Sutton View on IFLR: A Hedgie’s take on M&A in 2016

Mike Winston of Sutton View Capital discusses
the importance of intrinsic value investing at this point of
the cycle

At a time when many corporates, banks and law firms are
dedicating entire departments to preparing defences against
more aggressive, event-driven investors, others are just
beginning to recognise the value they can bring to the table.
Against this backdrop Mike Winston, founder and managing
principal of New York hedge fund Sutton View Capital, talks to
IFLR about activist tactics, overall trends in M&A and the
enduring impact of the dreaded interest rate rise.

What do you see as key M&A trends to look out
for in the US in 2016?

As we head into the sixth year of US economic recovery and
interest rates remain low, the prospects for global M&A
appear bright in 2016. Although deal volume fell 30%
year-on-year in January, several factors point to a prosperous
year. Sluggish top-line growth, limited opportunity for margin
improvement, $6 trillion (as of the fourth quarter of 2015) in
corporate cash, and increased boardroom confidence should
together help the pace of transactions.

While 2015 was the year of the mega-deal, 2016 may instead
be driven by a large number of small and medium-size deals. We
see positive trends in Asian outbound M&A and commodity and
financial institution-related deals. While private equity
players now face regulatory constraints on leverage levels,
they have $382 billion of capital available for investment
purposes and have shown a willingness to engage in increasingly
creative transaction structures, including large-cap private
investments into public equities.

What sectors or regions will you be focusing on in
2016, and why?

Commodity-related sectors such as oil and gas and mining are
ripe for consolidation. Low commodity prices have forced down
interest coverage ratios and credit ratings. The high-yield
market remains closed to exploration and production (E&P)
companies in particular. We would expect to see a wave of
reorganisation activity and consolidation. Many US
non-traditional oil and gas assets, in particular, have been
rendered unprofitable for the time being because finding and
production costs of $35-$50 per barrel do not generate profit
with prevailing oil prices in the low thirties. Whatever
happens to US non-traditional production capacity in the short
run, acquirers may reflect on how the re-emergence of the US as
a net exporter of oil – and its ability to switch on
fracking assets on short notice – may compress oil and
gas commodity cycles, cap petroleum prices and lower the value
of reserves.

Technology, media and telecommunications (TMT) and
pharmaceutical deals may continue as companies have an
opportunity to gauge any early success enjoyed by peers that
transacted in 2015.

Within TMT, independent cable TV channels appear ripe for
consolidation. The need for greater bargaining power with newly
consolidated cable companies and the threat from subscriber
cord cutting both make clear the need for revenue synergies and
cost savings. Cable channels will likely have some deadweight
subscriber losses, because viewers that leave will not
necessarily pick up a given channel via a tablet, smartphone or
over the top device, such as an Apple TV. Managing that shift
and coping with the subscriber losses are both challenges best
dealt with by larger, combined companies.

Regional banks may also see an increase in deal activity
because of increased regulatory burdens. Many small banks have
just one compliance officer, and so the cost savings from
greater scale in M&A may win out relative to spending on
greater staffing and infrastructure.

What effect, if any, has the Federal Reserve’s rate
rise had on deal flow, and how do you see it affecting it in
the future?

The expectation of rising rates pulled some deals into 2015
but rates are still historically low, and small rises in rates
should not slow the pace of M&A in the full year. The Fed
has not contracted its balance sheet – it buys new
treasuries as those on balance sheet mature – so even
with rising rates, the environment remains highly
accommodative. The spike in market volatility related to a rise
in rates has had a more meaningful impact on deal activity than
the rise in rates itself. The second order effect of higher
relative rates of interest in the US is a stronger dollar
– which may lead US corporates to acquire more assets
abroad. At the intersection of renminbi (RMB) depreciation and
US dollar strengthening rests a question that Chinese
corporates will likely turn to their M&A advisors to help
answer.

Have you noticed any interesting developments in
terms of deal structure in the past 12 months?

In terms of deal structure, the use of the demerger, or
spin-off, instead of the merger should be a continuing theme in
2016. At the behest of activist investors, spin-offs and
divestitures are viewed as a means to improving reporting
clarity and bolstering valuations.

We’ve seen the 60/40 inversion and board and shareholder
willingness to sell below the 52-week high. While we have also
seen a somewhat greater use of stock as a component of deal
consideration, we still observe otherwise limited use of
collars.

We have also noticed new all-cash Chinese acquirers in the
recent past, including Syngenta and Terex. While the
motivations of each Chinese acquirer vary, one cannot help but
suspect that the all-cash nature of the consideration reflects
a continuation of the exodus from the RMB on the part of
Chinese domestic residents and corporations.

With activism on the rise, there have been reports
of boards preparing more proactive defence mechanisms. What is
your opinion on this – do these tactics
work?

Goldman Sachs, Evercore and some other major investment
banks now have entire teams dedicated to activist defence, and
an increasing number of law firms are staffing for this
function. The surviving greenmailers and corporate raiders of
the 1980s have returned, along with a new crop of hedge fund
managers, to take on corporate mismanagement yet again.

Their tactics clearly work, though not every company fits
the same template. The composition of the shareholder base,
recent stock performance and corporate governance all have a
large role to play. As co-lead plaintiff against the board of
Dole Foods in their 2013 management buyout, we discovered that
the court system can sometimes be a more effective route than a
proxy fight. In Dole’s case, the CEO was found guilty of fraud
for providing one set of financials to his board and another to
his bankers. It was a huge win for shareholders, but not all
campaigns have as clear an endpoint as Dole.

It is easier to run an activist campaign in a bull market,
because confidence inspires risk-taking. Some of the Schedule
13D filings we see appear driven by those seeking to call
attention to a position that has fallen, rather than investors
initiating new positions in already depressed names and
pressing for change.

What are activist investors looking
for?

Like all event-driven investors, activists are looking for
returns and a clear path to completion for each situation. That
may mean targets should meet a set of criteria, for example, a
non-staggered board, a concentrated shareholder list, limited
anti-takeover provisions and a stagnant share price.

Do you see the trend of US activists targeting
Europe continuing in 2016?

Yes. If we look at European companies with a $100 million
market cap or more, activists launched 31, 57, 53, 33 and 67
campaigns in 2011, 2012, 2013, 2014 and 2015, respectively.
Those European campaigns accounted for roughly 20 percent of
global volume over the past five years, and 21% in 2015. Of the
67 campaigns from 2015, 44 of the 67 targeted companies had
over $1 billion in market capitalisation. So, large-target
European companies are fair game. While cultural attitudes may
to continue to act as a limiting factor in Europe, as in Japan,
the trend toward greater global corporate accountability is
supported by the observation that activist funds ended the year
with roughly $123 billion of assets under management.

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