M&A Review - Theory Chand Sooran

Develop a framework for understanding acquisitions and buyouts along the following dimensions of risk:

Valuation
Legal
Accounting
Tax
Transaction Mechanics

Seven Recurring Corporate Themes

From Copeland et al., Valuation:

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)

Some M&A Facts

Global M&A is growing exponentially, with particular growth in Europe

Big deals are advised, smaller deals (greater number) are not
Typical investment bank compensation: 0.25% for very big deals, 1% norm, 2-3% for smaller deals
Most corporates have M&A teams
Investment bank advantage: ability to raise capital
Three types of mergers: vertical mergers, horizontal mergers and conglomerate mergers
Mergers occur in waves (six in the 20th century)
Waves track periods of rising equity values
Out-of-market acquisitions are a recipe for disaster
Mergers typically do not work but when they do, their success is spectacular
7% underperformance in the first year
70% of the time, the merged company's PAT is less than the sum of the separate PATs from the previous year
It takes 5 years on average for margins to return to the industry average

Common justifications for mergers:

Changing industry economics (technological shifts; regulatory shifts)

Synergy (economies of scale and scope; efficiencies in production, distribution and procurement; reduction in SG&A)
Financial synergies (lower costs of financing with larger, putatively safer, firms)
Managerial inefficiencies (oust bad management)
Valuation errors (cheap are targets and overvalued use stock as currency)
Value transfers (tax; monopoly rent-seeking; union busting; from bondholders - buy a highly leveraged company)
Hubris

WACC DCF Valuation Methodology

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:

1. Determine the cash flows for years 1 to N

2. Calculate the appropriate discount rate
3. Calculate the terminal value at end of year N
4. Calculate the present value of the cash flows and of the terminal value and sum these two numbers, which is equal to the value of the firm
5. Subtract the value of debt to obtain the value of equity

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

Determining the Cash Flows:

Sales EBIT x (1 - Tax Rate)

-COGS + Depreciation
= Gross Profit (EBITDA) + Amortization
- SG&A + Other Non-Cash Charges
= Operating Profit (EBITDA) - Change in Net Working Capital
- Depreciation - Change in PP&E (CapEx)
- Amortization - Change in Other Assets
= PBIT (EBIT) = Free Cash Flow
- Interest
= PBT (EBT)
- Taxes
= Net Income

Calculating the Appropriate Discount Rate:

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

WACC = k D (1-t)(%D) + k E (%E)

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

kE = rf + b(Market Risk Premium)

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

The 1% is the liquidity premium

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

Calculating the Terminal Value:

There are three methods to calculate terminal value:

Liquidation Best for low growth firms

Perpetuity Best for stable cash generating firms
Multiples Best for high growth firms

The Liquidation method:

The termination value is assumed to be the book value of net assets in year n
TV = NWC + PPE + Other Assets

The Perpetuity method:

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)

The Multiples method:

Determine multiple of pre-interest earnings (EBIAT) at which comparables trade and apply to own project's EBIAT

Multiplecomparable = (MV Equity + BV Debt)/EBIATand compute average multiple

TVn = Multiple x EBIAT (or Revenues, or whatever other index used)

Putting It All Together:

Value of the Firm = Value of Equity + Value of Debt --> Value of Equity = Value of the Firm - Value of Debt

Value of the Firm = S PV FCF + S PV TV

Implementation Notes (from Cases):

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

APV Valuation Methodology

Useful in situations in which the firm is highly leveraged

1. Pretend the firm has a certain % of debt (the target %)

2. Value the all equity company, discounting at kA
3. Subtract the MV of debt it does have
4. Add the tax shields --> estimated value of the equity

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

Note: Unleveraging companies caluses P/Es to go up

Source: www.victoryrisk.com
Execution and Legal

There are 2 ways to gain control of a company:

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

2 old companies cease to exist, replaced by a new company

All old contracts etc. of old companies revert to the new company
Requires votes and approval of both sets of shareholders (generally, a simple majority)

Minority squeeze-out: merger consideration is forced on a dissenting minority

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

Requires that shareholders maintain their continuity of interest

Exchange shares-for-shares pursuant to the transaction
No taxes at the individual level
No taxes at the corporate level
Leveraged Buyouts

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:

