MERGER & ACQUISITION
Mergers and acquisitions (M&A) focus on the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.
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An introduction to Mergers & Acquisitions
The terms "mergers" and "acquisitions" are often used interchangeably, but they differ in meaning. In addition there is the "Hostile Takeover".
In an acquisition, one company purchases another outright. When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. Unfriendly or hostile takeover deals, in which target companies do not wish to be purchased, are always regarded as acquisitions. But friendly acquisitions are most common and occur when the target firm agrees to be acquired; its board of directors and shareholders approve of the acquisition, and these combinations often work for the mutual benefit of the acquiring and target companies.
Unfriendly acquisitions, commonly known as hostile takeovers, occur when the target company does not consent to the acquisition. Hostile acquisitions don't have the same agreement from the target firm, and so the acquiring firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition.
A merger is the combination of two firms, which subsequently form a new legal entity under the banner of one corporate name. A merger combines two firms, of approximately the same size, that join forces to move forward as a single new entity, rather than remain separately owned and operated. This action is also known as a merger of equals. Case in point: Both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created. Both companies' stocks were surrendered, and new company stock was issued in its place. In a brand refresh, the company underwent another name and ticker change as the Mercedes-Benz Group AG (MBG) in February 2022. A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies.
A deal can be classified as a merger or an acquisition based on whether the acquisition is friendly or hostile and how it is announced. In other words, the difference lies in how the deal is communicated to the target company's board of directors, employees, and shareholders.
The figure out a price, a company can be objectively valued by studying comparable companies in an industry and using metrics.
Types of Mergers and Acquisitions
Mergers - In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. For example, in 1998, a merger deal occurred between the Digital Equipment Corporation and Compaq, whereby Compaq absorbed the Digital Equipment Corporation.5 Compaq later merged with Hewlett-Packard in 2002. Compaq's pre-merger ticker symbol was CPQ. This was combined with Hewlett-Packard's ticker symbol (HWP) to create the current ticker symbol (HPQ).6
Acquisitions - In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or alter its organizational structure. An example of this type of transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, wherein both companies preserved their names and organizational structures.7
Consolidations - Consolidation creates a new company by combining core businesses and abandoning the old corporate structures. Stockholders of both companies must approve the consolidation, and subsequent to the approval, receive common equity shares in the new firm. For example, in 1998, Citicorp and Travelers Insurance Group announced a consolidation, which resulted in Citigroup.8
Tender Offers - In a tender offer, one company offers to purchase the outstanding stock of the other firm at a specific price rather than the market price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors.9 For example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million.10 The company agreed to the tender offer and the deal was settled by the end of December 2008.11
Acquisition of Assets - In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders. The purchase of assets is typical during bankruptcy proceedings, wherein other companies bid for various assets of the bankrupt company, which is liquidated upon the final transfer of assets to the acquiring firms.
Management Acquisitions - In a management acquisition, also known as a management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a financier or former corporate officers in an effort to help fund a transaction. Such M&A transactions are typically financed disproportionately with debt, and the majority of shareholders must approve it. For example, in 2013, Dell Corporation announced that it was acquired by its founder, Michael Dell.
Different ways of structuring a Merger
Mergers can be structured based on the relationship between the two companies involved in the deal:
- Horizontal merger: Two companies that are in direct competition and share the same product lines and markets.
- Vertical merger: A customer and company or a supplier and company. Think of an ice cream maker merging with a cone supplier.
- Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company.
- Market-extension merger: Two companies that sell the same products in different markets.
- Product-extension merger: Two companies selling different but related products in the same market.
- Conglomeration: Two companies that have no common business areas.
Two ways to become one
Mergers may also be distinguished by the way they become one.
- Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some kind of debt instrument. The sale is taxable, which attracts the acquiring companies, who enjoy the tax benefits. Acquired assets can be written up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.
- Consolidation Mergers - With this merger, a brand new company is formed, and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.
Ways of financing a Merger
A company can buy another company with cash, stock, assumption of debt, or a combination of some or all of the three. In smaller deals, it is also common for one company to acquire all of another company's assets. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business.
Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time period. Reverse mergers occur when a private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets. The private company reverses merges into the public company, and together they become an entirely new public corporation with tradable shares.
Both companies involved on either side of an M&A deal will value the target company differently. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the lowest price possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the following metrics:
Price-to-Earnings Ratio (P/E Ratio) - With the use of a price-to-earnings ratio (P/E ratio), an acquiring company makes an offer that is a multiple of the earnings of the target company. Examining the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
Enterprise-Value-to-Sales Ratio (EV/Sales) - With an enterprise-value-to-sales ratio (EV/sales), the acquiring company makes an offer as a multiple of the revenues while being aware of the price-to-sales (P/S ratio) of other companies in the industry.
Discounted Cash Flow (DCF) - A key valuation tool in M&A, a discounted cash flow (DFC) analysis determines a company's current value, according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization—capital expenditures—change in working capital) are discounted to a present value using the company's weighted average cost of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry wherein the key assets (people and ideas) are hard to value and develop.
How Does M&A Activity Affect Shareholders?
Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring firm will see a temporary drop in share value. At the same time, shares in the target firm typically experience a rise in value. This is often due to the fact that the acquiring firm will need to spend capital to acquire the target firm at a premium to the pre-takeover share prices. After a merger or acquisition officially takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends.
Note that the shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-upon conversion rate. Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders.