Chapter 9: Strategic aspects of acquisitions

Chapter learning Objectives

Upon completion of this chapter you will be able to:

• explain the arguments for and against the use of acquisitions and mergers as a method of corporate expansion
• identify and explain the corporate issues arising on an acquisition
• evaluate the corporate nature of a given acquisition proposal in a scenario
• describe the competitive issues surrounding a given acquisition proposal in a scenario
• explain the criteria for choosing an appropriate target for acquisition
• list and compare the various explanations for the high failure rate of acquisitions in enhancing shareholder value
• list and explain potential sources of synergy
• describe and evaluate in a given context the potential for the various categories of synergy gains
• list and explain the principal factors influencing the development of the regulatory framework for mergers and acquisitions globally
• compare and contrast the shareholder versus the stakeholder models of regulation for mergers and acquisitions globally
• for a given offer in a scenario, identify the main regulatory issues which are likely to arise
• for a given offer in a scenario, assess whether the offer is likely to be in the shareholders’ best interests
• list, explain and evaluate the available defence strategies available to the directors of a target company if offer is to be treated as hostile
• for a given offer in a scenario, advise the directors of a target company on the most appropriate defence if the offer is to be treated as hostile
• list and evaluate the various sources of financing available for a proposed cash-based acquisition
• evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal using pure or mixed mode financing and recommend the most appropriate offer to be made
• explain the distinction between merger and acquisition accounting and assess the impact of a given financial offer on the reported financial position and performance of the acquirer.

1 Mergers and acquisitions – the terms explained

Merger or acquisition

• A merger is in essence the pooling of interests by two business entities which results in common ownership.
• An acquisition normally involves a larger company (a predator) acquiring a smaller company (a target).
• Generally both referred to as mergers for PR reasons:
  • It portrays a better message to the customers of the target company.
  • To appease the employees of the target company.
• An alternative approach is that a company may simply purchase the assets of another company rather than acquiring its business, goodwill, etc.

When studying P4 and taking the exam you should not be concernedwith the strict definitions of mergers and acquisitions used in thecorporate reporting papers – the terms are often used interchangeablyin this area.

Types of merger/acquisition

Types of merger

The arguments put forward for a merger may depend on its type:

• Horizontal integration.
• Vertical integration.
• Conglomerate integration.

Horizontal integration

Two companies in the same industry, whose operations are veryclosely related, are combined, e.g. Glaxo with Welcome and the banks andbuilding societies mergers, e.g. Lloyds TSB and HBOS.

Main motives: economies of scale, increased market power, improved product mix.

Disadvantage: can be referred to relevant competition authorities.

Vertical integration

Two companies in the same industry, but from different stages of the production chain merger.

e.g. major players in the oil industry tend to be highly vertically integrated.

Main motives: increased certainty of supply or demand andjust-in-time inventory systems leading to major savings in inventoryholding costs.

Conglomerate integration

A combination of unrelated businesses, there is no common threadand the main synergy lies with the management skills and brand name,e.g. General Electrical Corporation and Tomkins (management) or Virgin(brand).

Main motives: risk reduction through diversification and cost reduction (management) or improved revenues (brand).

2 Organic growth versus growth by acquisition

Organic growth is internally generated growth within the firm.

Growth strategy

Assuming a standard profit maximising company, the primary purposeof any growth strategy should be to increase shareholder wealth.

• No external growth should be considered unless the organic alternative has been dismissed as inferior.

Advantages/disadvantages of organic growth and acquisition

Advantages of organic growth (disadvantages of growth by acquisition)

• Organic growth allows planning of strategic growth in line with stated objectives.
• It is less risky than growth by acquisition – done over time.
• The cost is often much higher in an acquisition – significant acquisition premiums.
• Avoids problems integrating new acquired companies – the integration process is often a difficult process due to cultural differences between the two companies.
• An acquisition places an immediate pressure on current management resources to learn to manage the new business.

Advantages of growth by acquisition (disadvantages of organic growth)

• Quickest way is to enter a new product or geographical market.
• Reduces the risk of over-supply and excessive competition.
• Fewer competitors.
• Increase market power in order to be able to exercise some control over the price of the product, e.g. monopoly or by collusion with other producers.
• Acquiring the target company’s staff highly trained staff – may give a competitive edge.

The reasons for acquisitions

Whilst the potential for synergy is a key reason given for growth by acquisitions other motives do exist:

• Entry to new markets and industries.
• To acquire the target company’s staff and know-how.
• Managerial motives – conscious pursuit of self-interest by managers.
• Arrogance factor/Hubris hypothesis.
• Diversification.
• A defence mechanism to prevent being taken over.
• A means of improving liquidity.
• Improved ability to raise finance.
• A reduction of risk by acquiring substantial assets (if the predator has a high earnings to net asset ratio and is in a risky business).
• To obtain a growth company (especially if the predator’s growth is declining).
• To create a situation where rationalisation (which would otherwise be shirked) may be carried out more acceptably.

