Valuation in M&A - Reports from the Field

In teaching finance to MBAs, I stress an analytical approach to decision making and strive to give the students the latest tools of our field and to discuss the latest empirical and theoretical research.  But I also stress that 'People Make Decisions', not algorithms or analytical techniques.  Also, it is people who implement decisions.  Certainly, this is crucial in the field of mergers where integration remains one of the major concerns.  Finally, I note that there is an Art and a Science to finance.  We can teach the science, but the art is nuanced and requires a great intuitive grasp of the subject blended with experience.

Here is an interesting article on how practitioners are actually valuing companies in M&A transactions.  It makes the same points.  The authors interviewed investment bankers who confirm use of the techniques often discussed in these posts: discounted cash flow and comparable transactions.  The article also highlights the use of judgement in making these decisions, noting:

"While leading practitioners routinely use DCF methods in mergers and acquisitions (M&A) valuations, the application is often far from “routine”; it requires art and judgment in the face of inherently uncertain business forecasts such as those surrounding merger synergies. Our results serve as yet another reminder that analytic techniques such as DCF do not make decisions but only inform them."

From "Company Valuation in Mergers and Acquisitions: How is Discounted Cash Flow Applied by Leading Practitioners? by W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins"

All the best,

Ralph

Lessons Worth Remembering

Warren Buffett’s letters are always worth reading. The 2014 letter is no exception. In this post I will comment on three acquisition related topics raised in that letter. The first topic concerns risk. He highlights that risk is not volatility. Risk is the exposure to consequences from uncertain events leading to permanent capital loss. Academics focus on volatility because it is easier to measure and quantify than the exposure based definition. Nonetheless, putting a probability distribution (usually the highly questionable normal distribution) on an event does not make it less certain. Worse, it can lead to unjustified over confidence leading to Black Swan type surprises. Most of what passes for risk analysis is nothing more than simple extrapolation of recent history. It is experience v exposure based. Furthermore, it ignores perhaps the biggest risk of all in M&A; namely price risk (see next paragraph). We should instead focus on total v systemic risk and use scenario analysis and sensitivity charts to gauge its effect.

Next, is the need to distinguish intrinsic value from price when evaluating acquisitions. Premiums to market and comparable transaction multiples relate to the price you have to pay now. Intrinsic value concerns what you hope to receive in the future. They are not the same thing. Keep in mind the following:

1)     What you pay = pre bid price + premium

2)     What you get = standalone value + synergies

3)     Usually the pre bid price equals the standalone value - if markets are reasonable efficient

4)     Thus, the transaction’s net value added depends on synergies exceeding the premium

Synergies are of course an expectation-hence risky as they may not materialize. The key is to avoid fanciful synergies-leave a margin of error/safety to cushion your downside if something unexpected (risk) occurs. Gauging the validity of synergies considers the following:

1)     Expense cuts are more believable than revenue growth

2)     Acquirer’s track record. An experienced acquirer has better chance of achieving synergies

3)     Expected performance consistent with industry base rate

4)     Acquirer is the best owner of the assets based on business model fit

Last, avoid playing the EPS bootstrapping game. Initially, you can always increase EPS by either acquiring a firm with a lower PE ratio than yours (using your stock as currency) or borrowing to acquire the target’s earnings stream. Post close your PE ratio will adjust to reflect the quality of earnings, growth and risk involved - AKA there” ain’t no free lunch or magic”.

The above represent simple principles to follow when in the heat of a transaction. Although simple to express they can be difficult to apply and seem to be constantly re-learned .

j

Building the Defensive Moat Rather Than Cleaning Up the Castle?

Yesterday's DealLawyer.comDealLawyer.com helped me uncover this set of information from FactSet on poison pills issued last year.  Before we get too excited about the graph, let's remember that we're dealing with just 18 observations here.  Still it is interesting that a new rationale for pills is added in a few firms - protecting Net Operating Losses.  While these losses are indeed a valuable asset, it is ironic that they would be protected through a poison pill.  Indeed, poison pills are designed to prevent hostile acquisitions.  Hostile acquisitions, of course are often motivated by a belief that additional value can be created at the firm, like... for example... when a firm is experiences losses!

Paul Malatesta and I did the first academic analysis of poison pills beginning our study during the winter of 1985.  At the time only 14 existed!  In November of 1985, however, the courts upheld the legitimacy of the pill in the Household International decision.  By early 1986 our sample had increased to over 100 firms.  By the end of that year over 300 existed.  By the end of that decade, pills were ubiquitous.

