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  1. 1. IB Essential ReferencesPrivate equity The core characteristic is financing the equity of firms, private or listed with the purpose to delist them; the exit strategy is usually an IPO and the managing rule can be to get involved (Hands on) or to leave the daily management issue to the entrepreneur (hands off). Some comments on the business structure: o VC type of business is the one that is focus on the early stage financing of corporation  In this category there are different kind of PE, there are some called Angel which are specialized in financing start-up with seed fund  This field is characterized by the difficulty to value early stage company, on which you cannot use Cash Flow based instruments. A possible solution is the Venture Method o LBO type of business which are focus on late stage financing which are experimenting some sort of distress or decline in market value or it is focus on company with stable and low growth rate, hence on company which enable to sustain an high leverage degree  A possible competitor is the hedge fund industry which competes in the distressed company field. It Must be noticed that this different kind of institution highly use derivatives, leverage and trade in public securities  There are several labels for this deal depending on the initiative of the action  The key elements of a company to be a LBO Target are: Mature market Strong market position Good management Idle cash there are inefficiencies that can be solved Low growth Presence of non-core asset to be disposed Low leverage o Some comments on its evolution  Nowadays this kind of business in the LBO part have suffered due to the credit supply reduction, the crisis has reduced the volume by more than 5 times,  The VC side of the industry have maintained the level of the pre-crisis and it is becoming one of the major source of financing for start-up and one first type of business  The big LBO funds are looking for new resource by joining forces with Sovereign wealth funds  There is no market leader, there is a big fragmentation since there is no big benefit form economic of scale o The performance for this industry are measured using two instruments that must be used to compare fund performance only by vintage period:  The IRR should be calculated only at the end of the end of the fund, however sometimes it is computed on-life measure  Cash multiple is a fast and simple measure of return  Both measures can be represented gross or net of the management fee or carry on unrealized/realized investments base Legal structure and rational behind it [US case and Italian one] o The LP and GP US form, where the first gives the money and the last will provide mainly with their competence on the field working as management. There will be one legal entity o The SGR and closed found Italian solution consists on creating two legal entities 1
  2. 2. o Both the legal form share a common rational which is to guarantee:  The investor must not be liable for the fund investment  These legal forms have a limited lifetime, so that the management is always obliged to rise new fund, so that they are aware to maintain reputation  properly behave  The committed capital is underwritten by LPs, but GPs usually contribute 1% of the total amount. This habit is a residual from previously legislation. It is common in the first or very big LBO funds to place notes rather than cash. In some case the GPs will make larger investments as in the first (to overtake the difficulties to raise enough money) in effort to show his commitment  The lifetime is usually 10 years, there are three main are: the pre phase where the management will raise new funds, the investment period and the management of the investment/divestituresCompensation and alignment of interest between LP and GP o Management fee is usually computed on the committed capital. This money are used to pay for the due diligence process and for searching new deal  Lifetime fees are the total cost for paying management fee. They are used to compute the invested capital and to assess the breakeven of the return on investment  There exist several variant on their payment reflecting the increase competition in the market o Carried interestis the real payment for the PE management. It is computed over the capital gain over the committed or invested capital, there are some possible features:  Hurdle rate: consists on granting a return to the LP prior to any management carry payment  Catch up clause: once the priority has been paid the additional flow are paid to GP so that the total cumulative capital gain division will be the same as there won’t be the hurdle at beginning  Claw back: it is a clause to grant to LP to take back from management any prior payment which are not justified by subsequent time evolution  there are fiscal and practical problems o Over all restriction to fund  There are restrictions on the size of Investments in any firm. These covenants have been made both to ensure that GPs do not attempt to save poor performing firm by investing more money on it and to ensure a minim diversification requirement  lowering the risk (volatility), to avoid the “dice problem”. There are many ways to do that: define percentage over the committed or assets value, or define an aggregate maximum exposure  Others covenants have been made to avoid indiscriminate usage of leverage. The most common restrictions will set certain percentage over committed or assets value or they will restrict the maturity of the debt to avoid any long term exposure.  There are restrictions on the co-investment between funds managed by the same GPs. These covenants will prevent any opportunistic behavior as in the circumstance of restrictions in the investment size per firms  save poor performance or increase it in effort to show better number in the next fundraising process.  Often there are covenants relates to reinvestment of profits, because the GPs fees are mainly based on the value of investments. o Restriction on the GPs’ activities:  GPs can’t separately invest their fund on LP firms; otherwise they will devote excessive time on these firms. Contracts could set different way to deal with this problem starting from totally forbidding any investment opportunity to seeking permission from advisory board or LPs  GPs can’t freely sell their stocks on the LP funds, otherwise their incentive to perform well and to monitor will decrease  Others restrictions on GPs are on future fundraising timing, because thanks to this the GPs will earn more management fees and this could reduce their incentives  Often the LPs could require more limitation on GPs extra activities. Usually these restrictions are set in the first years or for set of certain percentage of capital is invested 2
