Case study on Risk management in

Mergers & Acquisitions

Submitted by: Submitted to:

ANUJ KAMBLE (S0555276) Prof. KATARINA ADAM

VERONICA BARREDA (S0555505) Corporate Finance & Controlling

HTW Berlin

MBA&E WS2015

ii

Acknowledgement

This case study on Risk management in Mergers & Acquisitions is a part of our academic work

for the subject of Corporate Finance & Controlling for the Master’s Program at HTW-Berlin.

We assure you that the entire report has been prepared by us with the help of several sources

whose references have been mentioned in the bibliography section.

We would like to take this opportunity to thank our Professor Dr. Katarina Adam, for constantly

guiding us through the entire case study preparation period. She has helped us to focus on the

finer aspect of this topic & suggested changes wherever necessary which helped us to understand

the case in detail and to improve our report.

Anuj Kamble

Veronica Barreda

Berlin/ 21 Dec. 2015

iii

Abstract

The primary function of this report is to analyze Risks involved in M&A activity and their

impact on the involved companies. M&A activities are very complex and there are various risks

involved at different stages of M&A process. For our report we have just given overview of

financial risks involved in M&A.

This report highlights different definitions and types of risk. This report will also help you to

understand risk management process and its importance in company’s profitability.

This report gives an overview of the M&A and role of risk management in its success.

At the end of this report we have done case study on Actavis-Allergan Merger. We have also

given an overview of Pharmaceutical companies’ new business model. In the end we have given

our recommendation based on risks and opportunities that this new company will have.

Keywords: Risk, Risk management, Mergers, Acquisitions, M&A.

1

Table of Contents

1 Risks and types of risks ........................................................................................................3

1.1 What is Risk? .............................................................................................................3

1.2 Types of Risks ..............................................................................................................3

1.3 Inference .......................................................................................................................6

2 Risk management .................................................................................................................7

2.1 What is risk management? ...........................................................................................7

2.2 Why is it important? .....................................................................................................8

2.3 Techniques for identifying Risks ...................................................................................8

2.4 Risk Assessment techniques .........................................................................................9

2.5 Inference .......................................................................................................................9

3 Mergers & Acquisitions ..................................................................................................... 10

3.1 What are mergers & Acquisitions ............................................................................. 10

3.2 Motives behind M&A .............................................................................................. 12

3.3 Classification of mergers & acquisitions ..................................................................... 13

3.4 Merger Process Stages ............................................................................................... 14

3.5 Value at risk when M&A deal fails ............................................................................ 15

3.6 Risks involved in M&A ............................................................................................ 15

3.7 Risk management for M&A ........................................................................................ 17

3.8 Inference ..................................................................................................................... 18

4 Case study on Actavis and Allergan ................................................................................... 19

4.1 Introduction ............................................................................................................... 19

4.2 The Actavis-Allergan Merger ..................................................................................... 21

4.3 New business model .................................................................................................. 21

4.4 Evaluation of risks & Opportunities ............................................................................ 22

4.5 Recommendation ........................................................................................................ 24

5 Bibliography ...................................................................................................................... 25

2

List of Exhibits

Exhibit No Description Page No.

1 Industry’s portfolio of risks 4

2 A continuous Risk management Process Based on ISO31000 7

3 Selected Financial Data for Actavis 19

4 Selected Financial Data for Allergan 20

5 SWOT Analysis of newly combined company 22

3

1 Risks and types of risks

This year is set to go down as the biggest ever in terms of acquisition deals in the pharmaceutical

industry. M&A activities are complex and the results are uncertain. In this chapter we try to give

brief definition of risk and explain different types of risks which a company is exposed to.

1.1 What is Risk? 1 2 3

We all have used this word or even felt the anticipation, excitement or anxiety about facing new

and unknown event probably every day. We all have our own intuitions about the consequences

of our decisions, but the uncertainty of the potential outcome is Risk. The standard deviation

from the expected outcome indicates the level of risk.

There are many definitions of risk. The definition set out in ISO Guide73 is that “risk is the

effect of uncertainty on objectives”.1 In order to assist with the application of this definition,

Guide 73 also states that an effect may be positive, negative or a deviation from the expected and

that risk is often described by an event, a change in circumstances or a consequence. This

definition links risks to objectives. Therefore, this definition of risk can most easily be applied

when the objectives of the organization are comprehensive and fully stated.

The Chinese symbol for risk (风险-‘Fēngxiǎn’) which means ‘danger-opportunity’ best

represents both positive and negative impact of the risk.4 Mergers and acquisition transactions

are opportunities that bear considerable risks for a company.

1.2 Types of Risks

There are different types of risks according to situations and from where they originate. There

are some general risks which an individual or a company has to face which are unavoidable or

have any control over. In broader view here we are mentioning some general risks from World

Economic Forum’s-2014 global risk report.

Systemic Risk: “It is defined as the breakdowns in an entire system, as opposed to

breakdowns in individual parts and components.”5 When risk is shared amongst the

different systems and one system’s failure will cause the domino effect which will lead to

a bigger failure. Or when a system fails it will be unable to recover from that.

1 Bruner,Applied Mergers and Acquisitions,Wiley 2 A structured approach to Enterprise Risk Management (ERM) and the requirements of ISO 31000

3 AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August 2010

4 Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-Chapter1,Page 5,Para 2 5 World Economic Forum, ‘Global Risks 2014’ 9th edition, Page 9

4

Global Risk: “It is an occurrence that causes the significant negative impact for several

countries and industries over a time frame of up to 10 years.” 5 For example, Economic

risks, Technological risks, Societal Risks, Geopolitical Risks and Environmental Risks.

Now let’s see risks which are associated with Industries. These are the risks which will have

direct or indirect impact on management’s objectives.

