Did Breakingviews.com Forget Corporate Finance 101?
So I’m minding my own business, reading the weekend edition of the Wall Street Journal when it hit me: someone clearly skipped out on Corporate Finance 101. It brought back a rush of memories that are truly priceless. Consider the following story:
Buyout Shops’ Dull Edge
Is the buyout industry losing its deal-making edge? A tussle for high-end furniture and knickknack retailer Restoration Hardware
may pose an answer. Buyout firm Catterton Partners offered to buy
Restoration for $366 million earlier this month. Now, it may face a
rival bid from Sears Holdings.Before the credit crunch hit, strategic buyers such as
Sears found themselves at a disadvantage relative to private-equity
firms. Fast forward to today: Catterton’s weighted-average cost of
capital in this deal will be much higher than Sears’s.In addition to Catterton injecting its own equity,
four public shareholders will roll their existing shares into the new
leveraged entity. All told, equity will make up 70% of Restoration’s
capital structure — well more than the 30% that characterized
precrunch deals. So the deal’s after-tax cost of capital will be 16%,
assuming the equity investors expect a return of 20% a year.Sears has a net debt-to-cash-flow ratio of less than
one. It could raise debt to buy Restoration or use some of its cash.
Either way, its cost of equity — the upper limit on its overall cost
of capital — isn’t much above 10%. This means Sears could offer a much
higher price. The deal looks like another good illustration of just how
critical a component cheap debt was to private equity’s golden age.
Whoa. Using the way one finances an asset to determine the intrinsic value of that asset? I don’t think so. Now, for those with a taste for history, see if you can remember this one: The Coca-Cola Corporation and Columbia Pictures. Coca-Cola bought Columbia in 1982, which led to a very stormy relationship over the ensuing years. After much strategic and financial engineering, Columbia was finally purchased by Sony in 1989. Many thought that Coca-Cola paid an absurd price for Columbia back in 1982, with one significant driver of over-valuation: using its AAA-credit rating and low cost of equity as inputs to the cost of capital with which to discount back Columbia’s volatile cash flows. This yielded a very high NPV, as the discount rate did not reflect the riskiness of the cash flows being purchased but the riskiness of the entity doing the purchasing. Is this any way to value a business? Of course not. The way a deal is financed should not impact the value of the operating business. The value of financial engineering and leverage is a separate potential source of value (and risk) that needs to be considered separately. This was one of the case studies I learned as a young banker of how not to value a company.
So here we are 25 years later reading a story that is basically making the Coca-Cola argument: since Sears has a lower cost of capital than a private equity shop, it should be able to pay a higher price for the business. NO. NO. NO. Please, no. Deals are hard enough when you pay a theoretically fair price for the business then when you grossly overpay since you didn’t use sound corporate finance principles when valuing its cash flows. I wouldn’t have expected to see this kind of weak financial analysis in the Wall Street Journal. Tsk, tsk.
