“Volatility is contributing to the creation of more complex deal structures.”

Key Points

Volatility in the macro economy and greater regulatory scrutiny are contributing to more complex deal structures

Vito Sperduto: People need to be creative putting deals together in today’s volatile environment. What are some of the structural innovations we’re seeing?

Albert Chang: Some of today’s trends and innovations are a direct response to either greater clarity on the rules, or to regulatory changes.

If you think about tax, as an example, in the last 12 to 24 months, Treasury has provided greater clarity on their treatment of certain spinoff transactions. Over that period, they made debt-for-debt exchanges easier and less costly to execute, and the IRS issued guidance on how companies could achieve this type of exchange. That sharper clarity helped to make this type of capitalization more efficient.

Another driving force behind  innovation in deal structuring is the macro economy. Volatility in the capital and equity markets is making it more difficult to finance deals. In response, there’s more enthusiasm for exploring all the options. Whether it's a more creative approach to structures like joint ventures or trying to highlight the value of subsidiaries – such as attracting co-investment opportunities or taking capital from private capital sources. Do they invest through common stock or preferred stock, or tap more innovative private lending structures? I think you see those types of responses to the broader macro environment.

Larry Grafstein: Of the financial sponsor capital waiting on the sidelines, it's harder to put to work given the overall environment and the constraints on cost of capital. But I think there’s a similar trend within private equity firms to consider more bespoke or creative structures to invest in. Because if they don’t consider those opportunities, they won’t be able to invest enough capital to hit their targets.

Are more innovative and complex transactions becoming the norm?

Vito Sperduto: Often, the CEO needs to be in post for a while before they're comfortable pulling the trigger on a significant transaction. Before 2020, the average tenure of outgoing CEOs and the S&P 500 never went above 10 years on average in any one year. In 2020 and 2021 that increased to 11.25 years, which is statistically significant. With that longer tenure, I think boards and CEOs were more willing to be decisive and pursue complex transactions. Was that just a phase, or is that the new normal?

Albert Chang: I've observed a greater degree of sophistication and curiosity to explore many of the nuances of corporate focus and portfolio optimization. The introspection during COVID, the desire to shore up businesses and scrutinize what is core and what is non-core. These factors have prompted discussions around corporate separations, portfolio optimization and focus premiums. With increased investor understanding and sophistication,  and boardrooms recognizing the benefits of focus, a lot of these trends are here to stay.

What are the decisive factors to look for behind M&A transactions?

Larry Grafstein: For many years, we went through a period of ‘bias to action’, partly due to a favorable deal environment. After COVID, things bounced back for up to 18 months. Looking at the second half of 2023 and into 2024, how much of that bias to action continues? What are the deciding factors behind choosing to actually do something, as opposed to waiting? I think structure is always an important component.

Albert Chang: First and foremost, when companies are considering M&A, it must be strategic. There needs to be a commercial rationale. Yes, there are structuring enhancements that can improve the metrics, but fundamentally, deals must make sense commercially.

Companies also need to be well capitalized and structurally sound, so that they're not endangering themselves by pursuing a deal, and so that we can set up a financing structure to position the company for success.

Many of our clients have been sitting on the sidelines, but we have been helping them with shoring up their balance sheet or restructuring their portfolios. They’re now ready to move when macro conditions improve.

Larry Grafstein: The question of timing remains sensitive. Market conditions are volatile. Not every sector within the stock market has performed well, despite the general rebound.

Shareholders are trying to be catalysts for management to rethink their assumptions. That's a healthy thing, but at the same time, action for the sake of action calls for caution.

Measuring up: what do successful transactions look like?

Albert Chang: There's no single, perfect metric that informs us whether a deal has succeeded or not. You have to compare the company's actual performance against a hypothetical scenario where they did not execute the transaction.

In the short term, once the transaction is announced, metrics like the stock price will reveal whether investors support the deal rationale. Longer-term aggregate trading is another indicator; how do spinoffs perform when measured against both their divested and non-divested peers?

There are other ‘softer’ factors that are arguably just as important to emphasize, but harder to pin down. Has the transaction given management teams more time for greater focus on their business? Can they pursue innovation more effectively? Do they have more flexibility in capital allocation in M&A? Have we increased the range of strategic options available to the spun-off company?

It’s also important to remember the initial impetus behind the transaction. Typically, it's a decision made to address a specific challenge. A straight comparison of peer-to-peer performance may not reveal the value preservation that a transaction might have achieved. Sometimes being a trusted advisor means being a sounding board for management; highlighting the key ingredients for success, and looking at the models, even if the conclusion is to not proceed with a particular deal. Apart from that, the ingredients of a successful transaction come down to operational focus and excellence in execution.

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