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2
M&A
3
A Practical Guide to Doing the Deal
Second Edition
JEFFREY C. HOOKE
4
Cover image: © iStock.com / Vladitto
Cover design: Wiley
Copyright © 2015 by Jeffrey C. Hooke. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Hooke, Jeffrey C.
M & A : a practical guide to doing the deal / Jeffrey C. Hooke. — [Second edition].
pages cm. — (Wiley finance series)
Includes index.
ISBN 978-1-118-81699-8 (hardback) — ISBN 978-1-118-81704-9 (ePDF) — ISBN 978-1-118-81701-8 (ePub) 1. Consolidation and
merger of corporations—Finance. I. Title. II. Title: M and A.
HG4028.M4H66 2015
658.1′62—dc23
2014024067
5
CONTENTS
Preface
Recent Trends
Overview of the Contents
What’s New in the Second Edition
Part One: The Big Picture
Chapter 1: The Global M&A Market: Current Status and Evolution
An Upward Trend, Interrupted by Booms and Busts
M&A Activity by Geography
Deal Categories
Large versus Small Transactions
M&A: No Guarantee of Success
Note
Chapter 2: U.S. M&A History, Trends, and Differences from Other Nations
U.S. M&A History
Advanced M&A Industry in the United States
M&A in Wealthy Nations Other Than the United States
Emerging Market M&A
Notes
Chapter 3: The Need for Growth Spurs Acquirers to Buy Other Companies
Ten Buyer Motivations
The Most Popular of the 10 Motivations
Summary
Notes
Chapter 4: The Three Financial Tactics That Dominate the M&A Business
Enterprise Value
Earnings per Share Dilution
EBITDA Considerations
Tactic #1: Cost Cuts/Revenue Gains
Tactic #3: Financial Arbitrage
Conveying the Three Tactics to Investors
Discounted Cash Flow Analysis Supplements the Tactics
Summary
Notes
Part Two: Finding a Deal
Chapter 5: The Buyer Must Have a Methodical Plan in Order to Find a Quality Transaction
An Active Approach
The Acquisition Plan
Internal Assessment
Summary
Chapter 6: To Begin an Acquisition Search, the Buyer First Sets the Likely Parameters of a
Deal
Defining the Parameters
Case Study
Summary
Chapter 7: The Buyer Starts the Formal Acquisition Search by Alerting Intermediaries and
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Contacting Possible Sellers
Laying the Groundwork
Four Steps in Beginning a Search
Retaining an Intermediary to Assist in the Search
Summary
Note
Chapter 8: Finding a Deal: Likely Results of a Search
Due Diligence
Structure the Deal
Financing the Deal
Closing and Integration
Publicly Traded Companies
Summary
Notes
Chapter 9: The Four Principal Risks Facing a Buyer in the M&A Business
Overpayment Risk
Operating Risk
Debt Leverage Risk
Macroeconomic Risk
Downplaying M&A Risks
Summary
Notes
Part Three: Target Financial Analysis
Chapter 10: Sizing Up the M&A Target from a Financial Point of View
Starting the Historical Financial Analysis
Beginning the Historical Analysis
Normalizing Results
Absolute Amount Analysis
Percentage Changes
Common Size Analysis
Growth Ratios
Ratio Analysis
Industry-Specific Indicators
Comparable Company Performance
Review of P.F. Chang’s Financial Analysis
Notes
Chapter 11: To Facilitate Financial Projections, the Buyer Needs to Classify the Target as a
Mature, Growth, or Cyclical Business
Company Classifications
The Mature Company
The Growth Company
The Cyclical Company
The Declining Company
The Turnaround
The Pioneer
Summary
Chapter 12: How Practitioners Forecast an M&A Target’s Sales and Earnings
Means of Forecasting
7
Critiquing P.F. Chang’s Projection
Preparing Projections
Three Scenarios
Summary
Notes
Part Four: Acquisition Valuation
Chapter 13: The M&A Industry Typically Uses Four Valuation Methodologies
Assessing Each Methodology
Applying Multiple Methodologies
Summary
Chapter 14: The Use of Discounted Cash Flow in M&A Valuation
Discounted Cash Flow versus Comparables
The Discounted Cash Flow Valuation Process
Choosing the Right Discount Rate in Valuing a Standalone Business
Summary
Note
Chapter 15: Valuing M&A Targets Using the Comparable Public Companies Approach
Real Estate Analogy
What’s the Right P/E Ratio?
A Word about Value Multiples
Summary
Chapter 16: Valuing an M&A Target by Considering Comparable Deals and Leveraged
Buyouts
Control Premium Is Embedded in Comparable Acquisitions
Understanding Leveraged Buyouts
LBO Mechanics
Case Study: Crane Co.
Summary
Note
Chapter 17: Valuation Situations That Don’t Fit the Standard Models
Sum-of-the-Parts
The Cyclical Company
Speculative High-Tech Companies
Low-Tech, Money-Losing Companies
Turnaround Considerations
High-Leverage Company Considerations
Natural Resources
Emerging Market Acquisitions
Discounted Cash Flow (DCF)
Comparable Public Companies and Comparable Acquisitions in the Emerging Markets
Summary
Notes
Part Five: Combination, the Sale Process, Structures, and Special Situations
Chapter 18: Combining the Buyer’s and Seller’s Financial Results for the M&A Analysis
Combining the Buyer’s and Seller’s Projections
Reality Check
Financing Sources
Summary
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Notes
Chapter 19: When Is the Best Time for an Owner to Sell a Business?
Seller Categories
Timing Considerations
Making the Decision
Confronting Reality
Selling the Business versus an Initial Public Offering
IPO versus Sale
Partial Sale/Leveraged Recapitalization
Summary
Notes
Chapter 20: The Sale Process from the Seller’s Vantage Point
Retaining a Financial Adviser
Setting the Stage for the Sale
The Buyer’s List
Approach Tactics
Confidentiality, Operational, and Personnel Issues
Due Diligence Visits
Coming Up with a Bid
Final Due Diligence and Legal Documentation
Summary
Chapter 21: A Review of Legal and Tax Structures Commonly Used in Transactions
Acquisition Legal Structures
Legal Considerations
Triangular Merger
Simplified Tax Structures
Legal Documents
Summary
Note
Chapter 22: Unusual Transaction Categories
Tax-Free Deal
DEMERGER
Reverse Merger
Special Purpose Acquisition Corporation (SPAC)
Hostile Takeover
Summary
Note
Chapter 23: Final Thoughts on Mergers and Acquisitions
About the Author
Index
End User License Agreement
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List of Tables
Chapter 1
Table 1.1
Chapter 3
Table 3.1
Table 3.2
Chapter 4
Table 4.1
Table 4.2
Table 4.3
Table 4.4
Table 4.5
Table 4.6
Table 4.7
Table 4.8
Chapter 6
Table 6.1
Table 6.2
Chapter 9
Table 9.1
Table 9.2
Table 9.3
Table 9.4
Table 9.5
Table 9.6
Table 9.7
Table 9.8
Chapter 10
Table 10.1
Table 10.2
Table 10.3
Table 10.4
Table 10.5
Table 10.6
Table 10.7
Table 10.8
Table 10.9
Table 10.10
Table 10.11
Table 10.12
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Chapter 11
Table 11.1
Table 11.2
Table 11.3
Table 11.4
Chapter 12
Table 12.1
Table 12.2
Table 12.3
Table 12.4
Table 12.5
Chapter 13
Table 13.1
Chapter 14
Table 14.1
Table 14.2
Table 14.3
Table 14.4
Table 14.5
Table 14.6
Chapter 15
Table 15.1
Table 15.2
Table 15.3
Table 15.4
Table 15.5
Table 15.6
Table 15.7
Table 15.8
Chapter 16
Table 16.1
Table 16.2
Table 16.3
Table 16.4
Table 16.5
Chapter 17
Table 17.1
Table 17.2
Table 17.3
Table 17.4
Table 17.5
Table 17.6
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Table 17.7
Table 17.8
Table 17.9
Chapter 18
Table 18.1
Table 18.2
Table 18.3
Table 18.4
Chapter 20
Table 20.1
Table 20.2
Table 20.3
Table 20.4
Table 20.5
Chapter 21
Table 21.1
Chapter 22
Table 22.1
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List of Illustrations
Chapter 1
Figure 1.1 M&A Activity, 1993–2013, by Value in the United States.
Figure 1.2 Vertical Industry Diagram: U.S. Electric Power
Chapter 3
Figure 3.1 Optimal Track Record for a Business
Figure 3.2 Vertical Chain
Figure 3.3 Oil Exploration Business: Drilling For versus Buying Reserves
Figure 3.4 Capital Structures of Buyouts versus Normal Companies
Chapter 4
Figure 4.1 EPS Accretion/Dilution First Year after a Deal Closing
Figure 4.2 Like-for-Like Deal, Higher Stock Price
Figure 4.3 Discounted Cash Dividend Valuation Approach, Constant Growth Model
Chapter 8
Figure 8.1 The Acquisition Search Funnel: 12-Month Process
Chapter 11
Figure 11.1 Cyclical Company Earnings Plotted against GDP
Chapter 14
Figure 14.1 Different Rates of Return: November 2013
Figure 14.2 Sample k Calculation, October 2014, U.S.-Based Company
Chapter 15
Figure 15.1 Three Sets of Numbers at August 15, 2014
Chapter 16
Figure 16.1 Leveraged Buyout Capitalization: Debt and Equity Market Value
Chapter 17
Figure 17.1 Holding Company Structure with Three Operating Divisions
Figure 17.2 Comparing Problem Companies (In millions)
Figure 17.3 Natural Resources Acquisition—Valuation Methodology
Figure 17.4 Emerging Markets US$ Sovereign Bond Yield/Spreads Against U.S. Treasury
Bond
Chapter 21
Figure 21.1 Statutory Merger
Figure 21.2 Stock Purchase
Figure 21.3 Asset Purchase
Figure 21.4 Triangular Merger
Figure 21.5 Asset versus Stock Sale: Seller’s Point of View (in millions)
13
14
15
Preface
When most people hear the term “mergers and acquisitions,” the impression that comes to mind is a
merciless corporate raider, who acquires a weakened corporate behemoth, strips the business of its
assets, and fires thousands of innocent workers in the relentless pursuit of profit. This caricature is
the gist for Hollywood films, but it holds true for only a minute fraction of transactions. The vast
majority of M&A deals are friendly combinations between companies in the same, or a very similar,
business.
The arranging, financing, and documenting of these combinations is a large industry in and of itself
—employing a sizeable number of people in many vocations. The industry’s attributes—and the
process through which deals are conceived and closed—thus merit the close attention of a broad
cross-section of individuals, such as:
Investment bankers involved with mergers and acquisitions (M&A).
Equity analysts at hedge funds, risk arbitrage, pension funds, commercial banks, endowments,
insurance companies, mutual funds, and sovereign wealth funds, who invest in firms engaged in
M&A.
Private equity professionals at buyout funds, venture capital funds, and hedge funds, who
routinely buy and sell companies.
Corporate financial executives and business development professionals.
Institutional loan officers working with M&A and buyout transactions.
Business students at colleges and graduate business schools.
Investor relations professionals at corporations and public relations firms.
Business appraisers, including those at appraisal firms, accounting firms, and consultancies.
Lawyers who work with corporate clients on M&A-related legal, financial, and tax matters.
Independent public accounting firms that review M&A accounting.
Government regulators at the Federal Trade Commission (FTC), Department of Justice, Internal
Revenue Service (IRS), Securities and Exchange Commission (SEC), Federal Deposit and
Insurance Corporation (FDIC), Public Accounting Oversight Board (PCAOB), Comptroller of the
Currency, and Federal Reserve (and their international counterparts).
Government elected officials who are interested in privatization or M&A related effects on
economies.
Bank trust and private wealth advisers.
Sophisticated individual investors.
Consultants that assist acquirers in the M&A due diligence process concerning the information
technology, human resources, environmental records and nonfinancial facets of the seller.
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Recent Trends
During the 16 years since the first edition was published, M&A activity has skyrocketed—increasing
by a factor of four times—and the M&A community has expanded accordingly. Accompanying this
growth were important changes to the business, including the following:
Embracing of M&A by smaller firms. Previously the province of large companies, M&A is
increasingly a sought-after growth option for mid-market enterprises.
Private equity. The amount of capital provided to the private equity industry for leveraged
buyouts has increased exponentially. Private equity is a more significant player in the M&A
business than it was during the first edition’s introduction.
International. Like other facets of American business, M&A has gained international
acceptance, particularly in the developed economies of Western Europe. In recent years, M&A
activity in emerging markets, such as China and Brazil, has grown.
Natural resources. To complement traditional exploration programs, natural resource
companies have ramped up acquisitions as a means to gain additional reserves at a reasonable
cost.
Expansion of the Internet. The expanded use of the Internet has made the M&A process
easier for buyers and sellers, and thus it has facilitated the rise in transactions.
Increase in computing power, coupled with a decline in its cost. Information related to
prospective deals, their pricing, and their financing structure can be sliced and diced in
numerous ways. This allows industry participants to quickly size up likely scenarios.
Rise in activist investors. After a long hiatus, activist investors are stimulating M&A activity
among publicly traded companies, encouraging those considered “undervalued” to sell
themselves or conduct spin-offs. Publicly traded companies represent a small subset of the deal
universe, but they tend to involve the larger, more publicized transactions.
17
Overview of the Contents
The book starts with a bird’s-eye view. We begin with the state of the global M&A markets and the
motivations behind most acquisitions. I then synthesize the 10 principal motivations into the three
financial tactics that govern the preponderance of deals. These topics represent Chapters 1–4.
After this high-level review, the book covers the age-old question: How does a buyer find an
acquisition from the thousands of possible targets? The book outlines the methodical search process
of successful acquirers and ends the discussion with the key attributes of “good” versus “bad” deals.
This material is covered in Chapters 5–9.
Once the buyer has identified a few acquisition candidates, it assesses their financial histories and
future prospects (Chapters 10–12). Then, it must consider the appropriate price to offer the owners.
Chapters 13–17 provide a brief synopsis of corporate valuation techniques, the subject of many
books including one of my own: Security Analysis and Business Valuation on Wall Street (John
Wiley & Sons, second edition, 2010). The standard techniques for industrial and service firms
represent the limit for most valuation books, but here I also cover special challenges, like natural
resource companies, money-losing enterprises, cyclical businesses, and emerging markets firms.
The special cases are important; few acquisition targets are U.S.-based, “vanilla” companies with a
smooth upward trend of revenue and profit—that is, the kind you see in most textbooks.
If the buyer and seller are “close” on the seller’s valuation, the buyer then has to gauge the impact of
the prospective transaction on its balance sheet, income statement and future equity price. Chapter
18 reviews the basics of M&A financial accounting for the combined firms. From this initial financial
analysis, the buyer completes a computer model of the transaction. As Chapter 18 explains, the
model provides the basis through which other financial actors—lenders, equity investors, and rating
agencies—assess the deal. If the seller accepts buyer securities or contingent consideration, it too
will consider modeling the transaction. The book discusses debt and equity finance in Chapter 18.
Up through Chapter 18, I focus on the buyer’s strategy tactics, valuation, accounting, and finance
concerns, essentially descending from (a) the “big picture” viewpoint to (b) the day-to-day task of
the buyer’s deal analysis. Chapter 19 takes a diversion and it discusses the reasons why sellers sell
and why a sale is often preferable to an initial public offering (IPO). Chapter 20 then proceeds to
cover, in a step-by-step fashion, the process by which a sizeable business is sold.
Chapters 21 reviews the key legal documents encompassed in the sale process, as well as the
common legal structures. A proper legal structure can save the buyer or seller significant monies,
and it can offer either party substantial protection from unforeseen problems.
Chapter 22 examines several transaction categories, such as hostile takeovers, demergers, and
reverse mergers, which fall into the mainstream from time to time. Such transactions gain
popularity only to recede into obscurity, as economic or regulatory conditions change.
18
What’s New in the Second Edition
The methodical process needed to produce a successful M&A deal has not changed fundamentally
over the past 30 years. However, the transaction environment, valuation techniques, financial
accounting, and legal structures have evolved over time. This second edition provides the necessary
updates, additional insights, fresh examples, and current anecdotes. I have rewritten the majority of
the book to provide a more concise treatment of M&A and to reflect my broader international
experience. This edition takes advantage of the knowledge I have gained from closing more deals,
conducting executive education, and lecturing on M&A around the world.
To facilitate the reader’s understanding of the subject matter, the book is divided into five parts.
Part One: The Big Picture
Part Two: Finding a Deal
Part Three: Target Financial Analysis
Part Four: Acquisition Valuation
Part Five: Combination, the Sale Process, Tax and Legal Structures, and Special Situations
Instructors may visit the Wiley Higher Education website for M&A, Second Edition for Q&A,
PowerPoint Slides, Sample Exams, Cases and Exercises, and other classroom tools.
For convenience, the pronoun he has been used throughout this book to refer nonspecifically to
capital markets participants. The material herein will be equally useful to both men and women who
evaluate M&A transactions.
This book will help you consider corporate strategies, make optimal M&A transactions, close better
private equity deals, obtain superior arbitrage investments, and assess relevant regulatory matters.
M&A: A Practical Guide to Doing the Deal provides a practical, well-rounded view of the M&A
business and enables you to make sound judgments and to confront M&A’s many challenges.
JEFFREY C. HOOKE
Chevy Chase, Maryland
August 2014
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Part One
The Big Picture
20
CHAPTER 1
The Global M&A Market: Current Status and Evolution
This chapter reviews the global merger and acquisition (M&A) market and traces its expansion.
Transactions are segmented into several categories, with most deals being medium-sized, private
transactions. There is no guarantee of success in acquisitions.
21
An Upward Trend, Interrupted by Booms and Busts
M&A activity over the past 20 years has shown a marked growth trend, interrupted by peaks and
valleys related to financial booms and busts. Volume spiked during the Internet bubble (1998–1999)
and the private equity boom (2006–2007), only to drop significantly and then recover. Announced
deals in the United States in 2013 totaled $1.1 trillion in volume, encompassing over 15,000
transactions. Figure 1.1 shows the trend line.
Figure 1.1 M&A Activity, 1993–2013, by Value in the United States.
Data Source: Bloomberg and Reuters
As the figure shows, the M&A market is a cyclical business. Activity is tied to several variables:
Stock market valuations
Availability of debt financing
Optimistic views on the economy
When equity values rise in the stock market, an acquirer can offer his inflated stock to a seller as
currency for the transaction. Using high-priced stock in a deal makes the transaction’s mathematics
more attractive for the buyer. Alternatively, if the seller doesn’t want the buyer’s stock, the buyer can
complete an equity raise in the public (or private) markets, and provide the seller with the necessary
cash. The end result is thus identical.
For buyers to complete deals that make sense for their shareholders, borrowed money usually is part
of the financing package. M&A activity is thus dependent on lenders—such as banks, finance
companies, and bond funds—being open for business and willing to sign-off on the aggressive
assumptions that often drive transactions.
High-priced stock investors, liberal lenders, and motivated buyers are all reflective of positive views
on the strength of the economy, and this optimism promotes deals. Once a recession hits and the
psychology goes negative, transaction volume dries up.
22
23
M&A Activity by Geography
The United States and Canada represent a large share of M&A activity, and this continued to be the
case in 2013. Typically, transactions are aggregated by four geographies. See Table 1.1.
Table 1.1 M&A Volume by Value, Year Ended December 31, 2013
Data Source: Bloomberg.
Region
%
United States and Canada 44
Western Europe
21
Japan/Australia
12
Emerging Markets
18
100
The United States and Canada have about 22 percent of global gross domestic product (GDP), but
they account for almost double that percentage in deal volume. Emerging markets, which are
defined as countries having annual GDP per capita of US$9,000 or less, make up about 35 percent
of global GDP, yet their percentage of deals is much lower. We discuss these disparities in the next
chapter.
24
Deal Categories
M&A is segmented into four broad categories:
1. Horizontal
2. Vertical
3. Strategic/Diversification/Conglomerate
4. Private Equity
A horizontal deal is when a company acquires (a) a competitor, (b) a firm doing the same business
in a different geography, or (c) an enterprise engaged in a product line that is similar to that of the
buyer. Recent horizontal mergers include: (a) El Paso/Kinder Morgan, two U.S. pipeline companies,
$36 billion value; (b) Amgen (U.S.)/Onyx (U.S.), two drug firms, $10 billion; and (c) Valeant
Pharmaceuticals (Canada)/Bausch & Lomb (U.S.), two health-care product firms, $9 billion.
Horizontal is the most popular deal category because it presents the buyer with the fewest operating
risks. The buyer knows the target’s product line, suppliers, and customers, and it can institute cost
saving measures with little disruption to the seller’s operations. Furthermore, in the case where the
seller is a direct competitor, the acquirer has the added benefit of potentially raising prices with
minimal customer resistance. Perhaps three quarters of all M&A deals fit the horizontal category.
A vertical transaction occurs when a company buys a supplier, distributor, or customer. A coalburning electric utility that acquires a coal miner is one illustration. Most industries have drifted
away from vertical integration, with exceptions being the big oil companies, like Exxon and
Chevron. So, vertical deals tend to be quite rare. See Figure 1.2.
Figure 1.2 Vertical Industry Diagram: U.S. Electric Power
Strategic, diversification, and conglomerate transactions take place when the buyer is engaged in a
25
field that is unrelated to the seller. Sometimes, the buyer believes it has a set of strengths that can
propel the seller’s business (or vice versa), and the transaction is thus part of a grand strategy to
boost the buyer’s future. At other times, the buyer seeks to redeploy capital from its core business
into another primary line, rather than disposing of the cash by paying higher dividends or
repurchasing stock. Berkshire Hathaway, the insurance conglomerate, completed one of its many
diversification deals when it purchased railroad Burlington Northern for $34 billion in 2010.
Strategic, diversification, and conglomerate deals represent about 10 percent of M&A activity.
Private equity participates in M&A principally through the leveraged buyout (LBO). An LBO is a
transaction whereby a private equity fund (or a similar investor group) acquires a company and uses
borrowed money to meet most of the cost of the deal. The private equity fund does not guarantee the
loans, so the lenders look solely to the acquired company for repayment. Because an LBO is not a
combination of similar businesses, the opportunities for an LBO to cut duplicate costs are minimal,
and the investors rely on new management, new operating tactics, or a rising stock market to boost
values.
Through the LBO, private equity funds control many large U.S. corporations, such as Hertz Rent-ACar, Hilton Hotels, and Caesar’s Entertainment, and the funds have made substantial inroads into
Western Europe. At the LBO peak in 2006, such debt-funded deals represented 30 percent of M&A
activity, a figure that has since dropped to about 10 percent according to data generated by Capital
IQ.
26
Large versus Small Transactions
Large transactions involving publicly traded companies garner most of the media attention, and
they account for 60 percent of dollar volume, out of 30,000 to 40,000 global deals per year, based
on my estimations and data services. Three quarters of transactions involve privately owned firms
(or divisions of publicly traded companies) with annual revenue under US$100 million equivalent,
and 97 percent of purchase prices are under US$100 million.1 One big $10 billion deal, therefore,
equals the value of two hundred $50 million deals.
27
M&A: No Guarantee of Success
Despite all the hullaballoo surrounding M&A, numerous studies over the years have proven that
over half of acquisitions do not increase the buyer’s per share equity value. However, most buyer
executives, investment bankers and other practitioners fail to take such studies seriously, and they
think that their deal will beat the odds. Such action is a calculated risk, and it reflects the corporate
view that M&A is often the fastest means of growth. Why spend years developing new products and
cultivating new customers, when you can acquire both in a few months with an M&A transaction?
For many corporate managers, this logic is compelling and the opportunity for a big score outweighs
the risk.
M&A’s acceptance by United States’ operating companies and financial markets is facilitated by the
government’s light regulatory hand. Most deals involve competitors or similar businesses, yet U.S.
authorities rarely challenge transactions on antitrust grounds. Compared to other jurisdictions, legal
protections for those U.S. workers displaced by M&A cost-cutting are minimal; and, thus, acquirers
can realize cost synergies with little government interference. For large public deals, federal and
state regulations allow the buyer’s stockholders a minor role. Management dominates the process
even if the acquisition price appears overly generous and thus injurious to the buyer’s stockholders.
Finally, the U.S. government welcomes foreign corporations to buy into the United States.
The U.S. regulatory attributes are lacking, to one degree or another, in foreign markets, which
explains their relative lack of activity. We cover the differences in the next chapter.
28
Note
1. Bloomberg, “Global Financial Advisory—Mergers and Acquisition Rankings 2013.”
29
CHAPTER 2
U.S. M&A History, Trends, and Differences from Other Nations
The U.S. M&A market is more advanced than those of other countries, and, as a result, the United
States has a disproportionate share of transactions. The reasons behind the disparity are covered in
this chapter.
In my travels, I have given M&A seminars on several continents. Inevitably, the attendees want to
know how their local market stacks up against the United States, where the M&A business is highly
advanced.
30
U.S. M&A History
To give the response some context, a review of the U.S. market’s 120-year evolution is helpful.
Historians and M&A experts identify six merger waves.
First Wave: 1895–1907
The first wave saw a horizontal M&A boom, as larger enterprises gobbled up their smaller
competitors. Monopolistic firms, such as U.S. Steel and Standard Oil, became dominant, with a
number later broken up by newly empowered antitrust authorities. The wave ceased with the
financial panic of 1907.
Second Wave: 1920–1929
Vertical mergers gained popularity, as firms integrated backward by buying supply sources or
forward by acquiring distributors. Holding companies assembled many individual electric utilities
into vast corporations. A decade of economic prosperity saw new technologies, such as commercial
radio broadcasting, and higher stock prices propelling M&A volume. The wave ended with the 1929
stock market crash.
Third Wave: 1960–1970
With the introduction of modern portfolio theory in the 1950s, big corporations attempted to
minimize risk and to enhance equity value by becoming diversified conglomerates through
acquisition. This notion coincided with an economic boom that pushed equity prices higher and
contributed to increased M&A activity. A 1970 stock market collapse terminated this wave.
Fourth Wave: 1982–1989
The fourth wave was marked by Corporate America’s broad acceptance of M&A as a means to foster
revenue and earnings growth. Previously, blue chip corporate executives had an anti-M&A bias,
viewing an acquisition as the buyer’s admission that its core business was weak. Stimulating activity
was a huge rise in corporate restructurings and hostile takeovers. The latter was funded often by
junk bond financing, a new financial tool that enabled corporate raiders and companies with low
credit ratings to launch bids for established firms. The wave was damaged by 1987’s Black Monday
crash, when the U.S. stock market fell by 22 percent, and it ended on October 13, 1989, when a $7
billion LBO deal for United Airlines collapsed. This event caused a sizeable stock market drop and
augured the coming 1990–1991 recession.
Fifth Wave: 1992–2000
From 1992 to 2000, the stock market and the economy experienced an expansionary period,
precipitated in part by the Internet boom. Lofty high-tech stock prices spurred many stock-for-stock
mergers, as dot-com buyers took advantage of high equity valuations. The frenzy declined with the
bear market’s start in late 2000, and the S&P 500 index lost 50 percent of its value by October
2002. Investors and lenders pulled back, and wave-related activity dropped accordingly.
Sixth Wave: 2004–2007
As the 2000–2002 crash faded into memory, corporations, equity investors, and lenders plunged
into M&A once again. This wave featured a much higher percentage of cash deals, and LBOs played
a larger role than in prior waves. The 2007/2008 global financial crisis, stock market crash, and
economic recession caused a 60 percent drop in deal volume, from which the M&A industry slowly
recovered.
31
32
Advanced M&A Industry in the United States
During these M&A waves, a large group of U.S. practitioners representing a variety of disciplines
(including valuation, lending, investment banking, legal, accounting, exit planning, regulatory, and
tax) have established an M&A Industry, employing tens of thousands of people, whose principal
function is to provide advice and other services related to the successful completion of M&A deals by
operating businesses, private equity firms, and other entities (i.e., “buyers” and “sellers”). The
industry has a body of knowledge, customs, and procedures that tend to dominate the manner in
which businesses prepare for, and carry out, M&A transactions. Due to the influence, expertise, and
dominance of the industry in these transactions, corporate executives and corporate directors—
particularly in larger companies—find it necessary to familiarize themselves with the relevant
knowledge, because M&A, at times, is a contributor to corporate growth and shareholder value.
Practitioners convey this knowledge formally, to corporate executives and others, in books, articles,
presentations, and seminars. Universities, executive education institutes, family business
organizations, and other groups provide information on M&A as well. Formal presentations are
often portrayed from the point of view of the principal actors—that is, the buyer or the seller—
although a lengthy book, like this one, for example, incorporates multiple viewpoints. Many articles
and short presentations address special topics—leveraged buyouts and leveraged recapitalizations,
high-tech or natural resource industries, tax and legal matters, and postmerger integration.
Furthermore, in the United States, a publicly traded company CEO is approached by investment
bankers (or business brokers) offering to sell him smaller companies operating in his industry on a
regular basis. Privately owned enterprises also receive frequent contacts from investment bankers,
business brokers, and private equity firms, with the subject of the inquiry being whether the
enterprise desires to be acquired or needs capital.
33
M&A in Wealthy Nations Other Than the United States
Highly industrialized countries include most Western European nations, Japan, and Australia.
Relative to the United States, they have a smaller proportion of M&A to national income. Prime
contributors to the differential are:
Fewer publicly traded companies
Stronger layoff protections
Heavier regulation
Publicly traded companies help to drive M&A activity because they are under more pressure—
compared with family-owned or private firms—to generate revenue and earnings growth. They tend
to be more acquisitive. Publicly traded companies are less of a presence in other developed
countries, promoting the disparity. Relative to the United States, other wealthy nations have
stronger layoff protections for employees. These protections make a combination of like companies
less efficient, from a financial point of view, in countries like France and Spain when compared to
the United States. Other developed nations also tend to have more interventionist regulation in the
M&A arena, retarding deal volume versus the United States.
In Japan, the world’s third largest economy, the business establishment has never accepted the
notion of American-style M&A. Japan is still the home of sizeable conglomerate groups (both
vertical and horizontal conglomerates, called keiretsu) that have resisted successfully the
restructuring and core competency focus that has driven M&A growth in other nations. Inside the
keiretsu, layoffs are frowned upon, although smaller Japanese companies use such actions to cut
costs.
34
Emerging Market M&A
Emerging markets are poor countries with per capita income of less than $9,000. In contrast, the
United States has a per capita income of $50,000. These markets are extremely diverse in language,
politics, and culture, yet patterns of business circumstances are recognizable. The economic
influence of emerging markets is often overstated. With 85 percent of the world’s population, they
represent just 35 percent of global GDP. The top three emerging markets—China, Brazil, and Russia
—account for 19 percent of global GDP. Domestic economies are small—India, with 1.2 billion
people, has a GDP equivalent to the state of California—thus restricting the number of targets for
multinationals that seek domestic entry points, production platforms, and natural resources. Private
equity funds and local players face a similar dearth of acquisition targets.
Publicly traded companies are underrepresented relative to wealthier nations, and most emerging
markets have a handful (perhaps 30–50) of large capitalization firms. A number of such firms have
outgrown the home markets and now look abroad for expansion opportunities. Notable emerging
market acquirers of international businesses include China National Oil (China, oil), Mittal (India,
steel), and 3G Capital (Brazil, consumer).
With the exception of China and Russia, emerging markets are dominated by companies that cling
to the family business model, a factor that limits buying for the following reasons:
Less growth pressure: Family-controlled companies, even when publicly traded, have less
pressure (than an investor-owned business) to push acquisition-style growth, since the company
is immune to a hostile takeover or proxy fight prompted by a low stock price.
Less management incentive: Nonfamily managers generally have no stock options in the
business, and thus little incentive to achieve growth through acquisition.
Aversion to ownership dilution: As I discuss later in the book, buyers sometimes need to
sell equity in the business to finance a takeover. Many families are reluctant to take this action
for fear of diluting their ownership.
Anxiety regarding leverage: Similarly, deals sometimes require the acquirer to take on a
higher-than-normal debt load. High leverage is frowned upon by emerging market families, who
prefer a conservative stance to weather the volatile cycles in their home economies.
Seller attitudes play a role in restricting M&A activity as well:
Secrecy concerns: Emerging market family businesses are more paranoid about divulging
routine business information (to possible acquirers) than their developed country counterparts.
Among other reasons, “confidentiality agreements are difficult to enforce in emerging markets”
says Laura Aleran, a lawyer at Peruvian law firm, Payes, Rey, and Canvi.1 And furthermore, the
family business may keep two sets of books—one for the tax authorities and one for the family—
and information provided to competitors could find its way to local government officials.
Unrealistic views on valuation: With few local deals to provide benchmarks, the emerging
market business owner approached by a buyer tends to suggest a lofty valuation, making the
transaction untenable. The wide bid and ask gap reduces deal flow.
China and Russia
China and Russia have different issues. In China, M&A is heavily regulated by the central
government, which is reluctant to support deals for fear of initiating the speculative M&A bubbles
observed in the United States. Additionally, most of the large Chinese firms are controlled by the
state. Local bureaucrats fail to grasp the beneficial concepts of M&A, and many are reluctant to
pursue consolidations because of the social protests that job layoffs might cause. Thus, China, for
example, has 35 domestic carmakers and 12 foreign manufacturers, for a total of 47 participants, far
more than other large economies. Russian enterprises face regulatory obstacles as well, with the
government placing restrictions on local firms acquiring outside of Russia. Both countries are wary
of foreigners buying in country.
Local Finance Practices Inhibit Emerging Market M&A
35
M&A debt financing in the United States and Western Europe relies on the cash flow loan. The
buyer typically acquires the seller at two times (or more) its historical accounting value, so the
borrower sometimes lacks sufficient hard collateral to cover the debt obligation. Hard collateral
might be inventory, plant, or equipment. As a result, the lenders look to the future earnings power of
the combined businesses for repayment. In contrast, emerging market banks are uncomfortable
with cash flow loans. They want 150 percent collateral coverage as a requirement, which often
upends a transaction’s mathematics, according to Luo Yang of China Bond Research.2 Corporate
bond markets (including junk bonds) are undeveloped, and they can’t fill the void left by the skittish
commercial banks.
On the equity finance side, local investors in the emerging markets are unfamiliar with the buyer
benefits of an M&A deal. The analysts at brokerage firms and financial institutions are unfamiliar
with M&A accounting and they lack experience in sizing up transactions. The bias tends toward
organic growth, similar to the U.S. thought pattern in the 1950s and 1960s.
Emerging Market Structural Issues
Like Western European nations, emerging markets make M&A-related layoffs difficult (or
expensive) for the acquirer, thus undercutting cost initiatives from an M&A combination.
Governments discourage foreigners from controlling leading economic sectors or prominent brands,
and local monopolies seek protection from outsiders entering the country and creating new
competitors. Mexico, by way of example, has just two soft drink companies, two phone service
providers, two TV networks, two beer brewers, two cement companies, and so on. Meanwhile, the
world’s largest M&A market, the United States, is right next door.
36
Notes
1. Interview with Laura Aleran, November 20, 2013.
2. Interview with Luo Yang, China Bond Research, October 16, 2012.
37
CHAPTER 3
The Need for Growth Spurs Acquirers to Buy Other Companies
The need for growth sparks companies’ desire to acquire other businesses. Growth tends to promote
a higher stock price, which helps a firm to retain good employees and to sustain operations. In this
chapter, we look at the 10 principal motivations.
Most businesses strive for consistent increases in sales and earnings, as depicted in Figure 3.1.
Upward-trending track records bring publicly traded firms higher-than-average price earning (P/E)
ratios, premium stock prices, attractive financing offers, new business proposals, and many
acquisition opportunities. Much of the same holds true for similarly situated private enterprises.
Success breeds success.
Figure 3.1 Optimal Track Record for a Business
Companies make acquisitions in order to grow. Growth is critical to a profit-seeking enterprise for
several reasons:
Retain talent: A business needs growth in order to retain good employees. Growth provides
additional promotions and rewarding compensation schemes—such as stock options—for those
employees who otherwise might depart to greener pastures.
Capital: A growth record facilitates the raising of debt and equity capital needed to sustain
operations.
Constituent confidence: A growing business imparts confidence to customers and suppliers
that are vital for survival.
Fundamentally, a business has three strategies to promote this growth:
Customers: Gain more revenue from existing customers, or find new customers for existing
products.
Products: Develop new products.
Acquisitions: Obtain more products and/or customers through acquisitions (sometimes called
“buy” versus “build”).
The growth plans of large companies include elements of each strategy.
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39
Ten Buyer Motivations
Ten M&A motivations for a buyer are:
1. Economies of scale
2. Achieve oligopoly power
3. Speed growth through diversification
4. Vertical integration
5. Buying technical expertise
6. Avoid new product risk
7. Capture natural resources
8. Cut target’s costs
9. Enter new country
10. Private equity
Acquisitions are built upon these 10 buyer motivations.
1. Synergies/Economies of scale. When buying similar businesses, a company achieves
economies of scale, as fixed costs are spread over a wider production (or service) base. These
economies sometimes spill over into the revenue side, as the buyer may have superior marketing
or distribution systems that can help the seller’s operation. Acquisition-related cost reductions
and revenue enhancements are termed synergies.
