Auctions in M&A

Auction is a very important topic for all M&A practitioners for the following main reasons:

1. Auctions are widespread in business (e.g. hostile takeovers, privatizations of state-owned enterprises, sale of assets in bankruptcy, rights to exploit natural resources, etc.)

2. The auction process is a key element for negotiations and mastering this process often impacts on the outcome of the deal.

It is central to understand that the auction process involves strategic thinking. In fact auctions are a mix of behavioral finance, negotiations and clear rules.

The common definition of an auction is: a process by which an asset is sold by soliciting bids from buyers; the event is “public” and governed by rules of conduct that culminate in the sale to the highest bidder. Well, in M&A it might not be a single event, truly public, nor won by the highest bid. We can outline five auction methods (the first four drawn by McMillan):

· Beauty contest: Buyers are invited to present themselves to the target’s directors. The choice is made behind closed doors. If offers the seller a great flexibility (time, discovery of information, criteria on which a choice is made). However it often discourages potential buyers because of the opacity and the slow speed of this process.

· Lottery: The seller announces a sale at a specified price, invites potential bidders to participate and then a name is drawn randomly (e.g. from a hat). The disadvantage for the seller is that there is no price discovery and other considerations such as the technical competence of the buyer to operate the firm in the future are not taken into account. This method might be used by governments to sell some specific rights for example.

· First come, first served: The seller announce that the company is for sale and pursue a sale with the first buyer to show up. Once the potential buyer has discovered that there is no competition anymore, he will reduce the incentive to increase the bid and therefore the price discovery for the seller will be biased. Most of the SMEs use this kind of auctions.

· “True” auction: A true auction is run by rules and a schedule clearly expressed in advance. The clearer the rules and the commitment to those rules, the more the potential buyers will be motivated to participate to the auction. The process is transparent, goes fast and prices are revealed. The last one is the main difference with other types of auctions. It is often used for the sale of nonstandard items (e.g. a world-class athlete, great paintings or some companies).

· Friendly noncompetitive negotiation: The buyer persuades the target company to sell. This is a quite unstructured process and the buyer keeps quite a strong power during the negotiations. It is not directly an auction method, but it can become an auction, once other bidders come into the game.

Auctions differ from negotiations by the number of bidders, the structure and the speed of the transaction.

Furthermore, we can assume that there are more chances to close a deal with an auction process than with simple negotiations, because of the efficiency and focus of the auction process. There might be a back and forward between auctions and negotiations during a sale process (e.g. begin with auction and then negotiations with an exclusive bidder or negotiation with a potential buyer to test the market and then open an auction with other bidders, etc.). The main point to keep in mind is that auctions are competitive and negotiations are more or less exclusive.

There are four classic types of auctions, which have been described by McAfee and McMillan:

· English auction: this is the type of auctions used by art auction houses. Everyone can see the reservation price of the seller and then the price rises until no other bids are made. The asset is sold to the highest bidder.

· Dutch auction: this is mainly use in the sale of cut flowers in Netherlands. The auction begins with an arbitrary price determined by the seller and he then reduces it until a bidder accepts the offer.

· First price sealed bid auction: this works like an English auction, except that each bidder can only bid once and other potential buyers cannot see the bids. The bidder with the highest price gets the deal. It is used for example by governments for the sale of rights to exploit natural resources.

· Second price sealed bid auction: This is the same method as the first price sealed bid auction, but the winner pays the second-highest price, rather than the winning highest price. It mitigates the impact of the so-called “winner’s curve” among buyers (overpaying for an asset in an auction) and thus encourages more buyers and higher prices. This method is however rarely used in practice.

We can mention two main advantages of using auctions:

1. Price discovery: without auctions the buyer and the seller have each their own view on the intrinsic value of the asset and the price they would pay/accept. With an active and competitive auction, the different offers will help to determine the real (market) price of the asset.

