Arbs - Smart, Influential, or Both?

Consider several interesting, stylized facts about the role of arbitrageurs in acquisitions:

• Once a firm is in play, the new shareholder base is likely to be the arbitrageurs as existing shareholders sell out to lock in the jump in price surrounding the announcement of the deal and avoid the risk of deal failure.
• Arbs make a living taking this risk of deal failure.
• Most arbs don't try to predict who will be a target but take a position after a deal has been announced
• The risk profile of arbs is very low - arbs hedge their positions to minimize as much risk as possible.   In a stock deal, for example, they might go short the acquiring firm and go long the target, locking in the spread between the post announcement price and the offered price - usually a few percent.
• Arbs favor the rapid completion of a deal and when deals close quickly the few percent gained in the spread becomes a very high return when annualized.
• Arbs can lose their shirt if a deal collapses or they are not properly hedged.
• Arbs tend to earn superior returns around acquisitions.

So lets take the last point.  It has been known that arbitrageurs can earn abnormal returns around mergers.  What hasn't been clear is why.  There are two theories - one that arbs play a passive role and the other that they play an active role in facilitating deal completion.

The passive theory is that arbs are better at predicting deal success - studying the dynamics of a deal, the positions of the players and the likely regulatory positions.  They then take a position when the odds are in their favor.

The active theory is that arbs actually influence the outcome of a deal - that their shareholdings help tip the balance of power and facilitate deal completion.

In that article below, published in the Journal of Financial Economics co-author Jim Hsieh and I find evidence supporting both theories.  The abstract is below.  A copy of the published article is available through the link above.  A copy of the working paper is available here.

Determinants and Implications of Arbitrage Holdings in Acquisitions

Abstract:      

This study investigates arbitrage activities and their impact on acquisitions. The literature contains arguments for both passive and active roles of arbitrageurs during the takeover process. Larcker and Lys (1987) suggest that arbitrageurs are passive, having superior ability to predict offer success. Cornelli and Li (2002) and Gomes (2001) model arbitrageurs as active, influencing the terms and outcome of offers. We find evidence supporting both arguments. Using a simultaneous-equations framework to recognize endogeneity, we analyze 608 acquisition bids over the 1992-1999 period. Consistent with the passive arbitrage argument, the change in arbitrage holdings is greater in successful offers. However, changes in arbitrage holdings are also shown to be an important determinant of the probability of success, bid premia, and arbitrage returns. In addition, the change in arbitrage holdings is positively associated with both revision returns and the occurrence of subsequent bids within one year after initial bids are terminated. Overall, we find that merger arbitrageurs play an important role in the market for corporate control.

All the best,

Ralph

Finance Debt Fetish?

The go-to recommendation from many consultants and academics is to lever up your firm to increase your tax shield, lower your WACC and fend off activists. This approach may fit for some mature firms. It is, however, less well suited for other firms.

A useful approach to setting debt policy as reflected in a firm’s actual or implied debt rating is based on a firm’s life cycle. Consider the following:

1)     Early and growth stage firms: most of their value is reflected in growth opportunities from assets not yet in place. They have negative free cash flow due to operating losses, high business risk and high CAPEX. Hence they need flexibility to complete their investment plan and maintain access to capital. Such firms have high financial distress costs. Furthermore, they have limited taxable income i.e. tax shields have limited value. Such firms should and do have low debt levels.

2)     Mature firms: generate more cash than they can profitably invest due to high operating income and reduced investment needs. Business risk has decreased and the need for financial flexibility is low as is business risk. Additionally, they have high taxable income in need of tax shields. Finally, agency/incentive issues become prominent regarding investment allocations. In these circumstances, increasing debt makes sense. Witness the “old” tech firms like Apple that have pressured by activist to increase debt level to reduce the risk of misallocated capital. Also confirmed by consumer non durable firms which spend time on tax planning, including use of debt related tax shields, to reduce their tax burden.