Cost reductions fall heavily on the target as the buyer eliminates parts of the target’s business
that are readily duplicated by the buyer. For example, the buyer will have its own chief executive
officer, chief financial officer, general counsel, human relations (HR) department, and legal
department; and, therefore, such functions at the target are no longer needed. A working number
for cost synergies in a like-for-like deal is 2 percent of the target’s revenue, although this rule of
thumb varies by industry. In 2013, for example, Tenet Healthcare projected cost savings
amounting to 2 percent of the annual revenues of acquisition Vanguard Health Systems, a fellow
hospital operator.1
In many instances, the buyer’s marketing, sales, and distribution power are applied to the seller’s
business, and the result is a revenue gain for the seller. Such revenue synergies are harder to
predict than cost cuts, but buyers include revenue enhancements into many like-for-like deals,
despite the uncertainty. The combination of cost cuts and revenue increases often boosts a
seller’s earnings—postacquisition—by 20 percent or more. Economies sometimes increase a
buyer’s profit margins as well, as efficiencies are spread throughout both operations (this
incurred in one of my deals in which two distributors combined overlapping service areas.). As
the like-for-like deals multiply, the acquirer evolves into a member of an oligopoly, and it then
seeks motivation #2 below.
2. Achieve oligopoly power. In the long run, a profit-seeking business seeks oligopoly
positioning, where it has little competition, strong pricing power, and an enhanced ability to
pressure suppliers for lower costs. Acquisitions of competitors represent a prime vehicle to
accomplish this objective.
The United States, for example, is home to many oligopolies constructed through takeovers, such
as the cell phone, cable TV, airline, and commercial banking industries, to name a few. One job
of government is to prevent oligopolies, although regulatory success is spotty in the United
States and elsewhere. One example is the increase in airfares between Chicago and Houston, the
home bases of United and Continental. After their merger, average airfares rose 57 percent,
versus 16 percent elsewhere.2
3. Growth through diversification. Sometimes, a business decides to expand beyond its
existing industry niche. It may have reached its maximum market share, or management may
believe alternative industries represent better investment opportunities. The stage is then set for
a diversification acquisition, whereby the company buys into an unrelated industry. “It’s the
fastest means to diversity,” indicates Paul Murray, chief financial officer of Digital Management.3
Although such “buy-ins” seem illogical to many stockholders, these transactions are justified as
40
“strategic deals” because the acquirer maintains that the takeover is part of a scientific plan
designed to achieve a long-term goal.
Based on my observations, and those of several studies, the performance of strategic deals has
been substandard. Besides paying a takeover premium for the target, a buyer commits to a
business where it lacks skills and experience. The poster child for a strategic deal mistake
remains the Time Warner AOL merger, which resulted in a goodwill write-off exceeding $80
billion and a persistent decline in Time Warner’s stock price. History is littered with examples of
strategic M&A failures.
In recent years, the strategic deal has fallen out-of-favor on Wall Street for two reasons. One, the
track record of such transactions in enhancing the buyer’s own value is questionable. Two,
shareholders of prospective buyers achieve diversification on their own by purchasing equity
investments in alternate industries.
4. Vertical integration. Buying a customer can sometimes streamline the acquirer’s product (or
service delivery) process to the ultimate consumer, or it simply can enhance profits by cutting
out a middleman (see Figure 3.2). Both Coke and Pepsi have acquired their principal bottling
firms in recent years. The respective deals gave both Coke and Pepsi “more flexibility in
distribution and route to market” said John Sicker, editor of Beverage Digest.4
Acquiring a supplier, on the other hand, often represents an interest in firming up the product
line. When U.S. cable TV operator Comcast bought the NBC Universal media empire for $30
billion in 2011, it wanted to lock up content for its vast cable TV business.
Figure 3.2 Vertical Chain
5. Buying technical expertise. Acquiring a business for technical expertise is so popular in the
high-tech industry that the action has a nickname: an “acquirehire” or a “tech and talent” deal.
Frequently, acquirehire deals feature a target that has minimal revenue and substantial losses;
the road to success is elusive. However, as Dan Bobkoff of NPR’s “All-Tech Considered” points
out, “the tech giants don’t care about what the small companies (i.e., the acquisitions) were
producing. They just want the software engineers.”5
41
After the tech and talent deal closes, its products are shut down, and its engineering talent then
starts work on the parent company’s projects. With these transactions, sizeable companies avoid
both the expense and the hassle of assembling a large development team through the normal
hiring process.
In 2012 and 2013, for example, Yahoo! completed over 25 acquisitions, according to news
reports.6 Most were acquirehires.
6. Avoid risk of new product introduction. For an established corporation, starting a new
business from scratch is time consuming, laborious, and risky. A new product line has to be
invented, a new delivery infrastructure constructed, and a new customer base recruited. The
market’s demand for the product, the cost of its production (or delivery in the case of a service),
the product’s pricing, and its anticipated competition must all be predicted with reasonable
accuracy for the corporation to realize a solid investment return. Perhaps 10 percent of new
product introductions succeed, according to Nielsen Corporation.7 The uncertainty of result and
the long lead time tempt established firms into M&A as another means of moving ahead.
An M&A deal brings the buyer a business with a preset infrastructure, and a history of sales and,
possibly, of earnings. The acquisition has long passed the most risky stage of corporate life—
start-up and early development. The buyer’s main risk thus tends to be paying too much versus
operational failure.
7. Capture natural resources. In the energy business, there used to be a saying: “It’s a lot easier
to drill for oil on Wall Street than in the ground.” When one natural resource company buys
another, the store of value lies in the seller’s resource reserves. Seventy to 80 percent of stock
market values for oil and gas exploration and production (E&P) concerns are, by way of example,
represented by the worth of their energy reserves in the ground (i.e., reserves documented by
independent engineers, but not yet pumped to the surface to generate revenue).
As of this writing, the market for U.S.-based oil reserves is roughly $15 per barrel in the ground,
and E&P acquisition pricing is typically expressed as what the buyer paid per barrel of such
reserves, with the cost of working capital, plant, and equipment, and other assets being an
afterthought. For example, the enterprise value of Legacy Oil & Gas was expressed by one analyst
as equivalent to $15.34 per barrel.8
By buying a business with oil and gas reserves, the E&P acquirer eliminates the risk of drilling
dry holes (i.e., exploratory wells that do not produce oil or gas in commercial quantities). The
cost of a single dry hole can be tens of millions of dollars, particularly if the drilling is done
offshore, but a successful well pays for itself many times over. Thus, an E&P firm balances the
risk/reward of its own drilling program against the certainty of result (and cost) of buying
reserves through an M&A process. Similar logic flows through other natural resource industries,
such as mining. See Figure 3.3.
Recent natural resource deals include China Oil’s $15 billion takeover of Canadian oil producer
Nexen and a Polish copper miner’s $2 billion merger with Canadian copper miner Quadra FNX.
Figure 3.3 Oil Exploration Business: Drilling For versus Buying Reserves
8. Cut costs at target. Many small firms lack the management knowledge or the management
discipline to run a business at its optimal rate. A larger operator, with greater management skills,
can increase the target’s efficiencies, even if the two businesses are not directly related. This is
one motivation behind numerous conglomerate deals, and many private equity (PE) purchases.
By way of illustration, if a PE firm acquires a business for $200 million, and then increases
42
earnings by 25 percent, it stands to reason, all things being equal, that the value of the PE
investment has climbed by 25 percent, or $50 million (i.e., from $200 million to $250 million),
because most companies are priced off earnings power.
9. Enter new country. The business world has gone global, and everyone wants to expand
internationally. For many companies, exporting a product or a service to a foreign land is not
enough; to grow properly, the business requires a physical presence and an infrastructure in the
foreign market. Buying a local operation can be favorably compared to starting up an entirely
new venture, or entering into a halfway arrangement, such as a joint venture or a marketing
alliance with a local partner.
The acquired firm’s plant, technology, and employee base provide the buyer with a readymade
infrastructure on which to add the buyer’s own products. The target’s set of business licenses,
operating permits, and import/export quotas also enable the buyer to avoid the time-consuming
bureaucratic maze that accompanies a start-up.
In international deals, cross-cultural problems can easily arise between the buyer’s and the
seller’s respective managers. Both sets of executives may have trouble adapting. That’s why a
high proportion of multinationals step into the global arena gradually, starting with exports, then
joint ventures, and finally small acquisitions. A foreign M&A deal is the culmination of a longterm entry approach.
10. Private equity. Private equity firms are massive pools of capital, primarily supplied by large
institutions such as pension funds, sovereign wealth funds, and endowments. The firms aim to
beat the returns offered by public stock market indices, such as the Standard & Poor’s 500 Index,
by investing principally in businesses that do not trade publicly.
In the M&A market, private equity firms participate mainly through the leveraged buyout (“LBO”
or “buyout”) transactions, whereby the PE firm acquires an operating business with mostly
borrowed money. See Figure 3.4. The lenders finance the acquisition on a nonrecourse basis to
the PE firm, which means the PE firm does not guarantee the loan and the lenders look solely to
the acquisition’s assets and future cash flows for repayment. Since the acquisition’s resultant
capital structure has more debt (as a percent of the businesses’ total worth) than its peer group,
the return to the PE investor is enhanced (in a rising stock market) versus buying a similarly
situated public company. Of course, the reverse effect occurs in down markets. See Figure 3.5.
Besides added leverage, the buyout investors seek a premium return through improving an
acquisition. The PE firm might install changes that are over-and-above what alterations the
previous owners were willing, or capable, of doing. PE firms also give professional managers a
larger piece of the pie than they would receive in a family-owned, corporate divisional, or public
company context. The theory here is that these managers will then strive harder to maximize
their employer’s growth and earnings.
Buyout firms, by necessity, are limited to acquisitions in which lenders put up the bulk of the
purchase price. Targets that fit this description are profitable, low-tech, noncyclical businesses
with consistent track records. Pricing is generally less than 10 times annual earnings before
interest, taxes, depreciation and amortization (EBITDA). These criteria limit buyout firms to
perhaps 20 percent of the eligible takeover pool. Large 2012 LBO’s included the firms listed in
Table 3.1.
43
Figure 3.4 Capital Structures of Buyouts versus Normal Companies
Table 3.1 Large 2012 Leveraged Buyouts
Source: Capital IQ, SEC filings, author.
Target/Buyer
Value(Billions) EV/EBITDA Target’sBusinesses
Ratio
Ancestry.com/Permira Advisors
$1.6
10.0×
Family history, online
resource
Par Pharmaceuticals/TPG Capital
2.2
8.3
Drug manufacturer
Interline Brands/Goldman Sachs
Capital Partners
1.1
9.7
Distributor of plumbing and
hardware products
P.F. Chang’s Bistro / Centerbridge 1.1
Partners LP
8.5
Restaurant chain
Note: Enterprise value (EV) equals the market value of the target’s equity securities, plus outstanding debt, less cash.
44
The Most Popular of the 10 Motivations
Of the 10 buyer motivations, we have covered, numbers 1 and 2—economies of scale and oligopoly
power—play the dominant roles. The list of 10 large deals in 2012 provides evidence of this
assertion. See Table 3.2.
Table 3.2 M&A Transactions Dominated by Like-Like Deals
Data Source: Bloomberg.
Target/Buyer
Value
Buyer’s Motivation
(Billions)
Xstrata/Glencore
$47
Economies of scale (horizontal deal) in mining and metals
trading
Sprint Nextel/Softbank
37
Enter another country (United States) (horizontal deal) for
Softbank (Japan)
MetroPCS/TMobile
32
Economies of scale, oligopoly in U.S. cell phones
TNK-BP/Rosneft
28
Economies of scale, oligopoly power in Russia
Nexen/CNOOC
17
Chinese firm to capture natural resources in Canada
Grupo
17
Modelo/Anheuser-Busch
InBev
Brewing industry economies in Mexico
Archstone/Equity
Residential/Avalon Bay
Economies of scale in U.S. rental apartments
16
Cooper Industries/Eaton 12
Economies of scale in U.S. power distribution, supplies, and
diversification in industrial equipment
Pfizer Nutrition/Nestle
12
Economies of scale in global baby food market; greater
penetration in emerging markets
International
Power/GDF Suez
10
Economies of scale in global power distribution and
generation
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Summary
An acquirer seeks to maintain consistent increases in sales and profits. One way of trying to
accomplish this goal is to buy other businesses. M&A deals typically involve like-for-like
combinations, where the buyer’s and the seller’s respective product lines are the same, or very
similar to one another. A smaller percentage of transactions represent diversification, private equity,
and other rationales.
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Notes
1. Tenet Healthcare/Vanguard Healthcare, 2 percent.
2. Scott McCartney, “Past Airline Mergers Fell Short of Promises,” Wall Street Journal, A2, August
14, 2013.
3. Interview with Paul Murray, November 4, 2013.
4. William Spain, “Bottler Acquisition Could Be Risky Proposition for Coke,” Market Watch,
February 15, 2010.
5. Dan Bobkoff, All Tech Considered, National Public Radio column, September 12, 2012.
6. Amir Efrati, “Yahoo’s Marissa Mayer One Year Later,” Wall Street Journal, C3, July 16, 2013; Pat
Dewey, “Mayer’s Yahoo, A Work in Progress,” Washington Post, A14, July 17, 2013.
7. Nielsen Corporation, “2009 Study on New Product Introductions.”
8. Devon Shire, “Legacy Oil & Gas; Cheap by Every Metric,” Seeking Alpha, August 9, 2012.
47
CHAPTER 4
The Three Financial Tactics That Dominate the M&A Business
How do Chapter 3’s 10 motivations for acquisitions translate into a higher stock price for the buyer?
This chapter shows how the 10 motivations distill into three financial tactics, which are repeated
time and time again in the M&A business. These tactics are: (1) synergies from like-like
combinations; (2) the “swan effect,” where the deal favorably changes the investment market’s
perception of the buyer; and (3) arbitrage, a process through which an acquirer—whose stock might
trade at 10× EBITDA—purchases multiple smaller companies at 5× EBITDA (and the resultant math
increases the acquirer’s earnings per share [EPS]).
As you know, the overreaching objective of any M&A deal is to assist the buyer in developing
sustained growth in sales and profits. Absent other factors, such a track record enhances the market
value (or stock price) of the buyer, keeping shareholders, board members, executives, employees,
lenders, and other constituencies’ content. The reasoning behind a specific deal is found within the
10 motivations, of which three—(1) buying either a competitor, (2) an identical firm in a new
market, or (3) a like business—represent the preponderance of transactions.
The financial rationale underpinning most acquisitions is distilled into three tactics:
1. Cost cuts, revenue gains. The buyer obtains synergies from “similar business” acquisitions,
with little change in the buyer’s P/E multiple.
2. The “swan effect.” The deal propels the buyer’s P/E multiple (or its EV/EBITDA ratio)
upward, by altering the market’s perception of the buyer for the better. EBITDA is earnings
before interest, taxes, depreciation, and amortization, and is a popular measurement to
determine corporate value on Wall Street.
3. Arbitrage. A sizeable company, with a valuation of perhaps 10× EBITDA, gets bigger through
purchasing multiple smaller firms at 5× EBITDA. After the math is completed, the buyer’s
earnings per share (EPS) goes up, and so does its stock price.
Before discussing the analysis further, it is first instructive to introduce the concepts of “enterprise
value” and “earnings dilution.”
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Enterprise Value
The enterprise value (EV) of a business is defined as the market value of all the securities issued by
the company (typically equity, preferred stock, and/or debt) less the amount of cash and cash
equivalents owned by the company. EV is generally considered a superior measure of corporate
worth by analysts because it (1) accounts for differences in debt structure between the companies
being valued, and (2) normalizes the valuation for large cash balances that certain companies elect
to maintain. For publicly traded companies, equity value is determined by multiplying the number
of fully diluted shares by the current stock price. For debt and preferred stock, standard practice is
to value these securities at face value.
For example, if a company had 10 million shares outstanding valued at $100 a share, no preferred
stock, debt with a face value of $500 million, and cash of $200 million, then its enterprise value
would be $1.3 billion:
The process can also be reversed to determine an equity value from a corresponding enterprise
value. Utilizing the business in the example above, if we knew the company had an EV of $1.3
billion, then we would calculate the equity value of $1 billion as follows:
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Earnings per Share Dilution
Large acquisitions affect the buyer’s earnings per share in a meaningful way. One task of the buyer,
prior to committing to a purchase, is to measure whether EPS after the deal (i.e., pro forma, or “as
if” EPS) are higher or lower, compared to EPS with no deal. If pro forma EPS are higher in the first
year, the deal is accretive (i.e., it adds to the buyer’s EPS). If the pro forma EPS is lower in the first
year, the deal is dilutive, even if pro forma EPS is higher in later years. Table 4.1 and Figure 4.1
illustrate of these concepts.
Table 4.1 EPS Accretion and Dilution Examples Years after Acquisition Closing
Year 1 Year 2 Year 3
No Deal:
Buyer—No deal scenario
$1.00
$1.10
$1.20
Buyer—Accretive acquisition $1.02
$1.14
$1.28
Accretion:
Change in EPS
+0.02 +0.04
+0.08
Buyer—Dilutive acquisition
$0.98 $1.09
$1.25
Change in EPS
-0.02
+0.05
Dilution:
-0.01
Figure 4.1 EPS Accretion/Dilution First Year after a Deal Closing
Generally, Wall Street considers dilutive, deals as “bad” and accretive deals as “good,” indicates
Enrique Caceres, M&A analyst at the Arbitrage Fund in New York.1 In the public stock market,
investors deride transactions where the first year dilution is more than 2 percent, and they expect all
deals that are initially dilutive to be accretive by the second or third year.
By its nature, accretion and dilution analysis has a short-term focus, but its use is appropriate for
most deals, which are like-like combinations. Furthermore, it is the evaluation tool most used by
Wall Street analysts, despite its shortcomings.
50
51
EBITDA Considerations
EBITDA is an earnings measurement that many professionals use to price companies and to
evaluate M&A deals. For those firms where an EBITDA statistic dominates its valuation metrics
(e.g., the cable TV business), the buyer examines how pro forma changes in enterprise value and in
EBITDA impact the buyer’s stock price. We’ll look at some examples later in this chapter.
With this foundation of EV, EBITDA, and EPS dilution, we now advance to the three essential
finance tactics behind M&A.
52
Tactic #1: Cost Cuts/Revenue Gains
Cost cutting is the most popular, the simplest, and the easiest tactic to pull off. The buyer acquires a
competitor or a similar business, which it knows well and which can be integrated with its own
operations swiftly. The buyer eliminates seller personnel and operations that are redundant with its
own, thus increasing the seller’s earnings contribution. At times, a deal’s economies of scale can
decrease the buyer’s own operating expenses, and this increases existing profit margins. Or, the deal
makes the buyer a more attractive supplier to some customers, thereby piling new revenue on top of
the acquired revenue. And, finally, where an acquisition provides oligopoly power, the buyer boosts
its existing profit margins, along with those of the seller, through higher prices.
Table 4.2 shows a like-like combination where standard cost cuts and modest revenue gains provide
the buyer with enhanced earnings per share (EPS). In this illustration, the acquisition has a $160
million price, financed with $80 million of new buyer debt and $80 million of new buyer stock
(priced at $20 per share). The deal is accretive to EPS by five cents per share ($1.00 EPS before
versus $1.05 after).
Table 4.2 Pro Forma EPS for Like-Like Company Combination (in millions, except EPS)
Acquirer Target Adjustments Pro Forma Combination
Sales
$ 300
$ 100
$ 2a
$ 402
Cost savings
—
—
3b
3
EBITDA
$ 60
$ 20
$5
$ 85
Old D&A
(15)
(5)
—
(20)
(7)c
(7)
New D&A
—
—
Adjusted EBIT
45
15
(2)
58
Interest
(15)
—
(5)d
Pre-tax income
30
15
(7)
38
Income taxes
(12)
(6)
3
(15)
Net income
$ 18
$ 9
$ (4)
$ 23
EPS
$ 1.00
$ —
$ —
$ 1.05
—
4.0e
22.0
Shares outstanding 18.0
(20)
a Two percent gain in net revenue through economies of scale (“synergy”).
b Reduction of target’s costs (synergy), net.
c Increase in accounting value of target’s assets leads to new D&A.
d Borrow $80 million of purchase price at 6 percent interest.
e Issue $80 million of new equity at $20 per share, or 4 million new shares.
As Table 4.2 shows, the Buyer’s EPS rises from an estimated $1.00 to $1.05 per share in the deal’s
first year. At the same time, leverage remains at a modest level, with pro forma EBIT ($58 million)
covering interest ($20 million) by a factor of 2.9 times (50/20 = 2.9×). Both items are positive for
the stock price. However, because this is a like-for-like combination, the chances of the buyer’s P/E
multiple rising substantially above the industry average are modest. Accordingly, in determining a
probable change in the buyer’s stock price—as a result of the combination—I modestly increase the
P/E multiple from 20× to 21×. See Table 4.3 for the new stock price calculation (plus 10 percent)
and Figure 4.2 for an illustration.
Table 4.3 Probable 10 Percent Increase in Buyer’s Stock Price, Tactic #1
BeforeDeal Adjustments—EPS Accretion Pro Forma Combined
Buyer EPS
$ 1.00
+0.05
$ 1.05
Buyer P/E multiple
20×
+1×
21×
+$2.05
$22.05
Buyer stock price per share $20.00
53
Figure 4.2 Like-for-Like Deal, Higher Stock Price
The likely stock price increase from the deal, in this analysis, is $2.05 per share, or 10 percent
($22.05 ÷ $20.00 = 10%).
Pentair Example: Tactic #1
Tactic #1 is frequently on display in publicly traded company mergers. For example, according to the
Pentair Corporation, four of the key motivations to merge with Tyco Flow Control International
Corporation in 2012 were:
1. The potential cost savings resulting from the transaction, including the potential achievement of
operational synergies and tax strategies.
2. The potential for Pentair to achieve meaningful revenue synergies by enhancing cross-selling
opportunities between the Pentair business and the Tyco Flow Control Business.
3. The increased size and economies of scale of Pentair, which are expected to enhance
relationships with suppliers.
4. The expectation that the transaction will be accretive to Pentair’s earnings.
All of these motivations are reflective of Tactic #1, and Pentair’s disclosure on its rationale for the $5
billion deal was not unusual for like-like public deals.2
Tactic #2: The Swan Effect
M&A sometimes increases a buyer’s value multiple by changing, for the better, the market’s
perception of the buyer. Typically, a low-growth firm acquires a business in the fast-growing
segment of a related industry. The buyer hopes the “sex appeal” of the new acquisition transfers into
the buyer’s P/E multiple. The result: The ugly duckling becomes a beautiful swan.
This logic explains, in part, Sanofi’s $20 billion acquisition of Genzyme in 2011. Sanofi was a large,
traditional drugmaker, producing chemical-based pills. Genzyme, in contrast, was a biotech firm,
making medicines through modern biological processes. Sanofi, one of the old guard, thus
refashioned itself. Its P/E ratio rose more than its peer group in 2011 and 2012, reflecting the
transaction’s impact.
Traditional French utility EDF pursued a similar tact in 2011 when it acquired an $8 billion stake in
Energies Nouvelles, a green electricity pioneer. EDF, an old line coal and nuclear power firm,
entered the fast-growing, clean-energy business through M&A.
Understanding the Swan Effect’s Math
54
The mathematics behind the swan effect is straightforward. In Table 4.4, the hypothetical buyer has
$400 million in annual revenue, $1.00 in EPS, and a 10 percent growth rate. The stock’s P/E
multiple is 18×, indicating a per share price of $18.00 (i.e., 18 P/E times $1.00 EPS = $18 price per
share).
Table 4.4 Buyer before Swan Effect Deal (In millions, except per share and percent)
Operating Results Perceived Growth Rate
Sales
$ 400
10%
Net income
$ 40
10%
EPS
$ 1.00
10%
P/E multiple
18×
Price per share $18.00
To boost the market’s perception of its growth rate, and correspondingly, to enhance its P/E ratio,
the buyer makes a sizeable acquisition in a hot growth sector. The deal increases projected revenue
from $400 million to $550 million, and net income advances from $40 million to $60 million, even
after the new debt costs and the new depreciation and amortization charges. Additional common
shares drop the buyer’s EPS from $1.00 to $0.98. In other words, the transaction is dilutive to EPS
by 2 percent ($1.00 versus $0.98 is minus 2%). See Table 4.5.
Table 4.5 Buyer after Swan Effect Deal (In millions, except per share and percent)
Operating Results
Perceived Growth Rate
Before
After
Difference Before
After
Sales
$ 400
$ 550
$ 150
10%
13%
Net income
$ 40
$ 60
$ 20
10%
13%
EPS
$ 1.00
$ 0.98
$(0.02)
10%
13%
P/E multiple
18×
22×
4×
$21.56
$ 3.56
Price per share $18.00
Normally, a dilutive deal is harmful to the buyer’s stock price, but the higher growth outlook (10
percent before, 13 percent after) leads to a larger P/E ratio (18× before, 22× after). The price per
share rises from $18.00 to $21.56, a 20 percent jump, as Table 4.5 illustrates.
Executing the Swan Effect through Lower Risk
The P/E multiple is a statistic that encompasses (a) the perceived growth of a business, plus (b) the
perceived risk. Higher growth supports a larger P/E multiple, but more risk suggests a smaller
multiple, relative to one’s peers. The dynamics are reflected in Figure 4.3, which shows a stock’s
price based on discounted cash flows.
55
Figure 4.3 Discounted Cash Dividend Valuation Approach, Constant Growth Model
When risk increases, the rate of return (k) goes up in Figure 4.3, as shareholders want more
compensation. A higher k in Figure 4.3, all things being equal, depresses the stock price. Greater
growth (g), in contrast, pushes the stock price higher. The stock price moves due to changes in the
two variables, k and g, and so does the firm’s P/E ratio.
Most buyers adopt the swan effect tactic by acquiring a high-growth business, (thus boosting), but a
small minority takes the opposite approach. They reduce their cost-of-capital (k) by merging with a
lower-risk company. An extreme example is an African-based firm taking over a German- based
business. Equity return rates in Africa hover around 25 percent for large enterprises, yet the
corresponding returns in Western Europe are just 10 to 15 percent. By acquiring a German company
with a similar business and growth profile, an African firm can raise its P/E ratio by lowering its risk
perception. See Table 4.6 for an illustration.
Table 4.6 Swan Effect 2: Buyer Increasing P/E Ratio through Lower Risk M&A Deal (in millions,
except EPS, P/E Ratio and Per Share Price)
Before Acquisition After Acquisition
Sales in Africa
$ 500
$ 500
Sales in Western Europe
—
500
$ 500
$1,000
$ 30
$ 30
Net earnings in Africa
Net earnings in Western Europe —
20
$ 30
$ 50
EPS
$ 3.00
$ 2.90
P/E ratio
8×
10×
Per share price
$24.00
$29.00
By way of example, in the late 1990s Mexico was a growing economy. Nonetheless, Grupo Industrial
Bimbo, its dominant bread producer, sought to reduce its domestic concentration (and its Mexico
risk) and to find less volatile markets. It subsequently spent billions acquiring U.S. bakery units
from Mrs. Baird’s, Sara Lee, and George Weston. Non-Mexican sales now represent over one half of
its corporate revenue.
Atlantic Tele-Network started off as a monopoly phone operator in the unpredictable, impoverished
nation of Guyana, on South America’s northern coast. With the stock trading at 6 to 7 times earnings
in the 1990s, management diverted its monopoly profits into U.S. acquisitions. Today, Guyana is
less than 20 percent of total revenue, and the company’s stock consistently trades at a double digit
P/E multiple.
56
57
Tactic #3: Financial Arbitrage
Arbitrage is the practice of taking advantage of a price difference between two markets. An investor
capitalizes on the imbalance by buying an asset in one market at a certain price, and quickly resells
it in another market at a higher price.3 Arbitrage is conducted mostly in the financial markets,
although the principle is applicable in commodities and other sectors.
In M&A, the arbitrage process unfolds at a moderate pace that depends on the speed at which deals
can be closed. As one illustration, assume a buyer’s enterprise value (EV) trades at the equivalent of
10× the buyer’s annual EBITDA. To increase its worth, the buyer acquires similar, smaller
companies at a price of 5× EBITDA. Assuming a reasonable financing structure, moderate synergies
and normal M&A amortization charges, the effect of these deals is to enhance the buyer’s equity
value as set forth in Table 4.7. The buyer buys at 5× in the small company market and sells (its
stock) at 10× in the big company market, thereby creating a riskless arbitrage. At this writing,
FlatWorld Capital was pursuing such a tactic in the railroad services business, with a target equity
investment of $300 million in deals.4 The process continues as long as the buyer convinces the stock
market to value its business at 10× EBITDA. Financial arbitrage is the tactic behind many
acquisitive companies.
Table 4.7 Financial Arbitrage Increases Corporate per Share Value (in millions, except per share)
Acquisitions
Buyer Before A
B
C
Buyer After
EBITDA
$ 100
$ 20 $ 20 $ 20 $ 160
× Value multiple
10×
5×
5×
5×
10×
Enterprise value
1,000
100
100
100
1,600
Less debt
(300)
(50) (50) (50) (450)
Equity value
$ 700
$1,150
÷ Shares outstanding ÷ 7.0
Per share value
÷ 0.5 ÷ 0.5 ÷ 0.5 ÷ 8.5
$ 100
$ 135
Students in my university and executive education courses constantly suggest that such arbitrage
should depress the buyer’s 10× EBITDA ratio, assuming the financial markets are efficient. I reply
that this tends not to happen. The buyers successfully convince investors that the buyers will
improve the target’s operations, post-acquisition; and, therefore, the 10× multiple usually holds.
58
Conveying the Three Tactics to Investors
Institutional investors and equity analysts in the United States and Western Europe understand the
three tactics: (1) Cost Cuts/Revenue Gains, (2) The Swan Effect, and (3) Financial Arbitrage. Their
knowledge contributes to M&A activity in these areas because these players support both the deals
and the managers that make them. As one ventures outside of these regions, the level of
understanding drops significantly and even the best emerging market chief financial officer (CFO)
has difficulty explaining a transaction to local financiers. Without support from stockholders and
lenders, most deals can’t move forward.
59
Discounted Cash Flow Analysis Supplements the Tactics
Discounted cash flow (DCF) analysis supplements the evaluation provided by the three tactics. The
acquirer projects its free cash flow (FCF) before—and after—the proposed deal. It adjusts its
required rate of return, or equity cost of capital (k), to reflect its post-M&A business mix and capital
structure. If the DCF analysis shows that the present value of the acquisition goes up with the
transaction, then the buyer has an added motivation to proceed. Table 4.8 has an example where the
DCF value per share increases after a deal.
Table 4.8 Pro Forma DCF Analysis of M&A Deal: Before and After Year after Merger (in millions,
except percent and per share)
The buyer’s stock trades at 10× EBITDA.
The buyer finances the three acquisitions with 50 percent debt and 50 percent equity.
The buyer’s per share value rises by 35 percent ($135 versus $100).
Both projections assume buyer is sold in fifth year at about five times FCF.
Buyer issues 32 million new shares to finance the transaction.
Higher operating risk increases cost of equity capital.
In the $32 billion Duke Energy/Progress Energy merger, for example, J.P. Morgan, Duke Energy’s
financial advisor, conducted a DCF analysis that indicated a 1.3 percent increase in Duke Energy’s
share price after the deal.5 The analysis was quite conservative in that it did not take into account, as
J.P. Morgan acknowledged, the operating synergies (from a like-like combination), the lower cost of
capital (from market diversification), and the higher P/E multiple (from faster EPS growth).
The International Exchange Group’s (ICE) $8 billion merger in 2013 with NYSE Euronext Corp. was
evaluated by ICE’s investment banker, Perella Weinberg, on a DCF basis. Pro forma for the merger,
the ICE per share value had an estimated range of $134 to $143, versus a no-deal price of $128,
indicating a 5 to 12 percent rise in value with the transaction.6 As I noted earlier, the reliance of DCF
analysis on uncertain projections and arguable discount rates reduces its relevance in the M&A
business, and the three tactical approaches dominate. Nevertheless, a DCF analysis is a good reality
check for a buyer and one that is theoretically appropriate.
60
Summary
The financial tactics behind most M&A deals can be distilled into three approaches. The most
common tactic is increasing the buyer’s value through its acquisition of similar firms, whereby the
buyer imposes synergies upon the sellers.
61
Notes
1. Interview with Enrique Caceres, November 22, 2013.
2. Pentair, Inc., SEC filing, 14-A, March 28, 2011.
3. Merriam-Webster definition of financial arbitrage.
4. FlatWorld Capital investment bank release, December 3, 2013, and follow-up interview with Jeff
Valente, partner.
5. Progress Energy, Inc., SEC Filing, 10-K/A, March 17, 2011, 66.
6. Intercontinental Exchange Group, SEC filing, 14-A, April 30, 2013, opinion of Perella Weinberg.
62
Part Two
Finding a Deal
63
CHAPTER 5
The Buyer Must Have a Methodical Plan in Order to Find a Quality
Transaction
In previous chapters, we discussed the M&A environment, as well as the motivations and tactics
behind deals. Now it’s time to examine the M&A process. Chapter 5 begins with the buyer planning
to hunt for an acquisition. To avoid wasting time and money, a would-be acquirer develops a
methodical plan for expanding through M&A.
If the merger and acquisition business were like the images portrayed in movies such as Wall Street,
every M&A deal would be finished in two weeks. The buyer’s executives would read only a few pieces
of paper before making a decision, and the negotiations would take place in richly appointed, oakpaneled conference rooms studded with well-coifed, expensively tailored advisers. The discussions
would involve hundreds of millions of dollars, and toward the end of the process the requisite legal
documents would be drawn up in a jiffy, just waiting for the signatures of buyer and seller. This
glamorous ideal, unfortunately, is far from the truth. The Hollywood portrayal represents only a few
snapshots of the efforts needed to engineer a successful transaction.
To synthesize an entire deal on film would bore most viewers and discourage even the most intrepid
corporate strategist from entering the arena. The extended search process, the analytical study of
the targets, the frustrating negotiations with hardheaded sellers, and the complex legal documents
are all fraught with details and arcane minutiae. Nevertheless, the rewards of such toil-filled efforts
can be substantial. Not surprisingly, the merger business attracts some of the sharpest minds on the
American business scene.
The field of mergers and acquisitions can be properly called a business. One can say “I’m in the M&A
business,” in the same sense as saying “I’m in the computer software business.” Thousands of
transactions are completed every year and the value of the companies changing hands exceeds
hundreds of billions of dollars. A veritable army of professionals conducts the large volume of
transactions, consisting of thousands of corporate executives, investment bankers, business brokers,
lawyers, accountants, tax advisers, asset appraisers, commercial bankers, leasing and personnel
experts, information technology (IT) analysts, management, pension, and labor consultants,
investment fund managers, and risk arbitrageurs.
This list of functional specialists showcases the vast number of individuals who make their living
from merger transactions, and the breadth of skills that come into play. The primary mover behind a
deal—the buyer—needs at its disposal the proper mix of competence to work effectively in this
environment. Spearheading the buyer’s in-house efforts should be a well-rounded businessperson,
but actually buying a company involves specialized abilities beyond the resources of many
businesses. Knowledge in accounting, finances, negotiations, marketing, business analysis,
information technology, law, taxes, and the related paperwork is critical. The average buyer hires
and supervises several experts in these fields.
At any point along the way, a potential buyer has the option of hiring outside talent to find a
transaction, but buyers typically use outside advice only when entering in the final stages of an
acquisition. During the initial stages of the process, external expertise is poorly motivated. Outside
advisors realize the chances of closing a prospective deal are small. Since they make most of their
money on successful transactions, outside advisers are motivated and play a constructive role only
as a buyer gets close to finalizing a deal.
The most effective way of screening candidates, making preliminary evaluations, and developing
purchase prices is to do it in-house. An in-house executive is far more cost-efficient than outside
advisers in the early stages, and he has a far better sense of how a potential target fits with his
employer. The executive’s job continuity is also a plus, since the person has less incentive to oversell
a transaction merely to earn kudos from doing something. Many advisers and consultants have
ulterior motives for advancing transactions, no matter whether the adviser is paid by the hour or by
the deal.
The first reward for a company that has just closed an acquisition is the opportunity to review more
acquisitions. As the word gets around that so-and-so is a player, intermediaries representing sellers
64
or offering acquisition ideas will contact the new player. As a result, the buyer’s previously ad hoc or
part-time acquisition function can evolve into a full-time job, if the inquiries are answered properly.
As the buyer’s activities grow, its relationships with investment bankers, business brokers,
attorneys, accountants, and other professionals, built up over the course of a few transactions,
solidify and bring mutual understandings. This means that the deals themselves move faster and
smoother, freeing time for reviewing even more opportunities. Following the completion of a few
transactions, the in-house executive can look forward to a dynamic M&A operation.
65
An Active Approach
Potential buyers cannot count on intermediaries to bring in all the potential candidates. Any
effective development effort is proactive. As a matter of tactics, the would-be acquirer makes the
effort to approach potential targets and intermediaries directly. While investment banks,
commercial banks, and business brokers discuss their deal inventory freely with respectable buyers,
corporations that are not openly for sale are harder to find. The buyers must approach them on their
own, either by phone, e-mail, letter, or personal contact. The contacts are frustrating since
owners/managers often turn their backs on takeover invitations. This reaction is natural, given the
disruption that the rumor of a sellout gives to the candidate’s employees. As rejections pile up from
the proactive approach, the buyer’s managers should not be discouraged. The odds are in their
favor. About 1 in 10 businesses are open to offers, and perhaps another 2 in 10 are silent sellers,
companies that will talk with a persistent buyer.
