Prof. Ian Giddy, New York University
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
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.
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.
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.
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.
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.
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.
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:
The following motives are considered to not add shareholder value:
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.
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
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
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:
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.
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.
If your company is considering growth through acquisition, consider the following questions: