Key Note Speech to Cass M&A 30.9.15

Good afternoon ladies and gentlemen, it is a great pleasure for me to be back at my alma mater again, some 25 years after graduating with an MBA in Finance and Banking.

My qualifications for being here are largely down to the fact that I owed Scott (evidently); that I have recently been installed as the Master of the International Bankers Livery Company (more on that in a moment) and that after 43 years as a banker, most recently completing 25 years as a Vice Chairman in the Corporate and Investment banking business at Citibank, I might have some perspectives on the M&A market.

Just quickly then on the Worshipful Company of International Bankers – as some of you may know, Livery Companies were founded in the Middle Ages in the UK (and other countries) to regulate industries and to provide a structure for apprenteships. Our livery company was

only founded in 2000 when membership was extended from members of the Commonwealth and EU, to all nationalities. All livery companies have the same core aims, namely, Charity, Education, Fellowship and Promoting the Profession. If you are interested in learning more, please google international bankers – one word dot org dot UK or by all means contact me…...

OK – back to M&A…..

My talk is in 2 parts – firstly I thought it would be interesting to look at some past deals by way of introduction and example, before moving onto the specific conundrum set for me by Scot around the question of private equity vs strategic or trade buyer.

I’ve chosen as my initial example, the first hostile deal in the UK – partly because my wife’s grandfather was a prime mover in the tale but also because it probably marked the beginning of the modern age in M&A – certainly in the UK.

The contest between the Aluminum Company of America (known as Alcoa) and Reynolds Metals Company with its British ally Tube Investments Ltd (or TI) for a stake in the British Aluminum Company, became know as the Aluminum War (not to be confused with the Russian Aluminum Wars of the 1990’s when several people in the industry were assassinated every week – the 1950’s version was hotly contested as we’ll see but did not become physically violent – although a close run thing at times, I believe!).

Perhaps it would be helpful to have a little context first on the industrial dynamics of the aluminum industry – reflecting the technical and economic situation in the development of the product.

Aluminum production was always volatile largely because of the very large investment needed for new plant development (similar to the steel industry).

During the Second World War, demand rose sharply primarily due to aircraft industry demand. Immediately afterwards, the aluminum industry found it had too much capacity for peace-time demands. However, it spent a lot of time and ingenuity finding new uses for its products; namely in packaging, vehicle construction and house building. The result was that from 1947 onwards producers found themselves unable to satisfy the demands of post-war growth. This led to substantial investment in new plant to the extent that 10 years later by 1957, supply had again exceeded demand – with producers working at 80% capacity. Not only was the US aircraft industry in the doldrums but also it seemed likely that the US Government, that had been stockpiling surplus aluminum, would stop buying the following year. Having said that, there was confidence in the future as engineers demonstrated the advantages of lightweight alloys.

Alcoa had been the monopoly aluminum producer in the US until the war.Since then Reynolds and Kaiser Aluminum and Chemical Corporation had both grown to nearly the size of Alcoa. The other large producers were the Aluminum Company of Canada (Alcan), the British Aluminum Company and the Russians.

The American producers looked at this competition with growing unease and, the fear and greed that drives capitalism and hence M&A, meant that there was an opportunity to restructure the industry.

Battle commenced in late 1958 when Reynolds and Alcoa tried to gain control of British Aluminum, the largest UK producer and one that had just completed a new plant in Canada that would fit well with Reynolds expansion plans.

An important side issue was the role of the merchant banks, as investment banks were then known. Lazard’s and Hambros acted as joint advisors to British Aluminum

whilst Reynolds was advised by two up-start banks SG Warburg and Schroders! Reynolds was advised by Warburg to cooperate with a British firm, Tube Investments or TI, to mollify public opinion in the UK. TI was by this time a leading industrial group headed by my wife’s grandfather, Sir Ivan Steadeford.

On the advice of their banks, Reynolds and TI began acquiring shares in British Aluminum through nominees, as was allowed at the time – and by Oct 1958 they held 10% of the target without its knowledge.

Stedeford met with the Chairman and MD of British Aluminum a few days later and told them he’s like to have “an association for future development”. He was turned down as they were already negotiating with another party – Alcoa.When Stedeford returned a few days later with a definitive and attractive offer, he was not only rejected - but the Chairman refused to put the offer to shareholders.