Maintaining an aggressive approach in the acquisition search requires a plan that allows the buyer
to conserve its human resources. Just through intermediaries, the buyer can see dozens of
opportunities each week. Most are too small to merit the buyer’s interest, too far from the buyer’s
product line to represent a good fit, or too expensive to be a good financial investment. Nevertheless,
the buyer must review the candidates before making these determinations. To reduce the time spent
reviewing inappropriate deals, it sends intermediaries the guidelines that the buyer follows in
proactive contacts.
66
The Acquisition Plan
The acquisition plan has four components:
1. Management readiness
2. Financial capability
3. Target industry
4. Tactics
The first is an executive assessment: Is management prepared to acquire another business and take
on the added responsibilities? The second component is financial: How large a deal can the
company afford? How much added leverage? What earnings per share dilution are the shareholders
willing to accept? The third element of the acquisition plan narrows the number of target industries:
Is the corporate strategy to buy a competitor, to extend the product line, to diversify into related
businesses, or to integrate vertically? The final part of the plan is tactical: Does the company work
through advisers or take the direct approach?
67
Internal Assessment
A corporation contemplating an acquisition campaign should devote at least one executive full-time
to this effort. If this minimal commitment is impossible, the company should abandon any hope of
realizing benefits from takeovers. Assuming this decision is made, the would-be acquirer must
gauge the managerial capability required to add new businesses to the existing portfolio.
Many companies err on the side of optimism when evaluating the risks of integrating one business
into another. Potential problems are underestimated, and the synergies forecast at the start of the
deal go up in smoke. Two companies, a hotel operator and a retail chain, told me that their first
acquisitions almost bankrupted them. They had underestimated the time commitment of senior
management. With valuable resources drained into integration, the core business fended for itself
with near-disastrous results.
Besides examining human resources in this regard, top management should determine what
personality of acquisition is most suitable. All companies have character traits that govern how
groups perceive them. One company’s character might be called staid and conservative. Another
might be referred to as dynamic and entrepreneurial. We all know how organizations build
reputations that have human qualities. The buyer probes its in-house cultural and character factors
before selecting what business to pursue.
68
Summary
An acquiring company wastes time in surveying inappropriate acquisition opportunities. A business
plan assists the company in defining its objectives and limiting its survey costs.
69
CHAPTER 6
To Begin an Acquisition Search, the Buyer First Sets the Likely
Parameters of a Deal
At any given moment, hundreds of companies are openly for sale in the global market and
thousands more will consider M&A inquiries. With so many available deals, the buyer defines his or
her search parameters to narrow the scope of its search process.
A good parallel to a corporate M&A search is an individual’s quest to find a new condo. How do
people begin the real estate investment process? Typically, they select a neighborhood first, the
desired size of the condo second, their budget third, and likely amenities, such as the view and the
parking, fourth. The corporate course of action bears similarities.
70
Defining the Parameters
First, a potential acquirer targets an industry and geographical market (i.e., its neighborhood). It
decides on how large a company it can absorb in a combination, and what is a reasonable price to
pay. It then considers what specific attributes it wants in a deal, such as a certain customer base, a
dedicated supply line, a specific technology and so on. See Table 6.1.
Table 6.1 Setting Parameters: Individual Looking for Real Estate versus Company Searching for
Acquisition
Steps Individual Looking for
Real Estate
Company Searching for Acquisition
1
Select neighborhood
Choose industry and geography
2
Size of property, number of
bedrooms and baths
Revenue, profit, and asset levels of possible targets
3
Budget, price per square foot
for similar properties
Budget; P/E and EV/EBITDA multiples for similar deals
4
Desired amenities, such as
view and parking
Seek specific attributes for an acquisition, such as blue-chip
customers and specialized technology
By way of illustration, suppose a Chinese firm distributes information technology (IT) products
inside China. By virtue of its government contacts, it has a leading market share there, but it wants
further growth. Management wants to stay within its industry neighborhood—and it prefers the first
acquisition to be close from a geographical point of view, which means a Chinese competitor or an
Asian IT distributor. With a market value of $1 billion, the company believes the maximum size of
any deal should be $300 million, or 30 percent of the buyer’s value. This is a not uncommon “rule of
thumb” self-imposed by buyers to limit risk. Target EV pricing is in the 9–11 times EBITDA range,
based on industry valuations and expected EPS impact, a subject we cover in more detail in Chapter
18. Attractive, but not mandatory, seller attributes are Fortune 500-type customers, non-family
managers and light debt ratios. The initial parameter checklist appears in Table 6.2.
Table 6.2 Initial Acquisition Search Parameters
Parameter
Description
Geography
In which country or region should the target operate?
Industry
Competitor; like businesses, but different subsector; complementary
product line; diversification or strategy deal
Budget
One-third of buyer’s size or smaller?(Sufficient size guarantees buyer
interest.)
Pricing of similar
deals
P/E; EV/EBITDA; amount of EPS dilution buyer can sustain at current
pricing
Other key attributes of Dependent on buyer preferences
acquisition
71
Case Study
My investment banking firm, Focus, LLC, conducts search operations for buyers on a regular basis.
One foreign IT client was interested in entering the U.S. IT market. It had a number of large U.S.
customers that relied on it for outsourcing, but, as the business expanded, management recognized
the need to get closer to the customers by having a significant, on-the-ground, U.S. operation.
Like many prospective buyers, the buyer sought a target that was (a) large enough to command
management’s attention, but (b) not so big that it could jeopardize the home operation financially if
things went wrong. Management decided that an IT acquisition with annual revenues of $75 million
to $150 million was appropriate. The business should be profitable, serve only commercial clients
(no government), and have a sprinkling of Fortune 500 customers. A reasonable purchase price
would fall into the $50 million to $100 million range.
The United States is home to thousands of sizeable IT firms, but, on the basis of these criteria, Focus
was able to limit the target list to 90 possibilities, all of which were contacted. Eventually, the buyer
closed on a $72 million transaction.
72
Summary
To get the search process started, the prospective acquirer determines a few deal parameters as set
forth in Table 6.2. These parameters enable the acquirer to winnow the field of possible targets, to
focus management, and to provide direction to outside intermediaries.
73
CHAPTER 7
The Buyer Starts the Formal Acquisition Search by Alerting
Intermediaries and Contacting Possible Sellers
Once the buyer has outlined its priorities, the time comes for it to enter the M&A arena. The
resultant search process is a methodical grind through a wide array of prospective sellers, anxious
intermediaries, and related participants.
If a would-be acquirer has followed the process outlined in the last two chapters, then groundwork
has been laid, and the buyer is ready to search for suitable targets. A successful search program
combines methodical hard work with occasional instances of pure luck; that is, “being in the right
place at the right time.” But luck in the M&A business isn’t just happenstance. Being in the right
place at the right time is the result of considerable effort. Sifting through prospective acquisitions,
evaluating actual deals, stroking M&A intermediaries, and initiating direct contacts with other
companies are just four of the ongoing activities that require time and expense. The situation is
analogous to what a golf pro once told me: “There’s some luck in golf, and I found out that I’m
luckier when I practice five hours a day.”
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Laying the Groundwork
By way of review, an efficiently designed search program is preceded by these important
determinations:
Proposed acquisition strategy. Having concluded that corporate growth can be fulfilled
through buying other businesses, the buyer has made a self-assessment of its M&A objectives.
Within this self-imposed framework for expansion, it has selected specific geographies, industry
sectors, and product lines. In doing so, the buyer has erected the tent under which acquisition
ideas must fall.
Affordability. A proposed acquisition budget has been set by the buyer, limiting the buyer to
those deals with a worth of between 15 and 30 percent of the buyer’s own value.
Price. The buyer has studied the prices paid for recent transactions in its target industries.
Accordingly, senior managers know what is, and what isn’t, a reasonable asking price. Valuation
ratios such as P/E, EV/EBITDA, and Price/Book have been recorded by the buyer for recent
deals. The valuation criteria at the buyer’s fingertips forms the basis for the quick elimination of
sellers with unrealistic price goals.
EPS dilution. The buyer has a sense of what EPS dilution (or accretion) it can expect from a
transaction.
Target attributes. The buyer has in mind a number of nonfinance attributes for the optimal
target.
The buyer is now ready to enter the shark pit of investment bankers, business brokers, and dubious
sellers.
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Four Steps in Beginning a Search
The beginning of a search covers four basic steps:
1. Initiating the search with intermediaries.
2. Starting your own search program.
3. Screening the candidates.
4. Implementing direct contact.
By following these steps, a would-be acquirer generates leads.
Starting the Search with Intermediaries
For a larger company with annual sales of $250 million or more, the best way to begin a search is to
alert the elite members of the M&A practitioner community to the buyer’s acquisition interests.
Indeed, a firm of this size is already being showered with unsolicited ideas from investment bankers
and commercial banks. For a small to medium-sized firm with annual sales of less than $250
million, I recommend a similar alert tactic, but with an emphasis on the specialized and regional
intermediaries, since the larger practitioners are not interested in working on the $10 million to $30
million transactions consummated by such acquirers.
As mentioned earlier, the practitioner community encompasses a large army of businesspeople
whose work focuses on the processing of merger and acquisition transactions. The members that
tend to play an intermediary role include:
Investment banks
Business brokers
Other intermediaries
Law firms
Accountants
Leveraged buyout firms
A stream of acquisitions opportunities (or deal flow) is the lifeblood of an acquisition search. The
primary originators of deal flow are the firms in the intermediary category, which primarily
comprises investment banks and business brokers. Secondary sources of deal flow are the corporate
financial advisory departments of large commercial banks, management consulting firms, and
national accounting firms.
Investment Banks
Investment banks dominate the origination of large deals, considered to be those with a price tag of
$100 million and up; they also play an important role in sourcing medium-sized transactions. The
big New York–based investment banks have the largest concentration of advisory expertise, while
many regional investment banks have solid middle-market practices in the $20 to $50 million
range. Business owners that are selling out gravitate to investment banks because the banks offer
them the resources required to process transactions effectively. Typical services provided to sellers
include (a) valuing the business to be sold, (b) preparing a descriptive memorandum that is sent to
buyers, (c) conducting an orderly auction of the business, and (d) assisting in negotiations, legal
work, financing, and other matters related to closing the deal. Because of their high overhead, most
investment banks try to weed out clients that are not serious sellers. Their most effective device for
screening clients is a $100,000 to $200,000 retainer fee, payable prior to the bank commencing
substantial work on the client’s behalf.
Business Brokers
Business brokers are small operations with either a regional focus or industry specialty. Many have
only one or two principals, operating with little more than a phone, a desk, and a file cabinet. Small
deals in the range of $2 million to $10 million are the province of business brokers, who usually
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represent businesses that are either family-owned companies or small corporate divisions. The
fundamental strategy is volume. Dozens of clients are retained without up-front fees and little
investigation is done by the broker on his client’s operations. Brief descriptions of the broker’s
clients are routinely sent to a laundry list of possible buyers with little forethought. Beyond a few
earnings ratio clichés, brokers offer little valuation advice to their respective clients, and few brokers
bother to understand their clients’ businesses well enough to formalize a coherent marketing
strategy or to draft a meaningful offering memorandum. This lack of service is a result of the
inability of most brokers to charge up-front retainer fees that cover a portion of their overhead.
Their clients, who are typically hard-nosed small business owners, generally refuse to pay up-front
fees by arguing that the broker cannot guarantee a transaction.
To maximize the chances of closing a deal, most business brokers carry a broad inventory of firms
for sale. The majority of these are ill-suited for purchase because of the sellers’ unrealistic price
expectations, legal complications, income tax problems, or stale inventories. This portrait of the
business broker may be bleak, but the fact remains that this brand of practitioner carries a
substantial amount of acquisition inventory. A minuscule portion of this inventory is appropriate for
serious consideration by a thoughtful buyer.
Other Intermediaries
Other professionals are found in the advisory departments of large commercial banks, corporate
appraisal firms, and national accounting firms. These organizations seek to advise on deals $20
million and up. Like their investment banking brethren, these firms have the infrastructure to
provide services, but the quality of their advice suffers from a small deal flow relative to investment
banks. Knowledge, experience and contacts count for a lot in the M&A business and these
intermediaries are deficient in such areas.
Intermediaries are the source of many M&A deals because sellers hire them to provide advice on the
sale process. Valuing, packaging, and auctioning a business are specialized tasks that are best
handled by intermediaries that participate in M&A on a regular basis. A seller can accomplish the
task itself, but it risks closing the deal under suboptimal terms. In a court of law, the saying goes
that “a person who represents himself has a fool for a client.” This admonition is appropriate for the
M&A business.
Law Firms and Accountants
Law firms occasionally play a finder role by virtue of their extensive contacts in the business
community. Accounting firms, exclusive of those with a formal M&A advisory practice, can perform
the same function. Notwithstanding this sporadic finder service, law firms and accounting firms
play their primary roles during the closing phase of a transaction. This phase of the deal process
occurs after the seller’s intermediary has negotiated the basic terms and conditions of the sale with
the prospective buyer. At such time, both parties require comprehensive legal and accounting
services.
Step 1: Initiating the Search with Intermediaries
If a company has annual sales of $250 million or more, top management is already responding to
several acquisition proposals per week. Intermediaries introduce the majority of these proposals,
but the prospective buyer is responsible for increasing the number of deals presented and boosting
the quality of this “banker deal flow.” It cannot rely on the practitioner community to serve its
interests well. Improving deal flow can only be accomplished if the buyer is willing to dedicate one
manager toward maintaining a constant line of communication between the buyer and the
intermediary community. Too often, contact between potential acquirers and intermediaries is
fragmented and incomplete, when “it should be a vehicle for promoting the sharing of information,”
points out Doug Rodgers, President of Focus, LLC, an investment bank serving the middle
market.1The intermittent dialogue on acquisition suggestions between buyer and intermediaries is
often less than satisfactory. Frustrations are evident in the following comments that I have heard
repeatedly:
Potential Buyer Talking about an Intermediary
“They (the intermediaries) always show me a lot of junk, never a good deal.”
“They don’t understand my business or my acquisition strategy.”
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“There’s not enough analysis or information in their proposals.”
Intermediary Talking about a Potential Buyer
“They (the buyer) want to see every deal, so that they know they’re not missing anything. I have
no idea what they’re really interested in.”
“They complain about every deal I show them. Either it’s not the right ‘fit,’ or it’s too expensive.”
“That company doesn’t know what it wants.”
The best way for a buyer to avoid this miscommunication and to improve deal flow is to initiate and
maintain continuous contact with a wide variety of intermediaries. For large firms, this is not a
major problem. They are besieged by investment banks proffering corporate finance services,
including M&A advice and related acquisition ideas. For smaller companies, accessing investment
banks for M&A product is more difficult, but achievable by implementing a direct approach. To
begin, a small to medium-sized company should make direct contact with a large number of
intermediaries, perhaps 20 to 30. At a minimum, 10 investment banks and the 10 largest
commercial banks should be called, followed by the business brokers and the intermediaries
specializing in the industry, product line, or region in which the buyer is interested.
The names of these firms can be found in numerous directories, although the specific executive
working in your target area may not be identified. Finding this individual is important. Once you
identify the intermediary executive responsible for M&A deals in your target industry, begin contact
with a short email or letter addressed to this person, describing the buyer’s business, financial
performance, affordability quotient, and target industry. One or two weeks later, the in-house staffer
responsible for the acquisition search supplements this contact with a phone call. Where practical,
the in-house executive follows up the telephone call with a visit from the in-house executive to the
intermediary’s offices. Like any other business, the personal touch is important in the M&A
industry.
Assuming the buyer has the wherewithal to finance a medium-sized acquisition, perhaps in the $50
to $100 million range, the acquisition ideas and proposals should begin to roll in after 15 to 20 visits
to intermediaries. The buyer, however, will soon discover that the vast majority of the proposals are
unsuitable for its needs. Rather than dismissing the intermediaries as hopelessly poor listeners, the
in-house executive makes a conscious effort to respond to each intermediary suggestion within one
to two weeks. Rejections are phrased in the vocabulary used by the intermediary, such as the deal
was turned down on the basis of:
“The price is too high.”
“The size is wrong.”
“The proposal (or idea) does not fit with our product line extension strategy.”
Rejections based on the proposed acquisition’s asking price being too high, or its size being too large
or too small, are understandable to the average intermediary. Problems with are less easy to convey.
Step 2: Starting Your Own Search Program
Once the buyer has (a) determined its target outlines, (b) communicated with the practitioner
community, and (c) started reviewing deal flow, its next step is developing its own system for
identifying promising candidates. This is a straightforward process, because the buyer knows the
target industry well and the stage is set for a systematic search and screen program designed to
reach businesses that are not openly for sale.
The principal benefit to the buyer of working with intermediaries is that many of their ideas involve
true acquisition proposals. Money has changed hands—the seller has retained the intermediary for
the up-front fee, the intermediary has done an investigation into the seller’s business, and the
auction has commenced. A willing seller exists, as opposed to a reluctant owner that entered into
merger discussions without formally retaining an intermediary. A seller who retains an investment
bank or commercial bank is strongly motivated to consummate a deal. By this time it has: (1) spent a
small amount of intermediary up-front money to begin the sale process, and (2) risked the negative
effect of the news getting out about a possible sale. Yet, while intermediaries remove a lot of the
guesswork from the search process, a prospective buyer can’t wait and react only to opportunities
brought in by intermediaries; this is not a guarantee of a deal flow. The buyer doesn’t provide the
impetus for deal origination and, as a result, the transactions supplied by intermediaries are unlikely
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to fit well into the buyer’s acquisition criteria. Why shouldn’t the buyer directly contact those
companies that fit its approach?
The direct contact method is methodical, exhausting, and frustrating. Despite these serious
drawbacks, many buyers use it successfully. About 20 percent of business owners are silent sellers,
willing to consider any reasonable offer, but they are reluctant to commit to an orchestrated auction.
A diligent buyer takes advantage of this hesitancy by initiating discussions on its own. In this
instance, the buyer makes the first contact with a possible seller, instead of the reverse situation
when the seller’s representative starts the process. Because the buyer is making the first move and
has no knowledge of the owner’s state-of-mind, it endures a lot of turndowns from the 80 percent of
companies that are not selling. Besides these repeated rejections, the direct search method has
another big negative. In early negotiations, the seller has the upper hand, since he or she is the
pursued rather than the pursuer.
The buyer’s search program acknowledges first the broad landscape of American and international
business. Many established industries are fragmented and include a mélange of publicly traded
companies, private firms, and corporate subsidiaries. Obtaining data on these candidates means
researching numerous sources besides the buyer’s constituency and the practitioner community.
The Internet, data services, industry experts, product consultants, and trade reporters have to be
surveyed by the buyer, who collects the raw data on businesses participating in the target industry.
Data on publicly held companies is easy to find. Private company data is harder to locate, but
business databases and reference publications are available for this purpose (and most firms
maintain websites). In many of these reference sources, information is arrayed in multiple formats
that are helpful to the prospective acquirer, such as:
Industry classification
Size of operations
Product lines
Executive contact information
The private company business databases are computerized, and buyers can screen companies for
specific qualities, thus providing a quick glimpse of candidates qualified by one or two desired
attributes, such as size or profitability. Candidate lists that are generated by the computerized
databases are far from complete, however. As a result of misreporting, errors, or omissions, the lists
exclude many businesses, and important information may be left out. Detailed searches are akin to a
detective’s work.
One alternative to the grinding work of playing acquisition detective is to hire a search/survey firm
that can canvas entire industries. Companies that do this work charge from $50,000 to $100,000
per assignment.
The result of a buyer’s foray into screening will be a long list of firms. These prospects will be
classified into three categories of informational availability:
1. Publicly traded companies. Government reports provide an excellent sense of financial
strength and product line focus.
2. Divisions of publicly traded companies. Public reports filed by the parent company
provide basic data on divisional product lines, including summary financial results.
3. Privately held firms. Many privately held companies supply key financial and personnel
information to credit firms, which, in turn, provide information in written reports to trade
creditors and other interested parties. In certain Western European nations, private firms supply
financial statements to public databases. Private database services are able to obtain information
on many closely held businesses.
Step 3: Screening the Candidates
As the buyer develops a list of candidates from its in-house efforts, the process reduces the potential
acquisition universe from a large mass of eligible prospects to a smaller grouping. The principal
screening factor is size, as most companies fitting the buyer’s industry objectives will be either too
small to merit the buyer’s attention, or too large to be affordable. Over the course of a year, in-house
research can generate a substantial number of candidates, easily 100 or more, and an acquisitive
management needs to generate hard-and-fast criteria to quickly eliminate those candidates that do
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not merit further study. Geography, industry and size characteristics are usually the first hurdles for
a candidate. Candidates making the first cut are carried through a sequence of further screens,
based on the buyer’s detailed takeover criteria.
Step 4: Implementing Direct Contact
Depending on the scope of the buyer’s expansion strategy, the search and screen process develops a
substantial number of leads. Assuming a concerted effort has been made to study the target
businesses through databases, the buyer’s management assembles a short list of candidates. What’s
the next step? For small privately held companies (i.e., annual sales under $50 million) in which the
buyer has no direct contacts, a vaguely worded introductory letter for the chairman or chief
executive officer is a good start. The letter suggests the buyer’s general interest in a joint venture or a
marketing arrangement and advises the individual of a follow-up call, which the buyer’s
development executive places shortly thereafter. During this call the buyer discloses its true interest
in pursuing a deal. If the buyer is seeking a medium-size business, privately owned company, or the
small division of a publicly traded company (purchase price of $100 million to $200 million), the
initial contact is sometimes made through a go-between such as the buyer’s investment banker, its
outside attorney, or a board member.
When the target is a public firm, the method of contact needs to be considered carefully. Any
acquisition interest needs to be communicated with discretion or the public firm could be put into
play. By law, the firm must consider serious offers and alert shareholders. If its managers lack a
sincere desire to sell out, they are understandably reticent to respond favorably to any expression of
interest, no matter how preliminary, from an unsolicited buyer. This reluctance places the burden of
serious intentions on the buyer, which should conduct a serious study of the target’s business before
attempting a legitimate inquiry. The ensuing mating ritual with a public company then follows a
well-worn script prompted by the mutual desire of the parties to avoid damaging publicity and
costly litigation. Dictated by highly paid practitioners—who are mindful of the confidentiality
requirement, who pay strict attention to legal precedent, and who have detailed knowledge of the
regulatory environment—this script is de rigueur for all public-market transactions.
No matter what kind of business a buyer approaches—a publicly traded company, a corporate
division, or a privately owned firm—the unsolicited direct approach results in a high percentage of
outright rejections. The lack of interest should not discourage the buyer. Many of these candidates
can be contacted regularly, perhaps every year or so, to remind the owners that the buyer’s door
remains open if the candidate’s situation changes. The minority of candidates that enter into a
dialogue are then funneled through the buyer’s “sifting” process.
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Retaining an Intermediary to Assist in the Search
Investment banks, business brokers, finders, and the other organizations that perform intermediary
functions are not effective in the search process. The economies of these firms require that they
generate a continual stream of advisory fees, which can only come about through deals that close
(i.e., where money changes hands). While assisting with a search may lead to a closed transaction in
which the intermediary collects a fee, the search process is long and arduous, and the probability of
success on any one unsolicited contact is small. Accordingly, intermediaries are poorly motivated to
assist any buyer in an extensive search and screen process. A large retainer fee for an investment
bank on a search and screen assignment might be in the $100,000 range, whereas the success fee,
even on a small $20 million to $50 million deal, is typically $500,000 to $800,000. Larger
transaction fees climb into the millions of dollars. As a result, intermediaries devote far more effort
to advising clients on deals that have a good chance of closing, rather than allocating resources to
long shot search and screen activities.
Besides this low motivation factor, a buyer is well advised to avoid using intermediaries in the
search process for another reason: exclusivity. The intermediary retained to assist in the search
insists on the sole right to represent its client in all acquisitions over the retainer period, which
ranges from 6 to 12 months. There is no need for a rational buyer to lock itself into this restrictive
arrangement, with what undoubtedly is a poorly motivated adviser. The intelligent buyer’s logical
course of action is to bring a transaction to the stage where a closing appears likely, and then to
retain an intermediary to assist in negotiating and closing the deal.
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Summary
To maximize its chances for success, a smart buyer takes a proactive approach toward increasing its
acquisition opportunities. The first step in promoting deal flow is alerting the practitioner
community about the buyer’s acquisition interests. Regular communication with intermediaries is
maintained, and personal visits from the buyer’s executives to the intermediaries’ offices are
encouraged. These visits demonstrate the buyer’s acknowledgment of the intermediaries as
professionals in their own right, and they provide both sides with the personal touch that is
important in business life. Intermediaries are the source of many transactions, and they should be
dealt with carefully. On receiving an inquiry from an intermediary, for example, a would-be buyer
answers promptly. If the response is a form of “we’re not interested,” the buyer’s rationale for
turning down the idea is explained in terms that intermediaries can relate to easily.
Supplementing the deal flow provided by intermediaries is a stream of candidates generated by the
buyer’s in-house search efforts. A variety of reference sources and outside contacts are used to
develop lists of companies and corporate divisions that meet acquisition criteria. The buyer contacts
candidates making the first cut, perhaps 100 companies. Most of these contacts end with the
candidate rejecting the buyer’s overtures. In the case of a rejection, the buyer remembers to call the
candidate again after a decent interval of time. For those firms that invite the buyer into an
information exchange, the sifting process begins.
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Note
1. Interview with Doug Rodgers, president of Focus, LLC, December 2, 2013.
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CHAPTER 8
Finding a Deal: Likely Results of a Search
If a buyer contacts 100 candidates, it should expect to make just two offers, after conducting all the
search and follow-up effort. That means 98 contacts went nowhere, so the process involves a lot of
frustrating legwork.
The buyer has set up its proactive search program. Its management has provided intermediaries
with the buyer’s acquisition criteria, and it has implemented a methodical in-house search to
develop acquisition candidates aside from those presented by intermediaries. The effort results in
100 or more candidates. So how does the buyer narrow the field? How does it reduce this list to the
few potential acquisitions that merit serious, and sometimes expensive, study? It is critical that the
would-be buyer has a realistic system for separating the wheat from the chaff. Most acquisition ideas
are unsuitable for one reason or another, and the buyer’s objective is to eliminate the castoffs from
consideration as soon as possible, based on whatever information is on hand.
For starters, the vast majority of the 100 candidates will have been generated by the buyer itself. The
majority of candidates shown by intermediaries are unsuitable, as they are neither direct
competitors nor appropriate product line extensions. Of the 100 candidates contacted by the buyer,
only 20 will want to talk, indicating a slim hit ratio. The seller and these candidates will sign a
nondisclosure agreement (NDA) and then exchange information. Using the resulting data, the buyer
will qualify the sellers by studying their respective finances and operations. Of the 20 candidates, 10
won’t meet the buyer’s basic goals regarding geography, industry, product line, customer base, size,
and profitability. Thus, after 6 to 12 months of work, the buyer is left with 10 possibilities (see Figure
8.1).
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Figure 8.1 The Acquisition Search Funnel: 12-Month Process
Of these 10 possibilities, only five will have owners with realistic price expectations. The owners of
the remaining five candidates will expect purchase prices out of line with comparable deals. That
leaves five candidates that fit the buyer’s criteria, and therefore, five that require in-depth study.
The buyer’s research into the five remaining candidates typically reveals negative factors that cause
the elimination of two more targets, leaving three potential deals. During this investigation phase,
however, one of the three drops out of the process. The owner gets cold feet or decides the buyer is
not a good partner. The two companies left standing each receive an offer from the buyer.
For privately owned businesses, which comprise the bulk of M&A deals, an offer consists of a short
letter outlining the principal terms and conditions of a transaction. Inevitably, despite prior
discussions between buyer and seller, the written offer fails to meet one of the two sellers’ respective
needs, and subsequent negotiations fail to produce the desired result. The final target, however,
agrees to the terms, and the buyer commences its due diligence. The long march through 100
potential acquisitions ends in one deal.
Up to this point, the buyer has relied on the seller’s representation, either in written or oral form.
Supplementing this information are the buyer’s industry knowledge, contacts, and third-party
research. A foundation has been laid to make a reasonable offer. After the offer is accepted, the
buyer expends significant amounts of money to fully investigate the seller’s business, to prepare an
integration plan, and to structure, finance, and close the deal.
Principal Buyer Tasks after Its Offer Is Accepted by a Private Company (or a Division
of a Public Firm)
Due Diligence
Assemble a team of experts to investigate the seller’s business.
Verify information provided by seller.
Structure
Arrange cash, stock, earn-out, and other seller consideration.
Complete documentation for best legal and tax situation.
Finance
Consider pro forma EPS effects to buyer.
Raise necessary debt and equity.
Close
Receive regulatory approvals and complete legal documents.
Begin integration of the seller.
Note: Buyer usually has 60 to 90 days to complete the above.
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Due Diligence
Due diligence is the buyer’s investigation into the seller’s affairs before the closing of a deal. After
the seller agrees to an offer, the buyer assembles a team of experts, composed of external and
internal representatives of the buyer:
Outside accounting firm
Outside legal counsel
In-house personnel from multiple operating and staff departments
Investment bank and/or valuation firm
Environmental, IT, human resources (HR), and other specialized consultants
The experts verify that the initial data provided by the seller is true. They also look for undisclosed
risks, possible hidden values and new opportunities. Generally, due diligence uncovers more “bad
items” than “good items” because the seller was in marketing mode and overlooked its negative
attributes. The buyer accordingly adjusts the pricing downward. “A 5 percent to 10 percent change is
not unusual,” according to Steve Robinson, law partner at Hogan Lovells.1
The due diligence experts have physical access to the seller’s facilities, employees and outside
advisors, and their schedule to complete the work is 60-90 days. That is enough time for them to
catch egregious misstatements, but problems deeply embedded in IT systems, accounting reports
and legal matters are sometimes missed during the process.
By way of example, Hewlett-Packard’s 2012 $11 billion deal for UK software firm, Autonomy, was
undermined when H.P.’s auditors failed to detect inaccurate Autonomy financial reports. In 2013,
H.P. wrote down $9 billion of the purchase price. Bank of America (B of A) acquired Countrywide
Financial, a major U.S. mortgage lender, in 2008. B of A took billions in losses from Countrywide’s
exposure to future lawsuits, foreclosure mistakes, and mortgage value write-offs, none of which B of
A’s due diligence teams were able either to foresee or to convey properly to senior management. In
my experience with smaller deals, improper accounting dominates, with tax, IT, and legal problems
playing secondary roles.
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Structure the Deal
Concurrent with the due diligence, the buyer designs the transaction’s specifics. It arranges for the
cash, stock, earn-out, and other consideration for the seller. In negotiations with the seller, the
buyer designs the optimal legal and tax situation for both parties, which try to minimize their
collective exposures to future lawsuits and tax payments. Outside attorneys draft the lengthy
documents needed to close the transaction.
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Financing the Deal
If the acquisition is reasonably large, relative to the buyer’s own size, the buyer may have to solicit
financing over and above its existing credit lines. The new financing can take the form of debt
and/or equity, and it may be accessed through public and/or private markets. For private
financings, the buyer (and its financial advisor) prepares an information memorandum outlining the
buyer, the seller, and the transaction. Along with the memo comes an Excel financial model, which
allows prospective lenders and/or investors to see how the combined company performs under a
variety of economic and operating scenarios. For publicly traded firms, raising new money has a
similar bent, but they must follow a detailed series of disclosure rules mandated by the regulatory
authorities. Once the buyer has obtained commitments, its attorneys prepare finance documents on
the same timeline as the M&A paperwork.
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Closing and Integration
As the documentation comes to a close, the buyer has refined its integration plan and is ready to run
the seller’s business as soon as ownership changes hands.
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Publicly Traded Companies
The aforementioned acquisition search process focuses on the acquisition of a moderately sized (1)
privately-owned business, or (2) division of a publicly-traded corporation. As noted, (1) and (2)
represent the vast majority of M&A activity. When (3) the buyer is publicly traded and the deal size
is large, and/or (4) the seller is publicly traded, the government authorities “require a fair amount of
disclosure to protect the investing public,” says Dan Hurson, corporate attorney and former lawyer
at the U.S. Securities and Exchange Commission.2 There is also a heightened probability of
regulatory review on sizeable transactions, all of which tends to extend the process.
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Summary
A proactive search program likely begins with 100 acquisition targets. As the buyer contacts and
researches the targets, the list contracts. Over a period of 12 months, the buyer can expect to make
two offers out of the original 100 candidates, and to close one deal.
The hit rate seems low, but the alternative—organic growth—has similar levels of uncertainty.
Inventing a new product, or finding new customers for an existing product, is far from a guaranteed
success.
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Notes
1. Interview with Steven Robinson, law partner at Hogan Lovells, October 12, 2013.
2. Interview with Dan Hurson, lawyer for Hurson Law Office, December 12, 2013.
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CHAPTER 9
The Four Principal Risks Facing a Buyer in the M&A Business
The principal risk for a buyer in M&A is paying too much. Overpayment is a drag on the buyer’s
results for an extended period. Other major risks are (1) operating problems in putting the two firms
together, (2) excess debt incurred to finance the deal, and (3) recession that occurs shortly after
closing which then reduces the target’s value.
Four risks loom large for corporate acquirers: overpayment, operating, financial, and
macroeconomic:
1. Overpayment risk. The acquisition’s operations are sound, but the high purchase price
eliminates the possibility of the buyer receiving a satisfactory investment return.
2. Operating risk. The acquired business doesn’t perform as well as expected after the
integration.
3. Debt leverage risk. The acquisition is financed with debt, which strains the buyer’s ability to
fund its operations and service its debt at the same time. Leverage risk applies to deals that are
sizeable in relation to the buyer.
4. Macroeconomic risk. The deal occurs at the peak of the business cycle, and the target’s
earnings suffer during the ensuing recession.
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Overpayment Risk
Overpayment is the most common problem in acquisitions. A buyer senses the need to grow quickly
and becomes overzealous in pursuing a deal. In its calculation of the target’s contribution, the buyer
uses optimistic assumptions to justify the transaction. When the assumptions don’t pan out, the
buyer’s shareholders suffer, as the acquisition-related equity and debt conspire to dilute the buyer’s
earnings. If the failed transaction is large, relative to the buyer’s pre-deal size, then the buyer’s postdeal P/E multiple declines. The end result of all these factors is a lower stock price for the buyer.
M&A computer models allow the buyer to examine (1) changes in a deal’s price assumptions, and (2)
how those changes move pro forma EPS and stock price. The “moth” thus determines how close it
can get to “the flame” of high pricing, before disaster strikes. Tables 9.1 and 9.2, for example,
suggest a maximum acquisition price of $45 per share for the target, assuming cost synergies of 3 to
5 percent. We’ll discuss EPS calculations in more detail later in the chapter.
Table 9.1 Sample Computer Model: Buyer Pro Forma EPS: Accretion/Dilution for Two M&A
Assumptions
Cost Synergy
1%
3%
5%
Target
$50 (10)% (7)% (5)%
Purchase
$45 (7)% (3)% 2 %
Price per share $40 (1)%
5%
11 %
Note: Pre-deal EPS is $1.00. Six of nine acquisition scenarios show EPS dilution.
Table 9.2 Sample Computer Model: Buyer Pro Forma Stock Price for Two M&A Assumptions, Predeal Buyer Stock Price is $18
Cost Synergy
1% 3% 5%
Target
$50 $15 $16 $17
Purchase
$45 $16 $18 $20
Price per share $40 $19 $21 $23
Note: Pre-deal stock price is $18 per share, so the buyer’s stock price increases if it pays $40 for the target’s shares.
Rosy EPS estimates carry weight, but after having seen many deals go up in smoke, public equity
investors realize that investment bankers and corporate personnel can use projections to rationalize
almost any acquisition. Sophisticated shareholders, as a result, do their own analysis and evaluate
the assumptions implicit in any forecast, before supporting a deal.
94
Operating Risk
Operating risk refers to the buyer’s specific ability to manage the business of the acquired company.
External pitfalls, such as product obsolescence and new competition, fall in a separate category.
Where the buyer’s and acquisition’s businesses are closely allied, a true marriage takes place.
Product lines are combined, assets are rearranged, and the acquisition’s personnel are allocated
among the buyer’s departments. The obvious operating risk here is a melding process that goes
badly.
The greatest operating risk lies in the diversification deal. Here the buyer may have only a
superficial knowledge of the target’s business, and this inexperience can result in poor management
decisions. Experienced buyers try to foresee problems by preparing extensive integration plans.
Nonetheless, these plans have a hard time gauging the possibility of culture clash. Organizations,
like people, have their own personalities. Cultural differences can wreck the postmerger
environment just as easily as the buyer’s limited industry experience. Sprint’s $35 billion acquisition
of rival cell phone provider, Nextel, was one such example. Sprint’s authoritarian managers had
difficulty working with the entrepreneurial Nextel executives, and the like-like deal never achieved
its potential. Sprint took a massive earnings write down in 2008 and announced it was abandoning
the Nextel network a few years later.
95
Debt Leverage Risk
For most deals, financing with debt, instead of equity, produces a higher pro forma EPS for the
buyer. Table 9.3 shows a typical calculation. Similarly, for those buyers where EV/EBITDA is the
dominant value ratio, M&A debt enhances pro forma equity pricing.
Table 9.3 Typical Calculation Showing That Debt Supports Higher EPS on a Pro Forma Basis
No deal EPS projection (A)
$1.08 $1.17 $1.25
Pro forma EPS: all debt (B)
$1.07 $1.22 $1.33
Pro forma EPS: all equity (C) $1.05 $1.18 $1.28
Pro forma EPS advantage
All debt (B – C)
$0.02 $0.04 $0.05
Debt is a two-edged sword. If the acquisition’s projected results fall short in real life, a debt-laden
deal damages the buyer’s EPS far more than an equity-backed transaction.
