Current Valuation Issues

1
Current Valuation Issues

• Wayne Lonergan
• September 2007

2
Current issues

• Leverage
• Private equity
• Premiums for control
• synergy

3
Leverage and P.E.
4
10 P.A. profit growth
5
PE hurdle rate required to cover PE fees
6
Who gets the upside
7
Why the leverage?

• Debt is still cheap
• (But currently scarce)
• Earnings multiples have risen
• Lenders taking more risk (until CDO)
• Outcome of low volatility and spread compressed
  markets
• Volatility / spreads have recently blown out

8
Premium for control

• PE has no synergy benefits
• Yet pay normal premiums
• PE pays premium for control going in
• Gets only portfolio value on sale
• Is that clever?

9
Value leakage
10
P.E. back to the (early) 1980s

• P.E. conglomerates
• Failed last time around
• Equity top of market
• Interest rates low(1)
• Little / no management depth in P.E.
• Note
• 1 high in 1980s

11
P.E. rip off fees

• 2 to 4 P.A., plus
• 20 above benchmark R of R
• Benchmark R of R 8
• Pre-tax!!!
• Rf is 6
• But CAPM is 12
• After tax!!
• ASX accumulation is close to double CAPM (last 4
  years)

12
P.E. whats so clever?

• Increase debt / equity ratio
• Cut costs
• Manage cash tighter
• Save some o/h
• (Which ones couldnt capable management do?)

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Value implications

• PE major driver is leverage
• Is your leverage high enough?
• Review wtd cost of capital
• Accelerate mean reversion

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Premium for control what bidders pay

• Various studies (pre 2000 / pre 1990) 30 to 35

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Premium for control LEA Study (2000 2005)

• Average 33 - 37
• Adjusted for market movement 29 - 30
• Many traditional measures are flawed

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Why pay premium

• Obvious synergies (A.D.L.C.)
• Unique synergies
• Control cash flow / surplus asset / refinancing

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Is it worth it?
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Circularity effect if market under or over
estimates synergy
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Circularity effect if market under or over
estimates synergy cont

• Issues
• Are synergies gt P for C
• Does market believe this
• If large synergies, vendors want higher price

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Leakage pre-synergy
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Buyers dilemma

• Keep confidence (and wealth) of own shareholders
• Convince target shareholders that they are
  special buyer synergies (not general)

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What proportion of synergies should be attributed
to target?
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Notwithstanding Takeovers Panel decision much
less than 100

• Why?
• No value added if 100 paid away
• Purchaser takes risk of implementation
• Target cant generate synergies without bidder
  (and vice versa)
• Synergies need to be PVd
• Costs first, synergies later
• Potential dis-synergies

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How much do you pay away for synergy?
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Proportion depends on specific circumstances

• Relative bargaining strength
• Competitive bidding environment
• Ability of other purchasers to achieve synergies
• Nature of synergies
• Normally up to 50 bidders estimate likely to be
  conservative

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Relative bargaining strength

• Would you sell your business for 1 million if
  you knew it was worth 2 million to the buyer?
• Is FMV
• 1m
• 2m
• Somewhere in between?

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Assume cash bid (for simplicity)

• Paying control premium is value destructive for
  bidder
• Unless synergies gt 35

28
Offer cash when?

• Very sure of synergies
• Low costs to achieve synergies
• Quick synergies

29
Offer shares when?

• Less certain of synergies
• High costs to achieve synergies
• Delayed synergies
• Competitive bidding situation
• High PER for Low PER
• Bidders shares overpriced

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Nature of synergies
31
What PER for synergies

• Different growth rates
• Different PERs

32
Synergy examples
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Obvious synergies

• Listing fees
• Directors fees
• Audit and accounting fees
• Minimum capital value (for even smallest public
  co) 5m 7m ()
• Much larger (eg Rio 1bn ())

34
Apparent synergies Southcorp / Fosters

• Before
• 2 Trucks to 1 customer
• Saving 50

• After
• 1 Truck to 1 customer

35
Real synergies

• 2 trucks 60 full
• Saving nil

• 1 Truck 100 full
• 1 Truck 20 full

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Apparent synergies

• Distribution centres
• Packaging cost reductions
• Reduced material costs
• Spread fixed o/h over greater base
• Etc etc etc

37
Moral synergies are idiosyncratic!

• Rules of thumb are dangerous
• Remember the acronym