1 corporate strategy board m&a focus doing deals in a volatile environment how to modify the...
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Corporate Strategy BoardM&A Focus
Doing Deals in a Volatile EnvironmentHow to Modify the Deal Process for the Current M&A Climate
Key Questions Addressed
• What is the current business climate for doing deals?• How big an issue is volatility as a complicating factor in trying to do deals at this time?• Where is the deal process most likely to break down in a volatile or uncertain environment?• What emerging process fixes are corporate dealmakers considering or implementing?
Overview
On September 3rd, 5th, and 8th, 2008, the Corporate Strategy Board conducted small group discussions with a total of 15 Corporate Development Executives on the challenges associated with doing deals in a volatile environment. This document outlines the topics discussed, the data presented, and an overview of the key insights that surfaced from executives at each point in the discussion.
Discussion Moderator: Seth VerryDocument Author: Ross Katz
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Executive Summary of the Discussions
With private equity sidelined in the past 12 months, buying opportunities for corporate dealmakers have improved. Indeed, corporate deal-making on a transaction volume (not value) basis has actually gone up. But the current environment of volatility is complicating what could otherwise be a very productive period, with a bit of a "one-two punch” for corporate dealmakers.
First, the deal market itself is in a transitional period: coming down the from the deal-making peak of 2007, buyers and sellers are exhibiting mismatched expectations for price, with buyers hoping for bargains and sellers holding out hope for strong pricing. Earnouts, as a way to bridge these gaps, have become the “necessary evil” of the current environment. As appropriate as these devices are, they are extremely difficult to use in practice.
Second, the extreme volatility of the macro-economy and capital markets has several implications for the deal process. For instance, contract "adjustments" are more likely to be required between announcement and close as conditions change rapidly. Thus, deal executives should pay more attention to Material Adverse Change clauses and the other contract devices that buyers (and to a lesser extent sellers) can use to protect themselves from many aspects of volatility. The larger issue is the impact of uncertainty on deal approvals: confidence in valuation models takes a hit, and management teams become conservative and less willing to consider bold commitments of capital. Leading dealmakers are considering valuation techniques that better deal with uncertainty, but they are also finding that the real solution here has less to do with technical valuation and much more to do with reframing the business case – and sometimes the deal structure – to align with the current bunker mentality of management teams.
Table of Contents
I. Summary of the Current Deal Environment
• Volatility Complicates Dealmaking……….3
• Strategic Dealmaking Remains Strong…..4
• Prices are Down Yet Still Relatively High..5
• Drivers of Continued Corporate Dealmaking...............................................6
• The One-Two Punch of Volatility………….7
II. Challenges of the Current Environment
• Where Volatility Affects the Deal Process..8
• M&A Challenges to Dealmaking in Volatility……………………………………...9
• Key Challenges to Dealmaking in Volatility……………………………………..10
III. Valuation
• Valuation Overview………………………...11
• The Right Tools for the Right Time………12
IV. Negotiations
• Deal Structure Overview………….............13
• Pick Your Poison: Available Structural Provisions……………………………………14
V. Management Conservatism
• Management Conservatism Overview…....15
• Combating Management Conservatism…..16
• The Power of a Good Story: Cargill’s M&A Gameboard………………..……………........17
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Summary of the Current Economic Climate
Worldwide, deal volume has declined across industries, but this is a misleading outlook for the corporate dealmaker. Corporate M&A has grown 6% since this time last year, indicating that Corp Dev executives have continued to seek acquisitions as private equity has moved to the sidelines. PE deal volume is down 25% on last year (see page 4). Meanwhile, prices have declined slightly, but not significantly enough to reflect an opportunity for bargain hunting (see page 5). Most industries are still above their 10-year average EBITDA multiples, with notable exceptions (for instance, real estate).
We believe this reflects a structural shift occurring in the corporate M&A market. Acquisitions are being more widely used as vehicles for corporate strategy. This trend reflects the “open innovation” movement, the growing use of acquisition as a channel to customer solutions, and the growing acceptance of adjacency market entry as a valid corporate strategy. In addition, corporate development groups are being staffed to more effectively execute these strategies (see page 6). We contend that current economic volatility is impacting strategic M&A processes through two primary forces:
• The “Transitional” Market for Deals: Seller’s expectations have not yet returned to an equilibrium that might catalyze a spike in corporate bargain-hunting .
• Broader Macroeconomic Volatility: Volatility- in equity markets, debt markets, and input markets- renders the underlying assumptions of deals difficult to trust (see page 7).
