What's a Board's Revlon Duties when the Deal's 'Too Good to be True'?

Yesterday I had breakfast with a friend who’s quite accomplished in Corporate Law. Among other things, we had a good conversation regarding a Board’s Revlon duties when BuyCo uses significant leverage in its proposed acquisition.

In particular, we discussed the obligation of a Board of Directors when a bid for the company is so large that its likely consequence is to saddle the company with so much debt that its future cash flows may be insufficient to pay its obligations. Said simply: what if the bid is “too good to be true” – it’s a boon to current stockholders but a death sentence for the company’s ongoing viability?

I was prompted to ask him this question because of Tender Offer (Dormans). Dorman, reflecting on the offer Natomas received from Diamond Shamrock, reflectively poses the question: “when management is faced with the threat of a takeover, the question becomes: To which shareholders should one feel responsible? Investors seeking short-term profits will be best served by the highest takeover price, but those who want to see the best long-term results and have the strongest company emerge may be better served by [incumbent management fighting the takeover].” (p30). And later he again asks, “how strong a company would the new Diamond Shamrock be? What would be the impact on future profits of its borrowing $700 million to complete the transaction?” (p36).

The answer is straightforward: it depends. If the consideration is straight cash, then management should only look to the highest bidder. But if the consideration is stock from BuyCo, then management must be more careful. In that case, the Board has to consider that its shareholders will become owners in the new company (and its accompanying higher debt load).

This obligation of the Board is partially absolved by obtaining a “solvency opinion” (also from WSJ Deal Blog) from a banker. The solvency opinion is needed whenever the post-acquisition company acquires a significant amount of debt relative to its size. This is likely to occur either in a merger-of-equals or in a leveraged buyout. Thus, there the growth in private equity-led M&A during the “sixth wave” of M&A (2004-2007) made the solvency opinion increasingly important.

What was the consideration in the Natomas bid? It was a bit tricky. Diamond-Shamrock offered $23/share for the first 51% of outstanding Natomas stock, and then offered Diamond-Shamrock stock worth $23 for the remainder. So that transaction fell somewhere in the middle; not all cash, but not all securities. Though this offer probably moves into a gray area, I would guess that the Board has an obligation to ensure the resulting company is solvent. Therefore, simply seeking the highest bid will not do. Instead, the Board would have to be confident that the resulting corporation would have sufficient cash flow to service its debt.

"Deal" Reading List

It's getting colder, and maybe you're thinking about escaping to a beach for an otherwise-frigid January week.

What to read?

Well, if you're a deal-geek like me, there's plenty of good stuff out there. Here's what I've been reading, and what's on my list:

Books Recently Read:

1. Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion, by Steven Davidoff (aka, the "Deal Professor" on NYT's DealBook).
   Awesome book outlining the legal consequences, drivers, and limitations to many deals that happened in the last 24 months. The book provides great 'color' to the otherwise "surfacy" coverage provided my the media. Davidoff delves into the purchase agreements of numerous deals with scrupulous details and illuminates, with reference to DE Chancery Ct decisions, the "whys" behind numerous nuances of the deals. Awesome, but technical read.
2. House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, by William Cohan.
   This book gives vivid detail to the collapse of Bear Stearns.
   It's written in 3 parts: first, an up-close look at the 2 weeks in March '08 when BS' cash account went from $18B to a Chapter 11 filing. It shows the weakness of the public investment bank model that depends on overnight financing, prime brokerage accounts, and trust. Vicous circles -- whether rumors are true or false -- will kill the company. Second, it zooms out and shows the long history of BS. This part I found more helpful. It showed the firm's cultural penchant for risk, its bad-boy attitude on Wall Street, its conduct during LTCM, and how all of those events culminated in March '08. Third (perhaps most boringly), it detailed the creation of its two exotic funds - remember the "Enhanced Leverage Fund" - that killed the firm.
   Reading this portion was particularly interesting in light of the Securites Fraud case ongoing in 'real time' regarding Ralph Cioffi and Matt Tannin. (As an aside, this book made me want to learn to play Bridge - yet, after asking dozens of friends, it seems that that game is, almost without exception, played by the older generation.)

3. Big Deal: The Battle for Control of America's Leading Corporations, by Bruce Wasserstein.
   This is "Bid 'Em Up Bruce" 's tome, written from the insider's perspective, of the 80s' and 90s' battles for corporate control (No surprise there, given the title!). At 791 pages, I'm not sure whether the reader needs to read each page in gripping detail. But Bruce does a good job of both entertaining and teaching the reader about the industry from a strategic, financial, and legal standpoints (he went to HBS/HLS, and worked at Cravath before CSFB, then founding Wassersten Perella, and then CEO of Lazard). The last section, "Doing the Deal", is particularly educational for the aspiring deal professional.

