Mergers & Acquisitions: An Introduction

Prof. Ian Giddy. New York University

INTRODUCTION

This is an introduction to the subject of mergers, acquisitions, buyouts and divestitures as covered in my Mergers & Acquisitions course. The purpose is to delineate how and why a merger decision should be made. The course focuses on mergers and acquisitions in the context of private as well as publicly traded companies. Acquisitions of private companies account for the majority of transactions. To properly assess a potential merger we need to perform fundamental strategic and financial analysis, but remain aware of the idiosyncrasies that each potential merger contains.

A merger is a pivotal event for the companies involved. Both parties hope to benefit from the greater efficiency and competitive strength found in the combined company. Strategies are altered and as a result product lines are broadened, strengthened, or refocused; management systems and personnel are changed; and levels and growth rates of profits are shifted. In many instances, however, one side or the other (or both) lose substantial sums of money. Merger costs, including the direct costs of attorneys, accountants, investment bankers, and consultants, are substantial even though they are not a large percentage of the value of the merger. There is also substantial cost in terms of time required by key employees to evaluate, complete, and implement the merger. Perhaps half of all mergers and acquisitions fail or do not achieve the desired results. Many mergers fail because projected synergies do not materialize, often due to human obstacles. If a merger is not well received by the employees of the new entity, then its chances of success are greatly diminished. It is critical that the parties involved in a merger become skilled in managing change. Sometimes acquisitions fail for the acquiring company simply because it pays too much for the acquired company. An understanding of pre- and post-merger valuation analysis is required to avoid this pitfall.

Because an entire company is acquired in a merger, determining the advisability of a potential merger requires a much broader analysis of the factors involved than most other areas of financial management. In addition to the usual tax, legal, cash flow, and cash outlay considerations, competitive positions and strategies are important.

The occurrence of a merger often raises concerns in antitrust circles. Devices such as the Herfindahl index can analyze the impact of a merger on a market and what, if any, action could prevent it. Regulatory bodies such as the European Commission and the United States Department of Justice may investigate anti-trust cases for monopolies dangers, and have the power to block mergers.

The remainder of this article will discuss several topics important to understanding the basic nature of and issues surrounding mergers and acquisitions. These include methods of business combinations, motives for mergers and acquisitions, accounting for mergers, and before-and-after financial analysis.

METHODS OF BUSINESS COMBINATION

There are several methods for achieving a business combination. It is useful to have an understanding of these different methods. Hereafter, the term acquisitions will be used to refer to any type of business combination.

Acquisition

An acquisition usually refers to the purchase of the assets of a company. However, in the remainder of this course, the term will be used in a much broader sense to indicate the purchase of shares, assets, or companies in the merger process. Thus, the narrow, distinct meaning of the term will not be used.

An acquisition can take the form of a purchase of the stock or other equity interests of the target entity, or the acquisition of all or a substantial amount of its assets.

• Share purchases — in a share purchase the buyer buys the shares of the target company from the shareholders of the target company. The buyer will take on the company with all its assets and liabilities.
• Asset purchases — in an asset purchase the buyer buys the assets of the target company from the target company. In simplest form this leaves the target company as an empty shell, and the cash it receives from the acquisition is then paid back to its shareholders by dividend or through liquidation. However, one of the advantages of an asset purchase for the buyer is that it can cherry-pick the assets that it wants and leave the assets — and liabilities — that it does not.

Merger

In a merger, two separate companies combine and only one of them survives. In other words, the merged (acquired) company goes out of existence, leaving its assets and liabilities to the acquiring company. Usually when two companies of significantly different sizes merge, the smaller company will merge into the larger one, leaving the larger company intact.

Consolidation

A consolidation is a combination of two or more companies in which an entirely new corporation is formed and all merging companies cease to exist. Shares of the new company are exchanged for shares of the merging ones. Two similarly sized companies usually consolidate rather than merge. Although the distinction between merger and consolidation is important, the terms are often used interchangeably, with either used to refer generally to a joining of the assets and liabilities of two companies.

Leveraged Buyout

A leveraged buyout (LBO) is a type of acquisition that occurs when a group of investors, sometimes led by the management of a company (management buyout or MBO), borrows funds to purchase the company. The assets and future earnings of the company are used to secure the financing required to purchase the company. Sometimes employees are allowed to participate through an employee stock ownership plan, which may provide tax advantages and improve employee productivity by giving employees an equity stake in the company.

Holding Company

A holding company is a company that owns sufficient voting stock to have a controlling interest in one or more companies called subsidiaries. Effective working control or substantial influence can be gained through ownership of as little as 5 percent to as much as 51 percent of the outstanding shares, depending on how widely the shares are distributed. A holding company that engages in the management of the subsidiaries is called a parent company.

