Managment Engineer - Investment banking

2 - Additional Theory

Divided by topic

Contenido 1. Equity research report ................................ ................................ ................................ . 2 2. Mergers & Acquisitions ................................ ................................ ................................ 3 1. Ways to do an M&A ................................ ................................ ................................ . 3 2. Types of M&A ................................ ................................ ................................ .......... 4 3. Motives for an M&A ................................ ................................ ................................ . 4 4. Takeover defenses ................................ ................................ ................................ ... 4 3. Private equity and LBOs ................................ ................................ ............................... 5 1. Private Equity (PE) ................................ ................................ ................................ .... 5 2. Leveraged Buy -Outs (LBOs) ................................ ................................ ....................... 6 3. Exit strategies ................................ ................................ ................................ ........... 7 4. Project finan ce ................................ ................................ ................................ ............ 8 1. Organizationa l structu re ................................ ................................ ........................... 8 2. Financia l structu re ................................ ................................ ................................ .... 8 3. Assessment of economic convenience ................................ ................................ ...... 9 4. Assessment of financial feasibility ................................ ................................ ............ 10 5. Corporate restructuring ................................ ................................ .............................. 11 1. Introduction ................................ ................................ ................................ ............ 11 2. Portfolio restructuring ................................ ................................ ............................. 12 3. Fin ancia l restructuring ................................ ................................ ............................. 13 6. Initial Public Offering (IPO) ................................ ................................ .......................... 14 1. Equity research report The objective of an ERR is to calculate the “real” share price of a company, so we can decide whether to invest on it or not : - If the market price is clearly lower than the one we calculated, we should invest. - If the market price is clearly higher than the one we calculated, we should sell. - If the difference between the two is not to big, we should do nothing. In order to calculat e the share price, the ERR estimates the value of the entire company and then divides the equity value by the number of outstanding shares. The ERR is done by a financial analyst , who can be specialized in (listed) companies of the same country, industry, market,… Depending on its role, the financial analyst can work as: • Sell -side analyst : he works for a financial intermediary (investment bank,…) giving recommendations to its clients (buy, hold, or sell). These are blanket recommendations, and the clients d o not pay for the research directly, but in the for m of transaction fees. Sell -side analyst usually specialize in only one industry. • Buy -side analyst : he works for an investment company (private equity,…). He focuses on 2/3 industries looking for profitabl e investments for the company. • Macro trends analyst : they study the market as a whole. The link between the company, the investors, and the analysts is the investor relator . He represents the company in the financial community and explains the company’s st rategy and decisions to the analysts. The process of making an ERR involves: • Initial coverage , the first, big report made of a company, usually written when the company is created, when it goes public, or after years of no coverage. • Company updates , made periodically when there is new relevant information. • Coverage change , written whenever there is a change in the recommendation. The report usually includes: • Investment summary/thesis • Business description • Industry overview and competitive positioning • Financial analysis • Valuation (usually DCF and RV) • Sensitivity analysis (and/or Monte Carlo simulation) • Investment risks • Additional information (strategy, history, top management, ownership, HR,…) • Disclaimer (conflicts of interests,…) 2. Mergers & Acquisitions In most companies, the managers and the owners (shareholders) are not the same people. This creates the following concepts: - Agency costs : an internal expense that comes form an agent (management) taking actions on behalf of a principal (shareh olders). Core inefficiencies, dissatisfactions, and disruptions contribute to agency costs . - Market for corporate control : the mechanisms by which firms are matched up with management teams and owners who can make the most of the firm resources. The managem ent of the firm can change through the following mechanisms: • Proxy contest : a group of shareholders votes a new board of directors who elect a new management team. • M&As : a firm is purchased by a different one. When the acquiring company takes full control over the acquired it is considered an acquisition , while, when both companies stay on the same level (probably keeping 2 CEOs and staying separated when it comes to taking decisions), it is considered a merger . The acquired company might try to hide inform ation form the acquiring one, so an acquisition process is usually done before a merger, as this way the acquiring company is protected from the unknown information. An M&A process can cause an important change in the companies’ values, especially if there are synergies between them. • Leveraged Buy -Out : a group of private equity investors takes a public company private, usually with the idea of increasing its value and selling it again in ~5 years, making a substantial profit. • Divestiture : a firm sells part of its operations to another company or spins it off as an independent firm . 