Mergers and acquisitions
(M&A) and corporate restructuring are a big part of the corporate
finance world. Every day, Wall Street investment bankers arrange M&A
transactions, which bring separate companies together to form larger
ones. When they're not creating big companies from smaller ones,
corporate finance deals do the reverse and break up companies through
spinoffs,
carve-outs or
tracking stocks.
Not
surprisingly, these actions often make the news. Deals can be worth
hundreds of millions, or even billions, of dollars. They can dictate the
fortunes of the companies involved for years to come. For a
CEO,
leading an M&A can represent the highlight of a whole career. And
it is no wonder we hear about so many of these transactions; they happen
all the time. Next time you flip open the newspaper’s business section,
odds are good that at least one headline will announce some kind of
M&A transaction.
Sure, M&A deals grab headlines, but what does this all mean to
investors? To answer this question, this tutorial discusses the forces
that drive companies to buy or merge with others, or to split-off or
sell parts of their own businesses. Once you know the different ways in
which these deals are executed, you'll have a better idea of whether you
should cheer or weep when a company you own buys another company - or
is bought by one. You will also be aware of the tax consequences for
companies and for investors.
One plus one makes three: this equation is the special alchemy of a
merger or an
acquisition.
The key principle behind buying a company is to create shareholder
value over and above that of the sum of the two companies. Two companies
together are more valuable than two separate companies - at least,
that's the reasoning behind M&A.
This rationale is
particularly alluring to companies when times are tough. Strong
companies will act to buy other companies to create a more competitive,
cost-efficient company. The companies will come together hoping to gain a
greater market share or to achieve greater efficiency. Because of these
potential benefits, target companies will often agree to be purchased
when they know they cannot survive alone.
Distinction between Mergers and Acquisitions Although
they are often uttered in the same breath and used as though they were
synonymous, the terms merger and acquisition mean slightly different
things.
When one company takes over another and clearly established itself
as the new owner, the purchase is called an acquisition. From a legal
point of view, the
target company ceases to exist, the buyer "swallows" the business and the buyer's stock continues to be traded.
In
the pure sense of the term, a merger happens when two firms, often of
about the same size, agree to go forward as a single new company rather
than remain separately owned and operated. This kind of action is more
precisely referred to as a "merger of equals." Both companies' stocks
are surrendered and new company stock is issued in its place. For
example, both Daimler-Benz and Chrysler ceased to exist when the two
firms merged, and a new company, DaimlerChrysler, was created.
In
practice, however, actual mergers of equals don't happen very often.
Usually, one company will buy another and, as part of the deal's terms,
simply allow the acquired firm to proclaim that the action is a merger
of equals, even if it's technically an acquisition. Being bought out
often carries negative connotations, therefore, by describing the deal
as a merger, deal makers and top managers try to make the takeover more
palatable.
A purchase deal will also be called a merger when both
CEOs
agree that joining together is in the best interest of both of their
companies. But when the deal is unfriendly - that is, when the target
company does not want to be purchased - it is always regarded as an
acquisition.
Whether a purchase is considered a merger or an acquisition really
depends on whether the purchase is friendly or hostile and how it is
announced. In other words, the real difference lies in how the purchase
is communicated to and received by the target company's
board of directors, employees and
shareholders.
Synergy Synergy
is the magic force that allows for enhanced cost efficiencies of the
new business. Synergy takes the form of revenue enhancement and cost
savings. By merging, the companies hope to benefit from the following:
- Staff reductions - As every employee knows, mergers tend to mean job
losses. Consider all the money saved from reducing the number of staff
members from accounting, marketing and other departments. Job cuts will
also include the former CEO, who typically leaves with a compensation
package.
- Economies of scale
- Yes, size matters. Whether it's purchasing stationery or a new
corporate IT system, a bigger company placing the orders can save more
on costs. Mergers also translate into improved purchasing power to buy
equipment or office supplies - when placing larger orders, companies
have a greater ability to negotiate prices with their suppliers.
- Acquiring
new technology - To stay competitive, companies need to stay on top of
technological developments and their business applications. By buying a
smaller company with unique technologies, a large company can maintain
or develop a competitive edge.
- Improved market reach and
industry visibility - Companies buy companies to reach new markets and
grow revenues and earnings. A merge may expand two companies' marketing
and distribution, giving them new sales opportunities. A merger can also
improve a company's standing in the investment community: bigger firms
often have an easier time raising capital than smaller ones.
That
said, achieving synergy is easier said than done - it is not
automatically realized once two companies merge. Sure, there ought to be
economies of scale when two businesses are combined, but sometimes a
merger does just the opposite. In many cases, one and one add up to less
than two.
Sadly, synergy opportunities may exist only in the
minds of the corporate leaders and the deal makers. Where there is no
value to be created, the CEO and investment bankers - who have much to
gain from a successful M&A deal - will try to create an image of
enhanced value. The market, however, eventually sees through this and
penalizes the company by assigning it a
discounted share price. We'll talk more about why M&A may fail in a later section of this tutorial.
Varieties of Mergers From
the perspective of business structures, there is a whole host of
different mergers. Here are a few types, distinguished by the
relationship between the two companies that are merging:
- Horizontal merger - Two companies that are in direct competition and share the same product lines and markets.
- Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
- Market-extension merger - Two companies that sell the same products in different markets.
