“Board Walk or Parked Place? Acquiring Firms and the Director Labor Market”

A lot of attention has been given to the composition of a firm's board of directors.  Much less attention has been directed to changes in the board of directors, particularly around major events.  An important literature does address changes around mergers, but concentrates on target firms.  What about acquiring firms?  After all, mergers can represent dramatic shifts in the evolution of a firm.  It makes sense that monitoring and advising needs of boards should evolve as well.  The only evidence we do have on acquiring board changes around mergers suggests relative stability with few changes.  This evidence comes from the examination of target firms which finds that target directors are not often retained by the acquiring firm.  If these are the only changes, general stability of the acquiring board is implied.

In recent research with my colleagues David Becher and Jared Wilson, we find that stability is far from common with acquiring firm boards.  There are significant and substantial changes of boards over time and the changes are significantly different around mergers.  As just one indication the post-merger board typically consists of 7% target directors, but 11% of new directors unaffiliated with either target or bidder before the deal.  In addition, board size often changes either increasing or decreasing

“Board Walk or Parked Place?

Acquiring Firms and theDirector Labor Market”

Abstract

"This paper examines the stability and composition of acquirer boards around mergers.  Contrary to perceived wisdom, composition of the post-merger board changes substantially and these variations are significantly different from both non-merger years and non-merging firms.  These adjustments reflect firms upgrading skills associated with executive and deal experience.  Board changes also reflect bargaining between targets and acquirers rather than CEOs seeking a more friendly board.  Conversely, director selection in non-merger years is driven by general skills and diversity.  Overall, our analyses provide insight into the dynamic nature of board structure around mergers and characteristics valued in the director labor market."

All the best,

Ralph

Microsoft’s Nokia Adventure: Ballmer’s Parting “Gift”

Microsoft (MS) announced a $ 7.6B write-off of it disastrous September, 2013 acquisition of Nokia. MS shares were unchanged in a day in which the market faced a large sell-off. The write-off came as no real surprise as the deal was highly suspect from its inception. MS’s shares fell 6% when the deal was originally announced representing an over $15B market capitalization loss. The market was reacting not only to the deal itself, but also the strategic implications of the deal; namely MS’s deepening commitment to the highly competitive devices market and away from its core software business.

Two other strange facts surround the deal. First MS’s CEO, Steve Ballmer had recently announced his planned retirement. The market reacted with a 7%+ jump in MS’s stock on the announcement-not exactly a sterling endorsement of Ballmer’s performance. See Vanity Fair’s article for background on Ballmer’s management history. Next, it was uniting former MS employee Stephen Elop, Nokia’s CEO, with MS. Elop’s performance was equally uninspiring at Nokia as it was facing a rumored bankruptcy after losing billions. I guess you can call it a buddy deal involving the two Steves.

What is surprising is that such a deal championed by an out-going CEO with a checkered record could be approved given widespread apprehension within MS, including from its future CEO Satya Nadella. It essentially is a doubling down on Ballmer’s failed strategy to embed MS’s Windows software in smart phones where it had only a 3% share. MS was going up against Google’s Android and Apple’s IOS and expected to triple its share in 3 years. How it was going to do so with money losing Nokia against well entrenched competitors is the stuff of dreams-or is it nightmares?

I guess we should not be too surprised Nokia was approved given MS’s patchy acquisition record. Remember the $6.2B charge for aQuantive. Also there Ballmer’s $47B abortive Yahoo acquisition where he was saved by Yahoo Jerry Yang’s even bigger ego. MS was suffering from poor board oversight and bad governance. This seems to be endemic to many aging tech firms who use acquisitions in the elusive search for the fountain of youth to regain their mojo.

Ballmer’s Nokia adventure left his successor with both a strategic dilemma and a hemorrhaging acquisition. Their new CEO is addressing these “gifts”. Let’s hope he elects to let MS age gracefully by managing Windows structural decline with increased shareholder distributions instead of engaging in expensive adventures.

j

Tax Inversions and Economic Reality

We're written before about tax inversions and economic reality.  Businesses naturally gravitate to favorable environments.  Jobs follow.  A big part of a favorable environment relates to taxes.  Businesses, like all of us, prefer less taxes to more.  Unfortunately, our country has become uncompetitive in this regard and as a consequence businesses are leaving for more favorable terrain.  One way to accomplish this is a 'tax inversion' where a company in one country (say the US) merges with another company in a more favorable tax environment (say Ireland) and then also moves headquarters to that new location.  Politicians in the US were quick to implement laws making this process more difficult.  Unfortunately, when laws try to restraint natural economic forces the consequences are not pretty and the unintended consequences are downright ugly!  In our post, Mergers and Taxes, A Follow Up on 'Inversions', we concluded:

"A better long term strategy for the United States or any country is to recognize the economic reality faced by business and understand motivations for the inversions.  Imprisoning business with uncompetitive laws may work in the short run.  It will never work in the long run."

So pass a law to make inversions more difficult and the unintended consequence is that companies are still becoming targets due to the large tax burdens that can be avoided by being absorbed into other companies.  In an excellent article in Wednesday's Wall Street Journal, The Tax Inversion Wave Keeps Rolling Liz Hoffman, notes how Horizon, an inversion last fall and now headquartered in Ireland, is now acquiring other companies.  In particular, Horizon is going after Depomed, a California pharmaceutical company.  Hoffman notes that Depomed paid 38% in the US last year but that Horizon's acquisition could lower the rate (under Irish law) to 'low 20's' and that Irish Corporate tax rates are 12.5%.

