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Interesting Reading September 5, 2011

Posted by Manish Katyan in Startup.
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Marc Andreessen

David Cowan
Steve Blank
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Learning from Acquisitions at P&G April 29, 2011

Posted by Manish Katyan in Mergers & Acquisitions.
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Acquisitions are risky with a higher failure rate of over 70%. A detailed analysis of all acquisitions at P&G from 1970 to 2000 showed that only 20% to 30% of acquisitions succeeded in that period. An acquisition was successful if that “met or exceeded the investment case and going-in investment objectives.” An acquisition was partially successful if that “exceeded the cost of capital.”

The study above found five fundamental root cause of failure:

  1. The absence of a winning strategy for the combination
  2. Not integrating quickly or well
  3. Expecting synergies that don’t materialize
  4. Cultures that aren’t compatible
  5. Leadership that wouldn’t play together in the same sandbox

I have discussed above failure reasons in earlier post on Post-Merger Integration, quoting that post:

Buying a company is easy. Making that purchased company succeed in the post‐purchase environment is something else altogether. Just as anyone can get married, anyone can buy a company. But not everyone can make a marriage successful, and many companies wind up selling (divorcing themselves of) the very companies they initially enthusiastically acquired, often selling for a fraction of the original purchase price.

Further I discussed various topics Value Creation Strategies, Vision & Leadership etc in successive posts that outlines similar issues elsewhere and details aspects that should be kept in mind.

Coming back to P&G case, once above root causes were identified, the company worked on issues such as how should it organize each phase of acquisition, what processes should be in place, which interim measures would indicate whether the acquisition process is on track. So this is a disciplined approach with clearly identified  in-charge for each phase of the process.

These insights were used in the $57 billion USD acquisition of Gillette in 2005. The company identified all the value creation elements. It identified the integration the integration sequence and elements. It put a pretty senior manager in charge of every value creation initiative. It tracked progress for every value-creating initiative using a simple red (indicating not on track), yellow, green (indicating on track) process. It drove every phase of integration, every building block of value creation, to completion.

Above efforts resulted in delivering more than 150% of the originally estimated cost synergies. So the cost synergy alone created enough value to make the Gillette acquisition a success. The revenue synergies – such as in combining Crest and Oral-B brands and innovations in oral care products – all come on top of the cost synergies.

Source: Interview of A.G Lafley, Former CEO, P&G, HBR April 2011

Hot Sectors in PE February 5, 2010

Posted by Manish Katyan in Private Equity.
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  • Education: With an estimated $40bn market for private institutions, education sector will be one of the most favorite sectors for Private Equity and Venture Capitalists in coming years. A Venture Intelligence survey revealed that more than 80% investors are planning to make an investment of around $800MM in education sector over the next 12 months. Since 2006, $300MM has been invested in Indian education ventures.
  • Healthcare: Opportunity is being seen mainly in diagnostic services, medical devices, hospital chains and wellness products. India has a huge competitive advantage in clinical research. Hospitals are yet another area where a lot of investment to be seen in near future as the average number of beds is the lowest in India. During the last 18 months, PE players have invested $686MM in the health care sector.
  • Cleantech: PEs and VCs are likely to invest about $3.5bn in clean technology in next few years. Regulations in India (where 10% power is generated from renewable sources) are very positive for the sector.

Reference for survey and investment period: July 2009

Desired Regulatory Changes for PE February 5, 2010

Posted by Manish Katyan in Private Equity.
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  • Currently VC/PE firms make their investment decisions solely based on publicly available information. VC/PE companies should be allowed to conduct full due-diligence on listed companies to validate viability and sustainability. Lock-in period and NDA can be used to safeguard interests of targets.
  • Increase the threshold to trigger open offer to 25% from 15%.
  • Increase the time period to convert warrants from 1.5 years to 5 years.
  • PE/VC funds shouldn’t be treated as promoters or persons in control along with promoters and hence exempt from SEBI regulations for promoters.

Deal Design and Risk Management – Part II January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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Managing Risk in an M&A deal

In a stock-for-stock deal, the acquirer’s share price may drop before the deal is closed for various reasons including overvaluation of acquirer’s shares, market perception about over-payment, and weakening of operating and financial performance of the acquirer. This would reduce the deal value to the target shareholders. There are other risks to shareholders of the target such as exchange ratio may change or deal may not go through at all because of regulatory disapproval or walking away of the acquirer.

Similarly there are various risks to the shareholders of the acquiring company. The target’s operating or financial performance may deteriorate. There may be hidden liabilities in the balance sheet of the target. There is always a chance of paying too much, a competing bid or deal not going through at all because of regulatory disapproval or social issues. For example, target’s employees may go on strike fearing job loss post-acquisition.

