How Business Cycles Affect M&A Valuation

What's the difference between Deal Room and Firm Room? I get asked this all the time. I know if we could have made the branding any more confusing. So let me break it down for you. Deal Room is an M and A lifecycle management platform. It's perfect for any company that does two or more acquisitions a year. It manages your pipeline, diligence and integration, also divestitures. It automates pipeline reporting and follow ups so you stay focused on conversations with potential targets. And this is where it gets good. You can run full diligence for all parties involved internal, external and counterparty in one workstream. Then create a parallel work stream for all the integration planning. This allows your team to start integration planning at the start of diligence and iteratively update the integration plan with incoming information. This is how you get integration done faster. Nobody in the world does this better than Deal Room. I know that's a bold statement, but I will take bets on it now. Firm Room is a virtual data room that is as simple as it gets. Back in 2018, the team at Dealroom noticed many boutique investment banks and law firms that cared about their customers were just looking for a simple data room solution that wasn't charging ridiculous per page billing fees. So we did something about it and carved out the data room functionality in dealroom and made it into a dead simple self service data room offering. If your deal isn't that complicated, then probably simple Data Room is the way to go. You'll find the best value with Firm Room. Pricing starts at 500 bucks a month, but there you have it. Deal Room versus Firm Room settled once and for all. You can check them out for yourself@dealroom.net and firmroom.com Again, that's dealroom.net and firmroom.Com let's get to the interview. I'm Kisan Patel and you're listening to M and A Science, where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies and what actually happened during M and A deals.

Foreign.

A Scientists welcome to the M and A Science Podcast where we learn from the best in M and A to uncover proven techniques for enterprise value creation. If you're interested in learning more about.

How to optimize your M and A.

Practice, or want to get involved with our community of forward thinking M and.

A practitioners, visit mascience.com subscribe to our.

Free weekly newsletter for the latest in industry trends, insightful content and community events. If you want to keep up with us on the go, head over to LinkedIn and follow M and A Science.

I'm your host, Kisan Patel, CEO and founder of M and A Science. Joining me today is Alan Marks, Global project, Energy and Infrastructure partner at Milbank. Milbank is one of the nation's leading firms for corporate finance, M and A.

Restructuring, litigation and project finance.

It's known for its international work and.

Focus on the energy sector. Today we're going to talk about how business cycles affect M and A valuation and how to avoid blind spots in your deal. Alan, how are you doing today?

Good. Kisan, thanks very much for having me.

Thanks for coming to our studio here in Midtown on 40th and Park. Appreciate you taking the time today.

That's a pleasure. Easy hop from Hudson Yards.

I know you got a ton of deal experience I'm looking forward to talking about, but I'm most excited to talk to a fellow podcaster because you have a podcast. Can you tell me a little bit about what you create content on?

Sure, thanks very much for asking. Khsan. Yeah, it's nice to be on the other side of the mic for a change. And a little scary because at least when I host I get to decide what we're talking about and today will be different. But I created and host the podcast Law, Policy and Markets which covers a wide range of business related topics, mainly talking to other partners at Milbank, but also to other experts and clients.

Well, it should be an easy podcast for both of us then.

Yeah, it should be fun.

Can we kick things off with a bit about your background?

So I'm a lawyer and I've been a partner at Millbank for a long time and have been working in the energy and infrastructure space on a wide range of transactions. Some of those are M and A, some of them are private equity investments or infrastructure fund investments. A lot of it is also project development work and project financing, either on the side of the borrowers and sponsors or on the side of the lenders and institutional investors.

You've been doing deals for a while?

Yeah, 30 over 30 years.

That's a lot of deals. Do you keep tabs on how many deals you've worked on and what their aggregate amount is?

Not directly, no. I know that I have a shelf that's got a bunch of old deal toys on it, some even older volumes where we used to store the contracts before they were digital.

So you're past the point where the scoreboard doesn't even matter. You're just like.

I wouldn't say it doesn't matter. I mean, we're proud of it it's funny, you look at deal size and I could compare a couple of deals recently and even though they're very different in deal size, the complexity is similar. The importance of it to the parties in the transaction is similar. Not too long ago did a financing for the new Terminal 1 expansion at JFK Airport $10 billion deal straddled the COVID virus shutdowns and so forth. And a lot of people were committed to it. But there's another deal recently, it was around $150 million. And it had its own complexities and people care very much about getting the right outcome in either case.

That's true. There's more to it just than that. Big number.

Definitely. In fact, actually that's one of the challenges. If you look at whether it's M and A finance other transactions, sometimes the diligence that's required, the negotiations or the intensity of them, the risk allocation, a lot of that can be every bit as intense for a smaller transaction as it is for a large one. And the small deals can't always support the transaction costs then that go with that. I think there can sometimes be a tendency for people not to take them as seriously, and that's a mistake.

Fair point. The energy infrastructure space. I haven't directly worked energy infrastructure. I've seen some pitch decks that would at the end of it make my head spin. Maybe you can walk me through what makes this segment distinct to the broader M and A activity that we see in the market.

