MERGERS AND
ACQUISITIONS
Definition of Merger
Combining of two
business entities under common ownership (Arnold 2005)
Or
Two firms coalesce
and share resources in order to realise a common goal
But
One party almost
always dominates so
Corporations strive to increase their earnings per share over time.
Definition of Acquisition
One firm buys the
assets or shares of another
Takeover implies the
acquiring firm is larger than the target
Reverse takeover if
the target is larger than the acquirer
METHODS
– “Organic” approaches:
• Increase sales of existing divisions
while maintaining level operating margins
• Increase operating margins with constant
sales
– Mergers and Acquisitions:
•
Seek to merge or acquire another corporation, with resulting
corporation’s size and earnings enhanced by combination
A Brief History of Mergers and
Acquisitions
• M&A transactions date back to 19th
century
• Horizontal acquisitions: acquiring competitors in the same
industry and then systematically reducing costs of acquired company by
integrating its operations into acquirer's company
• Vertical acquisitions: acquiring companies in own supply chain
• Enormous trusts, or business
holding companies
A Brief History of Mergers and
Acquisitions
In the 1920’s,
1960’s, and 1980’s, M&A activity reached historic highs and corresponded to
positive performance of the stock market.
•
1920’s:
combinations of firms within industries
•
1960’s:
conglomerate approach (e.g. LTV, ITT)
•
1980’s: use of
large amounts of debt as the means to finance acquisitions of companies with
cheaply priced assets through leveraged buyouts
•
In the 2000’s, Wall Street declined due to lower asset values and
increased government regulation; strategic horizontal mergers are becoming more
common.
– Strong banks are absorbing weak ones
before/after FDIC seizes them.
– Chemical, pharmaceutical and commodities
firms are merging in order to increase global reach and reduce cost per unit of
production.
– Leveraged buyout firms (now private
equity firms) have decreased their activity due to losses from 2007/2008
vintage investments and reduction in debt availability.
–
Completed deals have lower levels of debt and therefore, either a lower
price or more equity.
How Companies Can Work Together
• Article 2 of the Uniform Commercial Code (UCC): set of contractual rules for sale
of goods between companies
• Vendor-customer relationships are
governed by purchase orders (POs): short form of contract, containing
standard provisions and blank spaces for price, quantity, and shipment date of
goods involved
• Strategic alliance (or teaming agreement): parties work
together on a single project for a finite period of time
•
Do not exchange
equity
•
Do not create
permanent entity to mark relationship
•
Written memorandum of understanding (MOU): memorializes strategic alliance and sets forth
how parties plan to work together
• Joint venture: parties work together for lengthy or
indeterminate period of time
– Form new, third entity
– Divide ownership and control of new
entity, determine who will contribute what resources
– Advantage: two entities can remain focused on
their core businesses while letting joint venture pursue the new opportunity
– Downside: governance issues and economic fairness
issues create friction and eventual disbandment
•
Acquisition: acquired
company becomes subsidiary of purchasing company
•
Most permanent
•
Eliminates
governance and economic fairness issues
•
Forms of acquisitions
•
Merger
•
Stock acquisition
•
Asset acquisition
•
Merger: two companies
legally become one
•
All assets and
liabilities being merged out of existence become assets and liabilities of
surviving company
•
Stock acquisition: acquired company becomes subsidiary of acquiring company
•
Asset acquisition: assets but not liabilities become assets of acquiring firm
How and Why to do an Acquisition
•
If acquisition will create positive present value when weighing outflow
(acquisition price) versus future inflow (cash flow of acquired company plus
any synergies), then transaction makes financial sense.
•
Difficulty:
determine what exactly are the outflows, inflows, and synergies (both
revenue/cost synergies)
•
Common synergies
•
Cost Savings:
– One has lower existing costs due to
efficiency, scale, etc.
