Without ‘free capital’ to pursue deals - Transcript

Vito (00:06):

Hello and welcome to Strategic Alternatives, the R B C M and a podcast. I'm Vito s Peduto, global Head of Mergers and Acquisitions at R B C Capital Markets. And as always, I'm joined by Larry Stein, deputy Chairman of Global Investment Banking. Hi Larry.

Albert (00:21):

It's good to be here. As always, Vito.

Vito (00:22):

Vito, today we're joined by a very special guest, Albert Chang, who is a managing director and head of m and a tax and structuring Advisoring here at R B C Capital Markets. Welcome to the podcast, Albert.

Albert (00:35):

Thanks for having me, Vito. It's great to be here.

Vito (00:37):

In his role, Albert leverages his expertise in tax, corporate separations, financing, and capital structure to advise our investment banking client base. Across the board, he helps our clients figure out how to solve difficult and complex obstacles that stand in the way of completing transactions and helps to structure transactions in a way that is most financially efficient and value maximizing. In short, Albert is RBCs m and a structuring guru. So Albert, I know I've given some description, but maybe tell us a little bit about what you do and sort of some of the examples of specifics that you bring to the table.

Albert (01:18):

So I've spent the bulk of my career in this m and a structuring role as you've described, where I've advised our mostly corporate clients, but also our financial sponsor clients and individual clients across all industry sectors on the execution, as you mentioned, of their most complex transactions. So a lot of this is and can be tax driven and really that's how this role originated within investment banks when it first popped up 15 or 20 years ago. But since then, structuring has also taken on a lot of additional dimensions and we've found that we can add a lot of value in areas like the intersection of m and a and financing and capital markets or shareholder analysis or creating new value creation frameworks and navigating regulatory challenges. So as you dely put it, we like to help our clients tackle their most difficult challenges, figuring out what transactions they could achieve in order to realize their long-term strategic objectives. And that's the expertise and experience that my role brings to bear.

Vito (02:21):

Let's think about the environment that we're in, and I think everyone's fairly aware of this as we think about year to date transaction volume in terms of announced transactions is off on the order of 35 to 40%, probably on the lower end of that spectrum is you'd look at a large market like the US being off about 35% year to date. And interestingly enough, larger transactions, transactions over 5 billion are off by a greater extent, roughly 45% down versus this time last year. When you think about that globally, those numbers are generally in line. Although the global statistics just given that Europe is actually off by a greater extent, are off just slightly more than the numbers I just quoted for the us One of the things we always talk about that we're waiting on is the resurgence of c e o confidence, and I think with some stability in the markets, we're hoping that in the third and fourth quarter of this year, c e o confidence rises and as we've always talked about, c e o confidence correlates to m and a deal activity.


So I think Albert, as we've been in a time period where whether you want to look at the first two quarters of this year or the last two quarters of last year, and think about the last 12 months as a time period where there's been a lot of introspection and companies have been looking internally and really trying to think about how to develop some transactions and achieve their strategic alternatives, maybe help us think about how the work that you're doing has evolved and are there any sort of new tactics? How are you looking at it today versus the past given your history?

Albert (04:03):

Yeah, that's a great question Vito, and I think I want to pick up on a word that you use there. Introspection, which has been a really key driving trend as part of all of the conversations that I've been having with our clients as they wrestle with what are the right strategic moves for us, both in the medium term and long-term. We've had a lot of discussions with clients on portfolio optimization, thinking about what are the right businesses to have within a company's portfolio and what are the businesses to potentially divest and what are the businesses to potentially add? But to really understand how we got there, I think it's important to pause for a moment and just think about the big macro trends that we've lived through for the last couple of years, including the most recent 12 month period, because I think that drives a lot of this recent trend towards introspection and self-evaluation.


So if you think about the big unknowns or the big macro trends that collectively we've wrestled with over the last, call it two to three years. First of all, we had Covid Covid obviously upended the world as an unprecedented global health event, but it also had a big impact on our clients. Supply chains were disrupted, consumer patterns changed, various industries were completely disrupted due to the changes in the way people live. We had geopolitical developments, obviously Russia's war with Ukraine, but also an increasing decoupling of China in the west and the potential future conflict in those relationships we had for the first time in many decades living through a true inflationary environment and the impact that had on rates. Hopefully we're beginning to get a little bit more clarity on that front, but that was certainly a trend that we worked through the last couple of years.