The situation is analogous to purchasing a house with a 90 percent mortgage (10 percent equity
down payment) versus a 50 percent mortgage (50 percent equity down payment). If the house
increases in value by 10 percent, the homebuyer’s rate of return (ROR) is 100 percent in the 90
percent mortgage scenario (10 percent ÷ 10 percent = 100 percent). The ROR is just 20 percent with
the 50 percent mortgage (10 percent ÷ 50 percent = 20 percent), before interest, maintenance,
taxes, and other holding costs. High leverage thus provides a much higher return, 100 percent
versus 20 percent. However, in the case where real estate values decline by 10 percent, the
homeowner’s return becomes minus 100 percent with high leverage, compared to minus 20 percent
with the modest debt scenario. See Table 9.4.
Table 9.4 Debt Leverage Magnifies Returns: Both on the Up Side and Down Side, Rate of Return
(ROR) Table for Simple Real Estate Investment
Change in Real Estate Values
+10%
–10%
Home financed with 90% Debt +100%
–100%
Home financed with 50% Debt +20%
–20%
Table 9.5 shows a computer modeling summary of a $500 million M&A transaction under (a) three
economic scenarios and (b) two financing alternatives. The EPS decline in a recession is greater with
the all-debt deal ($0.75 versus $0.81), so the stockholder suffers like the homeowner.
Table 9.5 Pro Forma Earnings per Share Calculations of Buyer’s Corporation: Three Economic
Scenarios (US$ millions)
Recession Moderate Economy Growth Economy
Probability
0.2
0.5
0.3
Buyer EBIT a—alone
$140
$180
$200
Seller EBIT—alone
30
38
45
Combined EBIT
$170
$218
$245
Operating Results
Financing with $500 Million Debt
Combined EBIT
$170
$218
$245
Adjustmentsb
(3)
(3)
(3)
Less: New interest
(40)
(40)
(40)
Earnings before taxes
127
175
202
Less: Income taxes
(52)
(71)
(82)
Net income
$75
$104
$120
96
EPS on 100MM shares (A) $0.75
$1.04
$1.20
Financing with $500 Million Equity, 25 Million New Shares
Combined EBIT
$170
$218
$245
Adjustmentsb
(3)
(3)
(3)
Less: New interest
—
—
—
Earnings before taxes
167
215
242
Less: Income taxes
(66)
(87)
(98
Net income
$101
$128
$144
EPS on 125 MM shares (B) $0.81
$1.02
$1.15
EPS difference A – B
$0.02
$0.05
$(0.06)
a EBIT means Earnings before Interest and Taxes.
b Combined purchase accounting and synergy adjustments.
The decision to use high leverage in an M&A deal centers around the buyer’s confidence in its
projections and its attitude toward risk. Practical limitations include the lenders’ willingness to play
along and, for larger firms, the credit rating agencies’ opinions on debt-servicing capability. At some
point, a leveraged balance sheet captures the attention of equity investors, and a debt-heavy public
company’s P/E multiple contracts, relative to its peer group.
97
Macroeconomic Risk
As noted earlier, buyers should include a recession in any forecast exceeding five years. This is only
logical since modern economies, such as the United States, experience a recession every 7 to 10
years. That being said, perhaps 95 percent of the financial projections I have seen as an investment
banker, private equity executive, and institutional lender show no recession. Virtually every forecast
I have observed in M&A-related textbooks and business-school case studies indicate no recession, as
the target’s sales and earnings climb steadily along with the host country’s GDP (see Table 9.6). The
only problem with this approach is that it conflicts with reality, which is closer to the depiction in
Table 9.7.
Table 9.6 Typical Projection of M&A Target: Developed Economy (in millions, except percent)
Year
1
2
3
4
5
Host country GDP change 2.5% 2.5% 2.5% 2.5% 2.5%
Target sales ($)
1,000 1,100 1,200 1,300 1,400
Target earnings ($)
70
80
90
100
110
Note: No recession in the typical M&A projection.
Table 9.7 Reality-Based Projection of M&A Target—Developed Economy (in millions, except
percent)
Year
1
2
3
4
5
Recession
Host country GDP change 2.5% 2.5% 2.5% (1.5)%
2.0%
Target sales ($)
1,000 1,100 1,200 1,100
1,200
Target earnings ($)
70
80
80
90
70
Note: Recession in the reality-based M&A projection.
Why is a recession bad for the buyer? Because the price it pays before the recession is inevitably
based on (a) the seller’s peak earnings year and (b) a robust stock market. When the seller’s earnings
fall as a result of bad economic conditions, the acquisition’s value drops accordingly, and the buyer’s
chances of obtaining a good return on its investment decline as well.
Macroeconomic risk is accentuated in emerging markets. Over the past 60 years, wealthy
economies, like the United States and France, have generally experienced smooth growth patterns,
interrupted by periodic recessions. After six to seven years of 2 to 3 percent annual growth, a mild
recession of negative 1.0 to 1.5 percent growth sets in, perhaps for 6 to 12 months. In contrast,
emerging markets, like Brazil and Russia, are known for boom-and-bust cycles, caused largely by
wrongheaded government policies and investor confidence collapses. A four- or five-year period of 5
to 6 percent annual growth is interrupted by a severe downturn, when economic activity declines by
7 to 9 percent for two years or longer. The cyclical pattern is summarized well by Arminio Fraga,
former president of Brazil’s Central Bank, “It was as if we’d [Brazil] get drunk, have a good time, and
then after that would come a terrible hangover.”1
The steep downturns are painful for acquirers, which see the earnings (and value) of their emerging
market deals plummet with the local stock market. See Table 9.8. The goals set in place by the
optimistic projections are left in tatters.
Table 9.8 Typical Western Company Projection of an Emerging Market M&A, Projections versus
Reality
Year
Typical Western Company Projection of an Emerging
Market Acquisition
98
1
2
3
4
5
GNP growth
4.0% 4.0% 4.5% 4.5%
5.0%
Product price (US$)
$.150 $1.58 $1.65 $1.75
$1.86
Divisional sales (millions)
$320 $340 $370 $400
$440
Likely Reality of Emerging Market Acquisition
GNP growth
4.0% 4.0% 4.5% (5.0)% 2.0%
Product price (US$)
$.150 $1.58 $1.65 $1.50 $1.55
Divisional sales (millions)
$320 $340 $370 $330
$340
On the other hand, buyers that close transactions at the bottom of the cycle are touted as geniuses,
when the targets become major profit centers a few years later. As indicated in Chapter 1, however,
the bulk of M&A activity takes place in the years leading up to a cyclical top. Acquirers who pick up
deals at the bottom are contrarians, swimming against the tide.
Some industry players run a recession scenario on their Excel spreadsheets to scope out the fallout
from macroeconomic risk. This downside case is contrasted by the buyer, lenders, and other
participants against two other cases: (1) an upside case (optimistic assumptions), and (2) a base case
(normal assumptions). The preponderance of weighting is placed on the two no recession cases,
which have the effect of pushing a transaction forward.
From a single M&A participant’s perspective, placing macroeconomic risk in its proper light is an
exercise in intellectual honesty. Unfortunately, doing so may be self-defeating from a career point of
view. Other deal actors, who stand to gain from a closing, will resent the intruder and will act to
silence, or sideline, him or her. As a result, I tell my students to acknowledge the issue, but to leave
the remedies, if any, to higher-ups.
99
Downplaying M&A Risks
As the chapter introduction pointed out, there are four principal risks: overpayment risk, operating
risk, financial risk, and macroeconomic risk. The M&A industry downplays the risks because of two
factors: (1) overoptimism, and (2) agency problems. A corporate manager, like any individual
contemplating a large financial commitment, must be confident that the investment will rise in
value. Hubris affects corporate pricing, much like it inflates individual home costs from time to
time. The agency problem, on the other hand, is a more pernicious assault on the M&A process.
Investopedia2 summarizes the issue as follows:
A conflict of interest inherent in any relationship where one party is expected to act in another’s
best interest. The problem is that the agent who is supposed to make the decision that would
best serve the principal is naturally motivated by self-interest, and the agent’s own best
interests may differ from the principal’s best interests. The agency problem is also known as the
principal-agent problem.
I set forth some manifestations of the M&A agency problem below:
Buyer’s managers: The managers are under pressure to “do something,” and they close a deal
through the use of questionable assumptions. Over the long term, the value of their stock options
suffers, but in the short term, they achieve job preservation.
Investment bankers: The bulk of investment banking fees are paid only at deal
consummation.
Commercial bankers: Substantial fees are payable only at loan closing. Individual bank
executives usually escape the blame for bad M&A loans, or they simply switch jobs if
accountability looms.
Private equity managers: Most private equity fees relate to investor commitments rather
than successful deal incentives. PE managers are motivated to place new assets on the books,
even if the acquisitions are shaky.
Lawyers, accountants, consultants, and similar participants: These professionals
generate billable hours for potential transactions that (a) go deep into the process or (b)
ultimately close. They bill fewer hours for deals that the buyer (or seller) terminates early in the
process. Thus, they have a tendency to be noncommittal at times, when the
buyer/seller/lender/investor looks for clarity and direction from them in killing a prospective
transaction.
100
Summary
Buyers confront four primary risks in the M&A business:
1. Overpayment risk
2. Operating risk
3. Debt leverage risk
4. Macroeconomic risk
Overpayment is the dominant contributor to failed deals, with the other three risks having varying
degrees of emphasis. In its desire to see deals closed, the M&A industry has a habit of glossing over
risk, and therefore buyers need to venture into purchases with an abundance of caution.
101
Notes
1. Arminio Fraga, quoted in Peter Fritsch, “Real Treatment: Brazil’s Big Gamble on Fraga Pays Off in
a Rapid Recovery,” Wall Street Journal, 20, June 2, 2000.
2. www.investopedia.com/terms/a/agencyproblem.asp.
102
Part Three
Target Financial Analysis
103
CHAPTER 10
Sizing Up the M&A Target from a Financial Point of View
Chapter 10 explains how a buyer sizes up a possible acquisition from a financial point of view. It
shows how to prepare a historical financial analysis that looks at the target’s track record in depth.
The would-be buyer has narrowed its choices to a few prospects, and it has considered the principal
risks of a deal. The next step is defining the relative contribution of each potential acquisition to the
buyer’s future earnings and cash flows, assuming appropriate purchase prices. This process begins
with an understanding of the historical performance of the target company. From this analysis, the
buyer creates a knowledge base from which to project a prospective acquisition’s operating results
with some confidence.
The experienced buyer defers making definitive projections until it meets with the seller’s
management and reviews its business. Face-to-face meetings answer many questions about the
factors influencing sales and earnings. The substance of these conversations focus heavily on the
seller’s historical results, since 95 percent of all projections are based on assumptions tied directly to
past experience. This is why historical financial analysis is a critical part of the up-front effort. As the
would-be buyer understands the drivers behind the seller’s recent performance, the groundwork is
laid for an appreciation of the target’s future prospects from a financial point of view.
A buyer’s investigation begins with the assumption that the accounting statements provided to the
buyer are not fraudulent. The risk of material misstatements is moderate if the statements are
audited by a certified public accounting firm. Audited data is always the case for publicly traded
firms and is generally the case for large private companies. While there is no requirement, many
medium-sized private firms also use outside accounting firms to audit the numbers, either for their
own purposes or to satisfy outside parties such as bank lenders or government clients that need this
information. For most small companies in the $1 million–$10 million sales range, the books are not
audited. With these small businesses, the incidence of sellers inflating their performance is high,
and the buyer typically awaits its own audit of reported results before relying strictly on the by-thebooks study. While important, the buyer’s self-audit of the seller’s accounts is expensive, and, for
reasons of seller confidentiality, it is usually one of the last steps in the purchase process. As a result
of the preceding factors, the initial development of acquirer projections and historical analysis uses
the data more or less as presented in the seller’s written statements and oral representations.
Having accepted the possibility of inaccurate financial data, the buyer executive studying the
acquisition candidate aims at preparing a reasonable estimate of current earnings power. In this
context “reasonable” means he doesn’t look for perfection in the early rounds of study. “This current
earnings estimate is subsequently used as the platform from which to base future earnings
projections,” says Antonio LaMota of First Eagle Investment Management.1 For example, suppose a
buyer executive concludes that Braveheart Corporation earned about $20 million per year in each of
the past three years, after stripping out the effects of all one-time items during the period. All factors
being equal, he had a logical basis for assuming that $20 million was a reasonable earnings objective
in year 4, as indicated in Table 10.1.
Table 10.1 Possible Acquisition—Braveheart Corporation (US$ millions)
Year Ended December 31
Actual
1
Sales
2
Projected
3
4
$302.0 $374.5 $381.0 $390.0
Net income 19.8
20.4
20.2
20.0
Basing earnings forecasts solely on past performance is akin to driving your car by looking in the
rearview mirror. Many acquirers fall into this trap and pay dearly for their mistakes, but a total
separation of the future from the past is illogical. Most businesses have a number of fairly stable
elements that are readily predictable, so the present and immediate past are good first steps in
departing for the future, as long as the recession possibility is kept in mind.
104
105
Starting the Historical Financial Analysis
What are the raw materials from which a buyer creates a historical financial analysis? Start with the
seller’s three financial statements and the attached footnotes:
The income statement.
The balance sheet.
Sources and uses of funds statement.
Notes to financial statement.
Financial analysis gives us four primary tools to evaluate corporate performance:
1. Absolute amount changes.
2. Percentage changes in growth.
3. Common size percentage statements.
4. Financial ratios.
Typically, these tools are applied over a five-year period, since interyear comparisons are the best
means of facilitating the discovery of trends, patterns, or anomalies. But, be forewarned. This sort of
analysis is a lot of work. For example, by applying the preceding four analytical tools to each of the
three financial statements in Table 10.2 for just a one-year period, you will have made 12 snapshots
of the candidate’s finances for that year. This means plenty of number crunching, but luckily, offthe-shelf software packages are available to lighten the load.
Table 10.2 Financial Statement Analysis Matrix of Accounting Data and Analytical Tools
Absolute Amounts Percentage Changes Common Size Ratios
Income statement
1
2
3
4
Balance sheet
5
6
7
8
10
11
12
Source and uses of funds 9
Historical financial analysis is the subject of many books, and this chapter does not duplicate these
efforts. It is a brief guide to the exercise, and readers wanting a thorough treatment can consult my
valuation book: Security Analysis and Business Valuation on Wall Street, Second Edition (John
Wiley & Sons, 2010).
106
Beginning the Historical Analysis
As an example of the recommended approach, consider P.F. Chang’s results for the three years that
ended December 2011. The company operates a Chinese restaurant chain based in the United States.
In 2012, private equity fund Centerbridge Partners acquired the business for $1.1 billion. Pre-deal
income statement and balance sheet data appear in Table 10.3.
Table 10.3 P.F. Chang’s Summary Financial Data (in millions)
Source: SEC filings.
Fiscal Year
2009
2010
2011
Income Statement Data
Net sales
$1,228 $1,243 $1,239
Cost of goods sold
326
325
326
Special chargesa
—
—
10
EBITDA
140
142
121
Net income
43
47
30
Balance Sheet Data
Working capital
$
Total assets
652
635
576
Debt
1
1
1
362
312
Shareholders’ equity 340
(9) $
(9) $ (36)
a Asset write-downs, discontinued operations.
A quick glance at this information enables the reader to reach the following conclusions: (a)
revenues grew slowly and profits fell, (b) cost of goods sold was stable, (c) the company had little
debt, and (d) a 2011 special charge depressed earnings.
107
Normalizing Results
To the extent special charges are truly one-time events, an analysis should eliminate their effect in
determining an acquisition’s future earnings power. Thus, P.F. Chang’s “restated” net income for
2011 is $36 million, not the $30 million as set forth in Table 10.3, because we add back the $10
million charge to EBITDA and then “tax effect” it (i.e., [1 – tax rate] × $10 million = $6 million).
108
Absolute Amount Analysis
Having modified the historical data to reflect an improved perception of P.F. Chang’s potential, the
analyst proceeds to the next step, which is a review of the changes in each financial statement item,
expressed in terms of absolute dollar amounts. Most practitioners tend to eyeball such changes,
rather than make the calculations that appear in Table 10.4.
Table 10.4 P.F. Chang’s Absolute Amount Changes: Normalized Data (in millions)
Source: SEC filings, author calculations.
2009 2010 2011
Income Statement Data
Net sales
+93
+14
−4
Cost of goods sold
+1
+9
+9
Special charges
–8
0
+10
EBITDAa
+18
+3
–11
Net income
+10
+3
−9
Working capital
+1
+3
–20
Total assets
+6
–40
–9
Debt
0
0
0
+22
–50
Balance Sheet Data
Shareholders’ equity +17
a Special charges eliminated from EBITDA and net income.
Table 10.4 clearly illustrates the revenue slowdown in 2010 and 2011. The impact of stock
repurchases is shown in the 2011 shareholders’ equity decline (–$16 million).
109
Percentage Changes
Researchers make extensive use of year-to-year percentage changes in financial results. As discussed
earlier, percentage growth statistics in net income and dividends are key drivers in establishing
acquisition prices. The analyst’s ability to predict future earnings with confidence is influenced by
his ability to determine relationships between sales, expenses, and the additional investment
required to sustain growth. Financial statements expressed in terms of percentage changes help in
making these determinations. The related information for P.F. Chang’s appears in Table 10.5.
Table 10.5 P.F. Chang’s Percentage Changes: Normalized Data
Source: SEC filings, author calculations.
2009 2010 2011
Income Statement Data
Net sales
+7% +1% 0%
Cost of goods sold
0
0
0
EBITDA
+15
+3
–8
Net income
+29 +7
–21
Balance Sheet Data
Total assets
+6% +7% –14%
Debt
0
Shareholders’ equity +3
0
0
+7
–16
Note the drop in sales growth. Assets and shareholders’ equity declined due to stock repurchase.
Table 10.5 indicates the sales flattening was accompanied by a drop in net income in 2011 (–21
percent). Cost of goods sold was steady (0 percent change). Total assets fell as the company spent
cash to repurchase shares.
110
Common Size Analysis
Another popular tool in financial analysis is the common size statement. In this presentation,
income statement and balance sheet items are expressed as a percentage of sales and total assets,
respectively. Since all accounting results are reduced to percentages of the same line item, the data
arranged in this way is referred to as “common size.” Information for P. F. Chang’s appears in Table
10.6.
Table 10.6 P.F. Chang’s Common Size Statements: Normalized Data (in millions)
Source: SEC filings, author calculations.
2009 2010 2011
Income Statement Data
Net sales
100% 100% 100%
Cost of goods sold
27
26
26
Special charges
—
—
1
EBITDA
11
11
10
Net income
4
4
3
Working capital
(1)%
(1)% (6)%
Total assets
100
100
100
Debt
0
0
0
57
54
Balance Sheet Data
Shareholders’ equity 52
Note: Cost of goods sold was stable, but net margins dropped.
The common size data facilitates comparisons of operating results between years. Table 10.6 shows
that profitability declined as a percent of sales. With cost of goods constant, the contributor to the
decrease was other operating expenses. Working capital fell as a percent of assets from minus 1
percent in 2010 to minus 6 percent in 2012.
111
Growth Ratios
Five-year compound annual growth ratios are as follows:
P.F. Chang’s Compound Annual Growth Rates 2006–2011
Sales
5.8%
EBITDA
5.9
Net income
(0.5)
The financial ratios paint a picture of a company that was, at best, a mediocre performer.
In summary, profit margins were flat and return on equity declined. The company was debt-free.
Sales growth was modest at 5.8 percent and net income declined slightly. In part, management
ascribed these developments to a weak U.S. economy, which contributed to restaurant traffic
reductions and an inability to push through cost increases. Another factor was a slowdown in P.F.
Chang’s new restaurant opening program.
112
Ratio Analysis
Ratio analysis relates income statement, balance sheet, and cash flow statement items to one
another. Like the other forms of analysis reviewed herein, ratios provide clues in evaluating a firm’s
current position and in spotting trends toward future performance. Ratios fall into four categories:
1. Profitability ratios. Measure return on assets and equity investments. Profit margins,
expressed as a percentage of sales in the common size income statement, are also defined as
profitability ratios.
2. Activity ratios. Measure the efficiency with which the firm is managing its assets.
3. Credit ratios. Measure the firm’s ability to repay its obligations, its existing leverage situation,
and its resultant financial risk.
4. Growth ratios. Measure the firm’s performance in expanding the business, a key criterion in
valuation.
Each category utilizes many different ratios. Sample ratios are calculated for P.F. Chang’s in Table
10.7.
Table 10.7 P.F. Chang’s Selected Financial Ratios
113
Industry-Specific Indicators
In the preceding financial analysis, we reached a few conclusions through the use of several
standard ratios and the evaluation of financial data arranged in various ways, but it cannot be
overemphasized that each situation is unique. Part of the art of analyzing corporate performance is
selecting which data is the focus of the investigation. Which ratios are meaningful? What trends are
important? What are the best comparative indicators? How reliable is the study of past results in
predicting future performance? A consideration of these questions prior to the start of any detailed
financial analysis represents a time saver for the buyer executives doing the actual work.
Notwithstanding the importance of financial statements, the interpretation of a company’s results
extend past the information contained in audited data. Most companies record certain performance
indicators, and the restaurant industry is no exception. Table 10.8 presents selected industryspecific data calculated by P.F. Chang’s for 2011.
Table 10.8 Industry-Specific Statistics 2011: P.F. Chang’s
Growth in “same store” sales
(2.1)%
Growth from acquisitions and new restaurants 1.4%
Sales per employee
48,000
Because restaurateurs can increase sales volume easily by opening new locations, financiers
developed a statistic that isolated (a) the sales growth accruing from established properties from (b)
the sale growth resulting from new units. This statistic is termed the growth in same store sales. An
examination of this statistic shows the strength of a firm’s underlying organic growth, without the
added capital expense of new stores. During 2011, same store sales growth was less than the
inflation rate, auguring possible problems in the firm’s base business.
114
Comparable Company Performance
Financial analysis of a company is not conducted in a vacuum. Statistics, ratios, and profit margins
are not meaningful numbers in and of themselves; they must be compared with something before
they become useful. Much depends on the type of industry involved. For example, a brokerage firm,
with a preponderance of liquid assets, can operate with a much higher degree of leverage than a
restaurant chain, whose primary asset is real estate. Evaluated within the same industry grouping,
however, single-company data takes on new meaning, as it provides the basis for comparisons and
facilitates conclusions. For this reason, “most of the tools used to evaluate corporate performance
are compared with identical data prepared for companies in the same industry,” says Jennifer
Cameron, President of Verdant Analysis, Inc., a fundamental analytics firm.2 The business that is
the object of study is then measured against its peer group. Has it done better, or worse, than the
competition? Do its yardsticks meet the averages for its industry? Are its results trending with those
of the industry? The answers to these and other comparable company questions are useful in
appraising the merits of a business.
In 2012, P.F. Chang’s had seven publicly traded comparable firms. To show the process, I use two
public firms in the full service, casual dining segment. (Note: If the target was a privately owned
firm, I would also use public comparables.) If the target lacks appropriate publicly traded
competitors, a buyer can contract with consulting firms that have access to similar, private company
results. The two comparables are:
1. The Cheesecake Factory: Operates restaurants primarily under the “Cheesecake Factory”
name, $1.8 billion in 2011 revenue.
2. Texas Roadhouse: Operates restaurants under the “Texas Roadhouse” and “Aspen Creek”
names, $1.1 billion in 2011 revenue.
Because P.F. Chang’s and the other two companies were similar in size, but not identical,
comparable analyses are more useful in the context of common size percentages and financial ratios.
Common size data is a typical starting point in a comparable analysis and Table 10.9 sets forth
relevant information from the income statement and balance sheet. Referring to the income data,
P.F. Chang’s ranked behind its two competitors in EBITDA/Sales ratio, and bottom-line margins for
the company were 4 percent, versus 5 percent for Cheesecake Factory and 6 percent for Texas
Roadhouse.
Table 10.9 Comparable, Common Size, Normalized Data: Fiscal 2011
Source: SEC filings, author calculations.
P.F. Chang’s Cheesecake Factory Texas Roadhouse
Income Statement Data
Net sales
100%
100%
100%
Cost of goods sold
26
26
33
EBITDA
10
12
14
Net income
4
5
6
Working capital
(6)%
(5)%
(3)%
Total assets
100
100
100
Debt
0
0
9
53
66
Balance Sheet Data
Shareholders’ equity 54
Note: P.F. Chang’s margins were lower, balance sheet items similar.
Comparable ratio analysis is shown in Tables 10.10 and 10.11. P.F. Chang’s ranked third in
profitability, activity, and growth.
Table 10.10 Comparable Financial Ratios, Normalized Data, Fiscal 2011
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Table 10.11 Selected Compound Annual Growth Statistics: Latest Five Years
Source: SEC filings, author calculations.
P.F. Chang’s Cheesecake Factory Texas Roadhouse
Sales
5.8%
6.0%
13.6%
EBITDA
5.9
5.2
14.9
3.5
13.5
Net income (0.5)
The industry-specific data points out that the two comparables had positive same-store sales in
2011, while P.F. Chang’s results were negative 2.1 percent. See Table 10.12.
Table 10.12 Industry-Specific Statistics, Fiscal 2011
Source: SEC filings, author calculations.
P.F. Chang’s Cheesecake Factory Texas Roadhouse
Growth in same store sales (2.1)%
1.8%
4.8%
Sales per employee ($000) $48
$52
$34
Note: P.F. Chang’s lags behind its peers.
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Review of P.F. Chang’s Financial Analysis
Any comparable analysis has flaws because few companies are totally homogeneous in their
activities and characteristics. Another drawback lies in the differences found among the accounting
practices used by companies in the same industry. Finally, past performance is only one guide to
future success. History is a base from which financial projections and corporate valuations begin,
not the end-all for the M&A practitioner.
The P.F. Chang’s financial analysis reached the following conclusions:
Sales growth was moderate.
Earnings growth was nonexistent.
Liquidity and credit ratios were strong.
Comparable analysis placed P.F. Chang’s behind two competitors.
To prepare a target’s financial projections, a buyer must understand the factors influencing its past
performance. From a financial point of view, buyers tend to examine established firms through the
prism of four tools:
1. Absolute amount changes
2. Percentage changes in growth
3. Common size percentage statements
4. Financial ratios
The statistics generated by these tools are contrasted to a target’s peer group. Large deviations from
the norm require explanation.
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Notes
1. Interview with Antonio LaMota, First Eagle Investment Management, December 13, 2013.
2. Interview with Jennifer Cameron of Verdant Analysis, Inc., December 14, 2013.
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CHAPTER 11
To Facilitate Financial Projections, the Buyer Needs to Classify the Target
as a Mature, Growth, or Cyclical Business
What is a growth company? A mature firm? A cyclical business? The M&A industry uses these terms
regularly, but what do they mean? Chapter 11 provides the tools for making these classifications, and
it builds on the analytical foundation constructed in Chapter 10.
In Chapter 10, we studied the results of P.F. Chang’s, an established business in a mature industry.
In this chapter, we consider markers that place a business in its corporate life cycle.
Most M&A textbooks focus on the mature, established business. This is appropriate for the
university environment, where the student is getting accustomed to financial analysis. Examining a
business with minor variances from year to year is a good place to start. As the student transforms
into a practitioner, though, he is subject to a rude awakening. The M&A landscape is littered with
firms that fall outside of the teaching model. Many firms exhibit sharp changes in year-to-year
operating performance—for both positive and negative reasons. A healthy percentage of acquisition
target firms lose money. Others complicate the buyer’s job by completing numerous acquisitions, so
one doesn’t know where the real business ends and the new acquisitions begin.
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Company Classifications
Wall Street likes to summarize a company’s attributes in a shorthand manner, preferably within six
classifications. The buyer’s financial analysis enables it to pigeonhole an acquisition in one of those
classifications:
Wall Street’s Six Business Classifications
1. Mature company
2. Growth company
Classic growth
Market share growth
Consolidator
3. Cyclical company
Business cycle is dominant
Other cycles
4. Declining company
5. Turnaround
6. Pioneer
In this chapter, we discuss these classifications.
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The Mature Company
As our study of P.F. Chang’s illustrated, the prototypical mature business exhibits steady, if
unspectacular, movement in sales and earnings. The standard ratios show small year-to-year
changes, and the impact of acquisitions and divestitures is easy to distinguish. See Table 11.1 for an
example.
Table 11.1 Mature Business (in millions, except percent)
Year
1
2
3
4
5
Recession
Sales
Base business $1,000 $1,050 $1,100 $1,070
$1,120
Acquisitions
50
60
Total sales
$1,050 $1,110 $1,170 $1,100
$1,180
EBITDA
$ 100
$ 106
$ 112
$ 100
$ 112
Total sales
5%
6%
5%
(6)%
7%
EBITDA
5%
6%
7%
(11)%
12%
60
70
30
Growth
In classifying a business as mature, the practitioner likes to see a moderate uptrend in base
revenues and stability in profit margins. From this predictable pattern, he forms an opinion on
annual earnings power, absent acquisitions.
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The Growth Company
A growth company shows consistent above-average growth in sales and earnings. The definition of
above average shifts with the times, but a 15 to 20 percent annual rate (or higher) in the base
business qualifies as a growth trajectory. Profit margins are stable or increasing, yet the business
consumes cash, since investment in new facilities, accounts receivable, inventories, and acquisitions
outstrips internal cash generation. The company issues debt and equity regularly to fuel the
expansion. Because management is learning the business and competitors are jockeying for
position, the growth company hits a bump in the earnings road from time to time. Overly generous
sales promotions, excess inventories, and supply bottlenecks are three common problems. Table 11.2
shows a growth company, Irish software maker Fleetmatics Group.
Table 11.2 Growth Company Example: Fleetmatics Group, plc (in millions, except percent)
Source: SEC filings.
2010 2011 2012
Sales
$65
$92
$127
Net income
(1)
3
4
Sales growth
47%
42% 38%
Cash flow from operations $(38) $(15) $(9)
Financings
$49
—
$100
Not all growth companies expand from the same set of underlying factors. There are three types,
described briefly here and in Table 11.4:
1. Classic growth company. This business offers a new product that no one (or no firm) knew
they needed before the product’s invention. These products are frequently the result of
technological innovation. The classic growth company often is part of a new industry comprised
of similar firms.
2. Market share growth company. This company participates in a mature industry, with GNPlike unit sales growth. Due to a superior marketing program or a better mousetrap, the business
grabs market share from its competitors. The mathematics appear in Table 11.3.
3. Consolidator. As noted earlier in Chapter 4, a consolidator operates in a mature industry that
is highly fragmented. Rather than achieving share through internal product and marketing
developments, the consolidator buys numerous mom-and-pop firms in its industry. Each
acquisition of a competitor means more market share. In addition, there are synergies resulting
from the combinations. Developing a consolidator is a favorite tactic of the private equity (PE)
industry. At any given time, there are dozens of PE-backed consolidators trying to build large
businesses that can either go public or attract a strategic buyer.
Table 11.3 Market Share Growth Company (in millions, except for percentages)
Year 1 Year 2 Year 3
Market revenues
$1,000 $1,060 $1,125
Percent growth in the market
6%
Company revenue
$ 200 $ 233
$ 270
Company percent of market
20%
22%
24%
Percent increase in company sales
15%
17%
16%
11%
10%
Result: Amount by which company’s growth exceeded market growth 9%
6%
6%
Table 11.4 Three Kinds of Growth Companies
Type of
Growth
Company
Description
Classic growth
Offers a new product for which there was no established demand. The product is
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company
typically the result of new innovation and technology.
Market share
Participating in a mature industry, this company grows quickly because it boosts
growthcompany market share through better product quality, image or service.
Consolidator
Operating in a fragmented and mature industry, the consolidator grows by
acquiring numerous other firms. Paying the right price and realizing synergies are
critical factors for success.
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The Cyclical Company
Both mature businesses and growth companies exhibit stable trends that lend confidence to
earnings power estimates. Without a strong argument to the contrary, practitioners continue these
trends in their M&A projections. After all, will people stop drinking Coca-Cola or eating McDonald’s
hamburgers? Cyclical companies pose another problem. Since their earnings exaggerate the
movement in the business cycle, boom times are followed by bust times, and this pattern repeats
every cycle. Figure 11.1 shows a common pattern, whereby EPS rises and falls much more than GDP.
Figure 11.1 Cyclical Company Earnings Plotted against GDP
Given the ups and downs of a cyclical business, there is no point in using current earnings as a base,
since that performance level is only temporary. If the cycle is peaking, the analyst knows that
earnings declines are just around the corner. Similarly, particularly poor performance may signal a
bottom, and one is justified in anticipating a recovery. Accordingly, the historical analysis considers
the firm’s average earnings over the last full business cycle.
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The Declining Company
It’s important to distinguish between a cyclical company in the down cycle and a business in a
permanent state of decline. Sometimes, purely cyclical factors are hard to differentiate from
coincidental changes in business fundamentals, such as shifts in customer preferences or changes in
product technology.
125
The Turnaround
In every mature industry and every growth business, there is a firm whose star has fallen. Once a
profitable enterprise with rising sales, the turnaround is now a laggard. Sales growth is flat to
negative, and profit margins lag behind the competition. Reasons behind the collapse are many and
varied, and while historical financial analysis synthesizes the problems in statistical form, it offers
little in the way of predictive ability. Usually, management has a plan to revitalize the business (i.e.,
the turnaround), but the implementation requires time and money. The acquirer focuses on the
target’s historical cash flow patterns to determine whether the time and resources needed to pull off
the plan are within the acquirer’s means.
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The Pioneer
Historical financial analysis is almost useless for the pioneer company. With few sales and no
earnings, the business is a poor candidate for the tools of absolute amount, percentage change,
common size, and ratio analysis. Buyers consider fanciful projections, or acquirehire motives, to
justify many such deals.
127
Summary
After completing the historical financial analysis of a possible acquisition, the M&A practitioner
places the enterprise into one of six business classifications. This effort facilitates the preparations
of projections. Forming a view on a target’s future is more important than describing the past.
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CHAPTER 12
How Practitioners Forecast an M&A Target’s Sales and Earnings
The buyer’s M&A analysis always incorporates projections of the company under study. Before
jumping into the business of making projections, however, you should know popular techniques and
common pitfalls. Moderating optimistic assumptions with reality checks is an important part of
forecasting.
The nuts and bolts of projections, such as assigning growth percentages to revenues and applying
inventory-to-sales ratios, are usually grounded in recent history. Takeover candidate P.F. Chang’s
was a good example, as its M&A forecast adhered closely to past trends. See Table 12.1. Key statistics
such as sales, gross margins, and EBITDA were anticipated to improve modestly over P.F. Chang’s
historical results, and neither a recession, a new competitor, nor a major market change was
predicted.
Table 12.1 P.F. Chang’s Historical Results and Projections (In millions, except percentage)
Source: P.F. Chang’s, Proxy statement, May 15, 2012.
Actual
Projected
2009 2010 2012 2012 2013
2014
2015 2016
Sales
$1,228 $1,243 $1,239 $1,261 $1,380 $1,490 $1,653 $1,775
EBITDA
140
142
131
121
143
164
194
218
Sales growth
7%
1%
0%
2%
9%
8%
12%
7%
EBITDA growth 15
3
(8)
(8)
18
15
18
12
EBITDA margin 12
12
10
10
10
12
12
12
Note: Sales and EBITDA show a steady, if unspectacular, rise in this conventional projection, which has no recession.
The vast majority of projections follow this pattern of the future reflecting the immediate past.
Indeed, it is difficult for acquirers to argue against the rearview mirror approach. Analysis,
economists, and other investment experts are notoriously poor at gauging when a reasonably stable
business, such as P.F. Chang’s, faces either a serious downturn or a rejuvenating upturn. As a result,
most forecasts involving established businesses extend historical performance into the future,
usually via a loosely derived mathematical model such as a regression, moving average, trend line,
or exponential smoothing.
To prevent total reliance on historical data for established companies, analysts should consider
alternatives to trending past history, as we discuss in the next section.
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Means of Forecasting
The base component of any forecast is the revenue projection. Most expenses and balance sheet
items flow directly from sales. Your first assignment is thus determining which technique is best for
estimating sales. The initial reaction of the average analyst is to look at past sales as the anchor for
predicting future revenues. While this technique is valid for many businesses, it must be tempered
with a review of prospective changes in the company’s product offerings, product prices, competitive
environments, and technologies. Even when firms operate in the same industry, “they contain
unique elements that make each projection a situational exercise,” says Bob Carlin, CEO of Diabetes
America.1 Many of these elements contain a strong historical bias, while others require an
independent interpretation.
A common approach to sales forecasting is placing the business in the six business classifications,
which carry sales growth patterns that are well known to the M&A industry. (See Table 12.2.)
Table 12.2 Six Ways of Defining the Candidate for Sales Forecasting
Business
Classification
Expected Sales Performance
1 Mature
Moderate increases in sales as market for the company’s product matures.
2 Growth
Steady growth in sales as product acceptance widens or acquisitions take
hold.
3 Cyclical
Established business in sector where sales are dependent on the economic
cycle (e.g., autos, home construction).
4 Decline
Sales decrease as customers are attracted to newer, innovative products.
5 Turnaround
Recovery from poor performance.
6 Pioneer
Unpredictable and volatile sales movements.
