IN THIS CHAPTER
Understanding the thinking behind the decision for firms to buy rivals
Seeing what kinds of firms make good acquisitions targets
Finding out how hostile acquisitions differ from friendly ones
Analyzing M&A deals and understanding the nuances of what makes them work
Understanding why some M&A deals fail
Buyers and sellers of companies engage the services of investment banking experts to try to make sure that in any mergers and acquisitions (M&A) transaction, a fair deal is struck. In this chapter, we tell you how investment banking is used to source potential business combinations and how price tags are put on a company that is being acquired. We examine why some firms want to be acquired and try to make themselves more attractive to potential suitors and why other firms don’t want to be acquired and actually try to make themselves less attractive to suitors. Finally, we show you why some business combinations are wildly successful and others fail miserably.
The basic goal of all M&A activity is value creation and growth. The rationale behind M&A activity is that the acquiring firm can more efficiently achieve value creation through acquisition rather than organic growth. Underlying nearly all M&A activity is the premise that some form of synergy exists in the transaction. Synergy is simply explained as 1 + 1 = 3. That is, the two firms combined are worth more than either firm is worth alone.
Fundamentally, there really is no difference between a merger and an acquisition. Both terms refer to a situation in which two companies combine and become one company. Typically, a transaction is referred to as a merger if it’s a combination of equals — that is, if both firms are approximately the same size — and if both parties agree to the combination. A transaction is typically referred to as an acquisition when a larger entity buys a much smaller entity or when the decision to combine is not mutual (in which case, it’s referred to as a takeover).
There are three basic kinds of mergers — horizontal, vertical, and conglomerate, referring to the business relationship between the two parties. Understanding the different kinds of mergers gives you insight into the motivations behind mergers.
A horizontal merger is one in which a firm acquires another firm in its same industry and with similar or compatible product lines. Horizontal mergers often result in the combined firm having a more complete product line and often provide greater geographic coverage with the products. A horizontal merger may also allow the combined firm to realize economies of scale — that is, cost per unit of output declines as output increases.
A vertical merger takes place when two companies combine that previously sold to or bought goods from each other. A manufacturer may merge with a supplier of parts or producer of raw materials, or it may merge with a retailer who sells the products of the firm.
The goal of a vertical merger is not necessarily to grow or increase revenue, but to cut costs and realize a higher profit margin. Another reason for a vertical merger is to ensure that you have access to needed supplies in the production process.
A conglomerate merger occurs when two companies with completely unrelated businesses combine. The primary motivation for a conglomerate merger is to diversify the firm and decrease risk. The idea is that when one part of the business is performing poorly, a completely unrelated business may be thriving. If the profits of the separate businesses are not highly correlated — that is, their sales don’t tend to move together — then the earnings stream of the combined business will be more stable.
Although there are only three basic kinds of mergers (see the previous section), firms have many motivations for seeking to combine with other firms. Some reasons are very sound and seek to maximize the value of the entity for its owners, while others are less so. In this section, we cover a variety of motives for firms to merge with other firms.
As we explain earlier, synergy is defined as 1 + 1 = 3, but how are synergies realized? If a bank acquires another bank, the combined entity can eliminate duplicate branches in the same local markets. In this manner, it maintains the same customers and has a lower cost structure. The same logic exists for mergers in which the combined firm has a much more complete product line. For instance, when two car companies merge, the dealers can sell the vehicles of both firms and duplicative dealerships can be closed down, or when a soft-drink producer merges with a fast-food chain, an outlet for the product is secured. In the “Overstated synergies” section, later in this chapter, we explain that many synergies are illusory.
Growing organically is tough and takes patience. It’s often quicker and more of a sure thing to buy growth via an acquisition than to patiently grow a business the good old-fashioned way. A company may not know how successful it will be in organically growing a business, but it knows exactly what it’s buying in an acquisition — or at least it thinks it does.
Mergers can result in increased market power. In particular, in a horizontal merger, there is less competition following the merger, so the combined firm will likely have more pricing power. In fact, many horizontal mergers are closely scrutinized for antitrust violations for precisely this reason — because they can dampen competition. On the other hand, in vertical mergers, the result is less supply-chain uncertainty and a likely increase in product quality because the firm has more control over its supplies.
Crossing borders can be very difficult for many businesses, and one of the easiest ways for a company to quickly and effectively access foreign markets is to merge with a firm from a different country. Crossing borders can be very difficult for a variety of reasons, most notably regulatory and cultural concerns, but merging with an existing firm can skirt many of those issues.
