Monday, September 13 2021
Cycles of acquisition and divestment are a feature of well-functioning economies. Square Inc’s recently proposed $40 billion takeover of Afterpay punctuates an M&A cycle in full swing, with Australia positioned as a target rich environment for strategic and financial suitors. Understanding the motivation behind transactions is essential for investors. Management teams have always sought to expand market share, bolt on strategic assets, expand vertically or diversify into conglomerates. For decades, private equity has stalked public markets for underperforming, undervalued (or underleveraged) opportunities. In a world flush with cash and the cost of capital approaching zero, the current merger and acquisition mania is in some ways a logical conclusion, but we observe several differentiating features in this cycle. With a number of large deals in train, and dozens of ASX listed companies in play, we assess the global trends in M&A and considerations in evaluating opportunities.
Volumes and values
Corporates hungry for growth have emerged from COVID-19 into an accommodative M&A environment and with strong balance sheets. The opportunities afforded by elevated earnings multiples, and seemingly limitless cheap liquidity has ushered a frenetic buying spree. Deal metrics tracked by data provider Refinitiv suggests 2021 will be a record year, following a modest slump at the height of the pandemic. Whilst not all deals will complete, the velocity of transaction continues to accelerate.
Data tracking M&A involving listed entities back to 2000 in Australia and the US, highlights the scale of activity since late 2020.
The trends also frame progressively larger deals, reflective of both valuation and availability of capital.
This time it’s a bit different
Private equity funds have been the mainstay of M&A markets for decades. Swelling global liquidity, met by institutions seeking alternatives to listed markets, has helped drive transactions to record levels. Distinctively, this current boom is also supported by a new phenomenon; the Special Purpose Acquisition Company (SPAC).
The popularity of SPACs, or “Blank Cheque Companies” exploded in late 2020. Alongside meme stocks, Non-Fungible Tokens (NFTs) and cryptocurrencies, SPACs greatly contributed to the speculative retail frenzy witnessed during the pandemic. Over the past twelve months, these vehicles have introduced additional and competing demand for assets.
The SPAC enables backdoor listings of private companies by merging with a publicly traded entity, IPO’d expressly for this purpose. The concept exploits an SEC regulatory loophole, originally providing an alternative to the traditionally slow, expensive IPO process. Wall Street deftly evolved the concept to capitalise on frothing retail demand. Whilst many SPACs are associated with established hedge fund managers or venture capital outfits, others simply recruited celebrity athletes to garner publicity. Sports starts including Shaquille O’Neill, Serena Williams and Steph Curry all lend credibility as SPAC board members or “strategic advisors”. The groups do not necessarily have target acquisitions identified, but often list under themes, such as decarbonisation, electric vehicles or sports betting. Outcomes for investors have been mixed, and their popularity has recently waned. Successful transactions including Diamond Eagle Acquisition Corp’s merger with DraftKings (up more than 400%) and DFB Healthcare Acquisitions Corp’s purchase of AdaptHealth (up 140%) contrast with calamities like VectorIQ’s merger with EV hopeful Nikola, whose CEO was charged with fraud and whose stock fell more than 85% from its highs.
Despite the market for these products having slowed, their committed capital now scours the globe for urgent merger opportunities. The payoff to the SPAC founders, via vesting of a significant (typically 20%) interest in the company, is triggered by a successful merger. Failure to execute a transaction within 24 months can see the SEC delist the stock, with capital returned to shareholders. This motivates operators to move on any opportunity fitting its mandate and with an agnostic approach to valuation.
The impact of these vehicles has reached the Australian market, with a series of slated transactions. Peter Thiel’s Bridgetown 2 Holdings is seeking to merge with REA-backed PropertyGuru. Brisbane based EV fast charging company Tritium, is likely to back into Nasdaq listed Decarbonisation Plus Acquisition Corp. II, and former Fortescue CEO Nev Power will lead battery minerals focused Metals Acquisition Corp.
SPACs have developed an ironically complicated relationship with more traditional private equity (PE) funds. In providing new exit paths for PE portfolio companies at attractive multiples, they are also outbidding for assets on the other side, pushing up valuations, and making re-deployment of capital more difficult.
Managing the probabilities
The cat and mouse game of bidding for public companies follows a predictable courtship pattern but yields unpredictable outcomes. Highly attractive offers may elicit immediate board recommendation, but most initial approaches are rebuffed. Markets subsequently vote on the likelihood of a deal proceeding, and price action can be instructive. If short term trading pushes the stock higher than the bid price, an increase will be required to consummate the deal. A material discount to the bid price can suggests skepticism of the suitor and their terms or recognition of regulatory hurdles.
For investors, it is important to recognise no deal is certain until the cash in the bank. Research by McKinsey and Company from 2019 highlights a cancellation rate for deals over euro €1 b at an average of 10.5%. The study also found that (in general) the larger the acquisition, the more likely it is to not complete.
For portfolio positions under takeover, the probability of success should be weighed against the opportunity costs of holding to completion. M&A deals for listed companies fall over for a range of reasons. Regulators may fail to approve on competition or national interest concerns. Targets can have unrealistic price expectations and board members can be reluctant to yield their coveted seats. In the absence of break fees, suitors may simply walk away after ‘lifting the hood and finding sawdust in the engine’.
Assessing the deals
Within our listed universe, we generally observe two legitimate reasons for acquiring business: strategic and opportunistic. Strategic purchases may provide access to markets, customers, IP or talent. Valuation may be an input, but the strategic value of an asset may justify a higher multiple than otherwise acceptable. Opportunistic acquisitions, at attractive or even distressed valuations, can deliver shareholder value with the appropriate management and capital allocation.
In our assessment, many acquisitions fall into a third category: questionable. Management teams suffering growth anxiety may be susceptible to the siren song of investment banker pitch-books. Business combinations are often modelled with rose-coloured assumptions, and by advisors with little recourse to poor outcomes. In the worst-case scenario, transactions are designed solely to fill future earnings holes with balance sheet putty. The magic of acquisition accounting can provide short-term cover for CEO’s under duress, but ultimately erode shareholder wealth. Understanding the motivations of management (and their financial sponsors) is essential in evaluating the merits of a deal.
The velocity of deals does not appear to be slowing, and a phalanx of bankers and lawyers are motivated to transact. The pressures of public markets can yield acquisitions at elevated valuations and with weak alignment to long-term shareholder value. In framing our analysis of M&A within listed companies, we seek answers to a range of questions including:
- Was the asset up for sale or were the vendors approached?
- What is the nature of the vendor, why are they selling, and how long has it been for sale?
- What synergies are presented and how do these stack up versus similar transactions?
- If the deal is crossing international borders, are management fully across cultural challenges and ways of doing business? Are they retaining local IP and talent?
- If the proposed deal appears very cheap, why has no one else made an offer?
- As a percentage of the deal – what fees are due to advisors?
- Are there any related party transactions involved?
- Is the accounting clean and on a per share basis, is the deal accretive to earnings?
- Does it make strategic sense, will it enable the business to push into new markets or new products and improve the long term earnings?
- Does it improve the quality of the business by reducing risk, adding diversity and enhancing the moat of the business?
- Are management participating in any capital raising or are they being diluted?
Despite the apparent frenzy, it remains important for investors to assess each deal on its own merits. Developing a clear understanding of motivations and incentives on both sides of transactions is crucial. History is littered with high profile M&A disasters, but also phenomenal successes. Undertaken with sound motivations, M&A can facilitate efficient capital allocation, and remains important feature capital markets.
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