4. Barbarians at the Gate: The Fall of RJR Nabisco, by Burrough and Hellyer. This is an absolute classic. And for good reason, too. The book is an absolute thriller - with amazing detail and great characters, it's impossible not to be drawn into this account of KKR's "coming out party" in its 1989 LBO acquisition of one of America's largest corporations. The $26B takeover remained the biggest deal ever consummated for well over a decade.
   But the book had some good info/technical info, too. It showed the value of creativity in putting together an offer (First Boston's bid was entertained b/c of its tax structure), plus the personality-dynamic (the Board's aversion to Mgmt/Shearson's offer due to F. Ross Johnson's personal handling of the offer).
   From a CorpFin standpoint, one thing the book reinforced was the valuable role PE plays in the market for corporate control through the disciplining of management. Part of the attraction of making a bid on RJR was the abuse, by RJR management, of the principal-agent problem. FRJ abused his role through the use of perquisites (the RJR Airforce and his squad of favored athletes on retainer) at the expense of the true owners of the firm. KKR fixed that problem by realigning mgmt-S/H interests.

5. Tender Offer: The Sneak Attack in Corporate Takeovers, by Dorman Commons. This 1985 book chronicles the at-first hostile, and then friendly takeover of Natomas Company by Diamond Shamrock. What makes this book excellent is that it's essentially a first-hand narrative by the CEO of TargaCo of what he did during those 10 days between announcement of hostile takeover and deal agreement. From the strategic, legal, and financial standpoints, this book gives good insight into why the deal industry is so multi-disciplinary.
   Another interesting part of this book is that the DS-Natomas deal fits into the larger en vogue corporate strategy of the 1980s: conglomeration. Barbarians at the Gate -- which chronicled the breakup of RJR/Nabisco -- serves as a natural bookend to this movement, since private equity helped the market learn that conglomeration is not a value-maximizing strategy: the sum of the parts is greater than the whole. Wasserstein chronicles this evolution very well.
6. Billion Dollar Turnaround: The 3M Spinoff that Became Imation, Bill Moynihan. Moynihan is the former CEO of Imation, and led it through its spinoff and its subsequent winnowing to its core competency of data storage.
   During that time, he shrunk the firm from 12,000 employees to 2,000. More impressively, he took the company from one that was saddled with debt to one that was lean and a strong cash generator. The book does a good job of describing the morale and management issues inherent in the spinoff of a brand new company from a staid, stable, and secure parent company. (The spinoff also fits into the time period where corporate America's lost its affection for conglomerates).
   My biggest disappointment was that Moynihan never discussed the rational that led to his financial decisions. What did the balance sheet look like upon spinoff? What did he get for the divisions he sold? And what was the multiple of that sale? This information would be more educational, as opposed to the chest-thumping that more often padded the book.

Books to Read:

1. Too Big to Fail, by Andrew Ross Sorkin. Sarkin -- the editor of NYT's DealBook -- gives a first-hand account (based on his contacts within High Finance professionals in Manhattan) of the backroom deals struck during the last 24 months.
   I've watched Sorkin's interview with Charlie Rose concerning the book, and am on the waiting list with Hennepin County for the book. I can't wait; it should be another thriller.

MPLS: Small City, Big Companies

After a fairly thorough reading, I throw away most of my magazines (Fortune, Barron's, TC Business). But I always keep my copy of Fortune
"Fortune 500". (May 4, 2009)

Last year, Minnesota had 20. But due to NWA's merger with Delta we are back into the teens. And, due to PepsiAmerica's merger with PepsiCo (which was featured in this week's Barron's), we'll be down to 18 next year!

But something else caught my eye this week: F500's HQ'd by city. More specifically, what caught my eye is that only NYC, Houston, and Dallas have more F500's than Minneapolis! We have more HQ'd here than Los Angeles or San Francisco, and are tied with the midwestern heavyweight of Chicago.

In the end, this may be somewhat of a moot point. The more relevant measurement is F500's by Metro area, and by that measure I'm sure MSP would fall somewhat compared to Chicago, SFO, LAX.

Nonetheless, I find it something to be proud of. Another way of conducting this assessment would be F500's per capita. In other words, there are 5.2 million Minnesotans and 19 F500s. That equates to a F500 for every 273,000 Minnesotans!

In comparison:

• Texas has a F500 for every 380,000 residents (64 : 24.3 million residents)
• California has a F500 for every 664,000 residents (51 : 33.9 million residents)
• New York has a F500 for every 348,000 residents (56 : 19.5 million residents)

I think this statistic indicates Minnesota's ability to maintain a "Big City" feel with a "Small City" touch - perhaps a unique combination.

Just this weekend, a friend was visiting from Silicon Valley. We were hanging out in Peavey Park on Friday evening. It was full of people coming-and-going from Holidazzle, as well as people on their way to Orchestra Hall.

While there, I "just knew" I'd run into a friend in the local finance community. Sure enough, my Securities Law professor walked by. It didn't surprise me, but my Silicon Valley friend was amazed. The "closeness" that we have here (as evidenced by my story) separates us from the Gotham City-ness of NYC, Chicago, or Silicon Valley. We get the best of both worlds.

Forstmann: "When it came to dealmaking...he was Picasso, and [his partners] were holding the ladder"

With my interest piqued after my visit to KKR's offices, I've finally taken the time to read Barbarians at the Gate. It is truly an astounding story: pride, hubris, rivalries, limousines, private investigators...all bankrolled by billions of dollars in junk-bonds and the glorious optimism of the BOOM that always preceeds the bust.

And I have a hard time reading books nowadays without the internet nearby. I'm constantly scribbling notes, looking up websites, etc. Of course KKR continues to exist, but with the book highlighting Ted Forstmann's bloodcurling rivalry with Henry Kravis, I wondered: whatever happened to Forstmann Little? No website existed, only a Wikipedia entry!