1. W a y s to do an M&A 1. The acquiring company assumes all the assets and all the liabilities of the other : ➢ Should have the approval of at least 50% of shareholders of each firm . ➢ The acquired firm ceases to exist and becomes part of the other . Its former shareholders receive cash and/or securities in the acquiring firm. Paying in paper (shares) avoids a cash -out but might give power to hostile individuals, so a combination of shares an d cash is commonly used. ➢ Either there is a clear acquiring company or both firms have equal share in the management 2. The acquiring buys the target ’ stock in exchange for cash, shares, or other securities : ➢ The acquired firm may continue to exist but it is n ow owned by the acquirer . ➢ The consent of the shareholders is not necessarily required. Shares can be bought directly from shareholders using a tender offer 3. The acquiring firm buys the target firm ’s assets (all or some of them): • The firm continues to exist but will have no business activity . 2. Ty p es of M&A • Horizontal : two firms in the same line of business (former competitors). Anti -trust laws can block these mergers. • Vertical : the buyer expands backward (toward the source of raw materials) or forward (toward the customer) . • Conglomerate : unrelated lines of businesses. 3. M o tives for a n M&A Good reasons: • Poor management performance : If the managers of one firm observes another firm underperforming, it can try to acquire the business and replace managers with its own team. • Synergies : sometimes, two firms are worth more together than apart: economies of scale, vertical integration, complementary resources,… • Mergers as a use of surplus funds : big firms in mature industries might have a lot of cash, but few opport unities to invest it. Giving dividends or buying back shares will shrink the company, and doing nothing won’t make it grow, so M&As can be a good investment for them. Dubious reasons: • Diversification : it does reduce risk, but it is cheaper and easier for t he shareholder than for the corporation. • The bootstrap game : M&As can make the stock raise in the short term without any real value creation. This can be done by increasing the earnings more than the number of shares (due to the M&A), and thus increasing t he EPS without creating value. 4. Ta k eover d efenses • Poison pill : a measure taken by a target company to avoid acquisition, like the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding. • White kni ght : friendly potential acquirer sought by a target company threatened by an unwelcome suitor. • Shark repellent : amendments to a company charter made to forestall takeover attempts. (e.g. the merger must be approved by 80% instead of 50% of shareholders). 3. Private equity and LBOs 1. P r ivate Equity (PE): A PE is a company whose business is acquiring companies (or merging with them), usually through an LBO , in order to increase its value and sell it again after ~5 years for a substantial profit. They usually have a wide network of contacts and very talented, experienced managers, so the idea is that by replacing the managers of the acquired company (or by joining them) they can make it more efficient and increase its market value. A PE is considered a financial company, not an industrial one , because: 1) They are financial investors who analyse the potential profit in detail, as any other investor would do. 2) They have a time frame for their expected financial gains (~5 years). 3) Their main objective is not to manage the industrial company, but to make a profit from increasing its value. 4) They don't usually manage target companies one by one, but they generally have more than one company (5 -10) at the same time in their portfolio. They do so because it helps them diversify their investments and reduce the risk, but also because they have a network of investors, managers, cus tomers, suppliers, companies,... which helps them increase the value of the target. PEs usually buy companies in their maturity phase or close to it, when it has already reached its maximum value with its current management, with the objective to control the target themselves. This defines them as opposed to vent ure capitals , whose objective is to support a company in its growing phase without controlling it. Some (but not all) of the advantages of a PE are: - They might offer synergies in R&D and technological development in general. - Their wide networks of contact s and experienced managers can help increase the company’s efficiency, both through management and through more advantageous deals with suppliers, banks, investors,… - They can help a company expand towards markets/regions/… in which it does not have enough knowledge to grow by itself. - If the company runs out of cash a PE might be able to “rescue” it, restructure it, and make it work again. - The different founders/managers/shareholders/... might hav e different ideas about how to run the company, and that can make it impossible to make decisions if none of the factions has enough power to take them. Of course a private equity solves that problem, as they will hold all the power once they buy the compa ny. - For the previous reason, t hey can also help overcome succession problems in family companies. Some immediate causes for a PE deal are: - Business is considered to be non -core by the mother company . - Underperformance of the business under current ownershi p. - Retirement of owner/manager leading to succession issue . - Investment cycle of current owner is ending (secondary/tertiary buyouts) . - Shareholder pressure in case of listed companies . Some characteristics for a suitable acquisition candidate are: • Qualitative : ➢ Market leading position . ➢ Strong due diligence (financial and commercial) . ➢ Strong management and sponsor . ➢ “Second way out” for investors . ➢ Debt push down possibilities . ➢ Positive industry dynamics . ➢ High barriers to entry . • Quantitative : ➢ Strong and stable cash flow. ➢ Potential cost savings. ➢ Proven track record (budget vs actual). ➢ Large and eligible asset base (strong collateral). 