Final-NDC.docx

Corporate governance Definition: System of rules, practices, and processes by which a company is directed and controlled. Purpose: Ensure transparency, accountability, and ethical decision-making to protect and enhance the value of the company for its stakeholders Sarbanes Oxley Act changed the U...

Corporate governance Definition: System of rules, practices, and processes by which a company is directed and controlled. Purpose: Ensure transparency, accountability, and ethical decision-making to protect and enhance the value of the company for its stakeholders Sarbanes Oxley Act changed the U.S. Regulatory Governance in 2002 with those provisions: Auditing oversight board. Auditor independence (independent directors on audit committee) CEO/CFO subject to criminal penalties if aware of accounting faults. Limitation on personal loans to executives/directors. G index (Governance): measure that assigns one point for each provision that a company adopts which limits shareholder rights. Buy firms in the lowest decile of the index (strongest rights, dictatorship portfolio) and sell firms in the highest decile of the index (weakest rights, democracy portfolio) The democracy portfolio outperformed the dictatorship one by 8.5% per year. Better corporate governance brings higher value to the firm. E index focuses on the following 6 provisions: staggered boards, limitations of shareholder bylaw amendments, poison pills, golden parachutes, supermajority provisions mergers, and for charter amendments. Agency costs arise when management pursue their own personal goals and do not run the company in a manner that will maximize shareholder wealth. Dual classifications increase agency costs. Board’s fiduciary duties: Shareholders have to put their trust in the board of directors and hope that they will look after their collective interests when they monitor management. Principal-agent problem: Conflict that arises between shareholders/employees and management, due to agency costs, whereby the agent avoids responsibilities, makes poor decisions, or otherwise engages in actions that work against the benefit of the shareholders/employees they represent. Shareholder wealth declines as the divergence between insider voting rights and cash flow rights increases. As this divergence increases, CEO compensation rises and the propensity to pursue value-destroying M&As grows. CEO compensation is negatively related to firm value. For each dollar paid to CEOs the shareholders are losing $100. Median CEO compensation at 300 large U.S. companies was approx. 11.4 million in 2013. Solutions (reduce incentives for CEOs and limit their ability): Give shares or stock options Improve monitoring Weaken provisions Ensure CEOs are not paid for “luck”. Comparable Company Analysis (CCA) Purpose: value a company, division, business, or collection of assets (“target”). Used in conjunction with other valuation methods. Uses economic rationale: Law of one price (2 identical assets should sell at the same price). Valuation multiples uses measure of value as Numerator + financial statistic as Denominator. CCA key steps: Select the Universe of Comparable Companies Locate the Necessary Financial Information Spread Key Statistics, Ratios, and Trading Multiples Benchmark the Comparable Companies Determine Valuation Frist Step: Select the Universe of Comparable Companies Study the target, read/study as much company and sector-specific material as possible. Then, once completed, Identify companies with similar key business and financial characteristics and similar opportunities and risks characteristics. Does a set of comparable companies already exists? If not, casts a broad list and narrow it down. Business Profile Financial Profile Sector Products/Services Customers/End Markets Distribution Channels Geography Size Profitability Growth Profile Return on Investment Credit Profile Public Targets Private Targets 10-K and 10-Q SEC filings. Consensus research estimates. Equity and fixed income research reports. Press releases, earnings call transcripts, investor presentations, and corporate websites. Corporate websites, sector research reports, news runs, and trade journals. Public competitors’ SEC filings, research reports, and investors presentations. Difficult to locate “pure” comparable companies as much “art” as “science”. Second Step: Locate the Necessary Financial Information Driven on basis of both historical performance (LTM financial data) and expected future performance (consensus estimates for future calendar years). SEC Filings (historical) 10-K (annual): overview of company and year performance (audited). 10-Q (quarterly): overview of recent quarter and YTD period (unaudited). 8-K (current): material corporate events or changes (“triggering event”). Proxy Statement: material information that shareholders will vote on. Equity Research (future) Analyst estimates of future performance and sales. Consensus estimates. Press Releases and News Runs Earnings announcements, declaration of dividends, management changes. Financial Information Services SEC filings, research reports, consensus estimates, and press releases. Bloomberg, FactSet, etc. Third Step: Spread Key Statistics, Ratios, and Trading Multiples Key Statistics and Ratios Size: Market Valuation Equity Value (“market capitalization”) = Share Price x Fully Diluted Shares O/s Fully Diluted Shares O/s: Basic shares o/s + in-the-money options, warrants, and convertible securities. Options and warrants - Treasury Stock Method calculate fully diluted shares o/s. See