Merger Waves in the Oil Industry?

We've talked about merger waves in previous posts, noting that typically some catalyst occurs that makes acquisitions attractive in a particular industry.  Typical catalysts include changes in regulation, consumer tastes, or economic factors within an industry.  Something changes within an industry that makes buying companies desirable.  A major catalyst affecting oil companies is the dramatic drop in the price of oil.

This isn't the first time this has happened.  It occurred most famously in the 1980s as oil dropped from $40 a barrel to $10 and interest rates rose from single to double digits.  Picture how those two changes factor into the present value equation and you will know why drilling for oil became a negative net present value situation.  Anyone who could turn off the let's drill button could create value in a company.  A famous case is the acquisition of Gulf Oil.  It was trading at $38 before the acquisition and overnight the price jumped to $80 as acquisition became imminent.  The source of the $40 plus gain per share can be completely explained by the value created by ending drilling.

Today's situation is a little different, but it looks like we are again set for a wave of oil mergers following the  Royal Dutch Shell's $70 billion acquisition of London's BG Group  announced Wednesday.

As an article in today's news notes, it now appears cheaper to buy oil by buying companies on Wall Street than by drilling for it.  It will be interesting to see what happens.

All the best,

Ralph

Forgive Them (Not)-They Do Not Know What They Do: Hewlett Packard Again

Hewlett Packard’s (HP) Autonomy acquisition is back in the news again. I previously covered this tale of woe back in 2012. HP was the target of lawsuits following the botched acquisition. The terms of a recently settled suit are pretty interesting. How HP missed “accounting irregularities” so large that they were forced to write-down $8B of the $11B acquisition soon after the close has always puzzled me.

As part of the settlement HP agreed to establish an M&A related risk committee to incorporate the views of the investment, finance and technology committees - now there is a novel thought (get other points of view). Also, they will require their due diligence teams to be better trained - you mean they have to know what they are doing? My God, now they decide to better handle M&A risk and due diligence more than three years after the disastrous Autonomy deal! What were they doing before that deal and since it closed? To be fair this is probably legalese - form over substance.

What I find especially appalling is that the current CEO, Meg Whitman, was one the board members who approved the deal over the objections of HP’s CFO - so much for accountability! You don’t need enhanced risk committees and better due diligence to know that it is a BIG-BIG-BIG red flag if the CFO objects to a deal. Some other less obvious indicators include:

1)     Pressure to grow: looking to cover up weak core operations with a large acquisition is always troublesome as was the case here.

2)     Transformation: big acquisitions away from your core rarely end up well.

3)     Over Priced: the CFO objected, inter alia, that the deal was massively over priced at 11X sales v comparables at 3X.

4)     Dissenting views ignored: like the CFO’s.

5)     Weak Due Diligence: everyone knew the answer the then CEO wanted and no one was going to stand in the way-at least not if they liked their job.

The incident is another example of a board rubber stamping the CEO’s wishes. Of course boards cannot run the firm. This does not excuse boards from exercising some minimum of oversight and basic judgment. This is critical when the board’s CEO selection track record is weak - as it was with HP prior to Autonomy with substantial CEO turnover. CEOs are frequently selected based on luck not skill. A CEO candidate who has a “successful” track record is deemed skillful, when in fact he could have been simply lucky. Such CEO candidates are frequently over confident AKA decisive. Thus, absent a strong board they are prone to behavioral errors in an acquisition setting.

J

Listening to Markets and Hearing Government

Readers of this blog know that Joe and I are strong advocates of listening to the market - being aware of current conditions and opportunities.  Certainly, in structuring a deal we must contend with economic reality; a situation suitable under one set of economic conditions may be far from optimal in another.

Many analogies and cliches apply - e.g., play the cards you are dealt.  The best quarterbacks in American football learn to read the defenses and take the best opportunities.  So too should we read the market and find the best solutions.

In the best of situations, markets reflect the economic equilibria of competitive forces.  But alas, they also reflect governmental restraints.  The Wall Street Journal recently published a very interesting article showing the impact of government activity on deal flow.  The article, entitled, "Buyout Firms Feel Pinch From Lending Crackdown" suggests that regulatory guidelines favored by the government are impeding deal activity and deal design.  In particular, the author notes that regulators urged banks to avoid putting debt greater than 6 X EBITDA in most industries.  Further, "So far this year, 21% of U.S. private-equity deals have been financed with leverage at or above levels regulators generally consider risky..." down from 35% last year.  The chart below (from the WSJ article) captures some of these dynamics.

