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Two of the largest parts of the corporate finance world are mergers and acquisitions (commonly referred to as M&A) and corporate restructuring. Investment bankers on Wall Street deal with M&A transactions every day. These deals involve bringing together two or more separate companies to create one larger company. The reverse of this process also occurs regularly when large companies are divided into smaller ones through spinoffs, tracking stocks or carve-outs. These transactions are often reported in the media as they are frequently worth a lot of money (sometimes over a billion dollars). They also play a large role in determining the future success and value of the companies involved. For executives (such as the company CEO) being involved in an M&A can be a career highlight. Every time you look in the newspaper you can expect to see at least one story concerning an M&A transaction. The next step is to consider what this corporate restructuring means for investors. In this section we will look at the forces behind mergers, acquisitions and other types of corporate restructuring. We will consider the execution of these deals and what they mean from an investment point of view. We will also discuss the tax implications of these transactions for both investors and the companies involved.
The fundamental idea behind M&A is the equation: one plus one equals three. This basically means that combining the two companies will be worth more to the shareholders than the sum of the two companies when they are separate entities. It assumes the companies are more valuable together than separately. This is a particularly appealing prospect during times of economic downturn. Strong companies aim to purchase smaller companies in order to become more efficient and competitive. The companies generally agree to the merger in the hope that they will achieve better results in terms of their market share or efficiency. These benefits often mean that smaller companies that are struggling to survive on their own will be more likely to agree to a merger.
Distinction between Mergers and Acquisitions
There is a slight difference in the meanings of the terms merger and acquisition. An acquisition refers to the situation where one company purchases another and asserts itself as the controlling company. The company purchased is known as the target company and ceases to legally exist. The purchasing company simply takes over the business of the target company and it becomes reflected in the value of its stock. A merger, on the other hand, takes place when two different companies of similar size agree that they will join together and do business as a new company. They will no longer be separately owned and operated. A transaction like this is commonly known as a “merger of equals”. The stock of the individual companies involved in these situations is surrendered and the new combined company issues new stock.
An example of a merger of equals occurred when Daimler-Benz merged with Chrysler. When this merger was finalized these two companies ceased to exist and a new company, DaimlerChrysler, was formed.
Mergers of equals are actually quite rare in practice. In reality, one company buys the other while agreeing to the terms of the deal that the acquired company can say was a merger of equals. This occurs because the act of being bought usually has a negative connotation and the managers involved in the deal are more agreeable to it being termed a merger, even, if technically, it is more like an acquisition.
The term merger is also used when the CEOs of both companies agree that joining forces is in both of their best interests. When a deal to purchase a company is hostile and the target company is reluctant to sell, the transaction will always be called an acquisition. The use of the terms merger or acquisition, in reality, depends entirely on the mood of the transaction; how people involved in the target company respond to the idea of being purchased and if it is friendly or hostile.
Synergy basically refers to the way that mergers enable the new company to improve its cost efficiency. This is based on enhancing revenue and reducing expenses. Companies hope to benefit from mergers in the following ways:
Reductions in staff. Mergers tend to be worry scenarios for employees as they generally result in job losses. Prior to the merger, each company will have its own departments to deal with accounting, marketing and other areas of business. Merging means that the new company can save a lot of money by reducing the staff where there is duplication. The CEO of the target company will also usually choose to leave with compensation.
- Economies of scale. Bigger companies can buy in bulk and placing larger orders saves money. Placing larger orders also improves purchasing power as there is greater scope for negotiating with suppliers.
- New Technology. Buying a smaller company that has made unique technological developments or has a business application that is in high demand means that a larger company can stay competitive.
- Improved visibility and market reach. Merging often gives both companies access to new market opportunities which increases their revenue and earning potential. Mergers can also improve the way a company is perceived by the investment community as investors are often more likely to invest capital in larger companies than in smaller ones.
Achieving the benefits associated with synergy is not automatic and, in some cases, it may be a difficult task. While the economies of scale theory sounds rational and certain, in a lot of cases, it just doesn’t work and the value of the new company created by the merger turns out to be less than the combined values of the separate individual companies. The CEO and the bankers involved obviously have a lot to gain from the merger being successful and they will often attempt to create an image that value has been added. The market will eventually realize that this is simply not the case and the company will be penalized with a discounted share price. The reasons behind M&A failures will be discussed in further detail in a later section.