I would divide energy and infrastructure into two different buckets. One of them would be traditional power and that would include renewable energy. It would include traditional fossil fuel fired power plants. Anything that relates to utilities. Even now I would include energy storage. Those are an area where there's a lot of regulation. The regulation is designed to keep power rates at the retail level, especially affordable to provide reliability and stability on the grid. And all of that tends to disincentivize radical change or innovation in a big way. So it becomes challenging when we have a transition, for example from say coal fired power plants or natural gas into greater penetration of solar or wind on a grid. How do you value that? How do you adapt to the new locations, the changes in power supply, how do you adjust to changes in power demand with EVs and electrification and mobility, with data centers becoming a huge sink for massive amounts of electrons that are needed to move information in the digital economy. And those changes are hard to reconcile with some of the boring old traditional utility models that in fact are evolving in very interesting and complex Ways they tend not to be high profit businesses. Compare it say to technology, compare it to retail or hospitality or travel or finance for that matter. In the energy sector, because you want to keep costs down and you want to keep rates down and because there's a regulator making sure that happens, you can't really have high margins. Generally you make up the value and you make up the earnings or the investment return through leverage. They're very highly levered, they're capital intensive and most of that money is borrowed. And when your capital stack is dominated by debt, especially non recourse project financing debt, that will maximize your return on equity, you also have to drive the risks down to almost zero. So there's again disincentive to taking on lots of optionality or lots of innovative technology. Most other businesses you might see where you can scale it up, make your profits that way or others where you have a high return and profit return on assets or return on low cost in and high cost profit resales.

So you have some big macro trends that are impacting the industry. It's generally a low margin industry and that's pretty well leveraged.

Yes, typically.

Not getting me too excited to jump into this space.

It's funny, there are people coming into innovative energy technologies with the expectation that I live in California. We have a large robust community of VC investors and tech may have boom and bust cycles, but one common thread through that you experiment and you hope to have a portfolio effect where you have a lot of losers, but you may have one that hits when it does. It can hit big if it can scale up and you have a nice exit on it. When those investors turn and pivot to clean tech or innovative energy technologies, a lot of them are surprised or they bump up against this wall of risk aversion and low profits through de risking and a goal instead on return through leverage.

We didn't even talk about the regulations.

Well, the regulations are a mix. They're a mix of federal and state in the United States and of course outside the US there's different ways of doing it. Fundamentally it's a matter of keeping the lights on. And I would say now in the age of climate change, it's a matter of keeping the lights on and the skies blue at the same time. And that means big shifts.

Is that a hurdle?

Yeah, I think it's a challenge. We're seeing shifting demand patterns for how energy is used and when it's used and where it's used at the same time. For areas where solar and wind power are becoming more Prevalent supplemented by energy storage. The people balancing the load on the grid between supply and demand have to have a bigger challenge, I think and a very locationally specific one as to how to manage that system as it's changing the that impacts asset valuations for each step of that, whether that's power generation, power transmission, power storage, power use. The complexity of that is overseen by regulators at both the state level, usually regulating the utilities that are by and large consuming the power and selling it at retail or at the federal level, especially on interstate transmission.

That's pretty intricate. Like they're not just looking at some simple non compete perspective like your FTC toj. They're looking a lot more in terms of how's this deal gonna impact a lot of things.

Yeah, they're looking at systems. So there's a macro view to it. You mentioned DOJ and ftc like on the antitrust. There's certainly a systemic question of what you're doing with market power and competition in the economy and so forth. But it's also on the micro level. And certain type of energy company or energy facility in a certain place may function very differently than if it's in a different place. In that case, it's almost like real estate. It's location, location, location.

Are they still looking at other aspects of the business beyond just the competitive nature that they're acting on?

From a regulatory standpoint, yes. So there are special rules for cybersecurity for anything which is connected to the bulk power supply. Power plants, for example. There are right now big swings in the costs and value of a lot of energy assets if they're new, depending on how dependent they are on imported equipment, especially things from China that may be subject to tariffs or trade policy and that can either limit supply or drive up costs.

Business cycles. Can you explain in simple terms about what a business cycle is and how it impacts the economy?

I've been doing this long enough to have seen a few, so that's actually always scary to me. As an aside, we think of business cycles like this boom, bust or expansion versus recession or contraction in the economy. And usually that's looking at a macro picture. You're looking at gdp, aggregate demand, productivity and employment for the most part, and what you might consider the real economy. Anybody who's been in finance, working for a large corporation, a lawyer or other advisor for less than about 12 or 15 years has never really seen a prolonged contraction. We obviously had a very rapid one, very deep one, but also a short lived one during the onset of the COVID Pandemic, but we've seen a recovery from that. Massive amounts of government stimulus with until recently, very low interest rates, historically very low interest rates. That fueled a big expansion that is somewhat still going on, despite the tightening in the credit cycle, which is different than the business cycle. But the business cycle affects valuations as well. Because when times are good, when the economy is expanding, when demand is increasing, there's more competition for assets, there's more confidence and certainty that those future values will be at least as good as they are today because we believe in growth or in expansion, and that tends to drive up valuations. Compare that to a contraction, there's less certainty about the future. There may be headwinds on demand, there may be contraction in productivity, there may be less production in an aggregate level. And the employment market is very different. In those situations, asset values tend to decline and there are fewer people bidding for them.

You mentioned credit cycle. I want to maybe distinguish between business cycle and credit cycle because I would assume the credit cycle falls under the business cycle. But maybe you got more to that than I know.

That's a really good question. What I described as the business cycle or sometimes the economic cycle, same thing. That's the economy writ large, expanding or holding steady or shrinking. The credit cycle is distinct from that. It's correlated to it, but it's distinct. I'll give you an example of how one can influence the other. The first example would be the business cycle. With an expansion making lenders, people providing debt, and maybe some equity investors as well, feel more confident. They loosen their purse springs and there's more money flooding into the economy. And in a situation like that, if it's not getting too hot too fast, money is easy. Lending terms may be lighter. The ability to refinance is usually easier. But often it's a company with interest rates being low, the cost of capital is low. And when a cost of capital is low, especially in an M and A, if you have a target that has a low cost of capital, that's going to increase the valuations. At some point things may get too hot. You can look, for example, at what happened the global economy and certainly here in the United States last year and the Federal Reserve made money more expensive. Now, the Federal Reserve does not control long term interest rates. It only controls short term interest rates. There's some impact, of course, of the monetarists on the money supply. If you make money more expensive, either by limiting the supply or increasing the cost of it by raising short term interest rates, that has a couple of Knock on effects that are designed as, like a loop that gives you a feedback loop. They're designed to bring the expanding, maybe overheated economy back down. Now you don't want it to contract. You don't want a recession. And so far it looks like we're. Whether it's luck or skill, but we'll take either one. That is managing to keep us from having a recession. And instead we're slowing things down from the expansion, which can, if it works, justify reductions in interest rates later this year. It's not just a matter of how much you cut rates or raise them. It's actually how quickly that happens that will tend to contract the economy. It'll affect valuations, it'll affect the appetite for new investments and so forth. So the cost of capital, the credit terms, the availability of credit, that's what I would refer to as the credit cycle. One cycle can cause either positive or negative effects in the other one. It's science to a degree, but it's also a lot of luck and a lot of art because we're also talking about human behavior, and that's psychology. Expectations may influence what's actually happening today.

