Develop a framework for understanding acquisitions and buyouts along the following dimensions of risk:
Valuation
Legal
Accounting
Tax
Transaction Mechanics
The Industry Shaper: Repeatedly spots discontinuities in industries and acts pre-emptively to shape the emerging new industry to its own
advantage (e.g. Amazon.com)
The Deal Maker: Systematically beats the market through superior skill at spotting and executing deals. This could be either through
superior insight into the inherent value of companies or through superior insight into specific industries (e.g. Cisco).
The Scarce Asset Allocator: Efficiently allocates capital, cash, time and talent across multiple business units (e.g. ABB)
The Skill Replicator: Repeatedly transfers particular skills across business units. The skill of lateral transfer is a distinct skill from the
functional skill itself (e.g. GE)
The Performance Manager: Has proven skills at instilling a high performance ethic with matching incentives and MIS processes across
multiple business units (e.g. Intel)
The Talent Agency: Institutionalizes a model for attracting, retaining and developing talent that is truly distinctive relative to all others in the
industry (e.g. BCG)
The Growth Asset Attractor: Possesses a proven and sustained record of consistently leading in innovation in multiple businesses
(e.g. IBM)
Objective: To obtain the present value of cash generated by net assets, thereby valuing debt and equity
Net Assets = Total Assets -(Current Liabilities - Short Term Interest Bearing Liabilities)
Net Assets = Net Working Capital + PP&E + Other Assets
Net Assets must be equal to the sum of Interest Bearing Liabilities and Equity
Value of Net Assets = Value of the Firm = Value of Debt (I.e. Interest Bearing Liabilities) + Value of Equity
Approach:
Free Cash Flow to the Firm: Cash generated that is available for creditors and shareholders
Free Cash Flow to Equity: Cash generated that is available for shareholders
We want to have a discount rate that is appropriate to the risks of the project under consideration and that incorporates the tax shield of debt
kD The opportunity cost of debt; what creditors could earn by lending to similar projects
kE The opportunity cost of capital; what shareholders could earn by investing in similar projects
%D The post-execution target capital structure
t The tax rate for ordinary income
We use the CAPM model to determine kE
rf = Long-term Treasury rate - 1% <-- trying to get a proxy for the long-term bill rate because the market risk premium relates to bills
Market Risk Premium = 8.8% (from historical performance of market relative to bills)
b found by looking at comparables
Find comparables
Compare debt structures --> Look at the ratio of MV Equity to (MV Equity + BV Debt) <-- assuming BV Debt = MV Debt
For each comp, unlever its b --> bunlevered = blevered x (MV Equity)/(MV Equity+BV Debt)
Calculate the average bunlevered
Relever this average --> blevered = blevered average x (MV Equity + BV Debt)/(MV Equity) <-- use target capital structure
The termination value is assumed to be the book value of net assets in year n
TV = NWC + PPE + Other Assets
g = annual growth rate in cash flows from year N to infinity (by assumption)
FCFn = FCF at year n
TVn = (FCFn) x (1-g)/(WACC - g)
Determine multiple of pre-interest earnings (EBIAT) at which comparables trade and apply to own project's EBIAT
Value of the Firm = Value of Equity + Value of Debt --> Value of Equity = Value of the Firm - Value of Debt
1. You want to use the capital structure that is unique and appropriate to the project
2. There are two sorts of systematic risk in the blevered: operating risk and financial risk (which comes from leverage)
3. The bunlevered reflects the operating risk of the assets
4. Only count as debt interest-bearing liabilities
5. If there is recourse debt, then you use the parent's cost of debt; if no recourse, then use the project's cost of debt
6. Don't just focus on valuation; consider other statistics as well
7. Don't forget to deduct the value of the debt when calculating the value of the equity
8. There are conditions under which multiples are inappropriate
Cyclical industry --> volatile multipliers
Multiples may not take into account any step-up
9. If you use a 5-year b, then use a 5-year capital structure
For each tranche of debt --> the tax shield of debt is equal to the interest payment (using average debt balances) x tax rate
Discount the tax shield of debt stream using the yield on that tranche
Source: www.victoryrisk.com
Execution and Legal
1. Acquire enough shares to constitute control according to the laws of the state in which the target is incorporated
This can vary from 50.1% to 90%+ (some states don't want outsiders to control their companies)
Typically executed via a tender offer to the public (e.g. Offer to pay $x/share in cash for y% of the outstanding equity)
Or, a private offer to a major holder (e.g. an institution)
Or, by acquiring shares in the open market quietly, using a creeping tender offer
2. Gain control of the Board of Directors (and then force the company to sell)
Technically, you do not need to own shares in order to be a Director (beyond some token amount)
Annual shareholders' meeting has elections for Directors
Propose a slate of Directors at the annual meeting --> shareholders vote
Practical considerations: staggered elections, different classes of Directors, etc.)