When the buyer establishes the fit between the acquisition candidate and its classification, he is in a
position to select the appropriate projection technique. Sales projections are segmented into three
categories: (1) time series, (2) causal, and (3) qualitative.
Time Series Forecast Techniques
The basic assumption underlying time series analysis is that the future will be like the past. Analysts
prepare sales forecasts, therefore, by examining historical results, which are then brought forward
through the use of moving averages, exponential smoothing, or trend lines. Using this technique, a
company with a five-year growth rate of 10 percent is likely to have a future growth rate of 10
percent. This rearview mirror approach is difficult to counter effectively unless someone has a fresh
reason for promoting a reversal.
The time series analysis has proven itself well in basic industries, such as food, electricity, and
medical care. As a result, it is popular in projections of stable and defensive concerns. Accurate
projections in these industries can be difficult at the firm-specific level, but they become easier when
the business controls a significant market share. Dominant firms, like Budweiser in the brewing
industry, are a proxy for the entire sector.
The weakness of the time series technique is its inability to predict turning points in a company’s
performance. Turning points are often the result of hard-to-predict new competition or product
innovation. How could a time-series analysis forecast BlackBerry after five years of dominating the
cell-phone business? Or, the explosive growth of software-on-demand providers? How about the
turnaround in Apple Computer’s fortunes?
The time-series technique also encounters problems with business cycles. These phenomena do not
appear on a preset schedule, and they vary considerably in their duration and magnitude,
particularly in emerging markets. Other predictive measures are required for the M&A analysis.
Causal Forecast Techniques
130
The causal methods forecast a company’s sales by establishing relationships between sales and
certain variables that are independent of the corporation. At times these relationships involve broad
economic statistics such as gross national product (GNP) or employment. To illustrate, cement
demand is tied closely to GNP growth, so a cement industry projection relies heavily on GNP
estimates. In other instances, demographic factors influence a firm’s future sales. For example, the
graying of America inevitably leads to predictions that the nursing home business will grow. With
other companies, industry-related factors drive revenue. Housing starts drive furniture sales.
Company-specific factors may be casual. In lodging, a lodging chain’s future sales are influenced by
a new hotel construction program. A computer chip maker’s revenues are impacted by a new
production plant, and so on.
Qualitative Forecast Techniques
We apply qualitative projection techniques to pioneer and growth companies that offer new
products and services. With little history to act as a guide, the sales forecaster is left with expert
opinions, market research studies, and historical analogies as his analytical tools. Sometimes the
result is nothing more than educated guesswork. The market reaction of truly new products is hard
to gauge. Imagine forecasting the results of the Crocs footwear business. Questions such as what will
be the level of acceptance, and what price will the consumer pay, are difficult to answer, even for
experienced professionals. Social media and wearable computers, for example, confounded Wall
Street prognosticators.
Any would-be acquirer is well advised to use qualitative techniques in developing projections, even if
the business in question has a consistent sales record. The added work is another part of an effective
study, and it might reveal an inflection point unnoticed by others. Important qualitative methods for
predicting sales are described in Table 12.3.
Table 12.3 Qualitative Forecasting Methods
Qualitative Description
Forecasting
Methods
Experts
The practitioner consults with an industry expert(s) to develop assumptions on sales
projections.
Market
research
Consumer studies are performed to estimate future demand and pricing for a
potential or existing product line.
Historical
analogy
Make a connection between the target’s sales and those of firms that offered a
related concept in the past. For example, Linked-In investors examined the
introduction of Facebook.
Futurists
A long view, say 5 to 10 years into the future, may require an unconventional
interpretation. The force, intensity, and speed of contemporary business bring
unpredictable change. Every industry has its visionaries who look beyond near-term
developments.
131
Critiquing P.F. Chang’s Projection
Confronted with a historically derived projection for an established business like P.F. Chang’s, the
careful practitioner weighs causal and qualitative means. First, in 2012 the U.S. economy was
advancing and the company’s sales were probably going to rise with the economy. Second, many of
the firm’s costs are fixed, so EBITDA margins should expand as sales increase. The 12 percent
EBTIDA margin anticipated for 2016 is in line with competitors; however, the projections in Table
12.1 exclude the recession possibility.
Accompanying the preparation of top-line sales projections are future assessments garnered from
your historical review. Is it likely that the gross margin will change in the future? Will SG&A expense
stay constant as sales rise? Will inventory turnover jump in the coming years? Applying the answers
provides the analyst with a framework for making his projection. In the case of P.F. Chang’s, an
objective practitioner might have prepared a forecast that was less sanguine than the data provided
in the 2012 merger proxy.
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Preparing Projections
With P.F. Chang’s or any projection, the practitioner should follow these seven steps.
Seven Steps to Making Projections
1. Complete a historical financial analysis.
2. Match company classification with appropriate sales forecast technique.
3. Select reasonable assumptions for relevant economic and industrial variables that are linked to
the acquisition candidate’s revenue.
4. Prepare an income statement.
5. Estimate external cash needs, if any, and structure future balance sheets and cash flow
statements.
6. Complete free cash forecasts, and contemplate three scenarios.
7. Perform reality check.
Steps 1, 2, and 3: Focus on Historical Financial Analysis
The first three steps draw from your historical research. Experience dictates a focus on critical
assumptions and linkages. For the average M&A target, such items can be summarized into one or
two pages. A normal forecast period is 5 or 10 years.
Step 4: Project Target Results to the EBIT Line
This initial seller projection helps the buyer establish a value for the seller’s equity. After projecting
EBIT, the buyer makes certain assumptions about how the seller finances its operations, which
affects the seller’s interest costs, free cash flows and outstanding shares going forward.
The capital structure assumptions are intertwined, of course, with the target’s expectations for
property and equipment, inventory, receivables, and other operating requirements. These items
change in tandem with sales.
Step 5: Structure Future Finances
The target’s ongoing performance and creditworthiness play an important role in the formulation of
the forward capital structure. A company with a strong track record and conservative balance sheet,
like Campbell Soup, raises debt financing more easily than a technology enterprise like 3-D Systems.
The analyst can logically assume that the latter firm is more likely to use equity instead of debt to
finance its business.
A common mistake among junior practitioners (and M&A students) is naively assuming that debt is
available to fill in the gap between future cash flows from operations and cash needs for growth.
This beginner’s mistake avoids equity sales in the future, but it doesn’t fit the real world. Only a
small minority of M&A candidates qualify as investment-grade credits (i.e., the elite corporate group
that has an easy time accessing the debt markets). Most firms are junk bond credits, and their debt
financing options are limited. Presumed leverage parameters have to be realistic, and that means
the subject firm issues more equity in the projection or pays fewer dividends.
Step 6: Complete the Free Cash Flow Forecast for the Acquisition Candidate
With the financing scheme in place, the buyer estimates the seller’s stand-alone interest expense
and outstanding shares over the projected period. He then calculates pretax income, net income,
and earnings per share for the income statement. The last step is filling in the balance sheet and the
statement of cash flows. See Tables 12.4 and 12.5 for a packaging company projection.
Table 12.4 Rock-Tenn Packaging Company Forecast Example as of November 2013 (in billions,
except EPS and percentages)
133
Source: SEC filings and author estimates
2014 2015 2016
Income Statement
Revenues
$10.0 $10.4 $10.8
EBIT
0.6
0.7
0.9
EPS
4.50
5.45
6.63
Balance Sheet
Total assets
$12.1 $10.9 $10.8
Debt
2.6
2.4
1.9
Equity
4.2
4.5
4.9
Cash Flow
Capital expense
$ 0.5 $ 0.5 $ 0.6
Free cash flow
(0.3) 0.1
(0.2)
Unleveraged FCF
0.4
0.5
0.5
Revenue growth
2%
4%
4%
EBIT margin
6
7
8
Cap ex/revenue
4
4
5
Base Case Assumptions
Table 12.5 Rock-Tenn Packaging Company: Three Forecast Scenarios as of November 2013 (In
billions)
Source: SEC filings and author estimates.
2014 2015 2016
Upside Case
Sales
$10.2 $10.7 $12.1
EBIT
0.7
0.9
1.1
Base Case
Sales
$10.0 $10.4 $10.8
EBIT
0.6
0.7
0.9
Downside Case
Sales
$ 9.7 $ 9.9 $ 9.5
EBIT
0.4
0.5
0.3
Note: The financial projection exercise often calls for three scenarios. Here, sales growth and profit margin are modified a few
percent in each scenario.
Step 7: Reality Check
With the final projection in hand, it’s time for the M&A practitioner to step back, perhaps for a few
days, and consider whether his numbers for the seller are sensible. From my experience, many a
practitioner gets swept up in running endless scenarios on his personal computer, when he should
be taking a second look at the fundamental assumptions driving his forecast. Sometimes another set
of eyes helps spot obvious inconsistencies, and I recommend that M&A participants show
abbreviated data to a colleague. “The tendency tends to be over optimism in projections,” observes
Gerald Turner, director of Seraphin Capital, a U.K. private equity firm, “so a reality check is critical
for credibility.”2
134
135
Three Scenarios
During the refinement of steps 1 through 6, the practitioner runs alternative scenarios, testing the
earnings and cash flow effects of different assumptions. These scenarios produce many forecasts to
consider, but the process usually boils down to three versions (1) the upside case (optimistic), (2) the
base case (best guess), and (3) the downside case (pessimistic). For the established business in a
mature industry, the initial EBIT spread is typically ±10 percent off the base case, and future EBIT
moves off this level. This approach is seen in many public M&A forecasts.
The upside case assumes no recession, smooth product introduction, and moderate competition.
Included in the downside case are the effects of recessions, price wars, and turning points. Many
M&A bankers pooh-pooh downside cases as too pessimistic, but thoughtful buyers need to examine
the financial cushion of a business if things go bad.
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Summary
The critical variable for most projections is sales, and practitioners emphasize three techniques to
forecast this item—times series, causal, and qualitative. Once a methodology is selected, the buyer’s
executives follow a six-step process to round out the remainder of the seller’s financial projections.
Common missteps during this task include naively filling in debt financing for the stand-alone target
and using overly optimistic assumptions. Positive thinking is an occupational hazard in the M&A
business, and practitioners are advised to prepare multiple scenarios and seek independent counsel
from time to time.
137
Notes
1. Interview with Bob Carlin, CEO, Diabetes America, December 3, 2013.
2. Interview with Gerald Turner, director, Seraphin Capital, September 18, 2013.
138
Part Four
Acquisition Valuation
139
CHAPTER 13
The M&A Industry Typically Uses Four Valuation Methodologies
The M&A markets use four methodologies to assess the worth of most acquisition candidates. The
methodologies are discounted cash flow, comparable public companies, comparable acquisitions,
and leveraged buyout.
Now that we have studied historical financial analysis and financial projections, it’s time to gain an
understanding of the methods by which buyers justify acquisition prices. In this chapter and
subsequent chapters, we review the four approaches that instill a discipline in the M&A market.
Four Business Valuation Methodologies in the M&A Industry
1. Discounted cash flow. A business’s intrinsic value equals the net present value of its
dividends. Intrinsic value is sometimes called fundamental value.
2. Comparable public companies. A firm’s value is determined by comparing it to similar
public companies’ values.
3. Comparable acquisitions. Calculate a company’s share price by considering its worth to a
third-party acquirer.
4. Leveraged buyouts. One prospective price for a business is its value in a leveraged buyout.
140
Assessing Each Methodology
These methodologies have pros and cons that are summarized here.
Discounted Cash Flow (DCF)
The pros of DCF are:
DCF is theoretically appropriate and the subject of many textbooks.
Corporate lenders use DCF on a regular basis for pricing loans and fixed-income securities.
The cons of DCF are:
Equity professionals are reluctant to emphasize DCF. It is heavily reliant on 5- to 10-year
projections. Forecasts are notoriously inaccurate past one year, much less 5 to 10 years.
Practitioners have difficulty in reaching a consensus on the right discount rate for the future cash
flows.
Small changes, such as 1 percent, in the earnings growth or discount rate assumptions produce
sizable value differences, damaging DCF’s credibility.
The assumed future sale price of the target often represents more than half of the DCF estimate,
reducing the importance of the cash flow forecast.
Comparable Public Companies
The pros of comparable public companies are:
The valuations of similar public companies are indisputable, since their stock prices are
published daily.
The calculations involving the enterprise value (EV)/sales, EV/EBITDA, P/E, and other ratios
have substance, since the underlying public firm’s financial results are audited.
The cons of comparable public companies are:
Many subject businesses lack a set of true comparable firms, so there is little with which to
relate.
There is no yardstick to indicate whether the entire group of comparables is properly valued.
During the dot-com boom, the pricing of the entire Internet sector was inflated.
Comparable value relies heavily on past track records and current prices, when acquirers should
focus on a target’s future.
Comparable Acquisitions
The pros of comparable acquisitions are:
Like public companies’ values, the acquisition prices (and price multiples) of similar public M&A
deals are a matter of public record.
The public acquisition prices can be supplemented with private deals.
The cons of comparable acquisitions are:
Generally, there are fewer M&A comparables than public trading comparables, diminishing the
validity of the acquisition approach.
Private M&A deals lack the information provided in public transactions, so the resulting
conclusions are less definitive.
Acquisition pricing is backward-looking and sometimes reflective of market hype, rather than set
in a commonsense approach to future fundamentals.
Leveraged Buyouts
141
The pros of leveraged buyouts are:
The principal assumptions behind the leveraged buyout (LBO) analysis—degree of permissible
debt, interest cost, and payment schedule—can be verified by private equity participants.
Private equity firms have a long history of closing LBO’s, lending credence to the methodology.
The cons of leveraged buyouts are:
Most subject companies lack the characteristics of an LBO candidate, such as low-tech business,
consistent earnings record, and near-debt-free balance sheet. This approach is thus unworkable
for these companies.
Competitors and strategic buyers typically pay more than private equity firms, so this approach
is sometimes a bottom price.
142
Applying Multiple Methodologies
The uncertain nature of the valuation process, and the situational aspect of many assignments,
frequently requires that an analyst use the four valuation methodologies in concert. Part of his job is
to apply different weights, or degrees of emphasis, in reaching an investment decision. Based on my
experience in different finance venues, the weighting attached by M&A professionals to the four
methodologies is as follows in Table 13.1.
Table 13.1 Typical Weighting of Valuation Methodologies
Valuation Methodologies M&A Industry Weighting
Discounted cash flow
20%
Comparable public companies 20
Comparable acquisitions
50
Leveraged Buyout
10
100%
In other words, in 100 random M&A assignments, acquisition value is the principal approach 50
times out of 100 (i.e., 50 percent). Or, in a task where the M&A practitioner combines
methodologies to achieve the optimal result, he or she frequently gives acquisition value a 50
percent weighting.
If applied objectively, the methodologies represent a good double-check, or reality check, on each
other. For example, when green energy stocks traded at six times annual revenue in 2009, many
possible acquirers were reluctant to use public company values because they thought the sector’s
pricing was inflated. When they ran their DCF models on green energy stocks, their base case
forecasts produced valuations of just two to three times revenue.
143
Summary
The M&A industry has four principal approaches to value acquisitions.
1. Discounted cash flow.
2. Comparable public companies.
3. Comparable acquisitions.
4. Leveraged buyout.
The acquisition approach receives the most emphasis, but it is far from foolproof. Most practitioners
use a combination of methodologies to get the best answer.
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CHAPTER 14
The Use of Discounted Cash Flow in M&A Valuation
Discounted cash flow (DCF) is the student’s first introduction to business valuation. It involves
multiyear forecasts and firm-specific discount rates. In determining what a buyer or seller should
consider in the M&A pricing process, practitioners deemphasize DCF in favor of comparable public
company and comparable acquisition approaches.
A company’s intrinsic value is the present value of its stream of future cash dividends. This value is
calculated with different formulas, depending on the situation at hand, and many books describe
DCF formulas under multiple scenarios. The simplest formula is used for firms that have a stable
capital structure and a stable growth rate.
Discounted Cash Dividend Valuation Approach: Constant Growth Model
where
P= Intrinsic value
D1 = Next year’s cash dividend
k= Annual rate of return required by shareholders. Note that this k relates solely to equity
holders and is therefore different than the weighted average cost of capital (WACC).
g= Expected annual growth rate of dividends
To calculate the intrinsic value, the practitioner plugs in the numbers for D1, k, and g. He derives D1
and g from his financial projections of the acquisition target. We discuss k later.
For companies that are not expected to have anything approaching a constant growth rate, such as a
cyclical business, a start-up venture, or a firm with an erratic history, the formula is modified. The
practice is to predict dividends for a 5- or 10-year period, after which time the business either pays
out dividends in a constant manner, or is sold to a new owner.
An analysis of the fictitious Atlas Tech Company is shown in Table 14.1. The ATC stockholder’s 11
percent rate of return objective is reasonable. Alternative investments with less risk (like in
government bonds) provide expected returns that are below 11 percent, so the ATC stockholder gets
paid for the extra risk.
Table 14.1 Atlas Tech Company (ATC) Common Stock
Compound annual dividend growth
8.0%
Next year’s dividend rate
$1.50
Expected constant dividend growth rate (g)
8.0%
Dividend payout ratio
50.0%
Earnings per share
$3.00
Compound annual earnings per share growth
8.0%
ATC stockholders’ annual rate of return goal (k), given a choice of alternative investments 11.0%
Using the information in Table 14.1, the analyst applies the constant dividend discount formula to
derive a $50 share price:
145
A prospective acquirer who disagrees just slightly with the 11 percent k and 8 percent g estimates
would have a substantially difference price. For instance, if one concludes that the growth rate is 7.5
percent (versus 8 percent) because of a slowdown in the firm’s service area, this small 0.5 percent
deviation places ATC shares at $43 (i.e., $1.50/[0.11 − 0.075]), a 14 percent difference.
146
Discounted Cash Flow versus Comparables
The variables k and g are popular subjects in business schools, but the inability of buyers and sellers
to agree on exact estimates for individual companies, and the huge price differences that small
changes in these statistics make, reduce their relevance in the real world. Indeed, both the U.S. tax
court and the IRS often reject DCF-based valuations because of the concern about manipulation of
both forecasts and discount rates. While believing that the DCF concept is intuitively correct, “a
large portion of the M&A community abandons it as unworkable from a practical point of view,”
indicates Ron Everett, partner at Business Valuation Center.1 In its stead has risen the comparable
company concept, which uses similar public firms (or similar M&A deals) as the basis for
establishing value. The theory is simple enough: if they participate in the same industry, companies
with comparable track records and balance sheets should have similar valuation yardsticks. Since k
and g statistics are indeterminate, the comparable school adopts substitute measures, the most
popular being the price to earnings (P/E) and enterprise value EV to EBITDA ratios (EV/EBITDA).
147
The Discounted Cash Flow Valuation Process
The DCF approach involves five steps:
1. Projections. Using your research up to this point, prepare 5- to 10-year projections for the
subject firm.
2. Terminal value. Estimate the firm’s acquisition value at the end of the projected time period
(i.e., terminal value).
3. Discounted rate. Calculate the appropriate discount rate and apply it to the forecast cash flows
to common stockholders.
4. Per share value on standalone basis. Divide the company’s net present value of cash flows
by the number of outstanding common shares.
5. Synergies. Consider the synergies brought to the combination by the acquisition, and adjust
the present value accordingly.
Let’s consider a brief example, Sample Service Company.
Step 1: Projections
As indicated in Chapter 12, a proper projection includes the income statement, balance sheet, and
sources and uses of funds. From these items, you prepare a summary of free cash flow that is
available to the target’s existing stockholders. Using historical research, an M&A analyst prepared
Table 14.2 for Sample Service Company. This business generates positive cash flow over the forecast
period and suffers an income downturn in the fourth year.
Table 14.2 Base Case: Stand-Alone Free Cash Flow Projection, Sample Service Company (in
millions)
Year
1
2
3
4
5
Recession
Net Income
$100 $115 $140 $120
Plus: Depreciation and amortization 30
35
Gross cash flow
140
Less: Capital expenses
40
45
150 170
160
185
40
45
50
30
40
Less: Incremental working capital
10
12
14
5
20
paydowna
10
30
50
45
25
Free cash flow from operations
80
63
56
80
100
Cash proceeds from sale
—
—
—
—
1,680
Total FCF
$ 80 $ 63 $ 57 $ 80
Less: Incremental debt
40
$ 140
$1,780
a The projection assumes no changes in shares outstanding over the period.
Step 2: Terminal Value
Step 2 encompasses the terminal value. Analysts generally estimate a firm’s terminal value, or
ultimate sales price, by examining comparable company acquisition pricing. In Table 14.2, that
number is $1.68 billion (year 5, cash proceeds from sale).
The buyer uses value multiples gleaned from similar public companies and comparable acquisitions.
If similar acquisitions trade at a median P/E of 12×, he might apply 12× to Sample’s year 5 net
income in order to obtain a $1.68 billion terminal value.
Calculating the Cash Proceeds from Sale
148
Final year net income = $140(a)
P/E of similar firms = 12 (b)
Terminal value = $1,680 (a × b)
Step 3: Discount Rate
With the base case projections in hand, we apply the 15 percent discount rate selected for Sample’s
future cash flows to equity holders. For each succeeding year, the rate is compounded: 1.15 for year
1, 1.32 for year 2 (i.e., 1.152), and so on. Thus, a dollar of cash flow in the initial years has more value
than a dollar in later years. In Table 14.3, we determine the present value of Sample’s free cash flow
and its sale price. Note how three quarters of Sample’s present value is attributable to its ultimate
end price. This is not unusual in DCF calculations.
Table 14.3 Applying the Discount Rate to Sample Service Company Forecast (in millions)
Step 4: Per Share Value
The next step is dividing the next present value of equity by the number of common shares
outstanding. Sample has 100 million shares outstanding and unlike most companies, it has neither
stock options, convertible bonds, or warrants. As a result, the $10.88 per share computation is
simple division, as set forth in Table 14.4.
Table 14.4 Sample Service Company Calculation of Net Present Value per Share on a Standalone
Basis
We prepared a $10.88 estimate of Sample’s per share value.
Step 5: Synergy
Most deals involve the buyer acquiring a business that is similar to itself. The combination thus
involves synergies that enhance the value of the buyer, seller, or both. The stage is thus set for the
buyer to make an offer in excess of the seller’s standalone pricing. We look at these considerations in
Chapter 18.
149
Choosing the Right Discount Rate in Valuing a Standalone Business
The credibility of the discounted cash flow approach is dependent on an accurate projection and an
appropriate discount rate. The discount rate is a representation of what return a reasonable equity
investor would expect from the subject company. This chapter emphasizes the equity rate of return,
rather than the weighted average cost of capital (WACC), which incorporates both a firm’s debt and
equity returns.
Investors base a firm’s expected equity rate of return on a relative analysis of the returns being
offered by competing investments, taking into account the respective risks involved. Investments
perceived as risky because of checkered track records or questionable prospects should provide a
high-expected rate of return relative to those thought of as conservative. Figure 14.1 illustrates a
risk/return matrix in graphic form. For an established, profitable business in the United States, a
typical expected equity rate of return is between 10 and 20 percent per year, reflecting a risk
premium (over the 10-year U.S. Treasury bond yield) of 7 to 17 percent.
Figure 14.1 Different Rates of Return: November 2013
Financial experts have written many books about the appropriate risk premium for equity
investments and M&A deals, and this book presents only a brief summary. The two principal
methodologies are the Capital Asset Pricing Model (CAPM) and the Equity Buildup Method. Both
look at the historical performance of publicly traded stocks to provide a guide on what the future
return of an equity investment (or its discount rate) should be.
CAPM
The CAPM examines the historical return of a publicly traded stock and compares it against the
return of a broad market index. The resultant statistic is called beta, and practitioners use it in an
equation to determine a company’s equity discount rate. See Figure 14.2. For a privately owned
enterprise, the custom is to examine the betas of similar public companies, determine a median
beta, and adjust the median for the subject enterprise’s specific attributes. See Table 14.5. This
adjusted beta is then placed into the CAPM equation and then the enterprise’s estimated equity
discount rate is determined.
150
Table 14.5 Beta of Public For-Profit Educators Summary Information, October 2013
Company
Beta Revenue (billions)
Apollo
1.4
$3.8
Career Education
2.2
1.3
Corinthian College 3.5
1.6
DeVry
1.5
1.1
ITT
1.8
1.2
Strayer
1.6
0.6
Median
1.7
The 1.7 median beta is used as a proxy for a nonlisted education company, before adjusting for the company’s specific attributes.
Figure 14.2 Sample k Calculation, October 2014, U.S.-Based Company
Equity Build-Up
Fundamentally, the build-up methodology states that a stock’s required return begins with a riskfree foundation to which succeeding levels of risk premiums are added. The ultimate return is thus
constructed as a set of building blocks. The premiums are based on rates of return recorded for the
classes of public equity securities that match the subject investment.
As a formula, the buildup method is expressed as follows, with five risk premiums:
Public common stocks’ expected rate of return = Risk-free rate
1. + Equity risk premium
2. + Industry premium
3. + Size premium
4. + Company-specific risk premium
5. + Country risk premium
The equity risk premium (1) corresponds to the same term outlined earlier in the CAPM. The
industry premium (2) is positive or negative, depending on the industry’s return performance over
time. For example, the defense industry has a negative industry premium, while the computer
components industry has a positive premium. The size premium (3) accounts for the fact that
smaller companies historically provide higher returns than larger companies in the same business.
Most computations include a company-specific risk premium (4). Such a premium is included “to
the extent the subject company’s risk characteristics are greater or less than the typical risk
characteristics of the companies from which the industry premium and size premium are drawn,”
according to Shannon Pratt and Roger Grabowski, authors of Cost of Capital, Fourth Edition (John
Wiley & Sons, 2008). In my experience, positive company-specific premiums result from factors
151
such as single-customer dominance or high leverage, whereas a negative premium derives from no
leverage or formidable patent protection. The country risk premium (5) usually looks at risk in the
acquisition’s principal market versus a similar U.S. company.
In Table 14.6, I estimate the equity discount rate for an M&A candidate that participates in the
Brazilian plastics industry. It has an estimated $1 billion equity value (a small-cap business in
Ibbotson terminology), and its revenue is concentrated among six customers. The resultant discount
rate is 12.9 percent.
Table 14.6 The Buildup Method for Equity Rate of Return: Hypothetical Brazilian Plastics Firm,
October 2013
Rounded
Risk-free rate
3.00%
+ Equity premium
+6.00
+ Industry premiuma
−1.60
+ Size
premiumb
+1.80
+ Individual company
premiumc
+2.00
+ Country premiumd
+1.70
Estimated discount rate
12.90%
a The relevant industry has less risk, and less return, than the broad equity market.
b The firm’s small size dictates a higher return.
c Concentrated customer base.
d Brazil country risk is higher than U.S.
As noted in Chapter 11, when preparing financial projections, the practitioner uses several scenarios
to reflect the uncertainty of any forecast. Similarly, the practitioner typically utilizes several discount
rates centered closely around a base number. There are thus multiple combinations of forecasts and
rates.
152
Summary
Of all the valuation methods used in the M&A market, the discounted cash flow method is the most
valid from a theoretical point of view. It also makes common sense. Particular care must be given to
the ending sales price calculation, which represents a substantial portion of DCF value estimates.
The large number of assumptions and calculations involved in devising a firm’s intrinsic worth limit
this method’s use on Wall Street. Professionals prefer short, concise value indicators, such as the
P/E and EV/EBITDA ratios, which summarize the relevant DCF statistics into one number. The
subject firm’s value ratios are then compared with those of similar businesses, just as the historical
analysis used comparable company data to study a firm’s financial condition.
153
Note
1. Interview with Ron Everett, Business Valuation Center, March 12, 2014.
154
CHAPTER 15
Valuing M&A Targets Using the Comparable Public Companies
Approach
For the purpose of pricing a target, the M&A industry favors the (a) comparable public company and
(b) comparable acquisition value approaches, which are sometimes referred to as “relative value.”
Comparable public company analysis is the subject of this chapter. To determine a price range for a
takeover opportunity (most of which are private), practitioners examine what stock market investors
pay for similar, publicly traded businesses.
The objective of comparable public companies analysis (i.e., relative value) is to establish the price
at which a privately owned business would trade on the stock exchange. To this hypothetical price is
added a “control premium” in order to reflect the fact that an acquirer purchases 100 percent
ownership, rather than the small amounts of individual firm equity that trade publicly on a day-today basis.
Relative value is a favorite topic of TV talking heads, Wall Street analysts, and corporate finance
executives. They discuss the positive and negative aspects of a stock, and then evaluate those
attributes against firms participating in the same industry. Valuation parameters are then compared
and contrasted, resulting in statements such as “Kroger is undervalued relative to Safeway because
Kroger’s growth rate is higher yet its P/E ratio is lower.” Other popular ratio comparators are
EV/EBITDA, EV/sales, and price/book. Rarely do commentators mention a discounted cash flow.
Thus, when an investment banker is asked to justify his recommendation of an M&A deal at 20×
earnings, the response inevitably begins with “comparable companies are trading at 20× earnings.”
If the subject company’s multiples are higher than its peers, the banker will typically provide a
recitation of the firm’s positive attributes, such as a better growth outlook, a better track record and
a better balance sheet. Table 15.1 shows a summary of a comparable companies’ analysis.
Table 15.1 Summary of Comparable Public Companies Analysis: Temporary Staffing Services,
October 2013
Source: Yahoo! Finance, SEC filings.
Value Ratios
Five-Year Growth Rate
P/E EV/EBITDA
CDI
19× 8×
6%
Kforce
24
12
8
Kelly Services
15
9
9
On Assignment 22
12
16
Robert Half
23
12
12
Median
22× 12×
9%
Note: The starting point for the private takeover target is the median. Then, the target’s attributes, relative to others, puts its stock
above or below the median.
155
Real Estate Analogy
For people with little exposure to relative value for businesses, a good analogy is real estate
appraisal. Anyone who has bought a house has seen an appraisal. The real estate appraisal lists
comparable sales within the subject house’s neighborhood. Alongside each comparable sale is a
summary of the attributes that make the comparable better or worse than the subject house;
discounted cash flow is never used in such appraisals. For example, if the subject house has three
bedrooms, two baths, a two-car garage, and a swimming pool, it has a $780,000 value relative to a
similar $800,000 property. See Table 15.2.
Table 15.2 Relative Value in a Real Estate Appraisal
Subject
House
Price: $?
Comparable Sale
$800,000
Attributes of Subject
House, Net Relative to
Comparable Sale
Comments
Three
bedrooms
Four bedrooms
$ - 25,000
Subtract $25,000 for one
fewer bedroom
Two baths
Three baths
- 15,000
Subtract $15,000 for one
less bathroom
Two-car
garage
One-car garage
+ 10,000
Add $10,000 for extra
garage space
Swimming No pool
pool
Add $10,000 for
swimming pool
+ 10,000
Relative difference, net $ - 20,000
Comparable sale price
$ 800,000
Appraisal of subject
house relative to
comparable sale
$ 780,000
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Based on its attributes, the
subject house is worth
$780,000
What’s the Right P/E Ratio?
As demonstrated in Table 15.2, residential real estate appraisal has accepted additions (or
deductions) for specific attributes, like an extra bedroom, bathroom, or parking space. In the
relative value approach for companies, unfortunately, there isn’t a gold standard that says how
many P/E multiples you knock off when your subject firm lacks certain characteristics. Life would
be easier if a 2 percent substandard growth rate mechanically reduced a P/E multiple by 3 (e.g.,
from 17× to 14×), but it doesn’t work that way. Too many extraneous variables enter the process,
particularly those hard-to-define future expectations. Nevertheless, investors constantly contrast
and compare attributes such as growth rate, profit margin, leverage, and productivity among
companies, both public and private.
To quantify how much a target subject company’s valuation multiple should be above and below its
public peer group median, some practitioners rank the firms according to performance statistics
germane to the industry. If the acquisition’s rankings are above average, it warrants an aboveaverage valuation multiple, all things being equal. Table 15.3 provides a brief illustration.
Table 15.3 Comparing the Target to Public Company Medians
Sample Grading
Criteria
Comparable Public
Company Median
Acquisition Target Acquisition
Results
Relative Grade
Growth rate
9%
10%
Above Average
Asset turnover
3×
3×
Average
Debt/Total capital
20%
5%
Above Average
13%
Above Average
EBIT profit margin 11%
Note: Growth tends to be the most important grading criteria.
In Table 15.3, the target’s operating results are superior to the public comparables. Thus, its owners
have some justification for asserting that the target’s hypothetical IPO value multiples should be
higher than the comparable company median. For example, if the median EV/EBITDA ratio was 7×,
a seller might suggest that its EV/EBITDA ratio as a listed firm would be 8×. This logic will extend
into its likely acquisition pricing.
Estimating a hypothetical public trading value for a target business involves six steps, which are
summarized below:
1. Select the comparable public companies: Find public companies that operate in the same
country, industry and subsector as the potential acquisition. Try to identify public companies
with similar size, profitability and leverage of the target. Few businesses have exact duplicates,
but in the United States, which has thousands of listed firms, most targets have 5 to 10 public
comparables. Sometimes the subject business participates in a new sector, and thus, there are
few, if any, similar companies with publicly traded stocks. In this case, the practitioner has to use
his common sense to select companies that have similar themes to the target. For example, when
Starbucks went IPO, there were no specialty coffee chains to relate to, so investors considered
novelty stores and snack outlets with price points of $5 to $10.
2. Make necessary accounting adjustments: Public U.S. firms take many earnings
adjustments by categorizing various losses and gains as one-time items. The independent public
accounting firms allow this treatment, and it is up to the practitioner to determine whether such
items are isolated occurrences, or normal operating accruals. If an item is truly one-time, then
you should erase it from your spreadsheet before developing value ratios. Likewise, consider the
effects of stock options and other items.
In Table 15.4, the target had a one-time loss on the sale of a division. “Tax-effect” the loss and
add it back to net income. All P/E and EV/EBITDA ratios then reflect this change.
Use the adjusted net income for comparable public company calculations.
Stock options, convertible securities: Many firms issue stock options or sell securities that are
convertible into common stock. If the target’s market value (per share) is higher than the strike
price of these items, you should assume the conversion privileges are exercised and the number
of outstanding shares increases. See Table 15.5. This assumption affects the “equity market
values” in your comparable public company analysis. Note that the computerized data services
157
often do not include potential new shares in their calculations. For the vast majority of public
and private firms, the ownership dilution caused by these items is less than three percent. Most
comparable public company analyses ignore such dilution.
Other accounting items: Out of 10 public comparables, one or two may have unusual accounting
entries such as large affiliate incomes or sizable debt guarantees. Judgment dictates the extent to
which your analysis is impacted.
3. Calculate the value multiples: Once the practitioner has accounted properly for one-time
items among the target and its public peers, he then calculates the many financial statistics that
go into a comparable analysis. Besides performance ratios, the valuation ratios are computed,
such as P/E, EV/EBITDA, EV/sales, and Market Equity Value/Historical Book Value.
Table 15.4 Adding Back a One-Time Loss to Net Income for Comparable Public Company Analysis
(in millions)
One-time pretax loss on sale of a division
$(30)
Implied tax savings @ 40%
+ 12
Amount to add to stated net income
18
Stated net income
50
Net income, adjusted for elimination of one-time item $ 68
Table 15.5 Adjusting for Stock Options (in millions, except per share)
Hypothetical public equity trading price (@ $50 per share)
$500.00
Add: Cash received from implied conversion of 2 million stock options at $30 60.00
Public equity trading price,
adjusted for stock option exercise
$560.00
Common shares outstanding
10.0
Add: Additional shares from options
2.0
Adjusted common shares outstanding
12.0
Price per common share (A ÷ B)
$ 46.67
(A)
(B)
Practitioners typically calculate the ratios for three different time periods, as indicated in Table 15.6:
1. Trailing 12 months: This ratio uses the firm’s latest 12 months’ historical results. If the firm
has a December 31 year-end, and the measurement date is August 15, 2014, for example, the
trailing 12 months stops at the latent quarter (June 30). The trailing 12 months’ P/E ratio,
therefore, incorporates net earnings from June 30, 2013 to June 30, 2014. See Figure 15.1.
2. Estimated year end: Estimated year earnings include six months’ actual results through June
30, 2014, plus six months’ estimated results up to December 31, 2014.
3. Projected year: We calculate the value ratios for financial results that are projected for the
next full fiscal year, that is, the year ending December 31, 2015.
M&A negotiations include debates about the ratios for all three time periods and the relevance of
each. The seller of a fast-growing business may prefer projected results, while the buyer may like
the certainty of historical data. Table 15.6 shows an example of the many calculations for the
EV/EBITDA ratio.
4. Interpret the range of value multiples: With the vast array of comparable performance
statistics and comparable valuation ratios at hand, the next step is to determine where the
acquisition target “fits in.” All of its relative positives and negatives go into the mix, and the
practitioner decides (a) what ratios are relevant and (b) whether the target deserves an above
average—or below average—valuation. Table 15.4 shows the selected multiples for the target
company, alongside public medians.
5. Apply appropriate multiple to the target acquisition hypothetical public trading
price: Having selected appropriate multiples for the target, the next steps are (a) to apply them
to the target’s financial results, and (b) to estimate hypothetical public equity value. See Table
15.7 for an illustration.
In Table 15.5, the target’s performance was better than its public peers, so I assigned higherthan-median multiples (column 3) to its results.