Divestitures

While divestitures do not represent a business combination, they are a means of facilitating the acquisition of part of a company. Sometimes divestitures are used by companies as a means to improve earnings and shareholder value, or as a means of raising capital. A divestiture involves the sale of a portion of a company. Two popular means of divestiture are spin-offs and equity carve-outs.

In a spin-off, a company distributes all of its shares in a subsidiary to the company’s shareholders as a tax-free exchange. The reorganization of AT&T is an example of a spin-off. AT&T was reorganized into three separate publicly traded corporations, and a fourth business was sold. What remained was AT&T, comprised of long distance and wireless phone businesses, a credit card business, and two other companies that were formed and spun off to shareholders by giving them stock in the two companies. One of these companies, now Lucent Technologies, was an equipment producer and research company. It was spun-off to avoid conflicts with customers of other AT&T products. The other company was NCR, a computer company. This was spun-off to remove the effects of a poor-performing business from AT&T’s results. An equity carve-out is similar to a spin-off. It occurs when a company sells some of its shares in a subsidiary to the public. This raises additional capital for the company.

Hostile versus Friendly Combinations

Acquisitions may be hostile or friendly. In a hostile acquisition, the acquiring, or bidder, company makes an offer to purchase the acquired or target company, but the management of the target company resists the offer. At that point, the bidder often tries to take control of the target through a tender offer, whereby the bidder offers to purchase a majority of the target’s stock at a predetermined price, set sufficiently higher than the current market price to attract the shareholders’ attention. Hostile acquisitions are typically more expensive for both parties since they involve more time and negotiations, fees to experts such as attorneys and investment bankers, and may result in a bidding war where multiple bidders enter the contest for control. The large number of hostile acquisitions in the 1980s led to the coining of the term market for corporate control. This terminology reflects the view that acquisitions are really market-based contests whereby corporate managers bid to control corporate assets, with the highest bidder receiving control.

Even though hostile acquisitions receive much of the media attention surrounding acquisitions, the great majority of acquisitions are; friendly. In a friendly acquisition, the management of both companies come to an agreement over the terms of the acquisition. Many acquisitions that begin as hostile end up being completed on a friendly basis.

MOTIVES FOR ACQUISITIONS

The overriding motive for any acquisition should be to maximize shareholder value. There has been increasing emphasis on maximizing shareholder value and managers are under more and more pressure to do so. The threat of a hostile takeover places pressure on all corporate managers to manage their companies to maximize value, or risk being taken over and restructured by another management. Increasingly competitive global capital markets, active institutional investors, active and independent boards of directors, and better informed market participants have all led to an increased focus by shareholders on shareholder value, and have placed increased pressure on corporate managers to maximize shareholder value.

Acquisitions are a means of creating shareholder value by exploiting synergies, increasing growth, replacing inefficient managers, gaining market power, and extracting benefits from financial and operational restructuring. However, for value to be created, the benefits of these motives must exceed the costs.

These motives are considered to add shareholder value :

• Economies of scale: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to theoretically the same revenue stream, thus increasing profit.
• Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and dtjdf its power (by capturing increased market share) to set prices.
• Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker’s customers, while the broker can sign up the bank’s customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products.
• Synergy: Better use of complementary resources.
• Taxes: A profitable company can buy a loss maker to use the target’s tax write-offs. In the United States and many other countries, rules are in place to limit the ability of profitable companies to shop for loss making companies, limiting the tax motive of an acquiring company.
• Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below).
• Resource transfer: resources are unevenly distributed across firms and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.
• Financial restructuring: a change in control can lead to a more cost-effective or safer capital structure, and more efficient use of financial assets.
• Business mix restructuring: the acquirer may divest non-core businesses.

The following motives are considered to not add shareholder value:

• Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.
• Overextension: Tend to make the organization fuzzy and unmanageable.
• Manager’s hubris: manager’s overconfidence about expected synergies from M&A which results in overpayment for the target company.
• Empire Building: Managers have larger companies to manage and hence more power.
• Manager’s Compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is rather linked to profitability and not mere profits of the company.
• Bootstrapping: Example: how ITT executed its merger.
• Vertical integration: Companies acquire part of a supply chain and benefit from the resources.

WHY GROW THROUGH ACQUISITIONS?