Why a company may want to be acquired

Many combinations are by mutual agreement, so small companies beingacquired may welcome such a move. Possible reasons for this include:

• Personal – e.g. to retire, for security, because of the problem of inheritance tax.
• Business – an expanding small company may find that it reaches a size where it is impossible to restrain growth, but funds or management expertise for this are lacking.
• Technical – increasing sophistication presents a problem for the small company, e.g:
  • cost of research and development may be prohibitive
  • inability to employ specialised expertise
  • inability to offer a complete range of services or products to customers.
• Can apply to companies that are quite large by most standards, e.g. Rolls-Royce Ltd was too small to absorb the research costs on one new engine.

Corporate and competitive aspects of mergers

• Need to decide in an exam question what is happening – i.e. is it a:
  • merger
  • acquisition
  • simply a purchase of assets
  • demerger
  • spin-off
  • management buy out

Methods of mergers and acquisitions

Though the terms are used loosely to describe a variety ofactivities, in every case the end result is that two companies become asingle enterprise, in fact if not in name, the end result is achievedby:

• transfer of assets
• transfer of shares.

The two methods of undertaking acquisitions and mergers are summarised as follows:

Corporate issues arising on acquisition

Various corporate issues can arise on acquisition of one company by another:

• Impact on board structure - a power struggle among the directors will not help the post acquisition integration of the two firms.
• Board hostility.
• Impact on corporate governance.
• Culture differences - this can be especially marked when the two companies are based in different countries.
• Loss of key personnel from target company.
• Integration difficulties – e.g. systems, operations.
• Adverse PR - especially if there is a threat of job losses as a consequence of the takeover.

Competitive issues

When considering acquisitions and mergers the competitive aspects need to be considered.

• One of the motives for acquiring a company is to remove competitive rivalry from the market.

For example, consolidation in the supermarket industry:

The purchase of Safeways by William Morrison in the UK in 2006reduced the number of supermarket chains and as such the level ofcompetition in this market.

Test your understanding 1: Fred’s group

Fred’s ironmongery was founded in 1845 by the Fred family andgrew over the next century into a national chain with 1,005 stores. In1975 it joined forces with Mary’s which had 375 stores and therefollowed a period of rationalisation where several of Mary’s storesclosed, became departments of Fred’s or were transferred to Fred’ssubsidiary company Fredrica’s. In 2004 Fred’s again joined forces– this time with Annette’s – unlike Mary’s, Annette’s hasmaintained its own logo and brand names rather than using thedistinctive Fred’s ‘F’. Both Annette’s and Mary’s operated inthe same market as Fred’s. Fred’s also has a history of purchasingsmall shareholdings in related businesses and purchasing company assets.Annette’s has maintained all its 976 stores and is dueto open a further 15 in late 2008.

On amalgamation with Mary’s – Matthew James the CEO of Fred’sreplaced nearly all the key personnel with Fred’s staff – statingthat:

‘A new era needs a new approach’. However, this approach hadaltered by 2004 when Pippa John from Annette’s was appointed DeputyCEO with the explanation – ‘We need to utilise the expertise of allareas of the Group’.

What is the corporate nature of the above two amalgamations ofFred’s?

In early 2007 Fred’s indicated that it is considering joiningwith Moira’s – in what is believed to be an attempt to obtainMoira’s impressive property portfolio, we are at present awaitingdevelopments in this situation.

List some of the issues that may arise on the amalgamation of Moira’s by Fred’s.

Test your understanding 2: Premier foods

The takeover of RHM by Premier foods will mean that Premier foods willbe the largest food producer in the UK. The takeover means thatPremier’s Batchelors, Branston, Lloyd Grossman and Quorn brands andRHM’s brands Mr Kipling, Sharwoods and Bisto are owned by the samegroup. There are likely to be factory closures and job cuts.

What competitive issues arise from this scenario?

3 Identifying possible acquisition targets

Suppose a company decides to expand. Its directors will producecriteria (size, location, finances, products, expertise, management)against which targets can be judged.

Directors and/or advisors then seek out prospective targets in the business sectors it is interested in.

The team then examines each prospect closely from both a commercial and financial viewpoint against criteria.

In general businesses are acquired as going concerns rather than the purchase of specific assets.

Steps in identifying acquisition targets

Steps to be taken

Assuming that external growth has been decided upon, the firm needsto consider the steps to be taken. A possible sequence of steps is asfollows (given in the context of acquisitions, although much will applyto mergers as well):

• Strategic steps
  • Step 1: Appraise possible acquisitions.
  • Step 2: Select the best acquisition target.
  • Step 3: Decide on the financial strategy, i.e. the amount and the structure of the consideration.
• Tactical steps
  • Step 1: Launch a dawn raid subject to relevant regulation.
  • Step 2: Make a public offer for the shares not held.
  • Step 3: Success will be achieved if more than 50% of the target company’s shares are acquired.

Information required for the appraisal of acquisitions

The following needs to be considered when appraising a target for acquisition:

• Organisation.
• Sales and marketing.
• Production, supply and distribution.
• Technology.
• Accounting information.
• Treasury information.
• Tax information.

