M&A Question Asked by PJT London

Hey all, I got asked to build a S&U for a Merger Model, as a part of an interview, by PJT London today. Here is exactly what I was told and what I made. The interviewer told me this was wrong and that talking to me was a big waste of time. Can someone comment if I really screwed this up? I wanted to argue with him but the Analyst hung up on me.

Co. A has Markt Cap of 200, Total Debt of 300 and Cash of 100.
Co. B has Markt Cap of 100, Total Debt of 100 and Cash of 50.

Co. A is going to offer a 50% premium for company B and financing mix will be 30% cash, 30% debt and 40% stock. Draw up the sources & uses and tell me what will be the proforma numbers for market cap, total debt and cash if we need to estimate EV? Feel free to ask any additional questions. I didn't ask any questions and within a minute had drawn the following:

Uses
Purchase of Equity 150
B's Debt Assumed 100

Sources
B's Debt Assumed 100
Cash on B's B/S 50
Cash used by A 30
Acquisition debt by A 30
Stock issued by A 40

I said proforma: Market Cap of 240 (200+40); Total Debt of 430 (300+100+30); Cash of 70 (100+50-50-30). Upon this, the PJT guy told me that this was an incorrect way to do it and that I didn't ask all the relevant questions to draw the correct S&U.

Can someone pls point to me where am I wrong? I think this guy is nuts and was purposely being a dick

 

Pls look at the market cap...

Good question here would be synergies creation, does the market accept them? Whats the P/E multiple of the sector / company to apply to them in order to calculate new PF Cap

 

What do you mean? It’s company A’s market cap + new stock issued, right? Where am I wrong?

How do the questions you ask impact the sources and uses? If the market doesn’t accept the synergies, proforma trading P/E may be lower or stock price may fall but this can be hedged with a collar structure meaning within certain bounds of stock price, total consideration to seller remains the same. Plus, I’m sure the interviewer was referring to Finding EV at t=0 immediately post transaction in which cases the questions you ask would have 0 impact

 

I may be wrong but I think usually in a merger, you assume that you'll be paying off the target's debt. and start with a clean balance sheet of only your own debt + new issued. So you calculate your payment based on market cap + debt paid = $ 250. Of that, 40% ($100) from stock, and 30% ($75) each to debt and cash.

 

Sure you can pay off debt but I didn’t. I assumed it. You can use seller’s cash and plug some of that as a source. But that’s just a different way of doing it. Doesn’t mean I am wrong, right?

 

Why can't you just ignore the debt and cash first? Isn't the purchase price 150, so your uses would be 45 cash, 45 debt, 60 stock?

Mkt cap hasn't disappeared, it has just changed hands so: A's market cap is now 200+150 (purchase price)=350 New cash is 100-45+50=105 New debt is 300+45(assuming external loan)+100=445

EV of 350+445-105=690? Or am I missing something here?

I don't know... Yeah. Almost definitely yes.
 

Well your market cap should be 260 per your eg right? Because only 60 is it in stock

 

I'll give it a try, but may be wrong. 1) 150 pp for B = 60 stock A + 45 new Debt A + 45 Cash (actually a reduction of Cash for A) 2) B uses cash of 50 to repay debt B of 100, so remaining debt B is 50 (to be assumed by A). 3) In t=O and c.p. Co A looks as follows: mcap of 200+60=260; debt of 300 existing+45 for pp+50 assumed=395; cash of 100-45 for pp= 55.

Am I overlooking something here?

In any event the way this guy behaved in the interview was very unprofessional. I doubt a proper MD would approve or condone such behaviour. It speaks volumes about the interviewer and his character. Keep your head up, no mistake (if at all) warrants such answer and ending the call in such unrespectful manner. Better luck next time, perhaps with more mature interviewers!

 
Most Helpful

Wow. I logged in for the first time after a near decade's hiatus to respond.

1) Your interviewer was a dick (was he French - that's something an insufferable French "grand Ecole" analyst would do

2) Think the answer is that you need to start from pro forma EV and work your way down. I'm not great at mental math but sounds like Company A's EV is 400 and Company B's is 150. So pro forma EV is 550. You paid a premium and bought B's equity for 150, 60% cash / 40% shares, so pro forma net debt goes up by 90 (60% x 150) and therefore net debt is 340 and pro forma equity value is 210. This is all pre-synergies.

The above might sound counterintuitive (pro forma equity value is only 210, while Company A started with 200 and issued 60 more) but if you think about it, the premium of 50 you paid is not value (i.e. you didn't create value out of thin air by paying a premium)...rather it is value leakage that is borne by the shareholders in the enlarged company in proportion to their shareholding.

