As the CEO of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), Warren Buffett personally experienced numerous cases of mergers and acquisitions, and is familiar with many M&A tricks. He cautioned that shareholders of an acquirer may become a lot poorer in an M&A deal, even the acquiree is fairly valued. And more often than not, the losses are disguised by acquirers’ management teams. A couple of cases were discussed in Buffett’s 2008 and 2009 shareholder letters to illustrate the hazard of the tricks.
Although the official terms are “acquirer” and “acquiree,” we use “buyer” to refer to the former and “seller” to refer to the latter for simplicity.
Nobody actively involved in an M&A deal bothers to talk about the tricks. Indeed, a deal is beneficial to all active players. Investment bankers who advise the deal earn fat commissions. A buyer’s management team who pursues the deal has their ego filled up as they will manage a bigger company. More importantly, their paychecks have more room to grow. A seller’s management team and shareholders who approve the deal are satisfied by a quick markup of their stock price.
However, buyers' shareholders are left out of the decision loop. And as a natural result, their interest is normally not considered.
In an M&A deal, a buyer can choose to:
- Pay cash
- Pay stock
- Issue new stock shares
- Sell assets to raise cash
- Issue new debts
Paying cash is the cleanest and is what Buffett prefers. Buffett always keeps a big pile of cash at hand for M&A opportunities.
The rest are trickier. If the instruments — stocks, assets, and debts — are mishandled, the buyer’s shareholders are at loss. In his 2009 letter, Buffett suggested if stock is involved in an acquisition, buyers' directors “should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through.”
In a stock deal, a buyer pays stock instead of cash to buy a company. The buyer’s stock is used as a currency. It is equivalent to a two-step approach: first to sell the stock at market price to raise cash, then to pay cash to buy the company. A part of the buyer is sold before it buys anything. Chances are it is sold at an unfavorable price.
The seller’s management team and shareholders will make sure their company is fairly valued. But the buyer’s management team generally doesn’t care about the price at which they sell a part of theirs. When communicating with their shareholders, they tell only the half truth that they are buying, sweeping under the carpet the inconvenient half that before buying, they have to sell.
“Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 1¼ shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.”
It might be a different story if a buyer’s stock is overvalued. But that usually happens when the entire market is euphoria about a booming economy. Most likely the seller’s stock is overvalued as well. Still the seller will ask for a markup — which is quite justifiable — at cost of the buyer’s shareholders.
On page 17 of his 2009 shareholder letter, Buffett told a story about a bank whose stock was owned by Berkshire. The bank quickly jumped to the idea to buy a smaller bank when the law was changed to allow banks to merge with one another.
The owner of the smaller bank, the seller in this case, was a shrewd businessman. Apparently he knew well about M&A tricks and he knew that Buffett’s bank, the buyer, is modestly undervalued. He asked for stock, not cash. He was at an advantageous position since there were other banks trying to buy his bank. He smartly priced his bank at three times book value, effectively exchanging one dollar for three since Buffett’s bank was priced at around book value by the stock market.
The senior managers of Buffett’s bank were also fine businessmen but at that moment behaved like “teenage boys who had just discovered girls.” They were so eager to show that they were doing something when every other bank was in hunting mode. And they couldn’t care less if the only loser was their shareholders. The deal went through.
The story didn’t end there. The seller was very concerned by the recklessness of the buyer’s managers, because after the deal he would become a shareholder of the buyer. He sent in a request and asked, in a diplomatic way, that the managers “never again do a deal this dumb”.
Issuing new stock shares for an M&A deal inherits all sins from paying stock. In addition, it immediately shrinks the value of shares in shareholders’ pockets. A company is like a pie and a share is like a slice of the pie. When a company issues new stock, the pie does not become larger. It just has more slices, and the size of each slice becomes smaller.
Buffett’s blockbuster deal to buy BNSF required Berkshire “to issue about 95,000 Berkshire shares that amounted to 6.1% of those previously outstanding”. Buffett was not happy about it. Like other shareholders, Buffett would see the value of his shares in Berkshire contracted by 6.1%. He decided to work out the deal because it was an opportunity to put $22 billion of cash to work. Nonetheless it was a close call. Should it have required Berkshire to issue more shares, Buffett would walk away.
Sometimes a buyer sells some assets to raise cash for an M&A deal. Similar to stocks, a piece of asset may not fetch a good price if market conditions are tepid. Besides, the government will take away a chunk of the cash, simply because capital gains are taxable.
When Kraft (KFT) bought Cadbury in 2010, Kraft sold its frozen pizza business for $3.7 billion to finance the deal. Because the pizza business had practically no tax basis, almost the entire selling price was booked as capital gain. Consequently $1.2 billion, which is more than 30% of the selling price, went to the IRS. The pizza business was fairly valued at 13 times pre-tax earnings of $280 million, but what Kraft received was only 9 times of that.
As the largest shareholder of Kraft, Buffett publicly expressed his objection to the deal. In a CNBC interview dated to Jan. 20th, 2010, Buffett said “I feel poorer” when he was asked what he thought of the deal.
The trickiest way to conduct an M&A deal is to issue new debts. Although Buffett frowns at it, it is a highly profitable business to some “specialists”. There is a term for it, the so called “leveraged-buyout”. When LBO became a bad name, those specialists labeled themselves “private equities”.
No doubt they are astute businessmen. They play with others’ money and offload risks on others’ shoulders. Normally a PE firm put in a small amount of their own cash. Using it as a seed, they borrow a big sum of cash from banks or other investors to finance the deal. And they offload the debts onto the target company’s balance sheet.
A direct result of loading up a lot of debts on the target company’s balance sheet is that it dramatically dampens the company’s financial strength. It would not be a problem when the economy is booming and credit costs are inexpensive. But a booming economy is often followed by a recession when companies with dire financial strength are under pressure.
Remember that equity is asset minus liability. A balance sheet that is loaded with ample debts means its equity – the cushion for losses – is thin. In his 2008 shareholder letter, Buffett observed that “A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating.”
An accompanying problem is a company with weak balance sheet has to pay more to borrow. Because short term debts are deemed less risky than long term ones, they are priced cheaper than the latter. PE firms habitually issue short term debts to finance long term deals. The problem is they have to periodically roll over the debts. It’s not a pleasant situation to issue new debts with a higher credit cost.
Credit is scarce during a recession and it is hard for PE firms to raise cash for any deals. Companies are a lot cheaper in a recession but PE firms have to miss the boat. When credit is abundant, companies are a lot more expensive as the economy is in expansion. PE firms’ dilemma is that their businesses are buy-low-sell-high, but their funding mechanism is buy-high-sell-low. By contrast, Berkshire is awash in cash and is better positioned than PE firms to take advantage of a recession.
Last but not least, PE firms’ exit strategies are always to sell target companies back to the public in IPOs. Their success depends on bigger fools. Buffett “haven’t bought a single company from an LBO operator”. Should you?
About the author:
An amateur trader / investor that tried many methods including buy and hold, technical analysis, quantitative analysis, day trading with pattern, and finally settled with fundamental analysis to discover undervalued quality stocks.