When considering a target for acquisition a company need to assesscarefully the following – this information would only be availablepre-acquisition where an agreed bid was negotiated.

4 Synergy

As in other areas of the syllabus the ultimate justification of anypolicy is that it leads to an increase in value, i.e. it increasesshareholder wealth. As in capital budgeting where projects should beaccepted if they have a positive NPV, in a similar way combinationsshould be pursued if they increase the wealth of shareholders.

Illustration 1: Synergy

Suppose firm A has a market value of £2m and it combines with firmB, market value £2m, with considerations at current market prices.

If the resultant new firm AB has a market value in excess of £4mthen the combination can be counted as a success, if less it will be afailure.

Essentially, for a successful combination we should be looking for a situation where:

Market value of combined companies (AB) > Market value of A + Market value of B

If this situation occurs we have experienced synergy, that is, thewhole is worth more than the sum of the parts. This is often expressedas ‘the 2 + 2 = 5 effect’.

Types of synergy

Revenue synergy

Sources of revenue synergy include:

Market power/eliminate competition

Firms may merge to increase market power in order to be able toexercise some control over the price of the product. Horizontal mergersmay enable the firm to obtain a degree of monopoly power, which couldincrease its profitability by pushing up the price of goods becausecustomers have few alternatives.

Economies of vertical integration

Some acquisitions involve buying out other companies in the sameproduction chain, e.g. a manufacturer buying out a raw material supplieror a retailer. This can increase profits by ‘cutting out the middleman’, improved control of raw materials needed for production, or byavoiding disputes with what were previously suppliers or customers.

Complementary resources

It is sometimes argued that by combining the strengths of twocompanies a synergistic result can be obtained. For example, combining acompany specialising in research and development with a company strongin the marketing area could lead to gains.

Cost synergy

Sources of cost synergy are:

Economies of scale

Horizontal combinations (of companies in a similar line ofbusiness) are often claimed to reduce costs and therefore increaseprofits due to economies of scale. These can occur in the production,marketing or finance areas. Economies of scale occur through suchfactors as:

• fixed operating and administrative costs being spread over a larger production volume
• consolidation of manufacturing capacity on fewer and larger sites
• use of space capacity
• increased buyer power, i.e. bulk discounts
• savings on duplicated central services and accounting staff costs.

These benefits are sometimes also claimed for conglomeratecombinations (of companies in unrelated areas of business) in financialand marketing costs.

Economies of scope

May occur in marketing as a result of joint advertising and common distribution.

Financial synergy

Sources of financial synergy include:

Elimination of inefficiency

If the ‘victim’ company in a takeover is badly managed itsperformance and hence its value can be improved by the elimination ofinefficiencies. Improvements could be obtained in the areas ofproduction, marketing and finance.

Elimination of inefficiency – bargain buying

If the ‘victim’ company in a merger is badly managed itsperformance and hence its value can be improved by the elimination ofinefficiencies.

Tax shields/accumulated tax losses

Another possible financial synergy exists when one company in anacquisition or merger is able to use tax shields or accumulated taxlosses, which would have been unavailable to the other company.

Surplus cash

Companies with large amounts of surplus cash may see theacquisition of other companies as the only possible application forthese funds. Of course, increased dividends could cure the problem ofsurplus cash, but this may be rejected for reasons of tax or dividendstability.

Corporate risk diversification

One of the primary reasons put forward for all mergers butespecially conglomerate mergers is that the income of the combinedentity will be less volatile (less risky) as its cash flows come from awide variety of products and markets. This is a reduction in total risk,but has little or no affect on the systematic risk.

Diversification and financing

If the future cash flow streams of the two companies are notperfectly positively correlated then by combining the two companies thevariability of their operating cash flow may be reduced. A more stablecash flow is more attractive to creditors and this could lead to cheaperfinancing.

Others

Other sources of synergy are:

Surplus managerial talent

Companies with highly skilled managers can make use of thisresource only if they have problems to solve. The acquisition ofinefficient companies is sometimes the only way of fully utilisingskilled managers.

Speed

Acquisitions may be far faster than organic growth in obtaining a presence in a new and growing market.

These gains are not automatic and for example diseconomies of scale mayalso be experienced. In an efficient stock market A and B will becorrectly valued before the combination and we need to ask how synergywill be achieved, i.e. why any increase in value should occur.

Test your understanding 3: Synergy

Explain why synergy might exist when one company merges withor takes over another company.

Test your understanding 4: Williams and GSL

Williams Inc is the manufacturer of cosmetics, soaps and shower gels. Italso markets its products using its own highly successful sales andmarketing department. It is seen as an employer of choice and as suchhas a talented and loyal work-forcewith a history of developing new andexciting products which have sold well. It is now considering extendingits range, however it has currently a build-upof unfulfilled orders due to alack of capacity.

GSL is a well-known herbal remedy for skin problems. GSL Co wasfounded by three brothers in the 1950s and until the death of theremaining brother in 2004 has performed well – however the newChairman has limited experience and the company has not performed wellover recent years. GSL has a dedicated team of herbalists who havedeveloped products, which would find a ready market – however, thereis insufficient funds and expertise to correctly market these productsand market share is low.

