Finding Synergies in the Strangest Places

I previously discussed the CIT-One West transaction. This post further explores the unintended subsidy benefits for a limited group of regional banks flowing from banking regulations. There are perhaps a group of 30+ regional banks who could obtain the net benefits from achieving Too Big To Fail (TBTF) status. Basically, they obtain funding cost advantages that could outweigh any regulatory burdens associated with becoming TBTF. This synergy-subsidy allows them to out bid other bidders and still have a value adding transaction. See the Attached .

J

The Power of Focus and A Sustainable Comparative Advantage

The concepts of focus and diversification are diametrically opposed, but both are crucial concepts in finance.  As investors, we are wise to diversify, to not put all of our eggs in one basket.  As one extreme, employees of Enron who also invested their personal assets in the fast rising company lost both their wealth and their income when the firm collapsed.

For companies (and for individuals considering career options), the opposite is true, and much research has found that those companies that focus on their core competencies are those that prosper.  Companies, like people, have distinct advantages at certain things - but not at everything.  Effective strategic leadership requires defining and honing a sustainable comparative (competitive) advantage.  Let's consider that phrase more fully:

• Comparative (competitive) Advantage means that you can deliver a service or product more effectively, or with higher quality or more inexpensively than your competition.  Now whether you focus on quality or cost is another major decision that we leave for later discussion, but the choice comes down to knowing your marketplace, to understanding customer wants and needs. But as my colleague Joe Rizzi points out, make sure your advantage is comparative: "Having smart people doesn’t mean anything if all your competitors have smart people as well."

• Sustainable - means you will continue to enjoy this advantage for at least the next several years.  This is why Warren Buffett and other great investors talk of finding companies with moats protecting them from competition.  The moat may be in the form of a superior product that cannot be duplicated -  perhaps due to technological knowledge, but more likely due to patents.  It could be from regulatory advantages or political alliances. It could also be from brand capital - the reputation of your firm in the marketplace.  A moat could also exist because of natural barriers to entry like regulation or other legal structures or because the business requires intense capital or other requirements, not easily copied.  There are many more ways to build a 'moat' but the concept is the same, find a way to stay ahead of the competition - a way that is not easily duplicated.

Note that managements can have moats built around themselves as well - a highly undesirable characteristic.  Moreover, management can be so enamored with the size of their empire that they forget the need to focus.  When this happens, external forces - takeovers or activists - step in to correct the situation.  Indeed, the need to focus, to find the sustainable competitive advantage is at the heart of much recent activist activity.  See Joe's recent post discussing Yahoo, Darden, Ebay, Hewlett Packard and DuPont (Royalists Vs. Governistas).  

You can think of sustainable comparative advantage as overlapping circles.  One circle contains the set of all things a company is good at - another partially overlapping circle contains the set of things the market will reward.  The intersection of these circles is the sweet spot where businesses (and people) can prosper.  For businesses and individuals with a sustainable competitive advantage, the sweet spot exists for a longer period of time, but even here the circles are continually moving as technology, consumer tastes, regulation, political climates and other catalysts shift the circles.  It is essential to stay ahead of the shifts.  

Note: for individuals considering career choice, I'd add a third circle consisting of things you enjoy doing.  If you find the intersection of those three circles in your life you are indeed fortunate, doing something you like, that you are good at, that the market values. 

All the best,

Ralph

Royalists versus Governistas

There is a very entertaining professional dispute between corporate royalists represented by the Wachtell law firm and academic governistas represented by Harvard Law School’s Lucian Bebchuk. You can follow it in the Harvard Law School Forum on Corporate Governance. The royalists argue management and the board knows best and should not be pestered by greedy short-term shareholder-activists. The governistas support shareholder-activists actions as a challenge to correct poorly managed firms with weak boards. I support the governistas position on two grounds. First, well run institutions with strong boards have nothing to fear from shareholder activists (AKA the chicken soup defense-it doesn’t hurt). Second, shareholder activists can provide a useful disciple for poorly performing firms.

Some recent examples of useful activist disciple include the following:

1)     Yahoo: the sum of Yahoo’s parts, Alibaba, Yahoo Japan and Yahoo USA, substantially exceed Yahoo’s current market value. This value gap represents the Marissa Meyer, current CEO, discount. Starwood, an activist shareholder sent a letter outlining a litany of issues including poor tax planning bloated overhead, and bad acquisitions. It also suggested a merger with AOL to help resolve some of the issues.

2)     DuPont: under pressure from Peltz’s Trian group to breakup because of among other things bloated overhead. Consider DuPont’s 2012 sale of its coatings division to Carlyle. EBITDA increased from $340 to 815 mm in just 2 years. Highlights inflated expenses and under management the division suffered while DuPont owned it. I hope DuPont kept some of the upside thru a retained interest as Schmuck Insurance .

3)     EBay: finally spinning off its fast growing PayPal division after continuous prodding from Carl Icahn.

4)     Darden Restaurants: another successful Starwood initiative relating to the long under- performing chain. Resulted in the replacement of the entire board and a new management team.

