The Curses of M&A: Winner’s and Seller’s

The buyer related Winner's Curse is well known. It involves overpaying for targets relative to the benefits received. Essentially, you do the deal you should have passed - a type I error of commission. The seller’s curse-sometimes known as Seller's Remorse, although less discussed, is equally dangerous. It occurs when sellers overvalue themselves and reject an offer they should have accepted - a type 2 error of omission. Both curses are based on over optimism. For buyers this means that they can obtain the needed improvements to justify the price. For sellers it means that future returns justify forgoing a current offer.

Firms go thru life cycles. The best owner of a business changes for each stage of the cycle. As firms age they, like cottage cheese, reach a sell by date. New owners can extract more value thru better execution of higher valued strategies. This is important in rapidly evolving industries like big phrama where value chains are changing, making current asset combinations obsolete. Current owners find this fact hard to accept due to emotional ties to their organizations.

These ties are difficult to overcome unless you have a disciplined process to determine if you have reached your sell by date. This requires comparing retained value from not selling with your private market price in the M&A market. Retained value, the floor or refusal price below which the firm should not be sold is analogous to the reservation or maximum price a buyer can offer without diminishing shareholder value. The retained value is the potential seller’s expected cash flows discounted at its cost of capital. Private market value is based on recent comparable transactions.

If the private market value is greater than the retained value, then the firm is worth more to someone else than to the current owners. M&A is based on differences between actual and potential value. There is no one true value. It depends on the owner-management team’s chosen strategy and execution ability. Sellers can capture the upside of selling to a higher valued owner through the buyer’s bid premium. Even if you elect not to sell, you at least know the opportunity cost of that decision.

Seller’s reluctance to sell, like the related winner’s curse, reflects a behavioral bias. Sellers are prone to the Endowment Effect, whereby, they ascribe more value to something they already own than what they would be willing to pay to acquire it. Thus, you develop unrealistic pricing expectations, and fail to execute a sale you should have completed by pricing yourself out of the market. Inexperienced first time sellers are prone to seller’s reluctance. Repeat sellers like private equity firms are less likely to suffer from this bias.

Overcoming seller’s reluctance requires an external review of the firm well before the actual exit to ensure objectivity and commitment. It involves thinking like an investor by asking ‘If you were not already the entity’s owner would you invest in it and if so at what price?’ An annual appraisal process to determine whether to sell, and at what price, should accompany a firm’s strategic plan update. It provides the basis to begin discussions with qualified buyers. Selling should be viewed as a valid aspect of strategy and not a last resort.

Seller’s reluctance is just as dangerous for sellers as the winner’s curse is for buyers. Knowing when to sell and at what price is as important as knowing when to buy. Any fool can buy. A wise person knows when to sell. Sell when you can and not when you must. Sometimes you have to let go. It is being smart not giving up.

j

European Private Equity Deal Activity 2014 update; Darden's Takeover Defenses

A key focus of our acquisition finance course is understanding the nature of changing deal markets and incorporating that knowledge into deal structure.  Pitchbook is out with their latest PE report on European Activity and it provides useful updates.  Just a few of the highlights:

For the 6th quarter in a row PE investment in Europe has exceeded 50 billion euros.  Also, the popularity of bolt on investments is increasing, now representing 44% or European buyout activity.  A bolt-on investment is one made through an existing portfolio company rather than a direct investment of funds in a new industry.  Whereas direct investments generally involve new areas of investment, bolt-ons are typically in the same or related industries as the portfolio company.   Further details on these and other highlights can be accessed here.
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Also, in last week's post regarding Allergan and Valeant we noted:

"The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself."

Allergan was taking a page from their suitors book and slashing R&D.  Another great example is in Bloomberg today.  Darden Restaurants, long facing hostile activist investors, has retired its chairman and CEO and opened the board for activist representation, all actions desired by the activists.  According the story, however, the actions may have been too little, too late.  

As we said, 'Don't wait to implement value increasing actions.'

