RPC Newsletter’s Advice Column – Best of February 2022
Each week, members of the RPC executive team answer reader-submitted questions about careers, finance, and more. To get your question answered, please fill out this anonymous Google form.
I recently learned about private equity and their ability to privatize public companies, and I was wondering if you could explain in simple terms Citrix’s take-private?
The Citrix Systems (“Citrix”) take-private is the first large leverage buyout of 2022, and one of the largest in recent years. The deal is particularly interesting because it is an archetype of private equity investing: financial engineering and operational improvements.
Buyer: The acquirer is a consortium formed by Vista Equity Partners and Evergreen Coast Capital Corp., the Private Equity arm of Elliott Management. A consortium structure is typically used during large buyouts to divide the risk undertaken, reduce the initial equity investment, and leverage the operational expertise of each partner. It is important to note that Elliott Management was previously involved as an activist investor in the company in 2015 and occupied a board seat until 2020.
Seller: Citrix is an American multinational cloud computing and virtualization technology company that provides server, application and desktop virtualization, networking, and cloud computing technologies. Their products are used by over 400,000 clients worldwide, including 99% of the Fortune 100. The company has recently struggled to undergo various business model transitions, posting underwhelming sales and profits for multiple consecutive quarters.
Deal Terms: The consortium is paying US$104/share in cash for a total deal value of ~US$16.5B (including debt). This corresponds to a ~30% premium to the company’s undisturbed share price.
Rationale: Citrix’s LBO follows the traditional private equity playbook. For financial engineering, private equity firms typically seek to maximize the leverage undertaken by their target company as it amplifies their returns. Software companies are therefore attractive since they can carry a significant amount of debt due to their high free cash flow conversion and recurring revenue stream (subscription-based offering, high switching costs, etc.). For operational improvements, private equity investors typically seek to enhance the quality (e.g., the same $1 of revenue is more stable) or the quantity (e.g., 1 customer generates $2 of revenue instead of $1) of the business operations. Here, the consortium plans to merge Citrix with Tibco Software (a Vista portfolio company), replace the management team, and transform Citrix’s offering into a subscripted-based cloud-focused model
RPC Opinion: Citrix was acquired for 24.8x EV/EBITDA, which is slightly below the 25.8x median paid for similar legacy tech companies over the past five years per Bloomberg. Given the company’s recent struggles and challenging business-model transition into the cloud, one of the most fiercely contested battlefields among business-IT providers, we believe that the company may have garnered a full valuation from the consortium. However, the value of “insider information signaling” is not to be neglected. Elliot’s 7-years involvement in the company suggests that the hedge fund believes that there is still hidden value to be unlocked in Citrix, especially now as the pandemic dramatically accelerated enterprises’ transitions towards the firm’s bread-and-butter: remote work. Furthermore, the potential for value-creation is enhanced by the involvement of Vista, which is widely regarded as the best PE operator in software.
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If the private equity consortium buying Citrix Systems is offering $104/share, why is the stock currently trading around $102? Couldn’t I just buy it and make $2 of profit?
In theory, your intuition is correct! If the acquisition closes following the announced deal terms, you will make a seemingly riskless $2 profit. This observation has been systematized into an investment strategy popularized during the 1980’s takeover boom: merger arbitrage.
Merger Arbitrage: Usually, acquirers pay a “control premium” over targets’ undisturbed share price. The uncertainty surrounding the deal closing due to various regulatory and shareholder-related hurdles is reflected in a “spread”, or the difference between the offered takeover price and the current trading price (here $2). The greater the uncertainty, the greater the spread. As the closure date approaches and the deal overcomes various hurdles, the target’s stock price converges towards the acquirer’s bid price. The investor benefits from the increase in stock price plus any dividends that are paid by the target company before the closure.
Deal Risks: There are many risks to ponder when calculating a merger’s success probability. Namely four: regulatory issues (regulators objecting to the deal because it infringes laws or regulations) (e.g., Visa <> Plaid), material adverse events (event unexpected by the acquirer jeopardizing the deal) (e.g., Air Canada <> Transat), shareholder rejection (acquirer’s/target’s shareholders voting against the transaction) (e.g., Aristocrat <> Playtech), and financing conditions (acquirer failing to secure the necessary financing). There are also subtler theoretical reasons, such as the time value of money (needing to discount the amount received at t=closing to present value).
Investment Strategy: A deal’s probability of success is calculated by dividing the potential downside (current share price minus unaffected share price) by the sum of the potential downside and upside (acquisition price minus current share price). Historically, around 94% of announced US deals close successfully. Thus, an arbitrageur should aim to create a diversified portfolio of takeover targets with an average implied closing probability of less than 94%. The spreads would be mispriced (too large) and by the law of large numbers, the arbitrageur will realize returns when more deals close (and thus the spread will be captured) than what is priced-in by the market.
Type of Arbitrage: The arbitrageur’s position depends on the deal structure. In a cash-for-stock acquisition, the arbitrageur buys shares of the target and receives cash compensation from the acquirer at closing. In a stock-for-stock acquisition, the arbitrageur would buy shares of the target and short shares of the acquirer proportionally. Upon closing, the target’s shares are converted into the acquirer’s shares and used to cover the initial short position. Note that there exist equivalent option portfolios replicating these payoffs.
The historical returns of merger arbitrage have shrunk from ~20% during the 1980s (53% for Warren Buffet!) to single-digit returns similar to bonds due to the institutionalization of the strategy and increased sophistication of the financial markets. To learn more about the strategy and its complexities, check out this book list from Merger Arbitrage Limited.
