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NEWS September 12 2019

M&A Essentials: A Practical guide to the Interaction between Corporate Finance & Law

 By Mohammed Assayed, Senior Associate, Corporate 

1.      Introduction:

Since the existence of corporations, the primary goal was and always will be maximising shareholders’ wealth via implementing various short and long-term strategies and financial planning,[1] which may include crucial investment decisions in capital projects that forms a large weight and long-term asset of the balance sheet in which the survival of corporations will ultimately rely on.[2] As a result, corporate finance (“CF”) came to life to mange and govern such crucial capital investment decisions i.e. whether a certain investment will add value to the company or not, and what is the best capital structure of such investment to be funded (issuing equity, raising debt, or both).[3]

One of the main departments of CF is capital budgeting, which is the process corporations use to assist their management in allocating and evaluating potential large expenses or capital projects.[4] The importance of such process stems from the fact that capital decisions cannot be reversed without incurring significant cost which can threaten the existence of corporations.[5]

The valuation of a capital project depends on many factors such as, but not limited to, the company cost of capital and the risk of default, which is the probability that the counterparty(s) will not be able to honour his debt obligations.[6] Consequentially, laws have been developed to mitigate such risk to a certain extend, by recommending various rights, laws and creating new instruments in the categories of corporate, securities, bankruptcy, and commercial all subcategories investors’ interests in corporations.[7]

Such instruments include securing debt payments by a way of security interest, and manipulate the priority of the financial asset by mainly subordinating other claims, imposing debt covenants, securitisation, or hedging risk by entering credit derivatives. On the other hand, the legal characteristics of various financial assets have a direct impact on the valuation and the associated costs of finance, therefore to the investment and funding decisions. Additionally, both investors risk and borrowers cost preferences have an important role in shaping the legal structure that are applied in the corporate finance world nowadays.

In this article, we will shed light on Net Present Value (“NPV”) as one of most common valuation techniques in CF, it’s relationships with some important financial tools such as Capital Asset Pricing Model (“CAPM”) and the concept of Weighted Average Cost of Capital (“WACC”). Finally, we will discuss an example on how these financial and valuation concepts are relevant in the legal world.

 

2.      NPV, CAPM and WACC – The Interaction:

As pointed out above, the primary goal for corporations is maximising shareholders value by investing in projects that add positive value to the company. One of the most valuable techniques in valuing potential projects and whether such projects have positive or negative value to the company is NPV.[8] NPV is defined as the project future free cash flows (“FCF”) (taking into account all revenues, expenses and any related capital costs)[9] discounted to present value at the company’s WACC minus the initial investment.[10] As a rule of thumb, as investors we should only accept projects with a positive NPV and decline the ones with a negative NPV, this rule called ‘NPV capital budgeting rule’.[11]

The preceding discussion about NPV glossed over an essential point, namely, the correct discount rate to use when calculating the present value of the expected future free cash flows. Such rate must account for the time value of money and the inherent valuation and default risk involved.[12] To determine the discount rate, we have to asses the company’s cost of capital or, more accurately, the company’s WACC[13], “which is the weighted average opportunity cost of capital that is used as a discount rate for capital investment proposals”[14]

WACC has a direct link to the company’s capital structure, as it is calculated by taking into consideration the value of both equity and debt to the total value of firm, multiplied by the company’s respective cost of equity and debt.[15] Cost of debt can be derived by simply taking the after tax cost of debt of relatively similar issues.[16] In contrast, calculating cost of equity is more complicated.

As mentioned earlier, understanding both valuation and default risk is the main factor to the success of any investment. Investing in equities involves two main risks, first, risk that is associated in the target company, called unsystematic risk. Second, risk inherent to the overall market, resulted from macroeconomic factors such as unexpected changes in the country fiscal and monetary policy, called systematic risk.[17] Portfolio theory proved that unsystematic risk can be managed and eventually eliminated via a proper diversification of investment. Thus, it is the systematic risk that investors shall be compensated from.[18]

In this regard, the CAPM is the most common tools used in determining systematic risk in equity investment and, consequently, assessing investors required rate of return. CAPM in simple terms is the premium required by investors of investing in the equity market over their (investors) relevant risk free rate, multiplied by the undiversifiable risk inherent in holding such investment known as beta.[19]

As a result, it is clear that the company’s WACC is a main pillar in calculating a precise NPV and therefore, in deciding on whether to invest in new projects or not as such investment will be only feasible to invest in where they produce return of equal to the company’s WACC at least.[20] In other words, “the company’s WACC represents the cut of rate for new projects”[21] The below graph shows the interaction between WACC and CAPM:[22]

     

 

MA article.jpgNow and after clarifying the relevant interaction between the NPV, CAPM and WACC, we will try to highlight the direct and extended legal context stemming out of these concepts via examining a hypothetical M&A example in the E-Commerce industry. In the following context we will assume the acquirer is named Company X and the target is Company Y.

 

3.      The Transaction & Legal context:

Company X, an international E-Commerce platform, announced that it had finalised the acquisition of Company Y, a Dubai-based online retail and marketplace platform for about $100 million. Obviously, one of the main motives for Company X for such a deal is synergy creation, and breaking into new emerging immature market where barriers to entry are still low and therefore, increase it is market share and achieving ‘revenue synergies’.[23] Nonetheless, the questions that asks itself is, has Company X paid the right price for acquiring Company Y? what are the financial and relative legal factors that led to reach $100 million deal?

To answer the above questions, we will look into the deal from the perspective of NPV, other factors associated with it, and implement some relative assumptions. As explained above, Company X should not have pursued this deal unless it had a positive NPV. Thus, the discounted projected FCF out of Company Y should be higher than their initial cash outlay i.e. $100 million. Such valuation is sensitive, as discussed above, to both WACC and growth rate of future FCF, the lower the WACC and the higher the growth rate, the higher the NPV.

For the sake of our discussion, we will assume that Company X had approached this deal by incorporating a new subsidiary in Dubai, named Company Dubai (“CompanyD”). CompanyD, assumingly, had financed this deal via equal issuance of equity and debt i.e. 50% equity and 50% debt. For equity issuance, as per the Article 10 of the UAE 2015 Companies Law (“the Law”), 51% of the capital has to be held by UAE national. Thus, Company X ended up owning 49% of CompanyD and 51% of common shares went to multiple UAE partners (the “Partners”) through a private placement at par (AED 1). In order from Company X to reduce the cost of equity involved to compensate the Partners for their residual claimants status i.e. they are only eligible to the surplus after all creditors have been satisfied, and from further dilution[24] , Company X, assumingly, had decided to grant them the following rights:

First, pre-emptive rights, which gives them the right of first refusal by offering them the option to purchase additional shares in any future capital increase.[25] Second, inserting tag-along and drag-along clauses on the shareholder agreement. Tag-along rights force selling shareholders to extend the offer of sale to other shareholders i.e. minorities.[26] While drag-along rights enables the selling shareholder to force other shareholders to participate in the sale transaction.[27] Finally, there was a lock-up period for two years on Company X, which prevents it of selling its stake during such period.[28]       

For debt issuance on the other hand, CompanyD, assumingly, issued $20 million of a hybrid debt securities i.e. convertible sukuk (Sukuk is an Islamic financial instrument similar to a bond, however as interest paying instrument is not permitted under Islamic law, the sukuk issuer sells certificates to investors, then uses the proceeds to buy a tangible asset, usufructs or services from a profitable firm, and finally the principle repayment should be the tangible assets current market price not the original sukuk issuance amount[29]) and $30 million of a 15 year syndicated term loan from a group of local banks (the “Banks”). It is worth noting here that as per Article 31 of the UAE 2015 Companies Law, CompanyD has to be a joint stock company to be qualified to issue debt securities.

Company X tried to reduce their cost of debt on their sukuk issuance by offering the creditors a convertible option in 2 years into the life of the issue, which gives them the right to convert into ordinary shares of CompanyD[30] at a specific conversion rate and a maturity of 10 years. Additionally, CompanyD managed to get AA rating from one of the most credible rating agencies, where one of the essential criteria of such high investment grade rating is to be sponsored by its parent Company X[31], which Company X have granted. Moreover, the sale and purchase agreement included positive covenants, which are covenants that state what the issuer has to do[32] i.e. by setting a maximum gearing ratio of 0.70x, and the ratio of times interest earned, which equal to EBITDA divided by financing costs, to 17x which is considered the norm in the e-commerce industries. The agreement contained a negative covenant as well, which are covenants that state what the borrower should not do[33] i.e. pay cash dividends for more than 20% of retained earnings until the sukuk is either fully paid or converted.[34] It is worth mentioning that the sukuk issue is structurally subordinated to term loans, whereby, in the event of default sukuk holders will only receive some value once the term loan has been fully paid.