And finally, if you just look at broader global economic trends, we had diverging economic trends in different parts of the world. And so when you think about all of these unknowns put together and you think about, well, what were boards wrestling with over the last two to three years, there was a lot of, as you put it, Vito introspection and self scouting on what does our business look like? Are we prepared to operate, survive, and thrive in a world where there were so many unknowns? And one of the dominant conversational themes that came out of that environment is how is our business constructed? Do we have the right mix of businesses within our portfolio? And that discussion naturally dovetails with the work I do, which is if we do need to reevaluate our portfolio mix, how do we do that? What's the most efficient way to do that?

Larry (06:50):

So Albert, if we look at this in historical perspective, really since the financial crisis in 2008, 2009, we've had 15 years a prolonged period of 0% interest rates. And in m and a, we always talk about confidence. As Vito said, we also always talk about the most important issues being valuation for obvious reasons and certainty of closure, which relates to regulatory and financial certainty. But it appears that as we move to a more higher interest rate world, perhaps a more normalized environment, some people would argue we're reverting to a mean that we haven't been at for a over a decade structure now becomes critically important and that's really what you spend your time doing. So give us a sense of how the transition from 0% interest rates to a more normalized interest rate environment impacts your work and also the advice that we're thinking about for clients.

Albert (07:48):

Sure. Although we did live in a zero interest rate environment for a very extended long period of time, zero interest rate environments in some ways can also distort some of the ways in which deals can be made by making financially readily available. And that can be obviously a very positive impact in certain circumstances. But I think what you're seeing with what you call the normalization potentially of rates we're no longer going to be a zero in a zero interest rate environment, and that has several knock-on effects on the way transactions are done when you don't have necessarily free debt capital essentially to be able to pursue deals. That does require greater flexibility in structuring deals, a willingness to take on different financing structures which have different tax implications and other implications. And so to give a couple of examples, when you think about how we've seen certain capital raises occur and how deals have been financed, you do see innovative techniques in certain deals such as seller backed financing, seller paper essentially, which is a construct that you don't really see in a zero interest rate environment where you can obtain debt capital more freely.


So for example, in a regular race spinoff, you may see just a 100% divestiture of the business in an environment where there is more benefit to raising capital as part of a spinoff. You see spinoffs where perhaps 80% of a business is divested, but the remaining 20% is sold for cash and that's permissible under the tax free rules under certain circumstances. But you see, I wouldn't call them innovations, but changes in trends in that direction, in an environment where one, there's a perceived need to manage risk and second, where management teams are thinking about the broader financing market and their ability to stay ahead of it.

Larry (09:53):

Yeah, and I think one of the corollaries of where we are in the deal environment is that there's almost a higher burden of scrutiny on transactions. And so whereas in a zero interest rate world, people were looking past the details of deals because as you say, financing was so inexpensive. Now we think when we're seeing this in live deals, the market, the buy side is holding companies to almost a higher standard of performance when it comes to putting transactions together. And so structure has become of increasing importance recently, and if we believe that interest rates are going to stay higher than they were the last decade or so for a period of time, then we think that trend will continue. And that's why what you're doing is so important for us and for our clients.

Albert (10:48):

As our listeners are probably well aware, there's a historic amount of dry capital available from the private world, from private equity, financial sponsors, different sources even beyond your traditional financial sponsor world. And again, in an environment where capital raising provides a larger incremental and relative benefit because of the financing market, we see more dialogue around concepts like co-investments or private investments into subsidiary businesses. These are deal structures that are not unprecedented, but also are not typically at the top of the playbook. But again, in an environment where you have willing investors on the buy side as well as companies that are looking to shore up their balance sheets to be able to take advantage of attracting capital in anticipation of perhaps a new macro and financing environment that we're going into, I think we'll continue to see a lot of dialogue along these lines.

Vito (11:53):

Albert, as we think about the number of separations, and I believe you and I were chatting and last year was a record year in terms of sizable separations that occurred in the marketplace, meaning spins, splits and the like, and that seems to be continuing. Certainly this introspection drives some of it, but is a portion of it driven by the fact that frankly, there is that willing buyer potentially if they create a cleaner or a more pure company through a spin. And as a result, the private equity capital that's out there and other readily available financing markets up until recently have created that other buyer pool that causes companies to think that there's greater value in a separation.