Business risk refers to the uncertainties of outcome of management’s decisions. It creates

question; whether a company will be able to cover its operating expenses and still

generate profit and able to hold its market position? Influencing factors in business risk

are cost of goods, profit margins, competition within the industry, bargaining power of

the consumers and suppliers, threat of new competitors and substitutes.6

Business risk is often categorized into systematic risk and unsystematic risk. Systematic risk

refers to the general level of risk associated with any industry sector, and companies usually have

little control over, other than their ability to anticipate and react to changing conditions. On the

other hand unsystematic risks refer to the specific level of risks which are associated with

specific industry sector. Companies can manage these risks through good management

strategies.6

Exhibit1: Industry Portfolio of risks7

6 Investopedia viewed on 21/11/2015 7 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective

implementation .2007,Page 5

5

Amongst Industry’s Portfolio of risks which we came across; we would focus on company’s

financial risks.

Company’s financial risk is the risk that involves financial loss to the company. It generally

arises because of the instability and losses in financial market which are caused by: Fluctuating

stock market, changes in interest rates and currency exchange rates.8

Financial Risks can be further categorized as Market risks, Credit risks and Liquidity risks.6

Market risks: This risk has a larger impact as it could affect several firms’ investments at

a same time, if not all. For instance when the economy weakens, all firms feel the

effects.9

Market Price Risk: It comprises of transactions exposure, Portfolio exposure and

Economic exposure. Transactions exposure results from particular transactions such as an

export where a known cash flow in a given currency will take place at a certain date so it

will be dependent on currency exchange rate. Portfolio exposure is dependent on interest

rate fluctuations. Economic exposure to the real business risk of the company, insofar as

it is tied to market interest rates and commodity prices.10

Credit risks: It is the potential risk that the company will fail to meet its obligations

according to the previous agreed terms with the bank. This risk is calculated according to

company’s credit score which depends on company’s revenue generating ability. Higher

the credit score lower is the credit risk. This is why companies try to maintain high credit

scores in order to generate future cash flow through debt financing.

Liquidity risk: It is referred to the risk that a company may be unable to meet short term

financial demands due to a lack of cash flow as well as when a company tries to generate

cash flow by selling a valuable asset but it cannot do so because of bad market

conditions.

So far we have seen different kinds of risks a company is exposed to. In next chapter we will

discuss about how risk management process helps company’s management to decide their

strategy against mitigating these risks.

8 Eshna,Financial Risks and its types -article 9 Damodaran,Aswath, “Value and Risk: Beyond Betas” (Nov.2003),Page6 10 Ian Giddy, NYU Stern School of Business, ‘Managing Financial risks’ Page no.34-40

6

1.3 Inference

While we were searching for the exact definition of the risk we came across the different

definitions with some focusing primarily on the likelihood of bad events occurring, some

focusing on rewards and some focusing on the downsides and upsides of the risks.

There are many types are risks some are avoidable some are not.

Risk represents threat as well as opportunities.

Company is exposed to various kinds of risks.

7

2 Risk management

2.1 What is risk management? 11

12

As we have already seen in previous chapter that risk has various definitions and it is directly

linked to the objectives of a company’s management. Therefore, this definition of risk can most

easily be applied when the objectives of the organization are comprehensive and fully stated.

Risk management is the continuous process which involves identifying and evaluating risks and

taking preventative action to mitigate impacts of risks on management’s objectives and set

strategy objectives accordingly.

Risk management is more than risk hedging as it is all about identifying those risks which have

opportunities for an organization by exploring and mitigating them rather than just avoiding

them.

Exibit2: A continuous Risk management Process Based on ISO31000 13

11 Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-Chapter1,Page 5,Para 2 12 AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August 2010,Page 1 13 A structured approach to Enterprise Risk Management (ERM) and the requirements of ISO 31000 Page No.9

8

2.2 Why is it important? 14

“Risks affecting organizations can have consequences in terms of economic performance and

professional reputation, as well as environmental, safety and societal outcomes. Therefore,

managing risk effectively helps organizations to perform well in an environment full of

uncertainty.”15

As we have mentioned earlier in Exibit1. The organization is exposed to various types of risks.

By using risk management, companies can determine the overall exposure to the particular type

of risk under consideration. Company’s Risk management drivers can be external or internal.

For example, for company’s financial risk management internal drivers could be: internal

control, fraud, liabilities, liquidity and cash flow. External drivers could be exchange rates,

interest rates.

2.3 Techniques for identifying Risks16

There are many risks and identifying the risks which would affect the company is the most

important task in risk management.

Now we know that risk is not a sudden event or just bad luck so... identifying the risk that the

company is exposed to and taking actions in controlling it in advance can potentially lead to the

mitigation of the risk. For example company A has taken steps to mitigate the systematic risk the

industry is exposed to and its competitor company B has not then in such scenario; Company A

has advantage over company B who has failed to do that. Company A could use this opportunity

as a bonus for its strategy against the mitigated risk.

There are various risk identifying techniques such as Brainstorming, Event inventories and loss

event data, Interviews and self-assessment, Facilitated workshops, SWOT analysis, Risk

questionnaires and risk surveys, Scenario analysis, the use of technology and other techniques.

We would like to describe SWOT analysis in brief as we also going to use this technique for our

case study.

SWOT Analysis:17

SWOT (strengths-weaknesses-opportunities-threats) analysis is a technique often used in

the formulation of strategy. Internal factors which company’s management can have

control over like: company structure, culture, financial and human resources decide

company’s strength and weaknesses. And external factors which company’s management

doesn’t have any control over such as: political, environmental and systematic industrial

risks decide opportunities and threats for the company.