Stable cash flows growing at the rate of inflation

Brand does the workd, not necessarily the steward

Profitable if you can fund with debt and earn a positive spread (leverage)

Lots of cushy overhead and a casual ex-ante management attitude

Trim fat and waste (agency problem)

Transaction Mechanics:

Example Transaction:

Kelly/KKR group want to do a LBO of Beatrice

Start with an acquisition vehicle P (a single purpose vehicle)

P borrows $6 bio from a syndicate of banks and investors

Kelly and KKR together contributed $400 mm in consideration for equity in P
This leaves them with a single asset of $6.4 bio in cash

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)

P becomes the de facto owner of Beatrice

S* (S+Beatrice) has a clean balance sheet, carrying only Beatrice's ex-ante debt
Valuation Issues:

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:

Staggered board election

Share buyback --> puts more shares in control of target firm and out of circulation
Issue of different classes of shares with voting rights contingent upon the period holding the stock
Reclassification of different classes of stock --> dilution of voting rights of potential acquirer
Make owning stock unattractive to the arbs
Share buyback premium --> pay exiting shareholders at the expense of those who are staying (since price will drop next day)
Sell the crucial asset in the target firm --> unattractive to the unwanted bidder
Accounting

There are two types of accounting treatment (as disconnected from tax treatment)

The desired treatment is Pooling of Interests

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

Alternative is Purchase Treatment

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

Could be either pooling or purchase

Asset Purchase:

Tax Treatment

Almost always taxable

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

Must use purchase accounting

Stock Acquisition:

Occurs when the acquirer obtains stock in the target in consideration for cash

Tax Treatment

Selling shareholders pay capital gains tax

Acquiring company does not revalue the assets of the target, carrying over the old basis in assets and liabilities
Unless the acquirer makes a 338(h)(10) election in which they have a deemed sale and repurchase of the assets, effectively
marking-to-market the position

Accounting Treatment

Purchase accounting

Accounting Treatment Tax Treatment

Stat. Merger Pooling or Purchase Follows accounting treatment
Asset Purchase Purchase Taxable with step-up and taxable to selling shareholders
Stock Acquisition Purchase Tax-Free (no write-up) unless 338(h)(10) election; CG tax to selling S/H
Corporate Governance

Directors have a responsibility to show:

1. Loyalty

Put shareholder interests above their own, acting in a disinterested manner

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

Principle: Courts do not want to second-guess board decisions

You can have a stupid board, but you can't sue them unless they acted in their own self-interest or they violated their duty of care

Penalties:

1. Personal liability (rare)

2. Injunctive relief (much more common)

Enjoin (or reverse) the decision of the directors, by the court

There are 3 big cases in M&A:

Revlon
Unocal
Society for Savings

Case Pressure Application Court Finding

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

Directors must maximize short-term value in the following situations:

Auctions of the company

A break-up transaction in response to a bid
Engaging in a sale transaction that results in a change of control

Last condition can be tricky if there are a large # of shares held in the hands of the public, freely trading them

Example: Paramount

Had a deal with Viacom (controlled by Sumner Redstone)

QVC (controlled by Barry Diller) makes an offer for Paramount that matches and/or beats the Viacom deal
Paramount and Viacom try to "put the deal away" (I.e. to make it impregnable to a third-party bid)

Termination fee of $100 mm payable to Viacom if deal is unfulfilled

Lockup option on Paramount stock granted to Viacom in respect of 19.9% of Paramount common
Note: If there is an increase in shares outstanding by > 20% without a S/H vote, NYSE will delist the stock 17(e)
Ensures Viacom handsomely compensated if QVC wins
No shop clause: Paramount couldn't talk to another party unless that party had the ability to finance the deal immediately
Court held that the directors of Paramount were bound by Revlon

If Viacom had succeeded, it would have been a change of control

Rescinded the protective provisions

Example: Society for Savings

SOCS starts soliciting bids in 1991

Received 9 bids, 2 of which are prominent

Goldman - leveraged deal, complicated, $19.25/share
Bank of Boston - all stock-for-stock deal

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

Strategic combination: --> stock-for-stock as evidence of joint economic interest

Problem: Wasn't it an auction? Was there a 'decent' interval of time?

Example: Unocal Precedent in Unitrin

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)

Court decided that the Unitrin response was excessive

Preclusive of a merger
Benefited a member of the Board