  3. 3.  Another class of covenants are related to the addition of new GPs. Less experienced GPs could reduce the oversight provided by the funds, as a result many funds require that new GPs be approve by either the advisory board or a set percentage of LPs  Many issue regarding GPs’ behavior are addressed thought other means, for example the vesting period of GPs’ interests will ensure LPs that GPs won’t leave the funds as soon as it has been formed o Restriction on the type of investments.  There are limits on the maximum investment on the same asset. However usually contracts allow some exceptions  The LPs will try to limit the possibility to invest in public securities or in others PE funds; otherwise the GPs fees aren’t justified.Form of control and alignment of interest between corporate & entrepreneur with PE o Covenants are contractual agreement made to avoid some misbehavior such as selling some asset or change in the management/control as well as key variables  The positives ones will offer incentive to produce reports, correct behavior, and fillthe entire obligation…  The negatives ones will restrict or limit detrimental behavior in effort to avoid increasing in the risk profile or preventing sweetheart deals for entrepreneurs’ friends  Change in control covenants will ensure the investors from any opportunistic behavior, usually any decisions must be approved by the investors  There is even the possibility to define a mandatory redemption rights in effort to force the liquidation or the merger of the firms  Define the number of board directors appointed by investors o Anti-dilution clauses to preserve the PE stake value in the company, this clause is really costly for entrepreneur, hence may undermine the investment evolution, in fact the entrepreneur can be reluctant to ask for more money. There are different possibilities:  Full ratchet: it is the most expensive; all the dilution is taken by entrepreneur. It consists on dividend the amount invested by the lower subsequent price paid in future tranche  Weighted averagewith narrow or broad base: both the approach lower the dilution for the entrepreneur (the last more). It consists in the correction of the original price by whom the past % ownership has been set. It consists on: o o o o Retribution of the entrepreneurs can account of different possibility starting from vestingto more sophisticated payoff of the PE stake to ensure higher return subordinated to some goals o Type of share issued in the PE industry belong to the general family of the Preferred stock, this choice has been made to grant to PE the first stake of liquidation procedure (a sort of capital guarantee against failure or misbehavior of the entrepreneurs)  Convertible Preferred stockgives the possibility to the owner to convert his preferred stock into common stock. The owner must decide either to exercise the convertible option or to retain the ownership over the preferred stock. This instrument will be less expensive for entrepreneurs. Usually contracts define both anti-dilution covenants, which will grant automatic adjustment in the conversion rate and mandatory conversion term before any IPO to match the underwriters willing. The drawn back of this instrument is the high implicit cost for all the following investor that will pay substantial higher price than previously investors  Redeemable Preferred stockshas no conversion right into equity; their value is only their face value plus any dividend rights they carry. Usually the PE transactions foresee a combination of common stock or 3
  4. 4. warrants plus the redeemable preferred. This will grant to the PE funds both earning in the preferred stock and in the common ones. This tool is very expensive for entrepreneurs, so there has been doing a shift to others market instruments.  Participating convertible preferred stock grants the right to receive both preferred stock benefits and equity participation as if the stock were converted. This instrument is usually issued when companies feel the IPO market as hot o The subsequent tranches are always senior to the first one. Important features in this area are the concept of pre and post money. These “words” are linked to the pricing of the new tranches, meaning it is the recognized value by the investor pre-moneyand the total value of the company after the investment post-money The VC method is used to price start up (high uncertainty don’t allow to use classic valuation methodologies) by assessing the stake of share needed to achieve the return desired correct by the risk o The PE needs to forecast a possible exit price (best scenario) usually really big, than will correct this big number by a big discounter factor considering risk and dilution for future tranches. Two big error in two different direction hoping they will cancel out o The ending number will the post money valuation, it will compared with the money invested by the PE and the PE will compute the % share ownership required o The dilution effect must consider the excepted future ignition of capital. Retention ratio o This method has been criticized because it is really conservative to evaluate the entrepreneurs ‘ project, it is basically imprecise, actually is double time imprecise in effort to compensate both the mistake The LBO Method is the one used to value a deal with high leverage usage o Creation of the SPV which will be fund with PE money and debts. The usually D/E ratio 30/70 at most, it is usually linked with the EV/EBITDA multiple. Each classes have its own source of value (senior, interest and principal, mezzanine, interest principal and equity kicker, shareholder exit value) o The SPV will acquire 100% of the Target’s stocks. There will be a pledge on the Target stock (guarantee the debt owner) lasting till the merger. o There will be the merger between the SPV and the Target. The existing debt is usually repaid back and substituted by the LBO debt financer  Senior loan: is reimbursed with yearly payment  Usually there is a cash sweep provision: no payment to shareholder till senior debt is repaid  The mezzanine debt is usually repay with a bullet repayment and they carry a warrant  Vendor Loan are sometimes used (even in M&A)  PIK = first interest payment are paid at maturity o The sources of value on this deal are:  Deleverage: the repayment of the debt will increase the equity stake  Arbitrage: the exit multiple will increase at exit (no internal motivation, just market evolution)  Growth: the EBITDA or the key variable used to assess exist value has increased over time o To compute the maximize affordable price of an LBO we need to assess: terminal value, debt capacity and return required  the debt capacity plus the present value at exit is the max price  The debt capacity is the max senior debt that at given date will be zero o The case is the MediaMedia, its main features are:  Presence of Vendor loan with PIK first two years  Low tangible asset (10 mil) more of the value was intangible  There has been the usage of the ECU (first time)  It is a MBO, the management buy the D&U division  The convenience has been computed by valuing the IRR for each investors category, focusing on equity Tax, deleveraging, growth, spread and fee costIPO [Equity] 4
  5. 5. The ECM division is specialized in providing services following a matrix structure: by deal (IPO or seasoned) by customers(Corporate, sovereign). It is a business area where economic of scale matter a lot, there is a minimum issuing size o IPO business characteristics and features:  Rational of an IPO, going public. There is the tradeoff of achieving some advantage (below reported) and the cost of going through the IPO [underpricing cost, fee to be paid]and cost related to the new status of public company [disclosure requirements, governance issue (more vulnerable to change of control for company with big floating) and be subject to supervisory control] Cash reasoning: rise fund or rise foreign currency Extra cash: reputation/gaining visibility, management compensation and shareholder liquidation  The IPO market moves in waves and there is the general rule to be the first to meet the investors’ appetite at the highest level  Elements that determine success of an IPO are (and must be properly addressed –crispy): Market Leadership Strong Management Solid Financial Position Corporate Governance High Level of Visibility and Disclosure Liquidity Interesting Valuation  What can be sold & technical words Primary or secondary offer: the share sold are new or old one (the old investor are cashing out) Domestic or foreign offer: it is related to the people that are buying the share not to market in which stock will be traded o Rules 144A allows to company to sell in USA their stock to accredited investors without the registration burden stone Onshore or offshore offer: which market will be chosen will depends on the level of the domestic market compered to international one (small or inefficient), the presence of a niche in other market, the market of the company is