Well, a little more google digging and I found this article from Fortune magazine. Nowadays, you can find interviews of him opining with his good friend Charlie Rose.

MAC Clauses: Faegre's wonderful & timely summary

The landscape of corporate America has undergone significant change in the last 24 months. Those changes, and their effects on projected future earnings, are a big risk for both private equity groups ("PEGs") and strategic buyers as they make acquisitions.

To control this risk, buyers often insert "Material Adverse Change" clauses into their purchase agreements (sometimes these are alternatively named "Material Adverse Effect" clauses). The general purpose of these clauses -- and I am drastically paraphrasing here -- is for the buyer to say "if your business significantly changes between signing and closing, then I don't have to buy your business."

How effective are these clauses? What specifical changes in the underlying business must a court see to enforce these clauses?

Matt Kuhn and Josh Nygren, attorneys at Faegre & Benson, have written an excellent summary of the case. It provides a summary, as well as excellent drafting pointers on MACs/MAEs. Of all the law firm write-ups on Hexion that I've read, theirs is the most helpful. You can find their article here.

Recent Delaware litigation provides partial answers to these questons. Buyers have sought to exit their investment, and have used the MAC clause as justification. Meanwhile, the Targets have fought the exit, trying to 'force the marriage'. These disputes ended up in court.

The most prominent case is Hexion v. Huntsman. In that case, Hexion Specialty Chemicals (a platform portfolio company of PEG Apollo Mgmt) was trying to back out of its purchase agreement with would-be add-on Huntsman. It claimed a MAC had occurred. The court rejected this argument, and for its reasoning relied on changes in EBITDA and the carveouts within the purchase agreement.

Caveat Emptor: Distressed M&A (legal perspective)

Since the 'hot' area of M&A has become distressed companies, I thought it would be apropos to make a post on the topic. This post comes courtesy of a recent Cooley Godward article.

Risks to BuyCo

1. Indemnification Largely Ineffective. By its nature, BuyCo in a distressed sale cannot avail itself of the Definitive Agreement's indemnification provisions. Practically speaking, BuyCo must "get it right" when the deal is struck because there is little opportunity to cry foul if/when the deal goes sour. TargaCo won't be around!
2. Fraudulent Transfer: Trap #1 that BuyCo may find itself in. If BuyCo's purchase is structured incorrectly, then the creditors of TargaCo may be able to "reach through" the transaction and sue BuyCo for its accounts receivable. The actual Minnesota law on the subject says a transfer made by a debtor is fraudulent if the debtor made the transfer "with actual intent to hinder, delay, or defraud any creditor of the debtor." s513.44(a)(1). The law prescribes a laundry list of 11 factors to determine "actual intent". s513.44(b)(1-11). More generally, if a transfer makes the seller insolvent, then creditors may pursue BuyCo to satisfy their claims against TargaCo. Importantly, the existence of a fraudulent transfer trumps indemnification provisions. Thus, BuyCo may be held liable even though BuyCo and TargaCo expressly provided otherwise in their Purchase Agreement. The fraudulent transfer doctrine is an attempt by courts to prevent corporations from evading their actual debts.
   
3. Successor Liability: Trap #2 that BuyCo may find itself in. The general rule in M&A is that successors aren't responsible for the actions of their predecessors. But exceptions exist - especially in the distressed company setting. One such exception is the generic merger. In a merger, BuyCo is assumed to have taken on the liabilities of TargaCo. This is the primary reason why lawyers never structures M&A transactions as a plain-vanilla merger (but instead use a subsidiary and either a reverse or forward triangular merger). This is true even when the words of a purchase agreement state that it is not a merger -- courts look to the circumstances of a transaction, rather than its title, to determine whether a de facto merger has in fact occurred. *** In some states (though not MN), a successor may find itself liable if the court finds that there has been a "continuity of the enterprise." *** The bigger danger is the "product line" exception. Under this rule, a successor is liable if BuyCo acquires all or substantially all of the manufacturing assets of another company, and undertakes essentially the same functions as the predecessor company. Ray v. Alad Corp., 560 P.2d 3 (Cal. 1977). *** If BuyCo is found liable as a successor, it may be required to pay for the taxes, environmental claims, employee claims, or product liabilities of its predecessor.
   
4. Result of the Risk: Due Diligence must be Excellent. Because the reps & warranties are not meaningful in a distressed setting, the legal (and financial) due diligence must be excellent. There is no room for error. Careful buyers should consider obtaining releases from creditors of TargaCo.
   

Benefits to BuyCo

1. Low Price AND Low Liability. When structured well, BuyCo can purchase a company for a great price and avoid assuming liabilities that would otherwise be impossible to avoid.
2. s363 Sale. 363 sales are a method of purchasing a company through Section 363 of the Bankruptcy Code. It is faster, less expensive, and carries less risk than buying a company out of a Chapter 11 plan. Most importantly, the transfer is blessed by the court. Thus there is no risk of liens/encumbrances/fraudulent transfers/successor liability. A s363 does not require approval by TargaCo's shareholders. *** s363 sales are always done through an Asset Purchase Agreement, since APAs allow buyers to pick-and-choose which liabilities they will assume.
3. Other Options. There are other options in the distressed setting, including the Assignment for the Benefit of Creditors (ABC) and a Friendly Foreclosure. Like anything else, there are goods and bads to each option.
   