So we can look at this credit cycle as essentially a lever into the broader business cycle. But not all be all lever. That's going to.

They're levers for each other.

So then. Yeah, because they might come back and use it. Like, we've seen the inflation, and then all of a sudden we're countering it with the change in the interest rate. That's what's been driving it.

And of course, inflation has lots of components. Right now we're seeing still a very strong labor market. Whether you look at job openings and quits, or you look at layoffs, you look at people looking for work, labor force participation is higher. It's a very strong labor market. And a lot of the transactions and companies I work with, One of the big challenges right now is a real shortage of skilled labor. Yes, interesting. I'll tell you a story I was just recently downed at a shipyard. One of the clients I'm working with is building some offshore wind projects. We were looking at the ships that are under construction for these offshore wind facilities. They're very specialized ships. They're very expensive, they're very large, very complicated, and they have some innovative technology in them. As you drive from New Orleans down to the shipyard, two different things which show you some of the challenges in the economy that affect the ability to make new investments in these areas. Retail stores were empty for lease signs Were everywhere. Gas stations were closed. That sector of the economy in that part of southern Louisiana having a harder time. Those are real people with real challenges. All of the industrial facilities along the way were having signs for help wanted because they can't find enough people to be welders and pipe fitters and electricians because we have a scarcity of skilled labor in those areas. That imbalance has a contracting economic effect ultimately and drives up costs and acts as friction that prevents some of those investments otherwise from going forward. So it's not enough to look at the big picture economy. You have to dig down deeply into what's happening in different sectors and, and for M and A or financing or corporate transactions, that also means that different types of investments in different sectors are going to behave very differently depending on what their costs are, their inputs and their expected demand.

Yeah, I guess I want to tie this back to how do you see business cycles? And it seems like they're unique. So I'd love to hear a little bit about the historical view in the terms of attributes to the cycles you've seen. But then ultimately how that comes back to impact M and A.

Sure, let's stay with energy for a second and come back to that because it's a good way. It's just an example to see how these things differ. For highly regulated sectors like power, the cycles are not meant to impact them very much. Demand may fluctuate somewhat, but these are basically inelastic items. You need power, you need water, you need it almost no matter what's going on. And the regulators are meant to make them inflation resistant. They're meant to make them resistant also to recessions. These are very stable assets. And that long term stable cash flow attracts not just debt, it also attracts institutional money. Pension funds, insurance company people trying to match long dated liabilities with long dated revenues and fairly predictable income streams very attracted to that. Other parts of the energy sector, fossil fuels in particular, you look at coal, you look at oil, you look at gas, they're not covered by long term contracts for the most part they are very exposed to changes in demand. Changes in supply can also dramatically in the short term change prices. There are longer term signals as far as shifts in technology may see that with decarbonization, but for now the noise of the volatility in those commodities can be quite high. Which means that values especially tied to assets in those areas, they maybe cannot be levered as much, but they'll attract more expensive equity capital. And there to mitigate that you need scale. And the scale Allows you the capital in order to weather those extreme volatility storms and make very long lead times. Significant investments that may be impacted by shifts in markets and in regulatory policy. But the investors for those have a bigger appetite for risk.

So there's really some unique things that impact even just a single segment, just based on some of the fundamentals. And you had a good point of here's a more predictable business model that institutional investors would gravitate towards versus on the other side. You got completely different dynamics. Okay, so we have a lot of variables within the segment itself, but how about just a broad view? We've obviously used the example of money costs going up this past year, which made this immediate impact in how we perceive value on some of the deals. What else have you seen in terms of cycles in the past and how it's impacted M and A?

