Private Equity (PE) Is From Mars - Corporate Strategic Buyers (CSB) Are From Venus

I have previously touched on the differences in Valuation and Capital Structure between PE and CSB. The differences go beyond these two factors and distort M&A averages. They reflect the differing incentives and objectives of the two groups of acquirers.

CSB have permanent capital and take a longer term strategic acquisition viewpoint. PE is transactional orientated with an intermediate investment horizon of 5-7 years. This reflects the temporary nature of their capital - 10 years per fund with a 5 year investment period. This distinction is critical. As Warren Buffett likes to say there are no called strikes in CSB M&A - you can wait for your pitch. In PE, the clock is ticking - there are called strikes. This difference raises the risk of forced errors for PE. I am not suggesting CSA does not error. Rather, I am suggesting PE errors have a different basis from CSB.

Some of style differences are as follows:

1)     Valuation:

a)     CSB use a WACC based DCF and perpetuity based terminal value.

b)     PE uses a cost of equity bases RETURNS TO EQUITY model with a 5 year exit multiple usually tied to the purchase price multiple.

2)     Debt Capacity

a)     CSB employ a permanent capital structure with an investment grade focus that is company determined. Additionally, they use simple funding instruments - straight debt and common equity.

b)     PE uses temporary capital structure focused on maximizing debt capacity. This means their capital structures are non investment and market not company determined. Also, they use complex structures with multiple debt layers.

3)     Value Added

a)     CSB value added is synergy related.

b)     PE value comes from financial engineering and exit multiple expansion.

4)     Affordability Constraint

a)     CSB EPS dilution from any required equity issuance serves as the main constraint. Typically prefer a dilution earn back of 2-4 years.

b)     PE maximum debt capacity and the IRR on the required equity (usually 35% of the price) serve as the main constraints.

5)     Holding Period

a)     CSB infinite

b)     PE 5 - 7 years with an outside limit equal to the fund’s life-usually 10years.

6)     Integration Risk Concerns

a)     CSB high as the acquisition is usually merged into the acquirer’s existing operations.

b)     PE low the target is usually treated on a standalone basis.

7)     Search Process

a)     CSB strategic focus

b)     PE opportunistic

8)     Incentives/Performance Evaluation

a)     CSB corporate level

b)     PE at the transaction and find level

Understanding the differences between PE and CSB allows a better understanding of their styles and allows improved recommendations.

J

Rejecting the Top Dollar

We’ve seen numerous multi-bidder deals this year.  (See, for example, Unique Synergies and theTyson Foods/Hillshire Merger.)  One of the more interesting is the current deal involving Family Dollar Stores.  Two bidders, Dollar General and Dollar Tree are seeking to own Family Dollar.  One of the bids (Dollar General) is clearly superior, yet management of Family Dollar favors the lessor bid of Dollar Tree.  One can wonder why.  (See Miriam Gottfried’s article in yesterday’s Wall Street Journal for additional details.)

 The Dollar Tree bid is valued at $74.50 a share.  The Dollar General bid is $80.   Advantage to shareholders: Dollar General.

Dollar Tree’s bid is 80% cash and 20% stock.  Dollar General’s bid is all cash.  Advantage to shareholders: Dollar General.

There is a breakup fee on Dollar Tree’s bid of $305 million agreed to by Family Dollar.  Dollar General said it would pay this.  Advantage to shareholders: Neutral.

Yet management of Family Dollar favors the Dollar Tree bid citing anti-trust concerns.  Are these valid?  True Dollar General and Family Dollar have similar business models, but there are other dominant competitors to the firms, namely Wal-Mart.  In addition, Dollar General has agreed to divest as many as 1500 stores in an attempt to head off any anti-trust issues. 

We have shown in our research that opposition by target management is the single biggest factor determining whether a deal goes through. So the opposition by Family Dollar clearly gives an advantage to Dollar Tree. The Dollar General bid is clearly superior from a shareholder’s point of view.  Management is supposed to represent the shareholders.  Management opposes the Dollar General bid.  Hmmm.  In view of the clearly superior bid by Dollar General, one must wonder at management’s own incentives and how (and why) they factor into the decision. 

Ralph

Mergers and Acquisitions: Market Update First Half of 2014

Our acquisition finance course this October in Amsterdam features a detailed look at the current European merger market.  Today's post contains some hightlights from the first half of 2014.

The global M&A market finally recovered from the crisis. M&A is at a 7 year high of $1.7T for the first half up from just over $1T for the same period last year. The U.S. represents about 40% of the total and is somewhat more active than Europe. This probably represents the stronger U.S. economic and stock market recovery compared to Europe. Interestingly, private equity related transactions represent only about 7% of the market compared to an average of 15%, and down from the pre-crisis 25% high. The reason for this, despite high levels of dry powder and substantial new fund raising, is the return of the corporate strategic acquirer (CSA). CSA have “crowed-out” private equity and offered record prices for large transactions. U.S. PPX are at recorded level levels of 15X+ compared to the pre-crisis of 12X and the post crisis low of just 6X. The number of deals greater than $10B for the half was 19 compared to 9 last year for the half.

