Mergers and Acquisitions – M&A
What Are Mergers and Acquisitions – M&A?
Mergers and acquisitions (M&A) is a general term used to describe the
consolidation of companies or assets through various types of financial
transactions, including mergers, acquisitions, consolidations, tender offers,
purchase of assets, and management acquisitions.
The term M&A also refers to the desks at financial institutions that deal in such
activity.
KEY TAKEAWAYS
The term mergers and acquisitions (M&A) refer broadly to the process of
one company combining with one another.
In an acquisition, one company purchases the other outright. The acquired
firm does not change its legal name or structure but is now owned by the
parent company.
A merger is the combination of two firms, which subsequently form a new
legal entity under the banner of one corporate name.
M&A deals generate sizable profits for the investment banking industry, but
not all mergers or acquisition deals close.
Post-merger, some companies find great success and growth, while others
fail spectacularly.
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What's an Acquisition?
The Essence of Merger
The terms "mergers" and "acquisitions" are often used interchangeably, although
in actuality, they hold slightly different meanings. When one company takes over
another entity, and establishes itself as the new owner, the purchase is called an
acquisition. From a legal point of view, the target company ceases to exist, the
buyer absorbs the business, and the buyer's stock continues to be traded, while
the target company’s stock ceases to trade.
On the other hand, a merger describes two firms of approximately the same size,
who join forces to move forward as a single new entity, rather than remain
separately owned and operated. This action is known as a "merger of equals."
Both companies' stocks are surrendered and new company stock is issued in its
place. Case in point: both Daimler-Benz and Chrysler ceased to exist when the
two firms merged, and a new company, Daimler Chrysler, was created. 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.
Unfriendly ("hostile takeover") deals, where target companies do not wish to be
purchased, are always regarded as acquisitions. A deal is can thus 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.
Types of Mergers & Acquisitions
Here is a brief overview of some common transactions that fall under the M&A
umbrella:
Mergers
In a merger, the boards of directors for two companies approve the combination
and seek shareholders' approval. Post merger, the acquired company ceases to
exist and becomes part of the acquiring company. For example, in 1998 a
merger deal occurred between Digital Computers and Compaq, whereby
Compaq absorbed Digital Computers. 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).
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 legal structure, and
often preserve the existing stock symbol. An example of this transaction is
Manulife Financial Corporation's 2004 acquisition of John Hancock Financial
Services, where both companies preserved their names and organizational
structures. Acquisitions may be done by exchanging one company's stock for the
others or using cash to purchase the target company's shares.
Consolidations
Consolidation creates a new company through 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
Traveler's Insurance Group announced a consolidation, which resulted in
Citigroup.
Tender Offers
In a tender offer, one company offers to purchase the outstanding stock of the
other firm, at a specific price rather than market price. The acquiring company
communicates the offer directly to the other company's shareholders, bypassing
the management and board of directors. For example, in 2008, Johnson &
Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438
million. While the acquiring company may continue to exist — especially if there
are certain dissenting shareholders — most tender offers result in mergers.
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, where 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 chief executive manager, Michael Dell.
The Structure of Mergers
Mergers may be structured in multiple different ways, 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 a cone supplier merging with an ice cream maker.
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.
Mergers may also be distinguished by following two financing methods--each
with its own ramifications for investors.
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.
Special Considerations
A company may buy another company with cash, stock, assumption of debt, or a
combination thereof. 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 tradeable shares.
Valuation Matters
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 as possible, while the buyer will attempt to buy it for the lowest possible
price. Fortunately, a company can be objectively valued by studying comparable
companies in an industry, and by relying on the following metrics:
1. Comparative Ratios: The following are two examples of the many
comparative metrics on which acquiring companies may base their offers:
2. Price-Earnings Ratio (P/E Ratio): With the use of this 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.
3. Enterprise-Value-to-Sales Ratio (EV/Sales): With this ratio, the acquiring
company makes an offer as a multiple of the revenues, again, while being
aware of the price-to-sales ratio of other companies in the industry.
4. 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 where the key assets – people and ideas
– are hard to value and develop.
5. Discounted Cash Flow (DCF): A key valuation tool in M&A, discounted
cash flow 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 costs of capital (WACC). Admittedly, DCF is tricky to get right, but
few tools can rival this valuation method.