Albert (12:38):

Interestingly enough, across the entire market, we've seen a lower volume of m and a transactions in the last several quarters. If you look over that same period of time, we really have not observed the same decrease of volume when it comes to spinoff transactions. Spinoff transactions of course, are self- help solutions. They don't require a counterparty. They are the result of a company management team and board doing the inward introspective work that we talked about earlier and concluding that a company is better off as two companies rather than a single company. And even in a market where we observe m and a slowdowns, spinoffs can really continue, there's a financing component, there's a capital markets component that can impact spinoffs, but generally speaking, spinoffs are more immune to the types of macro factors impacting m and a compared to your regular way acquisitions and sales of businesses.


And so I think that is an interesting side product of what we've seen the last few years. And to get to your question, Vito, of what's potentially driving this or what are the different factors that could be influencing management teams to continue to go in that direction? I think first and foremost, there's a continuing emphasis on strategic focus of businesses. So realizing both from an investor's perspective as well as an operational perspective that oftentimes being able to be focused on a single line of business or a few different lines of businesses is going to be more effective across the spectrum compared to holding businesses as a whole. And that has implications across not just the operational spectrum, but also from a capital markets and m and a perspective as well. One thing we observe for example, is that in general, companies with fewer business segments tend to trade at a superior multiple compared to similar performing businesses that have many different business segments.


But to your point of, well, what does this mean for m and a that can have several impacts including just companies trade better, and so they're in a better position to execute m and a from the perspective of broader strategic deals, whether the spinco or the RemainCo, whether they're acquirers, merger partners, or even potential targets. You see that streamlining and that operational and commercial focus can oftentimes make them more attractive candidates for these types of transactions. And so interestingly enough, when a spinoff does get announced, we frequently get calls or we initiate dialogues with our clients who are in similar industries who may have a renewed m and a interest with one of these businesses now that they have a more streamlined focus.

Vito (15:49):

It just highlights the fact that we're always in front of our clients updating 'em on their strategic alternatives and how to consider those in respect to the updated view on the market and whether that might be a change in the landscape of the players, if someone is right sizing, spinning a portion of their business off or what the spin or romaco looks like in that landscape or otherwise. Just maybe pivoting one second and thinking a little bit more about the regulatory environment. Clearly we're in a time period where the F T C has been challenged and has been rebuffed in a couple of cases, notably from a court perspective in terms of the pursuits that they've had with some of the mergers that are out there. But at the same time, they've also talked about and are about to consider implementing some extension of different regulations around H S R, which are going to create some more onerous requirements.


As we think about that and we compare it to say, a spin transaction that takes quite a bit of time to get done. Sometimes the concern about being out there with one of these separation transactions is the interim operating period and the fact that it's going to take so long from the time that you announce it to the time that you close and can you maintain the operations of the business, maintain the people, and not have the disruption that hurts the business long-term. Do you think that some of that has been moderated a bit in terms of some of that concern given what the F T C is proposing from an H S R perspective or is it still part of normal course operations?

Albert (17:29):

I think that's the key question, Vito, and obviously none of us have a crystal ball. You compared in your question, the impact on spinoffs compared to the impact on mergers. Both of these types of transactions, spinoffs where you're dividing into two entities or a merger can have a very potentially impact on companies that are going through this type of organizational change. I think the challenges of those two transactions are different. So in a spinoff transaction, typically we're actually creating more seats and more need and more jobs by separating two companies. So there's a unique operational challenge that comes in the spinoff context, whereas with mergers, large scale mergers and combinations of two businesses, the opposite tends to be true where you're trying to fuse two different entities together. The D O J and the F T C regulatory framework as it relates to antitrust uniquely impacts mergers and not so much spinoffs as you alluded to, because in a spinoff transaction, by its definition, it is not going to be something generally speaking that reduces competition. You're creating more entities and historically antitrust has not intersected with the field of spinoffs. And so when you think about the riskiness of transactions and the types of regulatory issues that could come up, I think the merger world is uniquely impacted by some of these trends in the antitrust world.

larry (19:01):

One of the interesting things about structure Albert as we talk to clients is they're also trying to anticipate potential shareholder or activist discussions that their investors may have with them about how to improve their stock price. We all know there are a few more headwinds in a rising interest rate world, and because spinoffs are something that you can control and because as you say, there's less antitrust scrutiny because you already own these assets, the process of separation is something that the companies really have to think about. Of course, you have to balance that against potentially challenging capital markets conditions, and you want to make sure that you actually are on a path to create value through focus, and each situation is different, which is why it's important to do the homework. But that contrast between spinoffs as a way to potentially create value from the perspective of buy-side investors on the one hand, and mergers may be being a little more difficult, even with the prospects of synergies on the other, is definitely a macro trend that we're going to watch in the next year or two.