158
6. Make a decision and apply 30% control premium: In Table 15.4, the analysis produces a
$340 - $400 million range of public enterprise value (EV) for the target. With the market
emphasis being on EBITDA for this target’s industry, the practitioner places the most weight on
the $380 million value. With two of the three remaining values under $380, $370 is a reasonable
conclusion.
Figure 15.1 Three Sets of Numbers at August 15, 2014
Table 15.6 Comparable Public Company Analysis, EV/EBITDA Ratio Computations for Three Time
Periods
Comparable Public Company Trailing 12 Months Estimated Projected
A
8.5×
8.2×
7.6×
B
9.3
8.9
8.1
C
10.0
9.5
8.7
D
9.1
8.9
8.2
E
7.8
7.7
7.4
Median
9.1×
8.9×
8.1×
Note: The EV/EBITDA ratio falls over time, since EBITDA is forecast to increase in this table.
Table 15.7 Applying Public Company Multiples to the Target’s Results (in millions, except for
ratios)
(1)
(2)
(3)
(4)
Statistic Target
Company
Results
Public
Company
Multiple
Median
Selected
Target
Multiples
EV (1 Less Add Target’s
× 3)
Debt Cash Hypothetical
Public Equity
Value (4 - 5 + 6)
Net
income
16.0×a
17.0×
—
EBITDA 50.0
8.5b
9.0
450.0 (80.0) 10.0
380.0
Sales
600.0
0.6c
0.7
420.0 (80.0) 10.0
350.0
Book
value
200.0
1.9d
2.0
400.0 —
—
400.0
Range:
$340.0 - $400.0
$ 20.0
(5)
—
(6)
—
(7)
$340.0
a P/E.
b EV/EBITDA.
c EV/Sales.
d Price/Book.
To reach an equity equivalent of this $370 million EV, the debt is subtracted from EV and cash is
added, producing a public equity value of $300 million. See Table 15.8.
Table 15.8 Converting Public EV to Public Equity Value (in millions)
159
Assumed EV public value
$370
Less: Debt
(80)
Add: Cash
10
Assumed equity public value $300
The $300 million public equity value reflects the value at which small amounts of stock could be
bought in the markets, assuming the acquisition candidate was publicly traded. To reflect the cost of
a 100 percent interest (i.e. an acquisition), one adds a 30 percent control premium. The application
of the premium establishes a reasonable equity takeover price of $390 million (i.e., $300 million ×
130 percent = $390 million). This equity value is the equivalent of a $460 million EV (i.e., $390
million equity value + $80 million debt - $10 million cash = $460 million). A practitioner therefore
says the appropriate takeover EV pricing is “around 9.2× EBITDA” (i.e., $460 million ÷ $50 million
EBITDA = 9.2×).
160
A Word about Value Multiples
The reader should consider the following observations when using the popular value ratios.
P/E ratio: The P/E ratio is a single statistic that doesn’t explicitly define investors’ assumptions
about a company’s growth or risk. Generally, a high P/E ratio suggests a strong growth outlook,
but it could also mean the business simply has a small positive earnings base. A low P/E might
mean a poor growth outlook or a high-risk enterprise. For companies with negative earnings,
P/E is not meaningful.
EV/EBITDA: This ratio is the most popular M&A valuation tool. It levels the playing field for
(a) firms with different capital structures (since EV includes equity market value plus net debt),
and (b) firms that have widely divergent depreciation and amortization (D&A) charges because
of differing levels of M&A activity (which contributes to higher D&A expenses). EBITDA is not a
GAAP term and D&A are real economic costs. Like P/E, the EV/EBITDA ratio doesn’t separate
risk and growth variables.
EV/Sales: Revenues indicate neither profits nor positive cash flow, both critical elements in
valuation. However, revenues suggest the business is doing something right by having a product
(or service) that customers want to buy. The EV/Sales ratio is used frequently for money-losing,
or marginally profitable companies.
Price/Book: The historical book value (or accounting value) of shareholders’ equity has little
relation to earnings power, particularly for firms with proprietary technology (e.g., Google) or
well-accepted brands (e.g., Coca-Cola). Book value may be inflated by sizeable amounts of
goodwill or intangible assets incurred through high priced acquisitions, and, thus, some analysts
prefer tangible book value, which deducts these items. Finance industry, real estate, and distress
situations use book value more than most sectors because nontangible assets have less influence
on results.
Value multiples are usually applied to single year results, so their use is problematic for firms with
volatile year-to-year performance. Practitioners sometimes use multiples based on average results
or weighted-average results to smooth out the cycles.
161
Summary
Many practitioner debates about M&A values center on comparable public companies. If the auto
parts group is trading at 6.0× EV/EBITDA, then a good starting point for an auto parts acquisition
is 7.8 × EV/EBITDA (i.e., 130 percent acquisition premium × 6.0x = 7.8×). If research shows the
target is a better performer than its publicly traded peers, it deserves a higher multiple. If its record
is worse and it has fewer prospects, it merits a lower multiple. Non-earnings-based factors, such as
hidden asset values or off-balance sheet liabilities, are then added to or deducted from the
benchmark estimate.
162
CHAPTER 16
Valuing an M&A Target by Considering Comparable Deals and
Leveraged Buyouts
In the two previous chapters we covered the “discounted cash flow” and “comparable public
company” approaches to valuing an acquisition target. In this chapter, we will discuss the two
remaining principal methodologies: “comparable acquisitions” and “leveraged buyout.” Of the four
approaches, comparable acquisitions receives the most emphasis in actual M&A negotiations.
Simply put, the prospective buyer looks at the valuation multiples of similar deals to establish a
target valuation range. As noted in Chapter 13, this approach is far from foolproof, usually owing the
lack of similar transactions, the information missing from private sales, and the deal comparables
being outdated.
The comparable acquisition approach follows a process that closely resembles the “comparable
public company” methodology set forth in Chapter 15. Instead of tracking publicly traded firms that
relate to the target, the practitioner identifies recent acquisitions that bear similarities. He then
analyzes the deals, computes their value ratios, and applies appropriate multiples to the target’s
results, given its unique attributes. Set forth below are the six steps for using the comparable
acquisition approach.
Steps in Comparable Acquisition Valuation Approach
1. Select the comparable acquisitions
2. Make the necessary accounting adjustments to establish true earnings power
3. Calculate the value multiples for the comparable deals
4. Interpret the range of value multiples
5. Apply the appropriate multiple to the target’s accounting results.
6. Given the range of valuation possibilities, make a decision on the target’s likely worth in the
M&A marketplace.
Identifying M&A comparables is more difficult than tracking publicly traded comparables.
Generally, the number of deals is smaller than the number of the public participants. Moreover, the
M&A information that the analyst compiles at any given time is dated, since developing a
representative sample of transactions requires going back a year or more. The more distant in time a
comparable is, the less relevance it has. Practitioners maintain a running inventory of transaction
data, which is amended as new deals crop up. Analysts wanting to track industry pricing can buy
M&A data from a number of services, such as Mergerstat, MergerMarket, Capital IQ, Thomson
Financial, Done Deals, and SDC Platinum.
To the extent possible, you should compare the financial and operating attributes of the prior
acquisitions to your subject acquisition, and then make the appropriate adjustments to the median
ratios before applying them to the subject’s results. For example, if your target is growing faster than
the comparables, you may want to assign a slightly higher value multiple than would otherwise be
the case.
Obtaining accurate pricing, revenue, EBITDA and net income data on private sales is problematic,
so, you’ll have a wider margin of error in this valuation approach than in comparable public
companies. By way of illustration, a January 2013 survey of medical insurance administrative
contractors revealed two public transactions and five private deals. EBITDA and net income
information was lacking. See Table 16.1.
Table 16.1 Selected Medical Insurance Administrative Takeovers, 12 Months prior to January 2013
Source: Capital IQ, Merger Market, SEC filings, author calculations.
Month/Year Seller/Buyer
Enterprise Value
(in millions)
163
Enterprise
Value to
Seller
Sales EBITDA
(Public/Private)
Nov 2012
Metro Health/
Humana
$741
1.0×
7.7×
Public
Aug 2012
MaxIT/SAIC
473
1.5
N.A.
Private
June 2012
Fidelity Healthcare/
Lightyear
335
2.8
9.9
Private
Jan 2012
APS Healthcare/
Universal
281
0.9
N.A.
Private
Nov 2011
Healthtran/BCBS
South Carolina
296
1.1
N.A.
Private
Oct 2011
UCI Medical/Towers
Watson
76
0.9
N.A.
Private
Mar 2011
Continucare/Metro
Health
338
1.1
7.9
Public
$335
1.1×
7.9×
Median
As Table 16.1 shows, prior to January 2013, seven medical insurance administrators accepted
takeover bids at EV/sales ratios of 0.9× to 2.8×, with a median of 1.1×. The median is typically a
starting point for assessing the valuation of an acquisition candidate. From there, one assesses the
target’s merits relative to the acquisitions in the sample. Good target attributes suggest a higherthan-median multiple, and bad attributes advocate a lower multiple. A candidate with slightly
below-average traits might be inclined to entertain EV offers at 1.0× annual revenue, slightly below
the 1.1× median.
164
Control Premium Is Embedded in Comparable Acquisitions
In Chapter 15, we added a 30 percent control premium to an acquisition candidate’s hypothetical
public trading price in order to establish a reasonable M&A offer. However, this step is unnecessary
in the comparable acquisitions approach because the control premium is already included in the
pricing. Why does a buyer pay over-and-above the public-equivalent price? Three reasons: control,
synergy, and leverage.
1. Control. An investor buying 1,000 shares of a publicly traded company has no power to change
corporate affairs, directors, or objectives. An entity buying a controlling interest obviously has
that power. Traditionally, a controlling interest costs 30 percent more per share than a minority
interest in a publicly traded company.
2. Synergy. A corporate acquirer justifies a takeover by assuming that its skills and resources,
once applied to the seller’s business, will ratchet up the seller’s sales and earnings. When
Facebook bought Instagram, the inclusion of Instagram’s community into Facebook’s marketing
and distributing system propelled Instagram’s revenues. American Realty’s acquisition of Cole
Real Estate didn’t increase the combination’s revenue, but the cost savings from eliminating
duplicative headquarters, marketing programs, and administrative functions increased the
combined firms’ earnings. In many deals in which I participated as an investment banker, cost
synergies alone boosted the acquisition’s bottom line by 10 to 20 percent. As a result, it follows
that an operating company can afford to pay more than a target’s public market price for control.
See Table 16.2.
3. Leverage. Management teams of established public companies are reluctant to use heavy
leverage, despite its cost-of-capital and tax advantages. In contrast, the private equity firms that
facilitate leveraged buyouts (LBOs) are unafraid of high debt. They can turn that advantage into
a premium purchase price from time to time.
Table 16.2 Projecting Synergies in a Takeover (in millions)
Acquirer Seller Adjustments Pro Forma Combined
Sales
$1,000
Operating expenses (850)
$ 500 $ +30a
$1,530
(425)
+25b
1,300
(20)
$ 250
Cost reductions
—
—
–20c
Operating income
$ 150
$ 75
$ +25
a $30 million in sales enhancements from cross-selling customers.
b $25 million in operating expenses related to $30 million sales gain.
c $20 million reduction in seller’s costs, related to diminution of duplicate overhead and other efficiencies.
165
Understanding Leveraged Buyouts
The basic principle behind the leveraged buyout (LBO) is simple: OPM, which stands for “other
people’s money.” The private equity (PE) firm specializing in LBOs acquires companies while
investing as little as possible of its own money. The bulk of the purchase price is borrowed from
banks or other knowledgeable lenders. The PE firm does not guarantee the related debt financing,
which is secured solely by the assets and future cash flows of the target business. Nor does the PE
firm promise the lenders much in the way of operating expertise, since it is staffed mainly with
financial professionals who know little about how to run a large manufacturing or service business.
The PE firm is basically a transaction promoter, which is a full-time job in and of itself. Finding an
acquisition candidate, pricing the deal, performing due diligence, finding financing, and negotiating
documentation is a lengthy and complex process, requiring combinations of contacts and skills that
are not easily duplicated.
Over 1,000 PE firms in the United States specialize in arranging leveraged buyouts (and hundreds
more in Western Europe). Many hedge funds, investment banks, and general investment funds
dabble in the field. Collectively, these buyers control large chunks of American and European
industry. Despite academic studies that show that LBO investments do not outperform the broad
market, net of fees, many state pension plans, sovereign wealth funds, and wealth managers
participate in the field, and they are the primary funding sources behind the vast equity pools
commanded by the PE firms. Like all M&A activity, LBO volume declines sharply during troubled
economic times, and early 2008 saw the peak of the 2002–2008 cycle.
By using large amounts of leverage, the PE firm enhances its returns because lenders share little or
none of the increase in value of the corporate assets. The PE firm can lose only its initial investment,
perhaps 25 percent of the deal’s purchase price, and enjoys practically 100 percent of the upside, if
any. Since corporate earnings have upward tendencies because of inflation and economic growth,
the LBO tactic of using lots of borrowed money to buy corporate assets is sensible, particularly if the
acquisition prices are in line with historical standards.
Buying right is the second linchpin of the PE firm because a premium price can spell failure.
Overpaying is costly for two key reasons. First, like any corporate acquirer, a PE firm faces smaller
returns with each extra dollar it pays for a deal. Second, it operates with a small margin for error,
even when it buys a deal right. When the PE firm overpays, the acquisition is loaded up with more
debt than is normally the case. If the deal’s operating earnings come in lower than forecasted, the
target’s ability to pay debt service is jeopardized. Such was the case with Energy Future Holdings, a
$32 billion LBO that couldn’t repay its borrowings.
Three LBO Principles
1. Other people’s money. Use as much leverage as possible in deals, thus enhancing prospective
equity returns.
2. Buying right. Search for businesses that can be acquired at relatively low value multiples.
3. Improve operating performance. Shift management’s orientation to acting as owners,
rather than high-paid employees.
The third leg of the LBO table is enhancing the target’s performance. After acquisition, the PE firms
seek above-average efficiencies from their management teams and assist them with operating
partners working exclusively for the PE firm. “Enhancing performance of our acquisitions enables
us to compete properly,” points out Brooke Coburn, managing director of the Carlyle Group, a major
buyout fund.1 Top executives are provided with equity participation and they are expected to run the
business like owners, instead of employees. Many respond by cutting expenses that they would
otherwise tolerate under the public ownership model. The result for the PE firm might be an
acquisition that exceeds its projections.
166
167
LBO Mechanics
The mechanics of implementing an LBO are well-known and center around finding a business that
can support the debt needed to finance about 75 percent of its purchase price. See Figure 16.1 This
degree of leverage is typical in real estate, banking, and airlines—to name a few categories—but it is
uncommon in most industries that manufacture a product or provide a service. Why? Because
operating company values fluctuate widely from year to year. Even the values of big-name
corporations exhibit wide ranges. In 2013, the price of Sears stock traded between $38 and $69, an
82 percent difference in just 12 months. DuPont shares moved within a $42 to $61 range, a 45
percent difference.
Figure 16.1 Leveraged Buyout Capitalization: Debt and Equity Market Value
To cut the risk of a significant value drop, LBO lenders look for borrowers with a few key
characteristics:
Low-tech. Lenders prefer businesses relying on technology that is not subject to rapid change.
Solid track record. Lenders favor businesses with a history of consistent profitability and a
pro forma ability to cover debt service.
Hard assets. As an insurance policy against potential operating problems, lenders like
borrowers with lots of tangible assets, such as real estate, plant and equipment, inventory, and
receivables.
Strong intangible assets. A borrower with powerful brand names or compelling patents is
also attractive.
Low indebtedness. To support acquisition debt, the target LBO needs to have low leverage in
the first place. Perhaps a 20 percent debt to enterprise value.
In reviewing potential buyout candidates, PE firms balance these lender preferences against likely
purchase prices. They perform basic calculations to determine a would-be acquisition’s appeal to
lenders.
168
169
Case Study: Crane Co.
Consider a buyout of Crane Co., a diversified manufacturer of industrial products. At December
2012, Crane had a consistent record of profitability, participated in a low-tech business, and had no
debt. Table 16.3 sets forth selected information.
Table 16.3 Crane Co., Inc.: Selected Financial Information (in millions, except per share data)
Year Ended December 31
2010
2011
2012
Revenue
$2,179
$2,500
$2,579
EBITDA
298
370
385
EBITDA minus capexb
269
336
356
Income Statement Dataa
At December 31, 2012
Balance Sheet Data
Current assets, excluding cash $ 180
Total assets
2,880
Current liabilities
512
Net debtc
—
Shareholders’ equity
918
a Excludes one-time items.
b Capex equals capital expenses.
c Excludes asbestos liabilities, generally billed as operating expenses. Net of cash.
How Much Can the Buyout Fund Pay?
Crane is a good LBO candidate, but how much can a buyout fund pay? The lenders provide most of
the money and their thoughts on debt incurrence provide a good indication. In reviewing LBO
candidates, lenders use a few benchmark ratios to gauge suitability, including: total debt/EBITDA,
annual debt service/EBITDA, and (EBITDA – Capital Investments)/Interest. The size of the ratio
changes with the capital markets but in early 2013 the benchmarks approximated 6.0×, 2.0×, and
1.6×, respectively. In this analysis, I base an LBO price on the latter ratio.
For 2012, Crane’s EBITDA (minus capital investments) was $356 million, and its three-year average
was $320 million. The required 1.6× interest average indicates that a Crane LBO can support $200
million of annual interest costs (i.e., $320 million ÷ 1.6 = $200 million). Figuring a 7 percent
interest rate (4 percent over the 10-year U.S. Treasury bond), Crane can shoulder about $2.9 billion
of debt (i.e., $200 million ÷ 0.07 = $2,857 million). Applying a debt to equity ratio of 75/25 to the
transaction means the buyout fund can assign Crane an enterprise value of $3.8 billion. See Table
16.4. That amount is roughly 10× trailing 12 months’ EBITDA.
Table 16.4 Crane Co., Inc.: LBO Enterprise Value
Millions Percent
LBO debt
$2,857
75%
Equity
953
25
LBO enterprise value $3,810
100%
Crane’s total debt in early 2013 totaled $400 million, or less than 10 percent of its enterprise value.
This existing debt must either be assumed or repaid by the LBO, so it is subtracted from the EV as
cash is added back. The net amount is Crane’s acquisition equity value, which is divided by shares
outstanding to provide a $66 LBO per share price (see Table 16.5). That number is 10 percent higher
170
than the public trading price at the time of this writing.
Table 16.5 Crane Co., Inc.: Per Share Value (in millions, except per share data)
Enterprise value
$3,810
Less: Existing debt
(400)
Add: Cash on hand
424
Acquisition equity value
Divided by outstanding
LBO per share value
sharesa
3,834
÷ 58
$66.10
a Before stock options exercise.
Over the years, LBOs have represented between 10 and 30 percent of M&A transactions, so
knowledge of the PE funds’ approach is helpful in M&A negotiations.
171
Summary
Comparable acquisitions and leveraged buyouts provide two additional sources of information for
determining the fair value of an acquisition candidate. Of the four principal valuation approaches—
discounted cash flow, comparable public companies, comparable acquisitions, and LBO’s—the
acquisitions methodology tends to dominate the other three in deliberations.
Nevertheless, industries go in and out of fashion in the M&A business, and recessions dry up lending
sources. Recognizing the vagaries of the financial markets, the acquirer investigates whether the
future of an industry justifies its M&A pricing.
172
Note
1. Interview with Brooke Coburn, Carlyle Group, September 14, 2013.
173
CHAPTER 17
Valuation Situations That Don’t Fit the Standard Models
In an ideal situation, the M&A target is a U.S. company with a history of improving sales and
earnings. Most acquisition candidates don’t fit this model. This chapter provides pointers on
evaluations that don’t meet the classroom example.
The ideal acquisition for most buyers is a U.S. company with a history of improving sales and
earnings. We saw several examples in Chapters 13 and 16. For many buyers, the perfect candidate is
either too expensive or not available in the desired industry. The wealth of potential deals that fall
out of the textbook, cookie cutter mold require adjustment to the conventional approach. We start
the review of these special cases with the conglomerate.
174
Sum-of-the-Parts
One of the problems with business valuation is the diversity of large corporations. Many are engaged
in disparate product lines, which means the evaluation of one company turns into the study of a
series of businesses. The painstaking valuation methodologies are thus repeated for each and every
business. As a result, the proper analysis of a conglomerate involves two or three times the effort of
assessing a one-industry operation.
Large corporations use a holding company to segment their businesses for legal, tax, and accounting
purposes. Each business line is encapsulated in a subsidiary, a separate corporation that receives its
permanent capital in the form of equity (and sometimes debt) from the mother company. The
subsidiaries own inventory, receivables, plant, and equipment, while the mother company’s primary
assets are the common shares of these subsidiaries. Its primary liabilities are the debt it issues to
finance its subsidiaries’ operating activities (i.e., the subsidiaries actually make the product and
provide the service that is sold to an outside party). The mother company obtains large sums of
financing at a cheaper cost than its subsidiaries can get on a stand-alone basis, and furthermore, it
retains the financial, legal, tax, accounting, human resources, and IT experts required to administer
services to each operating business. Figure 17.1 presents a diagram showing an organization
structure for a holding company.
Figure 17.1 Holding Company Structure with Three Operating Divisions
The relevant subsidiary (or division, as the case may be) does not have an independent capital
structure. Its few long-term debts are owed to the mother company, which also owns its common
equity. The concept of subsidiary net income does not exist on a stand-alone basis, since income tax
obligations are consolidated at the parent company level.
The business unit, however, reports an operating earnings figure, which is roughly equivalent to the
earnings before interest and taxes (EBIT) of a publicly traded firm. By making judgments on
corporate overhead allotments, income taxes and D&A charges, we arrive at sales, EBITDA, EBIT,
and net income for the divisional operations.
The remainder of the divisional valuation process follows the DCF, comparable public company, and
175
acquisition methods described earlier. Due to the lack of full accounting data, the divisional analysis
relies mostly on EV/EBITDA and EV/Sales multiples. To the divisional enterprise values are then
added (or subtracted) holding company assets and liabilities. The end result is an equity value,
before income tax effects, of a broken-up mother company. See Table 17.1 for a sum-of-the-parts
valuation.
Table 17.1 Illustration of Sum-of-the-Parts Valuation (In millions)
Division Estimated Annual EBITDA Appropriate EV/EBITDA Multiple Divisional EV
A
$50
7×
$350
B
40
8
320
C
60
6
360
Combined Divisional EV
$1,030
Add: Corporate Cash
70
Less: Corporate Debt
(100)
Sum-of-the-parts Equity Value
before Taxes on Break-upa
$1,000
a The income taxes on a corporate break-up depend on the tax basis of the divisions, as well as the manner in which the holding
company disposes of them.
As one real-life example, Southeastern Asset Management provided a sum-of-the-parts valuation for
Dell, prior to the $24 billion leveraged buyout (LBO) of Dell in 2013. See Table 17.2.
Table 17.2 Sum-of-the-Parts Valuation of Dell, Inc., 2013 before Taxes (in billions, except value per
share)
Source: February 8, 2013 letter to Dell’s Board of Directors from Southeastern Asset Management.
Net cash (after corporate debt)
$6.6
Dell Financial Services Division
3.1
Server Division
8.0
Support and Deployment Division
7.0
Personal Computer Division
5.0
Software Division
3.0
Acquisitions since 2008
13.7
Other, net
(3.6)
Equity value before taxes due to break-up $42.8
Value per share
$23.72
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The Cyclical Company
Both mature businesses and growth companies exhibit stable trends that lend confidence to
earnings power estimates. Without a strong argument to the contrary, practitioners continue these
trends in their projections. After all, will people stop drinking Coca-Cola or eating at McDonald’s?
Cyclical companies pose another problem. Since their earnings exaggerate the movement in the
business cycle, boom times are followed by bust times, and this pattern repeats every cycle. Table
17.3 shows truck-maker Paccar results, with its sizable cyclical moves.
Table 17.3 Paccar, Inc.: Cyclical Company EPS, Year Ending December 31
Source: SEC filings.
EPS
2007 2008
2009 2010 2011 2012
$3.29 $2.78
$0.31 $1.25 $2.86 $3.12
Change (%) (19)
(15)
(89)
Recession
303
128
9
Recovery
Given the ups and downs of a cyclical business, there is little point in emphasizing current earnings,
since that performance level is only temporary. If the cycle is peaking, the analyst knows that
earnings declines are just around the corner. Similarly, particularly poor performance may signal a
bottom, and one is justified in anticipating a recovery. Accordingly, the historical analysis considers
the firm’s earnings over the last full business cycle.
Average Performance and the Cyclical Company
Determining the average annual earnings power for the cyclical company complements the standard
analytical strategies. The average is computed over the entire cycle, which includes one or two bad
years and three or four good years. Analysts average EBITDA, EPS, and other performance
measures, which calculations are then applied against a sensible value multiple. See Table 17.4.
Table 17.4 Cyclical Business: Paccar Common Stock Valuation, Using Averages at December 2013
Average EPS over six-year cycle
$ 2.27
Sensible P/E multiple in takeover 20×
Takeover valuation per share
$45.40
Note: The averaging technique is used in conjunction with other valuation approaches.
177
Speculative High-Tech Companies
High-technology companies with little track record of sales, cash flow, and earnings are unusual
acquisitions. The vast majority of buyers want to see concrete results before investing sizeable sums
of hard cash in a business. For those acquirers wishing to roll the dice on a shaky tech deal, here are
a few valuation pointers.
Discounted cash flow: To compensate for risk, “use a high discount rate (25 percent or more)
to determine the worth of future cash flows,” says Sujan Rajbhandary, Vice President of Mercer
Capital, a prominent valuation firm.1
Comparable company multiples: The target and its peer group lack consistent sales and
EBITDA, and the relevant value multiples may be hard to find in the public and M&A databases.
The deal pricing thus relies disproportionately on five-year forecasts, after which time the
EV/EBITDA ratios of mature firms are applied to the target at the end of five years.
Venture capital pricing: Look at recent benchmarks. For example, if venture capitalists pay
either (a) 10× revenue or (b) $20 per discrete user for a social media business, that is a guide for
acquirers in the space.
Infrastructure replication cost: How much would it cost a buyer to replicate the target’s
workforce, technology, and brand, within a short time period? That amount is a possible M&A
value.
Using these techniques provides the buyer with a rational basis from which to give the seller a price
range. If the owners demand a greater valuation without a valid counterargument, you may want to
look elsewhere.
178
Low-Tech, Money-Losing Companies
Many established low-tech businesses are not deeply cyclical, and yet many lose money in any given
year. Nonetheless, in the public markets, their stocks typically have positive values, and in the
private markets, they often trade at substantial prices.
Before discussing a transaction, the acquirer determines which of two profiles match the target. See
Figure 17.2.
1. Turnaround. The underlying business is in trouble. At the operating level, it loses money. It
needs new managers, new product lines, or new funds. An acquirer bets on a reversal of the
downward trend.
2. High leverage. The enterprise is profitable before interest costs, but incurs losses after interest
expense is applied. This situation is unsustainable in the long run. Many LBOs face this problem.
Figure 17.2 Comparing Problem Companies (In millions)
179
Turnaround Considerations
Factors influencing a buyer’s decision on turnaround investing include:
Sales volume is a positive: Despite the operating losses, the marginal performer generates
revenues and has customers, so prospective acquirers think the target is “doing something right.”
Reversal potential: The buyer hopes the seller’s business can be “fixed,” either as a standalone entity or as part of the buyer’s operations. Hence, a money-loser transforms into a profitmaker.
Cheap takeover price: Problem companies sell at lower value multiples than healthy firms. If
healthy M&A targets are changing hands at 1× revenue, a likely price for a break-even business in
the same industry is 0.5× revenue. Should the buyer rehabilitate the troubled business, the
bargain price brings outsized profit.
180
High-Leverage Company Considerations
In certain high leverage cases, the target’s enterprise value (EV) is less than the principal amount of
outstanding debt. To gain control, the acquirer makes an offer directly to debt-holders, at a discount
to face value. A modest payment is sometimes directed to equity holders. Then, the buyer converts
the seller’s debt into equity via a prepackaged bankruptcy or another work-out solution. In Table
17.5, a reasonable takeover offer to the debtors is 60 percent of par value.
Table 17.5 Pricing a High Leverage Takeover (in millions)
Seller’s EBITDA
$30
× Takeover EV/EBITDA multiple
×8
Takeover EV
$240
÷ Outstanding
debtsa
÷ $400
Takeover offer as a percent of debts 60%
a Includes debt for money borrowed. Excludes accounts payable and accruals related to normal operations.
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Natural Resources
Manufacturing and service companies compete on multiple considerations. Price, quality,
reputation, service, brand name, technology, and other differentiating characteristics enable them to
compete and succeed. Natural resource companies, in contrast, participate in commodity markets
where the basic product—oil, timber, or iron ore, for example—is essentially the same. Furthermore,
the success of these firms is dependent on the regular replacement of resource reserves.
In valuing a natural resource acquisition, the practitioner focuses on five factors:
1. The appraisal of the company’s resource reserves represents a major component. In the
oil exploration and production (E&P) business, a reserve value to acquisition price ratio of 70
percent is not uncommon. Oil reserves, for example, are the equivalent of long-term inventories,
waiting to produce revenues.
2. The value of other physical assets is a contributing factor. The extraction, processing, and
distribution of a natural resource requires substantial plant and equipment. Furthermore, like
any other business, the natural resource business has cash on hand, accounts receivable, and
other tangible assets. Most resource companies carry substantial acreage that has yet to be
explored and exploited.
3. Net tangible assets are calculated by subtracting the accounting value of liabilities from the
sum of reserve values and physical assets. The result is also known as net asset value (NAV) in
Wall Street jargon.
4. Management’s ability to replenish the company’s reserves on an economical basis is a
nontangible asset, like goodwill. Management engages in a continual search for new reserves that
can be exploited and sold. Since the acquirer has its own management team, this factor may have
less importance.
5. The buyer’s own funding cost for similar reserves. Is buying reserves more economical than
drilling for them?
This five-factor approach is different from the methods that we used earlier, and the reasoning
behind it stems from the importance of reserves to a natural resource business. See Figure 17.3.
Unlike the brand name of the consumer firm, the reputation of the service provider, or the
technology of the software developer, the principal assets of the natural resource firm—its reserves—
have a finite life that is easy to calculate. Suppose an oil E&P company has one billion barrels of oil
reserves (i.e., oil in the ground) and a production rate of 100 million barrels yearly. Assuming the
reserve base is depleted evenly, the company, absent any replenishment, has a 10-year life (1 billion
barrels ÷ 100 million barrels/year = 10 years). Assigning an exact economic life to industrial assets
is far more complicated and this difference accounts for much of the change in valuation technique.
Figure 17.3 Natural Resources Acquisition—Valuation Methodology
182
Furthermore, since reserves relate to widely traded commodities, their cash value out-of-the-ground
is easy to determine. One need only pick up the Wall Street Journal, or consult a commodity web
site, to see the market price of oil, timber, or iron ore. That price is then extrapolated into the future,
and multiplied by annual production volumes to form a sales projection. Projecting revenues for an
industrial firm is far more problematic.
In-the-ground values are available for the most visible commodities, such as oil and gold.
Transactions in such reserves take place frequently and the prices appear in databases. Of course,
each reserve transaction has unique elements. Thus, the $15 per barrel of in-the-ground oil statistic
used in several 2013 E&P transactions was a value guide, rather than a precise appraisal of a firm’s
reserve base. See Table 17.6 for an NAV analysis of Carrizo Oil & Gas.
Table 17.6 Carrizo Oil & Gas: Net Asset Value Analysis at March 2013 (in millions)
Proven Reserves
121 Million BOE
Estimated sale value-in-the-ground
× $15/BOE
Reserve value
$1,815
Add: Net working capital
(90)
Other property and equipment
11
Less: Long-term debt
(968)
Net asset value before inclusion of Carrizo exploration skills and buyer synergies $768
Note: BOE is Barrel of Oil Equivalent. Source: SEC filings, author’s calculations.
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Emerging Market Acquisitions
Compared to their counterparts in the United States and Western Europe, “emerging market deals
have a higher risk profile in certain respects,” indicates Bob Yang, a Shanghai based investment
banker.2 Such risks include:
Political risk: The local government changes the rules under which the foreign acquirer runs
its local acquisition. In the extreme case, the government expropriates the investment without
adequate compensation, or the business is destroyed by civil war.
Macroeconomic risk: The developing economy is more volatile than the developed market,
with deeper recessions followed by faster growth. The values and earnings of acquisitions follow
the pattern.
Currency risk: Emerging market currencies have a history of rapid and sharp depreciations
relative to U.S. and Western European currencies. A firm bought with U.S. dollars could lose
value, even when its local earnings are rising. By way of example, the Turkish lira lost a third of
its value against the U.S. dollar in late 2013.
Information risk: The information on which the buyer makes its investment decision is less
complete than that of a corresponding deal in a wealthy nation.
To compensate for the added risks, acquirers modify the basic valuation approaches.
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Discounted Cash Flow (DCF)
Forecast
For a developed country acquirer, the DCF valuation of an emerging market acquisition begins with
the free cash flow (FCF) forecast. The preponderance of the target’s FCF is likely to be in the local
currency, so the buyer needs to convert the forecast into its own monies, such as U.S. dollars, Euros,
or Yen. This means projecting a foreign exchange (FX) rate for years ahead, even when these poor
nations lack an FX futures market to assist in making a reliable estimate. The buyer then takes the
target’s U.S. dollar FCF forecast and discounts it to the present. See Table 17.7, which includes a
recession/devaluation in year 4.
Table 17.7 Projecting Local Currency Results into U.S. Dollars: Brazilian Reals (in billions, except
FX rate)
Projected
1
Average FX rate (R$ to US$)
2
3
4
2.50 2.60 2.70 3.20
5
3.30
Target’s FCF in Brazilian reals (R$) 4.0 4.4
4.8 4.3
4.8
Target’s FCF in US$
1.8
1.5
1.6
1.7
1.3
(Recession)(Devaluation)
Discount Rate
Because of its risk profile, the emerging market acquisition carries a higher discount rate than a
developed country’s transaction. A number of data services, such as Economist Intelligence,
Ibbotson, and Duff & Phelps provide country guides on appropriate corporate-equity discount rates,
which can then be adjusted for a transaction’s specific circumstances.
At a minimum, the practitioner looks to the yield spread between the relevant emerging market
government bond (denominated in U.S. dollars) and the U.S. Treasury bond. Thus, if the yield
spread between the Tanzanian sovereign and the U.S. Treasury is 6 percent (which was the case in
November 2013), then a Tanzanian supermarket acquisition should have a forecast internal-rate-ofreturn (IRR) of at least 6 percent more than a similar U.S. deal. In actual transactions, my
experience suggests that buyers want emerging market IRR’s to have premiums larger than the
sovereign spread. Figure 17.4 provides several sovereign yield spreads as of November 2013.
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Figure 17.4 Emerging Markets US$ Sovereign Bond Yield/Spreads Against U.S. Treasury Bond
Typical IRR objectives for a U.S./Western European buyer in an emerging market deals are set forth
in Table 17.8.
Table 17.8 U.S./Western European Buyer IRR Objectives (US$) for Emerging Market Acquisitions
at November 2013
Country
IRR Objective (US$)
Low Risk
Brazil
Malaysia
15% to 20%
Poland
Medium Risk
China
Indonesia
20% to 30%
South Africa
High Risk
Bangladesh
Nigeria
25% to 30%
Venezuela
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187
Comparable Public Companies and Comparable Acquisitions in the
Emerging Markets
The comparable public companies valuation approach is where researchers assess the positive and
negative aspects of a stock against those characteristics of similar securities. The stocks’ valuation
multiples are then compared and contrasted. We discussed this approach in Chapter 15.
In most emerging markets, the practitioner has a small or nonexistent pool of comparable listed
stocks from which to derive EV/EBITDA, P/E, and other ratios. “To expand the base, he is often
forced to evaluate the relative merits of industry peers that are located in different countries,” says
Andrew Gunther, Managing Director at Darby Private Equity.3 Thus, Telmex (Mexico) is compared
to Telebras (Brazil), Telefonica de Argentina (Argentina), and CTC (Chile). There is an obvious
problem here. The macroeconomic environment for each of these enterprises is dramatically
different, since they are based in separate nations. See Table 17.9 for a cement industry table.
Table 17.9 Cement Industry Public Companies at November 2013
Source: Bloomberg and author’s calculations.
Company
Country EV/EBITDA
Ambuja Cements India
Indocement
7.5×
Indonesia 7.8
LaFarge Ciments Morocco 11.0
Siam Cement
Thailand 8.2
Torah Portland
Egypt
4.5
Practitioners should adjust the EV/EBITDA and P/E statistics used in the comparisons to reflect
sovereign concerns, but usually they do not, at least not in quantifiable terms. Country and currency
factors for these businesses are mixed into their valuation ratios, with little discussion of trade-offs.
Should we reduce a Brazilian stock’s multiple by 3.0× relative to the Chilean company, which is
arguably based in a less risky country? No one defines these numbers.
The end result is that emerging market practitioners blend the DCF and relative comparable
companies results in the same manner that we covered in Chapter 13. For emerging markets, a
typical weighting at November 2013 was 40 percent DCF and 60 percent comparables.
For comparable acquisitions in the emerging markets, the practitioner has a small pool of deals to
draw upon. He must cross borders to develop a sample, and needs to accept modest information
from which to make a conclusion. For the buyer, extra investigation is required to make a sensible
valuation estimate.