Varieties of Mergers
When considered from a business structure point of view, there are many different types of mergers. These are usually distinguished based on the relationship between the two companies. Here are some of the most common:
- Horizontal merger – the merger of two competing companies that have the same products and markets.
- Vertical merger – the merger between a customer and a company or a supplier and a company. Prior to the merger one party bought a product from the other.
- Market-extension merger – the merger between two companies who sold the same products to different markets.
- Product-extension merger – the merger of two companies that sell separate but related products in the same market.
- Conglomeration – the merger of two companies that do not have any business areas in common. This category is divided into two types which are distinguished by the way that the merger is financed.
- Purchase Mergers – in these situations one company is purchased by the other. The method of finance may be either cash or a debt instrument which means that the sale is taxable. The company making the purchase will often choose this type of merger because of the tax benefits for them. The assets that they purchase along with the company can be included in the purchase price; this will often mean that there is a difference between the book value and the price that they paid for the assets. When there is a depreciation in the value of the assets, there is also a reduction in the taxes that the company is required to pay. This will be discussed in greater detail in a later section.
- Consolidation Mergers – in these situations the merger results in the creation of a brand new company that buys both of the individual companies and combines them under the name of the new entity. This has similar tax implications as the purchase merger.
As previously discussed, there is often little difference in reality between a merger and an acquisition. The difference may in fact only be one of semantics. Acquisitions have the same potential benefits as mergers; such as creating economies of scale, improved market visibility and efficiency. Acquisitions always involve the purchase of one company by another and they will never have the exchange of stock or consolidation of two companies into one. The mood of an acquisition is often what sets it apart from a merger. While they may be congenial transactions which leave all parties satisfied, in other cases, they will involve a certain level of hostility.
When one company purchases another in an acquisition, they can pay for it using cash, stocks or both. Alternatively one company can simply acquire all the assets of the other company and is most common in smaller transactions. For example, Company X purchases all of the assets owned by Company Y with cash. This means that Company Y has cash and possibly debt as well and it will need to liquidate or begin a new business.
A reverse merger is a different type of acquisition in which a private company is able to quickly become listed on the stock exchange. This takes place when a strong company that is performing well and is interested in raising additional capital purchases a company that is publicly listed but has limited assets or business functionality. The two companies reverse merge and become a new listed corporation with shares.
No matter which category or structure they come under, mergers and acquisitions always have the same goal and that is to create synergy. For a merger or acquisition to be considered successful, the combined value of the companies must be greater than the sum of the two companies individually.
When a company is considering taking over another one, investors in that company need to consider whether or not the transaction will benefit them. To work this out they need to determine the true value of the company that is being acquired.
This can be a challenging exercise as either side of the transaction will present different information about the value of the target company. As in most deals, the buyer is trying to get the lowest price possible and the seller aims to value the company at the highest conceivable price. There are other effective ways to assess the value of target companies. The most obvious, and the most common, method is to consider the value of comparable companies in the same industry. Other methods include:
Comparative Ratios – Purchasing companies will often based their valuation on one of the following two comparative metrics:
(a) Price-Earnings Ratio (P/E Ratio) – The acquiring company uses this ratio to work out a purchase offer that is based on the earnings of the target company. They will often look at the P/E ratio for other companies in the same industry to guide them in reaching the conclusion.
(b) Enterprise-Value-to-Sales Ratio (EV/Sales) – As in the P/E ratio, the offer made by the purchasing company is a multiple of the target company’s revenues, however, they also keep in mind the price-to-sales ratio of similar companies in the same industry.
- Replacement Cost – In some rare cases, the value of the acquisition will be based on the replacement cost of the target company. Simply put, this assumes that the value of the target company can be worked out by adding the value of its equipment and staff expenses. The purchasing company offers this price to the target company with the threat that they could create a competing company for the same amount. Obviously, this is a weak argument as finding and/or purchasing management, property and equipment takes time. This method doesn’t work in industries that rely upon valuing and developing good people and ideas.
