Dell EMC Merger: Return of the Master

Michael Dell’s deal skills are second to none-including the Great Donald (Trump that is-the current presidential contender and author of “The Art of the Deal”). Michael took Dell PC (Dell) private at a very attractive price in 2013 utilizing clever vendor financing and high yield bonds. Now he is capitalizing on an activist motivated seller to make a beautifully structured acquisition of EMC, which will be the subject of numerous cases studies.

Both EMC and Dell are suffering serious business risk issues reflected in their declining revenues. EMC’s data storage business is moving towards the cloud, while PCs face a shift to alternative devices. Also, putting together the firms to create a technology conglomerate runs counter to others in the industry like Hewlett Packard that are spinning off divisions to achieve more focus.

Let’s consider the following:

1)     Deal Type: the deal is structured more like a LBO than a corporate acquisition with its high leverage, break-up fees and go shop clauses especially given the rumored shopping of the PC business for sale post close. The possible sale would also lower integration risk.

2)     Purchase Price: the purchase price multiple is around 11X EMC’s EBITDA-more in line with LBO multiples than higher priced corporate deals. The premium over the pre bid stock price is 20%. This is probably inflated given the use question value of the tracking stock being offer as partial payment. Adjusting for the post announcement fall in EMC’s price means the actual premium is closer to 13%. Dell appears to be getting a fair firm at a great price. EMC’s management is under attack by activist Elliott Management, and appears to be a very willing seller not necessarily acting in the best interests of EMC shareholders. Interestingly, Elliot sought the partial break-up of EMC by spinning off a majority owned subsidiary (VMware). Lawsuits will surely follow. The $2.5B break-up fee due Dell if EMC walks may mean EMC’s shareholders are stuck. Dell receives a substantial break-up fee should a competing bid arise during the go-shop period.

3)     Funding: this is where it gets really interesting. Dell, Silver Lake (partner in the original Dell LBO), et al are contributing around $4B in equity (not all cash?). The hard to value tracking stock representing a currently majority owned EMC subsidiary (VMware) supposedly represents $13B of the “equity” consideration. My take is the tracking stock is actually seller financing to close the funding gap facing Dell. The balance is $10B committed bank debt (plus a $3B revolver) and $40B in bonds. $5.5B of EMC’s existing formerly investment grade bonds do not need to be re-financed because they lacked covenant protection. Based on the combined EBITDA the funded debt multiple is around 5.5X EBITDA-modest by LBO standards and within banking regulator guidelines; hence the ability to secure the up-front bank group commitment. The bond financing portion is huge and market conditions remain unsettled. Nonetheless, Dell must feel comfortable based on the advice of his advisors because he is offering EMC $4B if he fails to obtain the financing.

Bottom line, Dell gets a modestly priced $67B firm with only $4B in equity and regains public market access. Hats off to Michael Dell if he can pull this off. It becomes even better if he can quickly reduce the debt thru the unloading of the PC business. The deal is not without risks, but my money is on Michael Dell.

J

AB InBev and SABMiller: Negotiating the Deal

Negotiating the deal is crucial to bidder success and target shareholder welfare.  From the bidder’s side, increasing the bid premium reduces the ultimate rate of return on investment, but paying a premium too low could result in a failed offer.  Target shareholders generally want the maximum price they can obtain, but other factors also come into play including timing of the deal, ownership after the deal, seats on the combined firm board, etc.

Both sides are concerned about deal structure and we’ve said many times that it is important to bargain on many fronts.  In addition to the bid premium we must consider form of payment, structure of the deal, timing, taxation, residual ownership, warranties and representations, employee and stakeholder welfare, regulatory concerns and numerous other factors. 

The maximum price a bidding firm should pay is the estimated net present value of the target under their control.  But paying this amount produces a NPV of zero, with no room for error.  The minimum price a public target will accept is generally the pre-offer market price.  Where the final deal settles in this range is determined by the relative bargaining power of the two sides.  Numerous factors go into bargaining power including ownership structure (concentrated or dispersed, toeholds owned by the bidding firm, the percentage of shares controlled by management, etc). 

Bargaining power is also impacted by how important the deal is to each side and this is related to the alternatives available to bidder and target. Is this bidder the only firm that can purchase this target?  Advantage – Bidder. 

Are many bidders vying for the target?  Are obvious synergies available to many parties?  Advantage target..  Is the target management really anxious to cash out?  Is the timing of the deal crucial to the bidder, etc.

There is considerable empirical evidence on negotiating tactics and shareholder welfare.  An overriding finding is that target shareholder value is maximized by management that forcefully negotiates, but does not ultimately block the deal.

A good illustration of these elements is the AB InBev acquisition of SABMiller.  According to the Wall Street Journal, both sides stood to gain from the deal but SABMiller’s chairman was convinced that AB InBev wanted the deal more.  His resistance and negotiation led to a sweetened offer – a 50% premium over the pre-offer (and rumor) market price and a $3 billion breakup fee if the deal doesn’t go through.  Other aspects of the deal including the social terms (who stays on the board, the name of the combined firm, etc.  are yet to be disclosed.  Also unclear is the degree to which regulatory authorities will oppose the deal or force concessions. 