– One has better cost management
– Combined company has greater economies of
scale
– One has better credit rating/balance
sheet and therefore cheaper financing costs
– Transactions costs eliminated in vertical
merger
– Reduction in employee costs (layoffs)
– Reduction in taxes if acquirer has NOLs
and is not limited by Section 382 of IRC
•
Common synergies (continued)
•
Revenue enhancements:
•
Use of each
other’s distributors and other channels
•
“Bundling”
opportunities from combined product offering makes company more attractive
•
Combined company
can raise prices (greater market power)
•
Companies will hire a group of advisors to assist in evaluating and
consummating transaction à investment bank, law firm with expertise
in mergers and acquisitions, accounting firm, valuation firm
•
Investment bank
•
Primary financial
advisor
•
Puts together
financial model to analyze cash flows of combined company on pro forma basis
•
Evaluates
comparable transaction in order to render advice on price
•
Offers advice on
tax and accounting structure for transaction
•
Helps raise
capital needed to complete transaction
•
Law firm
•
Responsible for
drafting and negotiation of transaction documents
•
Reviews
appropriate tax, employment, environmental, corporate governance, securities,
real property, and other applicable international, federal, state and local
laws
•
Advise Board of
Directors on fulfilling its fiduciary duties of care and loyalty to
shareholders
•
Accounting firm
•
Advise company on
proper tax and accounting treatment of transaction
•
Assist in valuing
certain specific assets
•
“Comfort letter”
on certain accounting issues
•
Consent letter
needed if publicly registered securities offering is made in connection with
transaction
The Politics and Economics of
Acquisitions
•
Key political elements of a transaction
•
Which entity will
survive or be parent company
•
What will new
company’s board of directors look like
•
Who will manage
company day-to-day
•
Smaller company
will typically become subsidiary of larger company
•
Smaller company
may have token representation on Board of Directors of parent
•
Management of
smaller company will typically either remain at subsidiary or exit
The Politics and Economics of an
Acquisition – Merger of Equals
•
Board positions
often allocated 50/50
•
“Office of the
Chairman” or “Office of CEO”: formed to share management authority
•
Murky lines of
authority or shared power can lead to difficulty and conflict
•
The Politics and
Economics of an Acquisition
•
Buyer will offer price
based on whether transaction will be accretive: increases earnings per
share of acquiring company
•
Seller will seek premium
over its existing stock price (if public) or price in line with public
traded comparables or recent public disclosed M&A transaction multiples
based on price to earnings, price to EBITDA or price to sales (if private)
LBOs, Hostile Takeovers and Reverse
M&A
•
Leveraged Buy Outs (LBOs): purchases of stock of company where a significant percentage
of purchase price is paid for with proceeds of debt
– Became prominent in 1970’s and 1980’s
with rise of LBO shop
– Debt financing to fund:
•
High yield (junk) bonds
• Hostile takeovers: acquisition in which “target’s” board of
directors does not consent to transaction
– Tender offer: Potential buyer or “raider” makes cash
offer directly to shareholders, thereby bypassing board of directors
•
Three major events altered landscape to reduce incidence of hostile
takeovers:
•
Creation of poison pills: companies issued convertible preferred stock to
exiting shareholders with provisions which made a potential tender offer
prohibitively expensive
•
State of Delaware passed new provision of Delaware General Corporate
Law, Section 203: requires hostile
buyer to acquire at least 85% of target company in order to consummate hostile
takeover
•
U.S. Congress passed revision of tax code: limited tax deductibility of certain
high yield debt (HYDO rules), thus reducing attractiveness of junk bonds as
means of financing acquisitions
Reverse M&A (add value through divestiture)
•
Four forms of
reverse M&A:
1. Simple sale of division or subsidiary: asset sale, stock sale, or merger
2. Spin-off: corporation issues dividend of shares
of subsidiary to be spun-off corporation’s shareholders
Shareholders of
parent participate in spin-off on pro rata based on their ownership percentage
in parent
Prior to
spin-off, parent may extract cash from subsidiary
“19.9% IPO”:
subsidiary is taken public and all or large portion of proceeds are then
allocated to parent
Transfer certain
debts to subsidiary so that parent ends up with less leveraged balance sheet
post spin-off
Parent has
subsidiary dividend to parent a portion of subsidiary’s cash
3. Split-off: shareholder in parent corporation
elects to take shares in subsidiary being split-off, but ends up with fewer
shares of parent corporation
4. Split-up: shareholder elects to take shares in
one part of split company or other
Less common than
spin-offs and split-offs because most shareholders like having parts of both
parent and entity divested