2. Positive for the seller: auctions motivate buyers to bid in a desirable way for the seller, i.e. buyers want to go fast and will put the highest offer the can in order to get the target. An auction with clear rules and deadlines help also the buyer to assess the cost of acquiring the asset.

But auctions have of course some disadvantages, such as:

· By entering an auction, the target faces a confidentiality risk, i.e. by disclosing information to many bidders, the target’s business might be affected (e.g. if suppliers were to be informed about some conditions that the target grants to other suppliers, etc.).

· Potential buyers will try to avoid the auction process to come back to negotiations. They might threaten not to participate at all or simply asking the target to cancel the auction (so-called “bear hug” letter).

· The target has a reputation risk from canceling the auction or deviating from the rules, i.e. other potential buyers might think that the target is not as attractive as originally presented.

· Auctions might discourage some prospective buyers to participate, because of the maximizing price effect of auctions. They also might be afraid for their reputation if they lose.

There are some practical considerations to sellers in auctions. An auction will better work if the asset is unique. If it is not the case (e.g. fairly comparable independent companies are on the market), then use negotiations. Strive to increase the number of bidders, e.g. by setting clear rules and deadlines, putting in place a well-managed data room and due diligence process, etc. This increases the confidence of buyers. Allow different types of buyers to bid, i.e. strategic and financial and allow them to use their strengths.

Price is one aspect of auctions. But a seller often considers a lot of other aspects like strategic fit, contingent payment, incentives for the management in place, social issues, etc. All those aspects must be taken into consideration when comparing different offers from potential buyers and the highest price might not always win in M&As.

How to finance acquisitions?

When choosing how to finance a deal, the CFO will consider many factors in order to optimize the financing structure. First of all, he will have to choose between debt, equity or a mix. We can underline four main factors influencing this decision. The first factor is the so-called pecking order theory, stating that managers tend to prefer internal financing versus external. So they tend to use internal funds first, then treasury stock, debt and finally equity. The second factor is how the leverage will influence the value of the company. Concretely there is an optimal financing mix where the present value of debt tax shields and the present value of expected distress and bankruptcy costs just trade off to produce a maximum value. The third factor is the momentum at which the company wants to issue debt or equity. There may be good and bad moments. Finally, depending on the asset base of the firm, lenders will allow the company to have more or less leverage.

Then, the CFO will have to choose the maturity at which he will issue the securities (short, intermediate or long term). This will depend on the risk strategy of the company. If the life of the firm’s asset (in this case the target just bought by the company) is shorter than the life of the liabilities, then the management faces a reinvestment risk, i.e. the firm will not be able to deploy the cash released by the target to achieve returns sufficient to service the liabilities. If the life of the firm’s asset is greater than the firm’s liabilities, the company faces a refinancing risk, i.e. the firm will not be able to refinance itself on favorable terms (e.g. lower interest payments). If the life of the firm’s asset is equal to the firm’s liabilities, we call it a risk-neutral maturity. Most firms do not have such a neutral structure, because of uncertainty on the asset’s life and manager’s insider information about the future of the company (and thus its risks).

The CFO will have to choose between fix and floating rates when issuing debt instruments. This depends primarily on expectations about future market interest rates and on whether the target’s returns depend on interest rates (e.g. possibility to match the type of interest rate to the type of target returns).

The problem of the currency will also influence the CFO’s choice. Regarding his hedging strategy, he will have to consider the firm’s exposure to foreign exchange rate fluctuations, but also make a good use of potential financing possibilities in global capital markets (e.g. arbitrage). The hedging strategy often reveals the management’s view on future movement of exchange rates and the future currency mix of the firm’s cash flows.

With today’s financial markets, the CFO might also use exotic instruments in order to reduce the firm’s cost of capital induced by the acquisition. There are plenty of financial instruments linked to debt, equity or FX like futures, options, swaps, FRA’s, etc. that the CFO has at disposal to optimize its cost of capital.