SABMiller’s ability to negotiate these terms is even more interesting given that Altria Group, Inc which owns about 27% of the target signaled they would back a lower bid.  But SAB’s chairman Jan du Plessis was also active in courting large shareholders, getting Colombia’s Santo Domingo family on his side.  The family controls about 14% of the company and is the second largest shareholder.

The skill of SAB’s chairman, comes in part, from experience.  According to the WSJ he was chairman of Rio Tino PLC when it fended off a takeover bid from Glencore PLC. 

All the best,

Ralph

The Changing Investor Menus of Acquisition Finance

Low interest rates have encouraged investors to increase their risk appetite in search of yield. Issuers and arrangers have accommodated them with aggressive deals and financing structures; thereby supporting growing M&A volume. These usually work out until something happens. The August correction is one of those things. Investors, post correction, have paused to reassess their marked down portfolios, and have reduced their risk appetites. This presents problems for unfunded deals structured in the pre correction 1H15, but are only now coming to investors for financing. We previously examined this problem in 2013 with Rue21 in which the loan underwriters incurred large losses.

A current example of the same problem is FULLBEAUTY BRANDS (Beauty). Beauty is an on-line plus sized clothing retailer owned by PE firms Charles and Webster Capital since 2013. In March this year Beauty levered up to pay its owners $215 Mln via a special dividend, and announced plans for a summer $250 Mln IPO. The IPO window was wide open at that time. It subsequently closed late summer resulting in its owners switching to plan B-the sale of the firm. Apax, the same PE firm as in Rue21, agreed to acquire (secondary buyout) Beauty for undisclosed amount funded in part by $1.650B in loans underwritten by JP Morgan Chase, Goldman, Jefferies, and Deutsche.  JP Morgan Chase and Jefferies were also involved in Rue21.

Some details are as follows:

1)     Loan Facilities:

$820 Mln First Lien Term Loan -7 year term at LIBOR+450 BPS

$345 Mln Second Lien Term Loan -8 year term at LIBOR+850 BPS

2)     Leverage

First Lien-4.7X EBITDA

Second Lien (total)-6.7X

3)     Rating “B-“

The loan underwriters are experiencing sluggish demand for the loans based on several factors. First, increased concern over a slowing economy is dragging down retailer prospects. Next, the deal is highly levered at 6.7X, which exceeds bank regulatory guidelines and reduces the potential investor base. Non bank loan investors (CLOs) usually fill the gap, but have suffered portfolio losses during the summer correction. They are becoming more credit quality sensitive-especially toward higher risk second lien loans.

The Beauty loan syndication is still a work in process. The underwriters’ options, absent a rebound in investor risk appetite, are somewhat limited. Attempts to increase loan pricing or reduce leverage are unlikely to be received well by Apax, absent bear market pricing or structural flex provisions. More likely, they will be forced to offer deeper discounts at their expense (loss) and hold larger than planned portions on the loans.

Like war, most of the time acquisition finance is calm and boring. It is, however punctuated by brief moments of terror when investors risk preferences changes.

J

Activists

This weeks WSJ had a special feature on the success of activists looking at 71 activist campaigns.  For those who missed it, I recommend taking a look.  The bottom line is that some activists are associated with gains in value and some not.  That's not a surprising conclusion.  Anecdotal analyses such as this one are interesting but are generally on a small scale and have a difficult time controlling for all of the various factors that can influence outcomes.

A more thorough analysis is contained in a recent article entitled: Myopic Investor Myth Debunked:The Long-term Efficacy of Shareholder Advocacyin the Boardroom.  They examine a sample of 1,039 activist campaigns.   In fairness, these authors reach a similar conclusion as the WSJ: activist representation on the board is the vehicle through which meaningful gains are produced.

In the same WSJ edition are the stories about Nelson Peltz investing $2.5 billion in GE (resulting in a 5.3% stock boost) and news that Ellen Kullman will retire after 'winning' an activist campaign at DuPont.

All the best,

Ralph

Managers, Pigeons and M&A

Nine month 2015 M&A activity is within 2% of the pre-crisis 2007 record. Most of the buyers are strategic corporate. Even LBO volume recovered in 3Q15 driven by large levels of PE dry powder. As Ralph outlined there are many reasons, some good and others not so good, for the increased volume. A sometimes neglected reason for M&A growth is based on B.F. Skinner who influenced animal (pigeons) behavior thru rewards.

Investors have reacted positively to buyer M&A announcements for the last 3 years. This is in contrast to their negative reaction for the 1996-2011period subject to anticipation effect adjustments. Since the end of the great recession, investors have rewarded firms who could profitably reinvest capital; those who could not were rewarded for the return of cash via dividends and repurchases. The initial acquisition, 2012-2014, spurt involved lower prices, both premiums and multiples, strong strategic rationale, and smaller targets. Bottom line they were attractive deals.