in a foreign market (be close to the final consumers) o To avoid a direct (costly) listing in USA there is the ADRs issuing. This instrument pays dividend in dollars a cheap way to diversify the risk. They can be sponsored by the issuer or not (in this case the registration is required). The limits are the flow back to original market (liquidity dry out)  Procedure forpricing, difference among countries and possible forms Auction is not really used in the market. There are two possible price mechanisms: the uniform- price and discriminatory price. o The free rider problem is solved by saying ex post a level above which the offer is cancelled out. There is still the case of coordination of fee rider o The action has the winner’s curseproblem  win but regret of the price o The French empirical case:  There could be a minimum price or open price or fixed price  It is an hybrid approach, but it still grant higher transparency Fixed price offer is the initial EU approach (privatization), but nowadays is really rare Underwriting agreement [US style] may take as long 6 months. The incentive of correctly price is the watch maker anecdote o Preparation: (pre-agreement Underwriting contract) there will be the preparation of the prospectus and all the due diligence needed to produce the equity story history, assessing the risk run by the business, description of the future advantage and evolution 5
  6. 6. of the company (competitive advantage) and to produce the first price range (business due diligence) and to properly meet all the disclosure requirement and legal form (legal due diligence)o Approaching the market: the pre-prospectus and pre-IPO report are publish (the IB cannot issue any other report on the company). The company will ask to authority for authorization and in parallel starts to collect info from the market  Pre- Underwriting agreement: it is sign between the part without any reference to guarantee of price  Pilot fishing: collecting info on the price from trusted investors to correct the initial prince range offer structure made  Roadshow: open presentation to all the possible investors in main financial location. Usually there is meeting with all the investors and then a one by one (prevent free riding) just for big player [feedback are important]. It may take two weeks for global, big offer, less for smaller Non bidding offer are collected (however withdraw is a negative signal for subsequent offering). The types of order are: strike bid (money or # of shares), limit bid, step did; each of them will provide different level of information (the best are step) The price is set using the info collected by the institutional tranche non bidding offer. Then the retail investor tranche is open setting a max price and request are collected It is still possible to withdraw the offer without losing credibilityo Going public: the final step consists on decide the correct price, hence the underpricing is decided. The company go public and trading starts  Underwriting agreement: the issuer and IB will sing the contract stating the price, 24Hr of exposure usually for IB  There is the distribution of the share among the different institutional classes, this phase will take into account the relationship with the IB, the size, the type of order posted and typology of the institution (pension fund, hedge fund) Compensate higher info provider Compensate the friends Give to institutional investors (choosing the long term)  In this phase there is the implementation of all the possible instruments used to alignment or reduce/support the price evolution Naked position: the bank will be forced after IPO to cover its short position, but it doesn’t have any call to cover it at IPO price, hence the higher the underpricing the higher the cost o There is the arbitrage of the Book runner to split the cost with the other underwriter retaining all the possible advantage Overallotment or Greenshoes: the presence of this agreement must be disclosure to investors. It consists on giving the possibility to IB to sell more shares at IPO price after the going public. It aims to stabilize the price and to reduce underpricing. Technically speaking the IB will borrow stock, but it has a call to buy at IPO price stock from issuer. o The IB will gain more fee on the new share issued 6
  7. 7. Lock up: it a contractual agreement that force old shareholders to not sell their shares for a given time Bonus share: it consists on giving more share at given time to avoid investors to sell right after the IPO their shares  It is criticized due to its opacity, but it is flexible. Internet bubble critiques Marketing or conflict of interest??  The involvement of IB and the role played by them. Their impact strongly depends on the issue size Production of all the legal documentation and producing the documentation needed by authority to grant authorization The pricing procedure will require a sort of certification of the IB involved, since any mispricing will damage the reputation (and reputation is everything) o It is crucial for IB to properly perform to achieve good ranking in the lead table Each IB will produce research increasing the coverage of analyst on the company Each IB will support the ex-post IPO by providing liquidity/market maker Create the syndicate to sell/distribute and to properly price the stock o Global coordinators: he participate in all the tranches and phase and he will coordinate all the activity (it is usually the book runner) o Book runner task is to run the road show, perform due diligence and build the book o Managing group: is composed by the book runner and joint book runner o Underwriting group (Mangers): it is the group of all underwriters o Selling group (co-Managers): they work at best effort basis and they are used to sell. o Their number depends on the geographical coverage and type of investors involved The distribution fees: the gross amount is divided in underwriting fee, selling concession and management fee (a praecipium 50/60% of management fee may be paid to boo-runner, and the reaming part is then divided among management group) o The selling concession is affected by the discretion power of the book runner in the allocation, hence he will gain more, furthermore sometimes part of the selling concession is pre-credited to book runner the left part (jump ball is left to the other participants o The designation can be made ex-ante (the investors will say which bank should be compensate, the book runner have the incentive to privilege its orders) or ex post (after the distribution the investors will say which bank should be account for) o There could be cap to the max fee compensation of the book runner o There is a penalty bidcharged to the IB responsible if the investor will sell its share right after the IPOo SEOoffer starts when the firms need restructuring resource (emerging situation) or in case of firm transformation (M&A). The main characteristics and features:  Right issue is a form very common in the continental Europe, USA companies usually avoid them It is a longer procedure, it may take 5 month and there must a prospectus and documentation for having the market authority authorization. o Announcement after Board approval, there will be the due diligence process o The trading will start right after the nulla osta form dog watcher institution o At the ending period of trading there will be the subscription period, rump placement The marketing activity and minority shareholder protection against dilution is max The decision on discount is neutral to old shareholders (ownership dilution); the final output is the same (economic dilution). The discount is also neutral to EPS Dilution [new accounting principle oblige to change all the EPS references, neutralizing the operation], trading multiple 7