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Summary
Most acquisitions don’t fit the classroom model of a U.S. business with consistent sales and
earnings. To price such transactions, the practitioner considers adjustments to the standard DCF,
comparable public companies, and comparable acquisition methods. The adjustments mean the
resulting valuation is less “scientific,” or less “exact,” than that of a stable U.S. enterprise. However,
the extra work enables you to provide a seller (or buyer) with a rational basis for pricing.
189
Notes
1. Interview with Sujan Rajbhandary, vice president of Mercer Capital, January 24, 2014.
2. Interview with Bob Yang, adjunct professor at China Europe International Business School
(Shanghai), and former managing director with HSBC Bank, October 14, 2013.
3. Interview with Andrew Gunther, managing director at Darby Private Equity, January 29, 2014.
190
Part Five
Combination, the Sale Process, Structures, and Special Situations
191
CHAPTER 18
Combining the Buyer’s and Seller’s Financial Results for the M&A
Analysis
In this chapter, we examine how the acquirer combines its financial projections with those of the
seller. The acquirer constructs a computer model of the deal and subjects it to a variety of operating
and finance scenarios. The acquirer then considers which valuation and financial arrangement is
acceptable to its constituencies. If the model indicates the M&A results are within the seller’s
expectations, the chances of a transaction are significantly enhanced.
At this point in the process, the potential acquirer has admitted certain facts and completed certain
objectives:
The acquirer acknowledges that M&A has no success guarantee.
The acquirer knows that most M&A deals involve either (1) one competitor buying another or (2)
a company purchasing a firm with a similar product line.
The acquirer has conducted a historical financial analysis of the seller.
The acquirer has completed financial projections of the seller.
The acquirer has calculated a reasonable price for the seller, based on several valuation methods.
The acquirer has considered the possible synergies in a deal.
With this foundation in place, the acquirer is ready to combine its projections with those of the seller
to determine if the transaction works from a financial point of view.
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Combining the Buyer’s and Seller’s Projections
Developing a transaction’s computer financial model involves five steps:
1. Combine stand-alone projections of (a) buyer; and (b) acquisition candidate. See Table 18.1.
2. Include synergies in the combined income statements.
3. Set a price and structure the debt, equity, and other financing needed to pay for the deal.
4. Allow for purchase accounting adjustments.
5. Complete pro forma combined projections and run multiple scenarios.
Table 18.1 Combining Sales Projections before Synergies (In millions)
Projected Year
Sales
1
2
3
Buyer
$1,060 $1,130 $1,200 $1,100 $1,150
Seller
550
600
4
640
610
5
660
Combined Sales before Synergies $1,610 $1,730 $1,840 $1,710 $1,810
Step 1: Doing Stand-Alone Projections for Both Buyer and Seller
Step 2: Include Synergies in the Newly Combined Projections
“The degree of cost cuts and revenue increases depends on what kind of buyer makes the
projection,” says Brett Carmel, managing director of investment bank Seale & Associates.1 A direct
competitor (of the seller) realizes the greatest synergies in most situations. See Table 18.2 for an
illustration of two hypothetical competitors joining forces. The sample cost cuts are 2.5 percent of
the seller’s annual sales and revenue increases are under 1 percent of the combined total.
Table 18.2 Sample Synergies from M&A Combination: Two Competitors Illustration (in millions)
Projected Year
1
Revenue increase
2
3
4
5
$10 $11 $12 $13 $14
Cost to produce extra revenue (9) (10) (11) (12) (13)
Additional EBITDA
1
1
1
1
1
Cost cuts
14
15
16
15
17
Total synergies to EBITDA
$15 $16 $17 $16 $18
Note: Synergies include revenue gains as well as cost cuts.
Step 3: Set a Price and Structure the Debt, Equity, and Other Financing
Using the valuation approaches set forth in Chapters 13 to 16, the buyer establishes an appropriate
price for the target. Then it considers financing options, if it lacks cash for full payment.
In step 3, the buyer’s own historical performance, stock market value, and creditworthiness play an
important role. These factors, along with the proposed integration of the acquisition, are behind the
assumptions incorporated in the projections. A buyer with a strong track record and conservative
balance sheet has an easier time raising debt financing than a technology business with a volatile
history. The latter company is more likely to use its common shares as acquisition currency.
Table 18.3 shows the before and after balance sheets of a hypothetical acquirer. The deal pricing is
$300 million, the seller’s historical equity value is $110 million, and the financing is 50 percent debt
and 50 percent equity. (More detailed examples for public M&A transactions are available in SEC
filings or foreign security regulator filings.) One good illustration is Eaton’s takeover of Cooper
Industries. Consult the pro forma condensed financial information in the September 9, 2012, proxy
193
statement filed with the SEC as well as projected synergies on page 226 of the proxy.2
In Table 18.3, the $300 million acquisition price is $190 million greater than the target’s $110
million historical shareholders’ equity (i.e., 300 - 110 = 190). The $190 million excess of purchase
price over book value is allocated to three accounts: (1) fixed assets, (2) goodwill, and (3) identifiable
intangible assets. Such allocations are typical in M&A accounting. On the liability and equity side of
the balance sheet, the new debt and equity finance is included and the seller’s shareholders’ equity is
eliminated.
Table 18.3 Pro Forma Combined Balance Sheet Example: Buyer Acquiring Seller for $300 million
(in millions)
Buyer Seller Adjustments Combinedg
Cash
$ 0
$ 0
—
$ 0
Other current assets
100
50
—
150
350
Fixed assets
200
100
50a
Goodwill
—
—
70b
70
15
70c
155
$ 370
$ 165
$190
$ 725
$ 30
$ 55
$ —
$ 85
—
150d
270
Identifiable intangible assets 70
Current liabilities
Long-term debt
120
(110)e
Stockholders’ equity
220
110
150f
370
$ 370
$ 165
$190
$ 725
a Fixed asset write-up from $100 million historical cost to $150 million appraised value
bGoodwill allocation of $70 million
cIntangible asset allocation, such as customer lists, brand name, and technology
dAddition of new acquisition debt of $150 million
eCancellation of seller’s old equity
fBuyer sale of $150 million in new equity at $15 per share (10 million shares).
gThe combined presentation ignores tax effects on the balance sheet for the sake of simplification
Step 4: Allow for Purchase Accounting Adjustments
In setting the allocations for fixed assets, goodwill, and identifiable intangible assets, the buyer often
employs an outsider appraiser to assist the independent auditor in establishing these pro forma
accounts. The appraiser and auditor also establish the economic lives of the accounts for
depreciation and amortization purposes. According to U.S. Generally Accepted Accounting
Principles (GAAP), goodwill has an indefinite life (so it isn’t amortized), but the lives of fixed assets
and identifiable intangible assets are well documented. Ten to 25 years for the former and 3 to 10
years for the latter are common numerical ranges.
Step 5: Complete Pro Forma Combined Projections and Run Multiple Scenarios
Table 18.4 is one scenario of the combined accounts of a $300 million deal. Using the immediate
past-year data for buyer and seller, the buyer’s pro forma earnings per share (EPS) rise from $1.00
(no deal) to $1.03 (with the deal). Thus, the transaction is accretive. In the first projected year (Year
1) the comparison is $1.07 EPS (no deal) to $1.15 EPS (with the deal).
Table 18.4 Buyer/Seller Pro Forma Combined Projections
Actual
Projected
Buyer Seller Adjustments Combined Year
1
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Year
2
Sales
Buyer
$1,000 —
—
$1,000
$1,060 $1,130
Seller
500
$500
—
500
550
600
Combined sales
1,500
500
—
1,500
1,140
1,190
Buyer
75
—
—
75
80
85
Seller
—
33
—
33
36
40
Combined EBITDA(Before synergies
and M&A accounting)
75
33
—
108
116
125
Revenue–EBITDA
—
—
1a
1
1
1
Cost cuts
—
—
14b
14
15
16
Old D&A—buyer
(15)
(8)
—
(15)
(16)
(17)
Old D&A—seller
—
—
—
(8)
(8)
(9)
New depreciation
—
—
(2)c
(2)
(2)
(2)
(10)d
(10)
(10)
(10)
EBITDA
Add: Synergies
Less:
New amortization
—
Pro forma combined EBIT
60
25
3
88
96
104
(10)
—
—
(10)
(10)
(11)
(9)
(9)
(9)
Interest
Old debt
New debt
—
—
(9)e
Total interest
(10)
—
(9)
(19)
(19)
(20)
Pre-tax income
50
25
(6)
69
77
84
(28)
(31)
(34)
Income taxes @ 40%
(20)
(10)
(2)f
Net income
$ 30
$ 15
$ (4)
$ 41
$ 46
$ 50
30
—
—
30
30
30
10
10
10
40
Buyer common shares
Preacquisition
New shares
—
—
10g
Total common shares
30
—
10
40
40
Earnings per share
No deal
$ 1.00 $ —
$—
$ 1.00
$ 1.07 $ 1.10
With deal
$ —
$—
$ 1.03
$ 1.15
$—
$ 1.25
aIncreased revenue (net of expenses) provides additional EBITDA of $1 million yearly. See Table 18.2.
bEstimated cost cuts are set forth in Table 18.2.
cThe new depreciation reflects $50 million of fixed asset write-ups with a 25 year life ($50/$25 = $2).
dThe new amortization reflects $70 million of identifiable intangible assets write-ups with an average seven-year life ($70/7 = $10)
eAssume 6% interest rate on $150 million of new debt (6% × $150 = $9)
f New income taxes.
gAssume 10 million of new shares sold at a price of $15 per share (15 P/E × $1.00 initial EPS = $15). Total new equity is $150
million.
The combined projections are incorporated into a computer model, enabling the buyer to run
multiple scenarios using differing assumptions. Eventually, this effect is synthesized into a base
case, from which the buyer considers its bidding and financing prospects. The projections
incorporate income statements, balance sheets, and sources and uses of funds. The buyer uses EPS,
EBITDA, and DCF analysis to make conclusions.
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196
Reality Check
Suppose the proposed transaction has survived the base-case scenario; the buyer’s M&A team has
made a big step in winning the battle for its top executives’ hearts and minds. The next step is to find
out whether the projection finance assumptions conform to the real capital markets. Because
acquisitions that are large in size relative to the buyer affect its financial status, the team needs to
consult informally with market sources. The discussions focus on determining if the deal, as
conceived in the projections, can be funded by the appropriate issuances of debt or equity. “Because
debt is a cheaper form of capital, the temptation is to try and use more debt to increase a deal’s
return,” says Ken Yook, finance professor at Johns Hopkins University.3
In running the numbers for the proposed deal, the buyer made reasonable assumptions about the
availability of $300 million in debt and equity finance. Standard lender credit ratio tests were
applied to the pro forma combined company’s results. The debt-to-equity ratio and interest coverage
ratios were in line with industry standards. At the same time, the projections on combined earnings
per share and EPS growth indicated the deal’s long-range ability to increase shareholder value.
Having completed its homework, the buyer now has to step back and provide this information—
perhaps without revealing the name of the seller—to a trusted commercial bank or investment
banker. These advisers evaluate the likelihood of the buyer receiving new money on the terms
assumed in the projections.
At times, these advisers play a valuable role—cautioning the buyer when the proposed purchase
price is too high, the suggested leverage is dangerous, or the business fit is too complicated for the
investor community to understand. More often than not, the advice from these advisers has to be
approached skeptically. Despite intentions to provide objective counsel, they have a built-in conflict.
Overwhelmingly, their objectives are short-term in nature (i.e., to generate transaction fees), while
the buyer’s goals are long-term in nature (i.e., to enhance shareholder value). Buyers utilize Wall
Street in developing tactics—structuring and negotiating the final deal—followed by marketing the
new finance.
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Financing Sources
M&A transactions attract a broad variety of debt and equity financing sources. In the United States
and Western Europe, the number of public and private options is extensive, and the capital market
offers many alternatives. Lenders and equity investors that support a deal want to review, among
other items, the buyer’s computer model of the combination.
Nowadays, most debt financings in excess of U.S. $100 million need a credit rating in order to be
properly marketed. The credit rating agencies use computer models to gauge a deal’s impact of the
buyer’s ability to service debt.
198
Summary
In assessing whether to make an offer (or not) to a seller, the buyer constructs a financial model of
the combined businesses. The model’s assumptions can be modified to reflect a variety of pricing,
financing and operating scenarios. It is a valuable tool in the decision-making process.
Outside parties such as investment bankers, independent accountants, lenders, private equity
investors and credit rating agencies frequently use the model in evaluating a transaction.
199
Notes
1. Interview with Brett Carmel, managing director of investment bank Seale & Associates, December
29, 2013.
2. The SEC database has illustrations of many pro forma financial combinations in its M&A filings.
3. Interview with Ken Yook, finance professor, Johns Hopkins University, January 17, 2014.
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CHAPTER 19
When Is the Best Time for an Owner to Sell a Business?
So far, this book has examined the buyer’s role in the acquisition process. On the opposite side of
every transaction is the seller. Indeed, most buyers become sellers at one time or another. The next
two chapters concentrate on seller issues. This chapter explores the proper moment for business
owners to sell out. The next chapter reviews the tactics needed to carry out a successful sale.
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Seller Categories
Sellers fall into five categories: (1) a family business, (2) an entrepreneurial enterprise, (3) a private
equity-backed firm, (4) a large corporation implementing a divestiture, and (5) a large corporation
giving up control. These sellers share a basic need for liquidity—either they must access more capital
to support their respective businesses, their private equity fund is terminating, or they choose to
disinvest from their ownership position and reinvest elsewhere. Causes linked to liquidity are many
and varied, but the following themes appear repeatedly.
Retirement
Whether driven by an estate tax issue, a lack of management succession, or a wish to smell the roses,
the impending retirement of a company’s owners is a common time to consider a sale.
The Target’s Capital Needs
If the target business is prosperous and growing rapidly, it may require capital that is unavailable to
the owners at a reasonable cost. An alliance with a bigger, capital-rich concern is appropriate in this
instance. Entrepreneurial firms frequently merge with larger companies for this reason.
The Seller’s Reinvestment Focus
The owner may need cash to invest in another industry. The sale of one business is therefore used to
finance another. This rationale is typical among larger, publicly traded companies that view
themselves as a portfolio of operating assets, rather than as an integrated whole. For example,
Ameren Corp. exited its merchant generation business (through a sale to Dynergy) in 2013 in order
to focus on its rate-regulated electric, natural gas, and transmission operations.1
Strategic Association
In today’s marketplace, sustainable growth for a business is dependent on obtaining access to
proprietary technologies, distribution outlets, and production strengths. For some companies, the
availability of such resources is more important than fresh capital. But the price is often steep: the
loss of control through a sale of the business to a strategic partner that can provide these items.
Private Equity Fund Time Limit
A private equity fund has a 10-year life. As a fund approaches its time limit, its investors expect the
sale of its portfolio companies.
Performance Problem
At times, the sale candidate suffers from operating problems that the present owners either can’t fix,
or don’t want to fix, because of the time and effort involved. For example, “In Africa, distress seems
the most common reason for sale,” says Fred Neur, CEO of Ghana’s Cornerstone Capital.2 A new
owner may be ready to tackle the challenge of turning the target around. In other cases, the
nonperformance issue centers on the candidate’s inability to service its debts, perhaps accentuated
by the use of high leverage. A fresh face is needed to restructure the company’s debts with its
creditor group, which may have grown weary of the previous owner’s failed promises. “We have
reviewed many troubled acquisitions,” remarked Mike DiCenza of GeoGlobal Energy. “The obstacle
is that most are too far gone by the time we see them.”3
Lack of Strategic Fit
From time to time, a large company changes its strategic orientation. As yesterday’s priorities
become today’s divestitures, certain business lines don’t fit into the owner’s new plans.
Alternatively, the stock market gives the parent company little credit for a small division’s
contribution, so its hidden value is unlocked through a sale.
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Opportunism
Industries go in and out of fashion. Opportunistic owners take advantage of peak valuation cycles to
cash out of their in-fashion businesses at a premium price. At the time of this writing, social media is
in and coal mining is out.
203
Timing Considerations
The best time to sell a company is when the owner doesn’t have to sell. This means neither the
company nor the owner is under financial pressure. The sell decision should also reflect the broader
financial environment. Businesses fetch higher prices when economic confidence is high, the stock
market is up, and interest rates are low. This combination of positive indicators occurs every few
years, so owners have to be ready.
If the candidate operates in a cyclical business such as home construction or auto parts, the sale
should be timed for the company’s peak earnings year. Most buyers are unduly optimistic with
respect to the inevitable downside, so the purchase price might be inflated. Similarly, a fashiontimer must act quickly when its industry’s popularity heats up. The market is fickle in anointing an
industry, and then is quick in discarding it. Likewise, mom-and-pops participating in a
consolidating sector should choose their timing with care. The buildup party only lasts so long, and
the small business owner wants to be invited at the same high value multiple as everyone else.
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Making the Decision
After making the sale decision, most sellers have a straightforward objective—achieving the top
price. This being said, entrepreneurs and family business owners sometimes display secondary
concerns. They may want to see the merged business carry on after the sale.
The emotional attachment of an owner to his business makes the sale decision a difficult
undertaking, but once the decision is made, the process should be implemented properly. Done
right, initiating an M&A transaction costs time and money. Reluctant sellers should think twice
before starting down this road.
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Confronting Reality
Before putting a business up for sale, the forward-thinking owner conducts research on valuation.
Knowing the approximate worth of one’s business is advisable before discussing the sale decision
with potential advisers. Think of it as getting an appraisal before placing your home on the real
estate market.
For medium to large-size sellers—particularly unsophisticated owners entering the market for the
first time—I recommend commissioning a business appraisal from an independent valuation firm.
Such an appraisal delivers a ballpark estimate that doesn’t incorporate the intermediary’s upward
bias. Furthermore, the appraisal only costs from $20,000 to $30,000 for most clients, and the
valuation firm completes the task without an involved due diligence effort.
If the research indicates that the company can realize an acceptable price, the time is ripe for
beginning the sale process. Before that discussion begins in the next chapter (Chapter 20), I review
the IPO option, which some owners naively compare to a sale decision.
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Selling the Business versus an Initial Public Offering
Some owners consider an initial public offering (IPO) of a business as one alternative to selling 100
percent control. The IPO’s negatives tend to outweigh its positives. Consider the following.
207
IPO versus Sale
Positives of an IPO
Owners retain control.
For the in industry, the IPO price is sometimes higher than the M&A price.
Negatives of an IPO
Not many companies are successful at IPOs. There are only 600–1,000 IPOs globally per year,
versus 20,000 plus acquisitions.
The IPO window tends to be more fashion-oriented than the M&A business.
The IPO market in the U.S. is limited to issuers with a market capitalization of $250 million or
more. This breakpoint is smaller in other nations, but the high limits keep most sellers out of the
IPO market.
An IPO requires public disclosure of matters the owner may wish to keep private.
The IPO underwriter discourages business owners from selling shares in the IPO for fear that
such sales inhibit the marketing process. The owner may have to wait many months to liquidate
a partial position. In contrast, in an M&A deal, 80 percent to 100 percent of the proceeds are
realized at closing.
After the IPO
After the IPO, the business is obligated to file voluminous reports with government regulators,
including quarterly earnings releases.
More often than not, the attainable IPO price is lower than the M&A value. Why? Because the
latter incorporates a control premium.
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Partial Sale/Leveraged Recapitalization
Between an IPO and a 100 percent sale is a middle ground. Here, the owner sells a partial stake to a
private equity (PE) firm, and the company concurrently borrows money to pay the owner a large
dividend. The end result is termed a leveraged recapitalization. Under this scenario, the post-deal
owner has a smaller equity position in a debt-heavy company, along with a new PE partner.
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Summary
Business owners consider carefully the proper time to enter the M&A market. An appraisal
beforehand provides the likely sale price. An IPO is not a substitute for a takeover.
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Notes
1. Ameren Corp. press release, December 2, 2013.
2. Interview with Fred Neur, CEO of Cap. Accra. Ghana, December 2, 2013.
3. Interview with Mike DiCenza, CFO of GeoGlobal Energy, November 8, 2013.
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CHAPTER 20
The Sale Process from the Seller’s Vantage Point
Chapter 20 outlines the M&A process from the seller’s point of view. Selling a company involves six
distinct steps and typically requires nine months from start to finish. Most sellers retain an
investment banker to guide them through the process.
A prospective seller operates far differently from a would-be buyer. Before making a commitment, a
buyer conducts an exhaustive analysis of the seller’s business from a number of viewpoints—
financial, operations, and legal, among others. At the same time, a buyer looks at the deal’s likely
impact on its future operations and stock market values. In contrast, the seller’s principal concern is
much narrower: price. In most cases, it needn’t worry about its operating results post-closing, and
its analysis of the buyer is limited to whether the buyer has (or can raise) the money required to
purchase its business. Despite the seller’s singular orientation, there are numerous steps between (a)
the seller entering the M&A market and (b) the seller receiving the sale proceeds. Chapter 20
reviews these steps, presents observations on tactics, and suggests ways of avoiding pitfalls.
Key Seller Steps
1. Retaining a financial adviser.
2. Setting the stage.
3. The buyer list.
4. Approach tactics.
5. Coming up with a bid.
6. Final steps.
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Retaining a Financial Adviser
Once the business owner has made the sale decision described in the previous chapter, the search
begins for a competent financial adviser. A financial adviser, such as an investment bank,
commercial bank, or business broker, is critical to the sale process because it occupies the best
position for conducting an orderly auction. Why use an auction? Because the competition fostered
by an auction is the best means for the seller to achieve an optimal price. Only an intermediary can
inject into the process the proper amount of cajoling, tension, and spirited competition that
advances the desired price objective. If the seller itself tries to orchestrate these same dynamics, it
comes off looking desperate and unprofessional, two qualities that don’t go very far in the M&A
business.
Large corporations with extensive Wall Street contacts know well the capabilities of the firms
offering merger advisory services. For these big companies, the selection of an intermediary is a
straightforward action. Either a trusted adviser is rewarded for some ancillary work, such as
recommending the parent company’s shares, or a specific firm is matched to the particular needs of
the transaction. The latter happens frequently with specialized industry deals. The biotech industry
is a prime example. An adviser with technical skills and good industry contacts is almost mandatory
for solid deal execution. On the other end of the corporate spectrum are small companies, which
make the advisory choice in a haphazard fashion. Retaining an intermediary in this way is a mistake.
All business owners should select a financial adviser rationally. Three criteria are critical:
1. Experience. It goes without saying that the advisory firm and the executive handling the deal
should have extensive experience in closing a variety of M&A transactions. With the increasing
globalization of the economy, an adviser with an international background is helpful when the
transaction exceeds $100 million. This size attracts multinational players.
2. Industry Expertise. Although most advisers can muddle their way through any sort of deal
(i.e., learning by doing), they enhance results when they have a track record in closing
transactions in the seller’s industry. The same due diligence questions, valuation issues, and
closing problems arise in related-industry deals, so there’s little point in the intermediary
reinventing the wheel for the seller’s benefit in one transaction. The primary pitfall for the seller
comes with choosing an adviser that is too close to that small group of participants representing
the logical buyers. The adviser may figure its most dependable income is with these repeat
customers, and accordingly, it may not bend over backward to achieve the highest possible price
for a one-time client. A secondary concern for the seller is whether the executives comprising the
adviser’s industry experience still work there. During my employment at Lehman Brothers, the
firm routinely showed retailing clients a marketing presentation with a laundry list of retailing
deals that Lehman had closed, thus demonstrating its expertise. The trouble was, however, that
most of the bankers who had executed the transactions had long since moved to competing
investment banks. Few prospective clients thought to ask this question.
3. Commitment. In most transactions, the optimization of the sale price depends on the
dedicated commitment of the adviser’s senior personnel. Too many intermediaries, feeling the
pressure to generate fees, use the venerable bait-and-switch tactic to attract new clients. A senior
executive wines and dines the owners, but he disappears after his firm receives the assignment
and the real effort commences. The seller’s transaction is then consummated by junior personnel
who are learning by doing. A careful seller demands senior executive commitment of its
transaction. If assurances are made and then not followed, the smart seller cancels the
arrangement.
As a means of ensuring senior-level commitment, a seller should try and match its deal to the
intermediary’s interests and capabilities. Table 20.1 is a good guide. Some sellers are tempted to
select the intermediary promising the highest price. While enthusiasm for a transaction is
important, a banker’s wishful thinking is no substitute for hard experience. Likewise, shopping for
the cheapest adviser ultimately can be counterproductive. If the intermediary’s fee schedule appears
expensive, negotiate an incentive that guarantees a big fee only if the seller receives a high price. As
a final note to the selection process, the careful seller makes a reference check, verifying the wouldbe adviser’s claims regarding experience, industry expertise, and commitment.
Table 20.1 Guidelines on Selecting an Intermediary
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Deal Description
Appropriate Intermediary
Small business, $2–$20 million Regional investment bank or business broker.
value.
Medium-size company, $20–
$200 million value.
Regional investment bank, medium-size money center
investment bank, or large commercial bank.
Large company, $200 million
value and up.
New York, London, or Hong Kong investment bank.
Specialized industries, $50–
$200 million value.
M&A boutiques with industry focus.
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Setting the Stage for the Sale
Retaining an intermediary is only the first step in readying the business for an orderly auction.
Subsequent preparation work costs money and consumes time. In the United States, the retainer fee
of a financial intermediary ranges from $0 for a business broker to $250,000 for a prestigious New
York investment bank. Follow-up costs include accountants, lawyers, and consultants, who usually
charge by the hour. Depending on the amount and complexity of the work involved, prepping a
business for sale requires anywhere from a few weeks to several months.
The investment banker acts as the coordinator of the sale process, including the prep work.
Following the signing of a retainer letter, the bank conducts a two- or three-day field visit,
inspecting facilities, interviewing management, and “getting a feel” for the business. With the result
of this effort and similar information gathering, the adviser commences three premarketing tasks:
(1) “dressing up” the candidate, (2) confirming a value range for the business, and (3) writing the
information memorandum (including financial projections), which is later provided to would-be
buyers.
Dressing Up the Sales Candidate
Big corporations that pay premium prices prefer clean businesses with readily understandable
products, demonstrable operating histories, and minimal extraneous issues. To have its client fit this
criteria, the banker may recommend that the candidate take remedial action. For example, if the
target’s earnings are derived 80 percent from life insurance operations and 20 percent from theme
restaurants, the banker may suggest spinning off the restaurant business. Why complicate
discussions with large insurance buyers by diverting them with the tangential restaurant operation?
If the client’s financial statements are unaudited, the banker may suggest an independent audit to
verify the historical income statement and balance sheet results. Many a deal has been derailed
when the seller’s results failed the buyer’s audit. If the seller has a problem that appears open-ended
to the casual observer, such as an environmental cleanup or a continuing lawsuit, the banker may
recommend solving the problem in advance. Why force potential buyers to spend time on
extraneous matters, when they need to hone in on the target’s core business?
Confirming a Valuation Range
The investment banker’s investigation permits a refinement of its initial valuation. The banker also
gains a further opportunity to polish its sales pitch explaining why the property is worth 10×
EBITDA, 3× book value, and so forth.
Writing the Information Memorandum
Public companies issue annual reports and financing prospectuses that provide detailed business
and financial summaries. Private businesses don’t publish these documents. In the sale of a
privately owned company, the information memorandum describing the business is the buyer’s first
introduction to the company. The memorandum is written with care, outlining the basic facts while
emphasizing the target’s positive attributes. Any financial projections should err on the side of
optimism, without succumbing to exaggerated claims of future performance.
From the lengthy information memorandum, the adviser writes a one-page executive summary,
commonly called a teaser. This document excludes the seller’s name and preserves anonymity in the
early going.
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The Buyer’s List
Assuming the information memorandum is near completion, the seller and its financial adviser
agree on a list of buyers to contact. The length and composition of this list is dependent on several
factors. In my experience, it breaks down into 100 to 200 contacts. Table 20.2 illustrates a buyer list
for a U.S. pillow manufacturer.
Table 20.2 Sample Prospective Buyer List for a U.S. Pillow Manufacturer
Buyer
Description
Categories
Competitor Other U.S. pillow manufacturers.
Like
businesses
Foreign pillow manufacturers.
Similar
Producers of related soft lines, such as blankets, sheets, curtains, and towels.
product line
Strategic
buyers
Producers of related hard lines, such as furniture and home accessories.
Conglomerates interested in diversifying into home furnishings.
Private
equity
Firms that consider almost any profitable manufacturer.
Each contact has to have the financial wherewithal to acquire the target. Providing that this
requirement is met, the seller and its adviser winnow out companies that are unsuitable to the
owner. At times, these rejects are direct competitors that the owner believes are not real buyers, but
the end result depends on the seller’s individual situation. Some companies, such as high-tech firms,
don’t appeal to LBO investors, so there’s no point in contacting the LBO community. Others offer a
unique product or service that doesn’t have direct competition, so the search focuses on related
firms.
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Approach Tactics
After the adviser draws up the list, it considers the multiple ways to approach the market, ranging
from calling a handful of likely buyers to contacting every name on the list. The tactics have
nicknames and are summarized in Table 20.3.
Table 20.3 Primary Marketing Tactics
Description
Comments
Rifle ShotThe banker contacts three to five likely
acquirers, which have independently contacted the
target earlier.
Sellers find it difficult to obtain top
dollar via the rifle shot route. There isn’t
enough competition.
Shotgun ApproachThe banker contacts 100–200 names, This approach is difficult to administer
encompassing many businesses that may have a remote smoothly. It is most appropriate for
interest in the client.
sizable targets (+$50 million) with solid
operating histories because they have
wide appeal. It is almost mandatory for
publicly traded companies.
Full-Blown AuctionThis is a derivative of the Shotgun
Approach. The added twist is that potential buyers meet
a strict deadline for responding with an offer, including
their comments on the prepackaged legal
documentation.
This technique instills speed and tension
into the process, but many large
corporations refuse to participate in fullblown auctions.
Modified AuctionThe financial adviser groups would-be
buyers according to their perceived level of interest (e.g.,
High, Medium, and Low). Each group contains 40–50
names. Beginning with the High category, the banker
contacts each group sequentially, stopping when three or
four real bidders surface.
The modified auction is appropriate for
most transactions. It doesn’t turn off
buyers, and it keeps the process
manageable by limiting the number of
interested parties at any one time.
With the sales tactic established and the prospect list set, the seller’s agent contacts a senior
executive at each of the would-be buyers. Following a brief description of the seller, the intermediary
asks if the executive has an interest in pursuing the matter. If the answer is yes, he receives an
information memorandum, along with a confidentiality letter requiring an authorized signatory.
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Confidentiality, Operational, and Personnel Issues
If the seller is a publicly traded company, the start of an auction is often a reportable event under
SEC regulations, and employees, suppliers, and customers learn right away of the company’s
intentions. If the seller is privately owned, or a small division of a publicly held business, it doesn’t
publicize the sale process. Private company owners maintain secrecy as long as practicable,
disguising due diligence visits as supplier calls, for example. Managers cope with the worries of
employees and assure customers to adopt a wait and see attitude regarding the possibility of new
owners. If a few months pass without a transaction, the uncertainty affects operations, so
investment bankers advise sellers to complete the process as soon as practicable.
Maintaining confidentiality with direct competitors is important. Competitors may know a lot of the
material in the seller’s offering memorandum, but they present obvious problems in the due
diligence investigation. Some bankers suggest a signed letter of intent before their clients open their
books to a competitor.
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Due Diligence Visits
The intermediary coordinates the buyers’ visits to the seller and manages the buyers’ data requests.
Faced with a buyer visit, a smart seller begins the on-site meeting with a formal presentation that
complements the information memorandum. For each buyer, the seller then arranges meetings with
senior executives in key functional areas such as finance, marketing, and operations. To assist the
buyer’s analysis, the seller’s data are readily available in a recognizable form. Under the full-blown
auction format, this information occupies a separate room and a separate cloud-based data file.
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Coming Up with a Bid
In a modified auction, sending out information memoranda, conducting due diligence trips, and
fulfilling information requests requires two to three months. Alternative tactics have different
durations, with the full-blown auction covering the shortest period, perhaps as short as 45–60 days.
In the face of a hostile takeover offer of a publicly traded company, the intermediary insists on
answers in 30 days or less.
The adviser’s primary challenge during this time is obtaining a bankable bid that is close to the
anticipated valuation. Note the adjective “bankable” before the word “bid.” Offers from prospective
acquirers that can’t raise the purchase money aren’t worth much. In a typical sequence of 100
contacts, 80 decline to review the information memorandum. Of the 20 that read the materials, 10
will be turndowns for a variety of reasons. That leaves 10 that visit the seller. See Table 20.4. Of
these 10, five lose interest after the visit, or the seller backs away. The remaining five result in two
solid offers near the valuation estimate. Once the banker has the first bankable bid in hand, he is
free to pressure the remaining would-be acquirers to accelerate their respective evaluations.
Recognizing the likelihood of its offer being shopped, the initial bidder sets a time limit for
acceptance (e.g., five days) so as to upset the seller’s shopping plans. Understandably, the adviser
stalls negotiations on the first proposal to permit time for recruiting competing offers. In an ideal
situation, two or three bidders function on parallel tracks, and the banker pits one against another,
thus achieving a good price. See Table 20.5 for a schedule.
Table 20.4 The Winnowing of Buyer Contacts
Number of
Contacts
Comments
100
Original contacts by investment banker to gauge interest in an acquisition.
20
Number of contacts signing a confidentiality agreement in order to receive
detailed information on seller.
10
Possible buyers that visit the seller’s management team.
5
Number of possible buyers that consider making an offer.
2
Actual written offers near the seller’s desired valuation.
Table 20.5 Illustrative Time Table of a Business Sale Process
Month Action
0
Decision to sell
1
Review valuation of the business in a sale
2
Retain investment bank
3
Work with investment bank to prepare information memorandum and buyer contact list
4
Investment bank contacts possible buyers
5
Exchange information with buyers; schedule management visits
6
Narrow buyer list to handful of interested parties
7
Receive offers and finalize an offer. Buyer proceeds to due diligence, financing and
documentation phase
8
Closing
In the common situation where the bid(s) come in lower than expected, the seller can choose to (1)
expand the contact list to find a higher bidder, (2) try and negotiate the existing bids higher, or (3)
withdraw the business from the market. Most choose alternative 1. This is a wise course of action if
the contact group has 100 calls or less. If the seller has no luck after 100+ calls, it needs to lower its
price goal or withdraw the deal. Alternative 2 works well when the bids are only 10 to 20 percent
below the valuation target, since bidders leave 10 to 15 percent of room in their offers. The
intermediary’s experience is helpful in making these decisions correctly.
At times, a buyer asks the seller to take the buyer’s securities in lieu of cash, and I have received
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these requests from both publicly traded and non-listed acquirers. The value of such securities is
intertwined with the buyer’s future results and the stock market’s fluctuations. Complicating the
decision is the buyer’s request that the securities be held for a minimum period, such as one to two
years. This restriction limits the downward pressure on the buyer’s stock, but it places market risk
on the seller. Because few corporate shareholdings can be perfectly hedged against price declines,
the seller balances the risk and rewards of owning the buyer’s securities for an extended period.
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Final Due Diligence and Legal Documentation
After the offer is accepted, the negotiating leverage in a transaction shifts from seller to buyer. This
change usually results in the buyer gaining small reductions in the purchase price as its due
diligence process unfolds. Most sellers exhaust the positive attributes of their businesses during the
solicitation phase, so the buyer is left ferreting out whatever negatives arise from its investigations.
Price reductions of 5 to 10 percent are not unusual. See Table 20.5 for an illustrative time table.
During the documentation drafting, the buyer tries to limit its exposure to possible problems that
aren’t discovered or anticipated through the due diligence process. The problem may never crop up,
but the buyer likes to be protected if, and when, it arises. Unless the target itself is a publicly traded
company, the owners of the seller usually provide some comfort to the buyer through an escrow
account or a warranty. These provisions give the buyer a strong legal recourse against the owners in
certain instances. Such negotiations focus on arcane points of law, and a rational seller acts in
partnership with its practitioner team—financial adviser, counsel, and accountant—before reaching
an agreement.
Finally, to further protect its interests going forward, the buyer may demand that the owners
promise not to participate in the seller’s industry for a fixed period, usually two to three years. Large
corporations divesting a division don’t mind entering into noncompete arrangements.
Entrepreneurs and family business owners reluctantly sign these provisions.
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Summary
A seller’s main concern is maximizing price. The objective is best achieved through an auction
conducted by an intermediary. Generally, the number of prospective buyers contacted by the
intermediary will exceed 100, and the number of eventual offers will be a small fraction of this
amount.
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CHAPTER 21
A Review of Legal and Tax Structures Commonly Used in Transactions
The tax and legal structure of a transaction can significantly affect its value to either the buyer or
seller. The structuring decision depends on tax considerations, liability concerns, and the
assignability of licenses and contracts. A common maxim is “a buyer prefers a sale of assets, and a
seller prefers a sale of stock.”
Many participants in the M&A industry lack knowledge of transactional legal and tax structures. As
a result, they fail to appreciate the economic impact of a deal’s design on buyer and seller. This
chapter reviews the fundamentals and provides you with the tools to talk sensibly with the legal and
tax experts. Please note that this chapter is an overview. There are hundreds of exceptions and
loopholes to the guidelines herein, enough to keep thousands of lawyers, accountants and lobbyists
busy year round.
The structuring decision depends on:
Tax considerations
Liability concerns
The assignability of the seller’s licenses and contracts
A general rule is the following:
The buyer prefers a sale of seller assets. Why?