M&A 101, by Faegre & Benson

I attended an excellent M&A overview by Faegre & Benson last Thursday. The event was organized by the Private Equity Alliance of Minnesota.

The most impressive part of the evening was that Faegre distilled a very complex topic into sixty minutes. It was a 35,000-foot overview of the subject.

There are 6 areas of M&A law. In chronological order, they are:

1. Confidentiality agreements
2. Letters of intent
3. Legal due diligence
4. Deal Structure (most complex, and merits a separate blog posting)
   
5. Definitive Agreement, and
   
6. Indemnification provisions

Here are a few highlights from each of those areas:

1. Confidentiality Agreements. There are actually two distinct CAs: the initial one between the company and its banker, and the subsequent CA between the company and various potential suitors.
   

• The purpose of the CA is to limit the consequences of TargaCo revealing sensitive information. The CA will state what purposes the recipient of the information may use the information for. This is especially important to prevent competitors of TargaCo from acting interested so that they can obtain proprietary accounting numbers from its competitor.
  
• The CA may further require that recipient must destroy the information within a certain amount of time.
  

2. Letter of Intent -- The legal due diligence comes after the business due diligence.

• The lawyers will look at all the "nooks and crannies" of TargaCo's contract and ensure that there is nothing in those contracts that would spoil the benefits of the transaction.
• Especially when TargaCo is a family-owned business there can be unusual terms from previous contracts. Common examples include determining the severity of existing lawsuits, determining what the change in control might trigger (parachute payments, rights of first refusal, or key supplier agreements).
  

3. Transaction Structure

• This can be complicated and confusing.
• To clarify, remember Bruce Engler's clarifying statement that "at the end of the day, the transaction must be either a stock deal or an asset deal."
• To be more thorough, there are two necessary steps for a transaction: 1) the consideration received (stock or assets), and 2) deal structure (reverse or forward triangular).
  

4. Definitive Agreement

• This document "sets in stone" the deal.
  
• It will be either a Stock Purchase Agreement or an Asset Purchase Agreement.
  
• All the information gathered in due diligence and structure strategizing (from accounting and tax standpoints) are brought to bear on this document.
  
• It articulates the purchase price and the composition of that price (cash, stock, debt, seller notes), the reps and warranties, covenants, conditions to closing, and indemnification provisions.
  
• Here are 2 interesting aspects to definitive agreements:

1. The reason why there is often a gap between signing and closing (an Executory Contract) is that, subsequent to signing there remains the need to get financing, third-party consent, or a Hart-Scott-Rodino filing is necessary (when deal size is greater than $70 million).
   
2. Covenants are much different than conditions to closing. A condition to closing, if not met, severs any obligation to fulfill the contract. It is much harsher. A covenant, in contrast, cannot break the fulfillment of the contract.
   

5. Indemnification Provisions

• Indemnification provisions are promises made by both parties in the Definitive Agreement that obligates the party to "make whole" the other party if what they said in the Definitive Agrement isn't true. If a rep/warranty of covenant is breached, the indemnification provision is the ex ante term the parties look toward to resolve their dispute.
  
• The most important term of indemnification is the basket:

1. Baskets set the threshold number when liability will accrue. There are both "deductible" and "dollar one" baskets.
2. In a deductible basket, the guilty party pays every dollar above the basket for the breach. Thus, if there was a $100 deductible basket and $120 in damages, the party would owe $20. Deductible baskets occur 78% of the time that a basket is present.
   
3. In a dollar one basket, the guilty party pays every dollar from "dollar one" once the threshold is crossed. Thus, if there was a $100 dollar one basket and $120 in damages, the party would owe $120. Dollar one baskets occur 22% of the time that a basket is present.
   

My visit to KKR

I took this photograph on Saturday while at KKR's 42nd floor office in Manhattan's Solow building. Not a bad view of Central Park!



I spent an hour speaking with an acquaintance who is an associate at the firm. Our conversation ranged from his career, (he was a St. Thomas undergrad in finance) to the last 2 years working in the capital markets, and from KKR's business strategy to its upcoming Dutch IPO. It was an excellent learning opportunity.



I also got the chance to pick up KKR's 2008 Annual Review and have spent a number of hours reading its contents.



While KKR does not have an office in MPLS, I thought that there is valuable information for us MPLS dealmakers to glean from the most respected private equity firm in the world.



In that vein, here are a few of my thoughts from my visit:

Point #1: The Public/Private Irony. Private equity firms argue that companies 'win' when they go private because they are not subject to the public scrutiny required by 8Ks, 10Ks, and the incessant need for manage earnings. Instead, the argument goes, companies can focus on creating long-term value. They can make investments now (R&D, or PP&E) that have long-term payoffs later. So, "it's better to be private" the argument goes.

But KKR has been trying for years to go public. In summer 2007, KKR filed with the SEC to issue a $1.25 billion ownership stake in its management company (this occurred 2 weeks after Blackstone's IPO). They pulled the offering after the credit crunch, and are trying to perform a reverse merger of its Euronext affiliate, KKR Private Equity Investors.

So how can PE funds legitimately say that going private is best, but still go public themselves? Isn't this a double-standard? No, it is not. I believe there is a legitimate reasoning, and it can be summed up in one word: funding.