  8. 8. The market usually reacts negatively to new issuing (the market believes that the company feel the price as overpriced, this will produce a loss for old shareholders) The company will issue rights that will be exchange between investors for a given time. o There is the possibility of “operation Blanche”: selling right to buy stock The value of the rights is the difference between TERPand exercise price correct by the conversion ratio, and it must be like that otherwise arbitrage are possible o o The new stock issuing is at discount: the gross discount is the difference between new issued price and old one; the net is the discount to TERP o The rational of the discount is to avoid that the fall of the price will reduce so that the rights doesn’t have any intrinsic value. It is higher if the market is really volatile. The presence of a discount is also to ensure to the company to collect money, hence there is a tradeoff between showing strong confidence putting low discount and the fear of failing to collect money or having a strong dilution effect on old shareholder given up rights to subscribe new emission The unexercised rights will create the rump placement, meaning they will be placed to investors, the underwriter bears this risk. This risk higher for small right value and it is binary: all the capital is subscribes or none  Accelerated issue avoid preemptive right issuing It is really fast (1/2 days form board approval): o The IB will start to call investors immediately after the board approval to have view o Before market opening the transaction is announced and book building starts: the market force starts to call everything o In the initial trading day the IB will have a taste on the procedure and will start the pricing of the new offer Market authority authorization needed no prospectus (10% max issue size) Since it is really fast minority shareholder can be penalized (no time to assess the offer)  Private placement consists on issuing new share for a specific investor No need of special documentation or authorization if agreed by the parties The offer is open to selected investors Time is flexible depending on the investors’ number narrow/broad (lower for the first) There is more confidentiality in the narrow, since the brad consists on sending teaser and memo on the offer to many investors (on list)  Bought deal consists on the acquisition of the newly stock directly by the IB which later place them The earnings consist s on the capital gain able to be charged by IB All the risk is on the IB, the issuer is free of risk The main documents to have in mind: o Prospectus o Underwriting agreement  definition of the obligation of the book runner and the condition of the offer o Engagement letter o NDA for investor  providing info on the firm (equity story, competitive positioning) o Business plan and valuation frameworkDebt offering & Syndicate loan Main concept & technicality of DCM division: the main areas are Debt offering and Syndicate loan, sometime even the structured finance (project finance, ABS, leasing and asset Finance, acquisition financing and LBO) is included in this division 8
  9. 9. o The syndicate loan aims to provide resource to big project by a pool of bank. It is seen as a diversification investment for commercial bank providing mortgages  Best offer vs. full underwriting: the risk retained by the banks depends on the model chosen  Joint vs. sub-underwriting. The rule "be the only runner since the building book approach basically reduces the underwriting risk to be negligible, so its possible to retain higher return”. notice that with joint mandate all the book runner are responsible for the whole amount  General syndication vs. sub-underwriting plus general syndication. In the first case the bank will just bank to participate to the syndication providing them documentation (it may last 1 year), while in the second case right after the mandate the runner will call for sub-underwrite (each of those will be responsible for its own part)  it is usually senior to all the other financing sources and those decisions are influenced by relationship needs o Securitization business allow to made illiquid asset liquid. It is the central of the originate to distribute bank business in which the bank is not anymore affected by the loan characteristics  Credit enhancement: internal or external  Cascade flow: tranches are a way to create different risk profile instruments  New source of fund o Debt offers is open to all investor, it is more standardized and it is a market offer.  Nowadays (even due to the credit crunch) there is unprecedented rush from Corporates to substitute bank debt with Debt Capital Markets financing  The instruments offered are long term one usually, divided in two main categories: Fixed rate or floating one are the classical bond Hybrid instruments they have an equity kicker that is the perfect compensation for risky company to reduce the downside risk by issuing instruments less affected by the volatility of the company, the warrant will be positive affected. o They will meet some types of investors needs o Less dilutive than equity offering o Optimize capital structure, half of the emission is considered equity  The price will be affected by the credit score, features of the debt, reputation of the book runner and market condition/similar issuer (even for credit scoring there is a sort of cyclical confidence on them) At opening there is the communication of the product to be sold to main player (initial guidance) The sentiment will assess the demand and there could a correction of the instruments’ features to meet the benchmark size (Revised guidance) Closing of the offering (size Targetannouncement) and allocation procedure (timing of the offer, relationship, type of investors and geographically diversification)Some definitions on DCM market: o Domesticvs.foreign market, it depends on the market and the issuer nationality o Foreign bonds vs.euro bonds, where the last are those which currency is different form the one of the country in which they are issuedHow to structure the offer (process) syndicate loan o The issuer will appoint a book runner (the winner of the bid offering). The section procedure is a two-step process:  The first consists on an initial offer trying to meet the issuer condition. Two strategies can be done: Really aggressive offer to win Offer to participate in second step and show the bank involvement to retain relationship  In the second step there is a correction of the offer using the more info collected on the issuer and there is a better understanding of the cost for the issuer Fees&Interest rate cost determines the issuer cost, they will reflect: 9
  10. 10. o Condition required: subsequent Capex, presence or not of sweep condition, collateral provided, and credit outstanding of the issuer,.. Facilities provided, tranches and cost: o Revolving debt to finance the working capital o Terms loan to finance the installment cost o Bridge loan for short term window to be repay by a new financing instruments Covenants required by banks o The winner will invite other bank into the syndication presenting them the products elements (maturity interest spread, other features) and the fee compensation scheme  It is crucial the reputation of the origination bank that knowing better the issuer may have the incentive to sell bad loan to other banks  The seniority and fee compensation will depends on the amount bid (there is a minimum requirements) o There will be the feed distribution:  Arrangement fee compensate the origination process and it is computed on the committed capital  Closing fees compensate on the credit screening. Since junior put less money, they will receive less than the closing fee, the residual pool income is divided evenly among seniors  Sub-underwriting fees compensate the underwriting risk o The syndicate participant are classified:  Arranger bank/book runner  Co-arrangers  banks providing money (final take)  Manger banks  Underwriter banks The role of credit