- Discounted Cash Flow (also known as DCF). This valuation tool determines the current value of a target company based on a formula that estimates its future cash flows. In making this calculation, forecasted cash flows equal the sum of operating profit, depreciation and amortization of goodwill, less expenditure, taxes and the change in working capital. This figure is then converted to current value using the weighted average capital costs (WACC). This tool is difficult to perfect, but it is a very popular method that often produces accurate results.
Synergy: The Cost of Potential Success
In almost all cases, a purchasing company will end up paying more than the actual stock market value to purchase another company. The reason behind this is the concept of synergy; the merger share price will increase due to the potential synergy and will benefit shareholders. Having to pay a premium is also due to the fact that rational owners of a company simply will not sell it unless it is financially beneficial for them. This means that the purchasing company will generally have to pay a lot more than the pre-merger valuation of the company that they want to buy. Buyers are willing to do this because they expect to achieve the benefits of synergy after the merger. There is an equation that investors often use to calculate synergy and to work out whether a merger transaction makes sense.
Whether or not a merger can be considered successful will depend on whether the value of the purchasing company is increased by the transaction. Unfortunately, for the purchasing company, in many cases, this doesn’t occur and the benefits that were expected to result from the deal cannot be realized. The synergy that the deal promised often fails to work out.
What to Look For
Assessing whether a deal is worthwhile can be a difficult task for investors. It is generally up to the purchasing company to prove that it is a good deal. The following list of criteria can be used by investors when considering the likely success of a merger:
Reasonable purchase price. Paying a premium of around 10% above the current market value is generally considered reasonable. When companies pay large premiums, around the 50% mark, they are not being very sensible as the synergy would need to be huge to make the deal worthwhile.
- Paying in cash. When the transaction is paid for in cash, the purchasing company tends to exercise greater caution. When using stock as the currency, the negotiations tend to be less disciplined.
- Sensible choice of target company. It makes more sense for a purchasing company to buy a smaller company that is in the same line of business because it is much easier to achieve synergy. Some companies over-extend themselves in mergers and end up with many different business lines and not a lot of synergy.
The most important consideration is whether the merger is sensible and has a good chance of working out in reality.
Doing the Deal
When the Executives of a company (the CEO and other high level managers) make the decision to acquire or merge with another company, they will begin the process of making a tender offer. This usually starts with them discreetly purchasing shares in the target company. They can only buy 5% of outstanding shares on the open market before they are required to file a report with the SEC. In this report they have to declare how many shares have been purchased and if the shares are simply an investment or their intention is to purchase the entire company.
The purchasing company works with investment bankers and financial advisors to determine the price that it is willing to offer for the target company. The offer and the deadline is the usually advertised in business media and they wait for the target company’s response.
There are several ways that the target company can respond to the offer:
Accept the Offer. If the executives and shareholders of the target company are happy with the deal, they will accept the offer and go ahead with the transaction.
- Try to negotiate. If the offered price is too low, or the terms of the deal are not very appealing, the target company may attempt to negotiate. This is usually of particular concern to the management of the target company as their jobs are usually at stake in a merger. They will often try to negotiate terms which enable them to retain their jobs after the merger or which give them a large compensation package. Obviously, if a target company is receiving a lot of offers, they will have greater negotiating power. Individual managers who can prove that they are vital to the future success of the merger will also have a lot of weight when it comes to negotiating.
- Poison Pill or other Takeover Defense. A poison pill scheme is one way that a target company can dilute the control of the purchasing company. They do this in situations where the purchasing company has bought a specific percentage of the target company’s stock. The target company will give all of its other shareholders the opportunity to buy additional shares at a reduced price. This action reduces the overall percentage of stock that the purchasing company owns and therefore, reduces its control.
- Use a White Knight. A target company can also try to find a friendlier company known as a white knight to purchase them for an equal or higher price than the hostile bidder has offered.
Regulatory bodies will often scrutinize mergers and acquisitions, especially where the transaction could potentially reduce competition or create a monopoly. For example, a merger between two communications companies, such as AT&T and Sprint, would need to be approved by the Federal Communications Commission (FCC).