2. Lev eraged Buy -Outs (LBOs): An LBO is the process through which PEs buy companies. - Paying entirely in shares would not be a good option as it would give a lot of decision power to the managers they want to replace. - Paying entirely in cash would cause a huge cash -out, reducing drastically the return of the investment (and the point of the whole thing for the PE is to make a profit) - A third option is to ask for a loan to pay most of the company. Usually in an LBO ~ 60 to 70% of the c ompany is bought through debt , which increases the risk of the investment (even more considering the target company probably has problems of some kind), but also its return. The high risk is not that much of a problem when asking for loans as PEs are known and trusted by banks, and they see them as competent enough to give the debt back and solve the company’s initial problems. The remaining 30 -40% is paid through equity (cash from the PE) and shares (giving a reasonable amount of shares to the company’s w orkers and old management helps align their interests with those of the PE). An LBO can also be performed by the current management of the company, instead of a PE. When that occurs it is called a Management Buy -Out ( MBO ). LBOs create value through the following mechanisms: • High leverage : it increases the risk of the investment but also its return, and it amplifies the equity stake in the transaction as well. • Multiple expansion : the company is valued at a higher multiple upon exit than it wa s at the purchase (EBITDA, EBIT,…). • Increase in operating value (usually EBITDA) through top line growth (sales growth), margin improvement (cutting costs), and working capital management. The process of an LBO usually goes as follows: 3. Exit strategies • Trade sale : the company is sold to an industrial company (usually a strategic buyer, who will be able to pay more thanks to the synergies he will get from the acquisition). • Secondary sale : the company is sold to a financial buyer (another PE), re -starting th e cycle of increasing leverage first and value second in order to sell the company again. PEs usually make the best offers when it comes to selling the company, so they might be the preferred option. • IPO : the company is sold publicly. This has the downside of PE not being able to sell 100% of the company, which can also be an upside if the company keeps improving its performance. • Leveraged recap (or dividend recap): the management issues new debt and uses it to buy back the company’s shares from the PE inve stors (kind of an MBO?). This is usually done when the company is performing better than expected and it looks like it will keep increasing its value: this way the third investors get their return, and the management/PE/… can get an even bigger profit by w aiting a longer time. 4. Project finance Project Finance (PF) is usually adopted for big, long term projects that require high investments and leverage (infrastructure,…). Given its nature, this kind of projects usually have trouble raising funds in the “traditional” ways, which is why they resort to PF. PF is characterised by the use of Special Purpose Vehicle ( SPV ) companies. SPVs are created by the main company taking care of the project, but the risk is undertaken entirely by the SPV , and the main company is legally independent from it. These SPVs are financed through non -recourse financing , which means the debt can only be repaid from the profits generated by the project, and, in case of default, the debt is backed solely by the collateral (usually the SPV’s assets) . Banks might be reluctant to give loans to SPVs, given the risk of not getting paid back in case of de fault . The public administration might be willing to help finance the project, but they usually lack the knowledge to do it by themselves. This is why SPVs in PF are usually controlled by a mix of private and public shareholders (Private -Public Partnership, PPP ). 1. O r g anizational s tructure • The sponsors are the equity holders of the SPV and can be both private and public sponsor, depending on the nature of projects . • Lenders provide debt capital to the SPV, and they are generally banks. Debt can have different priorities (senior, subordinated, mezzanine,…). Nowadays other long term investors (e.g. pension funds, insurance companies…) have an increasing role in providing funds. • Contractors and suppliers provide all the necessary skills and expertise. They are not generally involved in providing financial resources 2. F in ancial structure The financial structure affects cash flows (FCFF) generated by the project and the arranger works out the debt and equity mix through a trial and error approach after building a financial model. Simulation run through the financial model must satisfy the c ondition that operating cash flows have to be higher than debt service. 1) Planning of the operating cash flows (check economic convenience of the project). 2) Assumption of a viable financial structure. 3) Check if sponsors and banks receive an adequate return (Economic convenience for sponsors and banks). 4) Check if the cash flows are sustainable in the short run (check financial feasibility through cover ratios). 3. As s essment of economic convenience The project is economically convenient if its NPV is po sitive (that is, if the IRR is higher than the WACC) . Cash flows are measures using FCFF: In a similar way, the economic convenience for sponsors is reached if the NPV is positive (using FCFE and discounting with K e), or if IRR>K e; while the IRR for b anks is calculated using the Debt Service (DS) of each month as cashflows (DS = debt repayment + interests). The period of time between the beginning of the project and the point in which cash -ins become bigger than cash -outs is called Pay Back Period . 