5)     Hewlett Packard: finally responding to long suffering shareholders with the spinoff of its computer division.

Shareholder activists are not always right, but nonetheless, they should not be ignored. The activists are willing to bet with their own capital. Consequently, they have more skin in the game than the royalists. This, for me, makes them more credible.

I do not think the royalists are evil - just misguided. No one likes to be questioned. Also, organizational inertia makes it hard to change from previously successful actions even though they may no longer work due to industry changes.

So in my book it is governistas’ 4-royalist’s 0, but the game is not over.

J

Merger Activity and the Stock Market

In spite of this week's dip in the market, the recent trend has been quite positive.  So too is the increase in deal activity (and IB profits!  see Goldman Sachs Profits Jump).  In fact, mergers are strongly correlated with the stock market and it is instructive to consider  some of the possible reasons.

• Hot markets are often associated with catalysts providing opportunities.  At the beginning of an upturn, mergers provide opportunities for rapid expansion and additional synergies from expanded sales.  As the business cycle matures and product markets become more competitive, mergers provide opportunities for the synergistic reduction in costs.  
• Deals are easier to finance in market expansions.  Credit becomes more widely available and the acquiring firm's stock is higher priced.  Indeed, the use of stock financing as a form of payment is correlated with market levels.  
• Related to this, it is sometimes conjectured that acquiring firms can snap up bargains by using their 'inflated' stock.  Not so fast - it is likely that many targets have also experienced run-ups in price.  The resulting 'bargains' may exist, but are not mechanically generated by rising markets.
• However, there is a theory that firms with overvalued stock can 'lock in' that valuation by buying hard physical assets with that inflated currency.  The ability to implement this tactic requires sellers to be naive about the bidder's inflated price and assumes the hard assets are not also overpriced.  Indeed, bidders using stock tend to underperform those using cash at the announcement of a deal.  More broadly, firms issuing stock tend to drop 1-3% in value upon the announcement.  Issuing stock seems to act as a signal - why issue stock if it isn't at least fairly valued and probably overvalued?
• Confidence - buyers tend to have increased confidence when their stock price is high.
• Among the most intriguing reasons given for increased activity in hot markets is the 'pool of exhausted managements' theory.  According to this theory, many owners hang on to their firms in downturns waiting to sell when prices again rise.  The idea makes intuitive sense and corresponds with some known psychological findings:  we often anchor our price expectations on a historically high price.  Nevertheless, it doesn't explain why bidders are more willing to buy at this time - unless one factors in one of the reasons in the above list.

In any event, here is hoping for a renewed market rise and more deal activity.

All the best,

Ralph

Market Turbulence

The current market turbulence triggered a 7%+ decline in the S&P 500 over the last few weeks. The Euro markets fell even more. The impact of this turbulence will be minor if it passes quickly. I believe, however, it may be more long lasting than many perma bulls allege. I do not think this is 2008 version 2.0. Nonetheless, the turbulence may have some legs - economic basis. Consider the following:

1)     Weak Global Growth: World Bank cut the global growth rate.

2)     Continued Deflation Fears: This is especially true in Europe. The reason underlying is the Debt Deflation hypothesis first outlined by Irving Fisher following the 1930s Great Depression. Just as in the 1930s, consumer balance sheets were devastated by the 2008-2010 Great Recession. Consumer asset values, primarily their homes, fell below their liabilities. Consumers curtailed purchases to pay down debt and repair their balance sheets. The consumption drop and the resultant drop in the velocity of money take years to play out. Reinhart and Rogoff estimate it takes 7+ years from the end of the financial crisis to get back to normal. Thus, we about mid way thru the cycle.

3)     Europe: Is a basket case with a lack of political will to address underlying structural reforms.

4)     Emerging Markets: Impacted by commodity price declines.

5)     China: Affected by declining end markets for their exports.

6)     United States: Is the tallest midget in the room for now.

7)     Ebola: The quintessential Black Swan. No one saw this coming and no one knows how this will end. Nature throws curve balls like this every now and then just to remind us who is really in charge.

8)     VIX: The rise in the volatility index signals a potential downward shift in investor risk appetite.

So what are the possible implications of the above malaise on the M&A market, which heretofore experienced a strong rebound? If the volatility continues, deals could be pulled, delayed or canceled. Consider the following:

1)     Buyers: Become hesitant because you cannot project a price. The standard 30% premium over market is difficult to apply because the price to which you apply it against keeps changing. Whatever price you use could be even lower next week. Also, for deals using stock, a drop in the buyer’s stock price makes the deal more expensive regarding EPS dilution.

2)     Sellers: Are reluctant to sell when their market price is falling. Most sellers tend to anchor on their stock’s 52 week high. They believe the price could recover if they wait it out. This may be a long wait as one of the factors underlying equity prices, a strong IPO alternative, has shut down. Investors find it difficult to price IPOs when prices are so volatile.