Volatility Complicates DealmakingQuestions for Group Discussion
1. Does this capture the core dynamics of the deal environment you are seeing?
2. How big an issue is volatility as a complicating factor in trying to do deals at this time?
3. Which aspect of the overall volatility presents the greatest challenge:
• the overall macroeconomic volatility• the transitional nature of the market for
deals
Summary of Group Responses
Executives broadly agreed with our characterization of the market, citing a mismatch between buyer and seller expectations, unpredictable deal flow, fewer auctions, less debt financing, longer negotiation time frames, and management conservatism as the major complicating factors of volatility. Both macroeconomic volatility and the transitional marketplace contribute to these challenges.
Section #1: Summary of Current Deal Environment
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Overall Worldwide M&A VolumeNumber of Transactions By Quarter
Transaction Volume by Buyer Type % Change from Previous Year
Source: Thomson Datastream.
Strategic Deal Making Remains Strong
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000
Strategic Private Equity
Source: Dealogic.
-25%
6%
On a Volume Basis, Deal Making by Corporate Buyers is Actually Up This Year
Section #1: Summary of Current Deal Environment
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Prices Are Down Yet Still Relatively High
0
2
4
6
8
10
12
14
Q12002
Q32002
Q12003
Q32003
Q12004
Q32004
Q12005
Q32005
Q12006
Q32006
Q12007
Q32007
Q12008
Q3TD2008
6.3, Q4 2002
11.9, Q1 2008
EBITDA Multiples Have Corrected but Remain Far From Bargain Territory
9.7, Q3 2008
*Source: Thomson Datastream.
Median EBITDA Multiples*By Quarter
Section #1: Summary of Current Deal Environment
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• Structural shift in the role that deals play in several ways: – Acquisitions as means of product development via “open
innovation” – Continued use of deals (and partnerships) to deliver on “solutions”
strategies – Legitimization of “adjacent” growth strategies – often achieved via
deals • Growing basic competence and staffing of Corp Dev groups • Significant change in the market’s reaction to deals –more positive
than its used to be (McKinsey research) • Kicker?: in a volatile economy deals can advance objectives more
rapidly plus signal management’s confidence in the strategy• Bottom line: as long as there are strategies to advance, there will be
deals getting done
Drivers of Continued Corporate Deal MakingSeveral Structural Changes May Explain Why Corporate Buying Isn’t Slowing Down
Section #1: Summary of Current Deal Environment
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The One-Two Punch of Volatility
• The “transitional” nature of the market for deals – sticky seller expectations for price yet impatient buyers looking for
bargains (akin to real estate) – unclear when/if we reach a new equilibrium– multitude of variables at play
• exchange rate impact on cross-border bargain hunting • when PE comes off the sidelines • pace of financial market recovery • potential for post-election regulatory changes
• The broader context of macroeconomic volatility – an unprecedented period in modern economic history– wide range of indicators well outside of historical ranges
• oil, exchange rates, food prices, many commodities, real estate– corporate planners having to rethink the planning process– the focus of our Executive Workshop series this year
Corporate Dealmakers Are Dealing With Two Broad Dimensions of Uncertainty
Section #1: Summary of Current Deal Environment
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Corporate Strategy Board View
Based on our one-on-one conversations with members, we contended that all aspects of the deal process were affected by volatility. We captured these issues through representative quotations on page 9. We also synthesized those conversations into a map of the deal-making process with corresponding challenges for each phase, page 10.
Questions for Discussion
1. Which element of the deal process is most stressed by the current environment of uncertainty? And how?
2. What can be done to address the challenge?• Process fixes you considering or
implementing • Ideas you have heard about that pique
your interest• Ideas you would like to test among this
group of peers
Where Volatility Affects the Deal ProcessSummary of Group Responses
Participating executives expressed the greatest concern with the following three aspects of deal-making:
Valuation: Volatility is undermining the assumptions which are normally included in valuation models, causing executives to consider alternative methods of valuation, such as real options.
Negotiations & Deal Structure: In the current environment, executives are encountering a mismatch between buyer and seller price expectations. One executive observed that sellers were expecting 30-40% premiums on their 52-week highs rather than the currently depressed market value. Several cited this mismatch as the most complicating factor in the current economic environment. Mismatched price expectations are lengthening the time frames between LOI and close. Longer negotiation time frames are leading to revisited deal terms. One executive believed these time frames to be 30-40% longer than normal. Volatility during the lengthened negotiation period perpetuates more revision and uncertainty of deal terms up to the time of agreement.