next page. Enterprise Value (“firm value”) = Equity Value + Total Debt + Preferred Stock + Noncontrolling Interest – Cash and Cash Equivalents. Independent of capital structure. *Noncontrolling Interest, also known as a minority interest, is an ownership position whereby a shareholder owns less than 50% of outstanding shares. Size: Key Financial Data Sales: “Top line” of income statement, total $ realized, key factor for benchmark. Gross Profit: Sales-COGS, key indicator of operational efficiency and pricing power. EBITDA: Proxy for operating cash flow, independent of capital structure/tax regime, Non-GAAP. EBIT: Operating income, independent of capital structure/ tax regime. Net income: Residual profit, Wall Street views it as EPS. Profitability Gross Profit Margin: Gross Profit / Sales EBITDA Margin: EBITDA / Sales EBIT Margin: EBIT / Sales Net Income Margin: Net Income / Sales (Impacted by capital structure and tax regime) Growth Profile Historical and estimated growth rates. Compound annual growth rates (CAGR): critical value driver, smooths annual volatility. = ((Ending Value / Beginning Value) ^ (1 / Ending Year - Beginning Year)) – 1 *Historical EPS must be adjusted for non-recurring items. Return on Investment ROIC: return generated by all capital. EBIT / (Average Net Debt + Equity) ROE: return generated on equity provided by shareholders. Net Income / Average Shareholders’ Equity ROA: return generated by asset base. Net Income / Average Total Assets Dividend yield: annual dividends per share paid to shareholders. (Most Recent Quarterly Dividend Per Share x 4) / Current Share Price Credit Profile Leverage: debt level. Higher the leverage, higher repayments/interest expense, higher risk of financial distress. Debt/EBITDA Debt/Total Capitalization (Debt + Preferred Stock + Noncontrolling Interest + Equity) Coverage: ability to cover interest expense obligations. Higher coverage, stronger credit profile. Interest Coverage Ratio: EBITDA or (EBITDA – Capex) or EBIT / Interest Expense Credit ratings: ability to make full and timely payments of amounts due on debt obligations. Required for companies seeking to raise debt financing in capital markets. Primary credit rating agencies are Moody’s, S&P, and Fitch. Key Trading Multiples Equity Value Multiples P/E ratio: most widely recognized, how much investors are willing to pay for a dollar of company’s current of future earnings. Impacted by capital structure and tax regime. Higher P/E, higher earnings growth expectations. Not relevant for companies with little/no earnings. Share Price/Diluted EPS Equity Value/Net Income. Enterprise Value Multiples EV/EBITDA or EV/EBIT ratios: valuation standard for most sectors, EV/EBIT being less common due to differences in D&A. Independent of capital structure and tax regime. EV/Sales ratio: relevant to companies with little or no earnings. Less pertinent than other multiples, indication of size only. Fourth Step: Benchmark the Comparable Companies Objective: Determine the target’s relative ranking. Benchmark Financial Statistics and Ratios Benchmark the Trading Multiples Best comparables Includes Means, Medians, Highs and Lows. Fifth Step: Determine Valuation Use means and medians for most relevant multiple for sector to extrapolate range of multiples. Determine which period financial data is most relevant for calculating trading multiples. LTM: latest 12 months of data. Focus on 3 to 5 closest comparables. Valuation Implied by: EV/EBITDA P/E “Football Field” format PROS Market-based – reflects market’s growth and risk expectations, as well as overall sentiment. Relativity – easily measurable and comparable versus other companies. Quick and convenient – easy-to-calculate inputs. Current – based on prevailing market data (can be updated on a daily basis). CONS Market-based – skewed during periods of irrational exuberance or bearishness. Absence of relevant comparables – “pure play” comparables may be difficult to identify or even non-existent, especially if the target operates in a niche sector less meaningful. Potential disconnect from cash flow – significant disconnect from the valuation implied by a company’s projected cash flow generation (e.g., DCF analysis). Company-specific issues – fail to capture target-specific strengths, weaknesses, opportunities, and risks. Calculation of LTM Financial Data: LTM = Prior Fiscal Year + Current Stub – Prior Stub *Current Stub: Current year period & Prior Stub: Past year period Calendarization of Financial Data: Next Calendar (CY) Sales = (Month#/12)*(Fiscal Year Actual)+ ((12-Month#)/12)*(Next Fiscal Year) Adjustments for Non-Recurring Items (inventory write-down, restructuring charge, etc.) and Recent Events (M&A transactions, financing activities, stock splits, etc.). Rationale for Liquidity Discount 20-30% liquidity discount for privately held firms. Recommended adjustment if market-based EBITDA multiples were used in the target company valuation. Discount is typically attributed to the fact that the shares of privately held firms are less liquid than those of public firms and due to lower accounting oversight. Rationale for Control Premium 30%+ control premium for strategic acquisition. Synergies from control, valuations often feature control premiums which can enhance the value of an acquisition target by 30%+. Control premium amount depend on relative strength of bargaining positions. 