14 Adam, Corporate finance-KW 2-3,Risk management, Page 18-23 15 ISO 30001: http://www.iso.org/iso/home/standards/iso31000.htm , Visited on 15/12/2015 16 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective

implementation .2007,Page 7 17 Haupt,Denny, Stratergy Marketing and HR management- ‘Analysis of industry-Part3’.pdf , 24/11/2015,

Page 145

9

By using SWOT analysis management can identify risks which are internally driven like

if company has some department or product as a weakness management can take

appropriate actions against them. By analyzing threats management will come to know

about the external risks which are there and which will affect their business so that they

can plan the best strategy accordingly.

2.4 Risk Assessment techniques18

19

After the identification of risks it is necessary for the management to know the probability and

impact of the identified risks so that the management can have a consistent approach towards

risk assessment, evaluation and monitoring. “It helps management understand and quantify the

likelihood and consequences of the risk.”18.

By using risk assessment techniques management

can categorize risks according their nature and prioritize them accordingly.

There are three types of approaches to risk assessment: Qualitative, Quantitative and both.

Qualitative risk assessment techniques: FMEA (Failure mode analysis), HAZOP

(Hazard and operability study), Risk map with likelihood and impact, risk rankings,

identification of risk correlation.

Quantitative risk assessment techniques: VAR (Value at risk)

Qualitative/quantitative risk assessment techniques: Tornado charts, Benchmarking,

NPV, Scenario analysis, Risk corrected revenues etc.

In next chapter we will talk about the M&A process which is internal driver for the strategic risk

management process. We will see how risk management process plays an important role while

dealing with financial risks in M&A activity.

2.5 Inference

Risk management plays an important role in identifying and evaluating risks. Using

qualitative risk assessment technique management can prioritize risks according to their

likelihood and impact.

Risk management helps management to develop their strategy to reach company’s

objective successfully.

Looking at the importance of the risk management ISO30001:2009 has developed a

frame work for implementing risk management into organizations. This frame work is

based on 11 principles of risk management.

After 2008 financial crisis companies have realized the importance of risk management.

Now companies have started to integrate risk management in their organizational

processes.

18 Adam, Corporate finance-KW 2-3,Risk management, Page 27-35 19 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective

implementation .2007,Page 7

10

3 Mergers & Acquisitions

In Previous chapters, we have seen definition and types of risks, how risk management process

can identify which risks a company’s management should take to reach the set objectives. As a

part of company’s strategic risk management process a company’s management could decide to

increase their business through M&A activity. But M&A as itself is a very complex process and

has lots of risks involved in it. In this chapter we try to give brief definitions of Mergers and

acquisitions, explain their types, the M&A process and various risks involved at various stages of

this process. We will mainly focus on financial risks and their impacts on the companies

involved in the M&A and how risk management plays an important role in the success of M&A.

3.1 What are mergers & Acquisitions20

21

22

23

A merger or an acquisition can be defined as the combination of two or more companies into one

new company or corporation. The main difference between a merger and an acquisition lies in

the way in which the combination of these two companies happens.

Merger is the combination of two or more companies in formation of a new company.

Usually in a merger there are negotiations involved between the two companies before

the combination takes place. For example, assume that Companies A and B are existing

automobile companies. Company A has a renowned brand name and a large commercial

customer base. Company B is innovative car maker for domestic market. Both companies

may consider that a merger would produce benefits to the combined company as there are

some obvious potential synergies available. For example, company A can use innovative

ideas from company B and produce innovative cars under its brand name and sale them

globally. In this way Company B will also able to reach foreign markets. The two

companies may decide to initiate merger negotiations. When the negotiations are

successful both companies will merge and will form a new company. They can have new

brand name for the new company or they can simply combine their brand names or they

can choose to operate under acquirer’s brand name.

Generally in case of mergers the management can get shareholders’ approval easily if

they are successful to show that the potential merger will be profitable for shareholders.

The acquirer may offer either cash or share in merger transaction. Cash transactions will

give immediate profit for shareholders whereas share may give long term investment

opportunity for shareholders. Shareholders will make profit if potential merger is creating

value for the combined company. The value of share will increase faster when market is

up than when it is stagnant.

20 Damodaran,Aswath, “Acqusitions and tekeovers” Page1-8 21

Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” , 2010,Page 2-4 22 International Journal of BRIC Business Research (IJBBR) Volume 3, Number 1, February 2014 23 Hoang, Thuy Vu Nga- Lapumnuaypon, Kamolrat, “Critical Success Factors in Merger & Acquisition Projects”-

Page 3

11

Acquisition is the process when one company purchases the shares or assets of another

company to have control over the other company with or without mutual agreement. In an

acquisition the negotiation process does not necessarily take place. Rules about the

ownership changes according to countries in which the acquisition is taking place.

Countries have different laws and regulation for M&A activities. In acquisitions the

company who wants to acquire another company is referred to as the acquirer and the

company which will get acquired referred to as the potential target for acquisition. In

most cases the acquirer acquires the target by buying its shares. Achieving ownership

may require purchase of all of the target shares or a majority of them. For example in an

acquisition company A buys company B. Company B becomes wholly owned by

company A. Company B might be fully absorbed and cease to exist as a separate entity,

or company A might retain company B in its pre-acquired form. With this limited

absorption there is a possibility that Company A might sell company B in future for a

profit.

There are two types of acquisitions friendly and hostile. In the case of a friendly

acquisition the target is willing to get acquired. The target may view the acquisition as an

opportunity to develop into new areas and use the resources offered by the acquirer. This

happens particularly in the case of small successful companies or startups that wish to

develop and expand but don’t have sufficient capital. The smaller company may look for

a bigger company who is ready for such investments.