When choosing the financing structure, the CFO must also consider the impact on the control of the company. Issuing debt or new stocks can have a great influence on the control of the firm. An analysis must be done on: who controls the firm (creditors, actual shareholders, raiders, etc.) and how the financing structure can lead to a change of control; what are the degrees of control of the different players; and what are the triggers leading to a change of control (e.g. default on a loan covenant, preferred stock dividend, shareholder vote, etc.).

In order to analyze the most appropriate financial structure, it is often helpful to view the financing choice from different perspectives. From the investor’s point of view, the objective is to minimize the WACC and maximize the share price of the company in order to maximize the shareholder value. The creditor wants to balance its risk-return relationship and especially to minimize the risk of default. A technique often used is the so-called “6 C’s”: Cash Flow, Collateral, Capital, Conditions (economic), Course (use of funds, strategy), Character (management). An analysis from the competitor’s point of view means to compare the standard practices in the industry and the strategic position of the company versus competitors and the competitive implications of the financial structure. The CEO wants to preserve its financial flexibility, keep the firm’s financial policies and focus on firm’s strategic goals.

To summarize, many financial and strategic factors must be considered when choosing the financing structure and major stakeholders’ perspectives must be taken into account.

How to pay the acquisition: cash or shares?

In a transaction, once the price has been agreed by both parties, the next issue is how the total consideration should be paid, either in cash or shares (of the buying company)? From the seller’s point of view, the question is an investment issue. Should the seller reinvest the amount in the Newco (i.e. acquiring company including the target) to benefit from potential synergies and higher future value? Or should he take a cash payment in order to reinvest it other assets? The answer depends principally on the seller’s portfolio strategy, i.e. its risk and return objectives and investment constraints (liquidity, time horizon, tax concerns, legal and regulatory factors, and unique needs and preferences). From the buyer’s point of view, the form of payment is more of a financing issue. It will have an impact on its balance sheet and capital structure. However, both perspectives must be satisfied in order to have a viable deal.

Here are some elements to think about when choosing the form of payment. When submitting an offer, the acquiring firm should consider other potential bidders and think strategic. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid (without considering an eventual earnout). The contingency of the share payment is indeed removed. Thus, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer’s capital structure might be affected and the control of the Newco modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. The risk is removed with a cash transaction. Then, the balance sheet of the buyer will be modified and the decision maker should take into account the effects on the reported financial results. For example, in a pure cash deal (financed from the company’s current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution when making the choice. The form of payment and financing options are tightly linked (a more detailed overview on financing options will be posted at a later stage). If the buyer pays cash, there are three main financing options:

• Cash on hand: it consumes financial slack (excess cash or unused debt capacity) and may decrease debt rating. There are no major transaction costs.
• Issue of debt: it consumes financial slack, may decrease debt rating and increase cost of debt. Transaction costs include underwriting or closing costs of 1% to 3% of the face value.
• Issue of stock: it increases financial slack, may improve debt rating and reduce cost of debt. Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting and registration.

If the buyer pays with stock, the financing possibilities are:

• Issue of stock (same effects and transaction costs as described above).
• Shares in treasury: it increases financial slack (if they don’t have to be repurchased on the market), may improve debt rating and reduce cost of debt. Transaction costs include brokerage fees if shares are repurchased in the market otherwise there are no major costs.

In general, stock will create financial flexibility. Transaction costs must also be considered but tend to have a greater impact on the payment decision for larger transactions. Finally, paying cash or with shares is a way to signal value to the other party, e.g.: buyers tend to offer stock when they believe their shares are overvalued and cash when undervalued.

In conclusion, for the seller cash is often king, except if he believes in potential synergies and future higher value of the Newco. On the buyer’s side the mix between price, form of payment and financing must be carefully analyzed before submitting a deal structure to the target, in order to optimize the investment.

