As investors, we take our responsibilities very seriously – and we believe the companies we own shares in should too. This is what we expect from them when it comes to pursuing merger and acquisition deals
“It should go without saying the quality of a company’s management and board, how they are remunerated and the degree to which their interests are aligned with those of shareholders are very important considerations for us. If we do not believe a company is acting in the interests of long-term shareholders, we will do all we can as investors to try and bring about a change.”
So we wrote in Forget the acronyms towards the end of last year. And yet, to judge from the surprised reactions we still receive from some companies when we live up to those words and duly “do all we can as investors to try and bring about change”, our belief that the interests of businesses and their shareholders should be better aligned than they often are evidently does need to be spelled out more explicitly.
This, therefore, is the first in a regular series setting out the sort of behaviour we would like to see from the companies in which we invest, how we measure that behaviour and how we would react if we did not like what we saw. This time, we are going to focus on how we would like companies we invest in to approach merger and acquisition (M&A) deals.
Our preference, here on The Value Perspective, is that companies should normally refrain from M&A. If a company insists on indulging, however, its best chance of success lies in paying a very low price for whatever it is buying. By the same token, paying a high price is likely to end in tears.
One way we quantify whether the deal could destroy value – clearly the polar opposite outcome of what we are looking for as investors – is with the help of two financial measures. The first is ‘enterprise value’ – a common way of measuring a business’s value, which is calculated by adding its market capitalisation, debt and other liabilities and then subtracting the cash on its balance sheet.
The other is ‘earnings before interest and taxes’ – a measure of a business’s profits before interest and tax expenses are deducted – which we ‘normalise’ to remove the effects of cycles, one-off, unusual or seasonal factors – as a very broad starting place we might take the 10 year average margin. If, on our analysis, the business’s new enterprise value divided by its new normalised earnings (the original and the new company’s normalised earnings) before interest and taxes looks set to be higher after the proposed deal, then that is bad news. This is why we are against the Tesco Booker deal.
Threatens the balance sheet
The other major way we quantify if we should be for or against an M&A deal is if it threatens the strength of the company’s balance sheet – for example, through the business taking on excessive debt. The company may be completely confident it can pay off that debt in a few years but of course nobody can predict what will happen in the meantime and, in our experience, it is better to err on the side of prudence.
Two other warning lights for us are if financial details remain, for whatever reason, undisclosed or – in the case of larger mergers and acquisitions – if the value of the proposed deal is greater than 25% of the business’s enterprise value. In any and all of these circumstances, we will do everything we can to protect our clients and thus try and stop the deal happening including writing to the board to explain our opposition to the deal, voting against the deal and as a last resort going public with our opposition.
Here on The Value Perspective, we appreciate the reason some companies may be astonished we are against their deal is the investment bankers behind it may have offered them some fairly tortuous explanations and measures as to why M&A makes sense. We are therefore offering some significantly plainer measures as to what we are looking for and some blunt explanations of what will happen if we do not find it.