In reality, you could argue that the "real" premium that B shareholders are getting is 38%, not 50% - their 23% (60 / 260) stake in MergeCo is worth 48, and they get cash today of 90, so the value of the consideration they receive is actually 138. This is the argument used by GKN's advisors in their defence against Melrose's (successful) hostile takeover in 2018.

NB the PV of synergies needs to be > than the size of the premium in order for the deal to be value accretive for acquirer shareholders

-friendly BB M&A guy in London

 

Hey thanks for responding. While I think I am following you, I don't fully understand you. Here are my 3 questions that I'd be grateful if you can respond to.  

1)  In your example, you assume that debt of B remains on B/S (ie not paid off). If B's debt is paid off and its cash is used as a source of funds, here is what the combined debt and cash figures look like. Total uses of funds are now 250 (150 eq purchase + 100 of debt paid off) and with B's cash plugged in, A needs to put up a further 200 of which 30% cash / 30% debt / 40% stock  

Total Debt = A's Debt (300) + B's Debt (100) - B's Debt (100) + A's Acquired Debt (60) = 360 Total Cash = A's Cash (100) + B's Cash (50) - B's Cash (50) - A's Cash (60) = 40

So net debt is now 320 and if we are to assume that combined EV's are still the same, does that now imply proforma market cap of 230? How do I reconcile this with the 210 you arrived to? Should there have been a difference? 

2) Moreover, how will this premium that buyer offered to seller be reflected in the closing balance sheet proforma for the transaction? Are you saying that combined shareholders' equity (as appearing on the balance sheet) will only go up by 10 instead of 60, in your example? 

3) Assume that no synergies but the combined EPS regardless of financing mix chosen is > than buyer standalone EPS, does that change any of your calculations? 

I really look fwd to hearing your thoughts as my confidence in myself just took a hit. :) Thanks in advance. 

 

Can some smart and sage banker please respond to this?

 

My responses below:

1) I didn't make any assumptions about what gets repaid because it ultimately doesn't matter. At the end of the day, you need to acquire B's equity for 150. Remember the consideration to target shareholders is 60% cash (funded either by cash on hand or new debt) and 40% shares. 60% of 150 is 90. So pro forma net debt goes up by 90 - from 250 to 340. This holds true in all funding scenarios - looking at the bookends, i) you could fund the 90 using A's existing cash on hand - pro forma debt is 400 and cash is 60, ii) you could fund the 90 using all new debt, pro forma debt is 490 and cash is 150. If you repay B's debt and use all the pro forma cash you have for funding (150), you'd have to issue 40 of new debt (250 total uses - 150 cash - 60 equity) , so your new debt would be 340 and cash would be 0. So PF net debt is always 340.

2) I don't think I've ever looked at a pro forma accounting balance sheet in real life, but here it goes (for simplicity I'm assuming book value of equity = market value of equity): on the liability and equity side, you write off B's equity and replace it with the 60 that A issued (so PF balance sheet equity value falls from 300 to 260) and you increase net debt by 90 - so the net increase on this side of the balance sheet is - 40 + 90 = 50. The other side of the balance sheet must also increase by 50, which comes in the form of goodwill (i.e. you paid 150 for something worth 100).

3) Not if you are looking at value from the top down (i.e. starting at Enterprise Value). Sometimes people look at pro forma EPS and arbitrarily apply a PE multiple to it - in this scenario the equity value (and therefore EV) would likely change. I don't really like doing it this way as unless you are thoughtful, it can mislead you into thinking that you are creating value when you aren't. Simple example: if you buy a company for 100 with perpetuity cash earnings of 8 using cash on hand, your net income goes up by 8 each year (EPS accretive) but if your cost of equity is 10%, it was actually only worth 80 to you, and therefore you destroyed 20 of value. I guess what I am trying to say is that in these situations you need to consider the question from multiple angles and come to a view that way.

 

You could try thinking in terms of value for equity holders.

Company A equity is worth 200. They issue 60 in stock. Equity Value is worth 260. They buy a financial asset (B's Equity) for 150 although it's worth 100. NPV of this project: 100-150=-50. Value is destroyed in company A and someone has to pay for it: Equity holders or Debt holders. EV=550 and debt is safe so Equity holders are paying the bill.

Eqv=260 - 50 = 210

It works well in this case but in more complicated situations, I would favour the Entreprise Value method explained above

 

I definitely want to know more about those French Grande Ecole analysts. How are they?

 

Yes he can raise cash that way, use existing excess cash or raise acq debt. Raising cash through equity raise would still count as cash. The tArget will not be asked to invest in the raise - it’ll just be getting the cash that is raised. Being paid in stock implies that you’re recieving stock of the acquirer as consideration

 

Wondering what questions you were supposed to ask? Maybe what the treatment was for debt and cash? I know there's answers above but I didn't really understand them (they looked a bit complicated?). I would do the below in an interview setting and just mention my assumptions (and hopefully the interviewer doesn't mind..).