Albert (20:08):

Again, none of us I think have a perfect crystal ball as to exactly how the short-term antitrust story will play out, but of course, if you look at the last several years, there's been a perception that this particular antitrust regime was going to take a more aggressive approach towards scrutinizing transactions. I think the very recent decision in the Microsoft Activision case certainly made a lot of headlines and could potentially impact that stance. The legal commentators who have taken a deep look at this case have commented that this particular ruling should strengthen the traditional legal standards for antitrust. So it wouldn't surprise me if we did see a broadening window of opportunity as well as some management teams that could look at this and say there is more of an appetite and more of a window to pursue transactions.

Vito (21:06):

Maybe talk to us a little bit about where we stand from a historic perspective with regards to regulatory or tax changes. Are we in a period where we are operating primarily on what's been in place for a while? Are we digesting sort of recent changes that have been implemented and what are you focused on?

Albert (21:29):

So most of our listeners are undoubtedly aware of the big tax change that passed at the end of 2017 and was implemented starting in 2018. The Tax Cuts in Jobs Act, the T C G A, as we use the acronym, that particular tax bill had a number of major changes that impacted not just individuals like you and me, but really all the corporate clients that we dealt with and produced from our observation, meaningful changes in the way companies approach m and a and transactions and how they operate. So probably the most notable one that most listeners are aware of is the corporate tax rate changed. It went from 35% previously at the federal level to 21%. The tax bill also fundamentally changed the way in which foreign businesses and foreign subsidiaries were going to be treated by transitioning the US from what we call global tax system, where everything is subject to tax to a territorial system where foreign earnings and profits were not taxed in the same way that domestic earnings are.


The combination of those changes, as well as several others really impacted several dimensions on which companies operate. On the one hand, because the tax rate was lowered, you saw a little bit less sensitivity to doing taxable transactions. So when you look across m and a transactions where corporations were divesting businesses, you saw more of a willingness to engage in that type of transaction, and that's just a math equation where you're paying 21 cents on the dollar on capital gains instead of 35 cents. We also saw various incentives in the taxco temporary incentives that were intended to stimulate investment, but also had an impact on m and a. So one of the most notable changes in the T C J A was that it allowed acquirers of assets to immediately expense in year one and take a tax deduction in year one, the value of all the assets they acquired.


And so when we looked at the financial and taxed impact of asset acquisitions or asset divestitures, that had a big impact on the math because it provided an upfront incentive to get some of these deals done. Some of these rules, including the one that I just mentioned on year one, bonus depreciation were written in such a way that they were temporary unless the laws were extended. So for example, the 100% bonus depreciation rule that rolled off the books last year and beginning this year in 2023, that year one bonus depreciation has gone down to 80%, and next year it'll go down to 60% and the year after 40% and so on and so forth. And there's changes like that where there was temporary provisions put in place as part of T C J A that will continue to roll off. And I think as those rules roll off, you could see a shifting of behavior back to what we saw pre-tax reform law, which is again, a greater emphasis on the tax-free aspect of spinoff transactions compared to divestitures, for example, or certain behaviors in cross-border m and a as some of the rules around how we tax foreign subsidiaries revert to new thresholds and new rules.

larry (25:04):

And of course, we're facing a presidential election year, and while none of us can predict exactly what happens, tax policy or tax related issues will be on the table again, depending on what happens in 2024.

Albert (25:18):

That's a great point, Larry. So one of the conversations that I personally was a part of both before the 2020 election as well as the midterm elections in 2022 was around families selling businesses because there was a lot of speculation at the time around whether there would be changes to the individual capital gains rates. And so a lot of our clients in the privately held space that had family businesses that were looking at potential divestitures in those election years where the policy was a little bit up in the air and there was uncertainty as to which way it was going to go, we did see an uptick in both dialogue as well as actual processes to try to get some of these deals done in what was perceived at the time as a more uncertain tax environment. So I think that's certainly true.

Vito (26:09):

Well, Larry and Albert, thank you so much for the great conversation around the macro environment that's impacting m and a deal structuring. I really think there was a lot in there and looking forward to our next conversation.

larry (26:23):

Always a pleasure, Vito. Thank You.

Albert (26:25):

Thanks for having me. It was great to be here.

Vito (26:32):

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 website@rbccm.com. This podcast was recorded on July 18th, 2023.

Speaker 4 (26:57):

This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives. For disclosures, please visit www.rccm.com/disclosure.