2 sources of M&A data are Mergerstat and SDC Platinum. Precedent Transactions Analysis Aka Deal Comps is similar to CCA but has some differences: Provide higher multiples than trading comps due to the control premium/synergies occurring in most transactions. Equity Value= (“Unaffected” Share Price + Premium Paid)* Fully Diluted Shares O/s PROS Market-based – actual acquisitions multiples and premiums paid for similar companies Relativity – straightforward reference points Current – reflect prevailing M&A, capital markets, and general economic conditions Simplicity – few transactions can anchor valuation Objectivity – precedent-based, few assumptions CONS Market-based – multiples may be skewed Time lag – precedent transaction may not be truly reflective of prevailing market conditions Existence of comparable acquisitions – difficult to find a robust universe of precedent transactions Availability of information – may be insufficient to determine transaction multiples Acquirer’s basis for valuation – multiple paid by the buyer may be based on expectations Discounted Cash Flow Analysis Purpose: Value a company by discounting firm free cash flows to arrive at the present enterprise value of the firm. Similar to using NPV analysis to evaluate project investment. The value of both planned period CF and the TV, summed and discounted to present time, comprises our valuation. Two-step Approach to estimate Enterprise Value, as well as sensitivity analysis. Company cash flows are forecasted for the planning period and discounted back to present value. Estimated present value of all remaining cash flows is called the terminal value. Estimated by: Perpetuity approach (Gordon growth model) Multiples approach (EBITDA multiples) Enterprise value: present value of future cash flows in two segments. Planning Period (finite #) + Terminal Period (all years after) (50%+) *TV often represents more than 50% of EV. Gordon Growth Model Approach: *Uses mid-year convention for discounting both FCF and TV. Discount factor = 1 / (1+WACC))^(n-0.5) FCFF = EBIT (1-Tax Rate) NOPAT + Depreciation – Capex – Δ Working Capital + Increases in deferred taxes Often referred to as unlevered cash flow, as it represents cash flow prior to debt repayments. Once you have the value of the firm, you can subtract the debt and get the value of the equity: Equity value = Enterprise value - total debt + cash (- preferred stock - non-controlling interest ) (EBIT-interest) X (1-tax rate) = NI Because firms often pay taxes on income, they often pay less in taxes than is reported in the firm’s income statement. The difference accumulates in a deferred income tax liability. To adjust that, we add back any increase in the deferred income tax liability and subtract any decrease in this account. NWC = (Accounts receivable + inventory + prepaid expenses and other current assets) - (accounts payable + accrued liabilities + other current liabilities) ∆NWC = [(Current Assets - Current Liabilities)]t – [(Current Assets - Current Liabilities)]t-1 EBITDA Multiple Approach: Using EBITDA is beneficial because it ties the analysis of distant cash flows back to recent market transactions involving similar firms. Used for IPO’s, LBO’s, spin-offs, carve-outs, and equity valuation for investment purposes. *Uses mid-year convention for discounting FCF but not TV. EBITDA multiple and Gordon growth model should generate very similar terminal value estimates when there are no extraordinary CAPEX or investments in NWC. Breakeven Sensitivity Analysis Value Drivers: Cost of Capital Revenue Growth Rate Terminal-Value EBITDA Multiple Provide decision tools to support and background for the actual decision maker. Unlevering Beta Purpose: neutralize effects of different capital structures when calculating WACC for a private company. The computed average unlevered beta of the peer group is then relevered using the company’s TARGET capital structure and marginal tax rate. The resulting relevered beta serves as the beta for calculating the private firm’ cost of debt using the CAPM. Future growth and reinvestment Historical growth guide for future growth BUT Analyst forecasts/fundamental growth better. Geometric growth rates more accurate than arithmetic means: Considers account compounding Focuses on the first and last earnings observations in the series, ignoring intermediate observations and trends. Even better OLS regressions of EPS against time. Why? It uses every EPS data point within the time series, whereas CAGR uses only the first and the last. Fundamental growth rate of operating earnings: = Reinvestment rate * Return on invested capital Where: Reinvestment rate = (equity reinvested)/[EBIT(1-t)] Equity reinvested = Capex - Depreciation + Δ Working Capital Return on invested capital (ROC) =EBIT(1-t)/ (BVequity +BVdebt –Cash) Fundamental growth rate of equity earnings: = Retention ratio X ROE Where: Retention ratio = percentage of earnings retained in the firm WACC Assumptions and Problems Assumptions: Risks of cash flows do not change over time. Company maintains a steady capital structure. Problems: Often a constant discount rate is inconsistent with projected changes to capital structure. Solutions: Using a different WACC each period may be more realistic, or the APV approach which values interest tax savings separately from unlevered cash flows. A further improvement may be to use an LBO model to analyze performance under multiple financing structures and operating scenarios, itemizing sources and uses of funds. PROS Cash flow-based: reflects value of projected FCF, more fundamental approach to valuation. Market independent: insulated from market aberrations such as distressed periods. Self-sufficient: no need for