Just look at the last four years. We had a real peak in 2021. And I would say also in finance activity generally, a lot of that. What I saw in 2020, with the shutdown, the pandemic, and the uncertainty. You can look at the public stock markets. They don't really tell you much. They dropped way down in March and they came way back up. The public markets there are not that interesting. If you look at allocations of capital and M and A activity, whether that's corporate strategic investment, private equity, infrastructure funds that I might work with, all of that sort of went on hold in 2020, mainly because of uncertainty. It wasn't a cost of capital question. It wasn't interest rates. It was. Nobody knew what was going to happen and for how long it would last. And the governments are also figuring out what kind of stimulus they could throw at different sectors. Some sectors. Airlines come to mind, generally speaking, receive lots of help, especially in the United States and to a lesser extent in Europe, much lesser extent in most emerging markets. You saw this attempt for the governments around the world and the central banks to stabilize things when no one knew what was happening. Uncertainty Chills Investment 2021 Everyone realized, wait a second, this is uncomfortable and it's different at different places, but we're going to live through this. The government stimulus started to have a massive stimulatory effect on the economy and on investment. We had very low interest rates in most markets around the world. And there was this green light. Do two years worth of transactions in one year. And as rates stayed low through the end of that year, people pulled forward transactions, especially refinancings that they might have done later. You almost had three years of activity in one year. In 2021 that meant 2022 people have largely done what they're going to do, but you still had lower rates and people were inflated, interested in doing things and valuations were still going up. You see an uptick again in M and A activity compared to what you might have seen. But it was still much lower than it was in 2021. 2023, things are ticking up again. We're still not back to 2021 levels, but by 2023 you're still seeing a lot of activity early in the year and that kind of tapers off. And I think the main reason there is the rising interest rates. So you have a higher cost of capital. Another thing, rising cost of capital environment are discount rates on future cash flows change. And they change in a way where if you have a higher discount rate, the value of future cash flows goes down. For anybody valuing an asset based on DCF on discounted cash flows, which in my sector energy infrastructure is most of them, that becomes a real challenge for people valuing based on comparable sales. On other metrics. You look at enterprise value to ebitda, you look at multiples of EBITDA in other ways or price earnings ratios, whatever you're looking at, that all became more challenging. But I don't think the sellers had really registered that in 2023. They still had stars in their eyes of what their assets were worth or what their companies were worth. And that meant that there was a big gap this year. We're seeing a leveling of interest rates and potentially a drop in interest rates that could help discount rates come back down which would increase future cash flows. What we need will be confidence in those cash flows, confidence in asset values. It's an election year in the United States. That's going to be a wild card. There's geopolitics that influence now a lot of cross border transactions, but also domestic ones. That impacts not just energy markets, it impacts all sorts of things. Supply chains which were disrupted are largely back together, but geopolitics can affect that too. And of course the situation in the United States and China.

Do you think that affects certain industries more than others?

Definitely.

I'm just curious which are the big ones? Because you're doing a small little tech deal, maybe you aren't thinking about as much versus larger infrastructure deal.

Some of it's affected by the geopolitics. Just look at us China, some of it is affected by the response to that. If you have a business that depends on a just in time supply chain, you're more exposed. And maybe you'll consider onshoring some of that if you can. But that might increase your costs. If you are depending on imports, not just from China, but from elsewhere. What's happening in the Red Sea and the Suez Canal, they constrain or change some of your manufacturing timelines. One of the things we see in construction quite a bit, but also in other areas. Anybody providing a service or agreeing to build something or supply something in the future will insist on having longer schedules. And those longer schedules are meant to smooth over or allow cushion for potential supply chain disruptions or labor shortages, whatever they may be facing. The cost to that things take longer, they tend to cost more. If any of that's fueled by borrowed money, that means interest is also increasing. Interest expense is increasing over that time period, as well as exposure to volatility. And that pushes out when you'll have a steady state that you might be predicting or valuing. That means you have more uncertainty. So asset values come back down. I think sectors that depend on anything that's crossing a border, whether that's capital or goods or technology, they have that issue. By the same token, the response to that, for example, the United States, we have the CHIPS Act, a bipartisan law that stimulates investment in domestic manufacturing of semiconductors. We're seeing massive investment, billions going into chip fab plants here to reduce our dependence on Taiwan in particular. That's because of the geopolitics with China, by and large. And that will ultimately lead to a better domestic supply chain of those technologies, closer onshore test beds and production beds for the technology as it innovates. And with the expansion of data and data centers, the expansion of AI, of quantum computing, eventually these things that are just massive magnets attracting not just capital, but attracting real equipment and real investment. The fact that it's onshored, it'll increase costs. But I think that's offset, more than offset by the security of supply, especially.

If you get that level of confidence too, then things continue to be chaotic on the other end.

And there's a difference between being exposed to risk and perceiving risks. And that ties back to those business cycles. One is what is the inherent risk in your business? And some of that's internal and some of it's external. I How exposed are you to things that you can control or can't control? But the other one is how worried you are about that or how aware you are of that or what blind spots you might have it. I see quite a bit often people are either overconfident or they have missed some of the correlations that are inherent in the risk profiles for their business.

You used this line with me before. Lack of experience can lead to overconfidence when it comes to valuation.

Yeah, and some of that too I think is as I said before, if you've never been through something bad, you either don't fear it or you don't understand it, or you overreact when it happens. I think that's part of it. I think the other is we've had such a prolonged period of growth and expansion, not just in the economy, but especially in the financial sector, and a shift in sources of capital from intermediated bank dominated economies into private hands. Private equity now is probably valued more than public equity. Private capital is also being directed on the debt side. So private credit, now over a trillion dollars available to be deployed in that, but it's outside the fully regulated banking sector. When that's happening and everybody's winning and everybody looks good, we all look smart. The real challenge is and where the sorting begins is if we do end up with an economic contraction and the laws of business cycles have not been repealed, eventually we will have one. For whatever reasons, when the tide comes back down, you'll see which boats remain above it.

A lot of good stuff to think about here. Any other notes around cycles and how it impacts valuations? Cause we got a lot of dynamics, not like a clear cookie cutter thing. I like the perspective on just the certainty and the perception around uncertainty, the reference around just experience and not being as familiar with those blind spots. Is that just a natural tendency you think about at some point I'm gonna do the first deal for our company here, or just somebody getting into a new industry for the first time. Do they tend to overvalue assets? And that's just the cost to play in the field.

