Merger Activity and the Stock Market

In spite of this week's dip in the market, the recent trend has been quite positive.  So too is the increase in deal activity (and IB profits!  see Goldman Sachs Profits Jump).  In fact, mergers are strongly correlated with the stock market and it is instructive to consider  some of the possible reasons.

• Hot markets are often associated with catalysts providing opportunities.  At the beginning of an upturn, mergers provide opportunities for rapid expansion and additional synergies from expanded sales.  As the business cycle matures and product markets become more competitive, mergers provide opportunities for the synergistic reduction in costs.  
• Deals are easier to finance in market expansions.  Credit becomes more widely available and the acquiring firm's stock is higher priced.  Indeed, the use of stock financing as a form of payment is correlated with market levels.  
• Related to this, it is sometimes conjectured that acquiring firms can snap up bargains by using their 'inflated' stock.  Not so fast - it is likely that many targets have also experienced run-ups in price.  The resulting 'bargains' may exist, but are not mechanically generated by rising markets.
• However, there is a theory that firms with overvalued stock can 'lock in' that valuation by buying hard physical assets with that inflated currency.  The ability to implement this tactic requires sellers to be naive about the bidder's inflated price and assumes the hard assets are not also overpriced.  Indeed, bidders using stock tend to underperform those using cash at the announcement of a deal.  More broadly, firms issuing stock tend to drop 1-3% in value upon the announcement.  Issuing stock seems to act as a signal - why issue stock if it isn't at least fairly valued and probably overvalued?
• Confidence - buyers tend to have increased confidence when their stock price is high.
• Among the most intriguing reasons given for increased activity in hot markets is the 'pool of exhausted managements' theory.  According to this theory, many owners hang on to their firms in downturns waiting to sell when prices again rise.  The idea makes intuitive sense and corresponds with some known psychological findings:  we often anchor our price expectations on a historically high price.  Nevertheless, it doesn't explain why bidders are more willing to buy at this time - unless one factors in one of the reasons in the above list.

In any event, here is hoping for a renewed market rise and more deal activity.

All the best,

Ralph

Market Turbulence

The current market turbulence triggered a 7%+ decline in the S&P 500 over the last few weeks. The Euro markets fell even more. The impact of this turbulence will be minor if it passes quickly. I believe, however, it may be more long lasting than many perma bulls allege. I do not think this is 2008 version 2.0. Nonetheless, the turbulence may have some legs - economic basis. Consider the following:

1)     Weak Global Growth: World Bank cut the global growth rate.

2)     Continued Deflation Fears: This is especially true in Europe. The reason underlying is the Debt Deflation hypothesis first outlined by Irving Fisher following the 1930s Great Depression. Just as in the 1930s, consumer balance sheets were devastated by the 2008-2010 Great Recession. Consumer asset values, primarily their homes, fell below their liabilities. Consumers curtailed purchases to pay down debt and repair their balance sheets. The consumption drop and the resultant drop in the velocity of money take years to play out. Reinhart and Rogoff estimate it takes 7+ years from the end of the financial crisis to get back to normal. Thus, we about mid way thru the cycle.

3)     Europe: Is a basket case with a lack of political will to address underlying structural reforms.

4)     Emerging Markets: Impacted by commodity price declines.

5)     China: Affected by declining end markets for their exports.

6)     United States: Is the tallest midget in the room for now.

7)     Ebola: The quintessential Black Swan. No one saw this coming and no one knows how this will end. Nature throws curve balls like this every now and then just to remind us who is really in charge.

8)     VIX: The rise in the volatility index signals a potential downward shift in investor risk appetite.

So what are the possible implications of the above malaise on the M&A market, which heretofore experienced a strong rebound? If the volatility continues, deals could be pulled, delayed or canceled. Consider the following:

1)     Buyers: Become hesitant because you cannot project a price. The standard 30% premium over market is difficult to apply because the price to which you apply it against keeps changing. Whatever price you use could be even lower next week. Also, for deals using stock, a drop in the buyer’s stock price makes the deal more expensive regarding EPS dilution.