4. As s essment of financia l feasibility While economic convenience was measured with IRR, financial feasibility is measured with cover ratios . They are used by lenders (banks) to decide whether or not they should help financing a project . The objective is to m aximize IRR while respecting cover ratios. • Debt service cover ratio (DSCR) : it is the ratio between operating cash flows (FCFF) and debt service (debt repayment + interests). Debt services are known a priori, while FCFF are estimated. In Italy the expected DSCR values are between 1.4 and 1.6, but banks might ask for a higher one s in case of higher risks. During the construction the ratio is meaningless (=0/0), and during the first phases of operation it will stay lower than 0 until the pay back period is ended. For this reason it doesn’t make much sense to look for a minimum DS CR for all months, but rather evaluate the average one: • Average DSC R: it is the average DSCR through the whole project. Lenders will usually ask for a minimum DSRC value for each year and for a minimum ADSCR. It still has a big disadvantage: it doesn’t take into account when each cash flow occurs. An even better alternative would be to discount FCFF and DS cash flows. • Loan Life Cover Ratio (LLCR) : the cash flows are discounted using the interest rate on the loan, not the WACC, as these ratios are used by banks to decide whether or not they should give the loans. In Italy, expected values are between 1.4 and 1.6. With: - DR = Debt Reserve (cas h reserved for debt service) - s = moment of valuation - T = last moment of debt reimbursement - it = interest rate on year t - Ot = outstanding (remaining) debt at year t 5. Corporate restructuring 1. I n troduction The three main motivations for restructuring are: • Poor financial performance. • Large mistake in valuation in the capital market. • New corporate strategy / new business opportunity. The three main restructuring strategies are: • Downsizing : a reduction in the number of employees in a fi rm. Typical reasons to downsize are: ➢ Expectations of improved profitability form cost reduction . ➢ Desire or necessity of more efficient operations . The measures taken with downsizing (cutting costs, firing people, reducing the number of shares, raising debt ,...) will probably have a positive impact in the short run, but it might also have a negative effect on the long run . In case of a PE running the company we have to keep in mind that their objective is to increase its value on the short/medium term, whic h might not be in the best interests for the company in the long term. • Downscoping : elimination of businesses unrelated to the firm core business, in order to focus on it. ➢ It may be accompanied by downsizing , but without eliminating key employees from its primary business. ➢ Helps the top management firm manage the firm more effectively . With downscoping some business units of the company could be closed or sold, making the company focus on its core business ( split -up , spin -of f, carve -out ). This will lower the costs and/or give cash to the company, making it able to repay its debt and increase its efficiency. This could allow the company to improve its financial performance in the long term , at the cost of reducing its size. • LBOs : a party buys the entire company and makes it private, increasing substantially the company’s debt in order to pay for it (which will increase leverage and thus profitability, but also ri sk ). ➢ Can correct for managerial mistakes (managers doing what is best for themselves and not for shareholders). ➢ Can facilitate entrepreneurial effort and strategic growth. There are 3 approaches to execute a restructuring: operations and assets restructuring (grouped under portfolio restructuring), and financial restructuring. 2. P o r tfolio r estructuring A company can restructure its portfolio through 2 types of actions: • Assets restructuring : acquiri ng or divesting assets. ➢ Acquiring assets : Companies quite often decide to move into new lines of business to pursue a new strategy. One quick way for implementing this strategy is to acquire an existing company in that line of business. Such diversifying acquisitions are often of dubious value (diversific ation discount ). ➢ Divesting assets : A company might also decide to divest non -core assets (mainly Strategic Business Units , SBUs) to “refocus” the portfolio (downscoping). Those assets might be divested to another company, to the SBU management team ( MBO ), or to a private investment group (PE). Divesting an SBU can be considered a good idea if, after a detailed analysis, we find out that the SBU will be worth more to another entity than to its parent company. • Creating new ownership relationships : the main techniques tools and techniques to alter ownership relationships are: ➢ Split -ups : the company is split into 2 or more new companies. The current shareholders of the father company will now have shares on both companies, allowing them to decide if they want to stay with all the new companies or just stay with some of them and sell their shares of the others. They often occur when a merger goes wrong. ➢ Spin -offs : the company s elects part of its business and they take it out of the main company. Now both business units remain related to each other, like "sister" companies, sharing shareholders, which is the difference with a split - up. The fact of having the same shareholders wil l change over time as shares change hands. ➢ Equity carve -outs : once a split -up or a spin -off has already being performed, an IPO is done with the new company, selling the company to new shareholders and allowing it to raise capital. According to McKinsey’s research, a 2 stage carve -out (IPO+spin -off) is likely to outperform the market, while a one stage one (just IPO of a part of the subsidiary , which is usually 100% owned by the parent company) is likely to destroy shareholder’s value. 