THE ART OF DEAL MAKING
With a clear sense of déjà vu the global markets commenced 2016 with a return to extreme volatility. By Nicholas Assef
Whilst we of course hope that this negative environment is short lived, the CEO and Board of Directors always need to live by the old adage of ‘hope for the best, plan for the worst’.
As such it is useful to reflect on a number of the factors that took place during the GFC, and, with the benefit of hindsight, how best to position for the maintenance of shareholder value if this volatility continues.
Valuations Become Irrational
The media love a bad news story, and turbulent markets bring amplified ‘alarmist’ media comment.
Companies see their valuations trade in wide ranges, which often make traditional valuation approaches difficult. For Research Analysts covering sectors the task is difficult as the base input assumptions many use for their DCF models are often ‘fluid’. For the CEO & Board it is difficult to ignore share price action – often feeling as a helpless passenger on rough seas.
As noted below – the CEO must become an evangelist at these times with all stakeholders – internal and external. Stressing the positive differentiators as to why their company is the ‘investment of choice’ within its sector. Increased time and care needs to be taken on the development of investor presentations and various stock market releases— quality over quantity.
Board & Management Paralysis
During the GFC many public company Boards decided that no action was the best action. Unfortunately this ‘no action’ position is actually a decision of paralysis. Comparisons such as “we are doing the same as our competitors” do not win the applause of institutional investors or the investing community at large.
Conservatism should be replaced with flexibility and the ongoing search for innovation and excellence.
Ongoing positive communication with stakeholders of meaningful developments is mandatory. More shoe leather will be worn out in the process. Explore all options to generate positive shareholder value.
Astute Boards and CEOs also know that now is the time to opportunistically strike – when valuations are low and the alternatives for that interesting acquisition target are few.
Strong and decisive leadership will not make the markets settle, but it will ensure that the CEO’s company, its employees and stakeholders are confident that their Board and Senior Management are committed to finding a way through—and not being the proverbial feather blowing in the wind.
Higher Offshore Led M& A Activity
Currency fluctuation amplifies the valuation advantages often enjoyed by Bidders that operate in larger, more liquid capital markets. Those Bidders often have higher trading valuation metrics for a variety of reasons. Suffice to say they have a real strategic advantage.
We have seen a material increase in offshore inquiry as the Australian dollar has fallen. We expect this trend to continue – and the advantage of those Bidders to be amplified by the volatility.
For the CEO / Board under pressure it is important to ensure that they can market to international suitors who may look for established beachheads in countries such as Australia to launch into Asia. Astute Boards are proactively encouraging international strategic alliances to not only gain access to new markets at trying times (and hopefully generate foreign currency cashflows) but also to keep wired in to regions from where a Bidder may emerge.
Balance Sheet Health Can Change Quickly
CEOs and their Boards need to be acutely aware of the debt covenants inside their debt facility agreements, and how market volatility might affect them. Many facility agreements are not linked to things such as share price and market capitalisation – but some are.
There is nothing more problematic for the CEO/ Board to discover suddenly that there is a technical problem with existing debt packages – and any clarifying announcement to the stock market of a problem will likely be met with extreme negativity. Additionally, with increased counterparty risk a sensible assumption, cashflow can be placed under pressure with little notice.
Although it is not what CEOs and Boards want to hear, non core asset divestments, equity placements and debt refinancings early can ensure healthy Balance Sheets are maintained through this turbulence – and can even allow expansion opportunities to be moved upon when they undoubtedly present
I recall one CFO during the GFC noting to me that he was ‘spoilt for choice’ for deals as they had positioned well, and positioned early. With a lowly geared Balance Sheet and cash in the bank many beat a path to his door looking for a rescue deal.
The longer the volatility the more difficult it is for small and middle market companies to effect equity initiatives at decent valuations (discounts to attract capital become deeper). Prioritising the health of the Balance Sheet is always a safe option to navigate through volatility.
Cashflow King—Counterparty Risk Up
CEOs and CFOs need to be on guard about the stability of both their cashflows and counterparties (clients) with whom they deal. During the GFC many good companies quickly found themselves under pressure when it became clear that parties with whom they dealt were themselves stumbling. With soft commodity prices and stretched project financing, the Resources sector in particular becomes one where vigilance needs to be lifted even further on counterparty relationships.
An eagle eye on debtors needs to be maintained during volatility to ensure that cashflow stability is maintained. It can be prudent to refine various operational aspects of the Company such as refining credit terms to ensure the risk profile of inbound cashflows does not increase.
Innovative financing and refinancing
Commercial banks often become more conservative in dealing with both existing clients and new loans. For those public companies with loan maturing across 2016 and early 2017 getting started on the refinancing early is critical.
M& A financing can become effectively more expensive as a result of lower loan valuation metrics being imposed – with the equity to be provided by the Bidder increasing, and often as a result making the prospect of an acceptable financial return more difficult to achieve.
Offshore lenders, foreign bond issuers, mezzanine debt funds and multi-faceted lenders (including hedge funds) entered the market during the GFC, and we expect to see this trend lift again. There are multiple alternate sources of financing to the traditional banks, and the CEO and CFO need to understand the flexibility of alternatives to properly advise their Board.