- Product-extension merger - Two companies selling different but related products in the same market.
- Conglomeration - Two companies that have no common business areas.
There
are two types of mergers that are distinguished by how the merger is
financed. Each has certain implications for the companies involved and
for investors:
- Purchase Mergers - As the name suggests, this kind of merger occurs
when one company purchases another. The purchase is made with cash or
through the issue of some kind of debt instrument; the sale is taxable.
Acquiring
companies often prefer this type of merger because it can provide them
with a tax benefit. Acquired assets can be written-up to the actual
purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.
- Consolidation
Mergers - With this merger, a brand new company is formed and both
companies are bought and combined under the new entity. The tax terms
are the same as those of a purchase merger.
Acquisitions As
you can see, an acquisition may be only slightly different from a
merger. In fact, it may be different in name only. Like mergers,
acquisitions are actions through which companies seek economies of
scale, efficiencies and enhanced market visibility. Unlike all mergers,
all acquisitions involve one firm purchasing another - there is no
exchange of stock or
consolidation
as a new company. Acquisitions are often congenial, and all parties
feel satisfied with the deal. Other times, acquisitions are more
hostile.
In an acquisition, as in some of the merger deals we
discuss above, a company can buy another company with cash, stock or a
combination of the two. Another possibility, which is common in smaller
deals, is for one company to acquire all the assets of another company.
Company X buys all of Company Y's assets for cash, which means that
Company Y will have only cash (and debt, if they had debt before). Of
course, Company Y becomes merely a shell and will eventually
liquidate or enter another area of business.
Another type of acquisition is a
reverse merger, a deal that enables a
private company
to get publicly-listed in a relatively short time period. A reverse
merger occurs when a private company that has strong prospects and is
eager to raise financing buys a publicly-listed shell company, usually
one with no business and limited assets. The private company reverse
merges into the
public company, and together they become an entirely new public corporation with tradable shares.
Regardless
of their category or structure, all mergers and acquisitions have one
common goal: they are all meant to create synergy that makes the value
of the combined companies greater than the sum of the two parts. The
success of a merger or acquisition depends on whether this synergy is
achieved.
Investors in a company that are aiming
to take over another one must determine whether the purchase will be
beneficial to them. In order to do so, they must ask themselves how much
the company being acquired is really worth.
Naturally, both sides of an
M&A
deal will have different ideas about the worth of a target company: its
seller will tend to value the company at as high of a price as
possible, while the buyer will try to get the lowest price that he can.
There
are, however, many legitimate ways to value companies. The most common
method is to look at comparable companies in an industry, but deal
makers employ a variety of other methods and tools when assessing a
target company. Here are just a few of them:
- Comparative Ratios - The following are two examples of the many
comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio
(P/E Ratio) - With the use of this ratio, an acquiring company makes an
offer that is a multiple of the earnings of the target company. Looking
at the P/E for all the stocks within the same industry group will give
the acquiring company good guidance for what the target's P/E multiple
should be.
- Enterprise-Value-to-Sales Ratio
(EV/Sales) - With this ratio, the acquiring company makes an offer as a
multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
- Replacement Cost
- In a few cases, acquisitions are based on the cost of replacing the
target company. For simplicity's sake, suppose the value of a company is
simply the sum of all its equipment and staffing costs. The acquiring
company can literally order the target to sell at that price, or it will
create a competitor for the same cost. Naturally, it takes a long time
to assemble good management, acquire property and get the right
equipment. This method of establishing a price certainly wouldn't make
much sense in a service industry where the key assets - people and ideas
- are hard to value and develop.
- Discounted Cash Flow (DCF) -
A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value according to its estimated future
cash flows. Forecasted free cash flows (net income +
depreciation/amortization - capital expenditures - change in working
capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial
premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of
synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.
Let's face it, it would be highly unlikely for rational owners to sell
if they would benefit more by not selling. That means buyers will need
to pay a premium if they hope to acquire the company, regardless of what
pre-merger valuation tells them. For sellers, that premium represents
their company's future prospects. For buyers, the premium represents
part of the post-merger synergy they expect can be achieved. The
following equation offers a good way to think about synergy and how to
determine whether a deal makes sense. The equation solves for the
minimum required synergy:
In
other words, the success of a merger is measured by whether the value
of the buyer is enhanced by the action. However, the practical
constraints of mergers, which we discuss in part five, often prevent the
expected benefits from being fully achieved. Alas, the synergy promised
by deal makers might just fall short.
What to Look For It's
hard for investors to know when a deal is worthwhile. The burden of
proof should fall on the acquiring company. To find mergers that have a
chance of success, investors should start by looking for some of these
simple criteria:
- A reasonable purchase price - A premium of, say, 10% above the
market price seems within the bounds of level-headedness. A premium of
50%, on the other hand, requires synergy of stellar proportions for the
deal to make sense. Stay away from companies that participate in such
contests.
- Cash transactions - Companies that pay in cash tend to be
more careful when calculating bids and valuations come closer to target.
When stock is used as the currency for acquisition, discipline can go
by the wayside.
- Sensible appetite – An acquiring company should be
targeting a company that is smaller and in businesses that the acquiring
company knows intimately. Synergy is hard to create from companies in
disparate business areas. Sadly, companies have a bad habit of biting
off more than they can chew in mergers.
Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.
