Fin management materials / P4AFM-Session08_j08

SESSION 08 – MERGERS & ACQUISITIONS

OVERVIEW

Objective

¾To appreciate alternative strategies for long-term growth.

¾To understand the arguments for and against mergers and acquisitions.

¾To advise on the valuation of target companies.

¾To discuss the variety of methods of financing mergers and acquisitions.

¾To describe alternative strategies and tactics of mergers and acquisitions.

¾To discuss various defences against takeovers.

GROWTH BY

ACQUISITION

FINANCING TACTICS

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SESSION 08 – MERGERS & ACQUISITIONS

1ARGUMENTS FOR AND AGAINST MERGERS AND ACQUISITIONS

1.1Organic growth vs. external growth

¾If the strategy of a company is for long-term growth then this can come from:

organic growth − development of new projects by the firm financed by

retentions or new debt/equity; or

external growth − buying existing projects by acquiring another business.

1.2Advantages of acquisition

9Speed – often quicker than organic growth;

9Entry costs – if the cost of entering a new market is high it may be better to acquire a business already operating in that market;

9Barriers to entry – this may mean that acquisition is the only method of entry into a new market;

9Risk – organic growth may be riskier than acquiring an existing business;

9Undervaluation – “asset stripping” may be possible in an acquisition;

9Synergy – see below.

1.3Disadvantages of acquisition

8Cost – the control premiums paid over the existing market price are considerable, typically over 40%;

8Shareholder wealth – if the bidder pays too high a price for the target company this will reduce the bidding company shareholders’ wealth.

1.4Difference between an acquisition and a merger

¾An acquisition is where one company (the predator) buys the share capital of another company (the target or victim); creating a parent and subsidiary within a group. Both companies continue to exist as legal entities.

¾A merger is where two companies of similar size cancel their share capital and pool their net assets together into a new entity. The new entity then issues shares to the previous shareholders in an agreed ratio.

¾For financial management whether the transaction is classified as an acquisition or as a merger is not usually critical. It is often a more important distinction for financial reporting where merger accounting tends to report better results than acquisition accounting – although accounting standards worldwide are now removing merger accounting due to past abuses.

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1.5Synergy

¾The most compelling argument for a merger or acquisition is the creation of synergy i.e. the value of the two entities combined may be greater than the value of the two entities separately.

1.6Sources of synergy

¾Economies of scale – bulk buying discounts;

¾Economies of vertical integration – purchasing distributors/suppliers;

¾Economies of investment – use of common R&D, plant etc;

¾Economies of management – eradicating duplication of management skills;

¾Monopoly power – possible price increases;

¾Reduction in variability of cash flows – more stable cash flows might reduce borrowing costs and bankruptcy risk;

¾Surplus assets – sold off and proceeds invested in new projects;

¾Tax losses – reduced tax bills by acquiring a company with tax losses;

¾Tax shield – acquiring a company with low-gearing in order to gear up and gain the benefit of the tax shield on debt interest;

¾Cash cows – buying a company with surplus cash to reinvest profitably[

¾Skills transfer – using management expertise gained in one company to unlock shareholder wealth in another.

Two arguments about creation of synergy are not valid:

¾Risk reduction – diversification by a company can only reduce unsystematic risk. However if its shareholders have balanced portfolios they have already removed all unsystematic risk and are only concerned with systematic risk (which cannot be removed either by shareholder or company diversification.)

¾Bootstrapping – sometimes it is argued that if a company with a high P/E ratio buys a company with a low P/E ratio then the higher ratio will be applied to the combined entity creating an immediate share price gain. However in an efficient market a weighted average P/E ratio would be applied.

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1.7Winners and losers

¾Empirical evidence indicates that the “winners” in most M&A’s are the “victim” shareholders.

¾Bidding company shareholders often lose wealth due to:

−Bid premiums too high;

−Bid costs too high;

−Potential synergy either not unlocked or not great enough to cover costs.

¾M&A activity is often undertaken to meet the personal objectives of managers, e.g. empire building, rather than to increase the wealth of their shareholders.

2VALUATION OF ACQUISITIONS

2.1General Principles

¾In practice the directors of a bidding company often appear to offer too high a price to acquire a target company i.e. control premium > synergy benefits.

¾It is obviously critical to make an accurate estimate of the value of the target company i.e. the maximum price that should be offered.

¾What is relevant here is not the value of the target company as a separate entity but the increase in value of the acquiring firm after the acquisition has taken place.

¾Significant transactions such as mergers or acquisitions are likely to disturb the acquiring firm’s exposure to various types of risk (e.g. business, financial, default), hence changing its cost of capital and its own value.

¾Therefore the maximum price the acquirer should pay is the increase in its own value following the acquisition. Only in very simple cases will this be the stand alone value of the target firm.

¾From a valuation perspective we can categorize acquisitions into 3 types

2.2Types of acquisition

¾Type 1 - acquisitions that neither disturb the business risk of the acquiring firm nor require additional external financing, hence no change to the firm’s existing WACC. Usually such acquisitions are relatively small compared to the size of the acquirer.

¾Type II – acquisitions which do not disturb the business risk but do disturb the financing of the firm either through altering the firm’s debt or its exposure to default risk.

¾Type III – acquisitions that alter the firm’s exposure to business risk (and possibly its exposure to financial risk and default risk).

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2.3Valuation of Type I acquisitions

¾For valuing small unquoted companies it may be acceptable to use simple asset-based models (e.g. replacement cost, “book value-plus”), or relative models (e.g. priceearnings multiples, price to book ratios).

