20.1: Reasons for Business Combinations

20.1.1: Reasons for Combining Businesses

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

Learning Objective

Describe the reasons two businesses might combine

Key Points

The dominant rationale used to explain merging activity is that acquiring firms seek improved financial performance.
If used in a business application, synergy means that teamwork will produce an overall better result than if each person within the group was working toward the same goal individually.
Positioning involves combining two companies in order to exploit future opportunities.
Gap filling is a reason for merging, referring to the fact that the strength of one company may be the weakness of the other, and vice versa.

Key Terms

Synergy: Benefits resulting from combining two different groups, people, objects, or processes.
statutory merger: A type of merger whereby one of the companies remains a legal entity, rather than a part of an entirely new legal entity.

Reasons For Business Combinations

Business combinations are referred to as mergers. A merger happens when two firms agree to go forward as a single new company, rather than remain separately owned and operated. This kind of action is more precisely referred to as 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, actual mergers of equals don’t happen very often. Usually, one company will buy another and, as part of the deal’s terms, simply allow the acquired firm to proclaim that 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 triangular merger, statutory merger, etc.

Every merger has specific reasons why the combining of the two companies is a good business decision. The underlying principle is simple: 2 + 2 = 5. In other words, the combination of two companies will be worth more than the sum of its parts. The dominant rationale used to explain merging activity is that acquiring firms seek improved 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 that teamwork will produce an overall better result than if each person within the group was working 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 costs of the company 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 that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices.
Cross-selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker’s 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 their advantage by reducing their 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 over the long term balances out the stock price of a company, 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 simply hires the staff of the target private company, thereby acquiring its talent (if that is 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, the pay of certain executive management teams was 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 in order to exploit future opportunities.
Gap filling: The strength of one company may be the weakness of the other, and vice versa.

20.2: Types of Transactions

20.2.1: Types of Transactions

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

Learning Objective

Choose the best strategy and method for completing a merger or acquisition

Key Points

A cash deal is one whereby the acquirer buys the target’s outstanding equity (or assets) with cash. The acquirer may raise cash through a debt or equity offering or internally finance the deal using the firm’s cash on hand.
A stock deal is one whereby the acquirer offers its own shares for the shares of the target. Usually this involves the acquirer floating new shares or using internally held treasury shares.
The ongoing status of the target’s owners dictates whether the transaction is a merger (retained) or acquisition (replaced).
Whether a purchase is perceived as being a “friendly” one or a “hostile” depends significantly on how the proposed acquisition is communicated to and perceived by the target company’s board of directors, employees, and shareholders.

Key Terms

shares in treasury: Stock that is bought back by the issuing company, reducing the amount of outstanding stock on the open market.
liquidation: The selling of the assets of a business as part of the process of dissolving the business.

Basic Strategies of M&A:

The buyer buys the shares, and therefore the control, of the target company. Ownership control of the company in turn 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.
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 in order 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 that many jurisdictions – particularly outside the United States – impose on transfers of individual assets, whereas 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

Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder’s shareholders. If the buyer pays cash, there are two main financing options:

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.
Issue of stock: The buyer increases financial slack, which may improve its debt rating and reduce the cost of debt (although not WACC as cost of equity will increase). Transaction costs include fees for preparation of 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:

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

There are some elements to think about when choosing the form of payment. 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 control of the buyer 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 being a “friendly” one or a “hostile” depends significantly on how the proposed acquisition is communicated to and perceived by the target company’s board of directors, employees, and shareholders. It is normal for deal communications to take place in a so-called “confidentiality bubble,” wherein the flow of information is restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the companies cooperate in negotiations. In the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target’s 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.

20.3: Preparing for a Merger

20.3.1: 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.

Learning Objective

Value a target company prior to a merger

Key Points

Due diligence can be defined as the examination of a potential target for merger, acquisition, privatization, or a similar corporate finance transaction –normally by a buyer.
In order to reduce the number of failed mergers and acquisitions, it is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process.
As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right.

Key Terms

discounted cash flow: In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)–the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
intellectual property: Any product of someone’s intellect that has commercial value: copyrights, patents, trademarks, and trade secrets.
Synergy: Benefits resulting from combining two different groups, people, objects, or processes.

Valuation of the Target Company

In order to prepare an appropriate bid in the mergers and acquisition process, the buyer must be able to accurately value the target company. This valuation process is referred to as due diligence. Due diligence can be defined as the examination of 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:

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

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.

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.

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:

Asset valuation
Historical earnings valuation
Future maintainable earnings valuation
Relative valuation (or comparable transactions)
Discounted cash flow valuation

Professionals who value businesses generally do not use just one of these methods, but a combination of them, in order 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.

20.4: The Role of Investment Bankers in M&A

20.4.1: Overview of Investment Banking Functions in M&A

Many companies looking to expand, or streamline, their business will use investment banks for advice on potential targets and/or buyers.

