Fundamentally, when companies are considering M&A - Transcript

Vito (00:06):

Hello and welcome back to Strategic Alternatives, the R B C M and a podcast. I'm joined by Larry Stein, deputy Chairman of Global Investment Banking, and Albert Chang, head of m and a Tax and Structuring advising here at R B C Capital Markets. As we go into the second half of our conversation here, I think we're going to dive in more specifically into what we're seeing on transactions and then also what we're seeing from the teams that are making these decisions. So maybe to start, Albert, why don't we talk a little bit about some of the innovations that you're seeing in deal structuring. Clearly in this environment, we've seen people be quite creative in how they've put deals together. Talk to us a little bit about what you're seeing in this volatile environment and how it's changed versus how we operated in the past decade.

Albert (00:54):

So I think trends can be driven by a number of factors. Some of the trends that we're seeing are direct response to the specific regulatory framework and rules that are put into place. So that certainly informs the types of techniques and deal technologies that we see, and some of the trends that we observe are based on more macro factors that we talked about in the first part of our conversation. So I think we see a bit of both when it comes to specific deal making techniques. One of the areas where we've seen some movement in the last 12 to 24 months, and I'll start with tax, is just clarity from treasury as to how they're going to treat certain transactions in the spinoff world. So for example, a common monetization technique utilized by companies when they pursue a spinoff transaction is to capitalize the spinco with debt and then to take those proceeds to shore the balance sheet of the parent, which again, as we talked about in part one of our conversation really dovetails nicely with this idea of taking a more proactive and protective stance around the RemainCo in a volatile environment.


But specifically one of the changes that Treasury came out with in recent years is actually making something called a debt for debt exchange easier to execute and less costly to execute. So the I R S has actually issued guidance on how companies can achieve this type of debt for debt exchange in the context of a tax-free spinoff. And without diving too deeply into a tax rabbit hole, the upshot is the I r s has actually made it more efficient and less costly to execute this type of capitalization exercise. In previous eras, in regimes debt for debt exchanges required more market actions that had friction costs, but recognizing the importance of being able to right-size capital structures, the I R S actually passed rules that allowed companies doing spinoffs to do this type of capitalization exercise directly with banks directly through direct lending. And that's a regulatory change that has enhanced technology and enhance the way certain transactions are done.


Another type of regulatory guidance driven change in deal structure is the I R s similarly released guidance on how overlapping shareholders are counted in the context of spin merge transactions. So in transactions where a tax-free spinoff is combined with a merger, there's a specific ownership requirement, and the rule says that the spun off company shareholders have to own greater than 50% of the combined company. Well, one of the difficult execution or calculation questions that has traditionally appeared in this type of context is, well, how do you calculate shareholders that are shareholders of both companies? And how does that work within that shareholder ownership? Math treasury actually came out with guidance not long ago that blessed certain methodologies for how you count those overlapping shareholders. So that similarly has created additional clarity that allows companies to move forward with those types of transactions. And so to get back to your question, if part of the trends and part of the innovations that we see are a direct response to either clarity on the rules or rule changes that allow companies to proceed, I would say one of the other driving forces for innovation in deal structuring is just the macro world around us.


So earlier in our conversation we talked about volatility in the capital markets, the more difficult financing market that occur, as well as some of the volatility in equity markets. And so separate and apart from any sort of regulatory framework, whether it's tax or SS e c regulations or F T C and antitrust, you see a lot of innovation directly in response to those macro trends. So whether it's joint ventures or trying to highlight values of subsidiaries, you see a greater exploration of transactions such as attracting co-investment opportunities or taking capital from private capital, whether it's financial sponsors or other entities, do they invest through common stock or preferred stock or even tap more innovative private lending structures? I think you see those types of responses to the broader macro environment. I would just say.

Larry (05:52):

To that point that all of the financial sponsor capital that's been waiting on the sidelines, it's a little bit harder to put to work just given the overall environment and also the constraints on cost of capital. I think there's definitely a trend within the world of private equity to consider different types of structures they would invest in because I think they know some of these firms that have a lot of capital to put to work that if they don't themselves look at structures that are a little more creative, a little bit different, little more bespoke, if they don't look at those types of opportunities, they just won't be able to invest enough capital.

Vito (06:34):

Albert, as we think about the acceptance of these types of transactions, we often talk about the fact that the c e O, the C-suite, they need to be in the seat for a period of time before they're comfortable pulling the trigger on a significant transaction. And interestingly enough, before 2020, the average tenure of outgoing CEOs in the s and p 500 never went above 10 years on average in any one year. And what we saw in 20 and 21 is that that increased to about 11 and a quarter years on average, which is pretty statistically significant. Now we're seeing that come back down, but I do think as a result of that longer tenure, you probably had boards and CEOs more willing to make decisions to pursue complex transactions that required your services. And so as you talked about some of these trends, some of these innovations, are you seeing these as examples of what's happening at a point in time right now and that when regular way deals come back that those kind of go away? Or is this just a new age that we're going to be pursuing this regardless?