ratingis central due to the minimum credit rating for some institutions and it is need to assess the capital requirements and it is a good proxy for spread apply to the instruments o The case of slip rating will increase the uncertainty and the issuer will suffer form it o The rating is paid by issuer, but can be unsolicited (a sort of brides) o The credit scoring is function of industrial specific elements and Target financial situation and positioning The case is the Hong Kong, its main features: o The equity providers are Disney and Hong Kong o The debt providers are: subordinated (Hong Kong, good condition: long maturity first payment after 11 years) and syndicate loan (Term + Revolving; small part of the capital structure) o Winner bank Chase with a bid strategy (participate not too aggressive)M&A The M&A provides to firms services in order to maximize their financial policy, hence the core activity is to provide pure advisory, however the customers habit (one stop-shopping)push the industry to create conglomerate or create alliances between boutique and commercial banks. The sector characteristics are: o It happens in wave, based on the idea of informational cascade: the first mover will signal to the other competitive the profitability of similar actions. Low interest rate are usually a key driver o It is industrial cluster, meaning each sectors has his own rules o It is usually a reaction of market unexpected shocks o The M&A is classified according to the participant: horizontal, vertical and conglomerate o The tender offer is the direct offer to the Target shareholders, it may be hostile and it will come up with a M&A only if the minority will be squeeze out o The Takeover is the generic term to indicates the change of control. In proxy contests a group of shareholders attempts to gain controlling seats on the board of directors by voting in new directors. A proxy authorizes the 10
  11. 11. proxy holder to vote on all matters in a shareholders’ meeting. In a proxy contests, proxies from the rest of the shareholders are solicited by an insurgent group of shareholders. o Market reaction (empirical study base on Cumulative Abnormal return; event study) is cold for bidder, great for target, since achieving the expected synergies is hard  Request of Financial certification reduce the market sentiment (bad signal)  The cash acquisition have a better outlook for market participant (debt discipline on management)  Stock offer signal the overpricing of the bidder stock (negative)Rational to external expansion. There are several reasoning, all linked with the general idea of achieving synergies: o Increase the market power of the company o Create a larger company to better implement economy of scale [Roll up strategy] o Acquire Know-how and new products [Pick winnersearly and develop them] o Faster growth in new market [geographical expansion] o Consolidate to improve competitor behavior, meaning create oligopoly, which is hard both because the law is against this behavior because the company must be able to avoid new entrance in the market o Enter into a transformational merger, meaning use the M&A to totally modifying the underlying business, refocusing the business o Buy cheap business in down economyAssessing the Target’s value is the key element, IB will help company in this hard/art task: o The price may different form the theoretical standalone due to synergies and competition:  The Bidder needs to assess the fair value of the firm  The Target want to define the max price at which the Bidder is willing to buy  Since the value creation (synergies) is random and the market habit is more favorable for seller, the bigger part of the value is retained by the Target shareholders o There can be used several different methodologies starting from the classic DCF to multiple analysis depending on the type of transaction (minority or majority)  DCF allows to develop scenario analysis, offer a detailed analysis on source value creation, however is time consuming and really on heavy assumptions  Trading Multiples (Common stock Comparison) is really simple and fast to be compute and present, however really on the assumption on efficiency of the market Compare cash flow with the correct base Use the correct indictor to assess EV or equity value (i.e. for the first the flow must be the one available to all the investors)  Transaction multiple are better than trading one because they take into account the synergies valuation, however it is hard to find out comparable or similar market condition o The acquisition can be focused on asset or stock of Target firms:  The Bidder absorbs the Target that ceases to exit (forward merger)  In a reverse merger the Target is the one acquiring the Bidder  There is the case of consolidation the Bidder and Target cease to exist and a NewCo will be created  Forward triangular merger is the case of the creation of a subsidiary that will merger with Target o The extra money paid over the asset value is called Goodwill, there are some accounting issues:  The acquisition method: Goodwill is allocated to Cash Generating Units (CGUs). It is subsequently tested for impairment annually (rather than amortized). According to IAS 36 an impairment loss exists when the asset’s carrying amount exceeds its recoverable amount, where recoverable amount is the higher of its value in use (DCF) and its fair value less costs to sell  The partial approach: Goodwill is measured as the difference between the cost of acquisition for the Bidder and the fair value of share of net assets acquired, with the partial approach goodwill is considered an “unexplained” part of the Bidder’s investment. 11
  12. 12. Valuing synergy is a hard task since there is high uncertainty on the possibility of achieving them. Empirical research showthat the Bidder didn’t managed to meet its forecast o The synergies that increase the cash flow: Operating synergies  Cost sidemust be structured using disciplined methodologies, meaning we should allocate any improvement to a specific items, being clear and focus on how to achieve it. It is crucial to involve the experienced line management, and to compare the combined result with the comparable benchmark to avoid unrealistic plan  Revenue side must consider the possible loss of clients and value manger in the operation and the possibility to incur in additional cost to uniform the business model. Be explicit about where any revenue growth is going to be obtained  Empirical result shows that company are quite good in assessing the cost saving, while they are too optimistic on the revenue improvement side o The synergies that reduce the cost of capital: Financial synergies  Lower capital cost  Better capital structure  Different seasoning evolution o It is crucial in assessing synergies to take into account:  Timing need to achieve synergies: it is important to understand that any value source are not be on the table forever after the merger, hence it is crucial to capture all of it as soon as possible  Have an industrial view on the possibility of those forecasts  Possible destruction of value: loss of valuable human capital, loss of clients…  Old creditors may want to be reimbursed since the credit standing may changeM&A contractual features, procedure and IB involvement; Some briefly definitions: o The parties involved in the M&A transaction (besides the obvious) are chosen after pitch book presentation showing the expertise, past transaction and possible Target/Bidder divided into financial and strategic.  The compensation consists of two fees: retainer and success computed on the deal size. However the higher the fee the higher the speediness of the whole process  The role of the IB is to reduce asymmetry between firms and to provide a certification. There is empirical evidence showing that the higher the reputation the faster the transaction Legal advisor Financial advisor only for complex transactions Accounting advisors (auditing) Valuation consultant  The decision, beside reputation, is conditioned by previous relationship and the reputation of the bidder advisor (fear to be jeopardize by greater skills) o The first big difference is between hostile or friendly tender offer, where the first will call for defensive tactics. The M&A initiative can be from the Target(liquidation) or from Bidder(strategic or financial)  Private transaction main steps and documents Confidentiality agreement is the documents used to exchange reserved information[CIM] (written or oral) and there is the obligation to keep confidential and destroying/give back at the end [BCA] Letter of interest is the Bidder first proposal stating the value range, acquisition structure conditions and so on. It not legally bidding o There could be the Staple financing used by Targetfinancial advisors Due diligence is performed on the Target (i) before defining the acquisition contract (preventive due diligence), and/or (ii) following the signing of the acquisition contract (confirmatory due 12
