Capital allocation: Mergers & Acquisitions (M&As)

Capital allocation: Mergers & Acquisitions (M&As)

Author: Joris Kersten, MSc

Kersten CF: M&A advisory and Valuations @ The Netherlands. www.kerstencf.nl

Training: Business Valuation & Deal Structuring, 5 days @ Amsterdam. 4th – 8th November 2024, registration & manual @ www.joriskersten.nl . 130 recommendations @ https://www.joriskersten.nl/nl/reviews

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.

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Introduction

Among capital allocation alternatives, Mergers & Acquisitions (M&As) are by far the largest allocation.

Let’s take a look at annual M&A volume in the US from 1985 to 2021, as well as to M&A as a percentage of sales.

M&A deals in 2021 totalled nearly 2.6 trillion USD, and this was 13.5% of sales.

But as we know, M&A is very “cyclical”.

When we look at M&A volume as a percentage of market capitalization from 1985 until 2021, we see the following:

-M&A volume was 7.3% of the market cap on average.

And the peak was 14.2% in 1988.

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Private equity and M&A deals

Private equity (PE) entered into M&A actively.

PE activity grew sharply preceding the financial crises of 2008, and dropped heavily after the crises.

But ever since PE activity grew again.

PE deals have averaged 15% of total deal volume since 2000, and 12% when we look at the period from 1985 to 2021.

PE peaked at 2007 with a volume of 29% from the total, and the lowest point was in 1998 with 2%.

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When deals add value

M&A deals create value in the aggregate, measured by comparing the combined equity value of the buyer, and seller, before and after the deal.

The problem is that the value of the buying company often goes down following a deal announcement.

And this means there is a wealth transfer from the shareholders of the buyer, to the shareholders of the seller.

This is the result from the “premium” buyers pay in deals.

Deals from 1995 to 2018 showed that the stock price of the buyer went down in 60% of the cases, from the time of the announcement.

(please see the source I have used for this article, for the exact study done)

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The average change for all the deals was -/- 1.6% for the buyer’s stock price.

But there is a lot of variance, so plenty transactions create value for the buyer.

Here are a few insights for which type of deals generally add value:

·???????? Cash deals do better, on average, than equity funded deals or deals funded with a mix of cash & equity. The basic idea is: Stock is used when the company is overvalued, and cash is used when company is undervalued;

·???????? Deals between companies with similar operations generate better returns than those deals who seek to transform a business. With operational deals the core businesses of the target and acquirer are related (so called: “Bolt on deals”);

·???????? Companies with specialised M&A teams generally outperform those without these M&A professionals;

·???????? Higher control premiums are associated with lower excess returns, and lower premiums with higher returns.

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EPS accretion/ EPS dilution

Everybody involved in M&A knows that EPS accretion/ dilution analysis is a big, big, thing !

This phenomenon is modelled with a so called M&A model (the target is modelled on top of the buyer in Excel: P&L, BS, CFS, debt schedule etc).

EPS accretion basically means that the combined EPS, should be higher than the EPS of the target, in the upcoming years after the deal.

For example, when you buy an EBITDA multiple that is lower than yourself (the buyer), deals are always EPS accretive, even all equity financed !

But when you buy higher multiples (target has higher ebitda multiple than buyer), and pay all equity, then the deal is EPS dilutive !

But here (with dilutive deals) you can come up with for example “synergies” or use (lots of) debt in order to get the deal EPS accretive.

A survey shows (please see the source I have used for this blog) that executives, sell side analysts and investors care the most about EPS accretion/ dilution in M&A deals.

BUT, there is NO empirical foundation for this view !

Excess returns for the buyer’s stock is essentially independent on EPS changes.

Successful M&As

M&As, like other capital allocations, are successful when the value a buyer realises EXCEEDS the price the buyer pays !

So we need to look at our basics:

·???????? The Net present value !!

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Net present value of the deal = Present value of the synergies -/- premium paid.

The average deal premium for each year from 1985 – 2021 is 45%.

These are US deals and here every deal receives an equal weight.

Samples limited to larger deals have average premiums of around 30%.

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Shareholder value at risk (SVAR)

SVAR is useful to check the downside risk for a buyer’s stock price.

In a cash deal the SVAR is defined as the premium pledged divided by the market cap of the buyer.

SVAR basically represents the amount of wealth transfer from the buyer to the seller in case the combination of the companies has NO synergies.

So it gives you a sense of the size of the “bet”, and how much value is at risk.

The SVAR is always higher in a cash deal than in a stock deal.

This because in a stock deal, the SVAR is measured as the premium pledged divided over the market cap of the buyer + the seller (incl. the premium).

So the seller is now also sharing in the risk of achieving the synergies (which should justify the premium).

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Hope this was useful,

See you next week again with a new blog !

Best Joris???

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Capital allocation: Results, analysis and assessment. 2022. Michael J. Mauboussin & Dan Callahan.