Investment Banking: The Dark Side of Corporate Finance

Investment banker valuation and securities pricing are heavily used inter alia in IPOs (e.g. offering pricing ranges) and M&A (e.g. fairness opinion). They involve translating a firm’s expected operating performance into a price in markets subject to asymmetric information. The price estimates are often more influenced by momentum than fundamentals. Thus, they can diverge from intrinsic value based discounted cash flow measures-sometimes intentionally.

Investment bankers can help bridge the gap between price and value among buyers and sellers of capital and firms. They do so by posting their reputation (the value of which varies considerably) as a signal, for a fee, to give the parties comfort that the offered price is fair based on their due diligence and technical analysis. The analysis is based on well know business tools like discounted cash flow and risk adjusted returns-at least on the surface.

The techniques used, however, are frequently a fig leaf behind which many other factors (sometimes conflicting) are taking place. These include:

1)     Objectives: What price (value) is the investment banker seeking to justify for his client or himself?

2)     Inputs: How were the inputs selected based on the firm, industry and market considerations? There is a great deal of (black?)“art” (subjectivity) in selecting key estimates for sales growth, operating profit margins, taxes, working capital, CAPEX,  and WACC.

3)     Who does the Investment Represent? For example, with IPOs, although representing the issuer, the investment banker is frequently more concerned with maintaining good investor relations as the source of his long term franchise value. Therefore he is inclined to under price the offering.

4)     Reverse Engineering: Is the valuation really independent or reverse engineered to justify a desired result? Remember, Investment Bankers do not get paid unless the deal closes. As Warren Buffet notes -fees too often lead to transactions rather than transactions leading to fees. This why his 2014 annual report contains so many Investment Banking “slams”.

In theory, there should be no difference between practice and theory, but in reality there is a big difference. Surveys showing an alignment of academic valuation approaches and investment banking practice (see valuation from the field which references once such survey) should be taken with more than the customary grain of salt. Investment Bankers herd and like to hide behind “best practices” (i.e. “me-too-ism”) to look smart and reduce legal liability. No one wants to admit they are using “primitive” earnings multiples unadjusted for risk or the time value of money in their analysis.

Having practiced the black art for many years, I can assure you that Investment Bankers are in the sales business. Therefore, the real motivation behind the various valuation estimates must be considered when reading their presentation booklets. Cash flow matters, but the question is whose cash flow are we discussing-the client or the banker’s? The Salomon Brothers quote from Liar's Poker  says it best-“do you want to be a winner or the client?” Bottom line-do your own analysis and come to your own conclusions. Academic finance as practiced by Investment Bankers can be dangerous to your wealth.

Joe- a hopefully reformed ex-Investment Banker.

The Merger Fund

I've been an investor in the Merger Fund for a long time both for the risk adjusted returns it produces and for the wonderful discussions about merger activity in the most recent quarter.

The Merger Fund engages in merger arbitrage - betting on the outcome of deals.  Sound risky?  Not so fast.  The Merger Fund, like most arbs in mergers, hedges its bets, trying to lock in returns while minimizing risk.  The strategies that can be employed to do this can be complex, but let's just consider a simple example:

A target is trading for 30 euros and a bidder offers a stock deal suggesting a 40 euro bid price.  Right after the deal announcement, the price of the target rises to 38 euros, while the price of the acquiring firm settles at 60 euros.

We've talked elsewhere about the fact that the information above implies that, under simplifying assumptions, the probability of the deal being completed at 40 euros can be estimated to be about 80 percent.  But that is beside the point here.  A simple arbitrage strategy would be to short the appropriate amount of the bidder's stock and go long the target.  Assuming both stocks face similar market risks, this effectively hedges against market movements.

The hedge described is quite simple and not foolproof.  If the bid is abandoned and the target price returns to 30, the investor faces a substantial loss.  (There are other ways to hedge this, but we'll keep things simple here.)  More than likely, if this bidder loses, another bidder completes the deal at a higher price producing an even larger gain on the target than the 2 euro spread.  The original bidder would probably also experience price adjustments, perhaps gaining a bit and producing a slight loss for the investor.

But consider the returns if the deal is completed in, say,  two months: a 2 euro gain with little investment - in just a two month period.  

Now to be sure, many risks remain, but you get the idea. If you study the Merger Fund, you'll note that while its historical performance is below the S&P 500, so is it's volatility (and Beta).  It's Sharpe ratio is high.

Regardless, I offer the Merger Fund to you for the interesting commentary on deals.  See, in particular, The Quarterly Review.