The funding of private equity firms is likely to be very difficult for the next couple years. PE funds' investors are "LPs" (limited partners -- usually accredited investors under "Reg D"). The actual identity of these investors is almost always institutions: university endowments, pension funds, and HNW (high net worth) families. The money managers that run these funds usually have a specific sector allocation: 40% US equities, 20% fixed income, 10% private equity, etc.

Now, think of how quickly the value of some of those sectors get reported: at the end of every trading day, a money manager knows exactly how much his US equities portfolio is worth. But he does not know what the PE portion of his portfolio is worth -- those assets are not publicly traded. The result of this difference in reported valuations in the context of the Fall '07- March '09 selloff is that the percentage of a money manager's portfolio allocated to private equity has significantly increased in the past 18 months.

What does this mean for the manager of a private equity fund? It means that he will have a much more difficult time convincing LPs to provide new money into the manager's fundraising efforts. Liquidity dries up. This is especially pernicious when you consider that corporate valuations have come down, and PE managers may be spotting good investment opportunities.

So -- getting back to KKR -- the primary reason I believe that KKR is going public is so that it can quickly raise capital in a poor fundraising environment. Unlike at Blackstone, KKR's senior partners (Roberts and Kravis) are not selling any of their ownership in the fund. (Pete Peterson, founder of Blackstone and former CEO of Lehman brothers, did sell his ownership and received a $1.5 billion dollar check in the mail. ("pre-tax!", he reminds people -- see his Charlie Rose interview for more from him))

Point #2: Diversification. A second interesting point regarding KKR is its effort to diversify its abilities so that it can a) find new ways to develop cashflow and b) distinguish its capabilities from other firms. Put simply, KKR is not your regular buyout firm. KKR is increasingly providing a full suite of financial capabilities, including:

1. KKR Asset Management (KAM). In December 2008, KKR launched KAM to make investments across the entire capital structure of companies. The bulk of its assets are in senior secured (80%), but there is also high yield (15%) and second lien/mezz (5%). The thinking here is that, with capital markets still tepid, corporations will have a 'financing gap' that may be increasingly filled by non-traditional lenders like KAM.
2. Global Infrastructure Group (GIG). The GIG is an "upgrade" of the firm's energy industry team, and represents KKR's realization that there is a large global need to invest in infrastructure. KKR estimates that infrastructure -- especially in Asia where it has recently opened offices -- is a $3.0 trillion/year industry.
3. KKR Capital Markets (KCP). KCP supports transactions in its private equity, KAM and GIG. It's essentially an in-house investment bank that ensures dedicated banking services are available to all portfolio companies and retains the transaction fees that would otherwise go an I-bank. Among its capabilities are 1) raise debt/equity financing in public/private markets, 2) provide strategic capital market advice, 3) provide hedging strategies, 4) provide insight into adjusting/deleveraging capital structure, and 5) underwrite security offerings.
4. An "in-house global public affairs capability." With public scrutiny of large corporations getting stronger every day, KKR has astutely formed a team to address various stakeholder interests. The purpose of this group is to further the due diligence on a potential acquisition (or assist a portfolio company) on environmental, social, and regulatory issues.

In summary, KKR is expanding the types of services it provides so that it can ensure money is coming in the door, even when that money is not coming from its LPs. Additionally, providing these services makes KKR a more attractive suitor since any offer by KKR is accompanied by a best-in-class public affairs and capital raising teams.

While most Minneapolis firms are not large enough to provide this array of financial services, it is useful to see the strategic changes KKR is making amidst the chaning economic climate. Smart firms should consider how they can be making necessary adjustments too.

A thorough and concise analysis of the Crisis

Thanks to all of you who have been so encouraging lately regarding this blog. It is a fun way to exercise (and stretch!) my knowledge of banking, M&A, and the law surrounding it.

I took a break from studying today and re-read Jamie Dimon's 2008 Shareholder Letter. Warren Buffet (at his own shareholder meeting in April) said it was the one "must read" piece that dissects the financial crisis we just went through. I have found it prescient. Read it here.

"Secret" Conditions Precedent: Gray Plant Mooty makes Deal Professor's website

With the bar exam 5 days away, I haven't been as diligent with my blog in recent weeks. My apologies.

But I just came across a MN-based post on the Deal Professor's website -- you can find it here.

PostScript -- I emailed Professor Davidoff regarding this post, and he responded by saying that he would keep an eye on my blog! I'm honored to have his eyes reviewing my work (better double-check my citations and recommendations).

Enjoy.

How to Perform a Sensitivity Analsis

While clearing out my MBA locker the other day, my friend asked me "how do you do those sensitivity analyses -- they're so cool!" Colin, this is for you.

The purpose of a sensitivity analysis is to answer this question: "how bad could it get if the assumptions you're putting into your analysis are erroneous?" The S.A. isolates two key variables -- usually discount factor and EV/EBITDA multiple -- to answer this question.

I often perform a SA when doing a discounted cash flow (DCF) analysis. (By the way, a DCF is simply a way to determine what the projected future cash flows of a company are worth today.) We'll assume this is the case for this example.

Before we get to the SA, we first have to establish a base-case DCF.

