Mergers and acquisitions
Mergers and acquisitions represent the ultimate in change for a business. No other event is more difficult, challenging, or chaotic as a merger and acquisition. It is imperative that everyone involved in the process has a clear understanding of how the process works. Hopefully this short course will provide you with a better appreciation of what is involved.
You might be asking yourself, why do I need to learn the merger and acquisition (M & A) process? Well for starters, mergers and acquisitions are now a normal way of life within the business world. In today's global, competitive environment, mergers are sometimes the only means for long-term survival. In other cases, such as Cisco Systems, mergers are a strategic component for generating long-term growth. Additionally, many entrepreneurs no longer build companies for the long-term; they build companies for the short-term, hoping to sell the company for huge profits. In her book The Art of Merger and Acquisition Integration, Alexandra Reed Lajoux puts it best:
Virtually every major company in the United States today has experienced a major acquisition at some point in history. And at any given time, thousands of these companies are adjusting to post-merger reality. For example, so far in the decade of the 1990's (through June 1997), 96,020 companies have come under new ownership worldwide in deals worth a total of $ 3.9 trillion - and that's just counting acquisitions valued at $ 5 million and over. Add to this the many smaller companies and nonprofit and governmental entities that experience mergers every year, and the M & A universe becomes large indeed.
M & A Defined
When we use the term "merger", we are referring to the merging of two companies where one new company will continue to exist. The term "acquisition" refers to the acquisition of assets by one company from another company. In an acquisition, both companies may continue to exist. However, throughout this course we will loosely refer to mergers and acquisitions ( M & A ) as a business transaction where one company acquires another company. The acquiring company will remain in business and the acquired company (which we will sometimes call the Target Company) will be integrated into the acquiring company and thus, the acquired company ceases to exist after the merger.
Mergers can be categorized as follows:
Horizontal: Two firms are merged across similar products or services. Horizontal mergers are often used as a way for a company to increase its market share by merging with a competing company. For example, the merger between Exxon and Mobil will allow both companies a larger share of the oil and gas market.
Vertical: Two firms are merged along the value-chain, such as a manufacturer merging with a supplier. Vertical mergers are often used as a way to gain a competitive advantage within the marketplace. For example, Merck, a large manufacturer of pharmaceuticals, merged with Medco, a large distributor of pharmaceuticals, in order to gain an advantage in distributing its products.
Conglomerate: Two firms in completely different industries merge, such as a gas pipeline company merging with a high technology company. Conglomerates are usually used as a way to smooth out wide fluctuations in earnings and provide more consistency in long-term growth. Typically, companies in mature industries with poor prospects for growth will seek to diversify their businesses through mergers and acquisitions. For example, General Electric (GE) has diversified its businesses through mergers and acquisitions, allowing GE to get into new areas like financial services and television broadcasting.
Reasons for M & A
Every merger has its own unique reasons why the combining of two companies is a good business decision. The underlying principle behind mergers and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of Company A is $ 2 billion and the value of Company B is $ 2 billion, but when we merge the two companies together, we have a total value of $ 5 billion. The joining or merging of the two companies creates additional value which we call "synergy" value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues then if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses then if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.
For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the need to cut costs. Cost savings often come from the elimination of redundant services, such as Human Resources, Accounting, Information Technology, etc. However, the best mergers seem to have strategic reasons for the business combination. These strategic reasons include:
Positioning - Taking advantage of future opportunities that can be exploited when the two companies are combined. For example, a telecommunications company might improve its position for the future if it were to own a broad band service company. Companies need to position themselves to take advantage of emerging trends in the marketplace.
Gap Filling - One company may have a major weakness (such as poor distribution) whereas the other company has some significant strength. By combining the two companies, each company fills-in strategic gaps that are essential for long-term survival.
Organizational Competencies - Acquiring human resources and intellectual capital can help improve innovative thinking and development within the company.
Broader Market Access - Acquiring a foreign company can give a company quick access to emerging global markets.