truly comparable companies. Flexibility: allows banker to run multiple financial performance scenarios. CONS Dependence on financial projections: accuracy is challenging. Sensitivity to assumptions: small changes can produce meaningful difference. Terminal value: present value can represent as much as ¾ of DCF valuation. Assumes constant capital structure: no flexibility. Canadian Regulatory Framework Competition Bureau Canada: Main agency governing mergers in Canada. Commissioner of Competition have the authority to review any merger to determine whether it is likely to result in a substantial lessening or prevention of competition in Canada. Each province/territory has a securities regulator: Ontario Securities Commission Québec Autorité des Marchés Financiers Canadian stock exchanges also governs mergers (TSX, CSE, MX). TSX requires listed bidders attempting a merger to receive shareholder approval if issuing new shares for consideration in excess of 25% of outstanding non-diluted shares. Method of acquisition: Plan of arrangement (friendly mergers with court supervision): Single-step method of acquiring 100% of target firm shares. Target approval required but less regulations. Target shareholders most vote within 45-90 days after an arrangement agreement is entered into, often 2/3 vote approval required. Takeover bids: Made with or without target firm approval. Second step (shareholder meeting) required to obtain 100% if majority ownership is obtained. Bids must be open for at least 105 days. Acquiring 20% or more of voting shares in a public firm necessitates a takeover offer providing identical terms and conditions. Consideration offered must be at least equal to that paid by the bidder for shares within the preceding 90 days. Disclosure: Announce a merger once a definitive agreement has been signed. Prompt to disclose any material change and also report pending M&A approval if the board approval is considered probable. For “toeholds”, prompt disclosure must be made once 10% threshold is hit. Anti-takeover measures: Favor auctions and actions from target shareholders to decide on a bid. Poison pills (shareholders’ rights plans) are almost all chewable. Minimum bid-open period of 105 days poison pills not meaningful (only 10 days). Permitted deal protection measures: Public targets have the right to terminate negotiations in order to accept a superior proposal. Bidders may try to reduce this by utilizing a: No shop agreement: Prohibits target from soliciting competing bids. Right to match agreement: Allows bidder to match any competing bid. Break/termination fees agreement: Penalizes the target if the negotiation is terminated. 2-5% of target equity value. Antitrust: Governed by the Competition Act, all transactions are subject to merger review provisions. Only those exceeding each threshold below are subject to pre-merger notification provisions: Size of parties’ test – Aggregate assets (book value)/gross revenues of sales Canada > $400 million Size of transaction test – Target assets/revenues >$96 million Equity interest test – Merger would result in bidder owning > 20% (35%) of the public (private) target firm. This increases to 50% if 20% (35%) already owned. When such pre-merger notification is required, a 30-day waiting period is required before the transaction can be closed. Acquisitions by non-Canadians are delayed until the responsible minister declares that the investment is of net benefit to Canada. M&A General Definitions Merger: when two companies form a new joint organization (A+B=(A+B)). Most common type. Acquisition: acquiring company buys into majority interest of target retaining its name (A+B=A) Consolidation: integrating core operations while elimination previous organizational structures of both companies into a new corporation (A+B=C) Merger of Equals: two companies of roughly equal size and power Holdback provision: when payments to target are withheld to account for potential litigation/adverse events. Types of Mergers: Horizontal Merger: merger between two competing firms in the same industry. Why? Economies of scope/scale; synergies Government Regulation? High, due to potential anticompetitive effects. Vertical Merger: merger between buyer/seller within the supply chain. Why? Information + transaction efficiency Merger Waves: periods in which more mergers materialize than usual. Why? Economic, technological, and regulatory industry shocks Large capital liquidity Mis-valuation of firms Tender Offer: An acquiring firm makes an offer directly to the target’s shareholders. Hostile when the offer is made without the target board’s approval. Types: Any-or-all: shareholders have the flexibility to decide how many shares they want to tender at the premium offered by the acquirer. Conditional vs. unconditional: conditional means acquirer promises to buy as along as a certain threshold of shares (or some other condition) is met. Fairness Opinions: opinion issues by a third party (usually investment banker) on the value of the target company. This reduces potential liabilities of directors. Conflict of interests by arise. Successor Liability: target liabilities are assumed by acquirer when all shares are purchased. Trust Fund Doctrine: if the portion of target assets that buyer acquirers is considered “substantial”; the buyer is deemed responsibilities for target liabilities. *DOES NOT REQUIRE SHAREHOLDER APPROVAL POTENTIAL ADVANTAGE Holding Companies: they own sufficient (may be as low as 10%) stock in target to control it Advantages: Lower cost (does not have