Merger Waves: Health Care, Autos, and Semiconductors

Weve written several times before about merger waves.  They cluster in the aggregate economy, generally correlating with the stock market.  And – they cluster by industry.  The reason for the latter is generally that some catalyst has forced a change in the industry and consolidation is in order.

Consider what makes acquiring another firm attractive.  Simply put, a firm becomes an attractive target when the benefits exceed the costs.   There are three general components to this calculation – the cash flows, the discount rate and the costs.

First, consider the costs.  If something happens that decreases the cost and the benefits stay the same, the firm becomes an attractive target.  Costs could decline because the general value of the industry has declined or because a specific firm is not maximizing value.  Costs could also decline if a firm wanted an immediate sale (sacrificing price for liquidity).

Second, lets consider the discount rate: Picture the present value equation – a string of (generally) yearly projected cash flows in the numerator and an appropriate discount rate in the denominator. The present value or benefit of any asset is equal to the cash flows of the project discounted at an appropriate discount rate.  Appropriate means adjusting for risk and recognizing current market interest rates.  So if risk or current rates decrease, the value of a firm increases.  Some firms that were unattractive before become attractive now. 

Third, consider the cash flows. A similar thing occurs with the numerator.  If something happens that makes the cash flows larger, the value increases and the firm becomes more attractive.  If the cost has remained the same, some additional firms are likely to come into play.

How does this relate to merger waves in an industry?  As we have noted, industry merger waves generally occur because some catalyst has changed one of the three inputs above.  These catalysts include shifts in regulation, interest rates, consumer tastes, technology or other factors of production.    When these shifts occur, the net present value equation (i.e. present value minus the costs) is altered; firms in the industry become attractive and there is a jockeying to acquire them.  In today’s news we have several good examples:

• ·      Humana is reported up for sale – changes in federal health care laws (Obamacare) have altered the economics of the industry
• ·      Fiat –urges bigger rivals to recognize the need for consolidation in the industry because of overcapacity in the industry
• ·      Intel taking over Altera – to boost revenue following consolidation in the semiconductor industry
•  

There are plenty of other examples.  Just look for the catalyst and then look for the opportunity. 

Happy Prospecting,

Ralph

Exchange Rates and Cross Border M&A: Free Lunch or Expensive Banquet?

Ralph’s post raises some interesting valuation issues. A strong USD is supposedly aiding an increase of domestic firms acquiring foreign firms. The argument is, for example, the 25% appreciation of the USD against the Euro over the past years makes Euro zone targets cheaper. This, however, only looks at half of the exchange equation. You indeed pay less USD for the Euro assets (assuming the target does not change their price). You also receive less-the expected value of the future Euro cash flows when converted back to USD is also lower. This is the reason why many U.S. multinationals are now experiencing earnings declines. Some argue the translation effects should be ignored as noncash accounting noise. This of course assumes the FX effects will reverse. It also ignores the opportunity loss on the depreciated target cash flows during the interim period.

Others allege you are still better off buying today at a lower price and receiving depreciated Euro cash flows than buying last year at the higher prices. This assumes you can correctly forecast FX movement and market time your purchases. If you can, then why bother with M&A? Probably better to speculate directly on FX  rather than using the firm’s balance sheet.

I highlighted  approaches to valuing foreign assets based on parity among foreign exchange, interest and inflation rates. The first approach involves converting foreign cash flows into the home (e.g. USD) currency using interest rate parity relationships; then discounting the converted cash flows using appropriate USD discount rates. The second reflected below values cash flows in foreign currency terms:

Forecast target cash flows in local terms:

1)     Discount the target cash flows in local currency (e.g. Euros)

2)     Discount the Euro cash flows using local rates to calculate Euro NPV; expected change in FX rates reflected in local rates.