Mergers can also be driven by basic business reasons, such as:
Bargain Purchase - It may be cheaper to acquire another company then to invest internally. For example, suppose a company is considering expansion of fabrication facilities. Another company has very similar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities then to go out and build new facilities on your own.
Diversification - It may be necessary to smooth-out earnings and achieve more consistent long-term growth and profitability. This is particularly true for companies in very mature industries where future growth is unlikely. It should be noted that traditional financial management does not always support diversification through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the management of companies since managing a steel company is not the same as running a software company.
Short Term Growth - Management may be under pressure to turnaround sluggish growth and profitability. Consequently, a merger and acquisition is made to boost poor performance.
Undervalued Target - The Target Company may be undervalued and thus, it represents a good investment. Some mergers are executed for "financial" reasons and not strategic reasons. For example, Kohlberg Kravis & Roberts acquires poor performing companies and replaces the management team in hopes of increasing depressed values.
The Overall Process
The Merger & Acquisition Process can be broken down into five phases:
Phase 1 - Pre Acquisition Review: The first step is to assess your own situation and determine if a merger and acquisition strategy should be implemented. If a company expects difficulty in the future when it comes to maintaining core competencies, market share, return on capital, or other key performance drivers, then a merger and acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to protect its valuation, it may find itself the target of a merger. Therefore, the pre-acquisition phase will often include a valuation of the company - Are we undervalued? Would an M & A Program improve our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth targets (such as 10% market growth over the next 3 years) can be achieved internally. If not, an M & A Team should be formed to establish a set of criteria whereby the company can grow through acquisition. A complete rough plan should be developed on how growth will occur through M & A, including responsibilities within the company, how information will be gathered, etc.
Phase 2 - Search & Screen Targets: The second phase within the M & A Process is to search for possible takeover candidates. Target companies must fulfill a set of criteria so that the Target Company is a good strategic fit with the acquiring company. For example, the target's drivers of performance should compliment the acquiring company. Compatibility and fit should be assessed across a range of criteria - relative size, type of business, capital structure, organizational strengths, core competencies, market channels, etc.
It is worth noting that the search and screening process is performed in-house by the Acquiring Company. Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must be highly guarded and independent.
Phase 3 - Investigate & Value the Target: The third phase of M & A is to perform a more detail analysis of the target company. You want to confirm that the Target Company is truly a good fit with the acquiring company. This will require a more thorough review of operations, strategies, financials, and other aspects of the Target Company. This detail review is called "due diligence." Specifically, Phase I Due Diligence is initiated once a target company has been selected. The main objective is to identify various synergy values that can be realized through an M & A of the Target Company. Investment Bankers now enter into the M & A process to assist with this evaluation.
A key part of due diligence is the valuation of the target company. In the preliminary phases of M & A, we will calculate a total value for the combined company. We have already calculated a value for our company (acquiring company). We now want to calculate a value for the target as well as all other costs associated with the M & A. The calculation can be summarized as follows:
Value of Our Company (Acquiring Company) $ 560
Value of Target Company 176
Value of Synergies per Phase I Due Diligence 38
Less M & A Costs (Legal, Investment Bank, etc.) ( 9)
Total Value of Combined Company $ 765
Phase 4 - Acquire through Negotiation: Now that we have selected our target company, it's time to start the process of negotiating a M & A. We need to develop a negotiation plan based on several key questions:
How much resistance will we encounter from the Target Company?
What are the benefits of the M & A for the Target Company?
What will be our bidding strategy?
How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both companies to reach agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since having both sides agree to the deal will go a long way to making the M & A work. In cases where resistance is expected from the target, the acquiring firm will acquire a partial interest in the target; sometimes referred to as a "toehold position." This toehold position puts pressure on the target to negotiate without sending the target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the acquiring company will make a tender offer directly to the shareholders of the target, bypassing the target's management. Tender offers are characterized by the following:
The price offered is above the target's prevailing market price.
The offer applies to a substantial, if not all, outstanding shares of stock.
The offer is open for a limited period of time.
The offer is made to the public shareholders of the target.
A few important points worth noting:
Generally, tender offers are more expensive than negotiated M & A's due to the resistance of target management and the fact that the target is now "in play" and may attract other bidders.