to buy 51% or more) No control premium May get control without soliciting target shareholder approval. Disadvantages: Triple taxation of dividends (unless parent owns >80% of target tax exempt) Easier to disassemble if Justice Dept. finds Antitrust/Anticompetitive problems. Higher likelihood of shareholder disagreements Sell-Side M&A Sell-Side Advisors Goals: Want to achieve the optimal mix of the following: Value maximization Speed of execution Certainty of completion ENSURE THAT KEY OBJECTIVES ARE MET + FAVORABLE RESULT IS ACHIEVED Negotiated Sale: usually involve a natural strategic buyer with clear synergies and fit; bankers play critical roles for idea generation and/or intermediary before formal process begins. *GENERALLY FASTER THAN AUCTION (no marketing/prep/buyer contact) * Auctions: target is marketed to multiple prospective buyers; process provides comfort as the market will have been tested to show inherent value. Drawbacks: Information leakage Negative impact on employee morale Possible collusion between bidders Reduced negotiation leverage once “winner” is chosen. Taint on company’s reputation if the auction does not lead to any winner. Requires significant resources, experience, and expertise (team of bankers for day-to-day execution of transaction + collaboration with target’s management) Two types: Broad: maximizes probability of max sale price (more competition), widens pool of potential buyers, limits buyers’ negotiating leverage, difficult to preserve confidentiality, higher business disruption risk, unsuccessful outcome can taint reputation, some prospective buyers may decline participation in broad auction. Targeted: focuses on a few clearly defined buyers (strong strategic fit), more confidentiality, fewer internal disruptions, may not get full price (less competition), may exclude otherwise attractive candidates. Stages of an Auction STAGE 1: Organization and Preparation (2-4 Weeks): Identify Seller Objectives and Determine Appropriate Sale Process: Sell-side advisor works with the seller. Perform Sell-Side Advisor Due Diligence and Preliminary Valuation Analysis: sell-side advisor conducts valuation from the POV of buyer, target must do a Quality of Earnings (QoE) report or a market study. Select Buyer Universe: potential buyers are selected based on potential synergies, financial capacity, size, risk appetite, etc. *Strategic buyers can pay more by leveraging synergies and lower COC compared to PE firms* Prepare Marketing Materials: first introduction to prospective buyers. Two main documents presented: Teaser: first marketing doc presented to prospective buyers, designed to inform, and generate interest (1–2-page synopsis of target; company overview, financial info.) Confidential information memorandum/presentation (CIM/CIP): detailed written description of target (>50 pages) as primary marketing doc for target. Prepared diligently by deal team + target’s management. Includes historical + projected financial information (MD&A) Prepare Confidentiality Agreement (CA): legally binding contract between target and each prospective buyer that governs the sharing of confidential info. Drafted by target’s counsel. STAGE 2: First Round (4-6 Weeks): Contact Prospective Buyers: official launch of auction process; scripted phone call by sell-side advisors to buyers delivering teaser & CA. Advisory team maintains a contact log to monitor interactions with buyers. Negotiate/Execute CAs with Interested Parties: buyer’s and seller’s counsels negotiate terms of CA Distribute CIM and Initial Bid Procedures Letter: buyers have several weeks to review CIM + personal investigation on target (target answers questions). Buyers may seek external financial consulting (inv banks). IBP letter: includes bid submission deadline, bid format (form; cash vs. stock mix), financing sources, etc. Prepare Management Presentation: slideshow + hardcopy (structure/content: concise version of CIM) Set up Data Room: hub for buyer confirmatory due diligence; database holding target info. (supplier lists, labor/purchase contracts, debt, leases, etc.). Access is typically granted after Management Presentation. Prepare Stapled Financing Package (if applicable): involves stapling the bidder’s acquisition offer with the financing arrangement together and presenting it to target, attempting to expedite transaction process. Receive Initial Bids + Select Buyers to Proceed to Second Round: Advisors + target’s management decides. STAGE 3: Second Round (6-8 Weeks) *Longest step; to facilitate bidder teams’ due diligence process* Conduct Management Presentations: a detailed overview of the company is given by target’s CEO, CFO, and other key players. Buyers bring their own advisors/consultants to the presentations. Facilitate Site Visits: target’s operations, manufacturing plant, distribution center, and/or sales office. Provide Data Room Access: may be tailored to individual bidders or even specific members of bidder teams. Distribute Final Bid Procedures Letter: outlines the date/guidelines for final bid submission. Includes strict requirements about bid amount, form, financing, etc. to ensure transparency & fairness of final round. Draft Definitive Agreement: contract between buyer/seller given to bidder detailing terms and conditions of sale transaction. Ideally, buyer submits a revised form that it would sign immediately if the bid is accepted. Receive Final Bids: bids are expected to be final and firm, by the date indicated in FBP letter. STAGE 4: Negotiations (2-6 Weeks) Evaluate Final Bids: price, structure, and conditionality of bids are analyzed within the context of first round bids, target financial performance, and sell-side valuation. Negotiate with Preferred Buyer(s): Target should negotiate with >2 bidders to maintain competitiveness. Select Winning Bidder: S-S advisors + legal counsel negotiate final definitive agreement with winning bidder. Seller AND buyer may each withdraw at any time prior to the execution of a binding definitive agreement. Render Fairness Opinion (if required): target’s board usually requires it for public companies. Letter opining on financial fairness of deal, including overview of sale process run and objective valuation target. Receive Board Approval, then Buyer & Seller Execute Definitive Agreement. Announcement: formal transaction announcement is made disclosing key terms. STAGE FIVE: Closing (4-6 Weeks, sometimes up to 3-4 months) Obtain Necessary Approvals: directly following the execution of a definitive agreement. Antitrust approval: primary regulatory approval requirement is HSR Act; requires both parties to file reports with the FTC + Antitrust division of the DOJ. If there are significant foreign operations, it may require approval from foreign regulations. *Canadian regulatory authorities called “Competition Bureau” * Shareholder Approval (One-Step Merger): target shareholders approve/reject proposed transaction (50.1%). Must first get SEC approval (long) before documents are sent to shareholders to vote. Shareholder Approval (Two-Step Merger): first, conditional tender offer is made (20 business days to acquire a majority), then complete one-step merger mechanics (assured approval due to majority). If 90% of shares are tendered, then back-end merger to squeeze out last 10% (no approval needed). Financing: In accordance with approvals/consents from definitive agreement, buyer sources necessary capital to fund transaction (either instantaneous, or buyer must use marketing to source capital funding, which may take months). May use bridge financing. Closing: The receiving of capital by the seller from the buyer and meeting all conditions from the definitive agreement marks the closing of the transaction. Merger Strategy: Motives and Determinants of Mergers Growth: company may not be able to grow fast enough via internal expansion (organic growth); Acquisition provides faster growth, at a premium. Use evaluation techniques (NPV) to decide. External growth via M&A often justifiable to capitalize on time-expiring opportunities and/or geographic expansion. Must come at greater shareholder returns to be preferred. Operating Synergy: revenue enhancements and cost reductions (Economies of scope + scale) Cost-Reducing Synergies: easier to predict and achieve; for example, economies of scale. Revenue-Enhancing Synergies: harder to predict and achieve; ex: cross selling of products increased pricing power, combination of functional strengths (mixing A’s R&D with B’s manufacturing), entering faster growth/new markets Economic Basis for Mergers: NAV = PV(A+B) – [PV(A) + PV(B)] – PV(Expenses) |**POSITIVE NAV**| Financial Synergy: lowering the COC by combining cash flows that are negatively correlated (lower risk) Ex: lower flotation + transaction costs, better access to financial markets, lower borrowing costs Higgins and Schall claim: debt coinsurance does not create new value, merely distributes gains; benefits accrue to debtholders at the expense of equity holders. Equation: RT = Rs + Rb Diversification: poor motive for acquisition in isolation (poor track record; except GE). Shareholders can diversify much less expensively (no premium) than firms can for their shareholders. Advantages: learn a skill before continued expansion in that area, may lead to debt coinsurance. Disadvantages: diversification discount (studies differ), overall manageability is difficult. Horizontal Acquisitions: combination of two firms producing the same product at same level in chain. Benefits: elimination of duplicate facilities, broader product offering, market power Lerner index = (P – MC) / P falls between 0-1, where 1 is complete monopoly, and 0= no power Vertical Mergers: dependable source of supply, lower inventory and transaction costs, customization, etc. Backward Expansion: toward source of supply, Forward Expansion: toward the ultimate customer. Hubris and Managerialism Hypothesis: managers acquire firms for their own personal motives; economic gains are not the sole/primary motivator. Pride can lead manager to believe that their valuation methods are superior to market’s objectively determined valuation (result: overpaying) Proof? Stock prices often fall when the market realizes hubris was part of merger motives. Hubris: managers believe their valuation is superior to market overpay Managerialism: Managers may know they are overpaying but do so to pursue their own goals. Higher Executive Compensation: increasing firm size directly correlates to higher compensation. Improved Management: acquiring firm’s management can better manage target. if they are wrong, they paid a premium that did not translate to increase in firm value overpaid. Tax benefits: highly debated, Tax Reform Act removed many possible benefits, inversion (Bermuda) Pursuit of #1 ranking: acquire a company with to achieve #1 position with help of acquirer’s resources. Desirable Characteristics of Targets: Low P/E Ratio, but high BV | Firms with undervalued assets | High liquidity | High steady cashflows | Unused borrowing capacity | No antitrust issues | No potential takeover threats | Management amenable to Takeover | P/E Game: Acquirer purchases a target with the same EPS, such that its post-merger price increases by virtue of the acquisition. Only works if: investors continue to evaluate the acquirer’s P/E ratio as it was pre-merger (requires acquiring firm to operate target firm resources in just as profitably as the rest of the firm), Acquiring firm’s P/E ratio is higher than the target’s P/E ratio. Antitakeover Measures Preventative: Defenses installed in advance of a takeover (wall building) Poison Pills: Corporate Charter Amendments Golden Parachutes Making firm less attractive: increasing target leverage, disposing/locking up key assets, etc. Active: Defenses deployed at the onset of a takeover battle Tax Law Changes to Greenmail: Tax Reform Act of 1986: Limited the tax deductibility of greenmail payments. Premium over market value is not tax deductible. Revenue Act of 1987: Imposes a 50% tax penalty on any gains derived from greenmail if the raider threatened to take over corporation. Discriminatory Self-Tenders (Antigreenmail): tender offers initiated by the target to repurchase shares from certain shareholders. Illegal thanks to SEC reviewing of Unocal case Poison Pills Formal Poison Pill: Shareholder’s Rights Plan Shadow Pill: does not need to be pre-existing. Usually, a backup poison pill that activates after poison pill. Chewable pill: pill disappears or is redeemable by shareholders, rather than only by boards. Typical Poison Pill: shareholder rights plan whereby shareholders have the right to buy more shares at a discount, if an acquirer buys a certain percentage (e.g., 20%) of the company’s shares Timeline: first used in 1982, more famously in 1983, but not popular until 1985 (perfected by Martin Lipton) Lipton created poison pills that were rights that were convertible into shares of the combined company. Flip-over pills: allows the shareholder to purchase stock of the combined firm at a 50% discount off market price once buyer purchases 100% of the target. Grants shareholders benefits once triggering event occurs. Note: does not prevent an acquisition of a controlling interest that is >100% Flip in: occurs afters similar triggering event and merger allows holder to buy shares in target at 50% off. Voting plans: company issues dividends in preferred stock; if outside entity acquires a specific % of target’s stock, preferred stockholders get super voting rightsone right per share common right to purchase a share at the exercise price (typically 50% off) anytime during the exercise period (typically 10 years) Requires Board approval, but not shareholders. Delaware SC: Approved legality of poison pills in Nov. ’85. Pills don’t prevent firm from getting tender offer. Unfair Uses of Poison Pills: Maxwell vs. Macmillian and Rales vs. Interco (1988); pills were said to favour internal restructuring over external acquisition unfairly. Preventative Antitakeover Measures Supermajority Provisions: charter amendments requiring higher than majority voting approval for certain events (i.e., approving takeover); often 80% is required. Board out clause allows board to make decisions that supersede supermajority. Staggered/Classified Boards: not all directors come up for election at a time. Longer to gain majority control. Dual Capitalization: one or more classes of stock, where one has super voting rights, but low dividend. Fair Price Provisions: shareholder amendments that require bidder to pay a fair price for all acquired shares. Fair: Certain P/E, highest price paid for any shares, highest price stock traded over past year Reincorporation: reincorporate into another state which has stronger antitakeover laws (Cali + Pennsylvania) Antigreenmail Provisions: Charter amendments which prohibit payment of greenmail. Active Antitakeover Measures Greenmail: Payment of a premium to buy shares of a threatening shareholder. Antigreenmail: The act of doing, not the provision, is active. Standstill Agreements: Payment to threatening shareholder not to purchase any more shares. White Knights: Friendly buyer preferred to hostile takeover. White Squire: Friendly buyer of a block of stock that it is put in safe hands. Lock-Up Transactions: Sale of assets that make target less desirable. Lock-Up Options: An option that gives a third party the right to buy certain assets at an attractive price (illegal). Capital Structure Changes: Tie-up shares or alter leverage. Pac-Man Defense: Make bid for the hostile takeover of acquiring firm. Litigation: Delays can be advantageous. Examples of Capital Structure Changes: Issue more shares: General issue, white squire, Employee Stock Ownership Plan (ESOP) Buyback Own Shares: Self tender, target share repurchases, open market purchases. Recapitalization Plans Assume More Debt: Issue more bonds, take out bank loan. Takeover Tactics Influences of Choice of Tactic: Attitude of target management and board Distribution of voting power Strength of target’s defenses in place Presence of competing offers and or a white knight Merger Tactics Casual Pass: bidder attempts a friendly overture prior to initiating a hostile bid; done when bidder is unsure of target’s response. Target is advised not to discuss such deals, so bidder doesn’t get the wrong idea. Downside: may backfire because it gives advanced warning to target. Toehold: start by accumulate target’s share to avoid payment of premium, thereby lowering takeover cost. Downside: if takeover bid is unsuccessful, acquirer is caught holding shares, attracts other bidders. Bear Hugs: bidder brings