One of the dirty little secrets of merger activity is that some mergers are realized because it’s in the best interests of the management — and not necessarily in the best interests of the shareholders — to merge and create a larger company. The fact is, bigger organizations pay their CEOs more than smaller organizations’ leaders are paid. Size of the firm really does matter when it comes to CEO pay. And it isn’t just CEO pay, but the pay of the entire executive team. Not surprisingly, CEOs seek to increase their compensation and influence by building a bigger empire.
The primary motivation for conglomerate mergers is diversification and reduction of risk. If a cyclical firm (one that tends to see its profits rise and fall with the business cycle) acquires a counter-cyclical firm (one that tends to see its profits rise when the broad economy falters), for instance, the profit stream of the combined firms should be more stable.
For example, if an upscale restaurant chain acquires a staple food producer, the revenues of the upscale restaurant chain will be up when the business cycle is booming and will be down when the business cycle is depressed. The revenue streams of the combined firms should counterbalance each other to some degree and result in a more stable firm-wide income across the business cycle.
Some mergers take place because it simply makes good sense from a tax perspective. Specifically, if a firm has accumulated large tax losses, it may make an attractive acquisition target by a firm with a large tax bill. The combined firm will have a lower tax bill than the two separate firms. In addition, a firm that is able to increase its depreciation charges following an acquisition will save in taxes. These tax savings should result in an increase in firm value.
Rarely will a merger take place solely for the purpose of realizing tax savings, but it is a contributing factor.
Many companies are acquired because the acquirer believes that there is hidden value in the assets of the acquired firm that can be unlocked if it gains control. In other words, the company is mismanaged and the new management team can turn the enterprise around. If a company truly is being mismanaged, the value of the assets is not being maximized. If those assets can be acquired at a depressed price that reflects the current use of the assets, and the acquirer can make more effective use of those assets, then the hidden value of the assets can be realized through a change in control.
Everyone has heard the saying “Capital is king,” so simply having access to capital must be a member of the royal family. A source of hidden value is unused borrowing capacity. A firm may be an attractive takeover candidate if it has little or no debt on its balance sheet. An acquiring firm could acquire the assets of the firm and utilize the previously untapped borrowing capacity to acquire much needed capital and expand even further. If the firm can make more on the borrowed funds than those funds cost, it will realize an increase in value and add to the combined firm’s return on equity, making both the shareholders and the management happy.
The most attractive acquisition targets will have more than one of the qualities cited in the previous section. For instance, it would seem that an ideal target would be a mismanaged firm with significant unused debt capacity operating at either marginal profitability or at a loss and with unused tax credits. The belief is that the acquiring firm can acquire the company at a depressed price and subsequently improve the management of the firm and realize synergistic benefits that will improve profitability. The previously unused debt capacity can be tapped to increase the return on equity to the shareholders of the acquirer. If there are tax losses, those tax losses can be used to offset the profitability of the acquiring firm and lower the tax bill of the combined entity.
Typically, companies work with investment bankers to create an acquisition profile (a description of a firm that would be the ideal target). After that profile has been created, the investment bankers work with the firm to identify potential acquisition targets via several avenues:
Any or all these means may be utilized to identify potential acquisition candidates.
Business combinations can be characterized as either friendly or hostile. Although the end result is the same — the combination of two previously separate firms into one entity — the investment banking process differs substantially depending upon the nature of the transaction.
In a friendly merger, the two firms work together on the transaction, and the combination is approved by both the target firm’s board of directors and the acquiring firm’s board of directors. Essentially, there is a meeting of the minds, and both parties agree that the acquisition is beneficial to their respective shareholders.
In a hostile takeover, the transaction is opposed by the target company’s board of directors and management. Not surprisingly, many acquisitions are opposed by the management of the target firm — after all, they may find themselves unemployed if the transaction takes place. Because the deal is opposed, the acquiring company must gain control of the acquired firm to get it to agree to the transaction. Because the board of directors isn’t amenable to the business combination, in a hostile takeover the acquiring company will do one of the following to acquire the target company:
Make a tender offer. A tender offer is simply a public offer to buy the shares of the target firm at a fixed price that represents a substantial premium to the current market price. The tender generally has stipulations that the offer is good only if 51 percent of the shareholders agree to sell at that price. If enough shareholders agree to sell — or tender — their shares, the acquiring firm can take control of the company, change the composition of the board of directors, and ultimately acquire control of the company.
Tender offers are good news for the shareholders of the target company, because the typical market reaction to a tender offer is a dramatic increase in the stock price — reflecting the premium that the tender is to the current market price. Even if the tender offer doesn’t succeed, it signals to the market that the target firm is “in play,” and you may see other firms get into a bidding war.