Albert (07:51):

Going forward from my seat, I would like to think it's the latter. I think one of the things that we've certainly observed in our business is a greater sophistication across all constituencies as to some of the nuances of corporate focus, portfolio optimization and some of the topics that we've been talking about. And so to your question of is this a temporary trend that will subside based on the dialogue that we've been privileged to be a part of, I'd like to say no, that it's not. I think the investor sophistication, as I mentioned on the value of being focused, the sophistication within boardrooms of recognizing the benefits of focus that is here, and I don't think that's going anywhere. And it's not to say that there's never any benefits to diversification or having different business lines, but that is something that has always been a topic of conversation, but one that has received increasing attention in light of trends in activism over the last half decade, the introspection we talked about that occurred during covid, the desire to shore up businesses and really scrutinize what is core and what is non-core. All of those factors I think have given rise to discussions around corporate separations, portfolio optimization, focus premiums, and I just don't see that going away even in an environment where m and a activity is more actionable.

Vito (09:32):

As you think about the types of deals that are occurring, specifically the types of businesses that are being separated where they're trying to achieve greater value by focus either on the spinco or RemainCo, do you feel that today companies are more willing to divest businesses that maybe are the higher multiple businesses? Obviously historically the math has been that you divest the lower multiple businesses maybe in more difficult times or has any of that changed? What have you seen?

Albert (10:05):

When I first started in this business, a very senior investment banking colleague of mine used the analogy of when your kids leave the home comparing that to a spinoff, and in some cases the kid has graduated from your high school and you're proudly sending them off to college. And in other cases, to borrow from this analogy, the kid's getting kicked out of the house. And the analogy was used to describe two different commercial situations where on the one hand you may have an all-star growthy business that is not being properly valued within the context of the broader parent company. And on the other hand, as you pointed out, veto, there's other situations where management teams are evaluating their portfolios and they've determined that there's a non-core business within the existing portfolio that maybe is facing more commercial challenges, whether that's by the business environment that they operate in, or maybe it's just a business that's either more mature or has lower margins and lower growth.


And so you do actually see spinoffs of both flavors where you spin off high performing businesses to highlight that value, as well as spinning off businesses with more challenging financial metrics in order to shore up RemainCo typically in hopes of a multiple rerating or a multiple uplift in that RemainCo business. Once that business is separated, and if you go back and trace the history of spinoff, certainly in any given year, you will find examples of both types of transactions. But one of the interesting trends that we saw when our team pulled up the stats is in the last few years, there's actually been a higher number of spinoffs where the spinco business traded at a lower valuation multiple compared to the parent, compared to if you look back to the data from the middle part of the decade, call it 2014 to 2016, you actually saw an equal amount or in some years even a greater amount of spinoffs where the spinco was kind of the star business, the growthy business that traded at a more attractive multiple.


And so there's a variety of reasons for which that could be true. Some of that is just kind of statistics and natural variation. But I think to tie it back to our earlier discussion of the environment in which we're operating in where boards and management teams are looking around at the world around them and they're trying to assess different risks that they're trying to insulate the business from, part of protecting the business of managing risk, of protecting margins and shoring up the business and preparing it for a world in which there's unknowns has been this doubling down on what businesses are non-core. And if there are businesses that have more challenged financial metrics, exploring a separation to create value by creating independent companies there. So that's an interesting trend that we have seen in the last few years.

Larry (13:10):

We went through a period for many years where there was a bias to action, certainly in the public markets, partly because it was a favorable deal environment, cheap financing environment. We had a frozen period during C O D, and then things bounced back dramatically in 2021 and into the first part of 2022. So now as we sit here looking at the second half of 2023 and ahead into 2024, what is your assessment of how much that bias to action continues? Because as you just said, everyone is looking at their own portfolio, looking at optimization, anticipating perhaps shareholder pressure if their stock is in the doldrums, and yet at the same time there is also a little conservatism about where the economy's going and also just what market conditions might be like until we see a little more clarity on the fed side. So as you sit here today and you think about advising companies, what are the key criteria of decisions in terms of actually doing something as opposed to perhaps waiting? And I think structure is always an important component of that together with all the other things that we think about in the m and a world.

Albert (14:23):

At the outset of every m and a transaction, we emphasize the factors that lead to a successful m and a deal and what makes a successful m and a deal. And that of course informs the question of whether or not one of our clients ought to go forward with the transaction or not. And first and foremost, of course, when companies are considering m and a, it has to be strategic. There has to be a commercial rationale. To your point, there are certainly structuring that we can make to any particular transaction that improve those metrics, but fundamentally, deals have to make sense from a commercial perspective. And then we also have to have companies that are well positioned to take on m and a, meaning they're well capitalized, that from a financial point of view, they're not putting themselves in a precarious situation by pursuing a deal that we can set up a financing structure that positions the company for success in the future.