All the best,

Ralph

Mergers and Acquisitions: The Elusive Search for Growth

Firms have largely recovered from their near death 2008 Great Recession experience with margins and stock prices exceeding pre crisis highs. Revenue growth, however, remains disappointing. A low growth, low interest rate environment is partly responsible. Consequently, many firms have focused on cost cutting efficiency improvement and curtailed organic growth related CAPEX and working capital investments. Thus, free cash flow (EBIT [1-t) +DA-[CAPEX+WCI]) has grown resulting in excess cash. Firms have responded with massive dividend and share repurchases which could exceed $1T this year.

This development appears to have run its course. Repurchases are becoming difficult to justify at current price levels. Thus, investors are now seeking firms who grow their operations, not just increase shareholder near term distributions. Of course, not all firms can achieve such growth. 

Organic growth still remains tough. Therefore, firms are increasingly turning to acquisitions to achieve growth objectives. This is reflected in near record M&A volumes. As previously mentioned this comes with increased risk. The Q ratio, a quasi -market to book ratio indicates stock prices are fully priced. The “q” is at its highest levels since the 2000 tech boom peak and well above its historical mean. Adding the usual 30-40% M&A premium means you need to improve the targets’ contribution by 60-80% to cover the premium and yield a “home run”-sounds tough because it is.

 Making acquisitions in such a market becomes tricky unless managers can clearly distinguish between good and bad growth. Good growth occurs when returns on assets (ROA) exceed their cost of capital (WACC). Acquisitions earning more than cost yield such growth and increase shareholder value. The levers management can pull to achieve such results is to control how much they pay and make sure they execute to achieve the required synergies to earn out the purchase price premium. The higher the premium the more difficult this becomes. Failure to achieve ROA>WACC results in bad growth. Revenues may increase, but shareholder value suffers. This is usually a time lag before this result becomes clear, and by then the damage is done.

A checklist I use to help me sort thru these issues is:

I hope managers are not acquiring out of desperation over what to do with their excess cash. It is always better to return the cash to shareholders than making poorly advised acquisitions.

j

Leveraged Finance Market Developments

Leveraged finance involves an ecosystem of parties funding leveraged buyouts and acquisitions resulting in noninvestment entities. It includes originators like private equity firms. Also includes financial sources such as bank arrangers like JP Morgan Chase, Collateralized Loan Obligation (CLO) Funds, the end takers of bank arranged leveraged loans (they hold > 2/3rds of the term loans), and high yield bonds. The market is highly cyclical. Thus, it expected to benefit from the sharp surge in deal activity.

Leveraged finance activity so far, however, has been disappointing. The crowding out of PE by strategic acquirers has been previously discussed.  Leveraged activity is down almost 50% from prior year. Additionally, regulatory developments impacting banks (e.g. GECC) and CLOs has made traditional participant reluctant to bring new deals to market. Some of the major changes include the following:

1)     Basel III: new higher capital requirements for higher risk transactions may “spook” some capital sensitive banks like Deutsche.

2)     U.S. Regulatory Guidelines: joint agencies directive frowns upon transaction leveraged more than 6X FD/EBITDA. This concern is understandable given banks are using subsidized government guaranteed short term deposits to fund long term highly leveraged borrowers. Leverage levels seem to be behaving by hovering around the 6X limit. This makes it difficult to match the high price bids by strategic acquirers.

3)     CLOs: the Dodd Frank Act retained interest rules (effectively requiring more capital) are forcing CLO to restructure and possibly raise new capital.

Hard to tell how this all is going to play out. It is a work in process and it is still on-going. Nonetheless, some preliminary observations are:

1)     High Yield Bonds (HYB): HYBs are substituting for bank loans in the capital structure. Issuers can swap back from fixed to floating. HYBs are, however, less flexible than loans on matters such as early repayment.

2)     New Non Bank Lenders (AKA Shadow Banks): include brokerage firms like Jefferies, which is in the top 10 of leveraged loan arrangers. Jefferies is less leveraged than a bank. Additionally, it is much smaller than the major bank arrangers. Finally, it has suffered some setbacks like the Rue21 transaction. So the jury is still out.

3)     Business Development Corporations (BDC): another specialized non bank lender. BDCs have special tax and leverage traits which may limit their application for large deals. Traditionally, they focused on smaller higher risk middle markets deals where they can get the extra spread needed to compensate for their lower leverage. The irony is both brokerage houses like Jefferies and BDC are funded by banks via warehouse lines. So the banks may still be exposed to highly leverage deals.

Some serious unresolved issues:

1)     Revolving Credit Facilities: banks are needed to provide revolvers. Less desirable alternatives include prefunding a liquidity reserve (expensive) and bank revolver carve-outs (messy inter-creditor issues).

2)     Securitization: still going to need warehouse facilities probably funded by banks.

3)     Non Banks: need larger participants to achieve scale to fund larger deals. May need to return to Drexel  (the firm not the school) style Highly Confident Letter  in lieu of firm bank type underwritings

4)     PE Accept Lower leverage: impact their bidding ability to compete against strategic acquirers.