Let me say one thing first. A lot of this is basic human psychology. And I have blind spots too. We all do. That's just normal. What do you do about that? One of them is get other people who are other experts or other partners, business partners, whatever it might be, and battle ideas around and allow yourself to be challenged either institutionally or personally. That's, I think, really important. Second, we ask the question of whether people are overpaying in a MA context or any kind of an acquisition context. By definition, the buyer overpaid because they are valuing what they're buying at more than competing bidders and more than the seller. The sellers say, hey, I'd rather have your Cash or whatever it is we're trading. And they're the ones who by the way, know their asset best. So the person with the best knowledge is happy to part with it to somebody who has less knowledge despite diligence, despite doing the best work they can with their advisors. But that combination of asymmetric information and the fact that you definitely overpaid doesn't mean you shouldn't have done it, doesn't mean you can't make money while do transactions. But at the end of the day it means that you've got a little bit of extra you have to compensate for first before you get into the things that really create value. And then you have to look at why are you doing the deal. I think a lot of companies also are shedding non strategic assets. We're going to see a lot more of that probably in the coming year. They're focusing on their core competencies. Not necessarily because they're better at it, although they should be, but also they're more confident about it. And when they actually look at the uncertainties, the unknowns, the risks, risk you can model, uncertainty you can't. But they look at what's coming and their ability to either withstand or control it, focusing on what you know best is probably a pretty good idea.

Yes, there's that domain expertise. Even if you do have domain expertise and you're doing acquisition, you're right. There's essentially, I don't know if the lenses you're assuming you're overpaying, but there is a view of the synergies.

Yes.

That we're not buying this as an asset that's going to print out money for us. We're going to have to be proactive to extract value from this business. I think that's that clarifying point.

It is. Stay on that because I think for a corporate buyer, strategic buyer synergies are very important. And then the question becomes can we use economies of scale to cut costs? Can we, can we grow our market share? Perhaps not in a way which violates antitrust laws, but in a way that does create an appropriate level of defensible level of market power. Builds a bit of moat, maybe allows us to extract higher margins. I think integration and cultural integration, not just financial or production integration becomes very important in that case. And most of those buyers plan on holding those assets that they're buying or the companies they're buying for a very long time. But there is time to integrate them and grow them in a kind of an organic way. And, and if the cultures fit Those synergies can be real for other types of buyers. Some private equity buyers, not all, but some. There may be the idea that you buy the asset or the company and you find ways either to bolt it onto other things in your platform that achieve those same synergies. Great. You may find ways to improve the business and then sell it. The question really then becomes, what's your exit? And if you're just assuming that you're going to buy it today and sell it for more tomorrow because markets are going up and you don't have to be smart about what you're doing, you're not adding value otherwise. That, I think, is an overly optimistic bet.

I would agree. But there was a point in time when you could do that.

We may still be in one, but eventually when the music stops, the musical chairs, it's just you run out of chairs.

I'm not going to sound like my parents, but the good old days are over with. You could always find these kind of assets that were highly undervalued. I think everything's so competitive right now.

Well, part of that is because we actually do have better access to information than we've ever had. There's greater transparency, and it's not just because of disclosures and securities laws. A lot of it is, look how diligence is done. The ability to turn over vast amounts of information quickly and analyze it and assimilate it is higher. And AI is going to make that even easier because you'll be able to take big data sets of information about companies with very complex variables and processes. And if you use the right algorithms and you're intelligent about it. It's not that you'll make better decisions necessarily, you might. But you'll be able to make more decisions more quickly that are at least as good.

I mean, between LinkedIn and Glassdoor, I can figure out everything about your people and culture over there. Yeah, you start synthesizing some AI, which.

By the way, also helps on the downside. Sometimes when people buy a company or make an investment, they're blind to things that they would have liked to have known. Certain types of liabilities, litigation risks, maybe environmental risks that may come with a site or with a company, IP gaps and patent portfolios, whatever that might be. If you're not as blind to the downsides, that also, I think, helps quite a bit. Not just having confidence in what you're buying, but. But having appropriate confidence in what you're buying so that your valuation has a greater chance of being right.

That's true. Things we're listing are on the blind spot. But then there's overconfidence as well. In terms of blind spot, we talked about expanding the perspective that the attorneys with industry experience get the folks in there that may be operators and so forth and really look at that opportunity to help identify those blind spots. We also talked about just having almost mindset you are overpaying that you can really dig down through. What does that synergy plan look like for you to create value in the opportunity? Are there other views in terms of identifying blind spots?

I mentioned culture a minute ago. I think cultural blind spots, especially for companies that are trying to merge, that could be a real challenge. And we see it in other spaces. Private equity funds are merging, law firms are emerging. We had a lot of consolidation among accounting firms a few years ago and now we're still seeing some of those are having a hard time with succession at the very top. Hard time simulating different ownership or partnership structures. I think that's something that people often underestimate. Some of that is because we focus a lot on finance. People talk about esg, we do ESG diligence and people focus a lot on the E in that what are the environmental impacts and they may focus on governance ideally. And governance is one that should get a lot more attention to. There's a lot of blind spots around governance and how to make it more effective and fair and less likely to not work or to get stuck. All of those things. Not to defend or criticize esg. Either way, it doesn't matter. The point is there are non financial risks that companies should be attuned to, that investors should be attuned to, however you label it. And culture is one of those things.

Big one. It comes up a lot. Being really mindful of that and putting that right amount of emphasis on it. That's a tricky one.

It is tricky. That's why diligence should take some time.

By the time you really dig into culture, you sign an LOI and you sign an loi. It's hard to walk away at that point.

Yeah, well. And remember too, culture is not just do the CEOs get along. You got to look under the hood.

I agree. Do you believe in that? That there just should be a way deeper view before signing LOI on culture? Or is it more of being comfortable walking away for cultural reasons after signing loi?

Look, whether people walk away or not, there could be a lot of reasons for that. It could be culture. More likely it's when they do their diligence they find out it's not quite what they expected or the numbers don't add up. One cultural, by the way red flag is if you're doing diligence and you're the buyer, you're not getting responsive answers or it looks like what's being given to you is being cleaned or being delayed or being filtered somehow or it's just non responsive or they just seem incoherent and they can't. They're not organized, whatever it might be. Those are all red flags to maybe walk away, maybe just dig deeper.

These blind spots. Being blind to your blind spots is basically what leads to overconfidence.

Sure, that's the tautology.

