For the exam, you should be able to classify M&A activities based on how the companies physically come together (i.e. forms of integration) and how the companies' business activities relate to one another (i.e. types of mergers).
Forms of Integration
>> In a statutory merger, the acquiring company acquires all of the target's assets and liabilities. As a result, the target company ceases to exist as a separate entity.
>> In a subsidiary merger, the target company becomes a subsidiary of the purchaser.
>> With a consolidation, both companies cease to exist in their prior form, and they come together to form a completely new company.
Types of Mergers
>> In a horizontal merger, the two businesses operate in the same or similar industries, and may often be competitors.
>> In a vertical merger, the acquiring company seeks to move up or down the product supply chain. For example, an ice cream manufacturer decides to acquire a restaurant chain so it can have an outlet for its products and not rely on supermarkets or other restaurants. This is an example of forward integration, where the acquirer is moving up the supply chain toward the ultimate consumer.
>> In a conglomerate merger, the two companies operate in completely separate industries. As such, they are expected to be few, if any, synergies from combining the two companies.
Synergies. The most common motivation for a merger is the idea that it will create synergies in which the combined company will be worth more than the two companies would be worth if operating separately. Usually, synergy results from either reducing costs or increasing revenues. Cost synergies are exactly the strategy behind a pure horizontal merger. On the surface, who can argue with increasing economies of scale? This is one of the basic principles of microeconomics. Revenue synergies are typically treated by cross-selling products, increasing market share, or raising prices to take advantage of reduced competition.
Achieving more rapid growth. External growth via M&A activity is usually a much faster way for managers to increase revenues than making investments internally (i.e. organic growth). Growth through M&A is especially common in mature industries where organic growth opportunities are limited. In addition, it is typically a less risky way to generate growth by acquiring resources through a merger with another company rather than developing them internally.
Increased market power. When a horizontal merger occurs in an industry with few competitors, the newly combined company will typically come away with increased market share and a greater ability to influence market prices. Vertical mergers may also increase market power by reducing dependence on outside suppliers. Regulators closely scrutinize both horizontal and vertical mergers to make sure the combined company does not gain too much market power, which could potentially harm consumers.
Gaining access to unique capabilities. If a company is lacking a specific capability or resource (e.g., research and development or intellectual capital), you can either try to develop it internally or seek to acquire something that already exists. M&A activity can be a cost-effective way to acquire proven capabilities or resources.
Diversification. Managers may site the need to diversify the firm's cash flows as grounds for a merger. This makes no sense for shareholders but may be rational for the managers. It is much easier and cheaper for the shareholders to diversify simply by investing in the shares of unrelated companies themselves rather than having one company go through the long, expensive process of acquiring and merging the two firms' operations and corporate cultures. In fact, research has revealed that conglomerates trade at a discount relative to the sum of the value of individual businesses. In this case, the whole is less than the sum of the individual parts. This example demonstrates that mergers are not likely to increase value purely for diversification reasons.
Bootstrapping EPS. Another motivation for mergers is the bootstrapping effect on earnings-per-share that sometimes results from a stock deal.
Personal benefits for managers. Studies concerning executive compensation find there is a high correlation between the size of a company and how much a manager is paid. This means that there is a strong financial incentive for managers to maximize the size of the firm rather than shareholder value. In addition, being part of the executive team for a larger company implies greater power and prestige and is probably good for managerial egos.
Tax benefits. Consider the case of two companies where one has large amounts of taxable income and the other has accumulated large tax loss carryforwards. By merging with the company that has tax losses, the acquirer can we use the losses to lower its tax liability. Regulators typically do not approve mergers that are undertaking purely for tax reasons, but with the many potential motivations to enter into a merger, proving that tax reasons are the key factor is difficult.
Unlocking hidden value. When a company has struggled for an extended period of time, an acquire may believe it can pay a lower price to buy the company and unlock hidden value by improving management, adding resources, or improving the organizational structure. In some cases, a merger may occur because the acquirer believes it is purchasing assets for less than the replacement cost.