In 2019, Merck acquired all the outstanding shares of Immune Design, a developer of an immunotherapy for non-Hodgkin's lymphoma. The shareholders of Immune Design received a windfall profit, as Merck paid a premium of 300 percent over the share price prior to the tender offer.
Engage in a proxy fight. A proxy fight is a little different from a tender offer, but the goal is identical — to gain control of the target firm so that the acquisition is ultimately approved. A proxy vote is a situation in which a shareholder gives her vote (or proxy) to someone authorized to vote for her on a particular matter. In this case, it’s to seek a change in control of the organization and establish a board and management team that is favorable to being acquired. With proxy authority, the acquiring corporation is able to take control of the target company, replace the directors with its own appointees, and approve the merger resolution.
An example of a successful proxy fight was Weyerhaeuser’s 2002 acquisition of Willamette Industries. Upon rejection of two previous offers to buy Willamette, Weyerhaeuser secured control of the Willamette board via a proxy fight. This ended a protracted four-year process that began with a friendly merger offer and included two tender offers. Who said high finance was easy?
A separate team from different investment banking organizations works on opposite sides of any proposed acquisition deal. They serve as the representatives of each of the parties — the buyer and the seller — throughout the deal and work to ensure that a fair deal is reached. This is an important source of fee income for investment banks, and M&A activity represents a very profitable business for most investment banking firms.
When an investment banking firm is advising a firm seeking to acquire another company, the investment banking firm is referred to as a buy-side advisor. The buy-side advisor is responsible for
We cover each of these responsibilities in the following sections.
The buy-side M&A advisor will help identify potential target firms that meet the client’s criteria. They will reach out to the potential target firms to gauge their interest and discuss the potential transaction.
Due diligence in the context of an acquisition refers to an in-depth analysis of the target firm in order to gain a true picture of the firm — its strengths and weaknesses, with particular emphasis placed upon the firm’s financial condition. The process of due diligence involves gathering a great deal of information and analyzing and interpreting that information in order to determine if a deal could be potentially advantageous for the buyer and at what price a deal would make sense.
Much of this due process focuses on financial modeling in an attempt to determine the incremental value that would likely be created in the acquisition. The result of this modeling is the creation of pro forma financial statements (projected financial statements — such as balance sheets, income statements, and cash-flow statements — that attempt to show the financial performance of the firm if things go “as to form”). These projections are generally made several years out into the future and are used as inputs into the valuation process.
The due-diligence process should detail the strengths and weaknesses of the proposed transaction and highlight the significant risks of the transaction to the buyer, so that a reasoned decision can be made through consideration of all the relevant facts and conjectures.
The goal of the due-diligence process should be an unbiased estimate of the true value of the target firm to the buyer. This is where young associates of investment banking firms — most often recent MBA graduates — cut their teeth in the field by applying a wide variety of valuation methods in marathon sessions to determine that value. These associates pore over reams of data and run multiple iterations of financial models.
A major portion of the valuation exercise involves the accretion/dilution analysis. This is a part of the analysis that determines whether the earnings per share (EPS) of the buying firm will increase or decrease after the deal is completed. As you may imagine, shareholders don’t like transactions that will lower or dilute the EPS of the firm. In rare occasions, shareholders will support a dilutive acquisition, but only if it appears that the acquisition will result in a long-term increase in EPS.
In addition to the price, the investment banking team will negotiate the specific terms of the acquisition with the target firm. This includes negotiating the composition of the board of directors and management team, as well as any necessary employment contracts. There will likely be several rounds of negotiation in any merger situation with a great deal of give and take between the two parties. The final deal often looks substantially different from the first pass of the deal.
With respect to price, a good investment banking firm will tell the client when to stop bidding. In their zeal to complete a deal, many firms lose sight of the necessity to not win at any cost.
Both the acquirer and the acquired firm’s board of directors meet to approve the transaction. In addition, both the buy-side and the sell-side’s investment banks deliver a fairness opinion regarding the transaction to their respective clients. The fairness opinion states simply that the deal is fair and that no entity is over- or underpaid. Shareholders of both firms look to the fairness opinion as third-party approval that the deal was, indeed, aboveboard. Finally, in order for the deal to be closed, the shareholders of both parties must approve the transaction.
Although the sell-side M&A advisor will perform many of the same functions as the buy-side advisor, there are some fundamental differences, depending upon whether the firm wants to be acquired.
Many companies who are acquired were actually looking to be acquired — they welcome the overtures from potential buyers. In fact, increasingly, the dream of many entrepreneurs is to found a company, operate it successfully, grow the business, and then sell out to a major firm in the industry for a handsome profit. If that’s the case, the sell-side investment banking advisor will prepare an analysis of the company and recommend steps that should be taken prior to the firm looking for potential suitors to make the firm more attractive.
