“The phrase Mergers and Acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying and selling and combining of different companies that can aid, finance or help a growing company in a given industry grow rapidly without having to create another business entity”
The above sums up in a nutshell the concept of mergers and acquisitions. There are multiple reasons for companies to get into M&A activity whether to expand into a new market or geography, to gain market share in a current market, to overcome competition or for regulatory reasons as some governments make a tie up mandatory to operate in their local economy. However it is essential to mention that in the current economic scenario M&A has become an essential tool for companies to expand and grow, as successful M&A strategy can be a differentiating factor for successful organization.
The words and Mergers and Acquisitions are quite often used interchangeably in the current corporate world and hence can be seen in the project as well. Here is an attempt to list out some salient features which differentiate between the terms Mergers and Acquisitions.
A Merger can be descried as a combination of two companies into one larger company; such activities are normally voluntary in nature and involve a stock swap or cash payment to the target organization. Stock swaps allow the shareholders of both companies to share the risk involved in the deal. A merger normally results in a new company with a new brand and a new company name being created. Oxford Dictionary of Business defines mergers as “A combination of two or more businesses on an equal footing that results in the creation of a new reporting entity formed from the combining businesses. The shareholders of the combining entities mutually share the risks and rewards of the new entity and no one party to the merger obtains control over another.”
Acquisitions or takeover are different from Mergers. In the case of an acquisition a company unilaterally relinquishes its independence and adopts to the acquiring firms plans. As a legal point of view the target company ceases to exist as the buyer “swallows” the business.
Acquisitions have the following characteristics
- They are a part of a well-considered company development plan
- It is a unilateral process
- Top management structure will have fewer problems
- Contractual regulations are simpler
- Time taken for an acquisition is normally shorter than a merger.
However it is essential to mention here that whether a purchase is to be considered as merger or an acquisition actually depends on the whether the purchase is friendly or hostile or in the manner it is announced. The real difference hence lies in the way it is communicated and the way it is received by the shareholders, directors and employees of the target company.
History of M&A
Mergers and Acquisition movements were normally defined and associated with the behavior of US organizations. Various authors have tried to classify the merger movements into wave. The most prominent was Weston who in 1953 described three major periods of merger movements while studying the US business behavior.
Merger waves are a very generic way to describe the predominant strategy that was being adopted by organizations in that era. This has been interpreted by the different authors in different ways depending on how they have perceived by them. However it would be wrong to consider that all organizations followed the same strategy as described in the various.
The start or the first wave of the Merger movement is said to be have been post the Sherman Act in 1890. Prior to 1890 there was a predominance of the polypoly market structure, this was reduced post 1890 and partial monopolies started increasing.
The economic history has been divided into Merger Waves based on the merger activities in the business world as:
|1889 – 1904||First Wave||Horizontal mergers|
|1916 – 1929||Second Wave||Vertical mergers|
|1965 – 1989||Third Wave||Diversified conglomerate mergers|
|1992 – 1998||Fourth Wave||Hostile takeovers; Corporate Raiding|
|2000 –||Fifth Wave||Cross-border mergers|
The Great Merger Movement was primarily a US business phenomenon from 1895 to 1905. It is said that during this time 1800 of small firms disappeared into consolidations with similar firms to form large, powerful institutions that dominated their markets. The relaxation of corporate laws in the United States helped the mergers, transportation and communication networks were developed which helped achieved economies of size.
The second wave (1916 to 1929) saw even greater activity in mergers. The motive behind these mergers was vertical integrations. Organizations tried to achieve technical gains and to avoid their dependence on other firms for raw materials.
The third wave saw the large conglomerates looking at diversification in the 60’s. the process actually reached its zenith during the merge wave and was carried to its logical extreme by the conglomerate firms that rose to prominence during that time.
The fourth wave in 90s saw increase in hostile takeovers and corporate raiding by the large firms. This was a wave during which vulnerable companies were grabbed up by the larger firms.
The fifth wave has been categorized as starting from the year 2000 onwards and has seen a trend of increase in Cross border acquisitions. The rise of globalization has seen increased the market for cross border M&A. This rapid increase has taken many M&A firms by surprise as most of them never used to consider this due to the complexity involved in cross border M&A. The success of these acquisitions was also limited and we saw a vast majority of them failing. Even then in 1997 alone there were over 2300 cross border acquisition worth a total of approximately $298 Million.