3)     Spot the Euro NPV into USD

Under this approach, FX movements should not have a material effect on cross border acquisitions as the decreased price reflects the lower valued cash flows. Yet, as the Erel, et al article highlights FX rate movements do appear to be correlated with M&A activity. Perhaps, acquirers in strong currency countries are better performing because their economies are stronger. This may make these acquirers more confident as they feel wealthier and have higher risk appetites. Alternatively, they could be confused by the depressed Euro prices and interrupt them as being cheaper hence better buys than domestic USD dominated targets. A more sinister view is it may reflect disguised currency speculation.

My basic view remains unchanged; focus on the fundamentals. There “ain’t no free lunch”. You get what pay for. There are many complications in cross border M&A. Do not get side tracked with dubious “bargain” FX arguments. 

J

Cross Border Acquisitions

One of the most comprehensive analyses of cross border published in the Journal of Finance and analyzing deals from 1990 to 2007 notes:

"The vast majority of cross-border mergers involve private firms outside of the United States. We analyze a sample of 56,978 cross-border mergers between 1990 and 2007. We find that geography, the quality of accounting disclosure, and bilateral trade increase the likelihood of mergers between two countries. Valuation appears to play a role in motivating mergers: firms in countries whose stock market has increased in value, whose currency has recently appreciated, and that have a relatively high market-to-book value tend to be purchasers, while firms from weaker-performing economies tend to be targets."

"Determinants of Cross-Border Mergers and Acquisitions", Isil Erel, Rose Liao and Michael Weisbach  The Journal of Finance, June 2012

A lot has changed since 2007 but we still see the importance of many of these same factors.  A recent Wall Street Journal notes how the dollars strength is causing a resurgence of foreign deals.  (Of particular interest to our Acquisition Finance Course coming up in Amsterdam this December, the article notes that "FedEx cited the stronger dollar in its pending $4.8 billion takeover of Dutch carrier TNT Express N V").  Notice the graph below.  U.S. takeovers of foreign companies are on track to top even last year's record volume.  

Another major factor mentioned in the article is the opportunity to save on taxes by incorporating in more tax friendly countries.  See our blog post Politics, Taxes and Economic Reality.

All the best,

Ralph

Corporate CFOs Are From Venus and Private Equity GPs Are From Mars Part II

General Partners (GPs) in private equity (PE) firms behave differently than corporate chief financial officers (CFOs) concerning investment and capital structure decisions. CFOs tend to follow more textbook approaches; GPs, however, deviate from the textbook in several respects. This has gone largely unnoticed by academics until recently.

I have noted before how PE capital structure decisions differ from corporations. An interesting paper expands on the differences as follows:

1)     Corporations follow the textbook ratings based static trade-off approach when making capital decisions.

2)     PE firms do not follow the textbook. Rather, they use as much debt as they can get given existing market conditions. Thus, they use more debt in bull markets when debt is both easily available and inexpensive. This is consistent with my experiences when dealing with PE. As one GP stated it-“where I come from more debt and less equity is always better!”

3)     Higher debt levels allow PE to bid higher for investments. This in turn depresses returns on late cycle acquisitions leading to booms and busts.

PE also acts differently from corporations when making investment decisions.

1)     CFOs tend to follow the textbook or best practices valuation approaches. This means they use discounted cash flow based net present value models to evaluate investment opportunities. Furthermore, they use risk adjusted discount rates utilizing CAPM methodology.

2)     A survey of PE GPs reveals GPs do not follow textbook prescriptions regarding investments. First, they do not use net present value discounted cash flow methods. Instead they use MOIC (money over invested capital) multiples, which ignore the time value of money. Second they do not use risk adjusted hurdle rates or CAPM. Rather, they use flat 20-25% hurdle rates.

3)     This makes sense-why use complicated methods to evaluate projects when the driving force is debt based affordability based on market conditions? It is also consistent with my private equity experience. The investment committee never paid much attention to DCF or risk adjusted capital measures. All that mattered was the expected MOIC.

The obvious question is why does PE ignore the textbook and engage in primitive and value destroying methods compared to corporate CFOs? For me it comes down to incentives-people do what they are paid to do and not what they are told to do. The incentive arrangements in PE partnership agreements include:

1)     Limited investment period of 5 years. Either GPs use the LP’s commitments within that period or they expire and the fees and profits to GPs expire with them.