So, Stedeford went public with his offer that was at a 30% premium to the Alcoa bid!

Headlines exploded over the front pages of the press and the management and advisors of British Aluminum were angrily criticized for not consulting their shareholders. The board really hadn’t come to terms with the way shareholdings had graduated to major institutions that were increasingly concerned with return on investment rather than protecting the, perceived, national interest.

Needless to say Reynolds and TI carried the day and jointly acquired British Aluminum but not before much metaphorical blood had been spilt.

I include it partly because of family interest; partly because it was a seminal moment in being the first hostile deal – at least in Europe – but also to demonstrate the emergence of investment banks as major catalysts and players. Also a good example I think to enable us to see the

clear industrial logic of the transaction in a wider economic context…….

Moving swiftly along, the 1980’s saw the emergence of multi-billion dollar M&A deals, the largest being the famous or infamous “barbarians at the gate” - highly contested acquisition of RJR Nabisco by the private equity firm KKR. The cost at $25 billion, was roughly twice the size of other mega-deals of the time such as Chevron’s purchase of Gulf Oil; Kraft by Philip Morris and Squibb by Bristol Myers.

The Nabisco deal stood out not only because of its size (at the time) but also because it was the first deal of this size by an investment company rather than a trade buyer – and one using leverage rather than stock to complete the acquisition.

Around the same time, conglomerates such as the UK/US Hanson Trust were using similar leverage and asset stripping techniques to acquire assets that could be managed in a more aggressive way to

produce significant financial returns. Which reminds me of a story I was told about a transaction Citibank financed at about this time.

Hanson had acquired a retail newspaper-shops business as part of the acquisition of, Imperial Tobacco I recall. It sold the business in a management buy-out – the current corporate finance fad at the time. Citi financed it on the basis of a plan to squeeze working capital ----- this from a business being sold by the UK’s leading proponents of squeezing assets! Needless to say, it went bust very soon afterwards. A great example of the financiers not looking at the wider picture!

The mild recession of 1990 allied to the collapse of the junk bond market led to the unraveling of a number of high profile leveraged deals. WPP being a good example – if one that came right in the end. Martin Sorrell, having recently left Saatchi & Saatchi as CFO, acquired a small listed company called Wire and Plastic Products that made shopping

trollies. With funding from JP Morgan, Bankers Trust and Citibank he transformed WPP into a highly leveraged acquisition vehicle to acquire marketing company assets – most significantly J Walter Thompson and then Ogilvy & Mather.

Marketing budgets were pared to the bone during the early 90’s and it took a number of years for WPP to emerge from restructuring before roaring back to become the colossus we know today. Martin learnt several valuable M&A lessons – don’t over-extend on leverage; earn-outs are a good way of ensuring you get what you pay for; and a maniacal focus on cash ensures you don’t run short of liquidity!.........

In the 1990s, the markets became enthralled with consolidating deals known as roll-ups. Fragmented industries – like marketing services and advertising – were consolidated in a strategy to combine smaller companies into a national

business to enjoy economies of scale both in terms of costs and revenues.

Other examples were funeral businesses, printing, office products and floral products.

One that I was close to was BET which tried to roll-up the office services business in the UK by acquiring thousands of mom & pop small businesses to form a major FTSE-sized company.

It ran into indigestion issues as it sought to manage all these deals, struggled to integrate the businesses and when it did found that although they were in a good position then to bid for nationwide contracts, found that they could always be undercut on a local basis by minimum wage small owner-managed operators. It was eventually absorbed into Rentokil.

As the 90s progressed, the forces of economic growth and the pursuit of globalization affected all economies as companies sought to service global markets. By 1999, the value of deals in Europe was almost as large as that of the US, where starting in 1996 the dollar value and volume of deals had increased dramatically.

Furthermore, the end of the 90s also saw the emergence of M&A in Asia as many Asian economies began to open up, giving rise to sell-off and acquisition opportunities……

The end of the millennium coincided with another recession, and the technology company bust, but by 2004 M&A demand had begun to increase significantly. In part this was fuelled by demand from private equity, aided by a period of low interest rates and combined with a long bull run in the property and stock markets. How could one go wrong?!

EMI was one of the world’s great music companies, alongside Universal, Warner and Sony. It had run the usual gamut of horizontal, vertical and conglomerate activity over the previous century; was acquired by Thorn (an electrical engineering business) in 1979 then demerged in 1996.

