buyers: corporate buyers have returned with M&A volumes continuing to climb.

2)   Rich IPO prices: sellers can point to higher IPO prices as a credible alternative to a buyout, which buyers must match.

3)   Dry powder: PE firms have raised $95B in 1Q14.This is the highest amount since the heady pre-crisis days. Consequently, the fund raising tail will once again wag the PE dog as the money needs to be invested.

4)   Recaps: sellers can obtain interim liquidity thru a recap in the wide open debt markets.

5)   Strong stock market: sellers feel they can wait. This reduces the current availability of targets.

Not surprisingly, debt markets have responded with increased appetite for leverage to support increased buyer funding needs. Debt multiples have risen to over 5.6X EBITDA. This compares to the pre-crisis peak of 6.1X. Perhaps more important, the percentage of deals with funded debt multiples greater than 6X is 40% versus pre-crisis 50% level. This is important as U.S banking regulators have expressed concern over the growth of highly leveraged transactions exceeding 6X leverage. This could damper further bank funded leverage increases.

The current back-of-the- envelope funding gap, PPX of 9 less a debt capacity multiple of 6, now exceeds 3X EBITDA. As the London subway signs state-mind the gap. PE funds are attempting to mind the gap in the following ways:

1)   Operating improvements to increase EBITDA: there are credibility issues on size of improvements. There has to be some strategic basis to the expertise the PE firm brings other than just money. Pay particular attention to pro-forma deals which translate into EBITDA without the bad stuff.

2)   Asset sales: these can be tricky. The market can dry up. Thus, a bridge facility is needed. Also, the sale EBITDA X must be greater than the deal’s PPX. Otherwise, the EBITDA stream will be diluted and remaining debt capacity will decrease.

3)   Assuming your takeout multiple will exceed the purchase multiple. This is questionable given today’s high PPXs. Typically you need to fundamentally improve the target to justify a higher exit multiple, which gets back to point 1 above.

4)   Increase debt capacity thru financial engineering - but we may be reaching a limit at least for banking regulators.

We are approaching the fantasy finance stage in deal pricing as reflected below:

PE funds will continue to be funded by yield hungry investors into the stupid state. Nonetheless, just because you can do something does not mean you should. These types of situations usually do not end well for LPs as reflected in my wheel of misfortunate:

We appear to be in the “capital chasing deals” stage. Like riding a tiger, it is difficult to get off. As noted before in MergerProf the single biggest inhibitor of PE fund returns is overpaying for portfolio investments. This means paying a premium of 40%+ over the target’s pre-bid price. Compensating with an aggressive capital structure from an accommodating debt market further reduces the chances of success.

j

Shuffleboard, Chess and the Pilgrim, Hillshire Deal

Business strategy can learn much from chess, but in many ways it is considerably more complex.    In chess and in business, it is not enough to envision your next moves, you must anticipate your competitor's response to those moves and the other actions they are taking.  Thus an game theoretic approach is essential.

But the chess analogy only takes us so far.  In business, moves are made simultaneously, not sequentially as in chess.  In addition, the rules of the game (think regulations) are frequently changing and the space (chessboard) on which you play is constantly changing.  Moreover, your competition is not a single opponent but every player in your industry and every player in related industries.  

In today's news, the analogy to shuffleboard also seems appropriate, where a well placed move is slammed aside by a competitor.  Hillshire Brands had wanted to acquire Pinnacle foods for some time.  Recently it made a $4.3 billion bid for the company touting the synergistic possibilities of the deal.  

Those plans were disrupted today as Pilgrim Foods (owned by JBS)  offered to acquire Hillshire for $45. a share, a 25% premium to recent market prices.  However, the deal is contingent on Hillshire abandoning the Pinnacle deal.  The market prices of Pilgrim and Hillshire rose while those of Pinnacle declined.  

Also, of interest, is that Hillshire was aware of the interest by Pilgrim over two months ago.  In chess, white moves first and has a slight advantage.  One can only wonder if the Pinnacle deal was responsive and defensive, designed to thwart the revealed interest from Pilgrim.  

Unlike chess, the market continually appraises the value of the players.  The market price of Hillshire closed above the bid price of $45.  producing a negative speculation spread.  Apparently, the market expects further revisions to the Hillshire bid.  (Additional details are found in the Wall Street Journal.)

All the best,

Ralph

Astrazenca-Pfizer: Bird-in the Hand or Just the Bird?

Ordinarily we focus on buyer value destruction. The Astrazenca (AST) – Pfizer (PF) Drama illustrates sellers are also capable of snatching defeat from the jaws of victory. PF offered $120B - 45% in cash- representing a 45% premium to AST’s pre bid price. PF’s premium was based on cost synergies and tax savings from a planned Tax Inversion. AST claimed the bid undervalued the value of their drug development pipeline and the firm by at least 7% and rejected the offer. AST’s stock price dropped 11% upon the rejection while PF’s rose slightly. (This post will focus on the valuation issues of the bid and ignore the political issues of potential Job Cuts and U.S. taxes.)