Williams’ products and GSL’s products are made using similarproduction technologies and their financial and administrative systemsare similar and it is hoped savings can be made here.

Identify any potential synergy gains that would emerge from a merger of Williams and GSL.

5 Why is there a high failure rate of acquisitions?

Research conclusions

Research in this area has two major conclusions:

• Value or synergistic gains are in practice quite small.
• Bidding companies usually pay a substantial premium over the market value of the ‘victim’ company prior to the bid.

Illustration 2: Acquisition of Company D by Company C

Both companies having a market value of $2m each in isolation.

• Assume that when these are combined a small amount of synergy is obtained and their combined value rises to $4.5m.
• Assume that to acquire D’s shares C has had to pay a premium of $1 m, i.e. total cost of D is $3 m.
• The benefit/(cost) of the takeover to C’s shareholders is as follows:

• This loss will be to the cost of the acquiring company shareholders but to the benefit of the victim company shareholders (as they received the $1 m premium).

This in fact reflects the overall conclusion of research in this area: theconsistent winners in mergers and takeovers are victim companyshareholders; the consistent losers are acquiring companyshareholders.

More detail on causes of failure

Causes of failure

Reasons advanced for the high failure rate of combinations are:

• Over-optimistic assessment of economies of scale. Such economies can be achieved at a relatively small size; expansion beyond the optimum results in disproportionate cost disadvantages.
• Once a company has been bought, management move on to identify the next target rather than ensuring that predicted synergy is realized. The post-acquisition management phase is often critical.
• Inadequate preliminary investigation combined with an inability to implement the amalgamation efficiently.
• Insufficient appreciation of the personnel problems which will arise.
• Dominance of subjective factors such as the status of the respective boards of directors.
• Difficulty of valuation.
• Arguments given as justification for merger or acquisition are suspect.
• Laziness of management in looking for alternatives.
• Winners curse – where two or more predators bid to buy a target the winner has often had to pay an excessive premium to secure the deal.

For example,

• Racal’s original £65 million bid for Decca was approved by the Decca chairman and by 30% of the voting shares.
• After the intervention of GEC, Racal eventually took control with a bid in excess of £100 million.
• Such a large gap between the original and final valuation indicates the kind of variation in measures of value that can exist.

6 The regulation of takeovers

The regulation of takeovers varies from country to country butfocuses primarily on controlling the directors. Typical factors includethe following:

• At the most important time in the company’s life – when it is subject to a takeover bid – its directors should act in the best interest of their shareholders, and should disregard their personal interests.
• All shareholders must be treated equally.
• Shareholders must be given all the relevant information to make an informed judgement.
• The board must not take action without the approval of shareholders, which could result in the offer being defeated.
• All information supplied to shareholders must be prepared to the highest with standards of care and accuracy.
• The assumptions on which profit forecasts are based and the accounting polices used should be examined and reported on by accountants.
• An independent valuer should support valuations of assets.

The UK position

The acquisition of quoted companies is circumscribed by the CityCode on Takeovers and Mergers (‘the City Code’), which is theresponsibility of the Panel on Takeovers and Mergers.

• This code does not have the force of law.
• It is enforced by the various City regulatory authorities, including the Stock Exchange, and specifically by the Panel on Takeovers and Mergers (the ‘Takeover Panel’).
• Its basic principle is that of equity between one shareholder and another.
• It sets out rules for the conduct of such acquisitions.

The Stock Exchange Yellow Book also has certain points to make in these circumstances:

• Details of documents to be issued during bids for quoted companies.
• Such documents to be cleared by the Stock Exchange.
• Timely announcement of all price sensitive information.

The Office of Fair Trading (OFT) regulates the monopoly aspects ofbids. Many bids, because of their size, will require review by the OFT,and a limited number will subsequently be referred to the CompetitionCommission under the Fair Trading Act if the OFT thinks that a mergermight be against the public interest (i.e. constraining of competition).

As a rule of thumb the Competition Commission may investigate anacquisition if it will result in the combined entity acquiring 25% ormore of market share.

Their investigations may take several months to complete duringwhich time the merger is put on hold. Thus giving the target companyvaluable time to organise its defence. The acquirer may abandon its bidas it may not wish to become involved in a time consuming CompetitionCommission investigation.

The Commission may simply accept or reject the proposals or acceptthem subject to certain conditions, e.g. on price. There has been arecent surge in the level of merger activity within Europe due toreduction of barriers to overseas ownership and a desire bymultinational companies to enter the European market. These are subjectto regulation by the European Commission in Brussels.

In addition, if the offer gives rises to a concentration (i.e. apotential monopoly) within the EC, the European Commission may initiateproceedings. This can result in considerable delay, and constitutesgrounds for abandoning a bid.

Shareholder/stakeholder models of regulation

In the UK and US the market-based ‘shareholder model’ of regulation is used:

• Shareholder model – to protect rights of shareholders.
• Wide shareholder base.