Source: Boston Consulting Group Research Report “ The Brave New World of M&A-How to Create value from M&A”, July 2007
Types of Mergers and Acquisitions
There are various types of mergers and acquisitions depending on the type of the business structure. The classification can be based on the type of companies merging or by the way the M&A deal is being financed.
Here is some type of mergers on the basis of the relationship between the two companies that are merging:
- Horizontal Merger- This type or a merger is between two companies that share the same product line and markets and are in direct competition with each other
- Vertical Merger – This is between a customer and company of between a supplier and a company
- Market Extension Merger – This between two companies that sell the same products in different geographies or markets
- Product Extension Merger – This is between two companies that are selling different but related products in the same market.
- Circular Merger – A circular merger is very similar to a product extension merger however in this case the products being sold are completely unrelated. The merger brings in benefits by utilizing the same channels for marketing these unrelated products, allowing shared dealerships. An example of this kind of a merger is of McLeod Russel (A Team company) with Eveready Industries ( A batteries company) in 1997. McLeod Russel however was de-merged from Eveready in 2005.
- Conglomeration – This type of a merger is between two companies that have no common business areas.
Mergers can also be classified depending on how the merger is being financed as described below
- Purchase Mergers – This kind of a merger occurs when a company purchases another. The purchase is made through cash or through the issue of a debt instrument.
- Consolidation Mergers – In this type of a merger a new company is formed and both the companies are bought and combined under the new entity.
Type of acquisitions can be described as below
- Amalgamation – In this type of an acquisition a new corporation is created by uniting the companies voluntarily.
- Acquisition/Takeover – In this form one company acquires another companies total or controlling interest. The acquired company either operates as a subsidiary or can be liquidated completely.
- Sale of Assets – A company can sell off all its assets to another and cease to exist.
- Holding Company Acquisition – This involves the acquisition of either the total or majority of a firm’s stock by a company. The purpose of this form is mainly to gain management control of other companies
- Reverse Merger – In this form of an acquisition a private company with strong prospects buys a publicly listed shell company, usually one with no business or limited assets. This helps the private company to get publicly listed in a short span of time.
All mergers though have one common goal and that is to create a synergy between two companies which makes the value of the combined companies to be greater than the sum of the two companies
M&A process can be laid down in 3 basic phases
First Phase – Start with an Offer
The acquiring firm once decides that they want to do a merger of acquisition, they start with an offer. The acquiring company starts working with financial advisors and investment bankers to initiate contact with the target company. The acquiring must have a strategy for a merger programme, formulated by company management and approved by the director and majority stockholders. The acquiring company also at this point does a soft due diligence with the help of publicly available data and financial advisors. The purpose of this is to arrive at an overall price that the acquiring company is willing to pay for its target in cash, shares or both.
Second Phase – Target’s Response
Once the offer has been made the target company can do one of several things mentioned below
- Accept the offer – If the target companies top management and shareholders are happy with the offer they can simply accept the offer and go ahead with the deal.
Attempt to Negotiate –
If the target company management and shareholders are not satisfied with the offer they might try and work out more agreeable terms with the acquiring company. Since a lot is stake for the management of the target i.e. their jobs in particular, they might want to work out better deal to keep their jobs or leave with a big compensations package. Target companies which are highly sought after with multiple bidders would obviously have a better chance of negotiating a sweeter deal. Even manager who are crucial to the operation of an organization have a better chance of success into negotiating a good deal for them.
Execute a Poison Pill or similar Hostile Takeover Defense –
A poison pill can be initiated by a target company if it observers a potential hostile suitor acquiring a predetermined percentage of Target company stock. To execute its defense, the target company grants all shareholders – except the acquiring company – options to buy additional stock at a dramatic discount. This dilutes the acquiring company’s share and thwarts the potential hostile takeover attempt.
· Find a White Knight –
In this alternative a target company seeks out a friendlier company as a potential acquiring company. The friendlier company would offer an equal or higher price with better terms as compared to a hostile takeover bid.
Third Phase or Closing the Deal
Once the target company accepts the offer and all the regulatory requirements are met then the deal would be executed. The acquiring company will them pay for the target companies shares with cash, stock or both.
A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. When a company is purchased with stock, new shares from the acquiring company’sstock are issued directly to the target company’s shareholders, or the new shares are sent to a broker who manages them for target company shareholders
Concept of Growth
Growth in firms can be looked at by two broad views: organic growth, or inorganic growth. Organic growth is achieved through mainly internal expansion while inorganic growth is achieved through external expansion, i.e. through consolidations, acquisitions and mergers.