Closing the Deal
The final step in the process is execution of the transaction. This occurs after the target company agrees to the terms of the offer and the regulatory requirements are satisfied. The purchasing company will buy the target company’s shares using cash or stock or a combination of the two. If they use cash, the shareholder of the target company will receive a payment for each of their shares. This transaction is taxable. On the other hand, if the transaction is paid using stock, it is not taxable. The parties simply exchange share certificates and no tax needs to be paid. This feature makes stock-for-stock transactions a more popular option. In these transactions, shareholders in the target company are issued new shares in the stock of the purchasing company. This is sometimes managed by a broker. Target company shareholders will only be taxed if they sell the shares in the new company. At the finalization of the deal, investors in the company will usually receive new stock which is either the stock of the new entity created by the deal, or the expanded stock of the purchasing company.
Although companies getting smaller may seem counterintuitive, in many cases, corporate break-ups or de-mergers can produce good results for companies and shareholders.
The reasons for breaking up a company by using spinoff, carve-out or tracking stock are based on a concept of reverse synergy which states that the separate parts will be worth more than the whole. Companies are often restructured in a way that separates business units to allow them to raise extra equity. This can also have the effect of boosting the value of the company. Businesses often incur a lot of extra costs when they have many parts operating as one unit. Separating into smaller units cuts down on these expenses and the management becomes more focused. Another significant advantage is that shareholders receive more accurate information about the company when it is separated as each business unit will have to issue its own financial statements. This becomes more relevant when the separated units have different business lines. When each unit provides its own financial disclosure, investors can more accurately value the worth of the parent company. If this is positive the parent company will usually attract more investors, resulting in more capital. Separating business units can also mean that there is less internal competition for the capital of the parent company. This means that the company can be more cohesive and productive. Employees may also benefit from the creation of a new entity as they will usually be offered the chance to purchase its stock. In a large company stock options are often considered a poor incentive for subsidiary managers because their individual efforts are seldom recognized.
De-merged firms may suffer from the disadvantages associated with being a smaller company; for example they may have reduced access to credit and finance. It will also probably be more difficult to be represented on major indexes, and to be able to enjoy the advantages of synergy that larger entities have. For example, separating different business units will often have the effect of creating additional logistical expenses without providing any increased revenue.
Each of the different restructuring methods has its own advantages and disadvantages and these can be quite complicated to understand. The most common methods are outlined below:
Commonly referred to as a divestiture, a sell-off refers to the outright sale of a subsidiary by a parent company. This usually occurs when the subsidiary fails to fit in with the core strategy of the parent company. There may be a lack of synergy between the two entities that results in the market undervaluing the combined business. The Executive of the parent company will then decide that it is better for all concerned if the subsidiary is sold to new owners.
Partial sell off / IPO of shares
This occurs when the subsidiary is turned into a new publicly-listed company, but the majority of the shares are owned by the parent company so it has the controlling interest. This is also known as a carve-out and is mostly used when one particular subsidiary is growing rapidly so that its value outpaces the other activities of the parent company. This option has financial advantages for the parent company in that shares sold to the public generate extra capital, while at the same time, the increased value of the subsidiary works to also enhance the shareholder value of the parent company. The new company will have its own board of directors but usually the parent company will retain some level of control. Some members may actually serve on both boards. The two entities will have a strong connection as they have common shareholders and the parent company has a controlling interest.
On the other hand, sometimes a parent company will carve-out a subsidiary that is not performing well and is reducing the overall value of the company. These situations will generally not have good results for the subsidiary. They may be burdened with debt and lack the reputation to proceed on its own. In some cases a carve-out may also generate hostility between the subsidiary and the parent. Managers of the subsidiary often feel the pressure of being accountable to both their shareholders and the parent company.
Sell offs are an effective way for a company to raise cash to pay off debt. During the 1980’s and 1990’s companies regularly financed acquisitions by getting into debt. After the purchase, they would then sell off subsidiaries to pay the debt.
A spinoff involves the subsidiary becoming a new, independent entity. Shares in this new entity are distributed to shareholders of the parent company. No cash is generated by this distribution. This process is not used in situations where the parent company is hoping to build extra finance. The subsidiary has its own management and board of directors. Spinoffs are usually designed to create greater shareholder value. The management focus of the parent company is sharpened and the spinoff company also has the benefit of not having to compete for capital and attention from the parent company. Managers of the subsidiary also have the option to explore new opportunities.