In contrast, the European model looks at regulation from a wider stakeholder perspective:

• Stakeholder perspective to protect all stakeholders in a company.
• Stakeholders include:
  • employees
  • creditors
  • government
  • suppliers
  • general public.

Which model is better?

There is a wide ranging debate as to whether the shareholder orstakeholder model is better from an economic and a more general publicinterest viewpoint.

• Stakeholder model appears to be more successful at dealing with the agency problem and managerial abuse of their power.
• Shareholder model appears to be more economically efficient.
• In practice the shareholder model is becoming more dominant:
  • Due to strength of UK/US economies.
  • Power of US/UK capital markets.
  • The move is reflected in legislation.
• Synergy is often gained through redundancies in an acquired firm. Many are concerned with what they see as an unethical practise. A stakeholder model is more likely to give emphasis to employee protection.

Test your understanding 5: Hi TV and Gino Media

Gino Media has substantial business interests in all areas of the mediain the UK.

Gino Media is considering merging with Hi TV plc – a majortelevision company with control of a large proportion of the UK domesticcommercial TV terrestrial market.

There are currently concerns about the standard of programmes produced by Hi TV.

If the proposed merger was to be referred to theregulatory authorities (e.g. Competition Commission in the UK) whatissues are likely to arise?

Test your understanding 6: International gold GmbH

Builder Group plc, a UK company, currently subject to a takeover bidby International Gold GmbH – the German arm of the South African ownedKugel gold mining operation which also owns a significant proportion ofthe European building industry. Kugel wishes to expand into theEuropean markets to offset a downturn in its main markets of Africa andLatin America and is also attempting to alter its ‘dodgy’ image.

What needs to be considered when determining whether the offer is likely to be in the shareholders’ best interests?

7 Defence against hostile takeovers

• Every group is potentially subject to takeover.
• There will be a price at which the owners (shareholders) may be induced to sell their shares.
• If a bid is received, then the directors should consider it from the shareholders' perspective – if it will increase shareholder wealth, then the directors should recommend accepting the offer.
• A problem arises where a publicly quoted group, with a widely spread shareholding, receives an unwelcome (‘predatory’) bid, with the clear objective of buying the group at a price below the value that management put on it.
• Shareholders need to determine the management’s motives in defending the bid.
• The purpose of corporate defence is either to obtain a full and satisfactory price from an unwelcome bidder, or to ward off the bid, and remain independent.

Agency issues

It is important to emphasise that this is a management, as opposedto shareholders’, view, since presumably the latter, if they areinduced to sell, will be happy with the transaction, on the ‘willingbuyer, willing seller’ assumption.

It is also important to determine management’s motives indefending a bid strongly. The intention may genuinely be to obtain thebest price for the shares, and prevent them being sold below theirintrinsic value. However, the intention may merely be to maintain thegroup’s independence at any price – which may not be the bestsolution for shareholders.

Reasons for predatory bids

The circumstances under which a predator may seek to buy a group at less than full value are usually as follows:

• The share price is depressed. This can usually be identified by:
  • the group’s market value being below the net value of its shareholders’ funds; or
  • the group’s price/earnings ratio being below, or its yield being above that for its sector.

In this case, however, the predator may believe that under itsmanagement the group can recover and perform much better financiallythan under existing management.

• The group’s prospects are better than the share price would indicate. A period of fluctuating profits may be about to be followed by a good recovery. A predator might recognise this before it became apparent to the stock market as a whole, and seek to capitalise on the opportunity.
• The group occupies a strong position in one or more markets. The predator may see the acquisition of the group as a unique opportunity to purchase a major market share, and wish to do so without paying the market premium which should, in theory, attach to such a one-off situation.

Non-financial considerations

There are two non-financial reasons for strong resistance thatarise from time to time, regardless of the financial benefits toshareholders:

• Monopoly – generally defined by reference to laws regulating market shares but can also involve any transaction above a defined size and reviewed in terms of national economic interest.
• Employee interest – employment may be more secure if the group remains independent than it would be under a new employer whose objectives may be major rationalisation/divestment.
• The emphasis of current political attitudes to corporate law is increasingly on the rights of employees as well as shareholders.

Examples of defences

Strategic defences

The principal aim of strategic defence is to try to eliminate, asfar as possible, the attractions of the group to a would-be predator.

Defences can be split into pre- and post-bid defences.

Pre-bid defences

• Eternal vigilance

  Maintain a high share price by being an effective management team and educate shareholders.

• Communicate

  Investors may be told of any good research ideas within the company and of the management potential or merely be made more aware of the company’s achievements.

• Clearly defined strategy

  Communicate the strategy effectively to ensure that it is well understood, this will reassure shareholders and tend to maintain the share price.

• Cross shareholdings

  Your company buys a substantial proportion of the shares in a friendly company, and it has a substantial holding of your shares.

• Strong dividend policy

  The level of cash dividend is often held to influence share price.

Post-bid defences

• Attack the logic of the bid.
• A White Knight Strategy – Find a friendlier bidder instead.
• Improve the image of the company.

This can be done through revaluation, profit projections, dividend promises and public relation consultants.