Management Approval: Volatility is causing leadership teams to become increasingly conservative about engaging in acquisitions.
We introduced research and views on each of these areas, and discussed them at length, as outlined on pages 11-17.
Section #2: Challenges of Current Environment
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M&A Challenges of the Current EnvironmentRepresentative Quotes from Research Interviews
“The latest challenge is overvalued companies that prefer not to sell instead of dropping their ask price to reasonable levels.”
“Outside of the auction context, I am wondering how often potential buyers are characterized as being overly aggressive (e.g., taking too buyer friendly an approach on contract terms)….Does the current environment influence initial positioning in any significant way on this subject?”
“One of the challenges the volatile environment presents is to make "Adjustments" to the earlier agreed (but not closed) terms, when the environment was rosier then what it is now. What kind of adjustments can be made and what clauses can/need be incorporated in agreements to this effect (from Buyer and Seller perspective) .”
Section #2: Challenges of Current Environment
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Limits of DCF Method
• Standard techniques not well suited to the high levels of uncertainty in critical inputs
Mismatched Expectations
• Difficult to reconcile price expectations of buyers and sellers.
Terms Revisited
• Buyers seeking to renegotiate as conditions change
Management Conservatism
• Understandable management bias to “keep the powder dry” during current volatility
Potential Synergies Rendered Invalid
• Mid-cycle integration efforts needing drastic redirection as initial planning assumptions prove to be incorrect
Deal Stage
Unpredictable Deal Flow
• Deal flow becomes unpredictable (or diminished) as sellers revisit their intent to sell
Valuation Negotiations Approval IntegrationProspecting
Process Challenge
Valuation, Negotiations, and Approval are Most Challenging During Volatility
Key Challenges to Dealmaking in VolatilitySection #2: Challenges of Current Environment
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Valuation OverviewCorporate Strategy Board View
The current environment of uncertainty requires dealmakers to consider alternative methods of valuation, such as decision trees or real options. The matrix of valuation techniques outlined on page 12 illustrates that some valuation methodologies are more naturally suited to different types and levels of uncertainty. This matrix comes from a past CSB research on the global energy company Shell, which faces relatively high degrees of project- and market-based uncertainty in many of its initiatives.
Questions for Discussion
1. What challenges have you encountered when valuing companies in the current environment?
2. Are you utilizing different methods of valuation?• Real Options?• Decision Tree?• Other?
Summary of Group Discussion
Participating executives agreed that uncertainty in the current environment undermines the assumptions of discounted cash flow and other valuation models.
Triangulation is Preferred: Dealmakers are considering more complicated valuation tools, such as real options analysis, to better model the uncertainty of the economic environment. However, experienced participants advocated for using multiple valuation models to triangulate the value of a company rather than trying to accurately create one model for all of the uncertainties involved.
Stronger Attention to Sensitivity Analysis: During valuation, participants expressed the need to be more conservative with inputs and conduct a robust analysis of the assumptions underlying a valuation. This helps discover which valuations may be less sturdy in the current economic climate.
Section #3: Valuation
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The Right Tools for the Right TimeShell Leverages Different Valuation Tools to Address Different Types of Uncertainty
Section #3: Valuation
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Deal Structure Overview Corporate Strategy Board View
Corporate dealmakers have a wealth of structural devices for reconciling divergent price expectations and mitigating risk (see page 14). The challenges is that the tools that theoretically have the most potency – earnouts and MAC clauses – are arguably the most difficult to use in practice.
Questions for the Group
1. Are you altering deal terms to reconcile price and mitigate risk?
2. Which of the tools, presented on page 14, are you using?
3. What challenges have you encountered when utilizing these tools?
Overview of Group Responses
Participating executives agreed that structural tools were appealing when trying to reconcile price and mitigate risk, but they disagreed about the effectiveness of those tools. In particular, participants had valuable discussion about these options:
Earnouts: Participating executives expressed divergent perspectives on the use of earnouts to bridge the gap between buyer and seller price points. Earnouts can be exceedingly complicated. One executive described a meeting in which a parabolic formula was proposed to determine the amount of an earnout. She laughed at the prospect, “Lawyers are not mathematicians.” It would be difficult for an M&A lawyer to describe complex earnout schemes in a contract, let alone make them enforceable. Therefore, some executives explicitly avoid earnouts. Other executives expressed more comfort with utilizing them. These executives emphasized the need to keep them simple and explicitly align buyer and seller interests.