3. F in ancial r estructuring It involves a change in the capital structure of the company. The main approaches are: • Exchange offers : they allow for the exchange of one kind of security with a different one (debt vs equity): ➢ Stock exchanged for debt, reducing leverage . Shareholders incur capital gains tax liability – often exchanged when stock price is depressed. ➢ Debt exchanged for stock, increasing debt . If debt is redeemed at a price above issue price, then the company has a loss and the seller a gain. Leverage increases are often associated with an increase in stock price. • Share buy -backs : companies can use their liquid assets to repurchase their own stock (usually with a pr emium). Also called stock repurchase. ➢ This will give cash to a limited amount of shareholders (those selling their shares), as opposed to a dividend, which gives cash to all of them. It will also cause a reduction in the number of shares, and thus an incr ease in the share price and the EPS of the remaining ones. This occurs without creating any value, which is why it can be done in a malicious way by managers to inflate prices artificially and obtain a personal benefit from it. ➢ This can be done to compens ate shareholders , or to avoid dilution is the company is paying its employees (or other companies) in paper. It can also be done to ward off potential acquirers by raising share prices. ➢ Buy -backs can be done using new debt (levered recapitalization) : as share prices increase but no value is created, and thus risk is increased without any compensation. • Lever aged recapitalizations : a stock repurchase financed by the issuance of new debt. ➢ Similar to a LBO in terms of post -transaction leverage and its effects (it is also known as a public LBO). This is primarily used as a defensive move against takeover attempts , as potential acquirer’s might not be interested in buying a company with high levels of deb t, but it is also a dangerous move, as it increases risk without creating any real value. ➢ Differences in composition of debt financing have implications for post - transaction performance . 6. Initial Public Offering (IPO) Some of the possible motivations to make a company go public are: • Matching : being listed makes it easy to find “equilibrium” prices for the shares , as well as allowing people all over the world to easily invest in the company • Reputation : the IPO will have a marketing impact for the company, which could be good or bad . • Capital increase : an IPO can allow the company to collect capital from its buyers (that’s usually the case, but it doesn’t have to be like that). • Equity research reports : an IPO makes the comp any be noticed by investors while giving them a lot more information to work with, now that the company is listed. This means that analysts will write ERRs about it, which can be a source of funds and information for the company. In an IPO, companies are f orced by regulation to write a prospectus in which they explain in detail how the IPO will work, as well as much more information about the company in order to help investors estimate the real price of shares ( an ything relevant that might affect investors) . Only after the authorities have read and approved the prospectus can the IPO begin. The number of shares sold and the price range for shares are fixed in the prospectus document before knowing the number of buyers, and they can't be altered . T he exact price is chosen after the open window closes , once the company can estimate the number of buyers , and, if the number of buyers is too small, they might choose to sell them for a price lower than the minimum in the price range . During the open window investors choose how many shares they want to buy, not the amount of money they want to invest: they only know that once the window closes. This means that we might not be able to sell all the issued shares, or we might have more buyers than shares, which forces us to sell our shares for a lower price than the “ideal” one. If the latter happens, once the window closes buyers are usually chosen randomly, or through a FIFO, or through whichever mechanism is chosen in the prospectus. Some investor s might choos e to place multiple offerings to increase their probability to buy some shares, as it is the offers that are selected, not the buyers themselves. There is a minimum number of shares that any investor can buy with a single offer: this, together with the pri ce being fixed too, means that companies ca n fix a minimum investment, effectively leaving out of the market small investors if they want to do so. An IPO can occur with or without capital increase . • With capital increase : new shares are created , but all th e existing shares will experience dilution because of it . • Without capital increase : also known as direct listing or direct public offering ( DPO ). The company sells its own shares to raise capital without creating new ones, which means there is no dilution . As opposed to an IPO, there are no intermediaries in this process (investment banks, brokers, dealers, underwriters), which makes the process cheaper than a conventional IPO, an d more attractive to small companies. A placement can be public or private: • Public placement (IPO) : anyone can buy shares of the company. This includes the general public, not only finance professionals. The authorities regulate the process, mainly forcing the company to write a prospectus and to respect an open window to sell the shares. • Private placement : only a group of investors (chosen by the company) can buy shares. In this case the number of shares and the price is negotiated with the selected buyers before the placement, in order to make sure that offer and demand match perfectly. There is no need to write a prospectus or to use any kind of open window. It still is a capital increase (new shares are created), but the company is not listed after this process.