In our initial study, we found that firms issuing pills were less profitable than the firms in their industry.  Wealth losses of 2-4% were experienced when the pills were announced.  In addition, the CEOs of these firms had lower stock ownership positions than the CEOs of firms not issuing pills.  Hence they had less to gain from the bid premia and much to lose from a hostile bid (their jobs).  We haven't analyzed the current set of pills, but see our post on Netflix and the poison pill.

All the best,

Ralph

Private Equity and Buffett Envy

Remarks from the  2015 Super Returns Conference have implications concerning the future of PE. The industry is suffering from mediocre returns and LP dissatisfaction. PE firms are struggling with ways to react. Some are becoming asset managers, others investment banks and others smaller and more focused. This is important because record fund raising has pushed up the amount of dry powder (committed but un-invested) capital to over $1.2T. The investment fire power of that amount combined with a normal leverage multiple is huge. The money will be spent. The question is how wisely and what future returns can be expected as PPX are now 12X.

Blackstone hinted it is considering following Buffett’s Berkshire Hathaway by making long term investments in large public firms to take them private. An example is Buffett’s partnership with Brazil’s 3G to acquire H.J.Heiniz. Essentially, they seek permanent capital not subject to traditional investment and liquidation periods. Such investment in partnership with sovereign wealth funds would seek lower returns in the mid teens (usual PE targets are 20 %+) over a longer term horizon of 15+ years (compared to 10 years for PE). Is it realistic to expect PE success in copying Buffett? Is his success repeatable by others especially if many try to copy it at the same time?

Let’s first explore the source of Buffett’s alpha. My understanding of his Approach is as follows:

1)     Focus on investing in wonderful firms at a fair price. Wonderful is usually represented by consistent superior EBIT/Total Assets returns. Also, he focuses on low volatility assets (low beta).  Fair price means low EBIT/Equity Value. Academics call this a value or Bet Against Bet strategy.

2)     The above returns are modest and need to supplement thru cheap leverage. Here is Buffett’s secrete sauce-the cheap funding from Berkshire’s insurance float. Academics studies confirm the better route to higher returns is leveraged portfolio of low risk assets instead of high risk assets (like VC?). You are essentially monetizing risk reduction thru leverage.

Point #1 above is not always possible-especially in fully priced bull markets like now. Buffett has the discipline given his majority ownership to sit on his hands and do nothing in these markets and wait for his pitch before swinging. Not everyone has this advantage.

My concern with PE firms trying a naive copycat strategy is they will miss the nuances involved in implementing a contrarian leveraged high quality value strategy. Consider:

1)     Do PE firms have the discipline to sit out long periods of high bull markets with limited opportunities to invest at fair prices?

2)     Buffett does not charge fees or skim a co investment percentage of gains. Will PE change their business models to accommodate this difference?

3)     Can they resist the temptation to invest in high risk firms (e.g. First Data)?

4)     Can they supplement their returns with stable cheap leverage?

My take is the Buffett wanabes are unlikely to succeed. The basic problem remains of too much money chasing too few good opportunities in a bull market. In the meantime expect more “I am like Warren” fund raising strategies to be used. Nonetheless, investors collectively must hold the market. Thus, it is hard to be consistently difficult.

J

Doing a (Large) Deal? Expect to Get Sued

A year ago we posted  "Doing a (Large) Deal? Expect to Get Sued" which discussed research by Matthew D. Cain  and Steven M. Davidoff.  They've updated their sample to include 2013 and we've updated the original post accordingly.   The numbers are even more striking today.  The updated, original post is below. 