Growth is something for which most companies, large or small, strive. Small firms want to get big, big firms want to get bigger. As observed by Philip B. Crosby, author of The Eternally Successful Organization, “if for no other reason than to accommodate the increased expenses that develop over the years. Inflation also raises the cost of everything, and retaliatory price increases are not always possible. Salaries rise as employees gain seniority. The costs of benefits rise because of their very structure, and it is difficult to take any back, particularly if the enterprise is profitable. Therefore cost eliminations and profit improvement must be conducted on a continuing basis, and the revenues of the organization must continue to increase in order to broaden the base.”
Most firms, of course, desire growth in order to prosper, not just to survive. Organizational growth, however, means different things to different organizations. Indeed, there are many parameters a company can select to measure its growth. The most meaningful yardstick is one that shows progress with respect to an organization’s stated goals. The ultimate goal of most companies is profit, so net profit, revenue, and other financial data are often utilized as “bottom-line” indications of growth. Other business owners, meanwhile, may use sales figures, number of employees, physical expansion, or other criteria to judge organizational growth. Companies which are run by a product minded entrepreneur are more concerned with the growth and profitability of a firm as an organization for the production of goods and services. While companies run by empire builders type of entrepreneurs are continuously looking at expanding the scope of the enterprise. Empire builders are not satisfied are not satisfied with product improvement or maintaining competitive edge
In terms of access to finance there are broadly five growth stages in a company’s lifespan: inception, organic growth, purchased, IPO and Beyond IPO as shown in the figure below. Each stage has its own characteristics, risks and potential financial sources.
Organic Growth without M&A
In Organic growth, growth depends on the ability to avail the available opportunities and existing resources in a more efficient way. The extent of growth of a firm is actually determined by the ability of managers, product or market factors. There is no limit to the absolute size of the firm keeping in mind the assumption that there is no fixity of capital, labor and management and the firm is capable of acquiring these resources at a price. In addition it is also assumed that there are opportunities in the economy for investments.
The economies available within the firm (such as excess productive resources or managerial capabilities) disappear after the expansion is completed as they get utilized in a new activity. This means that it is only an “entry advantage”. However the firm may have these advantages in its new operations, often set up as new subsidiaries or divisions, which may grow in response to the economies in the same manner as the rest of the firm. New operations may later be spun off from the original firm without any loss of efficiency. Further, both the original and the spun off firms will have some unused productive resources which can then be used to develop new activities
Inorganic growth through M&A
The inorganic growth strategy is dependent on M&A. The idea of acquisition is that it accelerates the business model, giving it greater impetus than organic growth. Because acquisition gives the business what it cannot get quickly or incrementally. It may be a joint venture – an agreement that gives both parties something they want that the other has. Acquisition targets can include both complementary and competitive businesses – complementary when the target can give something an acquirer needs or competitive when the target can stop someone else having what the acquirer wants.
The risks in growth through acquisitions are significant, but they can be contained through planning and due diligence. The primary risk is integration: post the acquisition is completed the new arrangements have to work and people who were not party to the negotiation have to work together. The same goes for systems and expectations as different business would have grown in different ways. A consistent culture is laudable but a wholly consistent culture will be impossible. Add regional diversity to this and the risk would become even higher.
Motivations for M&A
Mergers and acquisitions can be motivated by either the share-holder wealth maximizing approach or the widening share ownership. The primary objectives of M&A activities are diversifications, market expansion, improving competitive position and depression immunity. Given these basic objectives a different rationale can be assigned – at both individual and collective levels.
From the standpoint of shareholders
Investment made by shareholders in the companies subject to merger should enhance in value. The sale of shares from one company’s shareholders to another and holding investment in shares should give rise to greater values i.e. the opportunity gains in alternative investments. Shareholders may gain from merger in different ways viz. from the gains and achievements of the company i.e. through
- Realization of monopoly profits;
- Economies of scales;
- Diversification of product line;
- Acquisition of human assets and other resources not available otherwise;
- Better investment opportunity in combinations.
One or more features would generally be available in each merger where shareholders may have attraction and favor merger.