For the term loan, CompanyD has entered into a syndicated loan agreement with a group of UAE banks where each participant contributed part of the loan and shared the rights and obligations associated with such lending.[35] As a result, a single agreement between the parties was put into effect, where all conditions and warranties were identical vis-à-vis each participating banks. CompnayD managed to get the liability of the Banks to be joint and several, which reduces the risk of defaults out of the Banks.[36] By syndicating the loan, CompanyD managed to reduce its cost of borrowing.[37]

Nevertheless, and in a move to reduce their cost of borrowing significantly, Company X offered their 49% equitable stake in CompanyD as collateral. Such a non-possessory proprietarily security interest is a form of a floating equitable charge, in this regard a security over the shares was drafted and particularity contained security clauses over dividends, interest and any other income out if the shares.[38] An equitable charge does not include transferring the shares legal title from Company X to the Banks although the terms and conditions associated with such charge generally allows the Banks to have the legal title of the shares in the event of default.[39] It is worth mentioning here that an equitable charge can be fixed in the case of the Banks retains the right to deal with the shares without the consent of Company X.[40]

The loan agreement contained the same positive and negative covenants as in convertible sukuk issue, however, a negative pledge clause has been inserted for the purpose whereby CompanyD undertakes not to form any new security interest or to escalate the secured amount by using existing securities i.e. Company X stake in CompanyD, to make sure that the priority of claims position of the Banks does not change through out the term of the loan.[41] In other words, if any new security interest created over Company X 49% equitable stake in CompanyD might trigger an acceleration and early termination of the loan.

In a move to strengthen its balance sheet and improving its cash flow position i.e. liquidity, therefore reducing it is overall cost of debt even further, CompanyD engaged into a collateralized debt obligation (“CDO”) which is type of securitization “whereby a pool of debt contracts housed within a special purpose entity (“SPE”) whose capital structure is sliced and resold based on differences in credit quality”[42]. Here CompanyD sold it is syndicated term loan to a new SPE who finances the purchase via issuing its own financial instruments, consist mainly of debt and a small portion of equity. These instruments are backed by credit default swaps, which is defined as “a private contract in which private parties bet on a debt issuer’s bankruptcy, default or restructuring”.[43]

 

4.      Conclusion:

In summary, I believe that NPV, CAPM and WACC are closely related and therefore any minor change in their calculation might impact the valuation significantly. Legal principles in this regard play a corner stone role by implementing techniques to reduce both cost of equity and debt and thus improving the overall valuation and its associated social benefits which is essential to the stability and credibility of the financial market and the legal industry as a whole.

Nonetheless, there is an argument stating that questions the underlying rational behind secured lending and categorize it as a “zero-sum game”, as any interest savings from secured lending will most likely cancelled out by a corresponding increase in interest charges applicable to unsecured lending. Consequently, the total amount of interest the debtor has to pay remains unchanged.[44]

 

 

Mohammed is a senior associate in our Corporate departement. For further information, please contact Mohammed on 04 354 4444.

______________________

 

Bibliography:

 Websites:

1.      'Investopedia' (Investopedia, 2019) <https://www.investopedia.com/> accessed 10 June 2019

2.      'About CFI | Corporate Finance Institute® - Financial Analyst Training' (Corporate Finance Institute) <https://corporatefinanceinstitute.com/about-cfi/> accessed 13 June 2019

3.      Somayajulu C, 'Help For ACCA AND CIMA Studies (Also Useful To Accounting,Commerce And Finance Students)' (Cvdsomayajulu.blogspot.com, 2014) <http://cvdsomayajulu.blogspot.com> accessed 13 June 2019

4.      'Debt Covenants' (Corporate Finance Institute) <https://corporatefinanceinstitute.com/about-cfi/> accessed 13 June 2019

5.      Soloway J, 'Preemptive Rights: Everything You Need To Know' (UpCounsel) <https://www.upcounsel.com/> accessed 13 June 2019

6.      'Tag Along Rights' (Uk.practicallaw.thomsonreuters.com, 2019) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019

7.      'Drag Along Rights' (Uk.practicallaw.thomsonreuters.com, 2019) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019

8.      'Joint And Several Liability' (Uk.practicallaw.thomsonreuters.com) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019

9.      'Syndicated Loan' (eFinanceManagement.com) <https://efinancemanagement.com> accessed 13 June 2019

10.  'Taking Security Over Shares' (Lexisnexis.com) <https://www.lexisnexis.com/en-us/products/lexis-advance.page> accessed 13 June 2019

 

Books:

1.      Corporate Finance (Wiley 2014)

2.      Klein W, J CoffeeF Partnoy, Business Organization And Finance (Thomson Reuters/Foundation Press 2010)

3.      Welch I, Corporate Finance (2014)

4.      Ferran E, Principles Of Corporate Finance Law (Oxford University Press 2014)

5.      Frank Partnoy; David A. Jr. Skeel, The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019 (2007)

 

Journals:

1.      Zabai A, 'Managing Default Risk' [2014] BIS Working Papers

2.      Huang PM Knoll, 'Corporate Finance, Corporate Law And Finance Theory' [2000] University of Pennsylvania Law School Penn Law: Legal Scholarship Repository

3.      Zolfaghari P, 'An Introduction To Islamic Securities (Sukuk)' [2017] Uppsala Faculty of Law

4.      'Methodology For Rating Sukuk' [2019] Standard & Poor's Rating Services

5.      Zhang W, 'The Paradoxes Of Secured Lending: Is There A Less Uneasy Case For The Priority Of Secured Claims In Bankruptcy?' [2011] SSRN Electronic Journal

 

 Statutes:

1.      UAE Companies Law 2015


[1] 'Investopedia' (Investopedia, 2019) <https://www.investopedia.com/> accessed 10 June 2019.