In case of hostile acquisition the target is opposed to the acquisition. Hostile acquisitions

are sometimes referred to as hostile takeovers. In hostile takeovers the acquirer may

attempt to buy large amounts of the target company’s shares from the share market. But

when sudden large purchase of shares of the target company is visible in share market

there will be increase in share price of the target company. To avoid this scenario the

acquirer may attempt to buy as much shares as possible in the shortest possible time,

preferably as soon as the markets open. Sometimes the target company may seek

opportunity of potential merger or acquisition by a favorable buyer who will rescue the

target company from the hostile acquisition by an unsuitable acquirer. If the target

company is managed to stop hostile acquisition with the help from his new acquirer then

the acquirer is called as ‘The White Knight’. We will see example for white knight in our

case study.

In both friendly and hostile acquisitions the decision on whether or not to sell shares in

the target lies with the shareholders. If all or a large proportion of target shareholders

agree to sell their shares, ownership will be transferred to the acquirer.

12

3.2 Motives behind M&A 24

25

26

Financial synergy: With financial synergies, the payoff can take the form of either

higher cash flows or a lower cost of capital. This can be achieved by-

When a large company with higher cash combines with a smaller company with

high return projects can yield a payoff in terms on higher value for the combined

firm. The increase in value comes from doing the high return projects which were

possible due to excess cash provided by the large company to the smaller

company.

When two companies are merged together; their earnings and cash flow may

become stable and predictable hence the debt capacity of the combined company

increases. This allows companies to borrow more than they could have when they

were separate entities. Companies can have better cash flow due to tax benefits

from the debt that merged companies have.

Tax benefits due to lower corporate tax rates: Sometime a company merges with a

company from another country where corporate tax is lower than the country in

which it is currently operating. This we will discuss later in chapter-4.

Operating synergy: Companies merge to have operating synergy which will allow them

to increase operating income, growth or both. This can be achieved by-

Economies of scale that may arise from the merger, allowing the combined firm

to become more cost-efficient and profitable.

Greater pricing power due to reduced competition and higher market share which

gives higher profit margins and operating income.

Combination of different functional strength. For example when firm with good

product line acquires firm with good marketing team.

Higher growth in new or existing market. For example when company acquires a

new company in an emerging market which has a good distribution network and

recognized brand name which can be used as strength to increase sales of its

product.

Diversification: Companies may use merger or acquisition for diversification-

To reduce risk- For example if a company is operating in a volatile industry it

may merge with another company from different industry to hedge itself against

fluctuations in its own market.

To have diverse product portfolio-For example company may merge or acquire

company with new product or services from same or different industry to have a

diverse product portfolio.

24 Damodaran,aswath, 25 Brealeay/Myers/Markus Fundamentals of Corporate Finance, Page 588-591 26 Berk,DeMarzo Corporate finance, Page 934-937

13

Investment motives: Sometimes as an investment opportunity a company may acquire

an undervalued company who has future growth potential but it is undervalued by

financial markets. If the acquiring company has sufficient funds to carry out the

acquisition then it can gain the difference between the value and purchase price as

surplus.

Managerial motives: Usually M&A activities are carried out by managers and their

motives can be different-

Empire Building- In this case management motive for M&A is to make their

company the largest or most dominant company in their industry.

Managerial Ego- some acquisitions start battle of bidding especially when

multiple companies are trying to acquire a same firm and which nobody wants to

lose because it could hurt manager’s ego or it will harm management reputation.

Compensation & side benefits: Sometimes management’s compensation contracts

are restructured after M&A. “If the potential M&A brings private gains to the

managers from the transactions are large it might blind them to the costs created

for their own stockholders.”27

3.3 Classification of mergers & acquisitions28

Classification based on previously mentioned motives behind M&A.

Horizontal M&A: When two competing companies from a same industry merge or when

the acquirer acquires the target company from the same industry then such M&A is

known as the Horizontal M&A. This trend is usually observed in industries like

pharmaceuticals, automobile and petroleum. For example the merger of two giant

pharmaceutical companies, Glaxo and SmithKline Beecham. As CEO of Smith Kline

Beecham mentioned that the aim of this merger was the R&D synergies to drive revenues

since in pharmaceutical industry new technologies and inventions of new drugs result in

enormous opportunities for revenue creation.29

Vertical M&A: Vertical M&A is usually the combination of companies which are client

or suppliers of each other. Vertical M&A has two types based on integration. Forward

vertical integration and backward vertical integration. For example when an OEM

acquires raw material supplier of its product then it is a backward integration. And when

an OEM merges or acquires its product retailer then it is forward integration. Using this

OEM can control the whole supply chain of its product. The best example of this vertical

27 Damodaran,Aswath, 28

Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” 2010,Page 7-9 29 Referred for horizontal integration example, http://www.referenceforbusiness.com/history2/56/GlaxoSmithKline-

plc.html,Viewed on 12/12/2015

14

integration is Ford’s River Rouge plant. Henry Ford adapted this vertical integration for

production of the famous Model-T.30

Conglomerate M&A: When companies operate in unrelated businesses involved in

M&A transactions then it’s a conglomerate M&A. Being a conglomerate company can

diversify its risks and attain economies of scope. For example ThyssenKrupp AG is the

German conglomerate which has 670 companies under its brand name operating

worldwide. ThyssenKrupp operates in Steel industry, Elevator business and also as a

supplier to automotive industry.31

Cross-border M&A: When two companies operating in two different countries or

economies involved in M&A want to have transactions then it is a cross border M&A.

For example to avoid high tax regulations and gain tax benefits a US based company will

merge with company where tax regulations are lower than the US.