But yes, the that's where you can get in trouble is if you're doing a deal or maybe you're taking too much risk.

Yeah, I want to be careful when I use overconfidence. That sounds critical and it really isn't meant to be. We're all confident or we wouldn't do any deals. Deals depend on confidence and you don't know whether you're overconfident until later.

Exactly. So you really don't know. It's a very biased thing. Was the person overconfident or not? And you should have a level of confidence to pull the trigger on a deal. Definition of itself, very subjective. How do we define it in a perspective of the deals that you really.

Shouldn'T be doing risk aversion or taking on too much risk too happily. What determines that one might be your psychology, your personality, your makeup. And that could be true of institutions, funds, not just of CEOs and fund managers. It could be true of anybody and they tend to reinforce if you're in certain institutions where everybody's the same. I remember doing a lot of work years ago for Enron and you walked into their office and guess what? There was a lot of groupthink. Everybody approached risk the same way. Another contributor to that is if you're spending somebody else's money, you should be aware that you have a fiduciary duty to that person. You should be aware that you should be more careful with somebody else's money or at least as careful with somebody else's money as you are with your own. There's in many corners of the economy, especially in the financial sector, many people lose sight of that and they may be more prone to take risk with somebody else's money than they might be with their own. Part of that is the incentive structure. You're getting a share of the money that you're holding. But you do need to deploy it. You have pressure to deploy it eventually. If you haven't deployed it, you better go. Because if you don't, you can't raise your next fund. Okay, fine. So you'll be prudent about that. You do that responsibly and you have incentive to make good investments because you're sharing in the upside, not necessarily sharing the downside as immediately, except to the extent that it constrains your ability to raise further capital in the future. And you also then of course are not sharing in the upside that you would have hoped to achieve the of some correlated interests, but not entirely. The combination of asymmetric information in the transactions and a lack of alignment of interests, I think is one of the things that contributes for any human to some of the overconfidence in that context.

I like that. That's a good way to look at it.

It's funny, I tell you. I teach at Berkeley and have for over 15 years, just as an adjunct and sometimes I have courses in law school, some in the business school. And when the courses have the MBA students and the law students together, you can do fascinating experiments while teaching them principles of finance or energy, project finance or MA or investments, whatever it might be. When you put them on teams, the law students tend to be risk averse and they also as a group, not to generalize, but I will. They tend also to have a hard time making a decision because they can see all sides of things and they're used to arguing all sides of things. So they're indecisive and risk averse and you put them on the same team. As an MBA student, most MBA students are highly confident. They make decisions quickly. They may have a good quantitative basis for those decisions or not. They like risk. It's fun to put the two together and really see what happens. And then add in a graduate engineering student or a graduate public policy student on the team and watch that completely different way of approaching problems and of managing them. What results from that is a discovery. I think eventually among all of those students that the multidisciplinary team, where they each listened to each other, makes much better decisions than any one of them could have themselves.

This is a great way to look at it.

Got to have the diversity, the diversity of views. That's diversity of risk spotting, diversity of risk management, diversity of risk appetite and a sensitivity to the fact that most complex transactions require multiple points of view. Some are technical, some are economic, some are commercial, some are regulatory, legal, whatever it might be.

That's like the golden theme of this podcast right here, is it?

I think so.

I want to talk about the bad deals. I want to talk about deals that go sideways without pressing putting any specific company in the spot. I want to extract some lessons learned maybe where they didn't have these diverse perspectives. Do you have any examples like that?

One that comes to mind is a toll road company that was very over levered. They had exposure, great exposure to risks that were correlated without realizing it initially in their financial plan. We had a big recession in 2008, 2009 and what happened? Toll revenues went down, traffic went down, the expected escalation of future toll revenues either didn't materialize or the curve that slopes up to the right with inflation or escalation shifted over to the right by four or five years. So the liquidity was not there to take care of debt service. And interest rates were very low. So that also exposed them on some swaps that hedge exposure that they had, which was meant to manage interest rates in a rising rate environment, but it ended up creating a significant additional liability alongside their senior secured debt or being upside down on the swaps. So what did they miss? You could run down sign sensitivities on your original financial model on every single one of those things. What was missed, obviously because it went, it became distressed was that those things were correlated, that rates would go down and stay down for a long time if you had a significant contraction in the economy. So this gets back to these business cycles and credit cycles and you would not be able to refinance at that point because your future cash flows were projected now to be significantly lower than they would have been before. And, and because people being afraid in 2009 and 10 after a big financial crisis were likely to discount things further because there's a risk premium. Those things coming together tend to be a disaster. Went through a bankruptcy and now that asset's doing wonderfully and it's got a great capital stacks and aligned and you can be certain that they won't have a capital structure that exposes them to those kinds of correlated risks again and it has new owners.

These deals tough. You have so many things that could change whole economic cycle on you and you're screwed.

Okay, but you look at what you can control and what you can't, you can predict there will be changes in economic cycles or demand for your product or your costs, whatever that might be. It doesn't matter the industry, you can look at that. But there will also be things you cannot control that are outside of that so how do you plan for those? How do you build in resilience? How do you build in downside protections? If you've got a capital structure which is dominated by short term debt, you're going to be more exposed to things than if you have long term debt. If you have preferred equity that doesn't have any kind of debt service requirement, maybe be smart in this kind of a period of the business cycle, for example, to swap out high yield debt and instead have pref that pref equity. Sit there and be patient. The economics may not be that different, but the resilience to downside could be significant.

Makes sense. Do you have more bad deal examples?

Oh, endless ones.

Let's do a couple more and then we'll do some good deals.