Having gained control of a company, there are 3 possible things can happen subsequently:
1. Election is made to do a statutory merger of the target with the acquirer (most exposure to unknown)
2. Make selected asset purchases and selected assumption of liabilities (implying limited liability)
3. Do nothing and keep as is --> target becomes a subsidiary of the acquirer (a stock deal) (least exposure to unknown)
A merger is a combination of the two companies terms of assets, liabilities and equity, referring to the liabilities both known and unknown
Some shareholders may object because they are being forced to surrender their economic interest in the
target for a different economic interest in the merged companies
Often goes to state court, minority arguing that they did not receive fair consideration
Miscellaneous:
1. The Williams Act of 1968 stipulates that tender offers have to be open for a minimum of 20 business days (30 calendar days)
2. If you own more than 80% of a target company, you can report its financial results as part of your consolidated financial statements
3. A White Knight is a third-party who intervenes on a target-friendly basis with a competing bid
4. Rule of Tender: You have until the last minute to revoke tender subscriptions
5. An exchange offer is an offer of stock-for-stock
Non-taxable to shareholders of target as they transfer old share basis to new stock
Non-taxable to target company since no realized P/L on assets
6. Rule 16(b) - "No Flipping/Short Swing Rule": Anyone who owns more than 10% of the stock is a constructive insider
Insiders cannot buy and sell within 6 months
If insiders trade, they must give back all profits and stand criminal trial
7. Rule 13(d) - "D is for Disclosure: Must disclose ownership and intention above 5%
8. "Sweeping the Street": Getting block shares (typically from institutions or arbs) in a single day (or a short period of time)
9. A Type C reorg: asset purchase in consideration for 100% stock, after which target liquidates and goes out of business
10. A 338(h)(10) Election is as if the acquirer sells the acquired assets to himself on Day 1
Assets are written up
Tax payable (at ordinary rates)
Used typically if acquirer has NOLs that it can monetize (I.e. by transforming into the step-up stream)
11. Greenmail: Money paid to a putative bidder to make him go away
12. Problem: How can you structure the deal in order to meet the interests of all of the parties?
13. Conglomerate Theory: Under sophisticated management, conglomerate forms an umbrella under which the companies can be operated
more efficiently and access capital markets more efficiently
14. Every state has rules that preclude the Board of Directors from deals that would leave the firm with negative equity pursuant to an action
by the board
15. A triangular merger is one in which one of the acquirer's subsidiary companies is merged into the target company
Statutory Mergers:
Generally structured as a Type A reorganization (from S. 368 (a)(1)(A) of the IRS Code of 1954
Use the target company's debt capacity to finance its acquisition, structuring the deal so as to take on as much debt as you think you can
handle, so that you as you pay down the debt, your equity slice becomes more valuable
Typically, LBOs or MBOs are executed where the target company has the following characteristics:
Transaction Mechanics:
Example Transaction:
Create a subsidiary S and put all the cash into the sub in consideration for stock
The subsidiary must guarantee P's loans (using an off-balance sheet item)
P makes a tender offer of $6.4 bio to Beatrice shareholders, conditional on receipt of Beatrice shares and a triangular merger of S into Beatrice
Approval required by both sets of shareholders (P's Board and Beatrice's shareholders)
1. Will cash flows be able to service debt and with what cushion
2. Need an exit multiple (IPO, typically)
3. Possible to have huge swings in valuation, bigger than size of equity piece
4. How do you pick a WACC with a dynamic capital structure (becoming progressively less leveraged)
Unlevered b theoretically overestimates the riskiness of equity at high levels of debt because debt becomes like equity
FCF methodology is very poor in valuing highly levered transactions --> APV is better
Two-tiered offer: Make a tender offer at one price for 50.1% (or control) and a second tender offer at a second price for the
remainder (often thought of as a coercive technique)
White Knight: A company that is friendly to the target company's management and that intervenes with a competing takeover proposal
Generally, if there is the potential for competitive bidding, the best chance for winning is with offering the best bid up front.