AST’s sales and income have fallen from $33.5B and $12.7B in 2011 to $25.7B and $3.7B, respectively, in 2013. The large decline is due to the Patent Cliff faced by many firms in the big phrama industry. AST alleges –warning: hockey stick alert - its new drug pipeline will return sales to 2011 levels by 2017. Furthermore, 2023 sales will increase to $45B - a 75% increase over current levels.

This raises a classic valuation duel. Is a $120B bird in the hand now worth more than a bush containing the promise of something –TBD - larger in 10 years? All valuation questions involve three questions:

1)   How Much: what are the cash flows - not just revenues but the costs and investments associated with a 75% sales increase over 10 years?

2)   How Long: gets to the time value of money- more dollars are needed in 10 years to offset a current dollar.

3)   How Sure: how risky are the cash flows?

The market response to these questions for AST was reflected in the lower pre bid price. Clearly the market did not share AST’s optimistic view of its product pipeline. AST can respond by stating the market did not understand the pipeline - but whose fault is that - investors or AST for not explaining it well enough? More likely, investors are concerned with the high-risk nature of developing drugs as reflected in the continued decline in AST revenues since 2011. So what is going on here? My belief is management is trying to preserve its jobs by staying independent - the shareholders be damned.

Hopefully, shareholder outrage over management’s rejection of a valuable bird in the hand in exchange for receiving a management bird in the face will result in one of the following:

1)   Shareholder Action will force management to reconsider the bid

2)   Replace management and the board - bring in the lawyers

3)   Tie management’s compensation to the targets they believe justify the rejection. If management wants shareholders to roll the dice on the new drug pipeline, then management should join the shareholders and put its money where its mouth is and wager their future compensation - ante up boys.

OMG you can’t make this stuff up-

J

Shareholder Lawsuits May Prove More Costly

We've noted the likelihood of being sued after completing a deal, especially a large one.  An article in the Wall Street Journal suggests that a recent court ruling may make those suits less attractive to plaintiffs lawyers.  In particular, companies are adopting a clause that requires plaintiffs to pay the firms legal fees if a suit fails.  The court upheld a bylaw a company had adopted requiring such payments.   The article also reveals declining awards for plaintiffs' attorneys over recent years. 

All the best,

Ralph

Cooked Geese and Boiled Frogs

We have discussed how the worst deals are done in the best of times. It reflects the pro-cyclical nature or M&A-merger waves. This in turn highlights a pro-cyclical risk appetite of managers. Deal volume and prices plummet during a market downturn. Some managers complete some smaller transactions which are successful, and M&A interest is rekindled. An improving economy and rising stock market add fuel to growing volumes. Herding in the final stages of the cycle completes the process.

Unfortunately as we get further into the cycle, deals become more expensive and somewhat more risky. The changes at first are small and frequently ignored - like frog placed into a pot of water which is slowly heated. Attached is a recent American Banker Article on the subject which provides more details on the phenomena in the debt markets.

Preventing your goose from being cooked requires a disciplined process. This is especially true for large complex deals with high levels of Shareholder Value at Risk due to high premiums and integration issues.

J

Dual Ownership, Returns, and Voting in Merger

Among the major events of Drexel's Center for Corporate Governance is our annual academic conference featuring scholarly papers from top researchers around the world.  This year we had over 60 submissions competing for just 5 slots.  

One of the five papers selected for the conference is particularly relevant for our readers.  

Suppose you owned shares of a target firm and you were offered a healthy premia for your shares.  You might be inclined to vote for the deal.  Now suppose you also own the bonds of the target.  Before voting you'd need to consider the effects of the deal on your combined portfolio of the target's stocks and bonds.  The way you vote wouldn't just be influenced by your equity position.  Interestingly, there may be cases where your thoughts on the deal are different from that of a pure equity owner.  In particular, you might be willing to accept a lower premium for the equity if you also gained on the debt.

Now consider the fact that institutions are major  holder of a firms equity (typically more than 70% of a large firm) and that these institutions can also hold the target firm's debt.   You have the motivation for the paper  Dual Ownership, Returns, and Voting in Mergers by Andriy Bodnaruk and Marco Rossi  The abstract of the paper is below.  

 Dual Ownership, Returns, and Voting in Mergers 

Abstract 

We document that in M&As a significant proportion of targets’ equity is owned by financial institutions that simultaneously own targets’ bonds (“dual holders”). Targets with larger equity ownership by dual holders have lower M&A equity premia and larger abnormal bond returns, particularly when dual holders stand to benefit more from appreciation of their bond stakes, e.g., when their bond ownership in the target is large and the target credit rating is non-investment grade. Dual holders are more likely to vote in favor of the merger proposal. Our results suggest the presence of coordination of decisions within dual holding financial conglomerates in M&A targets. 

The complete paper can be downloaded here.

All the best,

Ralph