3.4 Merger Process Stages32

33

We just want to give an overview of the merger process. In reality, merger processes are

more complex, to have control over them; these stages are subdivided into various small

stages and timely activities.

Pre-Merger planning stage: This phase is also called as inception phase in which the

management of a company initiates the process; Business and growth strategies are

defined and then companies identify the potential target companies for a merger. After

initiating the process feasibility stage comes which includes detail analysis of the

financial characteristics of the proposed merger with time scale for the activity, synergy

generation and other variables. Once all the factors are evaluated the management

decides to proceed for a merger commitment and allocates necessary funding’s and

resources.

Merger implementation stage: Then usually Letter of intention is submitted to the

target company and the management of the target company is invited for the merger

activity. After receiving Target Company’s acceptance on the Letter of intention then the

management commits to proceed with the merger activity. This followed by negotiation

phase which involves managements of the both companies that are involved in the

merger. Both the managements negotiate with each other to reach agreement on the

structure and format of the newly combined company. Usually in these negotiations both

companies involve their experienced lawyers and M&A advisory firms. The merger

contract sets out the rights and obligations of each company under the terms of the deal.

30 Referred for vertical integration example, Henry Ford, “My life & Work” 31 Referred for conglomerate example https://www.thyssenkrupp.com, Viewed on 12/12/2015 32

Bruner,Applied Mergers and Acquisitions,Wiley 33

Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” 2010,Page 7-9

15

Merger contracts can be extremely complex and are usually developed and finalized by

specialist external consultants working with in-house specialists.

Post-Merger integration stage: The implementation process starts as soon as both the

companies agree with the terms and obligations of the merger contract. Usually merger

integration activities are taken as a separate project. Companies assign their respective

project teams for the successful integration of both the organizations in a merger.

Companies may include outside project teams from M&A advisory firms like Goldman

Sachs and McKenzie. These project teams plan, monitor and executes the integration

activities for the new organization. This helps newly combined company adapt to the new

organizational structure. This phase is usually referred to as commissioning. In some

cases the commissioning phase may continue for several years.

3.5 Value at risk when M&A deal fails 34

M&A deals are exposed to various risks starting from the deal to the finalizing of the deal. The

value before consummation of deal includes research expenses which company has spent to find

the potential target and financial fees to various firms like legal firms, advisory firms and

auditing firms; management time & reputation; and the cost of lost opportunity. The value at risk

grows over the time period of a deal transaction, and reaching its maximum at the closing.

The opportunity cost will be massive where there are solid synergies or strategic options that

might have been created. Strategic options, synergies and other opportunity costs amplify the

value at the risk.

Moreover if the buyer company is a frequent participant in M&A activity, reputation

consideration will amplify the value at risk.

3.6 Risks involved in M&A 35

36

Company’s financial risks in M&A exist at different phases of the process: In the course of value

evaluation, transaction, financing, payment and company integration.

The Financial Risk before M&A:

Risk in value evaluation of Target Company: This risk mainly occurs when there is a

problem with the financial statements, and the value assessment of the target company.

From the perspective of value assessment of target enterprise, when making decisions in

M&A, the acquirer must correctly assess its merged capacity. The risks of M&A mainly

appear in over estimating or underestimating capacity of the target enterprise. The target

enterprise manipulates the financial statement or conceals the actual accounting

information. Because of this it is hard for the acquirer to assess the real asset value and

profitability of the target enterprise, which will probably make the acquirer over estimate

34 Bruner,Applied Mergers and Acquisitions,Wiley, Pages 637-640 35 Deng, Analysis of Financial Risk Prevention in Mergers and Acquisitions 36 Damodaran,Aswath, “Acquisitions and takeovers” Pages 45-58

16

the value of the target enterprise. The value estimation risk of M&A embodies the

expected deviation of future earnings and time needed to show benefit. The falsified

information and corrupt behavior during the course of M&A would result in financial risk

and financial crisis for the acquirer.

The Financial Risks during the Course of M&A:

Financing Risk: The financing risk of M&A refers to the risk of financial security and

funding resources required for M&A. The financing method includes internal financing

and external financing.

Risks of using Internal Financing: Internal financing method would tie up most of the

cash flow of the acquirer which will endanger the company’s liquidity. The acquiring

company may fail to pay its short-term debt and eventually fail to finish the financing

for the M&A activity.

Risk of using external financing: In case of external financing such as debt financing

if bad management is involved in the M&A it will reduce the ability of an acquiring

company to pay back the principle interest and eventually the acquiring company may

go bankrupt.

Payment Risk: The mode of payment will bring risk to the pricing which involves

capital liquidity and stock dilution. The payment methods involved in M&A mainly

include cash payments, equity payments, leverage payments, and mixed payments.

Different payment methods will produce different financial risks.

Risks of paying cash: It is the most convenient method of payment and it allows

acquirer to gain control over the target company with fastest speed, however the

increasing pressure on company’s cash flow will harm corporate liquidity and

meanwhile will slow the reaction ability of the enterprise to adapt to its external

environment. Furthermore, this mode of payment increases the enterprise’s debt

burden, and consequently produces the risk of debt and bankruptcy.

Risk of equity payment: In this mode of the payment acquirers share are dominant

and the deal is dependent on it. However acquirer’s share price is not fixed and it is

dependent on how market reacts with the news of new merger or acquisition so it may

go down and eventually the acquirer will have to settle the deal by overpaying for the

target company’s share value.

Risk of Preemption of Competing Bidder: This risk happens usually in case of hostile

acquisitions where the target company may decide to merge with or get acquired by a

favorable buyer. This can provoke a competing bid and the acquirer ultimately loss the

opportunity to acquire the target company.

