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Wednesday, February 4, 2015

How companies structure accretive/dilutive deals?

Merger & Acquisition has been a widely debated topic on whether it will bring value to existing shareholders. Of course, when we talk about this, investors and analysts will think the likes of accretive or dilutive deals.

In general, almost all existing investors would be happier to see an accretive deal being carried out. They would suck their thumbs if a dilutive deals is carried out. The reason for this is because an accretive deal increases the earnings per share of the company which would translate into a higher market price and for a dilutive deal vice versa.

The impact on EPS is by far the most emphasized metric used to evaluate an accretive or dilutive deals without any consideration for other reasons. Take a look at the survey done by A.T Kearney on recent M&A data collected, up to 75% emphasizes on EPS while a distant second emphasizes on other factors such as Enterprise Value or Debt Ratio.



But first, let's see how companies usually structure their deals to make it accretive or dilutive.

One of the easiest to make an accretive acquisition is finding an acquired company with a PER that is less than what the existing company is currently valued in. This is of course easier said than done, as we know there are so many factors to consider from before purchasing a company.

Another way the company can structure an accretive or dilutive deals is through the way the deal is being funded. There are generally 3 ways a company can fund the deals:

1.) Cash

Funding the acquisition via cash deal would almost definitely be accretive since the required rate of return we get from a fixed deposit will almost be lesser than the rate of return we are going to get from the acquisition. The reward and increase in earnings we get will almost certainly increase but in return we will get a higher form of risk from the reduction of a liquid asset.

2.) Debt

Having experienced a low rate environment for the past 4 to 5 years, funding an acquisition via a debt deal would almost be accretive since the required rate of return through an acquisition would almost certainly be higher than the cost of debt in the form of interest expense. Nevertheless, we will get a higher risk in the form of floating interest rate and refinancing issues when interest rates start to increase. The risk adjusted return spread between the return on investment and the cost of debt should substantially cover the risk it presents.

3.) Equity

Equity deals is the most expensive out of the three because as a company we are selling our shares to the public in return for cash to fund the acquisition. They are somewhat similar to IPO because the cost of equity is essentially the internal rate of return which is usually on the higher side. To make an equity funded deals accretive, the return on investment has to be higher than the cost of equity. Management would be least likely to use this method unless necessary.

Why not all accretive deals are creating "Value"?

Accretive or dilutive is such a loose word that everyone thinks that an accretive deal is creating value while a dilutive deal is destroying value. There are exceptions to this.

For example, if you are buying out a company that has a lower PER than your company has at the moment, the deal would be said to be accretive straight away. However, further investigation needs to be done on why the company you are purchasing is having a low PER. Usually, when a firm has a low PER, they are either off the book from the public interest or they could be having a weak outlook or low growth potential. In this case, notwithstanding the "accretive" deals made, this does not seem to be a good justification to purchase the company.

Another example that I can relate to is using your CPF Investment Account to purchase shares that yield higher than 2.5%. If you put these money into shares that yield higher, everything else equal, it is considered an "accretive" deal. However, we all know that replacing a riskless investment that generates 2.5% today with a riskier investment that generates a 3% for you isn't totally the same thing, caveat applies.

Conclusion

All of this ultimately comes down to perspective views about valuation. A company is frequently valued on the basis of its earning per share by applying the PER valuation method, which brings greater emphasis on accretive or dilutive deals that impact the EPS.

In reality, accretion or dilution is only a fact of doing deals but not a measure of potential value creation. For that, a company's fundamental is still the one that we should keep an eye on. Do you agree?

What do you think? Do you agree that too much emphasis is being targeted at accretive acquisition without justification?


7 comments:

  1. B,

    What would you do if your compensation is a % of Asset Under Management?

    That's why you do one thing with Other People's Money, and another with your own money ;)

    ReplyDelete
    Replies
    1. How about of collecting XX% of cash flow for fee but report as 0.X% of NAV and shouted about its low expense?

      Delete
    2. Hi SMOL

      If my compensation structure is under AUM, I'll do the same accretive deals (just to satisfy those shareholders who doesn't see beyond the shadow) but my goal will be to keep buying the assets, always at "fair" value :)

      Delete
  2. Hello B,

    I use a similar analysis on the Asset Enhancement Initiatives (AEIs) that S-Reits embark on, whether the Return on Investment (ROI) of the AEI is accretive or dilutive in nature.

    ReplyDelete
    Replies
    1. Hi SRSI

      There is more than meets the eye for just accretive or not actually. But all shareholders concern is increasing DPU. The rest can wait, this is the problem we will have.

      Delete
  3. Indeed, B,

    We need to look further, remember Singtel buying a loss-making Optus in Australia?

    Where are the critics now?

    Ability to turnaround a company is always a tough call, but it might be the cheapest and most accretive if one can do it.

    China Merchant Pacific Holdings buying of loss-making Jiurui is a good move on hindsight.

    Then there are also balant silly dilution. I know u will say LMIR, but I have sabana in mind actually.

    ReplyDelete
    Replies
    1. Hi Sillyinvestor

      Hahaha, I won't say LMIR lah actually....

      I think ultimately what is best if the management makes decent decisions that would benefit the shareholders in the long run. It can be dilutive at first but it has to have the right justification to do so.

      Delete

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