Material Adverse Change (MAC) Clauses: For acquisitions of public entities (where a time lag exists between agreement and close), volatility is causing dealmakers to more closely consider the usage and structure of MAC clauses. There is some disagreement about whether these clauses can be worded to be neither too narrow nor too broad, such that they can be enforced.
Closing Conditions: Warranties and Indemnities are being more strongly considered and debated to protect buyers during the longer timeframes between agreement and close. Participants expressed difficulty with evaluating the terms to put in a deal outside of an auction and deciding on the posture with which to approach negotiations.
Section #4: Negotiations
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Negotiation IntegrationClosing
LOI Announcement Close
• Material Adverse Change (MAC) Clauses
• Termination Fees
• Lock Up
• Go Shop
• Other Affirmative & Negative Covenants
• Earnouts
• Representations
• Warranties
• Hold-Backs
• Indemnifications
• Purchase Price Adjustments
• Excluded Assets
Pick Your PoisonBuyers Have a Wealth of Structural Devices for Managing Uncertainty
Discussion Question:
What of these tools are you now using to manage risk?
Section #4: Negotiations
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Management Conservatism OverviewOverview of Group Responses
Participants made these recommendations for overcoming management conservatism in a volatile environment:
Focus More Strongly on Strategy and Types of Synergies: Participants consistently agreed that the volatile environment called for even closer attention to how acquisitions fit with overall corporate strategy. Synergies should be closely examined to ensure that they can be delivered following integration. In addition, participating executives are doing more granular market analyses to determine which markets are desirable. This tactic ensures the deal stands up to criticism and ensures that key stakeholders are invested.
Find Desperate Buyers in Your Organization: One executive expressed the need to find desperate business heads to fund and support acquisitions. Desperate buyers tend to have more sound strategic logic and the commitment necessary to ensure that integration occurs quickly and smoothly.
Pick Your Battles: Participants agreed that executives should cautiously choose the acquisitions which are worth lobbying management to undertake. As discussed above, organizational commitment and alignment can be the most important factors in determining acquisition success.
Get Capital Out of the Equation: Conservatism has put stringent capital constraints on dealmakers’ purchasing resources. When combined with exorbitant prices, many dealmakers are becoming more open to alternative deal structures-such as alliances, licensing, or option agreements- to make deals happen.
Corporate Strategy Board View
There are at least three broad strategies for combating management conservatism when it comes to doing deals: 1) demonstrating the value of acting now, 2) reducing the cost of action, and 3) showcasing the risks of waiting. The following slide outlines these strategies along with representative tactics for pursuing them. Linking proposed deals to the strategy is the clearest tactic; it’s also something that many dealmakers believes they do well when in fact they do not. Page 16 presents Cargill’s M&A Gameboard, a tool Cargill uses to visually represent how each acquisition fits into its overall strategy.
Questions for Discussion
1. Which tactics have you used to combat management conservatism?
2. Which tactics have been most successful?
Section #4: Management Conservatism
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Combating Management ConservatismStrategies - and Representative Tactics - for Securing Management’s Approval
Strategies Representative Tactics
Demonstrate the Value of Acting Now
Link the deal to the strategy
Leverage tools that visually link depict how deals done today set up sequential moves that meaningfully advance critical strategies (example: Cargill’s M&A Gameboard and associated CSB PowePoint tool)
Showcase the (positive) empirical record
Leverage recent CSB work on ‘Winning in the Turns,’ or BCG’s work on doing deals during downturns; both analyses suggest that bold decisions (such as deals), have a greater chance of creating competitive advantage in uncertain or difficult times.
Reduce the Cost of Action
Take capital out of the equation
Pursue a joint venture, for example, or secure “first right of refusal” for the target while conducting further analysis.
Showcase the Risks of Waiting
Make the cost of inaction visceral and real
Use war-gaming techniques to show how existing or new competitors could seize the opportunity missed by not doing the deal yourself.
Source: Jeff Gell, Jens Kengelbach, Alexander Roos, “The Return of the Strategist – Creating Value with M&A in Downturns,” The Boston Consulting Group (May 2008)
Section #4: Management Conservatism
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The Power of a Good StoryCargill Uses its ‘Gameboard’ to Show How Each Deal Fits into a Coherent Strategy
Link to Excel-Based Tool to Create Your Own Gameboard
Link to Case Study for Further Detail on How Cargill Created and Uses the Gameboard
Section #4: Management Conservatism
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