These changes represent the third act of leveraged finance. The first being the entry of large arrangers like Bankers Trust in the 1980s. The second being the shift towards capital market style instruments to facilitate the entry of non bank investors. The current regulatory induce changes will take time and result in new winners and losers as this dynamic market continues to change.

J

Merger Waves: Health Care, Autos, and Semiconductors

Weve written several times before about merger waves.  They cluster in the aggregate economy, generally correlating with the stock market.  And – they cluster by industry.  The reason for the latter is generally that some catalyst has forced a change in the industry and consolidation is in order.

Consider what makes acquiring another firm attractive.  Simply put, a firm becomes an attractive target when the benefits exceed the costs.   There are three general components to this calculation – the cash flows, the discount rate and the costs.

First, consider the costs.  If something happens that decreases the cost and the benefits stay the same, the firm becomes an attractive target.  Costs could decline because the general value of the industry has declined or because a specific firm is not maximizing value.  Costs could also decline if a firm wanted an immediate sale (sacrificing price for liquidity).

Second, lets consider the discount rate: Picture the present value equation – a string of (generally) yearly projected cash flows in the numerator and an appropriate discount rate in the denominator. The present value or benefit of any asset is equal to the cash flows of the project discounted at an appropriate discount rate.  Appropriate means adjusting for risk and recognizing current market interest rates.  So if risk or current rates decrease, the value of a firm increases.  Some firms that were unattractive before become attractive now. 

Third, consider the cash flows. A similar thing occurs with the numerator.  If something happens that makes the cash flows larger, the value increases and the firm becomes more attractive.  If the cost has remained the same, some additional firms are likely to come into play.

How does this relate to merger waves in an industry?  As we have noted, industry merger waves generally occur because some catalyst has changed one of the three inputs above.  These catalysts include shifts in regulation, interest rates, consumer tastes, technology or other factors of production.    When these shifts occur, the net present value equation (i.e. present value minus the costs) is altered; firms in the industry become attractive and there is a jockeying to acquire them.  In today’s news we have several good examples:

• ·      Humana is reported up for sale – changes in federal health care laws (Obamacare) have altered the economics of the industry
• ·      Fiat –urges bigger rivals to recognize the need for consolidation in the industry because of overcapacity in the industry
• ·      Intel taking over Altera – to boost revenue following consolidation in the semiconductor industry
•  

There are plenty of other examples.  Just look for the catalyst and then look for the opportunity. 

Happy Prospecting,

Ralph

Exchange Rates and Cross Border M&A: Free Lunch or Expensive Banquet?

Ralph’s post raises some interesting valuation issues. A strong USD is supposedly aiding an increase of domestic firms acquiring foreign firms. The argument is, for example, the 25% appreciation of the USD against the Euro over the past years makes Euro zone targets cheaper. This, however, only looks at half of the exchange equation. You indeed pay less USD for the Euro assets (assuming the target does not change their price). You also receive less-the expected value of the future Euro cash flows when converted back to USD is also lower. This is the reason why many U.S. multinationals are now experiencing earnings declines. Some argue the translation effects should be ignored as noncash accounting noise. This of course assumes the FX effects will reverse. It also ignores the opportunity loss on the depreciated target cash flows during the interim period.

Others allege you are still better off buying today at a lower price and receiving depreciated Euro cash flows than buying last year at the higher prices. This assumes you can correctly forecast FX movement and market time your purchases. If you can, then why bother with M&A? Probably better to speculate directly on FX  rather than using the firm’s balance sheet.

I highlighted  approaches to valuing foreign assets based on parity among foreign exchange, interest and inflation rates. The first approach involves converting foreign cash flows into the home (e.g. USD) currency using interest rate parity relationships; then discounting the converted cash flows using appropriate USD discount rates. The second reflected below values cash flows in foreign currency terms:

Forecast target cash flows in local terms:

1)     Discount the target cash flows in local currency (e.g. Euros)

2)     Discount the Euro cash flows using local rates to calculate Euro NPV; expected change in FX rates reflected in local rates.

3)     Spot the Euro NPV into USD

Under this approach, FX movements should not have a material effect on cross border acquisitions as the decreased price reflects the lower valued cash flows. Yet, as the Erel, et al article highlights FX rate movements do appear to be correlated with M&A activity. Perhaps, acquirers in strong currency countries are better performing because their economies are stronger. This may make these acquirers more confident as they feel wealthier and have higher risk appetites. Alternatively, they could be confused by the depressed Euro prices and interrupt them as being cheaper hence better buys than domestic USD dominated targets. A more sinister view is it may reflect disguised currency speculation.

My basic view remains unchanged; focus on the fundamentals. There “ain’t no free lunch”. You get what pay for. There are many complications in cross border M&A. Do not get side tracked with dubious “bargain” FX arguments. 

J