The drivers underlying the return of CSA are as follows:

1)     Excess Cash: firms have large and increasing cash balances with limited deployment opportunities. Stock repurchases are difficult to justify given the 35%+ increase in the S&P over the past year.

2)     Rates: low rates and spreads translate into enhanced debt capacity and “cheap” funding.

3)     Pent-up demand (AKA mean reversion): the immediate post crisis blues appears to have past. Firms are returning to targets that had been tabled by the crisis.

4)     Positive Market Responses: ordinarily the stock market reacts negatively toward the buyer when an acquisition is announced - with average drops of 2-3%+. The current market reaction to announcements has, however, been positive with increases of 3%+ upon announcement. This reflects that the deals have strong strategic rationales - as is usually the case early in the M&A cycle.

5)     Return of Hostile Transactions: either you develop growth options or you become one. Hostiles now represent 20%+ of total M&A.

6)     Increased Confidence: rise in buyer stock prices has increased managerial confidence. Also, it provides an alternative funding currency - the buyer’s stock. The level of all cash deals has dropped to the lowest level since 2001.

Improving investor risk appetite promises to support continued robust M&A. Note the drop in CCC (lowest rated-highest risk bonds) from 3500BP in 2010 to around 600BP now which is close to the pre-crisis low of 500BP. Expect more aggressive transactions with higher debt levels as the cycle progresses. Also, expect the return of PE as the dry powder urge to buy becomes too much to resist. Of course, beware of potential geo-political risks and other black swans.

J

New Book for Acquisition Finance

This October we are using a new book for our Amsterdam course: Acquisition Finance - Structuring the Deal.  The book is Investment Banking by Joshua Rosenbaum and Joshua Pearl.  The book offers a step by step 'nuts and bolts' guide to valuing and structuring the deal.  The first three chapters review valuation by comparable companies, precedent transactions and discounted cash flow.  Chapters 4 & 5 cover LBOS and the last two chapters view M&A from the sell side and buy side.  It should be fun.  Of course, we will continue to use additional applied cases of actual deals to supplement the text.

A unique feature of our approach is Joe's experience and my academic background.  This produces a combination of sound theory and empirical evidence with lessons from the field.  The book is well suited for this approach.  If the material interests you, we hope to see you there.

All the best,

Ralph

Shareholder Activism Coming to Europe

Shareholder activism involves a minority shareholder with a significant non control ownership, 5 - 10%, seeking to influence of a firm’s strategy. It is directed at firms suffering from performance and governance problems. It has been active in U.S. and to certain degree in the U.K. Its shareholder economic impact is deemed largely positive - although activism is somewhat controversial with management and directors who do not like being second guessed. The same forces that spurred its rise in the U.S. and U.K. appear to spreading supporting an increase of activism in continental Europe-at least in certain countries.

The slow European recovery and resulting lagging company performance is encouraging investor groups to become more aggressive in change proposals. The investor groups include well known U.S. firms like Pershing Square and Elliot Associates expanding into Europe. European groups including Cevian and The Children’s Investment Fund also exist and the list is growing. It is somewhat harder to gauge the level of Euro activity as much of it takes place behind the curtains compared to the more public U.S. activity.

The financial crisis traumatized firms. Survivors, understandably, focused solely on surviving to the detriment of performance. In the U.S. investors started asking about performance again in 2011/2012 resulting in numerous activist actions. These actions were at first remedial, focusing on the return of cash, divesting noncore subsidiaries and reducing expenses. Now they have turned to strategic growth concerns - including the possible sale of the firm itself to better owners.

Europe appears a few years behind the U.S. in this regard with the current focus on remedies, primarily the return of cash through record dividends, not strategies. In Europe there is probably some more room for remedies. Euro firms tend to be more unfocused than U.S. firms. Consequently, Euro firms suffer from a much higher conglomerate discount. Shareholders, including long term pension funds and not just the alleged locus short termers, want to know about management’s longer term growth plans-internal and external M&A. Thus, Europe appears to offer rich pickings for activists.

The problem with Europe is it is a set of countries each with different rules and cultures. Consequently, activists need to recognize the process will be different in Europe. Based on the following:

1)     Legal System(s): the proxy rules differ not only from the well developed U/S./U.K. legal system, but also by country. Legal predictability is most predictable in Holland, Germany and Switzerland, and much less so in France, Italy and Spain.

2)     Nationalism: French firms are less likely to meet with upstart brash American activist firms than fellow French firms.

3)     Shareholder Ownership Structure: many continental countries have concentrated ownership among founding families, governments, foundations, and banks. These types of investors will side with management and likely remain hostile to any outsiders.

4)     Strategic/White Knight Acquirers: will have the upper hand compared to activists. Management may size on a sweetheart deal to protect itself at the expense of minority investors.

My prediction is activism will continue to increase in Europe, but at a slow speed than hoped for by many investors. Next it is likely to be local affair - French activists for French firm. Finally, activism will supported increased Euro M&A activity - both offensive and defensive.

J