  13. 13. diligence), Main analysis areas (variable according to the Target’s business) are: Legal, Fiscal, Accounting/Financial/Business, Insurance, Environmental and Real estate o It is created a digital data room where Bidders can vision info, Target can check what the Bidder is going to check and how much time is spent on it o The final report is long/summarize everything. Its production is helped by a Check list Negotiation of the contract and other potential ancillary agreements (acquisition contract), it is the core of the transaction, it states all the details: Parties, Premises [analytical description of the phases that have brought the parties to the acquisition contract], Definitions, Object, Price and potential adjustments, Conditions, Management of Target between signing and closing, Assets at closing, Declarations and guarantees, Indemnification mechanisms (cap, exemptions, timing limits, procedure),Final dispositions (non-competition, confidentiality, partial invalidity, costs, amendments, communications, tolerance) and Applicable law, relevant Court, arbitration clause o This documents must be authorize by market authority and anti-trust o There are several clause that clearly define when a why a counterparty can withdraw from the transaction and the guarantee provided by the Target o There are usually attachment and ancillary agreement between parties o At closing the transaction is processed and all the covenants are implemented, there could be a fairness opinion asked by Bidder (market is cold in this case)  Competitive auction: they are usually multi steps bidding, rules may change Before the CIM there is the teaser: some info without disclosing the Target name, all the companies that are willing to proceed must sing the Confidentiality agreement Information Memorandum produce by the Target is a very detailed description After these Target movement the Bidders will post their no bidding offer providing a range valuation here there is the difference between financial (looking to a certain IRR and debt capacity) and strategic (synergies) o Due diligence in this phase is usually limited o In this phase the financial advisor of the Target may offer a staple financing (Target usually forbid this practice, conflict of interest) Short list will be created and more info will be disclosure o Data room will be created o Complete due diligence Process Letter&Binding Offers Negotiation of the contract and other potential ancillary agreements [DMA]  Tender offeris usually a public offer (OPA) Confidentiality agreement Letter of interest Due diligence only sometimes (often missing) Negotiation of the main agreement and other potential ancillary ones Buyer’s information document if the Buyer is listed (if the transaction is “relevant”) Documentation for the OPA procedure (comunicazione102, offer document, cash confirmation)o The EPS accretion/dilution&P/E indicate the positive/negative effect of the transaction on the combined entity, this valuation depends on the mean of payment used for the transaction  Just cash the Target’s P/E should be compared with the implied P/E of the “cash” or better of the additional debt used for the acquisition Implied “cash” P/E can be calculated based on the following formula: o P/E cash=1/[(cost of additional debt for the acquisition)*(1-corporate tax rate)] The combined earnings must account for the cost of the new debt un deducible 13
  14. 14.  Blend no exercise or example proposed  Only stocks we will compare the implied P/E at transaction of the Target with the one of the Bidder We need to assess the combined earnings The number of share issued by the Bidder Compute the new combined EPS given the first two number: # new share/earnings o Price is not the only variables that is considered to decided which will be the winner: reputation, guarantee …How to pay and criterion on how to choose among them. There are two “consideration” *mean of payment available+,which have to take into account tax liabilities or other implications: o Cash payment can result in a lower premium compared with stock one, but there could be some financial constrain for the buyer  In case of a possible loss or misleading valuation of the value creation there is no possible compensation  The tax issue may be accounted since the old investor must paid tax on capital gain o Stock payment (the Bidder will exchange own stock (newly issued) with those of the Targetone) is a little bit more expensive, but there is the sharing of risk, so if you are not confident enough confident this method is the better, otherwise cash.  If the buyer’s P/E is greater than the Target’s P/E, the deal will tend to be accretive since the buyer’s currency is more valuable than that of the seller  The theoretical exchange ratio = pT / pB, the number of new share need will be outstanding share tie the theoretical exchange ratio  The maximum exchange rate for Bidder  The minimum exchange rate for Target o Blend payment are possible, their valuation performance is valued:  First we will consider the ex-post number of share needed to be issued (%of the price paid by stock)  We consider the cash payment and we will compute the aggregated value of the cumulative company, divided by the number of ex-post shares o There are other mean of payments to solve specific problems:  Vendor loan: sometimes Bidderdoesn’t have enough resource (multimedia case), hence the Target can help by providing a loan (usually really cheap condition)  Convertible: it is a compromise between cash and equity  Earn-out: it is more complicated and it is a sort of postponed payment related to the Target performance without issuing equity. It is a good compromise The Target will lock in a base value, and will participate in the upper side o It can be set on the overall business(warrants) or just to the Target one (contingent payment), each of them have its own advantage and cons The transaction can be speed up thanks to this clause The parties must decide how will be settle the compensation and the measurements of performance to be used o There could be problems on monitoring, external events and rise of conflict of interest. o That’s way it is crucial to properly address all the possible situations/problems It is possible to hedge this risk by using a collaroption to avoid downside by forgo the upper side. This may be good for the Target to reduce the volatility  Squeeze-out: the option to force minority with less 5% if the OPA reach 95% to sell  Sell-outright: sell the reaming 10% at the same condition 14