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One of the factors purported by media to explain the poor year-to-date performance of equity indices is inflation. I’m confused as to why exactly – could you explain why high inflation is bad for stock performance?
TLDR: Unexpectedly high inflation will generally lead to a net negative for equity markets as investors struggle to reassess risk premiums and companies haphazardly attempt to adjust their product pricing and cost structures.
While inflation is an abstract concept for Gen Z and Millenials living in stable economies, it is one of the fundamental forces driving financial markets. Historical inflation is defined as the rate of increase in prices over a period of time resulting in a loss of purchasing power in a given currency and is calculated by the Consumer Price Index. Note that many economists doubt the CPI methodology and claim that inflation is generally understated. Future inflation can be derived from estimations such as inflation surveys and the difference between the same-maturity inflation-protected and the risk-free rate (e.g., TIPS and treasury bills).
Fundamentally, inflation is an artifact of the modern monetary system: too much currency chasing too few goods mechanically bidding their prices up. The monstrous post-pandemic inflation can be attributed to a perfect storm hitting both sides of the equation. On the money side, liberal citizen cash hand-outs and aggressive quantitative easing from central banks caused an unprecedented increase in money supply (+$9T from Europe, Japan, and the US!). On the supply slide, supply chain disruptions and a tight labour market have created delays and shortages in products targeted by revenge consumption.
The impact of inflation on business on businesses can be negative, neutral, or positive depending on their relative exposure to the benefits (higher revenue growth and margins) and drawbacks (higher risk free rates, higher risk premiums, higher default spread, and higher taxes) of inflation.
(+) Revenue Growth: Revenue growth via increased prices for most companies. More specifically, winners have strong pricing power resulting in (almost) no resistance from their customers (e.g., Netflix not losing subscribers amid continuous membership price increases).
(+) Operating Margins: Margins stay constant if both revenue and costs “inflate” by the same proportion. To be beneficial, inflation must increase revenue more than costs (labour, raw materials, etc.) and vice-versa.
(–) Interest Rates: Economics 101 suggest that to fight high inflation, central banks raise the lead interest rate to tame consumption and incentivize saving (although basic economics do not apply to Turkey!). Since the risk-free rate increases, all investors’ expected returns shift upwards in a domino effect. This leads to increased discount rates, and thus lower asset value ceteris paribus.
(–) Risk Premiums and Failure Risk: Inflation has direct and indirect impacts on risk premiums. It increases default spreads directly because larger interest expenses (in absolute and relative terms, due to rising interest rates) are more difficult to cover by indebted companies. Also, it increases equity risk premiums indirectly by heightening the uncertainty about future inflation and about companies, governments, and economies’ responses to it.
(–) Taxes: Since the tax code is written in nominal terms, inflation tends to raise companies’ taxes. For example, building and equipment’s depreciation tax benefits decrease as inflation rises (effectively increasing the total tax rate) since they are calculated using their initial purchase price.
If you’re interested in learning more, you can consult Aswath Damodaran’s article on the topic ( “the valuation GOAT” – Idir H.).
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With sustainable and impact investing getting an increasing amount of media coverage, I have always wondered what their appeal is. Do they actually lead to abnormal returns?
To give all of our readers some background information: on the one hand, sustainable/impact investing is broadly defined as a method to balance conventional investing with environmental, social, and governance-related (ESG) insights to improve long-term outcomes. We here use the terms sustainable/impact investing interchangeably with clean technology or “clean tech” which refers to sustainable investing focusing on the E or environmental footprint companies have.
Although a popular myth would cite that sustainable investing is a noble way to lose money, over the last decade, impact investing and most specifically, climate tech, has matched or outperformed the broader market in a variety of segments.
In private markets, climate tech has outperformed the broader market over the past 10 years
In public markets, “Green Majors” have outperformed “Big Oil”
Although the first clean tech boom of the 2000s faced nothing other than headwinds with firms like CalPERS, Kholsa Ventures, and Kleiner Perkins launching funds that failed to deliver, the decade ahead represents nothing but opportunity for the sector:
Private markets: Starting in 2013, sustainable investing started to either match or outperform the broader private investments realm, suggesting sustainable solutions are driving returns. As explained by Cambridge associates, this can be tied back to the current cost reductions we are seeing in clean technologies. These sustainable solutions are now viable solutions for industries such as retail, manufacturing, and real estate and are reshaping the economics of sustainable businesses and presenting an attractive return profile over the long-term. In other words, we are seeing the historically capital-intensive clean technology solutions being replaced by economically viable solutions.
Public Markets: In only a few years, companies like NextEra and Enel have become large cap renewable energy companies basically going head to head with companies like Shell, the largest and most established oil behemoths. The green players have partly won the battle as they
Have perceived a drastic relative market cap change in the past decade as portrayed by the Wall Street Journal
Have significantly outperformed oil majors over the past 2 years. Most oil majors have experienced a negative performance compared to green giant’s outstanding returns.
Summary: Long story short, although impact investing has received a lot of attention from the venture and private investment community in the past year, it remains a polarized sector with many institutional investors being skeptical due to impact investing’s history of being an expensive PR scheme. However, if one were to take the time to dig into the past decade, realizing climate tech has outperformed its comparables across asset classes would almost be instinctive. As we look forward, the eventful economic and political tailwinds backing decarbonization make further investments (and returns) in clean technologies almost predestined to happen.