Achieving international business goals. Since the 1990s, international M&A deals have become an important way for multinational companies to achieve cross-border business goals. Many of these goals reflect the same motivations behind the domestic mergers, such as extending global market power or gaining access to unique capabilities. However, there are a number of factors driving international M&A that are specific to international business:
>> Taking advantage of market inefficiencies.
>> Working around disadvantageous government policies.
>> Use technology in new markets.
>> Product differentiation.
>> Provide support to existing multinational clients.
Pioneer/development phase. In the pioneer phase, it is generally still uncertain whether consumers will accept a firm's product or service. The industry typically has large capital needs to fund development, but is not generating profits. In this stage, younger, smaller companies may seek to sell themselves to larger, more mature companies that have ample resources and want to find a new growth opportunity, or they may merge with a similar firm that will allow both companies to share management talent and financial resources. As a result, the common types of mergers seen in this stage are conglomerate mergers and horizontal mergers.
Rapid growth phase. The rapid growth phase is categorized by high profit margins and accelerating sales and earnings. The product or service provided by the company is accepted by consumers, but there is little competition in the industry. Merger motivations in this stage are usually driven by capital requirements as companies look for more resources to finance their expansion. The common types of mergers seen in this stage are conglomerates, as larger, more mature companies are able to provide capital, and horizontal mergers as similar firms combine resources to finance further growth.
Mature growth phase. In the mature phase, new competition has reduced industry profit margins, but the potential still exists for above average growth. Merger motivations are generally focused on operational efficiencies as companies seek to generate economies of scale to reduce costs to keep profit margins high. As a result, horizontal and vertical mergers that provide synergies and expand power are most common in this phase.
Stabilization phase. In the stabilization phase, competition has eliminated most of the growth potential in the industry, and the rate of growth is in line with that of the overall economy. Companies in this phase seek mergers to generate economies of scale in order to compete with a lower cost structure. They may also acquire smaller companies that can provide stronger management and a wider financial base. In this phase, horizontal mergers are the most common as the strongest companies acquire the weaker companies to consolidate market share and reduce costs.
Decline phase. The decline phase is categorized by overcapacity, declining profit margins, and lower demand as tastes may have changed and consumers seek new technologies. In this stage, all three types of mergers are common. A company may seek a horizontal merger simply to survive, vertical mergers may be used to increase efficiencies and increase profit margins, and conglomerate mergers may occur as companies acquire smaller companies in different industries to try to find new growth opportunities.
This information is summarized on page 351.
The characteristics of a merger transaction are important because they largely determine how the transaction will take place, how it will be valued, and what regulatory and tax rules will apply.
Forms of Acquisition
The two basic forms of acquisition are a stock purchase or an asset purchase.
In a stock purchase, the acquirer gives the target firm's shareholders cash and/or securities in exchange for shares of the target company's stock.
>> With a stock purchase, it is the shareholders that receive compensation, not the company itself. As a result, shareholders must approve the transaction with at least a majority shareholder vote. Winning shareholder approval can be time-consuming; but if the merger is hostile, dealing directly with shareholders is a way to avoid negotiations with management.
>> Also, shareholders will bear any tax consequences associated with the transaction. Shareholders must pay tax on gains, but there are no taxes at the corporate level. If the target company has accumulated tax losses, a stock purchase benefits the shareholders because under US rules, the use of a target's tax losses is allowable for stock purchases, but not for asset purchases.
>> Finally, more stock purchases involve purchasing the entire company and not just a portion of it. This means that not only will the acquirer gain the target company's assets, but it will also assume the target's liabilities.
In an asset purchase, the acquirer purchases the target company's assets, and payment is made directly to the target company.
>> Unless the assets are substantial (e.g. more than 50% of the company), shareholder approval is generally not required.
>> Also, because payment is made to the company, there are no direct tax consequences for the shareholder. The target company will pay any capital gains taxes associated with the transaction at the corporate level.