Partial offers as well as toehold positions are not as effective as a 100% acquisition of "any and all" outstanding shares. When an acquiring firm makes a 100% offer for the outstanding stock of the target, it is very difficult to turn this type of offer down.
Another important element when two companies merge is Phase II Due Diligence. As you may recall, Phase I Due Diligence started when we selected our target company. Once we start the negotiation process with the target company, a much more intense level of due diligence (Phase II) will begin. Both companies, assuming we have a negotiated merger, will launch a very detail review to determine if the proposed merger will work. This requires a very detail review of the target company - financials, operations, corporate culture, strategic issues, etc.
Phase 5 - Post Merger Integration: If all goes well, the two companies will announce an agreement to merge the two companies. The deal is finalized in a formal merger and acquisition agreement. This leads us to the fifth and final phase within the M & A Process, the integration of the two companies.
Every company is different - differences in culture, differences in information systems, differences in strategies, etc. As a result, the Post Merger Integration Phase is the most difficult phase within the M & A Process. Now all of a sudden we have to bring these two companies together and make the whole thing work. This requires extensive planning and design throughout the entire organization. The integration process can take place at three levels:
1. Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into one new company. The new company will use the "best practices" between the two companies.
2. Moderate: Certain key functions or processes (such as production) will be merged together. Strategic decisions will be centralized within one company, but day to day operating decisions will remain autonomous.
3. Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both strategic and operating decisions will remain decentralized and autonomous.
If post merger integration is successful, then we should generate synergy values. However, before we embark on a formal merger and acquisition program, perhaps we need to understand the realities of mergers and acquisitions.
A Reality Check
As mentioned at the start of this course, mergers and acquisitions are extremely difficult. Expected synergy values may not be realized and therefore, the merger is considered a failure. Some of the reasons behind failed mergers are:
Poor strategic fit - The two companies have strategies and objectives that are too different and they conflict with one another.
Cultural and Social Differences - It has been said that most problems can be traced to "people problems." If the two companies have wide differences in cultures, then synergy values can be very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the "watchdog" within the M & A Process. If you fail to let the watchdog do his job, you are in for some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires a very high level of quality management. In the words of one CEO, "give me some people who know the drill." Integration is often poorly managed with little planning and design. As a result, implementation fails.
Paying too Much - In today's merger frenzy world, it is not unusual for the acquiring company to pay a premium for the Target Company. Premiums are paid based on expectations of synergies. However, if synergies are not realized, then the premium paid to acquire the target is never recouped.
Overly Optimistic - If the acquiring company is too optimistic in its projections about the Target Company, then bad decisions will be made within the M & A Process. An overly optimistic forecast or conclusion about a critical issue can lead to a failed merger.
The above list is by no means complete. As we learn more about the M & A Process, we will discover that the M & A Process can be riddled with all kinds of problems, ranging from organizational resistance to loss of customers and key personnel.
We should also recognize some cold hard facts about mergers and acquisitions. In the book The Complete Guide to Mergers and Acquisitions, the authors Timothy J. Galpin and Mark Herndon point out the following:
Synergies projected for M & A's are not achieved in 70% of cases.
Just 23% of all M & A's will earn their cost of capital.
In the first six months of a merger, productivity may fall by as much as 50%.
The average financial performance of a newly merged company is graded as C - by the respective Managers.
In acquired companies, 47% of the executives will leave the first year and 75% will leave within the first three years of the merger.
In the book Valuation: Measuring and Managing the Value of Companies, the authors note the following:
"Even in situations where the acquired company is in the same line of business as the acquirer and is small enough to allow for easy post-merger integration, the likelihood of success is only about 50%."
Do not despair - there is some good news in all of this! The success rate in recent years has improved dramatically. As more and more companies gain experience in the M & A process, they are becoming very successful. In 1997, Mercer Management Consulting released a study which showed that mergers during the 1990's substantially outperformed mergers during the 1980's.
So let us move on and see if we can better understand the nuts and bolts behind mergers and acquisitions.