BBK34133 | Investment AnalysisPrepared by Khairul Anuar

L5 – Mergers and Acquisition

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Mergers and Acquisitions

Content

10.1 Legal Forms of Acquisition10.2 Merger or Consolidation? 10.3 Acquisition of Shares10.4 Acquisition of Assets10.5 Classification of Acquisitions 10.6 Takeover10.7 Synergy10.8 Sources of Synergy 10.9 Valuation of Merger10.10 NPV of a Merger10.11 Two ''Bad'' Reasons for Mergers10.12 Defensive Tactics

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1. 3 Legal Forms of Acquisition

• 3 basic legal procedures that one firm can use to acquire another firm:

(a) merger or consolidation; (b) acquisition of shares; and (c) acquisition of assets.

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2. Merger or Consolidation?

• A merger refers to the absorption of one firm by another. The acquiring firm retains its name and identity, and it acquires all of the assets and liabilities of the acquired firm. After a merger, the acquired firm ceases to exist as a separate business entity.

• A consolidation is the same as a merger except that an entirely new firm is created. In a consolidation both the acquiring firm and the acquired firm terminate their previous legal existence and become part of the new firm.

• Because of the similarities between mergers and consolidations, we shall refer to both types of reorganization as mergers.

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2. Merger or Consolidation?

• 2 important points about mergers and consolidations:

A primary advantage is that a merger is legally straightforward, and does not cost as much as other forms of acquisition. It avoids the necessity of transferring title of each individual asset of the acquired firm to the acquiring firm.

A primary disadvantage is that the shareholders of each firm must approve a merger. Typically, votes of the owners of two-thirds of the shares are required for approval.

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3. Acquisition of Shares

• A second way to acquire another firm is to purchase the firm’s voting shares in exchange for cash, or shares of equity and other securities.

• This process may start as a private offer from the management of one firm to another. At some point the offer is taken directly to the selling firm’s shareholders, often by a tender offer. A tender offer is a public offer to buy shares of a target firm. It is made by one firm directly to the shareholders of another firm.

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3. Acquisition of Shares

• The following factors are involved in choosing between an acquisition of shares and a merger:

In an acquisition of shares, shareholder meetings need not be held and a vote is not required. If the shareholders of the target firm do not like the offer, they are not required to accept it and need not tender their shares.

In an acquisition of shares, the bidding firm can deal directly with the shareholders of a target firm via a tender offer. The target firm’s management and board of directors are bypassed.

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3. Acquisition of Shares

Target managers often resist acquisition. In such cases, acquisition of shares circumvents the target firm’s management. Resistance by the target firm’s management often makes the cost of acquisition by shares higher than the cost by merger.

Frequently a minority of shareholders will hold out in a tender offer, and thus the target firm cannot be completely absorbed.

Complete absorption of one firm by another requires a merger. Many acquisitions of shares end with a formal merger.

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4. Acquisition of Assets

• One firm can acquire another by buying all of its assets.

• The selling firm does not necessarily vanish, because its ‘shell’ can be retained.

• A formal vote of the target shareholders is required in an acquisition of assets.

• An advantage here is that although the acquirer is often left with minority shareholders in an acquisition of shares, this does not happen in an acquisition of assets. Minority shareholders often present problems, such as holdouts.

• However, asset acquisition involves transferring title to individual assets, which can be costly.

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5. Classification of Acquisitions

• Three types of acquisitions:

Horizontal acquisition: Here, both the acquirer and acquired are in the same industry. Lloyds TSB’s merger with HBOS in 2009 is an example of a horizontal merger in the banking industry.

Vertical acquisition: A vertical acquisition involves firms at different steps of the production process. The acquisition by an airline company of a travel agency would be a vertical acquisition.

Conglomerate acquisition: The acquiring firm and the acquired firm are not related to each other. The acquisition of a food products firm by a computer firm would be considered a conglomerate acquisition.

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6. Takeover

• Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another.

•  A firm that has decided to take over another firm is usually referred to as the bidder. The bidder offers to pay cash or securities to obtain the equity or assets of another company.

• If the offer is accepted, the target firm will give up control over its equity or assets to the bidder in exchange for consideration (i.e. its equity, its debt, or cash).

• Takeovers can occur by acquisition, proxy contests, and going-private transactions. Thus takeovers encompass a broader set of activities than acquisitions.

• If a takeover is achieved by acquisition, it will be by merger, tender offer for shares of equity, or purchase of assets. In mergers and tender offers the acquiring firm buys the voting ordinary shares of the acquired firm

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7. Synergy

• Is there a rational reason for mergers? Yes – in a word, synergy.