3)     Declining firms: here the emphasis shifts from value creation and taxes to value transfers among the firm’s various claimants. Debt holders, often purchasing the debt in the secondary market at a discount, are looking to squeeze-out shareholders and gain control of the firm’s assets in a disguised bargain purchase. Equity holders are seeking to protect their interests. The Caesar’s Palace’s bankruptcy has highlighted questionable transfers by PE firm Apollo to shield assets from creditors.

In addition to life cycle and taxes there are other reasons firms may favor debt. These include:

1)     Information asymmetry discount (AKA Pecking Order Theory ): debt is a contractual obligation v equity which is a residual claim. Hence, there is more informational uncertainty regarding equity, and equity investors require a higher discount to induce them to commit. Managers recognize this fact and exhaust internal funds and debt capacity before issuing additional equity.

2)     Ownership/Control: maintaining ownership and control (ownership v earnings dilution) is very important for private and smaller closely held public firms. Thus, equity is not a preferred funding instrument.

3)     Discipline: agency issues arise whenever management’s interests diverge from shareholders. Debt can provide the discipline needed to hold management’s feet to the fire. This is a driving force behind many LBOs (agency costs).

4)     Signaling: issuing equity for mature firms usually results in a stock price decline. Investors view the raise as a signal that future cash flows will be less than expected. Debt must be serviced (P&I). Management would not issue equity if they thought it was undervalued.  Conversely, management would not issue the debt unless it thought the firm could repay it.  Consequently, debt issues are viewed by investors as neutral.

5)     Value Transfers: see the declining firm discussion above. Creditors attempt to protect against this include seniority, security and covenants. Legal protections include substantive consolidation, fraudulent conveyance and equitable subordination.

The above framework can aid managers seeking to make capital structure decisions.

j

Valuation in M&A - Reports from the Field

In teaching finance to MBAs, I stress an analytical approach to decision making and strive to give the students the latest tools of our field and to discuss the latest empirical and theoretical research.  But I also stress that 'People Make Decisions', not algorithms or analytical techniques.  Also, it is people who implement decisions.  Certainly, this is crucial in the field of mergers where integration remains one of the major concerns.  Finally, I note that there is an Art and a Science to finance.  We can teach the science, but the art is nuanced and requires a great intuitive grasp of the subject blended with experience.

Here is an interesting article on how practitioners are actually valuing companies in M&A transactions.  It makes the same points.  The authors interviewed investment bankers who confirm use of the techniques often discussed in these posts: discounted cash flow and comparable transactions.  The article also highlights the use of judgement in making these decisions, noting:

"While leading practitioners routinely use DCF methods in mergers and acquisitions (M&A) valuations, the application is often far from “routine”; it requires art and judgment in the face of inherently uncertain business forecasts such as those surrounding merger synergies. Our results serve as yet another reminder that analytic techniques such as DCF do not make decisions but only inform them."

From "Company Valuation in Mergers and Acquisitions: How is Discounted Cash Flow Applied by Leading Practitioners? by W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins"

All the best,

Ralph

Lessons Worth Remembering

Warren Buffett’s letters are always worth reading. The 2014 letter is no exception. In this post I will comment on three acquisition related topics raised in that letter. The first topic concerns risk. He highlights that risk is not volatility. Risk is the exposure to consequences from uncertain events leading to permanent capital loss. Academics focus on volatility because it is easier to measure and quantify than the exposure based definition. Nonetheless, putting a probability distribution (usually the highly questionable normal distribution) on an event does not make it less certain. Worse, it can lead to unjustified over confidence leading to Black Swan type surprises. Most of what passes for risk analysis is nothing more than simple extrapolation of recent history. It is experience v exposure based. Furthermore, it ignores perhaps the biggest risk of all in M&A; namely price risk (see next paragraph). We should instead focus on total v systemic risk and use scenario analysis and sensitivity charts to gauge its effect.