  15. 15. Defensive tactics allowed for Target are country/area specific. There is the conflict of two principles: the efficiency of the market and the protection of national or valuable situation.In EU the new Takeover bid clearly define which tactics can be implement by Targets and Bidders, here there is a list of the most famous and used one: o White knights the Target will ask to another firm, which is consider friendly, to bid for the transaction o Golden parachute or silver one the Target grants to top management big compensation in case of hostile takeover, this rules is usually set to protect executive that will be fire after the transaction o Poison pillow the board will issue new stock at discount to increase the cost for the Bidder o Crown jewel the Target will sell all the valuable asset to other and will cash out o Labor agreements  they can hamper the Bidder possibility to effectively change productionDivestures area: Even if divestures create value and there are several empirical evidence that companies employing balanced portfolio approach perform better than companies that rarely disinvest, this procedure is undergo only due external pressure not for a proactive program o The management are typical against divesture due to the general idea that disinvest means failing and reducing the size of the company is a negative prospective(salary) o It could be hard to find an alternative for the proceed, in fact holding cash will lower the performance, repay debt will be the same of invest at the debt cost, which is usually by far lower than asset return and buy back stock can be problematic as well since the market can react negatively (the company doesn’t have future project) They happen in wave as M&A and nowadays public ownership transaction have become the principal mean for disinvesting  higher market capability/efficiency Sources of value are: o Disinvest form a underperforming business avoids the direct costs of bearing deteriorating results o The subsidiary can be morecompetitive or better managed under other ownership o There is the possibility to take advantage of asymmetric information o The possibility to focus on the core business Problems solved by divesture: o There could be the case of an incompatible culture or even a possible conflict of interest in managing the subsidiary business o The parent could not have the experience and skill to develop properly the business o Underperforming business brings down the value of the entire corporation To properly disinvest a company must dedicate regular and dedicated session for exit review meeting, forcing the management to evaluate all business: o The first step is to understand the entity of synergies and shared asset, services and system, in this way the management can understand which is the cost of the operation o The mixture of different type of business allows to reduce the operating risk, and this will grant an higher financial capacity o If the operation is undergo is really important to understand and well define the legal aspect of the operation to avoid any slow down during the transaction or unpleasant surprise after the transaction o Consider the market valuation to discover if there is a significant mismatch between intrinsic value and current valuation (exploiting asymmetric info). In a sense liquidity in the market allows divesture to be more attractive Type of transaction can be private or public, the first one is better if you can identify a proper Bidder, not all the transaction bring a cash proceeds, many create long term value by giving new share to existing shareholder: o Equity curve out: in this way the parent doesn’t give up control on subsidiary, to maintain same synergies  However, the separation is typically irreversible, due to possible dilution of parent ownership, hence it is important that parent executive need to plan a full separation since the beginning of the transaction 15
  16. 16.  The risk of unclear governance is present in this type of transaction, and this can destroy the benefits that were supposed to happen. Any subsequent reacquisition is typical a negative sign and empirical research shows that any blend strategy doesn’t grant positive return for the shareholders o Spin off: the parent gives up the control of the subsidiary, which shares will be divided through parent shareholders. This type allows the maximum strategic flexibility for the subsidiary. Sometimes this transaction is done with a two-step: at first a partial IPO followed by the spin off, this typology allows the existence of a market for the parent shareholder in the case they want to liquidate their stake  The subsidiaries show the higher performance improvement (empirical test) o Split off is an offer to parent shareholder to exchange their shares with those of the subsidiary, so the equity will be divided o Tracking stock is a new possibility that allows the parent to retain control, but create severe problem of governance, in fact the board will be the same  Each entity will liable to all the group debt, hence there is no financial advantage, furthermore empirical research have proven that there is no value creation for this transaction o IPO is the way the new share are issue in the market to new investors o Joint venture and Trade sale are the private transaction The case is FIATdemerging, the main features are: o FIAT business consists of two different businesses: Industrial and Auto; those business have different featured and risk profile (Auto much riskier and cyclical) conglomerate Dilemma o The Management believe that the aggregated value was lower than the standing alone, the market discount the risk of default of Auto which will destroy value even for the good business Industrial o The results has been positive, after demerging the two company traded at higher level than before o There has been a comp comparison to assess the undervaluationFinancial distress & action to be taken Key elements to be understand & technical words o It is a country specific issue  USA reference: Ch7: liquidation procedure in case of debtor failure to separate personal asset form corporate one, Ch11: continuing operating for the company with a restructuring plan [court must approve it within 120 days, the majority of the creditors must approve, there is cramdown if in the best interest of all creditors], Ch13: liquidation procedure by installments [3/5 years]  Italian reference: Accordo preventive, decreto Marzano, Amministrazione straordinaria: all this procedures are similar to USA Ch11 o There isn’t lots of literature on this topic o It is an holistic job, it needs to be performed knowledge of fiscal, industrial, financial and relationship ability to coordinate creditors and to properly communicate the plan to all the parties involved Typical problems & evolution of the corporate crisis o The company starts to suffer of inefficiency in the production, losingcompetitiveness, the sources are:  Lack of innovation incapability to catch up market innovation: product or production  No plan from the management basically the source of all the illness  Fixed cost in a decreasing market share environment reduction of margin  Inefficiency in the business model o Incapability of management to recognize a threat (anticipate problems) and to manage them when they show up. The usual step evolution is:  Reduction of margin drain of liquidity  Contraction of NI  erosion of equity D/E starts to increase  Incapability to repay debts insolvency 16