From the standpoint of managers
Managers are concerned with improving operations of the company, managing the affairs of the company effectively for all round gains and growth of the company which will provide them better deals in raising their status, perks and fringe benefits. Mergers where all these things are the guaranteed outcome get support from the managers. At the same time, where managers have fear of displacement at the hands of new management in amalgamated company and also resultant depreciation from the merger then support from them becomes difficult.
Mergers do offer to company promoters the advantage of increasing the size of their company and the financial structure and strength. They can convert a closely held and private limited company into a public company without contributing much wealth and without losing control.
Benefits to general public
Impact of mergers on general public could be viewed as aspect of benefits and costs to:
- Consumer of the product or services;
- Workers of the companies under combination;
General public affected in general having not been user or consumer or the worker in the companies under merger plan.
VALUATION OF TARGET COMPANIES
Valuation of target companies is an essential step in the M&A process.
Due Diligence of a company; answers the question of whether a deal is being done at the right time at the right price for the right reasons. It involves an investigation into the affairs of an entity and results in the production of a report detailing relevant data and points. The investigation is performed prior to the business’s acquisition, flotation, restructuring or other transactions
Due Diligence is performed by many advisors on the team. For example there may be a separate legal due diligence, financial due diligence, tax due diligence, environmental due diligence, commercial due diligence, and information technology due diligence. Financial due diligence is a vital part of the M&A process. Often a problem in the financial due diligence raises point to be dealt by other areas as well, for example a financial due diligence may uncover an unusual lease obligation which then feeds into the legal due diligence.
What a due diligence involves
Each M&A transaction is unique in its own sense hence the scope and extent of a due diligence process needs to be tailored to fit the needs of the buyer. However broadly it should cover the following aspects:
- The history and commercial activities of the business
- The organizational structure and employees
- Employee benefits and labor matters
- Its accounting policies
- The information systems
- A detailed review of financial statements
- A review of the financial projections
- Anything else the team may uncover that is relevant for the transaction
Methods of Valuation
The valuation of a target company normally depends on a lot of factors, it is not sufficient to evaluate the financial aspect alone. This is possible through a valuation of the 5 Ps which are:
- Personnel - senior management of the target company play an important role in an acquisition. The acquiring firm considers the motivation, energy and intelligence levels of the existing personnel before taking them on.
- Product – Proprietary products of a Target company increase the value of the company.
- Plant – The plant capacity and condition of equipments also affect the valuation of a company.
- Potential – The potential of a firms growth as compared to the industry is also a factor in its valuation
- Profit – The declared profits of the firm is the basis of determining price.
It is normally considered easier to evaluate public limited since most of the above data is publicly available in their annually published reports. In the case of a Private company it is a little more challenging to get the same information and the Acquiring company has to depend on a proper due diligence process to complete its valuation.
Financial valuation should answer the simple, but vital, question “What is something worth?” The analysis of target is hence based on either current projections or of the future. The process of valuations differ substantially for a listed and unlisted companies
Many types of valuation metrics are used, involving several sets of metrics. On of the most common is the standard P/E ration (Price to earnings ratio) however some of the other metrics include assets value, capitalized earnings, market value, investment value, book value, costs basis valuation, enterprise value and some combined methods as well.
P/E Ratio and Market Price – For an unlisted company the P/E ratio of a comparable listed company is referred to and discounted based on the voting rights in the company. For listed companies the modes of valuation can be based on either earnings or assets. The market price of shares reflects the earnings per share (EPS).
P/E ratio Calculated as:
The P/E ratio is the current price of shares divided by the EPS. The higher the P/E ratio the higher are the future earnings expectation The P/E multiple is calculated as the multiple of net profit used to compute the company’s purchase price. For example, an investor attempting to recover his initial investment in 10 years would have to earn an after-tax return of 10% on investment, plus adjustment for discounted cash flow and inflation. Discounted Cash Flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value.
DCF is calculated as:
- Assets Value – Tangible assets, such as land and buildings, and intangible assets are assessed as per existing business practices. Goodwill is based on the company’s excess earning power for certain number of years. The asset basis valuation is either on the fair value or the open market value. The dividend approach and the super profit approach can also be used for asset valuation. In the dividend, the present share prices are taken as the values of future dividends. While the super profit approach expects to get more value for a firm in addition to the value of the net assets.
- Capitalized Earnings – This method is based on the rate of return on the capital employed
- Market Value – This is on the basis of quoted share values at the stock exchange.