Establishing a base-case DCF:

1. Project out the next 5 years of cash flows. Doing any more than 5 years would be presumptious -- subject to too many unforeseeable variables. To project cash flows, take NOPAT (EBIT*(1-T)) and then adjust for working capital changes and depreciation and amortization. [The reason for staying at "operating level" metrics is because often this is done in an LBO setting, and PE firms will recapitalize the company, so they do not want their numbers to be complicated by irrelevant debt PMTs.]
2. Do this for the next 5 years.
3. Use the Constant Growth Model to find the present value (determined at Year 5) for all future cash flows. CGM = D1 / (WACC - g). Here, D1 is your projected cash flow in year 6, and g is your long-term growth rate (usually 3.5%, since that is historical nominal GDP growth).
   
4. Discount all those CFs by your weighted average cost of capital.
5. Sum those #s up -- this is your base-case discounted cash flow valuation of the firm.
   

Here's the important part: did you notice how the key to your DCF was the assumption of your growth rate (here, our base is 3.5%) and the discount rate? If you changed those inputs, your final output would be much, much different.

Bankers want to cover their butts (both for pride and liability reasons!), and so instead of giving a *precise* number to their clients (ie, "We think we can sell your company for $X million dollars") they give a *range*. Often, this range is the result of the SA that they apply to the base-case DCF analysis. Here is how it works.

1. Link a cell to the output you'd like to sensitize. For example, below I sensitized D41, which is the present value of a) the cash flows from 2009 through 2013, and b) the Gordon ("Constant") Growth Model.



2. The row (to the right) and the column (below) your sensitized cell will be your alternative inputs for the sensitivity table. I use 5 cells in each direction. The middle of those 5 cells is the "base-case" variable; in other words, 3 cells to the right of the sensitized cell is the 3.5% growth rate and 3 cells below the sensitized cell is my base-case discount rate (let's say it's 11.7% for our company.

It should look something like this:

...to be continued

MN Venture Capital Funding at 14-year low

This chart shows quarterly equity investments into US-backed venture capital since 2001. It comes courtesy of PriceWaterhouseCooper's MoneyTree report.

Only $3 billion was invested in Q1, an all-time low. That number is essentially half of the $5.7 billion from Q4 '08.

No sector was spared. Measured by both dollars spent and deals done, the numbers were down.

The sectors that grossed the highest net financing were (no surprise) software, BioTech, and Medical Devices. As a whole, they made up 53% of the financing. The sectors with the least financing were was electronics and retailing, with $27 million and $28 million, respectively.

Spotlight on Minnesota

The most active investing group -- which has an office here in Minnesota -- was Oak Investment Partners. Oak made 13 different investments in the quarter. It would be interesting to ask Jerry Gallagher why Oak was relatively bullish on the quarter -- ie, whether they have a fundamentally different view of the economy, or whether it was an isolated incident based on good deals in front of them. Per the Star Tribune, 4 Minnesota companies received a total of $56.1 million. The med-device startup Atritech received $30 million -- more than half of MN's total funding.

"The World is Over-Leveraged" (ACG Recap on Buying Distressed Assets)

Jeff Werbalowsky, co-CEO of Houlihan Lokey, stated in November 2007 that the "world is over-leveraged." (See video of the interview here.) Based on his comments from Tuesday's ACG Luncheon, I doubt he thinks much has changed in the 18 months since then.

Alongside Jeff was Daryle Uphoff (Mg Partner of Lindquist & Vennum) and Steve Rosen (co-founder of turnaround firm Resilience Capital). Houlihan's Jeff Arnesen acted as emcee.

Here are some highlights:

• Risk is currently overpriced. Rosen mentioned that had been underpriced in the past, but now believes that risk is being overpriced. The pendulum has swung too far toward fear, and away from risk, he said.


• Comment from Drew: Does this mean that it's a buyers' market? Rosen continued to be pessimistic about buying opportunities, which seemed to conflict with his "risk is overpriced" question. I wish I had the opportunity to ask him whether he's overall bullish or bearish on asset valuations.



• Goodbye, Refi. Gone are the halcyon days of easy hedge fund refinancing and corporate debt default rates. At the end of 2006, corporate defaults occured <1%.>. Find that here.



• A Broad-based Economic Downturn. Daryle noted that past recessions were contained because they were industry- or geographic-specific (1981 S&L crisis, 1998 Asian Currency/Long-Term Capital Mgmt and 2001 .com). This recession, in contrast, has had a 'systematic' effect. As a result, it's infecting all aspects on the economy. The fact that there are fewer industries that are doing well means there isn't an impetus to jumpstart the economy and adds to the fear of an "L" or "U" shaped recovery rather the "V" to which we've become accustomed

• The Slow Motion Commercial Real-Estate Tsunami. Werbalowsky argued that commercial real estate is the next bubble to pop. No one disagreed. His reason -- and I find this compelling -- is that the financing of real estate is on a different time horizon than banks. Banks are financed on overnight or 30-day commercial paper. Thus, when things go bad, the liquidity hits them quickly as they fail to roll over their liabilities. The opposite is true with commercial real estate: their tenants sign long-term contracts that renew on a much slower timetable than banks -- 12, 24, or 36 months. "That's my future inventory" Werbalowsky said.
• Connecting this comment to Uphoff's (regarding systematic vs. contained recessions), I am trying to determine how broad-based commercial real estate is. Are its 'tentacles' so broad that a downturn there has domino results elsewhere? Or, alternatively, does a downturn in commercial real estate mean lower SG&A expenses for other businesses (lower lease costs) and thus better margins? Does one compound the other, or is one's pain the other's gain?
• Your thoughts are welcome: askniffin@stthomas.edu

I'm off to canoe the Buffalo River for the next week, so be patient if I don't report anything immediately regarding the upcoming TGT shareholder's mtg.