The buyer can increase the tax basis of the seller’s assets, thus increasing future tax
depreciation.
Through an asset sale, the buyer minimizes its responsibility for hidden seller liabilities.
The seller prefers a sale of its common stock. Why?
The seller pays one level of income tax, as opposed to two or more in an asset deal.
A common stock sale transfers the seller’s hidden (or unknown) liabilities to the buyer.
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Acquisition Legal Structures
To begin, assume the respective buyer and seller are C corporations rather than flow-through legal
entities, like partnerships, limited liability corporations (LLC), real estate investment trusts (REIT),
or Sub Chapter S corporations. For the buyer, note that the same book accounting results (i.e.,
Generally Accepted Accounting Principles, or GAAP, results) could produce different tax
consequences, depending on the deal’s setup. Similarly, the largest sales price does not necessarily
bring the seller the most cash proceeds, net of taxes.
Three legal structures dominate the M&A business:
1. Merger
2. Stock purchase
3. Asset purchase
Each method has advantages and disadvantages.
Merger
A true merger ends up with two corporations becoming one. The selling stockholders receive buyer
securities, cash or other consideration. See Figure 21.1.
Figure 21.1 Statutory Merger
Note: Seller stockholders receive stock, bonds, cash, or other consideration from buyer.
Stock Purchase
In a stock purchase, the buyer acquires the common stock of the seller, but the buyer leaves the
seller corporation intact (as a buyer subsidiary). The acquisition payment to the seller’s owners
could be buyer securities, cash, or other consideration. See Figure 21.2.
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Figure 21.2 Stock Purchase
Asset Purchase
In an asset purchase, the buyer acquires certain assets (of the seller) and assumes certain liabilities.
The specific assets and liabilities are spelled out in the legal agreements. If a hidden liability
becomes known after the deal (like a lawsuit or tax problem), the leftover seller corporation is
responsible. See Figure 21.3.
Figure 21.3 Asset Purchase
Note: The seller corporation remains separate from the buyer in an asset deal.
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227
Legal Considerations
Statutory Merger
A statutory merger has a number of key advantages and disadvantages, as summarized below.
Advantages to the Buyer
A statutory merger brings simplicity in transferring the seller’s property titles, regulatory
licenses, equipment leases, and so on. For example, if one television broadcaster acquires
another, the last thing the buyer wants to do is reapply to the government for the seller’s TV
licenses.
Disadvantages to the Buyer
A merger means the buyer assumes the seller’s liabilities, including unknown liabilities that carry
over. The buyer’s due diligence sometimes fails to uncover such prospective problems.
The buyer cannot increase (or step up) the tax basis of the seller’s assets (assuming the purchase
price is larger than the tax basis) without the buyer facing extra income taxes. Some of these
payments are referred to as a recapture tax, whereby the government reclaims an income tax
deduction for an asset that is sold in excess of its depreciated value.
The merger requires two meetings so the respective stockholders can vote on the deal. Setting up
such meetings can be time consuming.
Stock Purchase
Attributes of the stock purchase are set forth below.
Advantages to the Buyer
Ease of transaction: The deal is a simple purchase of shares from the seller’s stockholders. No
vote needed, although the buyer usually requires 90 percent plus participation in the United
States before closing a transaction.
Speed: A stock purchase can be closed more quickly than a merger.
Since the seller corporation remains intact, there are few assignability problems on title transfers
and regulatory licenses.
With the newly acquired seller becoming a subsidiary of the buyer, the buyer is not directly
obligated for the seller’s hidden liabilities. A future lawsuit, for example, may diminish the
subsidiary’s worth, but the plaintiffs will have a hard time piercing the corporate veil and
attacking the parent company.
Disadvantages to the Buyer
The buyer still owns the seller’s hidden liabilities, albeit indirectly.
The buyer cannot step-up the tax basis of the seller’s assets, unless the buyer pays the recapture
tax.
Asset Purchase
As noted, the buyer tends to prefer an asset sale, but such deals have complications, particularly the
larger transactions with thousands of assets (and liabilities) to catalog.
Advantages to the Buyer
The buyer allocates the excess of purchase price (over the existing seller’s tax basis) to the seller’s
assets for tax purposes. The buyer gets the benefit of extra tax depreciation expense. Note that
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the excess of purchase price over accounting value is already allocated for financial reporting, or
GAAP, purposes.
The seller pays the recapture taxes on the step-up in basis. The seller is also liable for regular
income taxes, if any, on an asset sale.
Disadvantages to Buyer
Asset deals are more complex than mergers or stock purchases. The buyer’s assets must be listed
and appraised, and this effort is near-impossible with deals over $100 million in value.
The buyer may have difficulty obtaining consents for the transfer of the seller’s titles and
regulatory licenses.
Some courts may consider a substantial asset deal to be a de facto merger, thus increasing the
buyer’s exposure to hidden seller liabilities.
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Triangular Merger
To (a) retain the benefits of a statutory merger and (b) avoid the direct assumption of seller
liabilities, many acquirers use a legal format that is called a triangular merger. The transaction
occurs in five steps as follows (see Figure 21.4):
1. The buyer forms a transitory subsidiary (Sub) in which it places the merger consideration.
2. The seller’s shareholders approve the merger with Sub.
3. Sub merges into the seller, which continues in existence.
4. The seller’s previously outstanding shares are cancelled and the consideration is distributed to
seller’s shareholders upon surrender of their stock certificates.
5. The seller becomes a wholly owned subsidiary of the buyer. The seller’s titles, licenses, and leases
are transferred without the need for consents.
Figure 21.4 Triangular Merger
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Simplified Tax Structures
Buyer Considerations
As the previous section noted, in a statutory merger or stock purchase, the buyer cannot write-up
the seller’s assets for tax purposes. However, it must show the asset write-ups (i.e., allocations for
the excess of purchase price over historical accounting value) for GAAP reporting. In contrast, says
Brian McQuade, managing partner of accounting firm, McQuade Brennan, “with an asset purchase,
the buyer writes up seller assets for both book and tax purposes.”1 The buyer’s higher tax basis (on
the seller’s assets) provides greater depreciation charges against the buyer’s future taxable income.
(Note that the seller is left with the recapture tax.)
A buyer can estimate the present value of higher tax depreciation charges and, thus, the relative
worth of an asset deal (versus a stock deal), absent other factors. For example, if the buyer realizes
an additional $20 million of tax deductions per year (for five years) from an asset purchase (versus a
stock deal), the annual cash savings is $8 million, assuming a 40 percent income tax rate and a
profitable buyer. If the buyer’s weighted average cost of capital (WACC) is 10 percent, the tax
savings have a $30 million net present value (NPV). The NPV calculations appear in Table 21.1.
Theoretically, a buyer can pay more for a seller in an asset purchase.
Table 21.1 Net Present Value of Tax Depreciation Deduction, Asset Deal versus Stock Deal (In
millions)
Year
1
Extra tax depreciation $20
2
3
4
5
$20
$20
$20
$20
Tax rate
× 40% × 40% × 40% × 40% × 40%
Cash savings
$8
$8
$8
$8
$8
WACC = 10%
NPV = $30 million
Seller’s Considerations
The seller usually prefers a stock or a merger transaction, since the seller pays just one level of tax.
In Figure 21.5, an individual examines selling his company for $100 million in either an (a) asset
sale or (b) a stock sale. The stock sale provides much higher net proceeds. Given that the buyer and
seller derive different monetary benefits from different tax and legal structures, there is room for
negotiation.
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Figure 21.5 Asset versus Stock Sale: Seller’s Point of View (in millions)
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Legal Documents
Legal documents that participants encounter in the M&A process include:
Investment banking engagement letter
Confidentiality agreement (CA)/nondisclosure agreement (NDA)
Letter of intent (LOI)
Definitive agreement
Investment Banking Engagement Letter
Most sellers retain an investment bank to assist the seller through the sale process, but only a
minority of buyers use representation. The engagement letter approximates five to six pages in
length. Key provisions are:
Fees
The letter calls for several fees to be paid by the client.
Retainer fee: A modest upfront payment to cover part of the investment bank’s overhead.
Success fee: A large amount due to the bank upon a closing. The amount tends to be 3 percent for
small transactions, and scaling down to 1 percent (or less) for large deals.
Finance fees: When the investment bank represents a buyer, the letter may include acquisition
finance.
Provision
Even if the deal doesn’t close immediately, the payment of fees related to a transaction extend for 12
to 18 months after the engagement’s termination. In that way, the bank is compensated for its set-up
work, should a deal take place a short time after termination.
Exclusivity
The letter indicates that the client can’t work on the M&A project with other banks while the
engagement is in force.
Confidentiality Agreement (CA)
Often called a nondisclosure agreement (NDA), the CA is sent to prospective buyers. By signing the
CA, buyers pledge to keep seller information (obtained through the M&A process) confidential and
to use the information solely for deal evaluation.
Letter of Intent (LOI)
The LOI is a written summary of the principal terms. It represents the “engagement proposal”
before the “merger marriage,” and typically encompasses 5 to 15 pages. Principal terms include:
Price
Form of payment
Legal and tax structure
Escrow amount (a cash reserve to cover possible hidden liabilities, among other items)
Employment agreements for seller managers
Noncompete agreements for seller managers
No shop provision, whereby the seller cannot talk to other buyers for 60 to 90 days
The signing of the LOI commits the buyer to expend significant resources toward a deal closing.
233
However, it is not a guarantee of success, and the drop-off rate tends to be in the 20 to 30 percent
range.
Definitive Agreements
These are lengthy legal documents that set out all the terms and conditions of a transaction. Perhaps
75 percent of the words in such documents are legal boilerplate, repeated in similar deals. The seller
(and buyer) attest to many representations and warranties, and the agreement’s final terms reflect
the buyer’s increased knowledge of the seller, following its due diligence investigation.
Before the definitive agreements are complete, many hoped-for deals fall apart. Frequent
contributors to this situation are:
The buyer’s due diligence of the seller uncovers major problems.
Material adverse change: The seller’s business experiences a sudden reversal.
The buyer is unable to find financing.
The government raises anticompetition complaints.
The seller shareholders reject the deal.
234
Summary
A transaction’s legal and tax structure has a significant economic impact on either buyer or seller.
Three legal structures dominate the M&A business—merger, stock purchase, and asset deal—and
each has different tax and liability considerations. Many transactions are effected through a
multistep procedure called a triangular merger.
235
Note
1. Interview with Brian McQuade, managing partner of McQuade Brennan, accounting and tax firm,
January 15, 2014.
236
CHAPTER 22
Unusual Transaction Categories
In my M&A travels, businesspeople invariably ask, after a more general discussion, about a few
specific transactions: tax-free deal, de-merger, reverse merger, special-purpose acquisition
corporation (SPAC), and hostile takeover. These transactions are in the minority but they get a
disproportionate amount of publicity. This chapter reviews these deals.
We begin our review of these five transactions with the tax-free deal.
237
Tax-Free Deal
A tax-free deal does not eliminate income taxes (or capital gain taxes) for the seller; it simply pushes
such taxes into the future. A seller’s owners (in the United States) can avoid paying capital gains tax
on buyer common stock as consideration, usually as long as the voting stock represents 50 percent
or more of total consideration. The seller pays the tax when it eventually liquidates the buyer’s stock
in a taxable transaction.
In large public company mergers, the buyer often offers the seller’s shareholders the option of
accepting either cash or buyer stock as consideration. The $22 billion Sprint/Softbank merger
(2013) had such a feature. This tactic enables the seller’s shareholders taking Softbank stock to defer
taxes.
A seller who accepts buyer stock may find his investment portfolio to be concentrated in one
security. No problem. Wall Street has tactics that diversify the portfolio without triggering a tax.
238
DEMERGER
Many publicly traded companies become larger through mergers. A “de-merger” is the opposite
action, whereby a “company becomes smaller by separating itself from one of its principal
component operations,” says Ted Barnhill, finance professor at George Washington University.1 The
newly separated business has its own publicly traded stock, board of directors, management team
and legal structure. Synonyms for a demerger are spin-off and split-off. After a split-off,
shareholders of the original business have two separate stockholdings and, thus, they are free to
buy, hold, or sell one, or both stocks. Hopefully, the value of the two new shares exceeds the value of
the one old share. Motorola split into two sizeable companies, Motorola Mobility and Motorola
Solutions in 2011, and it achieved that goal.
A question that frequently arises in connection with split-offs is “Why doesn’t the parent company
just sell the split-off business for cash?” The answer is often found in the tax code. A cash sale can
produce a sizeable tax bill. If the split-off business has a low tax basis, the income taxes (on a cash
sale) can be high. The parent company’s shareholders receive more value by holding two sets of
shares, rather than just one share of parent company stock (the parent stock includes the priceincrease effect of a cash divestiture).
To gain some cash benefit from a spin-off, the parent company occasionally directs its subsidiary to
borrow money in order to pay a nontaxable dividend to the parent. The dividend is paid before the
demerger. In 2012, for example, Engility, Inc. borrowed $335 million to pay a cash dividend to its
parent, L-3 Corporation.
239
Reverse Merger
In a conventional initial public offering (IPO) of common stock, the issuer completes a lengthy
disclosure document (i.e., a prospectus) that is filed with government authorities. Then, investment
banks assist the issuer in marketing the stock to investors. The marketing is done in conjunction
with a road show, whereby the issuer’s management team provides presentations in major cities in
the United States and abroad. To attract investor interest, the IPO candidate needs a sizeable market
value ($250 million or more), a consistent track record, a moderate leverage ratio, and growth
potential. These necessary attributes deter the vast majority of enterprises from the conventional
IPO process. For a firm that believes a publicly traded stock furthers its corporate goals, an alternate
means of public listing is the reverse merger.
What is a reverse merger? A private business acquires a shell company, which is a listed firm that
has minimal, or no, business operations. The transaction is effected through a share-for-share
exchange. Because the acquirer is a real business, with revenue, operations, and employees, its
owners end up with the bulk of the publicly traded stock after the closing. The government
authorities require disclosure on such mergers, but there is no marketing campaign involving
investment bankers. Consider the case where (a) a buyer with a $20 million market value reverse
merges with (b) a public shell company that has a $100,000 market value (i.e., 1 million shares
outstanding trading at $0.10 per share = $100,000). The shell company issues 19 million new
shares to the buyer’s owners, leaving them with a 95 percent equity interest (19 million ÷ 20 million
= 95 percent) in the listed company. If investors price the postmerger stock properly, it should trade
at $1.005 per share, assuming no transaction expenses or illiquidity discounts (i.e., $20,100,000
value ÷ 20 million shares = $1.005 per share). See Table 22.1.
Table 22.1 Reverse Merger Illustration
As Table 22.1 points out, the buyer’s owners retain $19 million in value after the deal, versus $20
million before. The “lost” $1 million goes to the shell’s stockholders to compensate them for
facilitating the transaction. Postmerger, most reconfigured companies show little liquidity in the
stock. The lack of an IPO marketing campaign, and the presence of concentrated ownership, limits
public trading. To counter these problems, the companies mount public relations campaigns to
drum up investor interest.
Reverse mergers have a shadowy reputation, with repeated scandals involving many participants. In
recent years, hundreds of China-based companies conducted deals on North American exchanges,
and much of the disclosures were found to be incorrect. The Toronto-listed shares of Sino-Forest, a
240
Chinese timber company, collapsed in 2011 amid claims of fraud, and North American investors lost
over $2 billion.
241
Special Purpose Acquisition Corporation (SPAC)
A special purpose acquisition company (SPAC) is a shell company that undertakes an IPO with one
thought in mind—to use the proceeds to acquire quickly several businesses in a fashionable
industry. The principal promoters of SPAC’s are investment banks that stand to collect IPO fees and
M&A fees from the venture. Typically, a bank (or banks) assembles a few executives with prior
operating, M&A, or private equity experience in the target industry. Once the IPO closes, these
individuals have a predetermined time-line (usually two years) to spend the money on deals and to
lay the foundation of viable enterprise. They also receive a percentage of the SPAC equity.
In the United States, a SPAC might raise $100 million. After the deduction of investment banking
fees and start-up expenses, it has $90 million to invest, which, if leveraged 100 percent, results in a
$180 million acquisition budget. If no deals are closed, the money is returned to investors. SPACs
are popular in rising stock markets, and their use extends past the United States into other
economies.
242
Hostile Takeover
In a hostile takeover, a buyer purchases control of a publicly traded company without the approval
of the company’s management. The buyer makes a cash offer directly to the target’s shareholders,
who then either (a) vote “yes” on the deal by selling their stock, or (b) vote “no” by holding their
investment. In the U.S., the buyer makes its purchases conditional on obtaining a 90 percent equity
interest, which facilitates a speedy combination of the two enterprises.
This direct offer form of hostile takeover is obsolete in the United States, as promanagement courts
give targets the power to deflect a buyer’s intentions. Governance mechanisms such as poison pills,
staggered board terms, and supermajority voting plans protect the target. As a substitute, activists
use the proxy fight.
A proxy fight occurs when a buyer or agitator (a) takes a significant ownership (5 percent or more)
in a public company’s equity, and then (b) uses this commitment as a platform to advocate for major
changes. The proposed changes usually have an M&A connotation, such as:
Outright sale to the buyer
A sale to a third party (to enable the agitator to reap a control premium on his ownership
position)
A split-off of an undervalued subsidiary
The instigator of the proxy fight takes his arguments directly to the company’s stockholders, and
then asks them to vote for his nominees to the board of directors. Concurrently, the incumbent
managers urge stockholders to stay the course. If the outsiders win enough votes to become board
members, they direct management to implement the changes.
In the United States and elsewhere, a publicly traded company has multiple defenses against a proxy
fight. Furthermore, the incumbent management has virtually unlimited access to the company’s
cash, from which to finance a counter attack. Prospective acquirers and/or agitators must therefore
pick their targets carefully.
243
Summary
Five transactions receive a lot of attention:
1. Tax-free deal
2. Demerger
3. Reverse merger
4. Special purpose acquisition corporation
5. Hostile takeover
These transaction types are in the minority and it is unlikely you will encounter them in your day-today work environment. Nevertheless, they do receive a lot of media attention, and it is useful at
times to know their attributes.
244
Note
1. Interview with professor Ted Barnhill, George Washington University, January 9, 2014.
245
CHAPTER 23
Final Thoughts on Mergers and Acquisitions
M&A’s guiding principle is one company buying either a competitor or a like business. There is no
guarantee of success, yet the acquisition process remains popular with operating firms and financial
buyers. Hundreds of thousands of practitioners keep the M&A business vibrant and innovative.
Since the first edition of this book, M&A activity has accelerated at a rapid pace, reaching tens of
thousands of deals annually. Large and small companies alike recognize the importance of buying
versus building, and the trend has gone global. As operating firms build up their businesses through
acquisitions, they now compete with an expanding number of financial buyers. Leveraged buyouts,
consolidation transactions, and distressed deals have risen to positions of prominence, and their
promoters have access to hundreds of billions of investment dollars. From this environment has
evolved an army of M&A participants, all available to service the ever larger transaction volume.
This book has presented a succinct guide to mergers and acquisitions. It has followed the process
sequentially and offered a balanced assessment of the risks and rewards. For those who have read
this book, I hope it is clear that M&A is not rocket science. An intelligent person can easily discern a
deal’s underlying principles, given sufficient time to conduct an analysis.
M&A’s guiding principle is boosting the acquirer’s value through the purchase of a similar business,
but there is no guarantee that a transaction will make a positive contribution. Like any other
corporate investment, a deal’s potential benefits are tempered by its possible problems. Many
transactions have failed while others have been successful. So who is to decide? The very popularity
of acquisitions—thousands are completed every year—indicates that the M&A business is here to
stay.
From the buyer’s point of view, there is no substitute for adequate preparation, coupled with a
disciplined approach. The M&A market is a perilous place filled with unrealistic sellers, rosy
projections, and thick-skinned practitioners. The principle of caveat emptor reigns supreme and the
buyer must do its homework in order to prosper.
Overpayment remains the buyer’s number one risk. Comparable public companies and M&A
transactions provide an indicator of value, but each sale candidate is unique. Furthermore, every
deal takes place under conditions unique to the market, the buyer, and the seller at the time of
negotiations. To guard against paying too much, a careful buyer runs a series of pro forma combined
financial projections that show both the upside and the downside of any deal. Growth of future
earnings per share is an important yardstick. The in-house finance executive then consults with
operating personnel who provide a reality check on this data, which is subsequently confirmed by a
thorough due diligence process. Aware of the psychological elements embedded in stock prices, the
disciplined acquirer withdraws from expensive auctions rather than compromise on its synergy and
price expectations.
Smart acquirers know what they don’t know, and they aren’t shy about hiring expert advisers. If they
need to learn more about target valuations after finishing their research, they retain a financial
adviser experienced in that industry. If a deal has a thorny environmental issue, they employ the
proper consultant. Forming the right team is essential to closing deals. The companies that can’t
afford this kind of talent in-house contract for it on the outside.
Sellers must be mindful of the process through which they gain optimal pricing. And, timing is an
important consideration as well, since the M&A business is highly cyclical. Buyers may be lining up
one year and conspicuously absent the next. Tax and legal structures also impact the seller’s
economic returns.
The number of firms (and individuals) advising, financing, investigating, previewing, or betting on
prospective deals numbers in the hundreds of thousands. Many are expert in a narrow segment of
the M&A industry, and they can profit from this book’s exposure to broad concepts, evaluative
axioms, and specific tactics.
Buying is a vibrant alternative to building—the painstaking process of either inventing new products
or finding new customers—and the modern corporation stays alert for the next deal. Over the long
term, firms that ignore this message may be the next deal. By way of example, of the companies
246
appearing in the original Fortune 500 list in 1955, less than one fifth operate independently today.
Most of these large enterprises were merged out of existence, and it’s likely that their smaller
brethren shared a similar fate.
This book provides a practitioner’s view of mergers and acquisitions. It’s an intriguing field that
attracts some of the brightest minds in business, and it combines vision, glamor, and big money. Its
scope is exceptionally broad, encompassing almost every industry and manner of company. This
playing field results in opportunities for many participants, and their efforts and innovations
contribute to M&A’s progression.
247
About the Author
Jeff Hooke is a broad-based finance and investment executive with global experience throughout the
United States, Europe, and the emerging markets of Latin America and Asia. He has negotiated
numerous transactions, including mergers and acquisitions, public offerings, mezzanine financings,
private equity investments, international bank syndications, corporate valuations, and fairness
opinions.
He is a managing director for Focus Securities, a mid-market investment bank in the United States.
Previously, Mr. Hooke led deals at the Emerging Markets Partnership, a $5 billion private equity
group. He was a principal investment officer of the International Finance Corporation, the $30
billion private sector division of the World Bank. His New York investment banking career covered
two major firms, Lehman Brothers and Schroder Wertheim. He began as an investment officer in
the private placement department of Metropolitan Life Insurance.
Besides this book, he is the author of three other authoritative books: The Emerging Markets,
Security Analysis and Business Valuation on Wall Street, and The Dinosaur among Us: The World
Bank and Its Path to Extinction. Barron’s called Security Analysis and Business Valuation on Wall
Street “a welcome successor to Graham and Dodd’s Security Analysis,” the seminal work often
quoted by Warren Buffett. A portion of the book is required reading for the CFA exam, and the
second edition was released in May 2010. Three of Mr. Hooke’s books have been used as textbooks
at the graduate level.
Mr. Hooke has taught at several universities, and he lectures on finance at executive education
forums around the world. He has an MBA from the Wharton School of Business and a BS degree
(cum laude) from the University of Pennsylvania.
248
Index
Absolute amount analysis
Accounting firms
as intermediaries
production of accurate accounting statements
“Acquirehire”
Acquisition campaigns. See also Buyer motivations; Target financial analysis
acquisition search funnel
active approach
buyer's own search program
closing
components
defining search parameters
direct contact with target
due diligence
financing the deal
integration process
intermediaries in search process
internal assessment
laying the groundwork for search
for publicly traded companies
risks facing buyers
screening candidates
seller motivations to sell
structuring the deal (See Structuring deals)
Activity ratios
Advisors. See Intermediaries for buyers; Intermediaries for sellers
Africa
Agency problem
Aleran, Laura
Ambuja Cements
Ameren Corp.
American Realty
Amgen
Ancestry.com
Anheuser-Busch InBev
AOL
Apple Computer
APS Healthcare
Arbitrage tactics
249
Archstone
Argentina
Asset purchases
legal considerations
nature of
Auction process
full-blown auctions
modified auctions
Australia
Autonomy (UK firm)
Avalon Bay
Backward integration
Bank of America
Barnhill, Ted
Bausch & Lomb
BCBS South Carolina
Berkshire Hathaway
Bidding process and offers
BlackBerry
Black Monday (1987)
Bobkoff, Dan
Brazil
Burlington Northern
Business brokers, as intermediaries
Buyer motivations. See also Acquisition campaigns; Growth
capturing natural resources
cutting costs at target
diversification
entering new country
most popular
oligopoly power
private equity firms
risk of new product introductions
synergies/economies of scale
technical expertise
vertical integration
Buyer's audit
Caceres, Enrique
Caesar's Entertainment
Cameron, Jennifer
Campbell Soup
Canada
250
Capital Asset Pricing Model (CAPM)
Capital gains tax
Capital IQ
Carlin, Bob
Carmel, Brett
Carrizo Oil & Gas
Cash deals
Causal forecasting
Cheesecake Factory
Chevron
Chile
China
China National Oil
China Oil
Closing deals
CNOOC
Coburn, Brooke
Coca-Cola
Cole Real Estate
Comcast
Commercial banks
downplaying M&A risks
as intermediaries
Common size analysis
Company classification
cyclical company
declining company
in forecasting sales and earnings
growth company
mature company
pioneer company
turnaround company
Comparable acquisitions valuation approach
control premium
discounted cash flow (DCF) analysis versus
example
identifying M&A comparables
pros and cons
steps
target valuation in emerging markets
Comparable public companies valuation approach
accounting adjustments
251
applying appropriate multiple
calculating value multiples
control premium
decision process
discounted cash flow (DCF) analysis versus
example
interpreting range of value multiples
popular value ratios
pros and cons
real estate analogy
selecting comparable public companies
for speculative high-tech companies
steps
target valuation in emerging markets
Compound annual growth ratios
Confidentiality
Conflicts of interest
Conglomerate transactions
Constant growth model
Consultants. See Intermediaries for buyers; Intermediaries for sellers
Continucare
Control premium
in comparable acquisitions valuation approach
in comparable public companies valuation approach
Convertible securities
Cooper Industries
Corporate appraisal firms, as intermediaries
Cost of Capital (Pratt and Grabowski)
Cost reductions
buyer motivation for M&A
financial tactics based on
Countrywide Financial
Crane Co.
Crash of 1929
Credit rating agencies
Credit ratios
Crocs
CTC
Currency risk
Cyclical companies
Deal categories
Debt leverage risk
252
Declining companies
Definitive agreements
Dell, Inc.
De-mergers
Diabetes America
DiCenza, Mike
Digital Management
Discounted cash flow (DCF) valuation approach
Capital Asset Pricing Model (CAPM)
comparables versus
constant growth model
discount rate
Equity Buildup Method
per share value on standalone basis
pro forma analysis
projections
pros and cons
for speculative high-tech companies
steps
to supplement basic financial tactics
synergies
target valuation in emerging markets
terminal value
Discount rate, in discounted cash flow (DCF) approach
Diversification, in buyer motivation for M&A
Done Deals
Dot-com bubble
Due diligence
Duff & Phelps
Duke Energy
DuPont
Dynergy
Earnings dilution
Eaton
Economies of scale. See Synergies/economies of scale
Economist Intelligence
EDF
Egypt
El Paso
Emerging markets
defined
family business model
253
historical M&A trends
local finance practices as limitation
M&A activity
seller attitudes
structural issues
target valuation
Energies Nouvelles
Energy Future Holdings
Engagement letter
Engility, Inc.
Enterprise value (EV)
Equity Buildup Method
Equity Residential
Escrow accounts
Estate taxes
EV/EBITDA ratio
in arbitrage
in comparable public companies approach
considerations in transactions
debt leverage risk
earnings per share dilution
enterprise value (EV)
financial tactics based on
in high-leverage company valuation
in leveraged buyout (LBO) valuation approach
projecting target results
sum-of-the-parts in holding companies
Swan effect
in turnaround company valuation
Everett, Ron
EV/Sales
Exclusivity
Exxon
Facebook
Family business model
Fidelity Healthcare
Financial advisors. See Intermediaries for buyers; Intermediaries for sellers
Financial analysis. See also Forecasting sales and earnings; Projections; Target financial analysis
buyer's audit
combining buyer and seller financial results
in forecasting sales and earnings
pro forma analysis
254
Financial tactics. See also Structuring deals; Target financial analysis
arbitrage
conveying to investors
cost cuts/revenue gains
discounted cash flow analysis to supplement
Swan effect
FlatWorld Capital
Fleetmatics Group, plc
Focus, LLC
Forecasting sales and earnings
causal forecasting
combining buyer and seller projections
critiquing projections
historical information in
preparing projections
qualitative forecasting
scenarios
time series forecasting
Forward integration
Fraga, Arminio
Free cash flows
Full-blown auctions
GDF Suez
Genzyme
Geographical distribution of deals
George Weston
Glencore
Global financial crisis (2007/2008)
Goldman Sachs Capital Partners
Google
Grabowski, Roger
Growth
compound annual growth ratios
financial ratios
financial tactics based on
forecasting target sales and earnings
growth company classification
importance
strategies to promote
Grupo Industrial Bimbo
Grupo Modelo
Gunther, Andrew
255
Healthtran
Hertz Rent-A-Car
Hewlett-Packard
High-leverage companies, valuation methods
High-technology company valuation
Hilton Hotels
History of M&A
cyclicality
waves of activity
Holding companies
Horizontal transactions
Hostile takeovers
Humana
Hurson, Dan
Ibbotson
India
Indocement
Indonesia
Industry-specific indicators
Information memorandum
Information risk
Initial public offerings (IPOs)
Instagram
Integration process
Interline Brands
Intermediaries for buyers
downplaying M&A risks
due diligence
fees
initiating target search with
legal documents
retaining
in target search process
types
Intermediaries for sellers
approach tactics
bidding process and offers
confirming valuation range
conflicts of interest
dressing up sales candidate
due diligence of buyers and
fees
256
information memorandum
legal documents
list of buyers
retaining
Internal rate of return (IRR)
International Exchange Group (ICE)
International Power
Investment banking engagement letter
Investment banks
downplaying M&A risks
as intermediaries
Japan
J.P. Morgan
Junk bonds
Keiretsu
Kelly Services
Kforce
Kinder Morgan
Kroger's
L-3 Corporation
LaFarge Ciments
LaMota, Antonio
Large transactions
Law firms, as intermediaries
LBOs. See Leveraged buyouts (LBOs)
Legacy Oil & Gas
Legal issues
acquisition legal structures
documentation of deal
due diligence of buyer
law firms as intermediaries
regulation of M&A
retaining intermediaries in sale process
retaining intermediaries in search process
structuring the deal
Lehman Brothers
Lender credit ratio tests
Letter of intent (LOI)
Leveraged buyouts (LBOs). See also Private equity managers
basic principles
buyer motivation for M&A
capital structure versus normal companies
257
Crane Co. example
EV/EBITDA ratio
mechanics
partial sale/leveraged recapitalization
private equity fund time limits
pros and cons
in target company valuation
trends in M&A market
Leveraged recapitalization
Lightyear
Low-tech, money-losing companies
Macroeconomic risk
Mature companies
MaxIT
McQuade, Brian
MergerMarket
Mergers, statutory
legal considerations
nature of
triangular
Mergerstat
Metro Health
MetroPCS
Mexico
Mittal
Modified auctions
Morocco
Motorola
Mrs. Baird's
Murray, Paul
Natural resources
capturing through M&A
in target valuation
NBC Universal
Nestle
Neur, Fred
New markets, buyer motivation for M&A
New products, avoiding risks through M&A
Nexen
Nextel
Nielsen Corporation
Nondisclosure agreement (NDA)
258
“Normalizing” financial results
NYSE Euronext Corp.
Oligopoly power, buyer motivation for M&A
On Assignment
Onyx
Operating risk
Opportunism
Overpayment risk
Paccar, Inc.
Par Pharmaceuticals
Partial sales
Pentair Corporation
Pepsi
Percentage change analysis
Perella Weinberg
Permira Advisors
Per share value, in discounted cash flow (DCF) approach
P.F. Chang's Bistro
Pfizer Nutrition
Pioneer companies
Political risk
Pratt, Shannon
Price/book ratio
Price/earnings (P/E) ratio, in comparable public companies approach
Private equity managers. See also Leveraged buyouts (LBOs)
in advanced M&A industry in U.S.
buyer motivation for M&A
capital structure versus normal companies
downplaying M&A risks
Profitability ratios
Pro forma analysis
Projections
combining buyer and seller
in discounted cash flow (DCF) approach
of free cash flow
historical information in
Rock-Term Packaging Company example
structuring future finances
of target results
Proxy fights
Publicly traded companies. See also Comparable public companies valuation approach
acquisition campaigns
259
in driving M&A activity
regulation of U.S.
Quadra FNX
Qualitative forecasting
Rajbhandary, Sujan
Ratio analysis
activity ratios
credit ratios
growth ratios
profitability ratios
Recapitalization, leveraged
Recapture tax
Recessions, macroeconomic risk
Reinvestment focus
Retirement of seller
Revenue synergies
Reverse mergers
“Rifle shot” approach tactic
Risk
of buyer in M&A transaction
currency
debt leverage
downplaying
of entering new country
executing Swan effect through lowering
information
macroeconomic
of new product introduction
no guarantee for M&A success
operating
overpayment
political
securities in lieu of cash
target valuation in emerging markets
Robert Half
Robinson, Steve
Rock-Term Packaging Company
Rodgers, Doug
Rosneft Nexen
Russia
SAIC
Sanofi
260
Sara Lee
Scenario analysis
Screening targets
factors in
in-house approach
intermediaries in
SDC Platinum
Search process for targets. See Acquisition campaigns
Sears
Seller considerations
approach tactics
bidding process and offers
business appraisal/valuation (See also Target valuation)
categories of sellers
confidentiality
decision process
due diligence of buyer
legal issues
leveraged recapitalization
list of buyers
operational issues
partial sale
personnel issues
reasons for selling
retaining a financial advisor
selling versus initial public offering (IPO)
setting stage for sale
steps in business sale process
timing issues
Shell companies
“Shotgun” approach tactic
Siam Cement
Sicker, John
Sino-Forest
Small transactions
Softbank
Special purpose acquisition corporations (SPACs)
Speculative high-tech companies
Spin-offs
Split-offs
Sprint
Sprint Nextel
261
Standard Oil
“Step up” tax basis
Stock options
Stock purchases
legal considerations
nature of
Strategic transactions
Structuring deals
acquisition legal structures
debt leverage risk
de-mergers
financing choices in
hostile takeovers
legal documents
overpayment risk
pro forma analysis
reality checks in
reverse mergers
securities in lieu of cash
setting price for target
special purpose acquisition corporations (SPACs)
tax considerations
Subway
Sum-of-the-parts
Swan effect
executing through lowering risk
nature of
understanding math
Synergies/economies of scale
buyer motivation for M&A
in combining buyer and seller projections
in discounted cash flow (DCF) approach
“Tail” provisions
Target financial analysis. See also Target valuation
absolute amount analysis
accurate financial statements
buyer's audit
combining with buyer financial analysis
common size analysis
company classifications
comparable public companies performance
credit ratings
262
dressing up the sales candidate
forecasting sales and earnings
growth analysis
historical analysis
industry-specific indicators
“normalizing” results
percentage changes
P.F. Chang example
ratio analysis
review
Target search process. See Acquisition campaigns
Target valuation. See also Target financial analysis
comparable acquisition approach
comparable public companies approach
confirming valuation range
cyclical companies
discounted cash flow (DCF) approach
in emerging markets
forecasting sales and earnings
high-leverage companies
leveraged buyout (LBO) approach
low-tech, money-losing companies
natural resources in
reality in
seller business appraisal
seller considerations
speculative high-tech companies
sum-of-the-parts in holding companies
turnaround companies
Tax considerations
buyer
capital gains tax
for mergers
recapture tax
seller
“step up” tax basis
for stock purchases
tax-free deals
Tax-free deals
Teasers
Technical expertise
buyer motivation for M&A
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valuation of speculative high-tech companies
Telebras
Telefonica de Argentina
Telmex
Tenet Healthcare
Terminal value, in discounted cash flow (DCF) approach
Texas Roadhouse
Thailand
Thomson Financial
3-D Systems
3G Capital
Time series forecast techniques
Time Warner
Timing considerations, for seller
TMobile
TNK-BP
Torah Portland
Towers Watson
TPG Capital
Trends in M&A market
advanced M&A industry in U.S.
cyclicality
deal categories
deal size
emerging markets
geographical distribution
growth in transactions
historical
private equity participants
size of deals
wealthy nations other than U.S.
Triangular mergers
Turnaround companies
Turner, Gerald
Tyco Flow Control International Corporation
UCI Medical
United Airlines
United States
advanced M&A industry
“cash flow” loans
history of mergers and acquisitions
regulation of securities industry
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U.S. Steel
Universal
Valeant Pharmaceuticals
Valuation. See Target valuation
Vanguard Health Systems
Venture capital pricing, for speculative high-tech companies
Vertical transactions
Wall Street (film)
Warranties
Western Europe
Xstrata
Yahoo!
Yang, Bob
Yang, Luo
Yook, Ken
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