- Investment Value – This is the cost of establishing an enterprise such as the target company and the interest on the same.
- Book Value – This is the secondary factor in valuations and takes into account the total worth of the assets after depreciation. If the P/E multiplier is less than the book value then the book value has to be adjusted to reflect the true value. It takes into account the present net value of the real estate, machinery and equipment. Sometimes the book value may be understated in times of inflation and overstated during depression.
- Cost Basis Valuation – This is cost minus depreciation. Intangible assets are not taken into account.
- Reproduction Cost – This is the current cost of replacement of properties with similar design and material.
- Substitution Cost – Substitution cost is the cost of construction of the same utility and capacity.
- Enterprise Value – The valuation of a company is based on the Enterprise Value (EV) and its ratio to the company’s sales and operating profit (PBIDT – Profit before interest, depreciation and tax). Enterprise Value is calculated as:
- A = Market Capitalization of Stock + Total Debt on Company’s books
- B = Investments + Cash
- EV = (B – A)
The method accounting also has a significant impact on the valuation and price the seller will receive. The acquiring firm can use two principal accounting methods for valuations, they can either use the pooling of interests method or the purchase method. The main difference between them is the value that the combined firm’s balance sheet places on the assets of the acquired firm, as well as the depreciation allowances and charges against income following the merger.
Pooling of Interests Method –
The pooling of interests method assumes that the transaction is simply an exchange of equity securities. Therefore, the capital stock account of the target firm is eliminated, and the acquirer issues new stock to replace it. The two firms’ assets and liabilities are combined at their historical book values as of the acquisition date. The end result of a pooling of interests transaction is that the total assets of the combined firm are equal to the sum of the assets of the individual firms. No goodwill is generated, and there are no charges against earnings. A tax-free acquisition would normally be reported as a pooling of interests.
Purchase Method –
In this method, assets and liabilities are shown on the merged firm’s books at their market (not book) values as of the acquisition date. This method is based on the idea that the resulting values should reflect the market values established during the bargaining process. The total liabilities of the combined firm equal the sum of the two firms’ individual liabilities. The equity of the acquiring firm is increased by the amount of the purchase price.
Mark Up Pricing/ Premium
Markup pricing or premium is the percentage difference between the trading price of the target companies stock before the announcement of acquisition and the price per share paid by the acquiring firm. Bidding firms pay large premiums to acquire control of exchange-listed target firms. Normally premiums include pre-bid run up in the target firm’s stock price as part of the control premium paid by the winning bidders. The valuations by the bidder and the target depend on the information each party has at the time of the negotiation.
Mark Up or premium is partly decided on the basis of the relationship pattern of the acquiring firm. The pattern in some cases is that if interlocking directorship among firms. Most firms have stable and long standing relationships with professionals such as attorneys, investment bankers and accountants. These are likely to have similar effects as to interlock directorships. Managers take advice from both their interlock partners and professional firms when deciding how much to pay.
Financing an M&A
Organizations use various methods for financing an M&A deal. Often combinations of the below mentioned methods:
Cash payments. These are normally preferred since the organization does not have to dilute equity and there will be no change in the number of shares outstanding. Also cash transactions save time and cash can be re-invested at the face value.
Financing capital may be borrowed from banks or raised from issue of bonds. Acquisitions that are financed through debt are called as leveraged buyouts if they take the target private, and the debt will often be moved down into the balance sheet of the acquired company.
An acquisition can involve a combination of cash and debt or of cash and stock of the purchasing entity.
POST ACQUISITION INTEGRATION
After the acquisition is completed, the acquired company needs to be integrated with the acquiring company. The process of integration actually needs to be planned during the acquisition itself to ensure that the company integrates smoothly. The success of integration also depends on the managers who are responsible for the implementation.
The acquiring company needs to plan the post acquisition integration period. IN the initial period the target company is more receptive to drastic changes to make the company viable. Some of the basic approaches are as follows
- Adapting a program – This should be completely aligned with the companies goals and objectives of the company and should also take into account the limitations of the company.
- Effective organization and leadership structure – The integration process involves creating a group which focuses on creating value through specific activities and actions. A true partnership would mean involving the senior leadership of the acquired company as well in this strategic group.
- Minimize post acquisition exodus of critical resources – It is critical to have a preventing plan in place to minimize the damage that maybe caused to the new enterprise. Any loss of critical things like market standing, key employees, brand has to be avoided.