New CEO at Supervalu

Supervalu -- at $44B FY08 revenues Minnesota's 3rd largest company and the 51st largest in the country -- announced today that 62 year old Jeffrey Noddle will step down as CEO.

Craig Herkert, WMT's "president and CEO of the Americas" will take over. He is 49. Prior to WMT, Herkert was with Albertson's -- the company that SVU purchased 3 years ago in a massive acquisition whose synergies have largely never been realized. SVU stock was down on the news.

From the Strib: "Noddle was named CEO in 2001 and chairman of the board in 2002. He steered the company through its largest acquisition in 2006: the $17.4 billion purchase of Albertson's Inc. Supervalu paid $3.8 billion in cash and $2.5 billion in stock and took on $6.1 billion in Albertson's debt. Its partners in the deal included Rhode Island's CVS Corp., New York-based Cerberus Capital Management, Kimco Realty and Schottenstein Stores Corp. of Columbus, Ohio."

By coincidence, I have been modeling and studying SVU this semester. I value its stock at $37.29. This number is based on a 50/50 weighting of discounted cash flow and EV/EBITDA, using comp companies of Kroger, Safeway, and Wal-Mart. The DCF assumes zero revenue growth through 2013. (Sorry for the small screen shots -- I'll try to adjust)

1) Financial Ratio Analysis


2) DCF Analysis (note no revenue growth through 2013)

3) EV/EBITDA Analysis

		2009	SVU	KR	SWY	WMT	Industry Average
	Equity Value
		52 wk high	35.61	30.32	32.65	63.17
		52 wk low	9.02	19.46	17.23	46.42
		Shares O/S (m)	211.75	652.34	427.05	3910
			4,725	16,237	10,651	214,248
	(add) LT Debt Value		7,968	7,505	4,701	34,549
	(subrtract) Cash Value		240	263	383	7,275
	Enterprise Value		12,453	23,479	14,969	241,522
	EBITDA		-1,100	3,893	2,994	29,537
	EV/EBITDA		NM	6.0	5.0	8.2	6.4
	SVU Valuation based on Industry EV/EBITDA:
	1)	Normalize EBITDA as % of sales:
			EBIT	DA	EBITDA	Sales	%	Weighting
		2008	1,648	1,017	2,665	44,048	6.1%	60%	3.6%
		2007	1,305	879	2,184	37,406	5.8%	30%	1.8%
		2006	435	311	746	19,864	3.8%	10%	0.4%
									5.8%
	2)	Estimate FY 2010 Sales:
		43,239,600
	3)	Multiply #1 and #2 to obtain estimated FY 2010 EBITDA:
		2,489,423
	4)	Apply multiple to obtain estimated FY 2010 Enterprise Value:
		15,938,531
	5)	Add back estimated cash and subtract estimated debt to obtain Estimated 2010 Market Capitalization
		8,376,531
	6)	Divide by shares outstanding (diluted)
		$38.96

Pepsi Developments...

Pepsi Bottling Group rejected PepsiCo's squeeze-out buyout offer as "grossly inadequate". Their 8-K filing can be found here.

A Special Committee of Independent Directors was advised by Morgan Stanley and Cravath, Swaine, and Moore. The following reasons were given for the rejection:

1. Opportunistic Timing.
2. Inadequate Value.
3. Understated Synergies. **This was particularly interesting to me, given the 'modeling synergies' post I wrote in April. In theory, TargetCo should not receive any portion of the synergies value, since BuyCo brings that to the transaction. Nonetheless, PBG is making this one of its sticking points**

In addition, PBG announced the approval of a shareholder rights plan -- more commonly known as a "poison pill".

The interesting question is what effect this has on PepsiAmerica's evaluation of the offer it received. It is being advised by Briggs and Morgan's Brian Wegner, as well as Sullivan & Cromwell and Goldman Sachs.

PAS already has a poison pill plan, which was instituted in 1999 (It can be found in its latest 10-K at page F-36 and here).

Silence on Pepsi? Twins Fans Rejoice!

In a move to control distribution costs, PepsiCo. offered on April 20 $6 billion to purchase PepsiAmericas and Pepsi Bottling Group. According to Indra Nooyi's talking points, there are at least $200 million in negative synergies that can be eliminated through this transaction! PepsiAmericas (the local tie) filed its obligatory 8-K the next day.

Why isn't this grabbing the attention of the local press! $6 billion is never something to yawn at, but especially when there's a dearth of deal activity here in town!

The Pohlad family owns PepsiAmericas (PAS). PEP is offering $23.27/share of PAS -- 50% of the consideration is cash, and the remainder is PEP stock. With an extra 17% per share over the April 17 closing price, we could really compete in the AL Central (or purchase snow removal equipment for next April's games)!

PepsiCo. expects the deal to be immediately accretive by $0.15/share upon full realization of synergies. Because both companies are public, it's fairly easy to model this and test it. I am working on that, and will get back with my findings.

