Summary:
Acquisitions should be measured not just vs. WACC but vs. the opportunity cost of finding a better deal later
WACC is a flawed concept as it doesn’t address the cost of financial distress which increases with more leverage
We live in a world of low interest rates and thus low borrowing costs. It has been this way for a decade now. A generation of CFOs have come to know this as the “new normal”. Many believe their cost of capital is lower than pre-crisis because of low rates even as their growth and returns suffer. Boards have certainly bought in by lowering return hurdles for executive compensation.
With lower rates has come the temptation to borrow. After all, any deal can look good when I’m paying for half of it with 3% debt. Even better, if my other half is “excess capital” which is earning 1%. When my cost of my deal is 2%, anything can be accretive!
Unfortunately, too many CFOs justify deals on EPS accretion, a low bar, rather than is it more accretive if you did something else with the money or if you funded it at a normalized cost of capital.
But this isn’t meant to be a post about bad acquisition math. Rather, it’s about how companies should evaluate their capital capacity and decide whether to deploy it or not (whether it be for growth, M&A, or buyback). The main concepts I will address are scarcity value and the cost of financial distress.
Scarcity Value
This is largely another way of saying opportunity cost. Too often, companies act like excess capital is burning a hole in their pocket. If I have $1B of excess and I find a deal that will cost $1B and provides a 10% return, I should do it! After all, it’s much more accretive than investing at 1%!
However, this ignores the potential for something else better to come along. Instead of thinking of the excess as an exploding offer I have to use the first chance I can, think of it as a get out of jail free card. You really want to think about whether this is the right time to use it or if there will be a better opportunity later in the game.
Note, that when you think of capital deployment options in terms of opportunity cost, the cost of funds is (almost) irrelevant. I am deciding if the 10% return I can get on my $1B is good enough or if I can get 15% later.
The only reason the cost of the capital matters for this analysis is, if I am going to raise debt, the cost of that debt could be higher (or lower) in the future. However, in most cases, that risk is not enough to change the go vs. no go decision. Companies who spent their excess too soon on modest opportunities over the last few years have not yet benefited from locking in their low cost financing.
Perhaps another way to say it is it seems execs focus far too much on the “we’ll never be able to finance this cheap again” aspect rather than try to wait for the “we’ll never be able to buy an asset at this good a return again” option.
Financial Distress
Aside from opportunity cost, the other common mistake is when companies lever up for acquisitions or even buyback.
Again, I get debt is cheap. Someday it will be more expensive. But pretty much everyone has been too early predicting when that someday will be.
Because debt is cheap, CEOs worried about accretion math tend to want to use as much as possible to finance their deals. Often, we see companies going over their D/C targets and pledging to bring the ratio down post deal by turning off buyback and using free cash flow to pay down debt.
This is nothing more than sleight of hand. Let’s say a company is doing a consistent $1B of buybacks and announces a $4B deal. You announce you will finance with $1B of excess capital (that investors had earmarked in their models for future buyback), $1B by stopping buyback this year, and $2B of debt. But, don’t worry, we will get our debt ratio back down by not doing any buyback the next two years to get back to normal.
Well, guess what, you didn’t finance that deal with $2B cash and $2B debt. You financed it with $4B of equity because I took $4B of buybacks out of my model and the “debt” is really just bridge financing. Your deal is not accretive, sorry.
Anyway, let’s get back on point here. That $2B of debt you issued which took you above your range for your credit rating? The cost of that debt isn’t the coupon. It’s the coupon + the risk of future financial distress. Normally, the cost of distress is small so it may appear that your cost of debt capital is the coupon.
However, when you lever up, your cost of distress rises which means the debt actually costs more than the coupon. Theoretically, the debt buyers would realize this and demand a higher coupon but that is not how today’s world of “this is going into the index post issue and it’s 5bp wider than yesterday’s similar deal so I better buy a piece of it” works.
Before anyone says I’m being dramatic or this is just hypothetical, recall companies who levered up into the crisis when the skies were clear and were soon issuing debt at 8+% or even issuing equity below book because they had no room for debt. Leverage has a price. The price is paid when the tide goes out and you are forced to issue capital at onerous costs.
Using up all one’s debt capacity is a dangerous game. It works most of the time, but companies should be more honest in assessing the real cost of taking their leverage up.
Private Equity and Insurance Brokers
This is where someone might try to tell me, “the private equity guys are a lot smarter than you and they haven’t run into any issues levering up insurance brokers to the sky”. I would amend that thought to say “they haven’t run into any issues YET”.
We can debate whether the public insurance brokers are too conservatively levered at twice EBITDA. However, PE is levering the private brokers up to 6X (and paying peak acquisition multiples to do so)!
Clearly, there is no cost of financial distress in their WACC model! It appears the model is a DCF based on assuming the terminal value will be one turn higher (or two…or three!) than what we paid for it. In other words, hope trumps fear.
I will explore what could cause distress for the brokers in a future post, but let’s do a simple thought experiment for now. If some “disruptor” came along and was able to force commissions down from 15% to 12%, then $100 of revenue becomes $80.
If your $70 of cost stay the same in the short term, your margin drops from 30% to 12.5%. Debt has gone from 6X EBITDA to 14.5X. And your EBITDA is less than your interest expense. That’s distress! It may be remote, but it’s not impossible. If that day comes, a lot of bondholders are going to ask why they didn’t charge more of a premium to hold debt from a 6X levered broker vs. a 2X levered one.