[2] Corporate Finance (Wiley 2014).

[3] 'Investopedia' (Investopedia, 2019) <https://www.investopedia.com/> accessed 10 June 2019.

[4] Corporate Finance (Wiley 2014).

[5] Ibid

[6] Anna Zabai, 'Managing Default Risk' [2014] BIS Working Papers.

[7] Peter H Huang and Michael S Knoll, 'Corporate Finance, Corporate Law And Finance Theory' [2000] University of Pennsylvania Law School Penn Law: Legal Scholarship Repository.

[8] William A Klein, John C Coffee and Frank Partnoy, Business Organization And Finance(Thomson Reuters/Foundation Press 2010).

[9] 'About CFI | Corporate Finance Institute® - Financial Analyst Training' (Corporate Finance Institute) <https://corporatefinanceinstitute.com/about-cfi/> accessed 13 June 2019.

[10] Ivo Welch, Corporate Finance (2014).

[11] Ibid

[12] Eilis Ferran, Principles Of Corporate Finance Law (Oxford University Press 2014).

[13] Ivo Welch, Corporate Finance (2014).

[14] C.V.D. Somayajulu, 'Help For ACCA AND CIMA Studies (Also Useful To Accounting,Commerce And Finance Students)' (Cvdsomayajulu.blogspot.com, 2014) <http://cvdsomayajulu.blogspot.com> accessed 13 June 2019.

[15] Ibid

[16] Ibid

[17] Eilis Ferran, Principles Of Corporate Finance Law (Oxford University Press 2014).

[18] Ibid

[19] Ibid

[20] Ibid

[21] Ibid

[22] 'About CFI | Corporate Finance Institute® - Financial Analyst Training' (Corporate Finance Institute) <https://corporatefinanceinstitute.com/about-cfi/> accessed 13 June 2019.

[23] Corporate Finance (Wiley 2014).

[24] Peter H Huang and Michael S Knoll, 'Corporate Finance, Corporate Law And Finance Theory' [2000] University of Pennsylvania Law School Penn Law: Legal Scholarship Repository.

[25] Joshua Soloway, 'Preemptive Rights: Everything You Need To Know' (UpCounsel) <https://www.upcounsel.com/> accessed 13 June 2019.

[26] 'Tag Along Rights' (Uk.practicallaw.thomsonreuters.com, 2019) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019.

[27] 'Drag Along Rights' (Uk.practicallaw.thomsonreuters.com, 2019) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019.

[28] 'Investopedia' (Investopedia, 2019) <https://www.investopedia.com/> accessed 10 June 2019.

[29] Pegah Zolfaghari, 'An Introduction To Islamic Securities (Sukuk)' [2017] Uppsala Faculty of Law.

[30] Ibid

[31] 'Methodology For Rating Sukuk' [2019] Standard & Poor's Rating Services.

[32] 'Debt Covenants' (Corporate Finance Institute) <https://corporatefinanceinstitute.com/about-cfi/> accessed 13 June 2019.

[33] Ibid

[34] Ibid

[35] Eilis Ferran, Principles Of Corporate Finance Law (Oxford University Press 2014).

[36] 'Joint And Several Liability' (Uk.practicallaw.thomsonreuters.com) <https://uk.practicallaw.thomsonreuters.com/Browse/Home/PracticalLaw?transitionType=Default&contextData=(sc.Default)> accessed 13 June 2019.

[37] 'Syndicated Loan' (eFinanceManagement.com) <https://efinancemanagement.com> accessed 13 June 2019.

[38] 'Taking Security Over Shares' (Lexisnexis.com) <https://www.lexisnexis.com/en-us/products/lexis-advance.page> accessed 13 June 2019.

[39] Ibid

[40] Ibid

[41] Eilis Ferran, Principles Of Corporate Finance Law (Oxford University Press 2014).

[42] Frank Partnoy; David A. Jr. Skeel, The Promise and

Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019

(2007)

[43] Ibid

[44] Wei Zhang, 'The Paradoxes Of Secured Lending: Is There A Less Uneasy Case For The Priority Of Secured Claims In Bankruptcy?' [2011] SSRN Electronic Journal.

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