2)     Sellers: Are reluctant to sell when their market price is falling. Most sellers tend to anchor on their stock’s 52 week high. They believe the price could recover if they wait it out. This may be a long wait as one of the factors underlying equity prices, a strong IPO alternative, has shut down. Investors find it difficult to price IPOs when prices are so volatile.

3)     Hostile Takeovers-Activism: Could increase as a rising market no longer exists to cover over operating problems.

4)     Private Equity: The current M&A growth has been largely driven by strategic corporate acquirers. Private equity has been relatively quiet despite having substantial drop powder. As corporations drop out of the game PE firms may find less competition.

5)     Documentation: See the increased use of risk shifting clauses in Sale and Purchase Agreement and financing commitments.

6)     Cost of Capital: The Ten Year Treasury has fallen during the turbulence by over 30 BP to just over 2.2% as investors seek a safe haven. Rather than lowering the cost of capital as many pundits believe, the cost of capital may have actually increased. Consider:

a.     Debt Spreads: Have surged to their highest levels in over a year. Debt availability for the edge of the envelope 6X+ FD deals is also being tested as investors withdraw funds from high yield bond funds

b.     Equity Risk Premium (ERP): The ERP is usually calculated by taking the S&P 500 earnings to price ratio and subtracting the real 10 year rate, which is essentially 0 now. The 7% drop in the S&P means, if it holds and changes investor expectations, then ERP has also increased.

What are we to do? First, do not panic as this too shall pass. The factors supporting increased M&A still remain largely intact. The key is to remain solvent, liquid and to paraphrase President Obama - don’t do stupid stuff. Next, remain ready to move quickly as opportunities appear and conditions improve. A bull market makes us appear like geniuses. It doesn’t take a genius to recognize that volatility and deals do not mix well. So as your airline captain would say - ladies and gentlemen please fasten your safety belts we are experiencing some turbulence.

J

Deal Activity Over Time and Recently in the Netherlands

Next week is our Acquisition Finance Class in Amsterdam.  In preparation for that class and our discussions, I've updated the information on Deal Activity and trends since 1985 and recently as well.  Here are a few slides related to that discussion.  There is much to say about these charts and trends, but I'll be brief in this blog.

First, look at deal activity over time since 1985.  There are two obvious spikes in activity centering on the Dot Com boom and just before the recent crisis.  In general European activity has tracked that in the US.

The method of payment over time has been predominately cash and more so in recent years.

Finally, I list some interesting charts related to Deal Activity in the Netherlands and in Europe.

We'll skip the blogs during class next week, but perhaps I'll see you in Amsterdam!

All the best,

Ralph

No-This Time is Not Different

Leverage is increasing. YTD 50% of LBOs have FDX (funded debt multiples - Funded Debt/EBITDA) greater than 6X - 15% have FDX greater than 7. Additionally, creditor structural protections like financial covenants are disappearing. The driver is the increase in PPX (purchase price multiples - purchase price/EBITDA). Current LBO PPXs have increased two full turns to 11.5X since 2013. This reflects the increased pressure from competing strategic acquirers, a strong stock market and a recovering M&A market. PPX always increase to absorb any rise in debt capacity. Just as the Cash Burn Rate is important for venture capitalists so is the PPX for private equity sponsors - it represents a LBO burn through of value.

Some believe this time is different and the increasing debt levels are affordable. They believe an improving economy, low rates and low spreads translate into strong interest expense coverage and low default rates. They do, but this is a cyclical business and these pleasant facts can quickly change as we saw during the financial crisis when defaulted or restricted loans rose to double digit levels.