• Refer to regulatory authorities (e.g. Competition Commission).
• Encourage unions, the local community, politicians, customers and suppliers to lobby on your behalf.

Other potential defences

The following tactics are likely to be frowned upon by the Takeover Panel in the UK but are used in the USA:

(1) PacMan defence – (Reverse takeovers)

(2) Poison Pill Strategy

(3) Crown Jewels

(4) Scorched Earth

(5) Golden Parachutes

(6) Fatman

Test your understanding 7: Development of bids

Follow the developments of bids in progress every dayby reading a good financial newspaper. Can you see examples of where theabove anti-takeover mechanisms have been used successfully?

Acceptable offers

Any board recognises that there is a point at which an offer becomes irresistible:

• Offer strong and logical resistance right up to this point.
• Decision based primarily on price.
• Other important considerations being the interests of employees and customers.
• Directors recommending acceptance of a bid clearly have a duty to make sure that the price is the best available in the circumstances and that independence is still not a better course, bearing in mind longer term considerations.

Test your understanding 8: Downcrest plc

Downcrest Inc is a medium-sized quoted company whose 1 m shares inissue are currently traded at 18 cents each. Its shareholders’ fundsare $250,000, and its post-tax earnings are 3.25 cents per share. It hasmaintained steady earnings, and has been able to reduce its debt to$50,000; market interest rates are approximately 12% pa.

Rawhide Inc, also quoted, has quietly built up a 2.9% stake inDowncrest and makes a market raid at 25 cents per share, acquiring 14.9%as a result. Rawhide has been a persistent predator, although it isbasically in the same markets as Downcrest, and it has 10 m shares inissue currently trading at 80 cents. Shareholders’ funds are $8 m. Itslatest earnings are 11.7 cents per share and its acquisition activitieshave driven up its debt to $7 m. Both companies are paying tax at 35%.

(a) What defences could Downcrest mount against a full bid?

(b) How might Downcrest have avoided the raid in the first instance?

8 Methods of financing mergers

• In general a purchaser and a vendor will need to agree on three basic issues in regard to an acquisition:
  • Whether shares or assets are to be purchased.
  • Type of consideration.
  • Financial value.
• Although determination of value is likely to take place prior to the decision on the type of consideration, they are considered here in reverse order (see later chapter) as the complexity of valuation necessitates its own chapter.

Type of consideration

The means of transferring the financial value of the shares orassets of the business, the consideration, can be satisfied in acombination of several alternatives:

• Cash.
• Debt.
• Preference shares.
• Ordinary shares.
• Debt and preference share consideration that can be convertible into ordinary shares.
• Share and loan stock used as consideration are known as ‘paper issues’.
• If a share exchange is used – the target company’s shares are purchased using shares of the predator.

Cash – most popular method especially after stock market declines in 73–74 and October 1987.

For the acquirer

For the target shareholders

• The cash to fund the purchase may have been raised by a rights issue before the takeover bid.

Shares – second most popular method.

For the acquirer

For the target shareholders

• Many bids are mixed – cash or shares – to appeal to the widest range of potential sellers.

More detail on shares, cash and mixed bids

Shares

• Shares can be issued by one company in order to pay for the acquisition of another company.
• The value of ordinary shares issued is, generally speaking, based on their market value at the time of issue.
• Shares may be issued in exchange for the target's shares - the target company's shareholders becoming shareholders of the predator.
• Paper offers (shares) are often accompanied by an alternative cash offer.
• Paper offers lead to an increase in the issued share capital of the predator.

In principle the issue of shares is no more expensive to thepurchaser than cash or debt consideration, despite the implicitdifference in the cost of equity and debt. The reason for this is that,in general, projects, whether internal or external (i.e. acquisitions)should be considered to be financed from a ‘pool’ of financialresources based on the optimum relationship between debt and equity, andbasing the appropriate hurdle on the ‘blended’ cost of such a pool.If equity is issued as consideration for a project, the change in thedebt/equity ratio resulting is usually considered to be temporary, andthe group will subsequently make appropriate adjustments in the level ofdebt in order to optimise the ratio. Adjustments would equally have tobe made where debt rather than equity is issued.

• However, certain complicating factors need to be borne in mind and may go against the use of such shares:
  • Temporary depression of share price.
  • Dilution of existing shareholders’ interests.
  • Difficulty in valuing shares.
  • Maintenance of debt/equity ratio.

Temporary depression of share price

The acquirer may feel that the current share price might rise inthe future, either because the share market as a whole is depressed, orbecause the value of the acquiring company’s shares are temporarilydepressed. Thus, the vendor may be getting the shares ‘cheap’.

Dilution of existing shareholders’ interests

This will be a problem where the acquirer has a limited number ofmajor shareholders who may not, for control or other reasons, wish tosee their interests diluted.

Difficulty in valuing shares

Unquoted companies may have difficulty in establishing an appropriate price.

Maintenance of debt/equity ratio

If the change in the equity base is large in relation to thepre-acquisition level of equity, it may be difficult to get back to anoptimum debt/equity ratio. Under these circumstances, the ordinaryshares issue may indeed have a higher cost, closer to the cost of equityrather than to the ‘blended cost of capital’.