offer directly to target’s directors—may be friendly or hostile—least aggressive. Teddy Bear Hug: less threatening; does not include a price; not meant to be public. Regular Bear Hug: does include a price; meant to be public; meant for bidders reluctant to engage in tender offer, as it is less expensive. Two-Tiered Tender Offers: illegal; more expensive than negotiated deals due to legal, publication, info costs. Securities transfer=tax-free, but longer than cash due to SEC review requirement. Bypass Offers: unsolicited and was not preceded by negotiations or discussions between the two firms. Creeping Tender Offer: process of gradually acquiring shares in the market or through private transactions. Street Sweeps: sweeping up a large block of target shares from arbs after a cancelled tender offer. Proxy Fight: attempt by a single/group of shareholders to take control/bring about change in company. Successful when: management has insufficient voting support, poor operating performance, good alt plan. Advantages: less expensive than tender offer, but still has professional fees, printing, mailing, legal costs. Arbitrage and M&A Riskless Arbitrage: buying/selling shares in the same asset in different markets and different prices. Risk Arbitrage: buying shares in potential or actual targets and possibly selling shares in acquirers. Role of Arbitragers: acquire shares in hope that deal closes they get the difference between their purchase price of target shares pre-close and the closing price with its premium. They also sell acquirer’s shares short knowing that bidder’s stock price often declines after M&A announcements + including stock in deal. Risk Arbitrage Return (annualized): (Gross Stock Spread)/(investment by arbitrager) * (365/Investment Period) Stock Price Movement Due to Arbitrage: one study attributed half of bidder’s downward price to arb shorting. Fixed Exchange Ratio Deal: # of shares is fixed, but $ value changes as a function of acquirer’s share price. Fixed Value Deal: $ value is fixed, but number of shares changes as a function of corresponding share prices. Floating Collar: firm boundaries on top and bottom; gains/losses shared within range. Fixed Collar: payment is fixed if bidder share price remains within range; beyond range gains/losses shared. Leveraged Buyouts Definition: Acquisition of a “target” using debt to finance a large portion of the purchase price. Traditional LBO: 60% to 70% debt and 40% to 30% equity. Key Participants Financial Sponsors Private equity firms, hedge funds, venture capital funds, SPACs. *For PE firms, capital is organized into funds that are usually established as limited partnerships. Preforms due diligence. Investment Banks Provider of financing and strategic M&A advisor. Preforms due diligence and internal credit process. Bank and Institutional Lenders Capital providers for the bank debt. Bank lenders consist of banks, savings and loan institutions, finance companies, and the investment banks serving as arrangers. Institutional lenders consist of hedge funds, pension funds, prime funds, insurance companies, and structured vehicles. Performs due diligence and internal credit process. “Bank meeting”. Bond Investors Purchasers of high yield bonds. Consists of mutual funds, hedge funds, pension funds, insurance companies, and distressed debt funds. “Roadshow presentations”: 1-2 weeks process Target Management Marketing of the target, primary face of the company. Includes stock option-based compensation packages. Management Buyout (MBO): LBO originated and led by a target’s existing management team. Strong LBO candidate: Strong cash flow generation Leading and defensible market position Growth opportunities Efficiency enhancement opportunities Low capex requirements Strong asset base Proven management team Returns Analysis IRR: measure attractiveness of a potential LBO by measuring the total return on a sponsor’s equity investment. Cash Return: Multiple of their cash investment How LBOs Generate Returns? Combination of debt repayment and growth in enterprise value. How Leverage is Used to Enhance Returns? Smaller equity contribution generates higher returns. Higher level of debt provides the additional benefit of greater tax savings realized due to the tax deductibility of a higher amount of interest expense. Higher leverage increases the company’s risk profile (and probability of financial distress), limiting financial flexibility and making the company more susceptible to business or economic downturns Primary Exit/Monetization Strategies 5-year holding period. ¸ Sponsor seeks to achieve multiple expansion upon exit. Several strategies aimed at achieving a higher exit multiple: Increase in the target’s size and scale Meaningful operational improvements Repositioning of the business toward more highly valued industry segments Acceleration of the target’s organic growth rate and/or profitability Accurate timing of a cyclical sector or economic upturn Sale of Business: to another company “strategic sale” or to another sponsor. IPO: portion of its shares is sold to the public. Dividend Recapitalization: Issuance of additional debt to pay shareholders a dividend. Below Par Debt Repurchase: Private equity firms can purchase bank debt and high yield securities. LBO Financing Structure LBO Financing Selected Key Terms LBO Financing Primary Sources Equity Contribution: For large LBOs, several sponsors may team up to create a consortium of buyers, thereby reducing the amount of each individual sponsor’s equity contribution (known as a “club deal”).