The risk sharing is affected by the method of payment. In case of all cash deal, all pre-closing risk is entirely born by the shareholders of the acquirer company whereas in case of all stock deal, the risk is born proportionately by the shareholders of the acquirer and the target shareholders. During the negotiation phase, the buyer and seller maneuver to share the perceived risk and potential return. In doing so, substantial differences arise between the expectations of the buyer and seller.

There are several mechanisms of managing such risks and consummate the deal aimed to alleviate asymmetric information and provide incentives when the buyer and seller cannot reach agreement on purchase price. The following diagram shows risk management strategy in various stages of a deal:

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Deal Design and Risk Management – Part I January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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The deal design process is fundamentally about meeting as many objectives of the parties involved as required to reach overall agreement and determining a risk sharing mechanism.

The buyers may want to pay only reasonable price, use stock in stead of cash, sign non-compete agreement, retain key employees or make a certain percentage of the purchase price contingent on realizing some future events to minimize risk. For example, seller may claim an aggressive growth rate of the business. In this case the buyer may want to hold a certain percentage of payment till the claimed growth is realized.  Seller may be interested in fetching maximum price, tax advantages, rights to license patents or other assets or future reputation of the business.

Whether acquirer would assume all, some or none of the liabilities, disclosed or otherwise, of the target is about sharing of risk. This process can become fairly complex in a large transaction involving a number of parties, payment modes and source of financing.

Form of Payment for an M&A deal

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Valuation of LBO January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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Leverage Buy-out

A buy-out firm buys 100% of the target by levering it up and takes it private i.e. shares of LBO no longer trades in the open market. After improving operational efficiency and lowering leverage, the target is brought for IPO or is sold. The buy-out firm usually exits in 3-4 years. A large portion of the buy-out is financed by debt.

Characteristics of good target company

A good target for buy-out would preferably have low debt with high level of “bankable” assets and high growth potential with scope for operational improvement. The target’s cash flow should be stable and sufficient to meet interest and principal payments on the debt and provide adequate working capital. The target’s cash flow should also be protected by patents, strong brand or market leadership.

Though difficult to estimate, the financial distress cost of the target company should be low. When debt is very high suppliers may get concerned about company going bankrupt, stop giving credits and start working with competitors having better chance of survival. For example, if there is a high requirement for after-sales service and the customer think that company may not be able to make spare parts available in future; she would not buy at all – resulting in high financial distress cost for such a company.

The management should be cooperative and receptive for changes required for turn around.

Sources of value in LBO

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How much premium to pay for synergy? January 12, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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Value of a target firm is estimated as the sum of the value of stand-alone target firm, value of the synergy expected by the acquirer and value of liquidity and control premium.

The synergy can be either of operating or financial in nature. Operating synergy results from revenue and cost synergy that would have impact on cash flow.

Market believes in cost synergy as it is under acquirers’ control and hence possible to achieve. For example, reducing COGS or SG&A through economies of scale, elimination of overlapping operations and headcount reduction through right-sizing can be explained and achieved in a short span of time.

However, revenue synergy is affected by a number of external parameters such as economic outlook and competitive response and hence it’s is difficult to achieve. So market doesn’t believe in revenue synergy. Because of the same reasons, to value a business for higher discount rate is used for revenue synergy and lower for cost synergy.

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At a glance … January 11, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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Deal Design and Risk Management: Part I Part II

Analysis of Risk: Beta

Premium=How much X synergy

Private Equity in India: Challenges

Post Merger Integration

Reliance – LyondellBasell

Air France – KLM

How to value a business? January 7, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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Disclaimer: I am not an expert and below is based on my limited exposure of this area. This is a work in progress and I would keep updating it as I broaden my understanding.

Before discussing various methods of valuation, we should keep in mind that complex models don’t necessarily lead to better results. Accuracy of valuation depends upon the correctness of the assumptions and that is quite subjective. There are some thumb-rules and best practices but even those might not be applicable universally.

There are 3 components of enterprise value:

  1. Valuation of operating assets, i.e. valuing operations of the business. This can be estimated using free cash flow method of valuation.
  2. Valuation of non-operating assets such as investment in assets not directly related to the core business. This can be estimated using market value method of valuation.
  3. Valuation of opportunities and uncertainties. For example a company can have patent rights or some other intellectual rights.  This can be estimated using real option method of valuation.

There are 2 components of valuation. The first is determining the present value of explicit time horizon. The second is estimating the terminal value of the business with an assumption that after the explicit time horizon, the business will reach to a stable stage without much of growth opportunity. To calculate terminal value, perpetuity value method is used with the growth rate as industry or economy (usually take as 3%) growth rate. A conservative value should be taken for this growth rate otherwise one would get terminal value as significant proportion of the total value. There may be some companies that may be able to sustain their above-average growth rate because of superior innovation abilities or advantages such as patent rights.

Utilizing above components, following is an approach for valuation:

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