3)     Hostile Takeovers-Activism: Could increase as a rising market no longer exists to cover over operating problems.

4)     Private Equity: The current M&A growth has been largely driven by strategic corporate acquirers. Private equity has been relatively quiet despite having substantial drop powder. As corporations drop out of the game PE firms may find less competition.

5)     Documentation: See the increased use of risk shifting clauses in Sale and Purchase Agreement and financing commitments.

6)     Cost of Capital: The Ten Year Treasury has fallen during the turbulence by over 30 BP to just over 2.2% as investors seek a safe haven. Rather than lowering the cost of capital as many pundits believe, the cost of capital may have actually increased. Consider:

a.     Debt Spreads: Have surged to their highest levels in over a year. Debt availability for the edge of the envelope 6X+ FD deals is also being tested as investors withdraw funds from high yield bond funds

b.     Equity Risk Premium (ERP): The ERP is usually calculated by taking the S&P 500 earnings to price ratio and subtracting the real 10 year rate, which is essentially 0 now. The 7% drop in the S&P means, if it holds and changes investor expectations, then ERP has also increased.

What are we to do? First, do not panic as this too shall pass. The factors supporting increased M&A still remain largely intact. The key is to remain solvent, liquid and to paraphrase President Obama - don’t do stupid stuff. Next, remain ready to move quickly as opportunities appear and conditions improve. A bull market makes us appear like geniuses. It doesn’t take a genius to recognize that volatility and deals do not mix well. So as your airline captain would say - ladies and gentlemen please fasten your safety belts we are experiencing some turbulence.

J

Deal Activity Over Time and Recently in the Netherlands

Next week is our Acquisition Finance Class in Amsterdam.  In preparation for that class and our discussions, I've updated the information on Deal Activity and trends since 1985 and recently as well.  Here are a few slides related to that discussion.  There is much to say about these charts and trends, but I'll be brief in this blog.

First, look at deal activity over time since 1985.  There are two obvious spikes in activity centering on the Dot Com boom and just before the recent crisis.  In general European activity has tracked that in the US.

The method of payment over time has been predominately cash and more so in recent years.

Finally, I list some interesting charts related to Deal Activity in the Netherlands and in Europe.

We'll skip the blogs during class next week, but perhaps I'll see you in Amsterdam!

All the best,

Ralph

No-This Time is Not Different

Leverage is increasing. YTD 50% of LBOs have FDX (funded debt multiples - Funded Debt/EBITDA) greater than 6X - 15% have FDX greater than 7. Additionally, creditor structural protections like financial covenants are disappearing. The driver is the increase in PPX (purchase price multiples - purchase price/EBITDA). Current LBO PPXs have increased two full turns to 11.5X since 2013. This reflects the increased pressure from competing strategic acquirers, a strong stock market and a recovering M&A market. PPX always increase to absorb any rise in debt capacity. Just as the Cash Burn Rate is important for venture capitalists so is the PPX for private equity sponsors - it represents a LBO burn through of value.

Some believe this time is different and the increasing debt levels are affordable. They believe an improving economy, low rates and low spreads translate into strong interest expense coverage and low default rates. They do, but this is a cyclical business and these pleasant facts can quickly change as we saw during the financial crisis when defaulted or restricted loans rose to double digit levels.

FDX greater than 6X mean you cannot retire principal during the original term of the loan. This means the ultimate repayment source is either a refinancing or trade sale of the company. These depend on markets remaining open and liquid - which is clearly not always the case. We have moved in Minsky terms from a hedged phase (2009-2013) in which debt principal and interest can be serviced from internal cash flow to a speculative phase. During this phase only interest can be covered from internal cash flow. The final Minsky phase before a correction is the Ponzi stage in which neither interest nor principal can be internally covered. Instead they must both be refinanced as was the case the last Ponzi stage of 2007. We are, hopefully, a few years away from this, but no one knows for sure when markets will turn. All we do know is they can and do turn violently when the refinancing wall is hit.

This situation has been noticed by banking regulators. They have strongly signaled that transactions with greater than 6X FD ratios will be subject to greater review. Last year they criticized over 40% of the large syndicated loans, known as shared national credits or SNC, which are heavily weighted towards leveraged transactions. Recently, they have signaled out Credit Suisse for underwriting loans exceeding the 6X guideline. This is understandable as CS is a major LBO loan sponsor with a 13% market share and generating over $400mln in loan fees this year alone. CS will push to defend its market position. Regulators may require CS to hold more capital and criticize banks participating in their loan syndicates via the SNC review. Ultimately, this will push more of origination effort to non banks just as most of the ultimate holders of leveraged loans are now non bank CLOs.

This will not end well. As Hemingway stated about bankruptcy - first it happens slowly, then suddenly. It is difficult for banks like CS to resist getting dragged into the fray. How can you choose not to play the game on the field especially when your competitors are doing so?  Citi’s Chuck Prince noted, as long as the music is playing you have to keep dancing. The regulators are trying to turn down the music. Whether they succeed this time is questionable.

J