It had 2 businesses: recorded music that ran Capital Studios in LA and Abbey Road studios in London and it owned the rights to such iconic artists as the Beatles, Robbie Williams, Pink Floyd, the Spice Girls (it was a while ago now!!).

It was a global player if a little weak in the US compared to its peers. In its other business – Music Publishing, it was a world leader - holding and administering music rights on behalf of songwriters.

In 2007 it employs 6,300 people in some 50 countries and has a market cap of around £2.3 billion. Revenues are £1.75 billion with EBITDA margins of around 10%. 60% of EBITDA came from the

publishing arm and these were high quality stable revenues.

The recorded music business was being hit by technological and cultural changes as the business migrated to digital platforms - and revenues were under severe pressure.

Net debt, at this time, totals just over £1 billion giving the company a fairly racy leverage ratio of around 6 times – so its bankers are concerned about their loans, if somewhat mollified by the perceived value of the music publishing assets –by themselves thought to be worth over £1 billion and easily securitisable.

For the last 10 years EMI had been the subject of repeated failed attempts to merge with Warner Music (which was strong in the US) and would bring the combined entity to the same size and market presence as Sony and Universal.

However, regulators had always opposed this concentration of market power and the bids had foundered.

In late 2006, EMI had been approached by several private equity firms. So, Citibank, Deutsche Bank and Greenhill were retained by EMI as financial advisors to consider a sale. Futhermore, Citi and DB were also cleared to provide financing to potential bidders, provided appropriate Chinese walls were instituted to avoid conflicts of interest.

Early in 2007 EMI issued 2 profit warnings and indicated that a likely breach of banking financial covenants would follow on the next testing date – lenders were comforted by the on-going sale process.

In May 2007, Citi signed commitment papers to provide 100% of the financing for Terra Firms (Guy Hand’s private equity vehicle) to make a public bid for EMI. It was expected that DB, Barclays Capital and Bank of Scotland would join the financing group imminently.

What could go wrong?

In July 2007, Bear Stearns liquidated two hedge funds invested in mortgage-backed securities.

In August, the EMI bid goes unconditional and funding is made available by Citi in 2 tranches - £1.5 billion to fund music publishing, with an exciting leverage of 13 times; and £1.2 billion to fund the recorded music business at what turned out to be 30 times, as EBITDA dipped post closing.

In September 2007 there was a run on a little known building society called Northern Rock. Needless to say no further commitments of financing were forthcoming and Citi was stuck with the total financing of over £2.7billion.

2008 goes past in a blur as EMI’s financial situation deteriorates…….In September Lehmann files for bankruptcy, Merrill Lunch is acquired by BoA and AIG is rescued by the US taxpayer. The year

ends with 3-month treasury bills yielding minus 0.01% and 2-year treasuries yielding below 1%.

Early in 2011, EMI is placed into administration and becomes a wholly owned subsidiary of that well-known rapping and hip-hop band known as Citibank.

The businesses are recapitalized and Music Publishing sold for around £1.4 billion to a Sony-led consortium; and Recorded Music, to the now Vivendi-owned, Universal Music Group, for around £1.2 billion.

A combination of over-payment for assets that were in free-fall in a fast changing technological environment; a lack of due diligence and over-aggressive funding in what was imminently to become the financial crisis, all took their toll on the deal - with a good dollop of hubris all round!

So what does all this history tell us about the M&A market in general and in particular the continuous tension between private equity and strategic or trade buyers?

Claudia Zeisberger and Jan Vild in a recent paper entitled Strategic Buyers vs. Private Equity Buyers in an Investment Process suggested the following thoughts:

On fundraising, whilst unlike strategic buyers, PE firms have the challenge of external fundraising – this may also likely increase financial discipline on those firms.

On deal sourcing, strategic investors have the benefit of best knowing the sector/target. Conversely, PE firms tend therefore to go in for more rigorous analysis (of which more later).

It follows that on due diligence corporate buyers tend to look at the big picture (most notorious example being Lloyds acquisition of Bank of Scotland!) whereas

the PE firms will take a longer and deeper review in most cases (which may put them at a disadvantage in deal closing).