Here's an example of a company that actually is highly regulated, highly prudent in its finances, but nonetheless has been in bankruptcy twice. I worked on the bankruptcy originally for Pacific Gas and Electric. Big regulated utility, largest investor owned utility in California. And along comes with climate change, a much larger exposure to wildfire risks than we've historically had in California. For a variety of reasons related to extreme heat and to lack of rain and therefore dry vegetation. One can discuss to them whether the utility needed to spend more money to try to find fireproof its system. That's hard to do to trim trees more. You have underground lines and for high voltage long distance transmission lines, putting things underground is very expensive. Will the regulators let you do that when that has to be passed through to ratepayers? And remember we said power should be affordable. What happened is they had liabilities under California state law for billions of dollars of losses attributable to wildfires that were ignited by their equipment. Now they don't have liquidity to pay for that. So then the question is, who should? Is it their shareholders? Is it current ratepayers? Is it future ratepayers? Is it the state government? Is it the federal government? Is it insurance? And they were able to cobble together with a real alignment between creditors and the bankruptcy, the different agencies of the executive in the California state government, legislature in California and also the federal government ways to align that to solve the problem and not just kick it down the road, but create a pool of money that could pay future liabilities so you don't bankrupt the company again. And that can be available to make investments that are needed to make the system more resilient. That's an example of something coming in from the outside that the system wasn't set up to handle. So now we have to find ways to do that.

Good lessons learned. It sounds like they had another chance to fix it and go at it.

Yeah.

How about the flip side? How about something that companies really played smart, avoided some of these blind spots or.

Sure. So there were investors coming into JFK airport, new terminal one I mentioned to you earlier, that's a almost $10 billion new international terminal here at JFK. The initial financing for that was happening right before COVID So when Covid hits and I saw something similar representing investors in an airport in Latin America, in chile, right before 9 11. Similar pattern in a way because after 911 international air traffic fell through the floor in the Chilean airport case. The other thing that happened is we had a contraction in the world's gdp. So a business cycle which meant that demand for copper went down. Copper is a big chunk of the Chilean economy. So air traffic through Santiago, Chile is tied very much to copper prices in some macro longer term way. Not day to day, of course. So you look at Covid again, an exogenous shock. Now here we are, much more recently hitting expansion plans for New York's major international airport. So what was necessary was to have smart people and investors were pretty smart figure out a way working collaboratively with the Port Authority of New York, with state officials, with city officials, with the airlines that were involved, with other stakeholders, with contractors and the unions that were supporting construction projects, and really find ways to reshape it. So now the terminal is being rebuilt in a phased way. All the debt came in for the first phase and future as air traffic recovers and it is now recovering and as there's future growth in air traffic, they'll do separate phases of the terminal expansion instead of doing it all at once. And they're doing it all within the scope of the original federal permits, so you don't have to go through a new permit review cycle. The lesson from that is bringing in all those different stakeholders and finding a way to align their interests to resurrect a deal and get it done in a way that was creative and it was different than how it was originally structured.

Did they restructure it after setting on some initial terms?

Yeah, I don't mean they restructured it in the bankruptcy distressed sense because the loans had not yet closed, they had not yet started the actual construction.

So it was before they signed.

So what they did is they changed the structure of the deal. So contractually the structures were different before it was signed. Before it was signed. That's pretty good for me and my clients. The Difference between those two airport transactions. One of them, the big bad thing, Covid, came before we closed financing. The original Santiago, chile deal at 911 and the drop in air traffic happened right after we had closed financing.

Yeah, then you got to dig your stuff out. Any other good smart play examples of deals?

I guess in the M and A context, I can give you an example of a client of mine. They were initially family owned and then they were backed by some infrastructure funds. And by doing that, those investors were able to provide more liquidity. So you had a structure where you've got this original business that has some assets that it can cede, operating assets it could seed. And the fund is investing, but the fund is also providing liquidity for the future pipeline of expansion. And there the expansion was mainly acquisitions. And it's a very fragmented part of the North American rail market. So they found a way to make strategic acquisitions of companies that on their own just didn't really have the wherewithal to grow significantly. But as an integrated platform with strong management and economies of scale and the ability to train up employees and move them from one place to another to have bulk purchasing of all the equipment or things you might need, potentially proprietary technology, they were able to build a platform at scale that justified the acquisitions and that's what created accretive value. That's where the premium was. So those were real synergies. Now, I don't want to underestimate how hard that kind of integration is. It is very difficult. Not every management team can do it, but a good one can. As a result, the investments paid off for everybody.

That's pretty cool. They kind of got a good strategy to keep expanding and paying out everybody in M and A. What are the most common mistakes made in valuation and how can they be avoided?

One would be using only one valuation methodology. Another would be diligence. In particular, insufficient diligence. A third, I think, which gets back to that overconfidence we were talking about, is when things come up in diligence, missing them somehow either overemphasizing the wrong ones that look interesting. Sometimes potential litigation may be one that comes up, but it may not actually be core to the business. It may not be that big a problem. I think people sometimes focus on high magnitude things, even if they're low probability, but miss things that are higher probability, probably because they're lower magnitude. But those are ones maybe you should have focused on more and also failing to due diligence on things that might matter. Examples of that, I can think of a company that had a big cyber attack after a deal was done. And no one really diligent cyber like they should have just a few years ago. I think today that mistake would not be made.

Yeah, that's a good point. As a lot of things, it's important to have some experienced folks you're working with. You have to. I think that's what gets tricky. I'm always curious about just the whole maturity of a company building their MA muscle. It's like you have to go through some pains to get there.

And it is a muscle. I think if I had to think of anything else, it would be just the way deal teams work. Some are very hierarchical, so then you hope the person at the top is listening to others and making smart decisions. Some are more flat, consensus driven. Some don't make decisions much at all. They're paralyzed. It's not really a cultural issue so much as it's a management governance issue. Not in a formal legalistic way. This is a practical way. Who's making decisions? Who's calling the shots? Who are they including in that process? And not just on their internal management team, but also their outside advisors.