On a legal note, though, much of the buzz is discussing the structure of the deal. Whether it's a forward- or reverse-merger has significant tax obligations.

In short, in a reverse merger PepsiCo creates a subsidiary (which ultimately extinguishes by operation of law) and gets a "stepped-up basis" in PAS. This reduces its future tax liability when/if it sells off PepsiAmericas and PAS shareholders are forced to pay capital gains. PEP wins; PAS loses.

In a forward merger, PepsiCo again sets up a subsidiary, but this time the sub "swallows" PAS
so that PAS extinguishes by operation of law. Its a tax-free transaction for the Pohlads, but PEP receives a lower basis (read, higher tax bill in the future). PEP loses; PAS wins.

We will see how this plays out...

Piper Jaffray IPOs Rosetta Stone and BPI

Last Friday I met Andrew Duff -- CEO of Piper Jaffray -- while attending the Board of Advisors meeting for the UST MBA program. Our conversation quickly turned to the recent "thawing" of the IPO market, as evidenced by the recent (week of April 13) IPOs of both Rosetta Stone (RST) and Bridgepoint Education (BPI).

For RST, Piper acted as co-manager of the offering alongside Robert W. Baird. Assuming the standard management fee of 20% of the 7% gross spread, Piper hauled in 0.7% of funds raised for RST (20% of 7%, split two ways). On the $112.5mm raise, then, Piper received an estimated $787,500.

For BPI, Piper acted as co-manager alongside Signal Hill and BMO Capital Markets. Assuming the standard management fee of 20% of the 7% gross spread, Piper hauled in 0.47% of funds raised for BPI (20% of 7% split three ways). On the $202.5mm raise, then, Piper received an estimated $945,000.

Being a "manager" of an IPO is different than being an "underwriter". The manager assembles the syndicate of investment banks to underwrite the offering, while the underwriter guarantees the issuer that it will purchase an agreed number of shares at an agreed price. The underwriter therefore assumes the pricing risk inherent in the transaction (assuming it's a "firm underwriting", as most are).

Norwest Equity Partners had a 40% stake in RST -- I wonder how this local connection affected/enabled PJ to play a managing role in this successful issuance.

Note the bunching of offerings that has recently occurred in the for-profit post-secondary education sector. Even though the IPO market has been non-existent, BPI just IPO'd and in November Grand Canyon Education (LOPE) also did so. As HBS' I-Banking prof Josh Lerner says, "the bunching of offerings is even more dramatic when patterns are examined on an industry basis." p400.

This sector is booming given its counter-cyclical nature, demographic trends, and the education income gap. I recently convinced the Aristotle Fund to invest $60K of our $1.8mm endowment in Strayer Education (STRA) at $157/share.

Wall St. comes to Wacouta St.: What's a name worth?

I started this blog partially to highlight "deal" news that doesn't make the national/Manhattan level. But today the Wall St. Journal came to us!

In this article, the Journal discusses the Polaroid s363 auction out of Petters' Group's Chapter 11 filing. The deal was portrayed as a marquis example of the "new world of mergers and acquisitions" -- a world where Vultures soar high. Stephen Spencer of Houlihan Lokey handled the auction.

It appeared that Patriarch Partners (NY) auction bid of $88.1 million had won the iconic Polaroid. But later Judge Kishel announced that Polariod creditor committee preferred a $87.6 million cash-and-equity bid by PLR holdings, a joint-venture bid of Hilco (Trnto)/Gordon Brothers (BSTN). PLR offered the maximum 25% equity. Apparently, the creditors were attracted to the capitalization structure (particularly the minority shareholder's rights) that PLR offered.

Polaroid was purchased in 2005 for $426M. Ouch.

Given the utter implosion of the paper film industry, the purchase is primarily buying the goodwill/name-brand of Polaroid.

(The Strib had different bid #s: $86.4 for Patriarch and $85.9 for the JV.)

With $400M in FY08 revenue, the sale yields a 4.6x price-to-revenue multiple. Not a particularly helpful datapoint, but one nonetheless.

This is only the latest iteration of the Polaroid bankruptcy proceedings. There have already been 2 other 'sales'. On March 30, Partriarch appeared to have won with a $59.3M bid. PLR won the second 'sale' with $72.6M.

Modeling Tip: Determine Price w/o Synergies

In determining Enterprise Value, buyers (either financial or strategic) firms must determine the Target's standalone value. The Buyer will often project realization of synergies, but these must be removed from the model for valuation purposes.

Thus two models must be constructed: a standalone and a synergistic model. The standalone model is the value of TargetCo by itself (ie, the present value of its future cash flows -- discounted by its WACC), while the synergistic value is the result of reduced expenses and/or increased revenues as a result of the merger of the two companies. The difference between these two is the "synergies spread".

I missed this distinction during the ACG Cup. I had constructed a single LBO model, and was presenting its findings to a fictional PE firm (in reality this "firm" was the judges of the competition, composed of Houlihan Lokey, NEP, Grant Thorton professionals). Alan Thometz of Grant Thorton (Head of its Transactional Advisory Services group) asked me "aren't you asking us to pay for some of the value we bring to the table?" The answer was yes, but I didn't realize it at the time.

To correctly model a synergy-based buyout, be sure to model both a standalone and a "synergized" model.