There are numerous reasons for a company to want to grow. Growth is often considered vital to the health of a company. A stagnating company may have difficulty attracting high-quality management. Furthermore, larger companies may pay higher salaries to top management than smaller companies. In some industries, size itself may bring competitive advantages. For example, marketing dominance may be strengthened through improved access to advertising. In addition, a large company may have significantly higher production or distribution efficiencies than a smaller one. Sometimes growth is a means of survival. For example, companies in the telecommunications industry have grown through acquisition in an effort to compete to control phone lines, cable systems, and content. The merger of Viacom, Blockbuster, and Paramount created a conglomeration of television and movie production, video distribution and publishing, and cable channels in an industry where many companies are merging to compete to become comprehensive media powerhouses. Firms in the defense industry have merged to survive in a declining market. Finally, tax laws may encourage merger growth.

Despite these reasons to grow, growth by itself does not necessarily benefit either the stockholders or the managers of a company. Growth is not something that must be achieved regardless of its price. Throughout this course, emphasis will be placed on an acquisition’s impact on value. Careful comparisons between benefits and costs will be made. A good acquisition will be defined as one that can be expected to increase the stock price (other things being equal) of the acquiring company.

Furthermore, a merger is not always the best way to grow. A company can achieve internal expansion through investment in projects generated within the company itself. By doing so, efficiency may be improved, existing activities may be expanded, and new products may be introduced.

External expansion takes place through an acquisition. Because of the similarities between the acquisition and the capital budgeting process, the same approval and review forms, control procedures, and post-audit examinations commonly used for analyzing capital expenditures can be applied to an acquisition analysis as well. In addition, consideration should be given at the highest levels of the business to how the proposed acquisition fits in with the needs and strategic thrust of the company. With a good fit, even at a relatively high price, the company being considered may be viewed as a good investment. Without a good fit, the acquisition may not be a good deal at almost any price.

FINANCIAL ANALYSIS

An acquisition is essentially as an investment decision. An initial outlay is invested to obtain expected future benefits. A good acquisition will generate greater benefits, in present value terms, than its costs. The likely effect of a good acquisition will be to increase the stock value of the acquiring company. To properly conduct this type of acquisition analysis, some strategic concepts and many valuation tools are required. The discipline of corporate finance shapes both the strategic and the financial analysis necessary to identify and evaluate acquisition candidates and assess the impact of acquisitions on company value.

Acquisitions are financial decisions that should be consistent with the company’s goal of shareholder wealth maximization. Sound and thorough financial analysis should be a part of any acquisition. Many acquisitions that fail, in the sense that they do not add value to the acquiring company, do so because they were motivated by wishful thinking rather than sound and thorough financial analysis. This discipline starts with the methods for analyzing a company’s financial statements. The next step is is an understanding of lenders’ and investors’ required returns and corporate valuation analysis. Through this framework, the financial analyst will be better able to view the acquisition process as a competition with other stock purchasers, all of whom are looking for good buys.

Acquisitions are also strategic decisions that should be consistent with the mission of the acquiring company and fit into its overall strategic plan. The reasons for an acquisition must be understood in the context of a company’s strategic analysis. Acquisitions can be justified in terms of the competitive advantages they produce (for example, marketing positions may be strengthened or production costs reduced). Other motives include improved management, tax benefits, or defensive maneuvers to prevent takeover by other companies. Finally, many acquisitions produce benefits purely from the financial and business restructuring that follows a change in control — as illustrated by the value increases following leveraged buyouts.

ACCOUNTING FOR MERGERS

Two methods of accounting for acquisitions — purchase and pooling of interests — are often discussed. Financial statements that record the results of an acquisition must follow one of these two techniques. Financial managers must be aware of the accounting requirements as merger negotiations near completion.

Under the purchase method, the acquired company is treated by the acquiring company as an investment, analogous to a capital budgeting expenditure. A totally new ownership is assumed. Asset values are reappraised in light of estimates of their current market values, and the balance sheet is restated to the new levels. As a result of these adjustments, goodwill often results. Goodwill is the amount by which the price paid for a company exceeds the company’s estimated net worth at market value. Goodwill must be written off against future net income over a reasonable period. Such deductions against income aret deductible for tax purposes in most countries.

Under the pooling of interests method, the assets and liabilities of the two combining companies are simply added together. Since only the book values of the assets and liabilities are considered, no goodwill results. In most countries, there are severe restrictions on a company’s use of the pooling of interests method. As a result of these restrictions, the pooling of interests method is used much less today than it was in the past.

MERGER NEGOTIATION AND DUE DILIGENCE

Negotiating the merger can be difficult. The simple answer to making it work is: hire the best advisors. Thier job is to manage the negotiation process in such a way that it reaches a satisfactory conclusion — both parties must see a gain, and both parties must be proteced — and it does not run afoul of legal and regulatory constraints. The goal is to reach an agreement that is embodied in the sale and purchase agreement — which includes all the key terms of the deal, such as price, payment method, adjustments, constraints on the seller, etc as well as accounting definitions, accounting and tax warranties and indemnities, etc.