The merits of this regulatory guidance is a subject for another debate, although regular readers can guess where our feelings lie on the subjects of free markets, free choice and the law of unintended consequences.  To be fair, Joe and I have both warned of the dangers of highly leveraged deals and over-excited markets, but we prefer to take things on their merits and consider things in context to all of the other factors that go into structuring the deal.  One size rarely fits all.    But like it or not, the regulators are part of the world we mentioned and hence, their impact must be factored into our decisions.

All the best,

Ralph

Venture Capital Valuation Confusion

How real are the nosebleed high implied venture capital valuations being tossed around? For example, Pinterest raised $370 million which gave it an implied value of $11 billion. Snapchat has an implied $15 billion value following an Alibaba investment. The number of “pre-IPO” venture capital backed firms with implied values exceeding $1 billion (AKA unicorns) has increased from under 50 last year to almost 80 this year. My suspicion many of these implied values are “funny money” i.e. not real.

What passes for valuation in venture capital is really relative pricing based on what someone else paid for something similar, which could be wrong. This is especially true in today’s environment where investors are driven more by FOMO (fear of missing out) than reason. Implied value is at best a proxy for market value and is often misleading. Implied value is determined by dividing an investor’s dollar investment by the proposed ownership percentage the investor receives. For example if you will receive 10% of the firm for a $10 million investment, then the implied value is $100 million.

Looks simple, but there are serious complications to consider including the following:

1)     The ownership percentage is a negotiated item reflecting relative bargaining positions and not a traditional market price. Comparables used to substantiate declining ownership percentages can result in an overvaluation when the comps themselves are overvalued.  Venture firms flush with newly raised capital have reduced bargaining power with potential issuers. Thus, they are accepting smaller ownership percentages which inflate implied values.

2)     A reality check is needed to justify the implied price. This can be estimated by determining the future performance required to justify the price paid. The aggressive future performance estimates, currently exceeding 15X+ next year revenues, are often based on continued assumed weak competition due to first mover or network effects which are as elusive as merger related synergies. Thus, the needed future performance is becoming more difficult to achieve.

3)     Beware of receiving different terms. Venture firms usually invest in preferred not common stock. Liquidation preference (AKA the ratchet) differences in preferred stock can impact real values and are often ignored in implied valuations. These liquidation preferences allow the holder to receive more shares upon a liquidation event (e.g. a sale or IPO) if the price received upon that event is below their investing value. This gives certain investors an in-effect look back re-pricing option, which is valuable and needs to be considered when pricing an investment. Warren Buffett refuses to invest in situations when he is not pari passu with other investors and so should you.

4)     Limited financial information, due diligence and issuer financial infrastructure increases the risk of error or worse yet-fraud for pre-IPO unicorns. Also, there is no guaranty of an IPO; hence the investments are illiquid. Holding a minority position in a non public firm is a potentially unpleasant experience. Even if there is an IPO, it may be at a lower than expected price, which can trigger a ratchet.

      You can only accurately value your venture capital investment twice-once when you make it and once when you exit. Relying on implied values going in can lead to some nasty surprises when exiting the investment. The implied values for many unicorns may not be real.

J

Merger Waves: Are Private Firms Different?

We've talked quite a bit in these posts about merger waves. Previous research finds differential results for firms that merge before, during and after a merger wave in their industry.  Today's post links to new research that finds interesting results regarding how public and private firms participate in merger waves  and the resulting (and different) outcomes. The article, is entitled, "Private and Public Merger Waves" and is authored by Vojislav Maksimovic, Gordon M. Phillips and Liu Yang.  The abstract is below.

                                   Private and Public Merger Waves

Abstract:      

We examine the participation of public and private firms in merger waves and productivity outcomes. We show that public firms participate more than private firms as buyers and sellers of assets and their participation is more cyclical. Public firms are affected more by credit spreads and aggregate market valuation. Public firm transactions are also impacted positively by their stock market valuations and liquidity. Public firm acquisitions realize higher gains in productivity, particularly when their transactions occur on-the-wave and when their firms' stock is liquid and highly valued. We show that our results are not just driven by the fact that public firms have better access to capital. Using productivity data from early in the firm's life, we find that better private firms subsequently select to become public and that these initial conditions predict higher participation in asset purchases and sales five and more years later.

The complete paper can be downloaded here.

All the best,

Ralph

Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J