Risk of Litigation by competitors: Sometimes competitors could claim that the result of

the possible merger would eliminate competition in various products and on basis of this

they might file a lawsuit against the merging companies. Merging companies have to deal

with the lawsuit which will ultimately cost money.

17

Financial Risk After M&A: Integration Risk:

Liquidity Risk: Liquidity risk refers to the possibility of payment difficulty due to heavy

debt burden after M&A. This may affect company’s ongoing projects and ultimately cash

flow. If the company is unable to pay its short term debts then eventually it will affect

company’s creditability and it will also affect the company’s image.

Operational risks: Operational risk refers to the financial risk resulting from the loss of

enterprise funds. The deviation of actual income from expected returns results from the

contradiction of the financial management system and the setting of the financial

institution, financial fault, or financial behavior.

Loosing of key customers: There is a possibility that a customer is not happy with the

newly integrated company and chooses to go with the company’s competitor for future

projects.

Loosing important personnel: There is a possibility that some important people are

unhappy with the new organization structure and that they feel uncertainty about their

future with the new company and eventually they may decide to leave the company.

Loosing important people will ultimately affect company’s business.

Technological Synergic risks: There is a risk that companies may fail to create

technological synergies for example both companies were using different IT systems for

their operations earlier and now they have to invest money for the integration of their

different IT systems. In some cases companies may have to invest in developing new

technology which will be suitable for both the companies.

Social Risks: There is a risk of the working culture differences between the two

companies. For example newly integrated product development team is working on new

product but both the teams have their own way of handling this kind of projects because

of which they fail to launch new product on time which will ultimately generate cost to

the company.

3.7 Risk management for M&A37

Pre-M&A

Confirming own competencies for potential M&A:

Management should first evaluate and analyze their own strengths and weaknesses

especially financial strengths rather than just focus on the strategic objectives.

Management can involve external M&A advisory firms and auditing firms in Pre-

M&A phase.

.

37 International Business Research, Vol 3,January 2010

18

Evaluating the real value of target company:

Main cause of valuation risk in evaluating the real value of the target company is

asymmetric information’s between the two companies. Before any M&A activity

company should do due diligence for the potential M&A. Management should

include institutions like investment banks that could evaluate potential outcome of the

M&A and reasonably predict the future profit for the combined company.

Between M&A Process

Adopting various financing & Payout methods:

Once the value of the target company is confirmed the acquirer should adapt various

financing and payout methods such as cash, equity financing and debt financing, in

this way the acquirer can reduce the financial risks by diversifying in financing &

payout for M&A.

Involvement of the insurance firm in M&A:

As precaution against the financial risks involved in M&A, companies should involve

insurance firms in M&A deals.

Post M&A

Establishing the financial alarm management system:

For the survival and development of the newly integrated company after M&A, the

new company could establish a financial alarm management system which will take

precautions against financial risks and potential financial crisis induced by the

financial management mistakes during the M&A activity and the financial process

fluctuation during integration. This financial alarm system could evaluate, predict,

pre-control and continually remedy bad financial development tendency.

3.8 Inference

Even though M&A activities are look like short cut for a company to increase

shareholder value they are very complex and there are lot of risks involved.

There are various motives behind M&A activities.

M&A activities are classified on the basis of the motives behind them.

Risk management plays an important role in M&A activity.

19

4 Case study on Actavis and Allergan

4.1 Introduction 38

Actavis: Actavis (formerly known as Actavis Limited) was incorporated in Ireland on May 16,

2013 as a private limited company and re-registered effective September 18, 2013 as a public

limited company.

Actavis is a leading integrated global specialty pharmaceutical company engaged in the

development, manufacturing, marketing, sale and distribution of generic, branded generic, brand

name, biosimilar and over-the-counter pharmaceutical products. Actavis also develops and out-

licenses generic pharmaceutical products primarily in Europe through its third-party business.

Actavis has operations in more than 60 countries throughout North America and the rest of

world, including Europe, Middle East, Africa, Australia, Asia Pacific and Latin America.

Exibit3: Selected Financial Data for Actavis

(Source: Merger Prospectus, 2014, Published on: January 26, 2015, Page no. 48)

38 Merger Prospectus, 2014,Published on January 26, 2015, Page-67

Operating Highlights as on 30 Sept 2014 (In million, except per share amount)

Net revenue

$ 9,005.4

Operating income

$638.1

Earnings per share

$4.39

Weighted average ordinary shares outstanding

204.4

Balance sheet Highlights as on 30 Sept 2014 (In million USD, except per share amount)

Current Assets

$6252.3

Total Assets $53,467.4

Total Debt $15,537.1

Total Equity $29,145.0

20

Allergan: Allergan was incorporated in Delaware in 1950. Allergan is known for its famous

anti-wrinkle drug BOTOX. Allergan is a multi-specialty health care company focused on

developing and commercializing innovative pharmaceuticals, biologics, medical devices and

over-the-counter products. Allergan discovers, develops and commercializes a diverse range of

products for the ophthalmic, neurological, medical aesthetics, medical dermatology, breast

aesthetics, and urological and other specialty markets in more than 100 countries around the

world.

Operating Highlights as on 30 Sept 2014 (In million, except per share amount)

Net revenue

$ 5,327.4

Operating income

$1,382.6

Earnings per share for Allergan Stockholders

$3.32

Weighted average ordinary shares outstanding

297.5

Balance sheet Highlights as on 30 Sept 2014 (In million)

Current Assets

$6103.8

Total Assets $11,645.8

Long term Debt, excluding current portion $2088.6

Total Equity $7110.7

Exibit4: Selected Financial Data for Allergan

(Source: Merger Prospectus, 2014,Published on: January 26, 2015,Page no. 51)

21

4.2 The Actavis-Allergan Merger39

40

We have mentioned in previous chapter about the hostile acquisition and the White Knight term

related to it. Actavis-Allergan merger case is good example to understand the concept.