>> Asset purchase acquisitions usually focus on specific parts of the company that are of particular interest to the acquirer, rather than the entire company, which means that the acquirer generally avoids assuming any of the target company's liabilities.
The two basic methods of payment are securities offering and a cash offering. You should know that in many cases, mergers will use a combination of the two, which is referred to as mixed offering.
In a securities offering, the target shareholders receive shares of the acquirer's common stock in exchange for their shares in the target company. The number of the acquirer's shares received for each target company share is based on the exchange ratio. For example, shareholders in the target company may receive 1.3 shares of the acquirer's stock for every one share they own in the target company. In practice, exchange ratios are negotiated in advance of a merger due to the daily fluctuations that can occur in stock prices. The total compensation ultimately paid by the acquirer in a stock offering is based on three factors: exchange ratio, the number of shares outstanding of the target company, and the value of the acquirer's stock on the day the deal is completed.
Cash offerings are straightforward in that the acquirer simply pays an agreed-upon amount of cash for the target company's shares.
When an acquirer is negotiating with the target over the method of payment, there are three main factors that should be considered:
1. Distribution between risk and reward for the acquirer and target shareholders. In a stock offering, since the target company's shareholders receive new shares in the post merger company, they share in the risk related to the ultimate value that is realized from the merger. In a cash offering, all of the risk related to the value of the post merger company is borne by the acquirer. As a result, when the acquirer is highly confident in the synergies and value that will be created by the merger, it is more inclined to push for a cash offering.
2. Relative valuations of companies involved. If the acquirer's shares are considered overvalued by the market, the acquirer is likely to want to use its overpriced shares as currency in the merger transaction. In fact, investors sometimes interpret a stock offering as a signal that the acquirer's shares may be overvalued.
3. Changes in capital structure. Different payment structures have an impact on the acquiring firm's capital structure. If the acquirer borrows money to raise cash for a cash offering, the associated debt will increase the acquirer's financial leverage and risk. Issuing new stock for a securities offering can dilute the ownership interest for the acquirer's existing shareholders.
A merger offer will be viewed as either friendly or hostile by the target company's management.
Friendly merger offers usually begin with the acquirer directly approaching the target's management. If both parties like the idea of a potential deal, they will negotiate the method of payment and the terms of the transaction. At this point, each party to the merger will conduct due diligence on the other party by examining financial statements and other records. The goal of the due diligence process is for each party to protect its shareholders by confirming the accuracy of assertions made during negotiations. The acquirer will want to make sure the target's assets truly exist, while the target will want to make sure the acquirer has the financial capacity to pay for the transaction. Once the negotiation and due diligence process is complete, attorneys draft a definitive merger agreement that outlines the terms of the transaction and the rights of each party.
So far, the entire process for the merger has been kept secret from the general public in order to avoid violating securities laws related to material insider information. Only one each party signs the definitive merger agreement is the transaction announced to the public. In a friendly merger, the announcement is accompanied by an endorsement of the merger from the target's management and board of directors to encourage target shareholders to vote for the deal. The target company's shareholders are then given a proxy statement that outlines all of the pertinent facts of the transaction. Once it has been approved by shareholders and regulators, payment is made, and the deal is complete.
Hostile merger offers typically follow a much different process than friendly mergers. If a target company's management does not support the deal, the acquirer submits a merger proposal directly to the target's board of directors in a process called a bear hug. If the bear hug is unsuccessful, the next step is to appeal directly to the target's shareholders using one of two methods - a tender offer or proxy battle.
>> In a tender offer, the acquire offers to buy the shares directly from the target shareholders, and each individual shareholder either accepts or rejects the offer.
>> In a proxy battle, the acquirer seeks to control the target by having shareholders approve a new "acquirer approved" board of directors. A proxy solicitation is approved by regulators and then sent to the target's shareholders. If the shareholders elect the acquirer's slate of directors, the new board may replace the target's management and the merger offer may become friendly.
