Mergers and Acquisitions

Reasons for Combining Businesses

Business combinations seek to unlock value within either firm that would not be realized if the firms continued separately.

Reasons for Business Combinations

Business combinations are called mergers. A merger happens when two firms agree to form one new company rather than remain separately owned and operated. This action is a merger of equals. The firms are often approximately the same size.

Both companies' stocks are surrendered, and new company stock is issued in its place. In practice, however, mergers of equals do not occur very often. Usually, one company buys another and, as part of the deal's terms, allows the acquired firm to proclaim the action is a merger of equals, even if it is technically an acquisition. A merger can also be achieved independently of the corporate mechanics through various means – such as a triangular merger, statutory merger, etc.

Every merger has reasons why combining two companies is a good business decision. The underlying principle is simple: 2 + 2 = 5. In other words, combining two companies will be worth more than the sum of its parts. The dominant rationale used to explain merging activity is that acquiring firms improves financial performance.

The following factors are considered to improve financial performance:

• Synergy: Synergy is two or more things functioning together to produce a result not independently obtainable. If used in a business application, synergy means teamwork will produce a better result than if each group member worked toward the same goal individually. Synergy can take the form of higher revenues, lower expenses, or a lower overall cost of capital.
  
  
• Economy of scale: The combined company can often reduce its fixed costs by removing duplicate departments or operations, or lowering the company's costs relative to the same revenue stream, thus increasing profit margins.
  
  
• Economy of scope: This refers to the efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products.
  
  
• Increased revenue or market share: This assumes the buyer will absorb a major competitor and increase its market power (by capturing increased market share) to set prices.
  
  
• Cross-selling: For example, a bank buying a stock broker could sell its banking products to their customers, while the broker can sign up the bank's customers for brokerage accounts.
  
  
• Taxation: A profitable company can buy a loss maker to use the target's loss to reduce its tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to shop for loss-making companies, limiting the tax motive of an acquiring company.
  
  
• Geographical or other diversification: This is designed to smooth the earnings results of a company, which balances the company's stock price over the long term, giving conservative investors more confidence in investing in the company.
  
  
• Hiring: Some companies use acquisitions as an alternative to the normal hiring process. This is especially common when the target is a small private company or is in the start-up phase. In this case, the acquiring company hires the staff of the target private company, thereby acquiring its talent (its main asset and appeal).
  
  
• Diversification: A merger may hedge a company against a downturn in an industry by providing the opportunity to make up profits in the industry of the target company.

Additional motives for a merger that may not add shareholder value include:

• Manager's hubris: A manager's overconfidence about expected synergies from a merger may result in overpayment for the target company.
  
  
• Empire-building: Managers have larger companies to manage and hence more power.
  
  
• Manager's compensation: In the past, executive management teams were paid based on the total profit of the company instead of the profit per share. This would give management the incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders).
  
  
• Positioning: This involves combining two companies to exploit future opportunities.
  
  
• Gap filling: The strength of one company may be the weakness of the other, and vice versa.

Source: Boundless, https://courses.lumenlearning.com/boundless-finance/
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Types of Transactions

Transactions can be mergers or acquisitions, made with cash or stock, and they can be friendly or hostile.

Basic Strategies of Mergers and Acquisitions (M&A)

1. The buyer buys the shares and controls the target company. Ownership control of the company conveys effective control over the assets of the company. However, since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
   
   
2. The buyer buys the assets of the target company. The cash the target receives from the sell-off is netted against outstanding liabilities and returned to equity holders (owners). This type of transaction leaves the target company as an empty shell if the buyer buys out the entirety of the target's assets (a liquidation). A buyer often structures the transaction to "cherry-pick" the assets that it wants and leaves out the assets and liabilities that it does not.
   
   A disadvantage of this structure is the tax many jurisdictions – particularly outside the United States – impose on transfers of individual assets. In contrast, stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral.

Basic Methods of Financing M&A

Cash

1. Cash on hand: The buyer consumes financial slack (excess cash or unused debt capacity) and may decrease its debt rating. There are no major transaction costs.
   
   
2. Issue of stock: The buyer increases financial slack, which may improve its debt rating and reduce the cost of debt (although not WACC, as the cost of equity will increase). Transaction costs include fees to prepare a proxy statement, an extraordinary shareholder meeting, and registration.

Stock

Payment is made in the form of the acquiring company's stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the acquired company's stock. If the buyer pays with stock, the financing possibilities are:

1. Issue of stock (same effects and transaction costs as described above).
   
   
2. Shares in Treasury: The buyer increases financial slack (if they do not have to be repurchased on the market), which may improve its debt rating and reduce the cost of debt (although not WACC, as the cost of equity will increase). Transaction costs include brokerage fees if shares are repurchased in the market; otherwise, there are no major costs.

When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid.

Therefore, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers.

Third, with a share deal the buyer's capital structure might be affected and the buyer's control modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. This risk is removed with a cash transaction.

In the aftermath of a merger, there will be accounting issues to consider. The balance sheet of the buyer will be modified, and thus the decision maker should take into account the effects on the reported financial results.

For example, in a pure cash deal (financed from the company's current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution in the decision-making process.

Hostile vs. Friendly

Whether a purchase is perceived as friendly or hostile depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees, and shareholders. Deal communications commonly occur in a "confidentiality bubble," where the flow of information is restricted pursuant to confidentiality agreements.