  17. 17. o At default the company have to decide which procedure put in place to restore the companyPossible actions that could be taken are (keeping in mind that the key variable is the recovery ratio): o Work-out: it is a contractual form between creditors and shareholder/management. It is characterized by higher return, higher risk run by creditors and speediness. There are two solutions:  Liquidation: there is no consensus among creditors and the company will be dismissed  Restructuring: there will be the implementation of a restructuring plan, the company may survive and continuing to survive. If this procedure fails the creditor may go into liquidation (both in or out court option are available) o In-court process: are slower procedure since there is the need of judge approval for any operation (5/7 Years in Italy), however the risk profile is lower as well the recovery ratio achieved  Liquidation: there will be the dismissing of the firm asset  Ch11 [US case] or equivalent: the judge accepted the restructuring plan proposed (under the acceptance of the majority of creditors or cram-down option)Elements that explain the decision between in-court and out of court procedure: o Fragmentation of the creditor will increase the difficulty to create consensus,  The coordination problem is crucial since absence of it will produce suboptimal outcome o Category of creditors involved and presence of collateral  The small retailer doesn’t have the competence and the capability to get involved in a restructuring plan  Secured debtor don’t want to bear risk to increase the outcome for other class of debtors o The class of the investors within the classes may hamper the possibility to achieve consensus, different idea o The presence of intangible asset is important to assess the possibility to extract value form a continuing business activity, by stopping the firm will lose all the value o The condition of the company at default, meaning the debt sustainability to assess the firm capability to repay the current debt, there are three ratio that can be used:  Debt service cover ratio 1/1,2 x  Interest coverage 4/4,5 x  Net debt/EBITDA 2,5/3 x o The in court procedure may lead to lower recovery ratio (without uncertainty), but it will ensure a higher protection and loss are frequently tax deductible o The company can lose contract with clients or supplier, hence it will be difficult to restart the production without the suppliers/clients’ trust in the projectDescription of Work out procedure o There will be the appointment of a financial advisory (by shareholder if the company is not insolvent or from main banks) that will be in charge for the financial restructuring  The financial advisor task is to: credit analysis and debt Capacity, coordinates the creditors, fund raising (for ongoing business), due diligence and documentation setting up, he also provide knowhow In the Italian landscape its crucial to be able to communicate and properly manage the difference, many international investors don’t know the Italian landscape  The first task is to assess outstanding issue (legal one) and to value assets and debt sustainability o The financial advisor will coordinate/supervise all the work/implementation and will hire the consultant [industrial advisor] that will produce the business plan (industrial restructuring), which can be divided in two sections  Liabilities side procedure key elements are assessing the value of the project and to define which option are the best to be perform: The first and far most important document in the liabilities restructuring is around the “inter- creditors’ agreement” which will discipline the condition for the liabilities restructuring: Debt refinancing, cost of new financing, collateral, covenants 17
  18. 18. The creditors protect themself against further deterioration by imposing covenant (which breach will trigger the debtor’s default) o Limiting the amount of capex o Limiting or hampering the possibility sell asset o Limiting the dividends distribution o Asking to respect some financial covenants The option available are: o The debt restructuring: maturity is extended, Cost is strongly reduced Possible initial grace period (no principal payment) or Cash sweep o Debt write off it is proposed to creditors that don’t approve the restructuring (tax shield): a given % of the outstanding debt plus accrued interest o Debt equity swap where the debt is converted into equity (no additional fresh capital is needed and the D/E decrease) o Convert outstanding debt with convertible bonds and warrants Assessing the value of the plan is basically made compering the value (recovery) outstanding debt + accrued interest and the expected value implied in the plan o It is typically a capital budgeting exercise where you compare the return profile with the risk run. To properly value the possibility you need to choose the appropriate discount factor and to take into consideration the reinvestment of intermediate flow  The rate suggested is the WNCF: weighted marginal cost of funding  Asset side restructuring is basically a refocus on core business of the company and the parallel dismissing of non-core assets. The options available are the same describes in the distress section, some comments The first asset to be dismiss are the non-strategic and no core one (typically real estate) The second choice regard the dismissing of non-strategic, but core asset, the rule should be to maintain only those businesses where the firm has competitive advantage and synergies Besides the disinvestment the firm should reduce CAPEX expenditure and rationalize the cost o The restructuring plan is basically a mixture of financial plan (creditors, suppliers, customers, auditors) and industrial plan (union management shareholders, suppliers and clients),  Its approval is the consequence of the negotiation with all this players  Since the EV may lower than the debt value, creditors are usually asked to sacrifice part of their principle in order to save the firm o The implementation is supervised by the financial advisor The case is the Greenfield, it’s main features are: o The first equity swap in Italy, it’s structure:  The old equity holder has been wept out  better than be sued  The top senior lender remain debt  The second tier senior loan convert into equity  The equity structure: preferred stock: senior the management (incentive to meet the normal case), senior loan; normal equity to senior; other nonvoting equity to mezzanine (really diluted)and management (best case incentive) o This structure has been made togrant: in worst scenario coverage of the debt; normal payment of preferred, best even normal equity participate in the wealth sharingDUAL TRACK This process is an alternative way to collect money for a company, it consist on simultaneously applying for an IPO and looking from potential buyer of non-core asset dismissing o The rational of Dual Track and potential drawbacks are: 18
  19. 19.  The firm has more than one option, there could be a better outcome  The IPO process will speed up the merger process  It is a more complex and the problem of coordinating the timing (crucial variables), it requires more involvement of the management  The failure of one process may hamper the other  The market is becoming more volatile, it’s hard to properly manage auction with strategic and financial buyers (different needs)o The process (case base – Feretti-) consists on  The IB receiving mandate will define the objective and timing of the process To ensure confidentiality the IB should involve few investors: Private placement is can be a good alternative, but it is riskier Speed of the Bidder to find the resource needed Time is key, before IPO building book it is crucial to have unconditional binding bids  Due diligence is quite demanding since there is double documentation requirements: Documentation needed for internal and external use o Data room, business plan, pitch book, equity story… o Prospectus, analyst presentation roadshow o Purchase agreement, teaser Authorization needed o The dog watcher institution want to check the documents formal and contents o Auditor valuation/validation  Roadshowfor analystbegin and simultaneously send the company information package  Collecting the initial bidding for the sale and meeting with investors IPO roadshow  Collection of bidding offer and start the closing negotiation and pricing IPO  Final decision on which tool use considering: The risk beard by issuer in the operation Growth projection and business plan/story for the investors IPO The potential synergies creation, multiple and IPO valuation 19