I took a stab and basically made 2 assumptions: 1. The sellers debt has to be paid off (i.e. a "use") 2. The sellers cash was used as the plug

Info
Co A Co B
Mkt cap 200 100
Debt 300 100
Cash 100 150
EV (now) 400 50

Purchase price
Pemium 50%
Purchase price 150

Financing
Cash 30%
Debt 30%
Stock 40%

1 Show me sources and uses
Sources Uses
Cash 45 MEV 150 Debt 45 Debt 100 Stock 60 Total uses 250 Sellers cash 100
Total sources 250

2 What is pro forma market cap
260
3 What is total debt
300
4 What is total cash
150
5 What is estimated EV
410

I seem out to lunch based on the answers above - but if I mentioned my assumptions, wouldn't this be right?

Edit: hard to see with WSO formatting sorry.. hopefully makes sense

 

Why does it matter what the share count is? And how does dilution come in play? In other words, how does asking information about these impact the S&U and the proforma market cap, cash and total debt?

 

Some interesting discussion.

I disagree with the comment above that the incremental 50 does not add value to the acquirer, such that the PF EV is 550 instead of 600. While there is some validity, the reality is that the value that the asset will generate for the acquirer will depend entirely on the the PV of the future cash flows that the asset generates. If the asset generates 200 in value as the acquirer expects it to under its control, then the PF EV will be equal to 600 (400+200). Conversely, if the PV turns out to be less than what the acquirer paid, then the acquisition will have destroyed value for the acquirer.

The biggest problem with this question is that it is not very clear in a few areas. I'm not sure if that was the intent -- to test if the interviewee would ask the right clarifying questions -- or if it was just poorly worded.

If it were me, I would have clarified what the plan was for the target's existing debt. I think you made a reasonable assumption that the debt would be assumed and that the 30/30/40 mix would apply to the remaining 100 after the seller's cash was used. 9 out of 10 times you would be right. But if the debt was going to be retired, then the interviewer could have intended for the 30/30/40 mix to be applied to 200 (100 equity to be purchased + 100 debt to be retired). This would have changed your PF numbers.

I would also have clarified the premium. This is a much more nuanced point, so I doubt that it was the interviewer's intention. But I'll throw it out there, since it was the first question I had as I read the prompt. Half of the target's market cap is in cash. By paying 150, this means that the acquirer is effectively paying a 100% premium for the target's equity if cash is valued on a dollar-for-dollar basis. For example, if I owned a wallet that was worth 50 and it had a 50 dollar bill in it -- and you were willing to pay a "50% premium" for it -- would you pay me 150? Maybe, but probably not. You would probably pay me 75 for the wallet and 50 for the cash for a total of 125...because you wouldn't pay me 75 dollars for 50 in cash (in fact, in real life, if a target's cash is "trapped" somewhere, an acquirer might only pay 75 cents on the dollar for it or whatever). So depending on the interviewer's intent, that could have resulted in an offer for the equity of 125 vs. 150.

If I had to bet, my guess is that you went wrong around the treatment of the target's debt -- my latter point it a bit too nuanced for an interview. That said, based on the specific assumptions that you made, your PF figures are correct -- but the question is whether you made the "right" assumptions. Lastly, I also wouldn't discount the likelihood that your interviewer was wrong. It happens all the time.

 

Hey, that is an interesting example which you quoted. Sticking with your 2nd point, assuming a 50% premium, wouldn't you be willing to pay either 75 or 25 depending upon how you can use the cash? If I can't use any cash towards the purchase price, my effective price is 75 ($50 worth of wallet times a 50% premium), but if I can contribute the full 50 in cash towards it, the full effective price I would be paying is 25. I am using the wallet worth as a proxy for market cap, and so market cap + total debt - cash = enterprise value

 

I'm the poster who said the PF EV was 550.

I don't disagree with your comment - ultimately there are a lot of ways to think about PF value, and they each will get you a different answer.

In this instance, fundamentally from a corporate finance interview standpoint, I think the interviewer, among other things like sources and uses, is testing the concept of a control premium and the basic principle that in order for value creation to take place, the synergies have to be greater than the control premium.

I think the detailed capital structure points are a red herring to be honest.

 

It seems to me that there is no way you can answer perfectly this if you do not ask several questions...

1) For the uses and sources you need to first ask if debt is refinanced or not. This will also influence the adjustment for the PF BS.

2) Need to ask if target and acquirer have any other things on their BS to calculate EV.

Main message: Without some questions there is no way the interviewer can follow you and understand what you do. Hence your answer will be automatically wrong.

Still agree with everyone that the guy was a D in the way he behaved...

 

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