Suppose firm A is contemplating acquiring firm B. The value of firm A is VA and the value of firm B is VB. (It is reasonable to assume that, for public companies, VA and VB can be determined by observing the market prices of the outstanding securities.)

The difference between the value of the combined firm (VAB) and the sum of the values of the firms as separate entities is the synergy from the acquisition:

VAB > VA + VB  

In words, synergy occurs if the value of the combined firm after the merger is greater than the sum of the value of the acquiring firm and the value of the acquired firm before the merger.

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8. Sources of Synergy

• The possible cash flow benefits of M&A falls into 4 basic categories:

1. Revenue enhancement2. Cost reductions3. Lower taxes4. Reduction in capital needs

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8. Sources of Synergy(1) Revenue Enhancement

A combined firm may generate greater revenues than two separate firms. Increased revenues can come from marketing gains, strategic benefits, or market power.

(a) Marketing Gains  - It is frequently claimed that, because of improved marketing, mergers and acquisitions can increase operating revenues. Improvements can be made in the following areas: Previously ineffective media programming and advertising efforts A weak existing distribution network An unbalanced product mix

(b) Strategic Benefits - Some acquisitions promise a strategic benefit, which is more like an option than a standard investment opportunity. For example, imagine that a sewing machine company acquires a computer company. The firm will be well positioned if technological advances allow computer-driven sewing machines in the future.

(c) Market or Monopoly Power - One firm may acquire another to reduce competition. If so, prices can be increased, generating monopoly profits. However, mergers that reduce competition do not benefit society, and the government regulators may challenge them.

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8. Sources of Synergy

(2) Cost Reduction

A combined firm may operate more efficiently than two separate firms. A merger can increase operating efficiency in the following ways.

(a) Economies of Scale - An economy of scale means that the average cost of production falls as the level of production increases. 

Though the precise nature of economies of scale is not known, it is one obvious benefit of horizontal mergers. The phrase spreading overhead is frequently used in connection with economies of scale. This refers to sharing central facilities such as corporate headquarters, top management, and computer systems.

(b) Economies of Vertical Integration - Operating economies can be gained from vertical combinations as well as from horizontal combinations. The main purpose of vertical acquisitions is to make co-ordination of closely related operating activities easier. This is probably why most forest product firms that cut timber also own sawmills and hauling equipment.

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8. Sources of Synergy

(c) Technology Transfer  - Technology transfer is another reason for merger. An automobile manufacturer might well acquire an aircraft company if aerospace technology can improve automotive quality. This technology transfer was the motivation behind the merger of General Motors and Hughes Aircraft.

(d) Complementary Resources - Some firms acquire others to improve usage of existing resources. A ski equipment store merging with a tennis equipment store will smooth sales over both the winter and summer seasons, thereby making better use of store capacity.

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8. Sources of Synergy

(3) Tax Gains

• Tax reduction may be a powerful incentive for some acquisitions. This reduction can come from:• The use of tax losses• The use of unused debt capacity

• Net Operating Losses - A firm with a profitable division and an unprofitable one will have a low tax bill, because the loss in one division offsets the income in the other. However, if the two divisions are actually separate companies, the profitable firm will not be able to use the losses of the unprofitable one to offset its income. Thus, in the right circumstances, a merger can lower taxes.

• Debt Capacity - There are at least two cases where mergers allow for increased debt and a larger tax shield. In the first case the target has too little debt, and the acquirer can infuse the target with the missing debt. In the second case both target and acquirer have optimal debt levels. A merger leads to risk reduction, generating greater debt capacity and a larger tax shield.

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8. Sources of Synergy

(4) Reduced Capital Requirements

• Owing to economies of scale, mergers can reduce operating costs. It follows that mergers can reduce capital requirements as well. Accountants typically divide capital into two components: fixed capital and working capital.

When two firms merge, the managers will probably find duplicate facilities. For example, if both firms had their own headquarters, all executives in the merged firm could be moved to one headquarters building, allowing the other headquarters to be sold. Some plants might be redundant as well. Or two merging firms in the same industry might consolidate their research and development, permitting some R&D facilities to be sold.

The same goes for working capital. The inventory-to-sales ratio and the cash-to-sales ratio often decrease as firm size increases. A merger permits these economies of scale to be realized, allowing a reduction in working capital.

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9. Valuation of Merger

Stage 1: Value the Target as a Stand-Alone Firm

• The first stage in the valuation process is to consider the target as a stand-alone entity. This is the base-case valuation upon which the merger can be assessed. To value a company requires estimates of future cash flows and the appropriate rates for discounting the cash flows. The initial valuation should then be compared with the current share price of the target to form an initial opinion of the merger.