Incremental savings don't outweigh the risk of losing the first-mover surprise advantage
Anti-takeover techniques:
There are two types of accounting treatment (as disconnected from tax treatment)
Add up the balance sheets of the two companies at historical cost (assets, liabilities, other equity) <-- very simple
A marriage of two companies
Difficult to pass all of the requirements that FASB has set up for pooling (7 tests), including:
No assets sales for x # of years
No pre-agreed buyouts for a group of shareholders
Cannot merge acquired company into a sub
Cannot acquire a sub of a bigger company, merge it and call it a sub
Generally, only financial institutions qualify for pooling (Fed requires an immediate writeoff of goodwill ag. Reg. Capital)
Tax and accounting treatment very similar
Tax basis not adjusted, simply carried over
Biggest failure to qualify for pooling: A subsidiary, contrived acquisition vehicle ( a single purpose acquisition entity) typically bids
Not a true merger of equals, per se
Assets of one (and possibly both) must be written up to their Fair Market Value
Liabilities are restated at market
Any difference between FMV and the purchase price becomes goodwill
Goodwill is expensed --> lowers earnings
Book value is written up
Possible to have tax-free carryover of basis while writing up the basis for accounting purposes --> 2 sets of books
Statutory Merger:
Tax Treatment:
If pooling --> tax basis not adjusted, just carried over; tax-free transaction
If purchase --> could be either taxable or tax-free
Accounting Treatment
Asset Purchase:
Tax Treatment
Acquirer writes up the value of the assets and enjoys a depreciation benefit ("step up") going forward
Seller pays tax on any difference between price and basis at ordinary rates if asset is depreciable, capital gains otherwise
Accounting Treatment
Stock Acquisition:
Occurs when the acquirer obtains stock in the target in consideration for cash
Tax Treatment
Accounting Treatment
Purchase accounting
1. Loyalty
2. Care
Be well informed
Must not be negligent or close their eyes to the facts
Business Judgment rule: Directors are assumed to meet these standards unless proven otherwise
Penalties:
Revlon
Unocal
Society for Savings
Revlon Most onerous Auctions Directors must maximize short-term value --> must take highest price
Unocal Middle Unsolicited hostile offers The takeover defense must be proportional to the threat
SOCS Least onerous Strategic combinations Not obliged to maximize short-term value in a strategic combination
Revlon Principle
Last condition can be tricky if there are a large # of shares held in the hands of the public, freely trading them
Example: Paramount
May 1992: Board of SOCS says that they want to be independent --> no bid accepted
August 1992: SOCS announces merger with BKB, stock-for-stock at $17.30/share
Goldman reiterates its $19.25/share bid in cash
SOCS directors tells GS no --> BKB deal is a better strategic fit
SOCS investors sue under the Revlon principle
Court: Not obligated to take the higher price in a strategic combination
Unitrin --> 23% owned by Henry Singleton (also the CEO of Teledyne)
American General offers a 30% premium for Unitrin (skimpy-ish premium)
Unitrin response
Announces a shareholder rights plan in which anyone with over 15% of the stock needs a 75% S/H vote to do a merger
Announces a buyback of shares which if successful will give Singleton over 25% ownership (a blocking minority)
Preclusive of a merger
Benefited a member of the Board