A recent working paper by Matthew D. Cain  and Steven M. Davidoff entitled Takeover Litigation in 2013 provides some interesting statistics about the rise in merger related litigation.  Their Table A, reproduced below reveals a dramatic increase in litigation over the past eight years.  In particular, about 39% of deals involved litigation in 2005, while close to 97% involved litigation in 2013. Litigation rates over time Year Deals Litigation % with Litigation 2005 183 72 39.30% 2006 232 99 42.70% 2007 249 97 39.00% 2008 104 50 48.10% 2009 73 62 84.90% 2010 150 131 87.30% 2011 128 117 91.40% 2012 121 111 91.70% 2013 80 78 97.50% Total 1,320 816 61.80% Thus, the probability of being sued in a merger today is over 90%.  Keep in mind, however, that the size limitation on their sample is deals over 100 million.  The percentage would undoubtedly be smaller for smaller deals.  Also, as my friend Jan Jindra notes: "The result is, perhaps, not surprising, when private plaintiff attorneys are allowed to initiate class action lawsuits in names of nominal shareholder plaintiffs and finding a willing shareholder plaintiff is made easy and cost-efficient through the use of law firm internet websites. Rational economic agents, attorneys, find that filing a class action lawsuit circumvents the constraints imposed on derivative suits which are designed to limit opportunistic “strike” suits. Furthermore, ready availability of websites by law firms actively recruiting shareholders who have been involved in a merger helps in finding a shareholder plaintiff." See for example the website linked here. "These two ingredients make an increase in merger lawsuits likely." Certainly there are adequate reasons to have concerns about certain mergers and we've enumerated many in these posts.  Concern over the 'kneejerk' reaction of filing a lawsuit, however, is revealed in "Cash for lawyers - zero for you".  The article reports that over 70% of lawsuits resulted in no payment to shareholders.  Regardless of the merit of the litigations, the actions definitely increase the costs of mergers. They also increase the need for best practices in corporate governance and in planning and executing the deal.  We'll continue to explore these issues in this blog. Ralph

Venture Capital Discount Rates: Precisely Wrong or Roughly Right?

The standard  Discounted Cash Flow valuation approach discounts an investment’s expected cash flows at their risk adjusted cost of capital. This rate is usually estimated using a Portfolio Theory based approach like CAPM. These models concentrate on Systematic Risk not total risk. Idiosyncratic Risk can be diversified away. Hence investors can expect no compensation for holding it. An example is a resort island which has two firms-one selling suntan lotion and the other umbrellas. Holding shares in just one firm exposes you to weather risk (idiosyncratic).If you hold shares in both you are no longer exposed-you have diversified the risk. Nonetheless, you remain exposed to systematic risk of a tsunami.

Some take this to mean idiosyncratic risk can be ignored. For passive minority investments in larger more stable going concern firms this is a good enough approximation. For VC type startups idiosyncratic –total risk cannot be ignored. These firms are not and may never be going concerns due to their failure to execute their business plans. This risk is unique not systematic. In fact failure rates for startups is very high-greater than 50% in the first five years of existence. The firm never realizes on it growth potential, which represents the majority of startup firms’ value, if it fails. Furthermore, liquidation values for VC investments are usually low. This is because the assets are primarily intangible meaning they have limited value if the firm ceases to exist. Thus, the key to value creation is management’s ability to exploit the firm’s idiosyncratic opportunities. Successful venture capitalists can identify these unique undiversified winners.

The standard DCF approach utilizing portfolio theory understates the discount rate and over states value. This is why many venture capitalists use arbitrarily high discounts rates of 25%+ instead of the lower academically determined rates. The rates VC’s use vary depending on the stage of the investment with earlier stage investments having higher rates than later stage follow-on investments.

Another measure of failure risk is the Cash Burn Rate. This is the cash raised and remaining from the prior funding round divided by cash operating losses. Firms with high burn rates need access to get additional funding to fund continued losses. This access can be difficult to measure. It depends largely on VC market condition which can turn on a dime. One possible reason for the current buoyant VC valuations is inexperienced investors may be using low discount rates ignoring failure and refinancing risks.

Academics dismiss the venture capitalists’ ad hoc approach. They argue that instead of raising the discount rate you should adjust the cash flows downward to reflect their uncertainty. The problem with startups is how to make such adjustments when you lack historical operating history. Instead of the false precision from cash flow adjustment the rough approach of increasing the discount rates may not be so bad after all. As Keynes noted-it is better to be roughly right than precisely wrong.

j

The Empire Strikes Back: DuPont's Response to Trian

As readers of this blog know, contested offers, proxy fights, and activist campaigns produce heated exchanges between the parties involved.  The latest round in the DuPont/Trian exchange is from DuPont, filed with the SEC yesterday.   This is management's defense of its record and counter claims against Trian and occurs in a letter to shareholders.  See DuPont's response.

As the letter indicates, DuPont has outperformed the market in the last one, three and five year periods.  What remains unclear, however, is what additional value can be obtained through the actions Trian proposes, namely splitting up the company.  It is difficult to defend against projected 'what ifs' and admittedly, the track record of activists in general, is positive in terms of creating value. In many cases where activists attack, however, the target has been underperforming.  That certainly isn't the case with DuPont.  In Star Wars, the Empire represented the villains.  That's not clear here.  Stay tuned.

All the best,

Ralph