Merger and Acquisition Toolbox


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Article discusses valuation in a Merger and Acquisition Setting

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Merger and Acquisition Toolbox

  1. 1. A Mergers & Acquisitions Valuation Toolbox for Corporate Development Professionals Dominic Brault – – 216.373.2984Over the last several years, Stout Risius Ross, Inc. valuation tool utilized by management and the(“SRR”) has completed hundreds of transaction advisory Board of Directors to assess the economic meritsengagements which has provided the opportunity to of a transactionidentify critical valuation success factors employed mostly ■ Finally, comparable market multiples andby ‘serial acquirers’ that can be applied to improve the acquisition premiums are used by the moremergers & acquisitions (“M&A”) process for all corporate proficient acquirers to validate the finaldevelopment professionals. By way of this repository of contemplated purchase priceexperience, SRR knows there are valuation best practicesthat produce consistently higher quality financial analyses, Comprehensive Projectionswhich consequently may help reduce the risk, time and Set the Valuation Foundation ■ ■ ■costs associated with M&A transactions. Several of thesebest practices to better support a target company valuation The best-in-class acquirers focus their initial efforts onin the M&A arena include: developing very detailed cash flow projections, including comprehensive synergy and sensitivity analyses. The best■ Leading companies develop detailed and projections are always fully integrated with income integrated cash flow projections, including statement and balance sheet projections and result in an synergies and sensitivities, since they are the automated cash flow statement. The projection time frame focal point of a complete valuation typically ranges from five years to ten years, with long-■ Top companies identify the ‘next likely buyer’ term growth expectations (based on market research) in order to understand the competitive established for the time horizon beyond the discrete bidding landscape projection period.■ Best-in-class acquirers employ a thorough Internal The income statement models are built upon detailed Rate of Return (“IRR”) analysis, which – in conjunc- revenue (e.g., SKUs, price and volumes) and segment tion with the cash flow projections – provides a ‘build-ups’, supported by specific customers or product spectrum of potential purchase price alternatives opportunities, as well as industry, competitor and market and is a critical component of the valuation analysis share forecasts. The best-of-class will also forecast■ Leading companies also typically develop an expenses on a line-item by line-item basis as well as build accretion / dilution model, which is an important out comprehensive working capital, capital expenditure and depreciation estimates.©2008
  2. 2. Any changes to the base case assumptions can greatly alter the have the discipline to not pay more than an acquisition is worthultimate target valuation. The ‘serial acquirers’ are aware of this to them, the “art of the deal” is to also not pay significantly moreand use sensitivity analysis to present a best- and worst-case than what the ‘next likely buyer’ could pay even though a higherscenario. More importantly, they build a rigorous model that price may be justified due to potential certain synergies or a lowerfeatures expected synergy opportunities. This model is compiled cost of financing, the corporate development staff or transaction team withconsiderable input and execution accountability from operations The ‘next likely buyer’ can be a strategic or financial buyer or(i.e., sales, human resources, manufacturing, engineering, etc.). both since many financial buyers use strategic portfolio companiesCommon synergies include cross-selling opportunities, sourcing to make the acquisition. Since it can create additional value fromsavings, headcount reduction, manufacturing rationalization, an acquisition through synergies combined with its typically lowintegration costs, process improvements, working capital discount rate, the strategic buyer can oftentimes substantiate amanagement and tax savings, among many others. Consideration higher price than a financial buyer. Financial buyers, such as privateof negative market reaction such as potential lost customers is equity firms, use a combination of their firm’s capital and bankalso an important factor. As demonstrated in the chart, sensitivities debt supported by the target’s cash flow to fund acquisitions.are occasionally performed based on probability of synergy Since this type of buyer aggressively uses bank borrowings incapture – from “low hanging fruit” to long-term, difficult deals, they tend to be very aggressive bidders for companies withsynergy projects. positive cash flow. Most financial buyers require an annual return on equity ranging from 20% to 30% over the investment horizon, usually up to seven years. During the valuation process, Best-In-Class Typical Cash Flow Scenarios acquirers should run an LBO model using conventional assumptions in order to gain insight into the likely offer price of Synergies a financial buyer. On the other hand, it is much more difficult to Without Synergies With Synergies understand a strategic buyer’s offer without conjecture about Base Best likely synergies, unless the expected bidder is a direct competitor Case Best Scenario 1 Scenario 2 in which case synergies could be estimated. As an alternative to predicting synergies, companies can research comparable Sensitivity acquisition premiums or precedent transactions (discussed later) Case Base Scenario 3 Scenario 4 in order to assess potential strategic value. Worst Case Scenario 5 Scenario 6 Next Likely Buyer Analysis Strategic FinancialMost skilled acquirers also determine what synergies are ‘buyer- Typical Required Returns on Equity 10% - 14% 20% - 30%specific’ and unique to them and therefore would not be realizedby any other possible acquirer, as these synergies should be Use of Leverage Varies >50%excluded from any analysis applied to derive the purchase price Possible Synergies High Nominal(discussed later). ‘Buyer-specific’ synergies should only be Investment Horizon Long 4 - 7 Yearsconsidered in determining the overall return on the investment.The value of other general synergies, characterized as ‘market-participant,’ will frequently accrue (to some degree) to the The market environment can also provide insights into the ‘nextselling shareholders in a form of a higher purchase price (i.e., an likely buyer.’ Until recently, a weak economy and flat stockacquisition premium to intrinsic or stand-alone value). market kept many strategic buyers on the sidelines, even with record low interest rates. At the same time, private equity fundsA Bid Through the Eyes competed against each other for targets, driven by large amountsof the ‘Next Likely Buyer’ ■ ■ ■ of uninvested capital and the favorable credit markets. In manyIt is important to identify who the ‘next likely buyer’ is in order cases, the financial buyers outbid strategic buyers despite lackingto understand the competitive landscape, since there may be vast synergy value. Over the last year, the dynamic has shifted anddifferences between the price one company can pay versus the private equity firms are currently having difficulty borrowingprice another can pay. In the end, a critical success factor in money in the wake of the sub-prime mortgage crisis. As a result,M&A valuation is not only figuring out the maximum price your corporations with strong balance sheets have been able to docompany can pay but also attempting to quantify the maximum deals, in spite of weak equity prices, without as great a risk ofprice of the ‘next likely buyer.’ While the acquirer should then getting outbid by financial buyers. ©2008
  3. 3. Top Acquirers Set the Price ‘buyer-specific’ synergies or out-performance of the base caseBased on a Returns Analysis ■ ■ ■ projections would be considered ‘deal alpha’ or additional return that accrues to the acquirer’s shareholders.To this point in the valuation analysis, the buyer has developeddetailed projections combined with a ‘scenario analysis’ and has The goal of any acquisition is to maximize ‘deal alpha.’developed a good understanding of the competitive bidding In other words, in a strategic transaction with any expectedlandscape. However, in order to calculate a purchase price offer synergies, tremendous shareholder value or ‘deal alpha’ is createdand evaluate the potential investment, most leading companies if the price paid is less than or equal to the stand-alone value.rely on a detailed IRR or returns analysis. The real challenge ismaking sure the price paid does not exceed the economic value The chart below demonstrates how the IRR analysis yields ato the buyer. spectrum of potential purchase prices. For example, if an acquirer prices the deal based on its own cost of capital and fullSelecting the proper discount rate is the first step in the IRR synergy cash flow projections (see ‘Highest Justifiable Purchaseanalysis and is critical to making the right pricing decision. The Price’ on the chart), the purchase price borders rate can range from a low of the acquirer’s weighted This should only be done if the buyer feels the auction is veryaverage cost of capital (“WACC”) to a high of the target’s stand- competitive and that the acquisition is integral to their overallalone WACC. In most instances, the investment hurdle rate falls strategy. Any price paid based on assumptions below thesomewhere in between. Specifically, an investment’s hurdle rate acquirer’s WACC or above the full synergy model will likelyis typically equivalent to the acquirer’s cost of capital or WACC destroy shareholder value. Conversely, a transaction that is basedplus a risk premium to reflect the target’s specific risk characteristics. on very conservative assumptions and a high expected rate ofThe risk premium should include any sources of additional risk return will almost always be very accretive to the acquirer (i.e.,that are specific to the target, such as lack of management depth; high ‘deal alpha’). The red and blue ovals signify the customarylack of product, industry and geographic diversification, etc. In range of purchase prices offered by strategic and financialaddition to these factors, a small stock risk premium (above the buyers, respectively. As illustrated, the financial buyers typicallyreturns on large-cap companies such as those in the S&P 500) offer lower prices due to their lack of available synergies andmay be present, since investments in small companies are clearly leverage limitations.riskier than investments in large companies, everything else heldconstant. In a lot of instances, the size risk premium can besignificant, but is oftentimes ignored by the acquirer, since the Spectrum of Potential Purchase Pricestarget usually becomes a subsidiary of a larger, more diversifiedorganization. Based on information compiled by Morningstar,Inc., the historical additional size premium on equity for companieswith a market capitalization of less than $365 million is greaterthan 6%1. A frequent error made by strategic companies is pricingtransactions at their own WACC exclusive of any extra riskpremium, which ultimately results in potential overpayment andmakes hitting the projections all the more important. The acquirer’slower WACC can be considered a financial synergy and utilizingit to price a deal effectively transfers the financial synergy to theseller in the form of an incremental purchase price increase.Another important aspect of the IRR analysis is to identify whichcash flow stream to use in order to develop a purchase price. Asdiscussed previously, companies should not include ‘buyer-specific’ synergies in the returns analysis, in order to preventthese synergies from accruing to the selling shareholders in theform of a higher purchase price. Instead, the best-in-class Lastly, the most knowledgeable acquirers properly modifycompanies will value the target using the base case projections, the IRR analysis for an asset or stock deal structure. In an assetplus ‘market participant’ synergies (see red oval in the chart). As deal, the value of the target has increased because the buyer isa result, the calculated purchase price includes a premium to allowed to write up the basis of an asset to the fair market valuestand-alone value, which is almost entirely equivalent to the paid for the asset, which results in lower taxes due to higher‘market participant’ synergy value. Also, in this scenario, any tax depreciation.1 Morningstar, Inc., Stocks, Bonds, Bills, and Inflation Valuation Edition: 2008 Yearbook, (Chicago: Morningstar, Inc., 2008).©2008