Valeant made $180 a share acquisition offer to acquire Allergan. Allergan wanted to slip from

this hostile acquisition offer as Valeant was not the best suitor for Allergan. Allergan’s

management then approached Actavis with a merger proposal. Looking at the future growth

opportunities for both the companies Actavis agreed to the merger and offered a combination of

$129.22 in cash and 0.3683Actavis shares for each share of Allergan common stock, Valuing the

target $219 a share or $ 70.5 billion. That offer exceeded Valeant’s $180 a share takeover

proposal for Allergan and eventually Valiant stepped backed from its hostile takeover attempt.

Actavis played a role of ‘White Knight’ and rescued Allergan from Valeant’s long running

takeover attempt.

On 22 Jan 2015 Actavis made public announcement regarding the merger. The newly combined

company is known as Allergan and is listed at New York stock exchange under AGN. This

merger helped Allergan saving millions of dollar by shifting its corporate headquarter from the

US to Ireland where corporate tax is 17%. This cost saved through tax benefits will help newly

combined company to fund its R&D and produce new products in their R&D pipeline.

4.3 New business model 41

42

Every business has its own business model. To keep the market share and to be competitive in

market companies invests a lot in R&D for development of new product or innovation in

technology. Companies try to be innovative in technology and try to increase their market share

by launching new product every year and keep on growing their revenues to keep their investors

happy.

Many leading pharmaceutical companies feel pressure to cut costs as they approach their

expiring date for patents. Once a patent expires, other companies may begin producing generic

versions of the medicines which will considerably affect their price. According to Forbes the

study indicates that it costs $2.5 billion on average to bring a new drug to the market. New drug

has to go through long approval process from government agencies like FDA. These government

agencies have authority to discontinue the new drug and which affects pharma companies badly

as they have invested a lot of money in developing this new drug.

39 Jonathan D. Rockoff,The Wall Street Journal,Article dated 17/11/2015 40 Antonie Gara, Forbes,Article dated 17/11/2014 41 Amy Nordrum, International business Times,Article dated 27/7/2015 42

Jen Wieczner, Fortune,Article dated 28/07/2015

22

Now day’s pharmaceutical companies believe that acquisitions are the only way to keep their

revenues growing fast as investors expect. That’s why pharmaceutical companies are now

looking for merger and acquisitions instead of investing only in R&D.

In the first half of this year around 221 billion dollars were involved in pharmaceutical M&A

transactions. This M&A trend is also indicative of a new business model that has emerged within

the pharmaceutical industry. More often, major drug companies are leaving the research and

development up to smaller biotech firms and startups. Forbes describes it as a sort of pyramid,

with a handful of large drug manufacturers at the top purchasing the rights to make promising

drugs developed by many smaller companies.

By consolidating, pharmaceutical companies save on expenses and acquire companies which

have new products in their pipelines, which ensure them to have strong new drugs to bring to the

market and to compensate for their losses.

4.4 Evaluation of risks & Opportunities43

Exibit5: SWOT Analysis of newly combined company44

43 Actavis Client Report.pdf by Sontag Solutions

44 SWOT analysis derived from the Actavis 10K 2014

Strengths

More products in R&D pipeline

Enhanced Commercial Opportunities

across Global Markets.

Potential to create top 10 pharmaceutical

company with diverse product portfolio

Industry leading supply, Distribution

capabilities

Many drugs in FDA’s phase3 clinical trials

Weakness

Uncertainty in paying off debt

Low margins on generics

Opportunities

Merger with Pfizer

Synergies in distribution from

expanding their product portfolio

Expansion into Branded Pharmaceuticals

Threats

Failure to Integrate Acquisitions and

Dealing with the Explosive Growth

Medicine not making it through clinical

trials

Approval of competitor’s generic

pharmaceutical products that compete with

Actavis branded drugs.

Increasing Buyer (Wholesaler) Power

23

Risks for the newly combined company based on SWOT analysis.

Risk of integrating companies: The newly combined company has to integrate

its operations with new businesses while conducting their own day to day

activities. The other difficulties with the integration and which could delay this

process include: an inability to achieve synergies as planned, incompatibility of

corporate cultures, distracting management from day-today operations, costs and

delays in implementing system and procedures, and the difficulty of managing the

additional international locations of the company.

Risk of not getting approvals on new drugs: The newly combined company has

many new drugs at phase 2 and phase 3 of clinical trials which is crucial step for

them towards receiving FDA approval. Study shows that only less than 50 % of

new drugs pass through these clinical trials. Failure of these drugs to receive

approval will significantly affect company’s future sales.

Risk of not producing competitive revenues: The study shows that there is

growth in generics drugs this gives wholesaler’s ability of lowering prices on

purchases of generic drugs. This may affect company’s revenue through generic

drugs business as due to wholesaler’s pressure company keeps low profit margins

on generic drugs.

Risk of reduction in sale for branded drug business: The newly combined

company has large number of branded drugs in their portfolio. Branded products

comprise major percentage of total revenue. Generic equivalents for branded

pharmaceutical products are cheaper than the branded products. If competing

generic product has been introduced then it will affect sale of branded products.

This will ultimately lower the total revenue of the newly combined company.

Opportunities for newly combined company based on SWOT analysis.