FDX greater than 6X mean you cannot retire principal during the original term of the loan. This means the ultimate repayment source is either a refinancing or trade sale of the company. These depend on markets remaining open and liquid - which is clearly not always the case. We have moved in Minsky terms from a hedged phase (2009-2013) in which debt principal and interest can be serviced from internal cash flow to a speculative phase. During this phase only interest can be covered from internal cash flow. The final Minsky phase before a correction is the Ponzi stage in which neither interest nor principal can be internally covered. Instead they must both be refinanced as was the case the last Ponzi stage of 2007. We are, hopefully, a few years away from this, but no one knows for sure when markets will turn. All we do know is they can and do turn violently when the refinancing wall is hit.

This situation has been noticed by banking regulators. They have strongly signaled that transactions with greater than 6X FD ratios will be subject to greater review. Last year they criticized over 40% of the large syndicated loans, known as shared national credits or SNC, which are heavily weighted towards leveraged transactions. Recently, they have signaled out Credit Suisse for underwriting loans exceeding the 6X guideline. This is understandable as CS is a major LBO loan sponsor with a 13% market share and generating over $400mln in loan fees this year alone. CS will push to defend its market position. Regulators may require CS to hold more capital and criticize banks participating in their loan syndicates via the SNC review. Ultimately, this will push more of origination effort to non banks just as most of the ultimate holders of leveraged loans are now non bank CLOs.

This will not end well. As Hemingway stated about bankruptcy - first it happens slowly, then suddenly. It is difficult for banks like CS to resist getting dragged into the fray. How can you choose not to play the game on the field especially when your competitors are doing so?  Citi’s Chuck Prince noted, as long as the music is playing you have to keep dancing. The regulators are trying to turn down the music. Whether they succeed this time is questionable.

J

Common Errors in Valuation

The heart of merger analysis is valuation.  We spend considerable time in our acquisition finance course stressing best practices in valuation.  We've noted many times that value is estimated while price is paid.  Hence, errors in valuation can be crucial to deal success.  In this spirit, we note the article entitled 119 Common Errors in Company Valuations".  The abstract is below.  The complete article can be downloaded here.  

119 Common Errors in Company Valuations

Pablo Fernandez 

University of Navarra - IESE Business School

Andrada Bilan 

University of Navarra - IESE Business School 
This document contains a collection and classification of 119 errors seen in company valuations performed by financial analysts, investment banks and financial consultants. The author had access to most of the valuations referred to in this chapter in his capacity as a consultant in company acquisitions, sales, mergers, and arbitrage processes. We classify the errors in six main categories: 1) Errors in the discount rate calculation and concerning the riskiness of the company; 2) Errors when calculating or forecasting the expected cash flows; 3) Errors in the calculation of the residual value; 4) Inconsistencies and conceptual errors; 5) Errors when interpreting the valuation; and 6) Organizational errors."

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1025424

All the best,

Ralph

Blackstone’s Hilton Deal: The Best LBO Ever?

A recent Business Week article proclaimed Hilton the best LBO ever. This was based on the size, $12B, of Blackstone’s unrealized gain. Some details are as follows:

1)     Investment Size: Blackstone’s initial fall 2007 equity investment was $5.6B. This represented Blackstone’s largest single equity investment. It contributed another $820MLN as part of a 2010 restructuring. Blackstone had written off 70% of its investment in 2009 reflecting poor performance as the financial crisis impacted hotel occupancy.

2)     Deal: the deal was concluded at the height of the pre crisis LBO boom. It was overpriced, double digit purchase price multiple, and over leveraged with just 20% equity and a double digit funded debt multiple. The $20B in debt, was primarily Covenant-Lite loans.

3)     Restructuring: lack of financial covenants allowed Blackstone to control the restructuring process. In 2010, they contributed additional equity, got lenders to reduce billons in debt (AKA forgive) and extend loan maturities.

4)     Winter 2013 IPO: a partial $2.4B IPO was completed which gave Blackstone’s Hilton equity interest an implied gain of $10B. The stock price has improved. The implied gain now stands at $12B the largest single transaction gain for a LBO which represents a 2X multiple of investment (MOI).