  4. 4. Accretion / Dilution ■ ■ ■ For example, let’s assume the deal is priced at 10x EBITDA and implies a 40% premium. How do you know this is reasonable?Most strategic buyers, especially those that are publicly-traded, The first test is to compare the implied multiple on the proposedare sensitive to earnings per share (“EPS”) and will not make an transaction of 10x to multiples of: a) comparable publicly-tradedoffer that causes EPS to be diluted for an extended period of peers and b) recent similar M&A transactions, keeping in mindtime. As a result, the best-in-class companies build dynamic that the multiples implied by transactions will include some levelaccretion / dilution analyses, incorporating cash flow and synergies; of control / synergy premium whereas the multiples of theform of consideration (i.e., cash versus stock); and amortization publicly-traded peers will not. Under both methodologies,of intangibles and goodwill; among other considerations. differences between the risk and return characteristics of the target company and the selected comparables must be considered.Out of all of the model variables, the purchase price allocation The second test is to compare the implied deal premium of 40%has one of the more significant impacts on the accretion / dilution to premiums observed in acquisitions of publicly-traded companies.analysis through the identification of amortizing intangible Such premiums can be examined by type of interest (controllingassets and the ‘step-up’ of fixed assets, which results in higher vs. minority), transaction size, industry, type of transaction (e.g.,depreciation and amortization expense. However, estimating go private), accounting adjustments can be a complicatedprocess, as most adjustments are deal specific and dependent Conclusion ■ ■ ■upon numerous variables (e.g., purchase price paid, specificassets acquired, expected synergies, asset valuation methodologies, The valuation of a potential target in a competitive process can beaccounting promulgations, etc.).2 As a result, the proficient a complicated exercise. Making it more difficult is the fact thatacquirers often engage a third-party valuation consultant prior to the buyer is simultaneously working with tight deadlines andthe close of the deal in order to obtain an informed estimate of performing a lot of other due diligence. Further, some companiespost-transaction adjustments, which in turn improves the accuracy decentralize the M&A process, where business unit heads takeof any pre-transaction analysis presented to the Board and may the lead, which produces more stress as these individuals havehelp mitigate the risk of entering into a potentially dilutive many other operating priorities. In order to streamline thetransaction. For example, the detection of in-process R&D, an process, the best-in-class companies take a comprehensive andintangible asset that under current accounting conventions must be consistent approach to valuation issues, such as the projections,expensed at the time of the deal, could make a deal very dilutive. competitive environment, hurdle rate, IRR, LBO, accretion / dilution, pre-emptive purchase price allocation, and reasonable-An accretion / dilution analysis certainly has its limitations, as it ness check analyses. By applying these best practices and strictdoes not focus on fundamental value and is performed over a valuation process discipline, corporate development professionalslimited time frame (typically 1-2 years). Moreover, the EPS of a and Boards can steer their companies to the best acquisitions atfirm are impacted by accounting conventions and regulations. the right price.Some argue that the market is savvy or efficient enough to ‘seethrough’ this analysis, but the fact is that accretive transactions For many companies, recognizing that the M&A process isare generally well received in the market. Additionally, the complex, outsourcing key services, such as the valuation, maymarket will ‘forgive’ dilutive deals if clear rationale is given or if make sense. An acquirer that hires a third-party valuation expertthe company can earn its way out of dilution within a reasonable that is well versed in these types of transactions can help ensureperiod of time. Despite its shortcomings, the leading companies they enter deals that create shareholder value (or generate highwill utilize this analysis since EPS is a key measure on Wall deal alpha), not destroy it.Street, and it can serve as a proxy for the creation / destructionof shareholder value.Results can be Tested Against MarketMultiples and Acquisition Premiums ■ ■ ■Testing for reasonableness is another best practice that we haveobserved in the corporate M&A field. After deriving a purchaseprice, the best-in-class companies compare it to prices or premiumspaid in the market for similar assets. It is important to note thata bid price’s failure to pass the test (i.e., high implied premium)does not automatically mean the value is unreasonable, ratherfurther justification is required.1 Dominic Brault and Jason Muraco. Purchase Accounting: Corporate Development’s Bane. Mergers & Acquisitions Journal (May 2008). ©2008