All the best,

Ralph

The Beautiful Deal

CIT, the commercial finance company that became a bank following the crisis, announced the $3.4B acquisition of One West this week. It is the largest bank deal this year. It also propels CIT over the $50B strategically important financial institution (SIFI) barrier. Thus, CIT will be subject to additional regulatory requirements. Apparently CIT believes the strategic and financial benefits of the deal more than compensate for the incremental burden. Another benefit from becoming SIFI (AKA too-big-to-fail) is the implicit government guaranty which could reduce funding costs.

The market response, along with the simultaneously announced $500mm stock repurchase and substantial beat of the expected 2Q14 performance, was a very positive 14% increase. The deal is a joint cash ($2B) and stock ($1.4B) transaction. The One West shareholders will have a 15% interest in the new CIT post close. CIT’s Ba3/BB- ratings are expected to remain unchanged.

Both CIT and One West (formerly IndyMac) failed during the financial crisis. CIT reorganized in bankruptcy. It was a non bank before the crisis (banks cannot file for bankruptcy). IndyMac failed and was taken over by the FDIC and sold to a group of private investors including among others Michael Dell, John Paulson, George Soros, and Chris Flowers. The FDIC subsidized the deal through a loss share agreement agreeing to cover most of IndyMac’s loan losses. The continuation of the FDIC agreement is a condition of the deal.

This looks like a brilliant deal for the following reasons:

1)     Government subsidies: they get the FDIC and implicit SIFI subsidies. Although hard to quantify they are very real. This may encourage others not to fear the SIFI designation.

2)     Taxes: they get to accelerate utilization of CIT’s substantial NOLs.

3)     Pricing: the trailing P/E is 14X, the P/TBV 1.4X and a deposit premium of 6%. These are lean multiples. I cannot figure out why they got it so cheap except maybe for the historical baggage associated with IndyMac/One West. Another reason might be they are going early in cycle.

4)     Strategic Fit: similar to PACW’s successful 2.3B 2013 Capital Source acquisition-combining a deposit rich bank with a wholesale funded finance company. The deal lowers CIT’s funding costs and funding risk. DISCLOSURE: I am a PACW shareholder.

5)     Funding: the 60-40 cash stock split maintains financial flexibility and preserves ratings. The issue of whether CIT’s stock is undervalued remains open. The share repurchase helps moderate possible undervaluation concerns.

6)     Earnings Accretion: the combination of low price, stock repurchases and large funding costs savings promise significant 2016 15% EPS accretion. Academics frown on EPS as an accounting measure unrelated to value. For me, EPS accretion is a second order pricing indicator. It keeps management from over paying.

7)     Integration: the size seems manageable and the retention of senior One West officers should aid the integration. Also, the 15% ownership stake in CIT by One West shareholders helps cushion the downside if something goes wrong.

8)     Sale Process: negotiated versus auction of a private versus public firm moderates price competition.

An excellent combination of strategic and financial benefits makes this a good deal and an example of the whole deal concept at work. Kudos to the CIT team.

J

Allergan and Valeant - Lessons from the Market for Corporate Control

The current Allergan Inc. case illustrates many points we have made in these posts.  As we start to think about our upcoming Amsterdam class on Structuring the Deal, it is useful to review.  The Allergan situation is an important illustration of the importance of corporate governance and the fact that when internal governance mechanisms (e.g., management and the board) overlook value creating strategies, external governance mechanisms (e.g., hostile bidders, arbitrageurs and the stock market itself) will force that change upon the firm.  It is better to be proactive.

On April 22, 2014 Valeant announced a hostile bid for Allergan, explicitly noting its value creating strategy, with an estimated $80 billion in synergies to be achieved in the first six months.   Allergan rejected the acquisition offer by Valeant but is now implementing many of the same strategies Valeant has proposed.  Specifically, Allergan has focused heavily on research and development while Valeant has focused more on sales.  Valeant said it would cut up to 20% of Allergan employees, primarily in R&D.  Allergan rejected these initiatives but is now following a similar strategy in an attempt to pacify its shareholders.  It has announced that it will lay off about 13% of its workers.  Here are just a few of the lessons from past posts.

The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself.