• The type, cost and term/redemption arrangement of debt or preference shares to be issued is a matter for negotiation.
• However, the vendor’s capital gains tax may be deferred by the issue of either debt or shares of any type, the deferral being until repayment date/redemption date/date of sale of ordinary shares.
• Where debt or preference shares are concerned, there is often a quid pro quo exacted by the acquirer in the form of a lower interest and dividend rate than the going market, in return for the tax advantage conveyed.

Cash purchases

When the purchase consideration is cash, the shares of the targetcompany are purchased in exchange for cash. Hence the targetshareholders are "bought out".

Cash bid example

Easter Co and Pomerettes Co have net assets at book value of$3,000,000 and $100,000 respectively, and their respective expectedearnings are $450,000 and $75,000. The shareholders of Pommerettes haverecently accepted a takeover bid of $200,000 in cash.

Immediately after takeover Easter Ltd will have net assets of $3,000,000 + $100,000 - $200,000 (cash payment) = $2,900,000.

Its number of shares will remain unchanged.

Its expected earnings will be $450,000 + $75,000 = $525,000 lessany interest lost on the cash used to purchase Pommerettes, plus anysynergy gains.

Choice of payment type

Sometimes investors are given a choice in the method of payment,with the logic that different forms of payment might be attractive todifferent types of investor.

• Could influence the success or failure of a bid.
• Problematic for the bidder in that the cash needs and the number of shares to be issued are not known.
• Capital structure may alter in an unplanned manner.
• Ideally a bidder would like to tailor the form of the bid to that favoured by major investors in the targeted company.

Factors used to decide payment type

Test your understanding 9: Shareholder choice

Assume you are a shareholder in a target company that is subject to atake-overbid. Payment is to be by means of a share for shareexchange.

What factors are you particularly interested in?

Financing available: cash-based acquisitions

The main options for raising finance to fund cash purchases are:

Predator companies often raise loans to pay for a cash takeover which are:

• Unsecured and with a relatively high interest rate.
• Give the lender the option, after the takeover, to swap the loan for shares.
• Short-to-medium term.

(i.e. Mezzanine finance)

Merger and acquisition accounting

• There are two different methods of consolidation designed to reflect the substance of two different types of business combination.
• Acquisition accounting is used for the purchase of one company by another with the purchaser controlling the net assets of the subsidiary.
  • Net assets acquired are included at their fair values.
  • Only post-acquisition profits of the subsidiary included in consolidated reserves.
• Merger accounting is when there is a pooling of interests of two or more roughly equal partners. Effectively adds the two sets of accounts together.
• The investment in a new subsidiary will be shown as a fixed asset investment in the parent company’s own accounts.
• The amount at which this investment will be stated will depend upon whether merger accounting or acquisition accounting is used.
• Under acquisition accounting the investment will be recorded at cost (generally the fair value of the consideration given).
• If merger accounting is used the investment is recorded at the nominal value of the shares issued as purchase consideration plus the fair value of any additional consideration.

Comparison of merger and acquisition accounting - illustration

Fred makes an offer to all the shareholders of Ginger to acquiretheir shares on the basis of one new $1 share (market value $3) plus 25 cfor every two $1 shares (market value $1.10 each) in Ginger. Theholders of 95,000 shares in Ginger (representing 95% of the totalshares) accept this offer.

The investment in Ginger will be recorded in the books of Fred as follows:

If acquisition accounting is to be used on consolidation:

If merger accounting is to be used on consolidation:

9 Chapter summary

Test your understanding answers

Test your understanding 1: Fred’s group

• The amalgamation with Mary’s appears to be an acquisition – the removal of the company logo, the size difference, the absorbing of the stores into Fred’s and the replacement of staff would indicate such.
• The amalgamation with Annette’s appears to be a merger – the companies are roughly the same size, both provide key personnel post-merger and Annette’s keeps its logo.

Issues that may arise on amalgamation of Fred’s and Moira’s:

• Is it to be a merger, acquisition or purchase of assets?
• What are the operational, accounting and other issues arising from the above choice?
• How will this impact on the Board structure, corporate governance, and the organisational culture?
• Will there be hostility to such a move and from what level?
• Should there by a transfer of assets or a transfer of shares?
• What price should be paid?
• Is there potential for synergy (see later)?
• What are the competitive issues surrounding this (see later)?

Test your understanding 2: Premier foods

In areas where a food label owned by premier foods competes with oneowned by RHM, e.g. cook-insauces or gravy products then there will bea reduction in competition.

There may be a referral to the Competition Commission if anyproduct’s market share is deemed to be greater than 25% – this maydepend on how tightly products are defined, e.g. is the market for Oxostock cubes and Bisto gravy granules the same?