Next, is the need to distinguish intrinsic value from price when evaluating acquisitions. Premiums to market and comparable transaction multiples relate to the price you have to pay now. Intrinsic value concerns what you hope to receive in the future. They are not the same thing. Keep in mind the following:

1)     What you pay = pre bid price + premium

2)     What you get = standalone value + synergies

3)     Usually the pre bid price equals the standalone value - if markets are reasonable efficient

4)     Thus, the transaction’s net value added depends on synergies exceeding the premium

Synergies are of course an expectation-hence risky as they may not materialize. The key is to avoid fanciful synergies-leave a margin of error/safety to cushion your downside if something unexpected (risk) occurs. Gauging the validity of synergies considers the following:

1)     Expense cuts are more believable than revenue growth

2)     Acquirer’s track record. An experienced acquirer has better chance of achieving synergies

3)     Expected performance consistent with industry base rate

4)     Acquirer is the best owner of the assets based on business model fit

Last, avoid playing the EPS bootstrapping game. Initially, you can always increase EPS by either acquiring a firm with a lower PE ratio than yours (using your stock as currency) or borrowing to acquire the target’s earnings stream. Post close your PE ratio will adjust to reflect the quality of earnings, growth and risk involved - AKA there” ain’t no free lunch or magic”.

The above represent simple principles to follow when in the heat of a transaction. Although simple to express they can be difficult to apply and seem to be constantly re-learned .

j

Building the Defensive Moat Rather Than Cleaning Up the Castle?

Yesterday's DealLawyer.comDealLawyer.com helped me uncover this set of information from FactSet on poison pills issued last year.  Before we get too excited about the graph, let's remember that we're dealing with just 18 observations here.  Still it is interesting that a new rationale for pills is added in a few firms - protecting Net Operating Losses.  While these losses are indeed a valuable asset, it is ironic that they would be protected through a poison pill.  Indeed, poison pills are designed to prevent hostile acquisitions.  Hostile acquisitions, of course are often motivated by a belief that additional value can be created at the firm, like... for example... when a firm is experiences losses!

Paul Malatesta and I did the first academic analysis of poison pills beginning our study during the winter of 1985.  At the time only 14 existed!  In November of 1985, however, the courts upheld the legitimacy of the pill in the Household International decision.  By early 1986 our sample had increased to over 100 firms.  By the end of that year over 300 existed.  By the end of that decade, pills were ubiquitous.

In our initial study, we found that firms issuing pills were less profitable than the firms in their industry.  Wealth losses of 2-4% were experienced when the pills were announced.  In addition, the CEOs of these firms had lower stock ownership positions than the CEOs of firms not issuing pills.  Hence they had less to gain from the bid premia and much to lose from a hostile bid (their jobs).  We haven't analyzed the current set of pills, but see our post on Netflix and the poison pill.

All the best,

Ralph

Private Equity and Buffett Envy

Remarks from the  2015 Super Returns Conference have implications concerning the future of PE. The industry is suffering from mediocre returns and LP dissatisfaction. PE firms are struggling with ways to react. Some are becoming asset managers, others investment banks and others smaller and more focused. This is important because record fund raising has pushed up the amount of dry powder (committed but un-invested) capital to over $1.2T. The investment fire power of that amount combined with a normal leverage multiple is huge. The money will be spent. The question is how wisely and what future returns can be expected as PPX are now 12X.

Blackstone hinted it is considering following Buffett’s Berkshire Hathaway by making long term investments in large public firms to take them private. An example is Buffett’s partnership with Brazil’s 3G to acquire H.J.Heiniz. Essentially, they seek permanent capital not subject to traditional investment and liquidation periods. Such investment in partnership with sovereign wealth funds would seek lower returns in the mid teens (usual PE targets are 20 %+) over a longer term horizon of 15+ years (compared to 10 years for PE). Is it realistic to expect PE success in copying Buffett? Is his success repeatable by others especially if many try to copy it at the same time?