Current late in the cycle acquisitions are getting pricey in terms of premiums over bull market inflated stock prices (40 %+) and multiples often exceeding 12 X EBITDA. Furthermore, they are becoming quite large. Although dollar volumes are up the number of transactions is actually down this year. This is reflected in the number of large $10B+ deals, which now total 47. Larger deals combined with higher premiums put more acquirer shareholder value at risk (SVAR). Additionally, larger deals involve increased integration risk. Consequently, investors are justifiably becoming concerned with the recent number of higher risk announced acquisitions. Some managers, like Skinner’s pigeons, have been conditioned to think (all-most?) acquisitions will be positively received by investors, and are sailing full speed ahead.

Just like investors, mangers need to become more discriminating about acquisitions. This means addressing the following issues:

1)     Red Flags: be prepared to sit out current late stage acquisitions that involve SVAR greater than 20% of the acquirer’s pre bid market value due to size and pricing premiums unless you are REALLY REALLY sure.

2)     Timing: remember the best of deals are made during the worst of times; while the worst of deals are made during the best of times-like now.

3)     Growth: not all growth is good. The key is return on invested capital. Overpriced deals relative to value received never work.

4)     Best Owner: unless you are the best owner of the target you are likely to fall prey to the winner’s curse.

5)     Strategic Basis: why are you buying? The best answers include achieving economies of scale or scope, expand geography by expanding into adjacent markets, and to improve operations of a poorly run target.

Managers, just like Skinner’s pigeons, cannot expect positive investor reaction to all acquisitions. Investors are evaluating the fundamentals of each deal based on factors similar to those previously stated. This does not mean all M&A is bad again. Rather, it means managers need to be more selective just like investors and less like pigeons.

J

Mergers, Acquisitions and Restructuring: A Waste of Talent?

I'm always surprised when I hear someone suggest that people doing deals are wasting their talents.   The usual laments are that these individuals would better serve society if they "actually did something."  When pressed, this phrase is finally explained by statements like "I mean actually produce something or perform a useful service rather than just shuffling papers."

Hmmm.  Let's think about this.  Let's take the typical executive who spends their day "producing goods or services."  Presumably they better serve society by better meeting the needs of consumers - you know - the people who choose what to buy with their hard earned dollars.  I suppose these executives better serve society with high quality goods or inexpensive goods or some combination of these traits.

So good signs of a productive executive are increasing sales, reducing costs, eliminating unproductive assets and (yikes) making a profit!

Now I'm not suggesting that all deals or dealmakers are good, but those are precisely the attributes that characterize the best mergers!    So maybe we need a few more bumper stickers suggesting "Consuming? Thank your local investment banker!"

Just sayin'

Ralph

Share Repurchases and Agency Costs Revisited

Ralph and I engaged in a debate about the use and abuse of share repurchases here , here and here. I thought it might be useful to revisit the issue as repurchases are on pace to eclipse the pre crisis 2007 record.

First some review. The major motives for share repurchases include:

1)     Reduce Option Dilution: less of an issue once the accounting rules changed and require the expensing of options.

2)     Valuation Signal: useful to close a value gap. Management signifies its belief in future cash flows by return cash to shareholders. Can be strong when debt financed. Usually in response to real or imagined activist threats.

3)     Dividend Alternative: with growth elusive and CAPEX modest free cash flow is building. Firms need to do something with cash piles or face criticism (e.g. Apple and Icahn). Either acquire (M&A is also at a record pace this year) or return the cash thru dividends or repurchases.

4)     Rebalance the Capital Structure: debt financed repurchases are being used to capitalize on cheap debt market conditions. Could achieve the same result using a debt financed special dividend.

5)     Manage EPS (i.e. earn bonuses): hard to increase earnings late in the economic recovery cycle. Thus, incentive to reduce share count via repurchases to achieve EPS target.

Warren Buffett reminds us to repurchase only when the price paid is less than the firm’s intrinsic value; otherwise, remaining shareholders will suffer a value loss. You would expect firms to repurchase shares when their prices are low. The evidence, however, indicates they repurchase when prices are high. This propensity to buy high is consistent with my suspicion repurchases are used to manage EPS, and not because managers are bad market timers. Share prices are also likely to have recovered later in cycle as well (i.e. they are relatively high). Consequently, management is likely to manufacture EPS growth thru repurchases at high prices.

Interesting empirical support for this conjecture is provided by Almeida, et al. They find the probability of repurchases is higher for firms that would have just missed their EPS forecast without the repurchase compared to firms that just beat their forecast. This suggests managers are likely to use repurchases to meet analyst EPS forecasts. Furthermore, they find managers are willing to cut investments in favor of EPS motivated repurchases. It appears late cycle repurchases, just like late cycle M&A, tend to have higher risk of being overpriced. In fact, record repurchases and M&A volumes may suggest the market has peaked (cyclical leading indicators?).

I am all for returning excess cash to shareholders. My concern is over the best method to return the cash-dividends or repurchases. My preference is to keep it simple-use dividends, regular or special, unless management can demonstrate a compelling alternative reason. Taxes may be such a reason. Nonetheless, since most shares are held by institutions this may not as important as you would think. Boards should carefully examine repurchase requests for firms experiencing difficulty in achieving analyst EPS forecasts-there may be an agency cost problem lurking in the request.

J