Learning Objective

Describe the role investment banking plays in the M&A process

Key Points

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).
One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction.
Banks will also source deals by studying the market themselves and approaching companies with their own strategic ideas.
One of the main roles investment banks play is to introduce new securities to market in order to finance M&A activity.

Key Term

market maker: A person or company who undertakes to quote at all times both a buy and a sell price for a financial instrument.

Role of Investment Banking In M&A

With increasing competitive pressures being placed on businesses and the trend towards globalization, companies are engaging more and more in M&A activity. Many companies looking to expand or streamline their business will use investment banks for advice on potential targets and/or buyers. This normally will include 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 Banking

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

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 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 actually 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 straight forward. The advisory work itself is simple enough: The investment bank contacts the firm their client wishes to purchase, attempts 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. In fact, one of the main roles investment banks play is to introduce new securities to 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.

20.5: Additional Topics in M&A

20.5.1: Other Topics in M&A

M&A also includes the areas of value creation, corporate alliances, private equity, and divestitures.

Learning Objective

Explain why a company may want to divest itself of an acquisition

Key Points

Despite the goal of value creation and synergy, results from mergers and acquisitions are often disappointing compared with results predicted or expected.
A form of corporate cooperation lying between a merger or acquisition and internal growth is called a corporate alliance or strategic alliance.
From an M&A point of view, a private placement is similar to a merger because it usually involves an institution (rather than numerous public investors) acquiring a stake (assets) in a company.
A divestiture is the reduction of some kind of asset for either financial or ethical objectives, or the sale of an existing business by a firm.

Key Terms

distribution channel: The institutional arrangement by which goods or services are conveyed from producer to user.
empirical: Pertaining to, derived from, or testable by observations made using the physical senses or using instruments which extend the senses.
Synergy: Benefits resulting from combining two different groups, people, objects, or processes.

M&A Value Creation

Despite the goal of value creation and synergy, results from mergers and acquisitions are often disappointing compared with results that are predicted or expected. Numerous empirical studies show high failure rates of M&A deals. Some reasons for failed mergers include lack of strategic fit, difference in corporate culture, lack of due diligence, poor integration, over-optimism, and failed valuation leading to too high of a purchase price. Employee turnover also contributes to M&A failures. The turnover in target companies has been found to be double the turnover experienced in non-merged firms for the 10 years following the merger. However, higher success rates have been experienced recently, due to firms gaining more and more experience with the M&A process.

Corporate Alliances

A form of corporate cooperation lying between a merger or acquisition and internal growth is called a corporate alliance, or strategic alliance. This is a relationship between two or more parties to pursue a set of agreed upon goals or to meet a critical business need while remaining independent organizations. Partners may provide the strategic alliance with resources such as products, distribution channels, manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual property. The alliance is a cooperation or collaboration which aims for a synergy where each partner hopes that the benefits from the alliance will be greater than those from individual efforts. The alliance often involves technology transfer (access to knowledge and expertise), economic specialization, shared expenses, and shared risk.

Private Equity and M&A

When raising funds for a merger or acquisition, firms may not seek funds from public offerings – either out of necessity or by choice. The company may not be big enough; the markets may not have an appetite for their issues; or the company may simply prefer not to have its stock be publicly traded. In such a case, a firm may choose to raise funds through private placements. The process of raising private equity, or debt, changes only slightly from a public deal. Often, one firm will be the sole investor in a private placement. In other words, if a company sells stock through a private placement, usually only one firm or a small number of firms will buy the stock offered. From an M&A point of view, a private placement is thus similar to a merger because it usually involves an institution (rather than numerous public investors) acquiring a stake (assets) in a company.

Private Equity

Private equity firms, such as NBGI, provide funds for companies unable or uninterested in obtaining funds publicly.

Divestitures

A divestiture is the reduction of some kind of asset for either financial or ethical objectives, or the sale of an existing business by a firm. Firms may have several motives for divestitures:

A firm may divest (sell) businesses that are not part of its core operations so that it can focus on what it does best.
To obtain funds. Divestitures generate funds for the firm because it is selling one of its businesses in exchange for cash.
A firm’s “break-up” value is sometimes believed to be greater than the value of the firm as a whole. In other words, the sum of a firm’s individual asset liquidation values exceeds the market value of the firm’s combined assets.
To create stability.
A division is under-performing or even failing.
A divestiture could be forced on to the firm by the regulatory authorities – for example, in order to create competition.

Often the term is used as a means to grow financially in which a company sells off a business unit in order to focus their resources on a market it judges to be more profitable or promising. Divestment of certain parts of a company can occur when required by the Federal Trade Commission before a merger with another firm is approved. The largest, and likely most famous, corporate divestiture in history was the 1984 U.S. Department of Justice-mandated breakup of the Bell System into AT&T and the seven Baby Bells.