One important point for investors to remember is that parent companies will often create subsidiaries in order to separate themselves from legal liabilities or bad debt. Shareholders who receive shares in the spinoff entity will often quickly get rid of these shares and this has the effect of decreasing their value.
This is becoming a very popular way for companies to increase shareholder value. A subsidiary of a company is made public using what is known as a “raiders initial public offering stock dividend”. This means that shareholders are given different voting rights for these shares when compared to the main stock. It usually means that the shareholders’ vote will be worth less (maybe half or a quarter) and in some cases they will have no voting rights at all in relation to this stock.
Tracking stock is a variety of stock that a company issues to monitor the value of a particular segment of the company. It enables the different business units of a parent company to receive different values according to how attractive they are to investors. This is a particularly useful tool for a slow-growth company that has one business unit that is performing much better than the others. It can be very useful for that company to issue a tracking stock in the high performing unit so they can assess the market value of that aspect of the business. The main advantage as compared to spinning-off or carving-out the particular business unit is that the parent company stays in control of the subsidiary. They don’t lose the benefits of synergy and the reduced logistical costs that come from being joined. Also, the parent company can use the valuable tracking stock that it owns to finance new acquisitions. An important point for shareholders to remember is that these tracking stocks have a class B price-earnings ratio.
Why They Can Fail
Everyone with an interest in business knows that a lot of mergers fail. The benefits of merging can often seem so obvious and sure; combining staff and equipment needs, forcing down costs due to the larger size, and increasing revenues, should result in the merged company being more profitable than the pre-existing separate entities. Further, the increase in profit should be large enough to justify paying a premium price for the transaction to go ahead. However, in many cases, it simply doesn’t work.
Historical data suggests that around two-thirds of mergers result in a loss of stock market value. One of the main reasons is the fact that motivations behind mergers are often flawed and the companies involved fail to benefit from the expected economies of scale. There are often concrete, identifiable problems involved in mergers. Some of these are outlined below:
The dangerous reality is booming stock markets have a tendency to encourage mergers. In times of economic prosperity, deals between companies can be cheap and easy, and this means that the people involved often don’t approach the transaction as cautiously as they really should. Another danger comes when companies try to imitate other mergers, with company executives trying to keep up with what others are doing. Many executives may also treat mergers as a way of boosting their ego and glory, rather than properly considering the business strategy. The ego of the Executive plays a large role in the world of M&A, particularly when there are so many other people (lawyers, bankers and advisors) who stand to benefit financially from encouraging a merger. CEOs generally have reached their positions because they are seriously focused on success and executives involved in mergers will usually receive a large bonus regardless of the resulting value of the share price.
Another factor to consider is that mergers may result from generalized fear. An uncertain economic landscape (effected by the forces of globalization and technology) may create an incentive for companies to engage in defensive mergers. Management often feels that their only option is to purchase their rival before they themselves are purchased. This is based on the idea that competition means only the big players will survive.
The Obstacles to Merger Success
Dealing with a merger can mean top managers in a company spend all their time on merger negotiations and fail to take proper care of the core business. Potential difficulties with the transaction are frequently overlooked by managers who are too excited by the prospect of the deal. Success is less likely if the companies have very different corporate cultures. Cultural differences in the companies are often ignored in acquisitions that focus on the products or market involvement of the companies. Personnel issues can also be very difficult for companies to overcome. If employees at a target company are accustomed to a particular management style, they may be very reluctant to adapt to the culture of the purchasing company. The overall result of these changes may be resentment, hostility and a reduction in productivity. A study conducted by McKinsey provides further insight into the reasons behind merger failures. This study found that many companies direct a lot of focus on cost cutting after a merger and, at the same time, their revenues and profits often decrease. If they focus too much on integrating the two companies after the merge to the extent that they neglect their core business, customers are likely to leave. This leads to a loss of momentum that reduces the value of the merge for shareholders.
Remember though, that many mergers are successful. Increased size, market reach and strong management are huge advantages that make companies more efficient. Investors need to carefully scrutinize the terms of the merger and the promises made by the people involved. The deal makers need to be realistic and the companies must be able to integrate smoothly while still paying attention to their business operations.
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