During a friendly transaction, the companies cooperate in negotiations. However, in a hostile deal, the board and/or management of the target are unwilling to be bought, or the board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become friendly as the acquirer secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer through negotiation.

Airline M&A: The aviation industry has seen increased consolidation through M&A activity in the last 20 years. Pictured is a plane belonging to United Airlines, one of the world's largest carriers, fresh off a 2010 merger with Continental Airlines.

Preparing for a Merger

Valuing the Target and Setting the Price

To prepare an appropriate bid for a target company, the buyer has to accurately value the target company through the due diligence process.

Valuation of the Target Company

To prepare an appropriate bid in the mergers and acquisition process, the buyer must be able to value the target company accurately. This valuation process is referred to as due diligence. Due diligence examines a potential target for merger, acquisition, privatization, or a similar corporate finance transaction – normally by a buyer. Due diligence involves a reasonable investigation focusing on material future matters and the asking of certain key questions, including how do we buy, how do we structure the acquisition, and how much do we pay? Moreover, due diligence is an investigation on the current practices of process and policies and an examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The due diligence process framework can be divided into nine distinct areas:

1. Compatibility audit: This deals with the strategic components of the transaction and, in particular, the need to add shareholder value.
2. Financial audit.
3. Macro-environment audit.
4. Legal/environmental audit.
5. Marketing audit.
6. Production audit.
7. Management audit.
8. Information systems audit.
9. Reconciliation audit: This links/consolidates other audit areas together via a formal valuation to test whether shareholder value will be added.
   
   

WIPO Headquarters in Geneva: Intellectual property is an asset of a business that must be included in the overall business evaluation. This photo is of the headquarters of the World Intellectual Property Organization in Geneva, Switzerland.

In business transactions, the due diligence process varies for different types of companies. Areas of concern other than the ones listed above include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions.

It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions. The five most common methods of valuation are:

1. Asset valuation
2. Historical earnings valuation
3. Future maintainable earnings valuation
4. Relative valuation (or comparable transactions)
5. Discounted cash flow valuation

Professionals who value businesses generally do not use just one of these methods, but a combination of them, to obtain a more accurate value. As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right. Synergies are different from the sales price valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm's point of view. Synergy creating investments are started by the choice of the acquirer and, therefore, they are not obligatory, making them real options in essence.

The Role of Investment Bankers in M&A

Overview of Investment Banking Functions in M&A

Companies that want to expand or streamline their business use investment banks for advice on potential targets and/or buyers.

With increasing competitive pressures on businesses and the trend toward globalization, companies are increasingly engaging in M&A activity. Many companies looking to expand or streamline their business use investment banks for advice on potential targets and/or buyers.

This normally includes a full valuation and recommended tactics. The investment bank's role in mergers and acquisitions falls into one of either two buckets: seller representation or buyer representation (also called target representation and acquirer representation).

Investment banks, such as Barclays (the headquarters pictured here), play a vital role in mergers and acquisitions.

Valuation

One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction. Investment banks are experts at calculating what a business is worth. They are also able to predict how that worth could be altered (i.e., what happens to the value of a company in a number of different scenarios and what those potential futures would mean financially).

Financial models are constructed by investment banks to capture the most important fixed and variable financial components that could influence the overall value of a company. These models, depending upon the proposed transaction, can be extremely complex, with special variables being added for special areas (i.e., there are different financial factors to consider in different sectors, countries, and markets when predicting or measuring a company's value).

Because of their expertise in business valuation, investment banks can also provide the service of arbitrage opportunities for their clients. For instance, if a bank has performed a valuation on a potential target company that suggests its market value (or the value of its shares in the marketplace) is less than what the business is worth, it may facilitate a merger or acquisition of this target company for its client that carries with it substantial profit opportunity.

Buyers Versus Sellers

Investment banks do not just rely on buyers and sellers approaching them. They will also source deals by studying the market themselves and approaching companies with their own strategic ideas (i.e., they might suggest that two companies merge, or that one company acquires, or sells to, another). An investment bank that represents a potential seller has a much greater likelihood of completing a transaction (and therefore being paid) than an investment bank that represents a potential acquirer.

This seller representation, also known as sell-side work, is the type of advisory assignment that is generated by a company when it approaches an investment bank and asks it to find a buyer of either the entire company or part of its assets. Generally speaking, the work involved in finding a buyer includes writing a Selling Memorandum (a detailed sales document) and then contacting potential strategic or financial buyers.

In advising sellers, the investment bank's work is complete once another party purchases the business up for sale (i.e., once another party buys the client's company or assets). However, representing a buyer is not always as straightforward. The advisory work is simple enough: The investment bank contacts the firm their client wishes to purchase and tries to structure an acceptable offer for all parties and make the deal a reality.

However, many of these proposals do not work out; few firms or owners are willing to readily sell their business. Because investment banks primarily collect fees based on completed transactions, they are often forced to defend their proposals.

Provision of Financing

Of course, buying a company will require the funds to do so. Options available to a company wishing to raise funds include selling shares in itself or raising debt financing. Investment banks can, yet again, play a role in making this happen. One of the main roles investment banks play is introducing new securities to the market. Not only can an investment bank determine the best price for new issues–be they equity or debt–by valuing the company and examining the market, but they can also find buyers for those new issues. Therefore, they are referred to as market makers since they perform the functions of both a buyer and seller.