The global economy is experiencing unprecedented turbulence. The advice and consent of directors has rarely been as simultaneously important across all industries and all sizes of companies. It is likely that your management team is managing your company through this difficult period by assiduously monitoring expenses, capital expenditures, liquidity, and key balance sheet accounts. However, in this volatile economic environment lies great opportunity. Consulting studies of corporate acquisitions and historical results of private equity funds have shown that the best performing acquisitions and investment returns were achieved during periods of significant economic decline.
Over the next 12 months there will be numerous M&A opportunities for stable corporate and financial acquirers as heavily levered acquisition targets face even greater financial strain. Management teams that remain vigilant about looking outside their organizations for attractive near-term acquisitions could find multiple opportunities to improve and grow their companies. The thought process for directors and management pertaining to potential M&A opportunities remains constant — i.e., will it enhance shareholder value?
To answer this question in the current environment, directors of well-positioned companies are evaluating their company's acquisition strategy, including the approach to valuation, deal structure, and financing along the following guideposts:
• Fundamental discounted cash flow (DCF) financial analysis is the best method to evaluate how potential acquisitions could impact shareholder value, as several “shorthand” valuation metrics have become misleading. The best theoretical and practical gauge of assessing and addressing whether an acquisition should increase shareholder value is fundamental DCF analysis (the present value per share of your company's future free cash flows discounted at your cost of capital). When discussing a prospective acquisition, participants in an M&A transaction all too easily fall into the use of “deal jargon”: sales multiples, P/E and other earnings multiples (based both historical and future earnings), and stock price premiums.
These are arithmetically correct calculations, but they are only cap rates or “handles” that attempt to summarize the more complete relationship fully embodied in the DCF analysis. These calculations often rely on historical transaction data that are no longer relevant in this market, or on financial projections for the next 12 months that do not appropriately capture the long-term earnings potential of the target. In addition, the use of comparable valuation multiples can be misleading in environments when the market value of certain corporate assets is opaque and can diverge substantially from current book values. A thoughtful DCF analysis enables a buyer to factor in multiple scenarios of five- to seven-year financial forecasts when assessing the projected impact to shareholder value.
One caveat — experience suggests that human nature is frequently too optimistic about the magnitude and timing of synergies and expense savings that can be realized in M&A transactions. Incorrect assumptions in this regard could pose liquidity issues after the acquisition (e.g., the impact of integrating two organizations on the combined cash cycle) and reduce the present value of an acquisition for your shareholders if incremental profitability is moved to future years.
• M&A targets in the current environment should be closely aligned with your company's business. Directors will be called upon to advise and consent on the analysis compiled by your management. Embodied in the DCF analysis for the target is their best judgment of the future for both your company as well as the target company. This judgment is challenging in periods such as today, with little or no visibility on consumer behavior (accounting for 70% of U.S. GDP) and how that will ultimately impact your company and the target company. Management's ability to render their judgment with respect to the future of the target company becomes more difficult the further the business of the target company is removed from your company's core business. The risk associated with the forecast therefore increases disproportionately.
As a director, you are regularly making decisions predicated on your management team's best judgments of the future at any given point in time. Extending this judgment to analyze the future prospects of a target's business that is closely aligned with your company's is a prudent way to consider any acquisition or merger. The target will necessarily be facing similar issues and challenges to those your company is facing and addressing.
• Deal structures are changing. Directors should realize that there is a distinct difference between the intrinsic value of a target and the purchase price your company can afford to pay for a target. The value of a target should first be determined as a standalone entity with no sales or cost synergies based on your management's best judgment of the target's future prospects and the target's cost of capital. The value your company can afford to pay for the target is capped at the purchase price at which the transaction becomes dilutive to your shareholders' present value, based on the present value of DCF per share. How your company will pay for the acquisition may also impact this assessment, particularly if some or all of the consideration is common stock. It is likely that the number of M&A transactions in which corporate buyers pay some portion of the consideration in common stock will increase over the next 12 months as corporate buyers seek to retain cash to remain as liquid as possible. In addition, earn-out structures for the acquisition of nonpublic companies are also likely to increase to help bridge the valuation gap between what buyers are willing to pay at closing and what sellers believe their company is worth.
The constraints in the financing markets also continue to have a substantial impact on M&A activity. Current borrowing rates are above, and lending advance rates are below, historical averages. This is the inverse of the 2006-2007 period. Prudence is necessary in assessing your company's long-term cost of capital, which may differ markedly from vagaries of the current lending market. Capital availability is at a premium given current depressed stock prices and reluctance of lenders in the middle market to underwrite loan facilities or hold more than $20-30 million on their books.
Also, corporate buyers are carefully evaluating if raising additional debt to fund add-on acquisitions will enable lenders to renegotiate the pricing and terms of existing low-cost loans. The positive aspect is that the dampened lending market and lower stock prices have brought down valuations in middle-market M&A transactions.
Between now and Labor Day there will likely be meaningful ramifications for heavily levered companies as relatively strong quarters of 2008 roll out of the latest-12-month calculation of bank covenant ratios and are replaced with substantially weaker results in the first and second quarters of 2009. This may lead to increased M&A activity despite depressed valuations. Again, if the past is prescient this will be a great opportunity for prudent corporate and financial acquirers.
Your company has realized consistent success from directors' advice and consent based on your management's best judgment. Today is no different from yesterday in this regard. â–
The author can be contacted at broman@harriswilliams.com.