¾Theoretically it is superior to use flow based models e.g. dividend valuation model, Free Cash Flow to Equity, Free Cash Flow to the Firm or EVA™.

¾Discount rates should be the acquiring firm’s WACC (if using Free Cash Flow to the Firm or EVA), or its cost of equity geared if using DVM or Free Cash Flow to Equity.

¾If using Free Cash Flow to the Firm or EVA remember that the resulting valuation will be that of the target firm in total i.e. its equity plus its debt. Usually in acquisitions we are buying the shares but not buying the debts.

¾Equity valuation = total value of the firm – value of debt

2.4Valuation of Type II acquisitions

¾Adjusted Present Value (APV) is the technique which appears to deal well with a change in the level of debt. Steps would be:

Use the asset beta to find the cost of equity ungeared. Use this to discount the forecast operating cash flows of the target company (including ay synergy benefits)

Calculate the present value of the tax shield on the target company’s debt discounted at the pre-tax cost of debt.

Total = APV = total value of the target firm i.e. value of equity + value of debt

Deduct value of debt to arrive at equity valuation i.e. the maximum price to offer for the target’s equity.

¾Whilst APV may be an acceptable approach under exam conditions it is unfortunately not an accurate method. With the new company “embedded” the acquiring firm’s WACC will change due to the change in debt - this in turn changes the value of the acquiring firm. Therefore the target company cannot be viewed as a stand alone entity.

¾A superior method would be based on Free Cash to the Firm:

Estimate the acquiring firm’s existing value at its existing WACC

Estimate the combined companies cash flows i.e. the acquirer’s cash flows, the target’s cash flows and any synergy benefits

Estimate the acquiring company’s post-acquisition WACC

Value the combined cash flows at the post-acquisition WACC

Deduct from the existing value of the acquiring company.

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Deduct the target company’s debt to arrive at the increase in equity due to the acquisition.

¾However even the approach above runs into problems! The change in value of the acquiring company will itself change the firm’s gearing, and hence change its cost of capital, which then changes its value.

¾We have a circular problem as we don’t know the final gearing level. The only way to solve this is using a spreadsheet such as EXCEL which has an “iteration” function i.e. runs the model an infinite number of times until it reaches its final result.

2.5Valuation of Type III acquisitions

¾As per type II the superior approach is to value the acquiring company prior to the transaction, value it again with the target company embedded, and find the difference.

¾However there are even more complications due to the change in business risk:

before the post-acquisition WACC can be found an estimate is required of the postacquisition level of business risk i.e. asset beta.

this is a weighted average of the business risk of three cash flow streams 1) the acquiring firm 2) the target firm 3) synergy effects.

the asset beta of each of these streams should be weighted according to the value of the streams.

however the streams cannot be valued until the WACC is known, but the WACC is not known until the streams are valued!

¾Again a circular problem and iteration required to solve it.

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3.4Loan stock

Advantages/disadvantages to bidder

9saves cash

9reasonably certain value

8 increases gearing Advantages/disadvantages to victim

9no Capital Gains Tax (initially)

9reasonably certain value

8changes character of investment i.e. no longer owners

3.5Convertible loan stock

Advantages/disadvantages to bidder

9 saves cash

8increases gearing

8uncertainty as to eventual outcome Advantages/disadvantages to victim

9 no Capital Gains Tax (initially)

8changes character of investment (but option to convert back to equity)

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SESSION 08 – MERGERS & ACQUISITIONS

4STRATEGY AND TACTICS

4.1Strategy

¾Identify potential target.

¾Approach board of directors in confidence to judge reaction.

¾Determine price to offer.

¾Determine terms of the offer.

¾Determine tactics of acquisition.

¾Possible tactics are:

dawn raid

offer via the City Code.

¾The City Code is an attempt to regulate the process of mergers and acquisitions although with no statutory backing. The general approach to an offer under the City Code is:

bidder puts offer to the board of the victim;

as soon as a firm offer is made shareholders must be informed by press notice;

an announced offer cannot be withdrawn;

directors must act in the interests of the shareholders;

all documentation must be prepared with the same care as if they were a prospectus being prepared under the Companies Act;

shareholders must be informed of all relevant facts;

once 30% of shares have been acquired an offer must be made to the remaining shareholders. This offer must include a cash alternative.

Under UK law once 90% of the shares in the target company have been acquired the predator can force the remaining 10% of victim shareholders to sell their minority stake.

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4.4Merger and acquisition activity in different countries

¾Merger activity is much more prevalent in the UK and US than Germany or Japan. This is because in Germany and Japan a large proportion of a company’s shares are often held by banks who would not consider selling to a predator.

¾Shares in the UK are usually held by institutional investors who will realise a profit if the price is right.

¾Some argue that the UK situation is better as it leads to market efficiency. Others argue that it leads to short-termism.

5DEFENCES AGAINST A BID

5.1Hostile bids

¾In some instances a merger will be agreed by both boards and the victim company directors will recommend the shareholders to accept the offer.

¾However in many instances the bid will not be initially accepted either because the directors fear for their own futures or because they are holding out for a higher price.

5.2Defences before a bid is made

¾If a company wishes to avoid the attention of a bidder there are a number of actions that it can take to make it appear less attractive:

minimise cash holdings;

hold strategic cross-shareholdings with other-companies (common in Japan);

“Poison pills” – e.g. debentures that become instantly redeemable upon takeover;

“Golden parachutes” – where the directors have the right to leave with substantial pay-outs if the business is taken over;

“Crown jewels” – sell off assets that might make the company attractive to predators;

“Fat man” – grow the company to such a size that it would not be practical for anybody to buy.

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