Like buy-side advisors, sell-side M&A advisors prepare a detailed valuation report on the company, specifying a range of values that the firm should conceivably sell for. Where warranted, this analysis will also provide a summary of selling part of the company — certain product or business lines — in lieu of the entire company. In fact, the firm may find that by selling off parts of the firm, it may be able to command a higher price than by selling the entire firm to one buyer.
A major difference between buy-side and sell-side M&A advising is that the sell side focuses on marketing the firm. Therefore, sell-side advisors provide clients with advice on a business plan that makes the firm more attractive to potential buyers. This relationship may start several years in advance, because the company generally prepares for the day when it will be sold. Sell-side advisors also prepare detailed marketing materials for distribution to potential buyers.
A major part of marketing the firm involves initiating contact with potential buyers and gauging levels of interest. Connecting the buyer and seller is one of the most important functions of the sell-side M&A advisor; all the avenues detailed earlier for the buy-side advisor (see “Identifying potential acquisition targets”) may be utilized by the sell-side counterpart.
If, on the other hand, the firm does not want to be acquired, the sell-side M&A advisor consults with firm management and the board of directors on a game plan to enact some of the takeover defense strategies outlined in the “Shark repellant” sidebar, earlier in this chapter.
It may seem like much of the analysis of mergers and acquisitions involves the application of financial models and is very cut-and-dried, mathematical, and technical, but a great deal of art is involved in the deal. In fact, two investment banking teams can draw dramatically different conclusions even when presented with an identical set of facts and data to analyze. That is, in essence, what makes the financial world work — there is a buyer and a seller for every transaction.
Some mergers and acquisitions simply shouldn’t see the light of day because they’re basically bad ideas from the start. But there are incentives all around to get a deal done — a successful M&A deal results in many individuals getting paid and others, notably the management of the acquiring firm, building a bigger empire to oversee. So some of the analysis may not be unbiased, but may be influenced by other factors. Recognizing when those factors are at play is difficult, however, because there is a great deal of judgment involved in the due-diligence and valuation processes. Plus, many investment bankers and their teams remind us of the time-worn joke about accountants: When asked what 2 + 2 is, the accountant replied, “What do you want it to be?” With the changing of an assumption, the investment banker can transform a deal from marginally unattractive to a must-do.
The financial models that are used by investment banking firms are discounted cash-flow and relative valuation models — standard fare in the industry. Rarely is the analysis faulty because improper models are being applied. A simple tweaking of an assumption here or there in the analysis — perhaps a sales growth rate that is a couple percentage points higher or a discount rate that is a couple percentage points lower — can make all the difference in the world when it comes to making a transaction appear profitable or unprofitable and providing the client with the answer they want to hear.
Forecasting future cash flows is very difficult, especially out several years in advance. Just ask that great American ballplayer and philosopher Yogi Berra, who once said, “It’s tough to make predictions, especially about the future.” Yet, much of the modeling in an acquisition setting requires investment bankers to do just that — predict the future.
Some mergers and acquisitions fail because the investment bankers and management teams are simply overly optimistic about the synergies that can be achieved. In fact, over-optimism may be the single biggest reason that shareholders are disappointed with the results of a merger or acquisition. The benefits described on paper are not realized and simply can’t be translated into the real world.
Many mergers and acquisitions are unsuccessful because of the difficulty of integrating companies with distinctly different firm cultures. Bringing two firms together to operate under a single umbrella involves more than just combining assets and liabilities on a balance sheet — it also involves bringing people together to work productively with each other.
Anyone who has participated in an auction has likely set a price at which they would feel comfortable buying a particular lot or item. You tell yourself you won’t go beyond that price — “I’ll pay $500 and not a single penny more!” Yet, when it comes time to bid on the item that you’re interested in, you find that the bid quickly escalates and exceeds the price limit you set. You justify your change in strategy because you’ve waited and invested your entire day in the process, becoming emotionally invested in “winning,” which you now define as ending up with the item, not ending up with the item at a reasonable price. You don’t want to see that rival bidder outbid you for the item — how can you let him win? You end up paying much more than you intended, but you didn’t go home empty-handed — you won! Or did you?
Just like the individuals in the popular TV series Storage Wars (where individuals bid against each other at auctions for abandoned storage lockers), corporate executives find themselves in bidding wars to acquire firms and go beyond the prices that they rationally set for the target company. Initially they set price limits at which the acquisition makes good economic sense for the shareholders. But, as soon as they get into a bidding war, it’s no longer just about acquiring the firm for a price that makes economic sense — it’s about winning … at virtually any cost.