When valuing a target, strategic buyers will normally focus on preparing DCF models to enable them to identify the biggest value impact synergies, whereas the PE firm will use an LBO model which by leveraging the transaction increases their IRR.

It is often felt that strategic buyers show a lack of financial discipline relying on optimistic cost synergies to support what are thought of as must win strategic deals!

PE firms’ repeated experience in structuring and negotiating deals often gives them an advantage in closing transactions as long as they avoid putting noses out of joint!

In most cases, strategic buyers will be looking to fully integrate the acquired target as quickly as possible to realise planned synergies. However, it is

estimated that a high proportion of M&A transactions falter due to poor execution often due to culture clashes. PE firms likely avoid this issue as the target continues to stand alone as a business. Again PE firms’ vast experience in post-acquisition execution tends to stand out.

Finally, the ability of strategic buyers to think longer-term than the IRR-focused PE firms can benefit the former by ensuring investment over a longer period.

Let’s review some of these issues in practice by looking at the position of a specific seller of a business and his experience. Paul Spiegelman sold his business BerylHealth to a strategic buyer a couple of years ago. He gives 6 reasons why he chose a strategic buyer over a sale to private equity:

Firstly, he found that PE firms were focused on short-term financial returns that could force decisions NOT in the best interests of the company whereas the strategic buyer wanted to build for the long

term and perhaps more importantly therefore was very patient in the way it went about its negotiations. This is always going to be a big positive point for strategic acquirors as PE funds by their very nature usually run for 10 years and average holding of assets will tend to be 5-7 years.

Secondly, the acquirer sent a large team to do due diligence at the target but were reasonable and fair whereas his experience of PE was that there was a distrustful view taken of numbers and projections which set a more negative tone to negotiations. This is not all that surprising given that PE firms will not usually have cost synergies to soften the blow of projections missing targets.

Thirdly, he just failed to find an emotional fit with the expensive tastes of the PE employees with fancy cars, expensive expense accounts and so on. Hard to debate such a visceral issue.

Fourthly, on a similar theme, he just didn’t trust the PE team to stick with the company if it didn’t hit its financial goals. He found the strategic buyer team much more humble I their approach believing they could learn much from the target.

Fifthly, and similarly he simply LIKED the people at the strategic buyer – they had a caring attitude to their workers.

Sixth and lastly – and key – was that he was looking for a partner who could help him achieve his dreams – beyond the price issues.

All of this is, I think, interesting in that it is predicated on a view from someone who is staying in the business post acquisition – much more likely to be the case when you sell to Private Equity in practice.

Let’s turn to another live situation where, not unusually, a PE-owned company is approaching an IPO when a strategic buyer suggests a merger. (As you all know “merger” is just code for an

acquisition – it just sounds friendlier and more consensual!) The management of the target would clearly prefer to be running their own company, rather than to run the high risk of being “let go” by a new parent. The PE owners will have a more objective evaluation to make as to whether the expected future NPV of the asset exceeds the strategic buyer’s offer. Not easy to determine and will have to be considered within the context of its existing portfolio.

In summary, selling to a strategic buyer will tend to mean the following:

1) the owner or owners are selling out and are unlikely to be involved in the company going forward.

2) You are most likely to get the best price for your company from a strategic buyer, as it is likely that the acquirer will be able to extract cost and add revenue synergies from combing the target with its existing business.

3) Most selling owners will see that the management is taken care of either by having them absorbed into the new combine and/or by cash or equity on close.

Conversely, private equity will likely keep on the existing management and potentially the owners and will empower management with control and/or strong incentives to meet financial targets and hence returns for the PE fund.

Of course, this is to suggest that it is simple decision to choose between these two exits, whereas, in reality, there are other options available to raise capital and there are numerous variants in terms of structures to raise capital. However, the seller has to establish his or her priorities between cash and legacy.

Finally, it is estimated that PE firms are currently sitting on an estimated $3.6 trillion of assets under management including a third of that in cash to be invested. Public companies are holding even larger cash balances. Debt is still

cheap by historical terms and is likely to remain so even given a likely move up over the next year or so. Public companies have spent the last several years cutting costs but investors want growth so CEOs are under pressure to do M&A. With that as a backdrop, M&A this year and next is likely to continue to grow at a fast pace….comfort for investment bankers and prospective investment bankers and M&A research directors…

Thank you for your attention.