And obviously every m and a deal ultimately comes down to execution. But coming out of our current environment, a lot of the dialogue in the last few years in the midst of an uncertain environment where there is a lower volume of m and a deals done was if you're a company today, how can you position yourself so that when that cloud does lift and when there is a more opportune environment, how can you be in a position to do deals? And so you've seen companies either shore up their balance sheet or restructure their portfolio so that they can be in a better position to pursue transformative m and a transactions. And so for a number of our clients, they have been sitting on the sidelines waiting for the macro conditions to improve, but also doing things behind the scenes from a capital structure financing portfolio optimization perspective to be in a place where they're ready to act on day one. And so to the factors that you mentioned regarding the economy and A C E O confidence, which we talked about earlier on the podcast, those things I think will remain to be seen. But as those conditions improve, the companies that have done the work to prepare themselves for m and a certainly are going to be in the best position to take advantage of the opportunity.

Larry (16:40):

I think that's a very important point because companies are doing preparation now, but the question of timing is a very sensitive one. Market conditions are volatile. Not every sector within the stock market has performed well, even though we've had a rebound in 2023 generally of the indexes. And it's easy for a shareholder or an activist just to say, depart from the status quo, but we all know the better part of wisdom is often to launch a new company or consider a new corporate initiative or undertake a complex merger when the time is right, because when you want to send a new company out into the world or when you want to affect a combination transaction, you want the conditions to be right and you want to hit the ground running in a positive way. And it's not always clear across the board in a non-zero interest rate environment that those conditions hold.

Vito (17:36):

Well, Albert, we always talk about, and I'll paraphrase, success is in the eye of the beholder. And so from your perspective, how do you just success in these types of transactions?

Albert (17:48):

Well, there's a number of metrics that we commonly look at to give us clues and to give us indications as to whether a transaction has been successful or not. Sometimes the answer is quite clear. Oftentimes the answer is more muddled in the short term, once a transaction is announced, you can look at metrics like immediate stock price reaction to see if investors appreciate the initial rationale of the deal or not. Longer term aggregate trading is another indicator. So how do spinoffs perform in the aggregate when measured against RemainCo and spinco peers? And then there's often softer factors that are more difficult to quantify but are nevertheless important. So has this transaction created an environment where management teams can focus more on their business? Do they have the ability to pursue innovation? Do they have more flexibility in capital allocation in m and a? And are you increasing the range of options available to the spun off company?


Absolutely. So there actually have been empirical studies. When you look at that long-term value creation, aggregate trading and the results have been a mixed bag. You get some transactions that clearly outperform some transactions that maybe have only performed in line with peers or in some cases even below peers. But one thing I would caution against reading too much into that statistic is, again, if you think about what gives rise to some of these transactions and what gives rise to a spinoff, typically it's a decision made in order to address a specific challenge or issue that the company has identified. So to offer a straight comparison of how a company is performing against its pure set of dimes does not capture the value preservation that a transaction could preserve, because again, we don't know exactly what would've happened in a scenario where the company did not execute on this type of transaction.


But apart from that, I would say, we talked earlier about what are the ingredients of a successful m and a transaction? And really those factors are no different in the context of a spinoff. It comes down a lot to operational focus and excellence in execution. And when we speak to clients about that, we always come back to what are the key kind of strategic and operational levers that will drive success or not. And we like to highlight specific case studies as examples or models that can be followed, assuming good execution. So I'll just throw out one example out there. If you look at the spinoff of iconic and how many aerospace, that was an example of a spinoff where you had a business that had higher growth prospects, higher margins that operated with a different product set, it had less commodity exposure. And if you look at the aggregate of both the RemainCo as well as the spinco, both businesses actually ended up performing better following the spinoff. And if you look at the aggregate spinoff performance, there was a clear case of shareholder value creation, and there's different examples that we can point to that offer a similar story. So to kind of sum up, there's a variety of factors that we can point at. I would say no metric is perfect, but for our clients who are thinking about this type of transaction, we like to highlight the key ingredients for success, look at the models of success, and determine that we can fit within that before proceeding.

Vito (21:26):

Like any alternative. I would say that we've probably modeled more of these situations and have actually been executed, but it's always provided value to our clients so that they can understand how to compare that relative to the other alternatives that they have available to them and help them make a decision as they're pursuing one of those alternatives or pursuing the status quo.

Albert (21:48):

Absolutely. We talk in our business and in our firm a lot about our role as a trusted advisor and our desire to be that trusted advisor and sometimes being a trusted advisor is to be a sounding board for management teams, even if the conclusion is to not proceed with a particular transaction. And so that's spot on. Vito, I couldn't agree with you more.

Vito (22:13):

Albert, Larry and I would like to thank you very much for joining us today, and I think for our audience, hopefully you've gotten a flavor for what are some of the trends in Albert's universe today, and you understand how he really helps clients figure out how to solve difficult and complex obstacles that stand in the way of them completing a transaction. So Albert, Larry, thank you very much for joining today and look forward to further conversations.

Larry (22:40):

Thanks as always, Vito and Albert. This is an ongoing exercise on our side to continue to monitor changes in the regulatory taxation environment, and you help us do that, and we appreciate your time.

Albert (22:52):

Well, it was great to be here. Thanks for having me.

Vito (23:00):

You've been listening to Strategic Alternatives, the R B C M and A podcast. Join us for more analysis about what's moving the m and a market in our next episode. If you'd like more information on any of the topics discussed today, please contact us directly or visit our This podcast was recorded on July 18th, 2023.

Speaker 4 (23:25):

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