I question whether this is the best LBO ever-particularly from the limited partners’ (LPs) viewpoint.  Consider the following:

1)     Unrealized Paper Profit: Blackstone and its LPs still have received no cash. They are feeling better than in 2009 with a gain instead of an unrealized 70% loss for sure. The PE model is based on the precept that there is no exit until cash is returned. Some will argue that it is smart to hold on to the stock because it is appreciating. Remember, that Blackstone gets 20% of any stock appreciation. It would be better for LPs to get the cash and buy Hilton on their own to keep 100% of any gains.

2)     Not Risk Adjusted: This investment is volatile and represents a huge concentrated bet of LP capital. Wonder if LPs are happy with the returns given the IRRs-especially what they could have received on an alternative high risk assets. Consider an equally leveraged $26B equity portfolio in 2007 would have also yielded a $12B gain.

3)     So-So IRRs: IRRs are mediocre even based on the implied values. The December, 2013 implied IRR was in the mid teens, while the current IRR is in the low teens. I am sure these are below what was initially projected when the investment was proposed.

4)     Over Betting: You can always manufacture high dollar returns by investing large amounts. This does not mean, however, you have created value. As the Kelly Criterion shows, beyond a certain point, taking more exposure becomes suboptimal due to a higher risk of ruin in bad states-i.e. you crap out of the game too early.

I am not taking anything away from them - I am glad things worked out. Sometimes, it is better to be lucky than smart. The Business Week story mistakenly assumes the current positive outcome flows from the original decision. The Hilton gains, however,  come from a lender value transfer who accepted a large discount on their loans and leverage - not from the investment target selection.  The deal does show, however, how PE, Wall Street and apparently some journalists think. Despite what you learn in business school, they do not care about risk or the time value of money. The key metric for them is MOI. Additionally, it demonstrates the value of covenant - lite loans for borrowers, which comes at the expense of lenders.

J

Deal Making in the Beer Industry

The recent merger activity in the beer industry illustrates several interesting items that we typically cover in our upcoming Acquisition Finance course.  Given that the class is held in Amsterdam which is the home of Heineken only accentuates the interest.  

To recap:  Heineken rejected overtures from SABMiller to consolidate.  Meanwhile Anheuser-Busch InBev is reportedly raising a financing package of over $100 million purportedly to acquire SABMiller.  What can we learn from this activity?

Mergers occur in waves within the economy.  Merger activity is known to correlate positively with the stock market and has for more than a century.  It is not surprising that we are seeing increased activity near market peaks.

Mergers occur in waves within industries.  This phenomena is more interesting.   Industry merger waves occur because some catalyst makes deals attractive.  Typical catalysts include changes in consumer tastes, new technologies, new markets, changes in regulations and overcapacity within an industry.   Each creates opportunities (or needs) to merge.

As internal growth declines, companies seek deals.  This can be value enhancing or merely a ploy to avoid the realities of the marketplace.  Growth at Anheuser-Busch InBev is now projected to be much lower than in the past.  According to the Wall Street Journal, SAB generates 70% of its earnings from emerging markets which could nicely complement the market positions of Anheuser-Busch InBev.

Mergers occurring early in a deal cycle tend to generate higher returns.  This makes sense as companies enjoy the lower hanging fruit first.  Companies with the greatest opportunities for improvement or synergies are typically acquired first.  

Mergers can be a defensive move.  This could have been a reason SAB was courting Heineken, although from geographic diversification point of view the Heineken combination also makes sense.

Ownership structure plays a crucial role in mergers.  According to the WSJ, Atria and the Santo Domingo family control about 42% of SAB.  Such large positions are likely associated with increased monitoring and avoidance of bad deals.  When ownership structures are family dominated, hostile deals are quite unlikely.  Heineken Holding N.V. owns just over 50% and the family controls that firm.  

Of course, all this is best contemplated while trying the products mentioned.  I look forward to having a Heineken in Amsterdam while overlooking the Amstel river.

All the best,

Ralph