Test your understanding 3: Synergy

Synergy might exist for many reasons including:

Economic efficiency gains

Gains might relate to economies of scale or scope. Economies ofscale occur through such factors as fixed operating costs being spreadover a larger production volume, equipment being used more efficientlywith higher volumes of production, or bulk purchasing reducing costs.Economies of scope may arise from reduced advertising and distributioncosts when companies have complementary resources. Economies of scaleand scope relate mainly to horizontal acquisitions and mergers. Economicefficiency gains may also occur with backward or forward verticalintegration which might reduce production costs as the ‘middle man’is eliminated, improve control of essential raw materials or otherresources that are needed for production, or avoid disputes with whatwere previously suppliers or customers.

Economic efficiency gains might also result from replacing inefficient management as the result of a merger/takeover.

Financial synergy

Financial synergy might involve a reduction in the cost of capitaland risk. The variability (standard deviation) of returns of a combinedentity is usually less than the weighted average of the risk of theindividual companies. This is a reduction in total risk, but does notaffect systematic risk, and hence might not be regarded as a form ofsynergy by shareholders. However, reduced variability of returns mightimprove a company’s credit rating making it easier and/or cheaper toobtain a loan. Another possible financial synergy exists when onecompany in an acquisition or merger is able to use tax shield, oraccumulated tax losses, which would otherwise have been unavailable tothe other company.

Market power

A large organisation, particularly one which has acquiredcompetitors, might have sufficient market power to increase its profitsthrough price leadership or other monopolistic or oligopolistic means.

Test your understanding 4: Williams and GSL

• Operating efficiencies – the unused capacity at GSL can be used to produce William’s products without adding to costs and capacity.
• Marketing synergies.
• If the cash flow streams of Williams and GSL are not perfectly positively correlated then by acquiring GSL – Williams may reduce the variability of their operating cash flow. This being more attractive to investors may lead to cheaper financing.
• The ‘dedicated’ herbalists of GSL and the R+D staff of Williams may be a complementary resource.
• Fixed operating and administrative costs savings.
• Consolidation of manufacturing capacity on fewer and larger sites.
• There may be bulk buying discounts.
• Possibility of joint advertising and distribution.
• GSL is badly managed – thus the elimination of inefficiency could allow for financial synergy.

Test your understanding 5: Hi TV and Gino Media

Issues likely to be considered include:

• What is the definition of the market or markets being considered:
  • For advertising revenue how wide is the definition of market – all media – just TV advertising – or just a sub-section of channels?
  • For television viewing – which sections of the market (free-to-air, pay-TV) are to be considered – or are all areas to be included in the definition of market.
• Would the merged company have control or a large influence over a section of the TV media and if so would this be beneficial or detrimental to the viewing public?
• Would the merger reduce competition for TV advertising revenues?
• What would be the impact on other television and media companies?
• What would be the impact on advertisers?
• How might the pricing structure for advertising be altered by such a merger?
• How the parties involved intend to comply with legislation specific to the industry and how have they complied in the past?
• What would the impact be on the quality and pricing of programming?
• Would the merger be in the public interest?

Test your understanding 6: International gold GmbH

• Need to assess potential offer from the point of view of both the target shareholders and that of the predators shareholders.
• The cost of preparing information to defend any potential breach of European market share regulations would reduce the profits of the ‘merged’ firm and potentially the wealth of shareholders.
• If the bid fails due to a breach of regulation then the money spent on the bid would reduce the predator’s profit and may lead to a reduction in share price.
• Similarly the costs of defending any case as to whether the merger was not in the country’s interest would reduce profits.
• Despite an initial increase in shareholder wealth should the merger occur there may be a reduction in post-acquisition share prices if Kugel maintains its poor image.

Test your understanding 7: Development of bids

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Test your understanding 8: Downcrest plc

• Downcrest’s defence is likely to have three prongs:
  • In view of Rawhide’s position in the same market, it would certainly seem, prima facie, as if the regulatory authorities should be consulted to see whether they would consider blocking the bid on competition grounds.
  • Downcrest would also argue that the price of 25 c proposed was too cheap, being exactly equal to its book shareholders’ funds and with no regard for its business prospects. It would in the first instance revalue its property assets, if appropriate, and emphasise its future earnings and cash generation capacity, with forecasts as appropriate, including a dividend forecast.
  • Downcrest would argue that Rawhide’s actual performance in the same industry was in reality worse than its own, as follows:

• It allowed Rawhide to buy nearly 3% without noting the build-up in shares. This could have been avoided by watching the level of new shareholdings, and any unaccounted-for nominee accumulations in the shareholders’ register.
• The fact that it was, before the raid, selling at a sizeable (25 - 18) / 25 = 28% discount to net asset value, despite a better underlying trading performance than Rawhide, indicated that its financial communication programme could be much improved.
• It appeared to have given no thought to a possible ‘white knight’ in the event of an unfriendly bid. Given Rawhide’s low level of attraction such an alternative bidder should at least bring some enhanced commercial value to Downcrest.
• It should give thought to increasing its gearing through good quality investment and acquisition in order to increase the return on shareholders’ funds.

Test your understanding 9: Shareholder choice

• Synergy.
• Acquisition premium.
• Dividends.
• Gearing.
• Intrinsic value.
• Future prospects.
• Control.

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