Let’s first explore the source of Buffett’s alpha. My understanding of his Approach is as follows:

1)     Focus on investing in wonderful firms at a fair price. Wonderful is usually represented by consistent superior EBIT/Total Assets returns. Also, he focuses on low volatility assets (low beta).  Fair price means low EBIT/Equity Value. Academics call this a value or Bet Against Bet strategy.

2)     The above returns are modest and need to supplement thru cheap leverage. Here is Buffett’s secrete sauce-the cheap funding from Berkshire’s insurance float. Academics studies confirm the better route to higher returns is leveraged portfolio of low risk assets instead of high risk assets (like VC?). You are essentially monetizing risk reduction thru leverage.

Point #1 above is not always possible-especially in fully priced bull markets like now. Buffett has the discipline given his majority ownership to sit on his hands and do nothing in these markets and wait for his pitch before swinging. Not everyone has this advantage.

My concern with PE firms trying a naive copycat strategy is they will miss the nuances involved in implementing a contrarian leveraged high quality value strategy. Consider:

1)     Do PE firms have the discipline to sit out long periods of high bull markets with limited opportunities to invest at fair prices?

2)     Buffett does not charge fees or skim a co investment percentage of gains. Will PE change their business models to accommodate this difference?

3)     Can they resist the temptation to invest in high risk firms (e.g. First Data)?

4)     Can they supplement their returns with stable cheap leverage?

My take is the Buffett wanabes are unlikely to succeed. The basic problem remains of too much money chasing too few good opportunities in a bull market. In the meantime expect more “I am like Warren” fund raising strategies to be used. Nonetheless, investors collectively must hold the market. Thus, it is hard to be consistently difficult.

J

Doing a (Large) Deal? Expect to Get Sued

A year ago we posted  "Doing a (Large) Deal? Expect to Get Sued" which discussed research by Matthew D. Cain  and Steven M. Davidoff.  They've updated their sample to include 2013 and we've updated the original post accordingly.   The numbers are even more striking today.  The updated, original post is below. 

A recent working paper by Matthew D. Cain  and Steven M. Davidoff entitled Takeover Litigation in 2013 provides some interesting statistics about the rise in merger related litigation.  Their Table A, reproduced below reveals a dramatic increase in litigation over the past eight years.  In particular, about 39% of deals involved litigation in 2005, while close to 97% involved litigation in 2013. Litigation rates over time Year Deals Litigation % with Litigation 2005 183 72 39.30% 2006 232 99 42.70% 2007 249 97 39.00% 2008 104 50 48.10% 2009 73 62 84.90% 2010 150 131 87.30% 2011 128 117 91.40% 2012 121 111 91.70% 2013 80 78 97.50% Total 1,320 816 61.80% Thus, the probability of being sued in a merger today is over 90%.  Keep in mind, however, that the size limitation on their sample is deals over 100 million.  The percentage would undoubtedly be smaller for smaller deals.  Also, as my friend Jan Jindra notes: "The result is, perhaps, not surprising, when private plaintiff attorneys are allowed to initiate class action lawsuits in names of nominal shareholder plaintiffs and finding a willing shareholder plaintiff is made easy and cost-efficient through the use of law firm internet websites. Rational economic agents, attorneys, find that filing a class action lawsuit circumvents the constraints imposed on derivative suits which are designed to limit opportunistic “strike” suits. Furthermore, ready availability of websites by law firms actively recruiting shareholders who have been involved in a merger helps in finding a shareholder plaintiff." See for example the website linked here. "These two ingredients make an increase in merger lawsuits likely." Certainly there are adequate reasons to have concerns about certain mergers and we've enumerated many in these posts.  Concern over the 'kneejerk' reaction of filing a lawsuit, however, is revealed in "Cash for lawyers - zero for you".  The article reports that over 70% of lawsuits resulted in no payment to shareholders.  Regardless of the merit of the litigations, the actions definitely increase the costs of mergers. They also increase the need for best practices in corporate governance and in planning and executing the deal.  We'll continue to explore these issues in this blog. Ralph