Once your firm is in play, the ownership quickly shifts to arbitrageurs.  The Speculation Spread between the offered bid price and the post announcement market price reveals the market's anticipated outcome for the deal (e.g., successful or unsuccessful acquisition and whether the bid will be revised).  Once arbitrageurs are the major owners, a deal is much more likely to happen as their interest coincide with deal completion.  As we noted in April, "The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant." Allergan's shares closed at $171.14 on Monday.

This deal is reminiscent of the numerous oil takeovers in the 1980s.  During the late 1970s, many companies began an extensive drilling program searching for more oil.  By the 1980's two factors made that strategy hugely unprofitable.  First, the price of oil fell from $40. a barrel to around $10. a barrel. Second interest rates rose from single to double digits.  Thus, in terms of the present value equation, the numerator declined while the denominator rose.  Not a good combination.  Firms that failed to adjust were subsequently taken over.  

To repeat, it is necessary to always consider if your current strategic course is the best one for maximizing value.  If you get this wrong, you are likely to find out the hard way.

All the best,

Ralph

21st Century Fox-Time Warner: Round I

FoxA made a preliminary $80B hostile Bid for TWX. The bid was rejected on pricing grounds. The deal represents a $17B - 20% - premium over the pre-announcement price and 12.6X trailing EBITDA - neither of which is particularly rich. FoxA is willing to consider a higher bid once it gets access to TWX data. The deal is 60% cash and 40% nonvoting common FoxA shares. The Murdoch’s control Fox thru the 38% family ownership of the voting shares. The deal makes strong strategic sense - especially given the consolidation taking place in the industry. Initial estimates are of $1B in common synergies with the potential for $2B+ additional synergies to be confirmed upon due diligence once access to additional TWX records is granted.

The 60% debt financed cash component of the price is initially covered by a Goldman - JP Morgan $25B bridge acquisition loan, which will be subsequently termed out with long term debt. The post close capital structure will have a FD to EBITDA multiple approaching 5X. Large diversified media can tolerate higher debt levels than other industries given the historical stability of their cash flows. Nonetheless, this multiple is reaching the upper bounds of FoxA’s current Baa1 rating. The nonvoting status of the stock consideration is raising some questions concerning its valuation and governance issues. See Damodaran for a discussion of the valuation issues with nonvoting shares.

Ordinarily, corporate acquisition funding is rather straightforward - long-term debt and common. Here, there are funding constraints giving rise to interesting structuring questions. FoxA has limited additional debt capacity assuming it wants to maintain its Baa1 rating. Issuing more stock also has issues. First, TWX shareholders may have issues about nonvoting stock given the governance concerns associated with a family controlled business run by an 83 year old man. Second, the Murdoch’s are unlikely to issue voting shares which would dilute their voting control of Fox.

What will Fox do to fund the expected higher bid for TWX given these constraints? Some possibilities include some or all of the following subject to market availability:

1)     Sacrifice the Baa1 rating-dropping to Baa2 or Baa3. Rumor has it that the Murdochs are reluctant to take this action-at least for now.

2)     Issue voting shares. Probably a deal killer for Rupert and his sons.

3)     Issue more nonvoting shares to the public to reduce initial debt levels.

4)     Additional asset sales: antitrust issues will probably require some asset sales. TWX’s CNN is a potential candidate which could bring $8-10B. This only makes sense if the assets can be sold at a price exceeding their value to Fox. This depends on market conditions. Also, the sale of non TWX assets such as FoxA’s Sky unit could be used.

5)     Joint Venture-Partial Sale licensing arrangements.

6)     An Equity Carve-Out .

7)     Issue some sort of preferred stock. The nonvoting common is similar to preferred. The dividend rate and other features - e.g. cumulative and convertibility- need to be determined.

8)     Rights offering of the voting shares allowing the Murdochs to maintain their proportionate interests - assuming they are willing to invest.

9)     Assets securitization of contract receivables. Need to consider possible negative credit implications.

10)  Board Seats: consider offering TWX shareholders board representation as per Gabelli.

There are many open issues-competing bidders, antitrust, integration, Rupert’s age, 

succession plan, and governance issues. In any event, this promises to be an interesting structuring case.

J