Liquidity In Trading Volumes
For Mid Market and Small Cap public companies volatility can lead to rapid illiquidity in their share trading activity. An incredibly frustrating situation for the CEO and Board.
The ‘flight to liquidity’ often means that both institutional and retail shareholders rotate their portfolios to Index rated companies where liquidity continues during turbulent trading conditions.
This shift in focus also can have a knock on effect for market participants such as stockbrokers, who change the focus in the way they change the servicing of their clients from speculative to conservative.
CEOs need to be innovative in their approaches to ensure existing shareholder support is maintained, and for potential new shareholders that the Company is highlighted as being an ‘opportunity of choice’ despite irrational valuations and low liquidity. Placements and other equity capital markets initiatives should be considered where strong appetite from a party is expressed. Dilution should be a secondary consideration to Balance Sheet health and attracting new investment before it is needed.
It is not difficult to reflect on the share prices of quality players during the GFC and to see the impressive returns made by those that supported quality management teams during those times.
Sellers & Private Equity
Declining valuations and illiquidity are ideal market conditions for Short Seller Funds, Activists and PIPE players (Public Investment By Private Equity). The majority of Board Members and CEOs of public companies have not had experience in dealing with these market participants – and turbulent markets can be a tough time for the first lesson
PIPE players have the opportunity to take public companies private at heavily discounted valuations to those in normal trading conditions.
Activists and short sellers can also take the shape of ‘wolf packs’ and informally (not forming legal ‘associations’) gang up on CEOs and Boards to attempt to force change. Responding to such disruptors is time consuming, expensive and distracting – reducing the time the CEO and Board have for optimising efforts to manage and grow sh are holder value. Board and CEO paralysis are the ideal conditions for ‘disruptors’ to flourish.
If one of these players turns up get experienced advice—quickly...
The good news is that if the CEO and Board are flexible, innovative and pro active in navigating the turbulent market the likelihood of a disruptor arriving will be dramatically reduced – they will look for other easier targets. Experienced advce in handling these players is invaluable.
Mergers of necessity
In this environment merger for necessity can be a rational outcome and for the CEO and Board flexibility in thinking in this area can pay dividends. The longer the volatility the more difficult it is for small and middle market companies to effect equity initiatives at decent valuations (discounts to attract capital become deeper). Being the initiator as opposed to the respondent to a Merger Proposal is preferential.
It is not difficult to reflect on the share prices of quality players during the GFC and to see the impressive returns made by those that supported quality management teams and Companies during those times.
Higher quality deal making
Warren Buffett is famous for his saying in his 2004 Berkshire Hathaway Chairman’s letter: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be
‘Prioritising the health of the Balance Sheet is always a safe option to navigate through volatility.’
fearful when others are greedy and greedy only when others are fearful”.
Turbulent markets are a rich hunting ground for astute Bidders, and savvy management teams that see the opportunity of Public to Private transactions. Paralysis should be replaced with that sense of opportunity to drive shareholder value with a compelling transaction or transactions.
Key Take Away For CEOs & Boards of Directors
Volatile market conditions pass. For the astute CEO and Board the opportunity is to understand how to both maintain and maximise shareholder value in trying market conditions that are trying for all companies.
Three key learnings from the GFC period that should be front of mind are: • Balance Sheet gearing can have a direct impact on the equity valuation of the Company. Equity value can be driven down irrationally where it is perceived that there is either too much or poorly structured debt (including near term refinancing requirements). • Certain market participants flourish in these conditions. CEOs and Boards need to have specific strategic plans to deal with Activists, Short Sellers and opportunistic Takeover Proposals— in particular where presented by Private Equity players who are on the whole both patient and sophisticated • Opportunity knocks. Maintaining flexibility and being pro active pays dividends. The deal that may be a ‘company maker’ is likely within reach at a compelling valuation and attractive terms. Expansion with strategic alliances (both domestically and cross border) should be considered and pursued. Be on the front foot. Plan how to grow stronger and execute those plans. Hopefully these market conditions will settle in the coming months, but in the event they don’t then for the CEO and Board understanding both the challenges that will come and having decisive positive action plans to deal with those potential challenges is a prudent and logical investment of time.
Start today. Get a jump on your competitors that will likely assume the position of paralysis.
About the author Nicholas Assef LLB (Hons) LLM MBA Nicholas’ career has spanned the legal profession, academia and the corporate world for over 25 years
Formerly an attorney with Allen Allen & Hemsley’s corporate practice in Sydney, Australia his career evolved to investment banking after completion of his MBA at the world ranked Simon Business School at the University of Rochester (New York). Whilst in the USA Nicholas also had the opportunity to undertake study at Harvard Business School. In academia Nicholas has been on staff at both Macquarie University’s Applied Finance Centre and Bond University’s Law School.
Nicholas works across the Australian and South East Asian markets, specialising in M& A, shareholder value driven initiatives, corporate performance and complex commercial negotiations. He has also had extensive specific experience dealing with Activist investors (acting both for them, and against them).
He is the founder of Lincoln Crowne.