2)     The carried interest is an option. Option values increase as risk increases. Hence GP become risk seeking thru higher risk investments or increased leverage.

Thus, there are real agency conflicts from the misalignment of GP and LP interests. The next obvious question then becomes why do LPs put up with this? Consider there are similar agency conflicts between LP’s and their beneficiaries. The LP’s and their consultants are evaluated (i.e. compensated) based on nominal not risk adjusted returns. Furthermore, most LPs cannot lever their investments. Investing in PE allows them to gain implicit leverage which they are willing to pay for by accepting the agency costs.

In any event institutional factors can drive financial behavior as is apparent with GPs.

J

Drexel's 8th Academic Conference on Corporate Governance

As I mentioned before, last month we hosted our 8th Academic Conference on Corporate Governance at Drexel.  I say academic, because we also host specific practicioner events including our Director's Dialogue.  I'll recap that in a subsequent post.

This year's conference featured five top papers from over sixty submissions.  Many good papers didn't make the cut.  The audience features top researchers in Corporate Governance from around the world.

The five papers this year addressed issues in executive compensation (CEOs getting bonuses when corporate pensions are frozen and curious firm behavior in contract years) , Norway's gender quotas on boards (suggesting previous work was mistaken);  the role of passive institutional investors (hint, they aren't passive in terms of governance), and takeover defenses (what works, what doesn't).

The complete program along with links to the papers is available here.

All the best,

Ralph

Game or Illusion: Unicorn Valuations

I have been puzzled by seemingly irrational venture capital implied valuations. The number of unicorns (start-ups with implied values greater than $1B) just keeps growing-The Economist estimates over 100 worldwide. Some possible explanations include:

1)     New Paradigm: AKA this time is different-it never is. If something cannot go on forever then it ends (Stein’s Law). The “this time is different” explanation was the justification mistakenly used during the late 20^th century dot com bubble.

2)     Investor Irrationality: not so sure about this-just seems too easy an excuse. Usually reflects we just do not fully understand the economics underlying the set of facts.

3)     Pseudo Pricing/Valuation: price comparisons are difficult as unreflected /underpriced terms (e.g. downside liquidation preferences) are involved. As Ralph likes to remind me you can name the price if he can name the terms and he will win every time (yes-Ralph is tricky). Further complicated by inefficient markets without short selling to correct optimistic momentum based investors.

4)     Manipulation: interesting Fenwick & West report suggesting later round implied value prices are manipulated. The reasoning - reaching Unicorn status is an important badge of accomplishment for young firms. The increased credibility that comes with it conveys advantages in attracting employees, customers and additional financing. Thus, “wanabe” unicorns will work with investors to structure the terms specifically to reach the unicorn threshold. The report offers some interesting stats:

a)     The average price increase in the unicorn financing round is 100% higher than in the prior financing round.

b)     The unicorn financing round is led 75% of the time by nontraditional (not venture capitalists) investors.

An obvious implication is (a) later round financings led by nontraditional investors, (b) in which the price is substantially (e.g. 100%) higher than the previous financing round price and (c) the implied post money value magically reaches unicorn status are rigged. This manipulation hypothesis gets my vote for what is happening-combined with too much VC capital chasing too few deals (VC fund raising is at its highest level since the dot com crash). Remember, there is no SEC to worry about as these are private offerings-sometimes characterized as private IPOs (inter alia-limited due diligence and disclosure). Someone can sue if harmed, but caveat emptor may bar their claim-no one forced them to buy. Do not think courts should protect those who do not know what they do. Everyone should know the base rate success for venture capital is very low (i.e. most such investments fail). Thus, they should take the implied values with more than one grain of salt.

Provided investors realize it is all a game like fantasy football, and not real, things will remain benign. Unfortunately people can sometimes get confused and start to believe the prices/values are real (e.g. noise traders). Then, trouble occurs when everyone realizes there was gambling going on and they have been had.

J