KUHN CAPITAL Wednesday, December 13, 2017
Dispatches from the front

What M&A Takes Today
(6/15/2002)

It is common knowledge that both M&A transaction volume and deal values have been depressed for over a year now. In certain industries like information technology (IT), the declines have been precipitous, according to some sources exceeding 50%.

While we have good theories as to why this M&A pullback has occurred, there has been less discussion about whether the situation is good for business in general, and if not, whether there are reasons and techniques to remedy it.

In fact, reduced M&A volume -- though not today’s lower transaction values -- is generally bad for business, and there are reasons and ways to complete successful deals despite the economy.


Why the Dearth of Deals?
The underlying reason why M&A has slowed today is slackened company sales revenue which, in turn, narrows operating margins or worse, triggers operating losses. Anemic demand therefore presents a host of related concerns for prospective buyers and sellers, and it is these concerns that the press more frequently reports.

For sellers, flat or declining sales and depressed profitability usually translate into low transaction value. Therefore, if they can afford it, many such sellers prefer to hunker down, await demand’s return, and then presumably enjoy stronger enterprise value later. For some sellers, however, waiting is problematic: their weak balance sheets don’t tolerate continued losses well, and especially for IT and professional services companies, external capital is nearly unobtainable. Even long-term status quo operation has a downside: both employees and investors weary of going “sideways”.

So such players – already having cut overhead as much as practicable -- are gambling that demand will return by a specific time. Or course, the downside to this strategy is a culminating financial crisis, bringing on unpleasant decisions that overshadow the risks of engaging in an M&A transaction.

On the other hand, prospective buyers, many of whom enjoy stable financials, may hesitate to purchase another company for fear they will compromise their current financial health by taking on a less profitable entity. Or they don’t want to take their eye off the ball with an “extraneous” distraction. Since all positions have a downside, this one is a failure of vision to exploit the opportunities for cheap growth presented by the current buyer’s market.

As a final observation, both buyers and sellers may find it difficult to calculate transaction value in these times of depressed demand and sometimes rapidly changing market conditions. Obviously, in order to quantify value in any point in time, the parties must devise some valuation mechanism or formula. These are of two types: call them “absolute” and “relative”.


Matters of Value
For example, absolute values may be derived from models of discounted cash flow or enterprise value estimates. Especially in the current environment, these absolute valuations often fail to attract seller enthusiasm, certainly if seller forecasts fail to show creditable increases in future demand. After all, the seller’s financial performance may be marginal or even cash flow negative. Outside of minimal liquidation value, what’s a company losing money worth?

Therefore, to realize a meaningful absolute value, the buyer must also see clear operating synergies to be derived from the combination. That is, both parties must agree that substantial economies are imminent in overhead reduction or in increased sales opportunities.

This gimlet-eyed approach to the real value of synergy is in contrast to the vague strategic promises of M&A combinations in years past. Yet, despite heroic buyer efforts to ferret out tangible synergies, in today’s environment even this undertaking can fail to generate seller enthusiasm for a transaction.

However, one can also calculate a “relative” value from a comparative analysis of what the two parties bring to the table. They jointly devise a “gearbox” mechanism to relate the companies to each other -- typically ratios between market capitalizations, or revenues or profitability, etc. As an example, if the buyer’s revenues were $60 million and the seller’s revenues were $20M, then all other things being equal, the seller’s value represents about 25% of the combined entity’s value. In practice, of course, relative valuations usually contemplate some weighted mixture of current sales, profitability, future growth, balance sheet items, tax issues, who bears the transaction costs and whether one party is public while the other is not.

At any rate, the relative value calculation is made simple when the seller accepts a large proportion of buyer equity in the transaction: now we’re dealing with trading apples for apples. In contrast, if the seller requires a large proportion of cash, the chances of killing the deal rise dramatically. As both buyers and sellers well know, cash is the dearest of commodities today: both want it as a hedge against uncertainty. But to extract cash from either company’s balance sheet denies it to the surviving entity, and raises the risk that the seller will then disengage from contributing to the necessary joint tasks ahead.

With either absolute or relative valuation, material variances in either party’s sales, profitability and market caps pre-close can wreck carefully laid value-fixing plans. But that’s particularly true in the case of relative values, based as they are on expectations of both party’s stable future operating performance. Even flexible valuation gearboxes have limits which, if they’re exceeded, can kill a deal.


Reasons to Deal
While the reasons not to engage in selective M&A transactions are clear, what’s less well understood is why to do them at all. As mentioned above, there are downsides to inaction -- wishful financial thinking (“Our ship will come it, it’s just not visible yet.”) or excessive caution (“Maybe we’ll be spared if we keep our eyes firmly on the ground.”).

Our own in-house survey research clearly indicates that -- with the exception of certain public companies – seller’s expectations of price are at historic lows, both buyers and sellers agree that now is “definitely” a good time to acquire, and that the opportunities for cost savings through consolidation have rarely been more obvious. (For more survey results, see our recent news release.)

These conditions favor the bold while they punish the timid, and they punish timid would-be M&A players two ways: those who could act but don’t are forced to settle for the tighter margins and limited resources brought on by competing on price against a field of more desperate competitors; and they pass up the opportunity to realize substantial immediate gains in sales and profitability unavailable any other way.


So How to Get It Done
In sum, when cash is more than king (when it is more like a despot), and when demand is down, one way to finesse these transaction obstacles is by adapting relative valuation strategies that feature a large proportion of buyer’s equity – a stock-for-stock deal. Doing so has several implications:

1) Avoiding the use of an absolute valuation raises the prospect of increased seller interest.

2) Using buyer’s equity allows the surviving entity to preserve its cash war chest, granting greater financial flexibility going forward.

3) Shared equity raises the probability that the combined management team will also share future motivations and forge a consensus on strategies, and it allows both parties to participate in the gains to be reaped by executing operational synergies. The deal looks more like a merger of partners than an outright acquisition with one party emerging as the “victor”.

4) Using equity reduces the proportion of sellers’ compensation exposed to capital gains taxation.

5) Stock-for-stock deals set a higher due diligence bar compared to the acquisition of specific assets and liabilities, since equity acquisitions can result in the later unhappy discovery of hidden liabilities. Usually, the process of discovering whether such liabilities exist before the fact is made easier in the case of a public company (though the recent continuing revelations of bogus public company accounting make you wonder.)

6) For such a structure to work, the transaction must be between companies operating in reasonably similar industries with comparable business models. Otherwise, sellers are presented with a scenario in which they are to become the proud owners of equity in a business about which they have little knowledge and therefore to which they can make only limited future operating contributions. But this requirement to determine if the business models are actually comparable is good news: it focuses the parties once again on whether the hypothesized operating synergies are likely to happen.

On way to think about such a transaction approach and structure is to understand its most salient effect: it defers the real question of exit value to a later date when the surviving entity may be more “fairly” priced in the stock market, when demand picks up, or when another white-hat buyer appears on the horizon, this one cash rich. Meanwhile, it delivers immediate value in the forms of increased financial performance and market share.

It does make one key demand on both parties: higher levels of trust in good intentions and management capability than that required by yesterday’s traditional “fire and forget” acquisition approach.

Ryan Kuhn


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