Post-Offer Defense Mechanism
Poison pill. Poison pills are extremely effective anti-takeover devices and were the subject of many legal battles in their infancy. In its most basic form, a poison pill gives current shareholders the right to purchase additional shares of stock at extremely attractive prices, which causes dilution and effectively increases the cost of the potential acquirer. The pills are usually triggered when a shareholder's equity stake exceeds some threshold level (e.g., 10%). Specific forms of a poison pill or a flip-in pill, where the target company's shareholders have the right to buy the target's shares at a discount, and a flip-over pill, where the target's shareholders have the right to buy the acquirer's shares at a discount. In case of a friendly merger offer, most poison pills plans give the board of directors the right to redeem the pill prior to a triggering event.
Poison put. This anti-takeover device is different from the others, as it focuses on bondholders. These puts give bondholders the option to demand immediate repayment of their bonds if there is a hostile takeover. This additional cash burden may fend off a would-be acquirer.
Restrictive takeover laws. Companies in the United States are incorporated in specific states, and the rules of that state apply to the corporation. Some states are more target friendly than others when it comes to having rules to protect against hostile takeover attempts. Companies that want to avoid a potential hostile merger offer may seek to incorporate in a state that has enacted strict anti-takeover laws.
Staggered board. In this strategy, the Board of Directors is split into roughly 3 equal size groups. Each group is elected for a three-year term in a staggered system: in the first year the first group is elected, the following year the next group is elected, and in the final year the third group is selected. The implications are straightforward. In any particular year, a bidder can win at most one third of the board seats. It would take a potential acquire at least two years to gain a majority control of the board since the terms are overlapping for the remaining board members. This is usually longer than a bidder would want to wait and can deter a potential acquirer.
Restricted voting rights. Equity ownership above some threshold level triggers a loss of voting rights unless approved by the Board of Directors. This greatly reduces the effectiveness of a tender offer and forces the bidder to negotiate with the border of directors directly.
Supermajority voting provision for mergers. A supermajority provision in the corporate charter requires shareholders support in excess of a simple majority.
Fair price amendment. A fair price amendment restricts a merger offer unless a fair price is offered to current shareholders.
Golden parachutes. Golden parachutes are compensation agreements between the target and its senior management that give the managers lucrative cash payouts if they leave the target company after a merger. In practice, payouts to managers are generally big enough to stop a large merger deal, but they do ease the target management's concern about losing their jobs.
"Just say no" defense. The first step in avoiding a hostile takeover offer is to simply say no. If the potential acquirer goes directly to shareholders with a tender offer or proxy fight, the target can make a public case to the shareholders concerning why the acquirer's offer is not in the shareholder's best interests.
Litigation. The basic idea is to file a lawsuit against the acquirer that will require expensive and time-consuming legal efforts to fight. The typical process is to attack the merger on antitrust grounds or for some violation of securities law. The courts may disallow the merger or provide a temporary injunction delaying the merger, giving managers more time to load up their defense or seek a friendly offer from a white knight.
Greenmail. Essentially, greenmail is a pay off to the potential acquirer to terminate the hostile takeover attempt. Greenmail is an agreement that allows a target to repurchase its shares from the acquiring company at a premium to the market price. The agreement is usually accompanied by a second agreement that the acquirer will not make another takeover attempt for a defined period of time.
Share repurchase. In a leveraged recapitalization, the target assumes a large amount of debt that is used to finance share repurchases. Like the share repurchase, the effect is to create a significant change in capital structure that makes the target less attractive while delivering value to shareholders.
Crown jewel defense. After a hostile takeover offer, a target may decide to sell a subsidiary or major asset to a neutral third-party. If the hostile acquirer views this as essential to the deal (i.e. a crown jewel), then it may abandon the takeover attempt.
Pac-Man defense. After a hostile takeover offer, the target can defend itself by making a counteroffer to acquire the acquirer. In practice, the Pac-Man defense is rarely used because it means a smaller company would have to acquire a larger company, and the target may also lose the use of other defense tactics as a result of its counteroffer.