Expansion into Branded Pharmaceuticals: Previously Actavis was known for

its generic pharmaceutical business. This merger has created a global brand

pharmaceutical business with leading positions in key therapeutic categories. The

new company has six blockbuster franchises with combined revenue of

approximately $ 15 billon expected.45

Possible Merger with Pfizer: Pfizer Inc. and Allergan Plc announced that their

board members have approved and companies have entered into a merger

agreement. And the deal is valued approximately $160 billion.45

45 Allergan Plc website

24

4.5 Recommendation

By looking at the risks and opportunities this new company has, we would like to give the

following recommendations:

The new company should focus on the successful integration of both, the companies and

their other subsidiaries.

Both management teams should work as an effective team and integrate same corporate

culture throughout all the organizations.

The new company should focus on getting their new products clear through FDA’s

clinical trials.

The new company should combine their separate teams of physicians to use their R&D

synergies more effectively.

The new company should focus on investing in R&D and its current drug pipeline while

setting a firm plan to integrate its recent acquisitions.

The new company should develop a strategy against increasing revenues in generic drug

business by overcoming wholesalers bargaining power.

The new company should focus on their firm strategy for successfully completing the

coming merger opportunity with Pfizer.

25

5 Bibliography

1. Bruner,Applied Mergers and Acquisitions,Wiley

2. A structured approach to Enterprise Risk Management and the requirements of ISO

31000

3. AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August 2010 4. Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-

Chapter1,Page 5,Para 2

5. World Economic Forum, ‘Global Risks 2014’ 9th

edition, Page 9

6. Investopedia viewed on 21/11/2015

7. Institute of Management Accountants. Enterprise risk management: Tools and

Techniques for effective implementation .2007,Page 5

8. Eshna,Financial Risks and its types, http://www.simplilearn.com/financial-risk-and-

types-rar131-article

9. Damodaran,Aswath, “Value and Risk: Beyond Betas” (Nov.2003),Page6

10. Ian Giddy, NYU Stern School of Business, ‘Managing Financial risks’ Page no.34-40

11. Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-

Chapter1,Page 5,Para 2

12. AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August

2010,Page 1

13. A structured approach to Enterprise Risk Management (ERM) and the requirements of

ISO 31000 Page No.9

14. Adam, Corporate finance-KW 2-3,Risk management, Page 18-23

15. ISO 30001: http://www.iso.org/iso/home/standards/iso31000.htm , Visited on 15/12/2015

16. Institute of Management Accountants. Enterprise risk management: Tools and

Techniques for effective implementation .2007,Page 7

17. Haupt,Denny, Strategy Marketing and HR management- ‘Analysis of industry-Part3’.pdf

, 24/11/2015,Page 145

18. ADAM, Corporate finance-KW 2-3,Risk management, Page 27-35

19. Institute of Management Accountants. Enterprise risk management: Tools and

Techniques for effective implementation .2007,Page 7

20. Damodaran,Aswath, “ACQUISITIONS AND TAKEOVERS” Page1-8

http://www.stern.nyu.edu/~adamodar/cfin2E/refs/online.htm

21. Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” ,

Edinburgh Business School, 2010,Page 2-4

22. International Journal of BRIC Business Research (IJBBR) Volume 3, Number 1,

February 2014

23. Hoang, Thuy Vu Nga- Lapumnuaypon, Kamolrat, “Critical Success Factors in Merger &

Acquisition Projects”-Page No.3

24. Damodaran,aswath, http://people.stern.nyu.edu

26

25. Brealeay/Myers/Markus Fundamentals of Corporate Finance, Page 588-591

26. Berk,DeMarzo Corporate finance, Page 934-937

27. Damodaran, http://people.stern.nyu.edu

28. Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” ,

Edinburgh Business School, 2010,Page 7-9

29. Referred for horizontal integration example,

http://www.referenceforbusiness.com/history2/56/GlaxoSmithKline-plc.html,Viewed on

12/12/2015

30. Referred for vertical integration example, Henry Ford, “My life & Work”

31. Referred for conglomerate example https://www.thyssenkrupp.com, Viewed on

12/12/2015

32. Bruner,Applied Mergers and Acquisitions,Wiley

33. Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” ,

Edinburgh Business School, 2010,Page 7-9

34. Bruner,Applied Mergers and Acquisitions,Wiley, Page no. 637-640

35. DENG, Analysis of Financial Risk Prevention in Mergers and Acquisitions, International

Business and Management, Vol. 9, No. 2, 2014, ISSN 1923-8428 [Online]

36. Damodaran,Aswath, “ACQUISITIONS AND TAKEOVERS” Page45-58

http://www.stern.nyu.edu/~adamodar/cfin2E/refs/online.htm

37. International Business Research, Vol 3,January 2010-www.ccsenet.org/ibr

38. Merger Prospectus, 2014,Published on January 26, 2015, Page-67

http://ir.allergan.com/phoenix.zhtml?c=65778&p=irol-allergan

39. Jonathan D. Rockoff,The Wall Street Journal,Article dated 17/11/2014

http://www.wsj.com/articles/actavis-agrees-to-buy-allergan-1416233901 Visited on

20/12/205.

40. Antonie Gara, Forbes,Article dated 17/11/2014,

http://www.forbes.com/sites/antoinegara/2014/11/17/allergan-agrees-to-219-a-share-

actavis-takeover-over-bill-ackman-backed-valeant-deal

41. Amy Nordrum, International business Times,Article dated 27/7/2015,

http://www.ibtimes.com/teva-allergan-acquisition-why-are-pharmaceutical-companies-

making-so-many-deals-right-2026053

42. Jen Wieczner, Fortune,Article dated 28/07/2015, http://fortune.com/2015/07/28/why-

pharma-mergers-are-booming

43. Actavis Client Report.pdf by Sontag Solutions

44. SWOT analysis derived from the Actavis 10K 2014

45. Allergan Plc website http://ir.allergan.com/phoenix.zhtml?c=65778&p=irol-

newsArticle&ID=2114596