Stage 2: Calibrate the Valuation

• It is very unlikely that your initial valuation of the target firm will be equal to its share price, and any differential in valuations needs to be explained. Share prices may also reflect takeover probabilities and potential takeover premiums. In addition, the share price may not incorporate private information that has been gained as a result of your in-depth analysis. For example, private information could be provided by the management of the target firm if the merger is friendly and fully supported by the target’s board.

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10. NPV of a Merger

• In section 8, we learned that the difference between the value of the combined firm (VAB) and the sum of the values of the firms as separate entities is the synergy from the acquisition is follows:

VAB > VA + VB  

• The net incremental gain from a merger is

• The total value of Firm B to firm A, VB* is

• The NPV of the merger is therefore:

NPV = VB* - Cost to Firm of the acquisition

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11. Two ''Bad'' Reasons for Mergers(1) Earnings Growth

• An acquisition can create the appearance of earnings growth, perhaps fooling investors into thinking that the firm is worth more than it really is.

(2) Diversification

Diversification is often mentioned as a benefit of one firm acquiring another. However, we argue that diversification, by itself, cannot produce increases in value.

Systematic variability cannot be eliminated by diversification, so mergers will not eliminate this risk at all. By contrast, unsystematic risk can be diversified away through mergers.

Diversification can produce gains to the acquiring firm only if one of two things is true:

Diversification decreases the unsystematic variability at a lower cost than by investors’ adjustments to personal portfolios. This seems very unlikely.

Diversification reduces risk and thereby increases debt capacity. This possibility was mentioned earlier in the chapter.

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12. Defensive Tactics

(1) Deterring Takeovers before Being in Play

• Corporate Charters - The corporate charter refers to the articles of incorporation and corporate by-laws governing a firm. Among other provisions, the charter establishes conditions allowing a takeover. Firms frequently amend charters to make acquisitions more difficult.

• Golden Parachutes - This term refers to generous severance packages provided to management in the event of a takeover. The argument is that golden parachutes will deter takeovers by raising the cost of acquisition.

• Poison Pills - The poison pill is a sophisticated defensive tactic that is common in the US but illegal in Europe. In the event of a hostile bid, a poison pill allows the target firm to issue new shares at a deep discount to every shareholder except the bidder.

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12. Defensive Tactics(2) Deterring Takeovers after the Company Is in Play

(a) Greenmail and Standstill Agreements - Managers may arrange a targeted repurchase to forestall a takeover attempt. In a targeted repurchase a firm buys back its own equity from a potential bidder, usually at a substantial premium, with the proviso that the seller promises not to acquire the company for a specified period. Critics of such payments label them greenmail.

(B) White Knight and White Squire -  A firm facing an unfriendly merger offer might arrange to be acquired by a friendly suitor, commonly referred to as a white knight. The white knight might be favoured simply because it is willing to pay a higher purchase price. Alternatively, it might promise not to lay off employees, fire managers, or sell off divisions.

(c) Recapitalizations and Repurchases - Target management will often issue debt to pay out a dividend – a transaction called a leveraged recapitalization. A share repurchase, where debt is issued to buy back shares, is a similar transaction. The two transactions fend off takeovers in a number of ways. First, the equity price may rise, perhaps because of the increased tax shield from greater debt. A rise in share price makes the acquisition less attractive to the bidder. Second, as part of the recapitalization, management may issue new securities that give management greater voting control than it had before the recap. The increase in control makes a hostile takeover more difficult. Third, firms with a lot of cash are often seen as attractive targets. As part of the recap, the target may use this cash to pay a dividend or buy back equity, reducing the firm’s appeal as a takeover candidate.

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12. Defensive Tactics

(d) Asset Restructurings  - In addition to altering capital structure, firms may sell off existing assets or buy new ones to avoid takeover. Targets generally sell, or divest, assets for two reasons.

• First, a target firm may have assembled a hotchpotch of assets in different lines of business, with the various segments fitting together poorly. Value might be increased by placing these divisions into separate firms. Academics often emphasize the concept of corporate focus. The idea here is that firms function best by focusing on those few businesses that they really know. A rise in equity price following a divestiture will reduce the target’s appeal to a bidder.

• The second reason is that a bidder might be interested in a specific division of the target. The target can reduce the bidder’s interest by selling off this division. Although the strategy may fend off a merger, it can hurt the target’s shareholders if the division is worth more to the target than to the division’s buyer. Authorities frequently talk of selling off the crown jewels or pursuing a scorched earth policy.

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