Quite often, a proposed merger or acquisition gets canned or valued down following conflicts over intellectual property rights, personnel, accounting discrepancies or incompatibilities in integrating information technology systems. The process of researching, understanding and, in some cases, avoiding these risks is known as due diligence.

Due diligence is going in and digging a hole in the ground and seeing if there’s oil, instead of taking someone’s word on it, says Joseph Bankoff, a lawyer. If you don’t do a sufficient amount of due diligence, you don’t really know what questions to ask.

Due diligence for mergers and acquisitions requires broad and deep data analysis of assets and liabilities, including large balance sheet items such as accounts receivable, inventory, and accounts payable to establish fair market value. It also means analyzing

collections of receivables and inventory to identify doubtful accounts or obsolete stock, and analyzing cash receipts and billing files using historical trends to assess the reliability and adequacy of projected cash flows. The due diligence team must sift through press reports and regulatory filings to uncover any actual or potential legal, environmental, or other problems. In the case of a technology acquisition, a due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a high-end system.

<> Due diligence entails taking all the reasonable steps to ensure that both buyer and seller get what they expect and not a lot of other things that you did not count on or expect, Bankoff explains. The process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers and key developers. It helps to identify potential risks and red flags.

FINANCING THE DEAL

Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:

A company acquiring another will frequently pay for the other company with cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder’s shareholders alone. An acquisition can involve a cash and debt combination, or a combination of cash and stock of the purchasing entity, or just stock.

A merger or merger of equals is often financed by an all stock deal (a stock swap), known in the UK as an all share deal. Such deals are considered a mergers rather than acquisitions because neither company pays money, and the shareholders of each company end up as the combined shareholders of the merged company. There are two methods of merging companies in this way:

• one company takes ownership of the other, issuing new shares in itself to the shareholders of the company being acquired as payment, or
• a third company is created which takes ownership of both companies (or their assets) in exchange for shares in itself issued to the shareholders of the two merging companies.

Where one company is notably larger than the other, people may nevertheless may be wary of calling the deal a merger, as the shareholders of the larger company will still dominate the merged company

If cash is paid, the cash can be raised in a number of ways. The company may have sufficient cash available in its account, but this is unlikely. More often the cash will be borrowed from a bank, or raised by an issue of bonds, or of equity. Acquisitions financed through debt are known as leveraged buyouts, and the debt will typically be moved down onto the balance sheet of the acquired company. Many leveraged acquisitions include a component of mezzanine debt, which falls between senior secured bank debt and equity.

POST-MERGER INTEGRATION

Some problems must inevitably occur when two companies combine; however, these problems can be anticipated and minimized. Managers of the acquired company will feel some loss of autonomy since their decisions must now be meshed with the policies of the merged company. Once-simple procedures become complicated by a new control system. Furthermore, the acquired company’s managers are often concerned about personal recognition, advancement, and job security in the new company. Historically, many managers of acquired companies have lost their jobs following an acquisition.

Problems in the acquiring company will emerge as well. Its strengths and weaknesses and the skills and potential of its personnel will not be immediately apparent in the combined company. In addition, the staff of the acquiring company may lack the expertise to understand completely the production processes of the acquired company and may therefore be unable to make appropriate decisions about them. Disciplines, procedures, and controls that have been well established over time may not work as well in the new environment. There may be a clash of corporate cultures.

Solutions to these problems cover too broad an area for satisfactory coverage in this brief introduction. Several suggestions can be given. Immediate arrangements should be made for orientation of the new staff, for discussing procedures with operational personnel, and for making shifts in assignments where necessary. Teams who are responsible for preventing the imposition of inappropriate controls on the new division, and for educating top management about the characteristics of the unfamiliar company, can be appointed during the merger planning process. Furthermore, the increased opportunities for advancement in the larger, merged company can be communicated to lower-level employees. Finally, a special effort can be made to listen to what is happening during the initial period of difficulty.

Questions:

If your company is considering growth through acquisition, consider the following questions:

1. Why is growth through acquisition a better option than internal expansion? Will the growth be profitable for the owners of the company?
2. Do we have the expertise to carry out this acquisition? Where will we turn for the necessary strategic, legal, and financial advice?
3. Do we have the people in our organization to plan and value and execute an acquisition? If not, where will we get them?
4. How will we screen for appropriate acquisition candidates?
5. How will we negotiate the terms of the acquisition?
6. Who will help us finance it? With what methods?
7. How will we handle integrating the two companies?
8. How will we assess the success or failure of the acquisition after it is completed and implemented?