White knight defense. A white night is a friendly third-party that comes to the rescue of the target company. The target will usually seek out a third-party with a good strategic fit with the target that can justify a higher price than the hostile acquirer. In many cases the white knight defense can start a bidding war between the hostile acquirer and the third-party, resulting in the target receiving a very good price when a deal is ultimately completed. This tendency for the winner to overpay in a competitive bidding situation is called the winner's curse
White squire defense. In today's M&A world, the squire analogy means that the target seeks a friendly third-party the buys a minority stake in the target without buying the entire company. The idea is for the minority stake to be big enough to block the hostile acquirer from gaining enough shares to complete the merger. In practice, the white squire defense involves a high risk of litigation, depending on the details of the transaction, especially if the third-party acquires shares directly from the company and the target's shareholders do not receive any compensation.
Pre-offer merger defense mechanisms are usually easier to defend in court than a post-merger defense mechanisms once hostile takeover has been announced.
Comparable company analysis uses relative valuation metrics for similar firms to estimate market value and then adds a takeover premium to determine a fair price for the acquirer to pay for the target.
Comparable company analysis involves the following steps:
1. Identify the set of comparable firms. Comparable company analysis involves identifying a set of other companies that are similar to the target firm. Ideally, the sample of other companies will come from the same industry as the target and have a similar size and capital structure.
2. Calculate various relative value measures based on the current market prices of companies in the sample. Some analysts use relative value measures based on enterprise value, which is the market value of the firm's debt and equity minus the value of cash and investments. These include EV to free cash flow, EV to EBITDA, and EV to sales. Other relative value measures use equity multiples such as price to earnings, price to book, and price to sales. Depending on what industry the target firm is in, some industry-specific multiples may also be appropriate.
3. Calculate descriptive statistics for the relative value metrics and apply those measures to the target firm. Analysts will typically calculate the mean, median, and range for the chosen relative value measures and apply those to the estimates for the target to determine the target's value. Value is equal to the multiple times the appropriate variable; for example, using the P/E ratio:
value = EPS x (P/E)
Ideally, the different relative value measures will produce similar estimates for the target's value in order to give the analyst confidence in the valuation estimates. If the valuation estimates are significantly different when using different metrics, the analyst will have to make a judgment about which estimates are most accurate.
4. Estimate a takeover premium. A takeover premium is the amount that the takeover price of each of the target's shares must exceed the market price in order to persuade the target shareholders to approve the merger deal. This premium is usually expressed as a percentage of the target's stock price and is calculated as:
TP = (DP-SP)/SP
DP=deal price per share
SP=target company's stock price
To estimate an appropriate takeover premium, analysts usually look at premiums paid in recent takeovers of companies most similar to the target firm. SP should be the price of the target stock before any market speculation causes the target stock price to jump; this typically occurs during the early stages of the process when the target company is first identified by the market as being a potential takeover opportunity.
5. Calculate the estimated takeover price for the target as the sum of estimated stock value based on comparables and the takeover premium. The estimated takeover price is considered a fair price to pay for control of the target company. Once the takeover price is computed, the acquirer should compare it to the estimated synergies from the merger to make sure the price makes economic sense.
In any merger that makes economic sense, the combined firm will be worth more than the sum of the two separate firms. This difference is the gain, which is a function of synergies created by the merger and any cash paid to shareholders as part of the transaction.