The concept of earnout in M&A deals

When buying a company, a frequent question asked by the acquiring firm when analyzing the business plan of the target company is: will the target achieve these objectives? Most firms use DCF valuation and since it is based on future cash flows, the business plan proposed by the management of the target will have a direct impact on the price offered by the potential buyer. This plan has to be realistic and should not underestimate nor overestimate the target’s capacity to meet its objectives. But what does realistic mean? Obviously a realistic view for the buyer tends to be more pessimistic than the seller’s realistic view. So what happens when both parties can’t agree on a common realistic future of the target company? A frequent tool used to bridge this “realistic future” gap is the so-called “earnout”.

An earnout is a contract which regulates the portion of the total consideration paid by the buyer, which varies on the basis of mutually agreed future events (i.e. performance goals). The total consideration is thus the up-front payment (fix portion paid at the closing) plus the earnout (variable portion paid at a later stage).

The earnout is not limited to the function of bridging the future realistic view of the parties. The tool is also used by the buyer to retain the managers/shareholders of the target company and to motivate them. Since part of the payment will be at a later stage, the managers/shareholders have to stay and/or to perform in order to get paid.

Earnouts are therefore a very useful tool, but has drawbacks too. Earnouts can indeed be complex to define, could cause post-acquisition integration issues, performance goals could be too aggressive and/or managers don’t own a significant earnout claim which in both cases demotivates them.

When structuring an effective earnout, some key elements must be considered. First of all, the earnout amout, which is based on the difference between the fix amount paid up-front and what the seller wants to receive (i.e. the price gap). Generally it varies between 20% and 70% of the total consideration. However, we consider that 30% should be appropriate for both parties. Secondly, the earnout period: the shorter the period, the higher the present value of the expected payments. Thus, seller wants generally a shorter and buyer a longer period. It is important to notice that the period also has an impact on the retention and motivation of managers/shareholders. Third, the performance goals must be clearly defined, mutually understood, attainable and easily measurable. Common criteria include: Revenues, Gross Margin, Pretax Profit, Cash Flow or EBITDA, or Milestones (e.g. new product). Each criterion has advantages and disadvantages. The lower the criterion is on the Income Statement (top being the Revenue and bottom the Net Profit after Tax), the more performing the target must be. A mix of different criteria is also not uncommon. Then, the payment schedule includes two dimensions: the amount of each payment and the timing of those. The amount varies, when the target company meets or fails to meet its performance goals. The amounts are often caped or floored, in order to reduce risks for both parties. The payments can be done in different point in time or as a lump-sum at the end of the earnout period, to reduce volatility.

Once those key elements defined, some issues must be taken into account. The most common are shortly described here. The impact on the potential effectiveness of an earnout might not work if the buyer intends to integrate the operations of the target. In this case, parties should choose performance goals, which allow necessary integration or have a shorter period in order to integrate the target after the earnout period. Then, the Sales and Purchase Agreement (SPA) must also clearly regulate: the accounting rules and performance measurement for the calculation of the earnout; the availability of financing for the target (e.g. if the buyer does not provide the necessary capital, the target needs authority to obtain funds from external sources); how the target’s management will conduct the business (e.g. approval processes); and what happens in case of change of control (i.e. it should not affect the target’s ability to achieve its performance goals). An important point when structuring an earnout is also to submit the earnout proposal to competent tax and accounting advisers!

To value an earnout, the first step is to model different scenarios (e.g. low, high and most likely) of future expected cash flows with key value drivers. Then, simulation can be used to determine the distribution of the present value of those future expected cash flows. The important here is to understand that with the same earnout structure, both parties will have a different estimated value of the earnout. The agreement between both parties will be found, when the total consideration, including the earnout’s present value, will be equal or less than the valuation of the target (e.g. DCF, multiples, etc.) according to the buyer and inversely equal or higher than the value of the target estimated by the seller.

An earnout could be complex to define, but might really help to unlock deadlock situations, if properly structured and then executed.

Welcome

Hello and welcome!

The objective of this blog is to provide M&A professionals, students, buyers and sellers with interesting insights on the practice of mergers and acquisitions. The aim of this blog is not to be comprehensive; it is only an overview on some key areas faced by professionals during transactions.

I hope you will enjoy it.