So which is better 38% of nothing or 12.5% of something?  The answer is obvious to all but representatives who refuse to take steps to make our country more competitive, preferring instead to play Whack a Mole in denying economic reality, smacking every unintended consequence that arises with new laws.

An interesting chart from the article showing other deals is below:

Also see our post, Politics, Taxes and Economic Reality

All the best,

Ralph

 

Corporate Funding Process

The basic goals of corporate finance are (A) fund the firm’s strategic plan and (B) provide enough liquidity to satisfy the firm’s obligations as they come due. This involves a process incorporating strategy, operations, capital structure, and capital markets timing. This is the stuff of the practice v theory of finance-cash flow budgeting not models usually not covered in detail in textbooks.

The following diagram highlights the process:

The steps in the process are as follows:

1)     Investment Opportunities/Requirements: matching product market opportunities with the strategic plan gives rises to the investment budget. I find it useful to use Porter’s Five Forces model to gauge investment opportunities. Your strategy determines how fast you plan to grow and investment needs-CAPEX, working capital investment (WCI) and operating expenses like headcount and R&D.

2)     Financing Need: based on cash flow available for debt service (CFADS) = Net Income ( after interest and taxes) +DA-(CAPEX+WCI) +/- (AS-AA + CND) with DA being depreciation and amortization; AS-AA representing asset sales or acquisitions; CND being changes in net debt. Mature firms with excess CFADS focus on shareholder distributions (sometimes prefunded debt financed share repurchases i.e. recapitalizations) while growth firms with negative CFADS need to raise cash.

3)     Funding Sources: selection of instruments depends upon market conditions and financing preferences.

a)     Capital market conditions: influenced by macro factors such as rates and economic growth. Just like ordering lobster -prices and availability are subject to market conditions. We saw an extreme example of this during the market crisis years of 2009-2012 when markets shut.  Some key factors include market depth, cost, terms, access, and disclosure. You can only take what the market gives.

b)     Financial strategy: the objective is to match sometimes conflicting financial preferences with market conditions in a cost effective manner to assure certainty of funding. Key factors include

Control-closely held firm will be reluctant to fund with equity if it upsets control positions

Dilution-equity financing impacts dilution and can be an impediment

Flexibility-growing firms need flexibility hence avoid debt with covenants and prepayment restrictions

Ratings-rating targets influence the debt versus equity choice and debt capacity

Cost-both absolute and relative cost among instruments

Public or Private-firms seeking confidentiality balance depth of public markets with disclosure requirements

Dividend Policy-high dividend policy constrains debt capacity

Investor Base-banks, private equity, hedge funds, etc.

Liquidity Needs-financial slack is valuable especially for growth firms as s#$% happens

Speed-how soon you need the funds determines which sources you seek

Currency Preferences-USD or others

Nature of Funding Need-one-off or on-going; if on-going focus on relationship type investors

Hedging Policy-for financial exposures like rates and currencies

Accounting Policy (on/off balance sheet)

Taxes

Maturity Structure

4)     Instruments: the funding instruments choice usually becomes apparent once you go thru the above process. The key is to customize the instruments to capitalize on investor segments to achieve the best terms. Most firms utilize a Pecking Order approach to minimize information asymmetry costs reflecting the following order:

Debt

Hybrids-convertibles and warrants

Equity-preferred and common

5)     Repeat Step 2 once the cash flow implications of the choices are determined. Reflect plan in cash flow budgets and use scenario analysis to ensure it works with a sufficient margin for error.

The funding decision is like playing with a Rubik's Cube trying to match up sometimes conflicting goals under time constraints in an uncertain dynamic capital market environment. Compromises are needed to ensure adequate funding under all states of nature-not just the current state. As a general rule- raise funds when you can and not when you must as many capital challenged firms learned the hard way during the great recession.

J

Merger Waves: Pharma, Telecom and the Scramble for Position

We've talked about merger waves many times in these posts.  In general, some catalyst produces shocks in an industry and creates opportunities (and sometimes necessities) for consolidation.  The shock can be a change in technology, consumer tastes, regulation or any other shock that alters the costs or benefits of acquisition.  

In the current environment, Telecom and Pharma represent merger waves with multiple parties scrambling for position.  Let's consider Pharma: The Pharma wave has been under way for quite some time.  As far back as 2009 we saw the mergers of Merck/Schering-Plough, Pfizer/Wyeth and Roche/Genetech.  We continue today with deals by players such as Sun Pharmaceuticals and Bayer.
Among the catalysts for Pharma are the exploration of patents as companies search for new sources of growth, and the realization that some of the large R&D expenditures of the past haven't paid off.

For Telecom the catalysts include deregulation and dramatic changes in technology including increased use (and uses) of hand held devices, tablets, and smart phones.

As rivals combine, the competitive landscape in any industry changes and firms scramble to maintain viability.  In today's market many deals in Pharma and elsewhere remind some of the heyday of 2007 with high multiples as too many bidders search for too few deals.  

Indeed, there is empirical support for different valuations at different stages of a merger cycle.  Harford (2005), for example, notes that bids later in a wave cycle are associated with lower returns.  This makes practical sense as well - when a catalyst makes various firms attractive, the low hanging fruit is the first to be acquired.  As attractive targets become scarce, bid prices rise and acquiring returns decline.

Some experts appear unconcerned about the current high multiples, but as Joe has said many times, when they start telling you "this time is different" grab your wallet!  While good deals remain, acquirers must be careful to assess risk and return objectively and only make those deals that are value additive and consistent with a firm's strategy.  It is important to beware of behavioral biases especially when deals are occurring quickly all around you.  Nevertheless,  while markets are efficient, deal makers are human.  Tread carefully,

All the best,

Ralph