In equation form, we can denote the post-merger value of the combined company as:
V(AT) = V(A) + V(T) + S - C
V(AT) = post merger value of the combined company (acquirer + target)
V(A) = pre-merger acquirer
V(T)= pre-merger target
S = synergies
C= cash paid to target shareholders
Gains Accrued to the Target
In most merger transactions, acquirers must pay a takeover premium to entice the target's shareholders to approve the merger. The target company's management will try to negotiate the highest possible premium relative to the value of the target company. From the target's perspective, the takeover premium is the amount of compensation received in excess of the pre-merger value of the target's shares, or:
Gain(T) = TP = P(T) - V(T)
Gain(T) = gains accrued to target shareholders
TP = takeover premium
P(T) = price paid for target
V(T) = pre-merger value of target
Gains Accrued to the Acquirer
Acquirers are willing to pay a takeover premium because they expect to generate their own gains from any synergies created by the transaction. The acquirer's gain is therefore equal to the synergies received less the premium paid to the target's shareholders, or:
Gain(A) = S - TP = S - (P(T)-V(T))
Gain(A) = gains accrued to the acquirer's shareholders
Cash Payment versus Stock Payment
In addition to the price paid, the ultimate gain to the acquirer or the target is also affected by the choice of payment method. Mergers can be either financed through cash or through an exchange of shares of the combined firm. The chosen payment method typically reflects how confident both parties are about the estimated value of the synergies resulting from the merger. This is because different methods of payment will give the acquirer and the target different risk exposures with respect to misestimating the value of synergies.
With a cash offer, the target firm's shareholders will profit by the amount paid over its current share price (i.e. the takeover premium). However, this gain is capped at that amount.
With the stock offer, the gains will be determined in part by the value of the combined firm, because the target firm's shareholders do not receive cash and just walk away, but rather retain ownership in the new firm. Accordingly, for a stock deal we must adjust our formula for the price of the target:
P(T) = (N x P(AT))
N= Number of new shares the target receives
P(AT) = Price per-share of combined firm after the merger announcement
Effect of Price
With any merger deal, the acquirer and the target on opposite sides of the table because both parties want to extract as much value as possible for themselves out of the deal. This means that the acquirer will want to pay the lowest possible price (the pre-merger value of the target, V(T), while the target wants to receive the highest possible price (the pre-merger value of the target plus the expected synergies, V(T)+S).
Effect of Payment Method
Cash offer. In a cash offer, the acquirer assumes the risk and receives the potential reward from the merger, while the gain for the target shareholders is limited to the takeover premium. If an acquirer makes a cash offer in a deal, but the synergies realized are greater than expected, the takeover premium for the target would remain unchanged why all the acquirer reaps the additional reward. Likewise, if synergies were less than expected, the target would still receive the same takeover premium, but the acquirer's gain may evaporate.
Stock offer. In a stock offer, some of the risks and potential rewards from the merger shift to the target firm. When the target receives stock as payment, the target's shareholders become part owner of the acquiring company. This means that if estimates of the potential synergies are wrong, the target will share in the upside if the actual synergies exceed expectations, but will also share in the downside if the actual synergies are below expectations.
The main factor that affects the method of payment decision is confidence in the estimate of merger synergies. The more confident both parties are that synergies will be realized, the more the acquirer will prefer to pay cash and the more the target will prefer to receive stock, and vice versa.
In this section, we discuss ways a firm can reduce its size. Divestitures, equity carveouts, spinoffs, split-offs, and liquidation are all methods by which a firm separates a portion of its operations from the parent company.
Divestitures refer to a company selling, liquidating, or spinning off a division or subsidiary. Most divestitures involve a direct sale of a portion of the firm to an outside buyer. The selling firm is typically paid in cash and gives up control of the portion of the firm sold. Divestiture is often used as a generic term for disposing of assets, so a carve-out, spin off, or liquidation may also be considered a divestiture.
Equity carve-outs create a new, independent company by giving an equity interest in a subsidiary to outside shareholders. Shares of the subsidiary are issued in a public offering of stock, and the subsidiary becomes a new legal entity whose management team and operations are separate from the parent company.
Spinoffs are like carve-outs in that they create a new independent company that is distinct from the parent company. The primary difference is that shares are not issued to the public, but are instead distributed proportionally to the parent company's shareholders. This means that the shareholder base of the spin-off will be the same as that of the parent company, but the management team and operations are completely separate. The parent company does not receive any cash in the transaction.
Split-offs allow shareholders to receive new shares of a division of the parent company in exchange for a portion of their shares in the parent company. The key here is that shareholders are giving up a portion of their ownership in the parent company to receive the new shares of stock in the division.
Liquidations break up the firm and sell its asset piece by piece.