What's impressed you the most in terms of seeing that right structure?

It's ones where there's a high degree of internal argument and debate because different points of view are heard. But at the end, there tends to be a lot of consensus kind of getting around. Eye on the ball. What is our goal here? What are our limits? What is our exit strategy? How does this investment further that? And what do we know are the next steps we're going to do right after? You're not going into something thinking it's going to be easy without a plan of how to integrate or how to execute. This idea of being good at executing, not just good at doing the deal. I think for people who can do both, that's a much stronger combination.

So it's debate getting to consensus and then the ability to really execute post.

Close, which I wouldn't underestimate. Not all companies or investors have that ability.

That's very true. Aside from valuation, what are other early stage M and A considerations?

Practitioners should focus on the team, the relationships. You do a joint venture agreement or a partnership agreement or a merger agreement, and you can't miss the fact that if there's frictions or a lack of compatibility, you can't paper over that. The documents, the legal documents, we work very hard on that. And remember, deals are collaborative. It's not like litigation where one side is suing the other and they're adversaries. People around a deal table are all fundamentally working in the same way to make a deal happen if it should, because it's good for everybody in a way that's ideally trading off those interests. So it's fair and everyone's glad. So when you have a closing, no one thought that they lost. They all thought that this is good for everybody. So finding a way to collaborate on all of that is pretty important, but at the same time not just saying, well, the deal has to get done at all costs. If things come up where it shouldn't, the parties can't agree, or they have different views of things, or diligence reviews problems, or the seller discovers that, lo and behold, the buyer is proposing one thing and then proposing something different. Or there's an ethical issue that comes up for sure. Those are all things where maybe you want to stop and pause. So it's not just the deal that matters, but the collaboration around it I think is critical.

You're going to have to deal with a lot of broad, unpredictable macro elements of climate you operate on, but there are some pretty tangible things that you should really concentrate on for sure. Alan, what's the craziest thing you've seen in M and A?

You can think of some crazy things in project development of ants. Having worked in Southeast Asia during the Asian financial crisis and being physically on the ground in Jakarta for a deal when that all unfolded and there was a bombing in the hotel where we were staying at the shopping mall underneath it as Indonesia, we had the Suvarata government fail. We spent time moving expats in to run the company and six months later everybody was evacuated and we were making force majeure claims. And the currency, you know, 10x, those were challenges. I think in the.

Sounds like a whole podcast right there.

That was a good one. But I think in the M and A space. So there's a deal I was doing in Mexico. I represented the sellers, but not all of them, but some of the sellers of the equity in a telecom company, the cell phone company. One of the selling shareholders was wealthy family and her signature was needed on the documents. We'd been flying around the world for a year negotiating the deal. We had parties involved from California, we had meetings in Miami, we had people in Madrid. The buyer was from Europe. Lots of meetings in Mexico City. And most of the time we spent were looking at very complicated, sophisticated issues. This is of course a regulated business, but cell phone technology was relatively new at the time compared to today, so the business model was evolving and they needed more capital to build because you're never done building out your network. You're always investing and expanding it and upgrading it and modernizing it. So they needed that liquidity and they needed government support. But after all of these negotiations and all of this work, we needed to get a signature on a piece of paper from one of the minority selling shareholders in the family that was associated with the business. So people are saying, where is Carmela Burrillo Ascaraga? And the answer was she was on her yacht or one of them in the Mediterranean. And we wanted to close, wanted to close that day. We couldn't get her signature. We weren't really sure exactly where the boat was. And people are running around doing like crazy trying to solve the problem. And if you have to have the signature authenticated, it does really matter where you are. Here in New York, if I need a notary, you go down to the corner, you get a notary, you're done in the law firm, they come to the conference room, and 10 minutes later, it's been notarized. If I'm in Mexico, I've got to arrange the notary. It's going to take a couple of days, and it's got to be stamped the right way and so forth. And it's a bigger process. And if I'm overseas, may have to go to a consulate or an embassy and have it apostille. And there's other things going on. But where was the boat? What jurisdiction was it in? A lot of us assumed that this was a fascinating question of international law. It wasn't. We were wrong. We were trying to figure that out. The boats in the waters of France versus Italy, the rules might be different and so forth. It's like a, do you like fish?

Sort of, yeah.

Okay, so if you go into a New York restaurant, you get broncino. Not even an Italian restaurant. Like any restaurant, bronzino's everywhere on the menu. Bronzino fish, when it's sailing around the Mediterranean, changes names. If it swims from Italy to France, it's not broncino, it's ludomar, it goes to Greece, it's livraki. If it's roblato in Portugal, it's the same fish. So her yacht sailing around was the same thing. Which kind of notary thing do we need? The problem is we were all being too sophisticated and smart and smug. This was just a simple, practical problem. And one of the legal assistants at the Mexican law firm picked up a phone, called somebody, they called somebody else. They got a hold of a port agent in Monaco, found the boat, had her sign it. All done. It was a logistical problem that everybody was making. The bankers and lawyers all were making this far too complicated and they put a lot of fax and got it over there and it worked out just fine. Some things are just practical and logistical and not all sophisticated and complicated.

It's easy to overcomplicate things.

That's probably one of the, I don't know, the craziest thing, but it's one that comes to mind.

This has been great, Alan.

Likewise. I really appreciate your questions.

I appreciate you taking the time helping me become a better M and A scientist today.

Thanks very much.

Those of you that want to hear more from Alan, check out his podcast, Law, Policy and Markets on Spotify, Apple Podcasts. Whatever you listen to, I'm sure you'll find it. I hope you enjoyed today's conversation. Till next time, here's to the deal.

Thank you for taking the time to explore the world of MA with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M and a function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email Kisan K I S o n a science.com or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit MA for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.