Mergers and Acquisitions
Within the context of financial management, managers will seek to increase shareholder wealth. At some stage most firms will consider a strategy of acquisition to boost shareholder wealth. This page looks at mergers and acquisitions and whether they do, indeed, increase shareholder wealth.
Mergers and acquisitions - the terms explained
- 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.
Types of merger
The arguments put forward for a merger may depend on its type:
- Horizontal integration.
- Vertical integration.
- Conglomerate integration.
- Two companies in the same industry, whose operations are very closely related, are combined,
- e.g. Glaxo with Welcome and the banks and building 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.
- 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 and just-in-time inventory systems leading to major savings in inventory holding costs.
- A combination of unrelated businesses, there is no common thread and 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).
Main arguments for and against acquisitions
Organic growth versus growth by acquisition
Organic growth is internally generated growth within the firm.
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.
As in other areas of financial management, the ultimate justification of any policy is that it leads to an increase in value, i.e. it increases shareholder wealth. As in capital budgeting where projects should be accepted if they have a positive NPV, in a similar way combinations should be pursued if they increase the wealth of shareholders.
There are many types of 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 could increase its profitability by pushing up the price of goods because customers have few alternatives.
Economies of vertical integration - Some acquisitions involve buying out other companies in the same production 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 by avoiding disputes with what were previously suppliers or customers.
Complementary resources - It is sometimes argued that by combining the strengths of two companies a synergistic result can be obtained. For example, combining a company specialising in research and development with a company strong in the marketing area could lead to gains.
Sources of cost synergy are:
Economies of scale - Horizontal combinations (of companies in a similar line of business) are often claimed to reduce costs and therefore increase profits due to economies of scale. These can occur in the production, marketing or finance areas. Economies of scale occur through such factors 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) and savings on duplicated central services and accounting staff costs.
Economies of scope - May occur in marketing as a result of joint advertising and common distribution.
Sources of financial synergy include:
Elimination of inefficiency - If the "victim" company in a takeover is badly managed its performance and hence its value can be improved by the elimination of inefficiencies. Improvements could be obtained in the areas of production, marketing and finance.
- Tax shields/accumulated tax losses - Another possible financial synergy exists when one company in an acquisition or merger is able to use tax shields or accumulated tax losses, which would have been unavailable to the other company.
Surplus cash - Companies with large amounts of surplus cash may see the acquisition of other companies as the only possible application for these funds. Of course, increased dividends could cure the problem of surplus cash, but this may be rejected for reasons of tax or dividend stability.
Corporate risk diversification - One of the primary reasons put forward for all mergers but especially conglomerate mergers is that the income of the combined entity will be less volatile (less risky) as its cash flows come from a wide 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 not perfectly positively correlated then by combining the two companies th evariability of their operating cash flow may be reduced. A more stable cash flow is more attractive to creditors and this could lead to cheaper financing.
Other sources of synergy are:
Surplus managerial talent - Companies with highly skilled managers can make use of this resource only if they have problems to solve. The acquisition of inefficient companies is sometimes the only way of fully utilising skilled managers.
Speed - Acquisitions may be far faster than organic growth in obtaining a presence in a new and growing market.
The reasons for acquisitions in the real world
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.
- 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 is there a high failure rate of acquisitions?
Reasearch suggests that, with hindsight, many acquisitions are viewed as a mistake and erode shareholder value.
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.
The regulation of takeovers
The regulation of takeovers varies from country to country but focuses primarily on controlling the directors. Typical factors include the 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 City Code on Takeovers and Mergers, which is the responsibility 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 Competition Commission under the Fair Trading Act if the OFT thinks that a merger might be against the public interest (i.e. constraining of competition).
As a rule of thumb the Competition Commission may investigate an acquisition if it will result in the combined entity acquiring 25% or more of market share.
Their investigations may take several months to complete during which time the merger is put on hold. Thus giving the target company valuable time to organise its defence. The acquirer may abandon its bid as it may not wish to become involved in a time consuming Competition Commission investigation.
The Commission may simply accept or reject the proposals or accept them subject to certain conditions, e.g. on price. There has been a recent surge in the level of merger activity within Europe due to reduction of barriers to overseas ownership and a desire by multinational companies to enter the European market. These are subject to regulation by the European Commission in Brussels.
In addition, if the offer gives rises to a concentration (i.e. a potential monopoly) within the EC, the European Commission may initiate proceedings. This can result in considerable delay, and constitutes grounds for abandoning a bid.
Hostile takeover bids
- Every company (but especially quoted ones) 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.
It is important to emphasise that this is a management, as opposed to shareholders', view, since presumably the latter, if they are induced to sell, will be happy with the transaction, on the "willing buyer, willing seller" assumption.
It is also important to determine management's motives in defending a bid strongly. The intention may genuinely be to obtain the best price for the shares, and prevent them being sold below their intrinsic value. However, the intention may merely be to maintain the group's independence at any price - which may not be the best solution 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 its management the group can recover and perform much better financially than 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.
Defences against hostile bids
The principal aim of strategic defence is to try to eliminate, as far as possible, the attractions of the group to a would-be predator.
Defences can be split into pre- and post-bid defences.
- Eternal vigilance
Maintain a high share price by being an effective management team and educate shareholders.
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.
- 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)
The bidding company is itself the subject of a take-over bid by the targeted company, it has seldom been used successfully.
(2) Poison Pill Strategy
Make yourself unpalatable to the bidder by ensuring additional costs will be incurred should it win. The most common method is to give existing shareholders the right to buy future loan stock or preference shares. If a bid is made before the date of exercise of the rights then the rights will automatically be converted into full ordinary shares.
(a) Flip-in pills involve the granting of rights to shareholders, other than the potential acquirer, to purchase shares of the targeted company at a deep discount. This type of plan will dilute the ownership interest of the potential acquirer.
(b) Back-end rights are usually in the form of a cash dividend allowing shareholders other than the potential acquirer to exchange their shares for cash or senior debt securities at a price determined by the Board of Directors. The price set by the Board is usually well in excess of the market price or the price likely to be offered by a potential acquirer. Because the price that the target shareholder would receive is likely to be higher than that offered by the potential acquirer, shares will not be tendered.
(3) Crown Jewels
This is the tactic of selling off certain highly valued assetsof the company subject to the bid, those that are of greatest interest to the raider.
(4) Scorched Earth
In practical terms, this means that the targeted company liquidates all or substantially all of its assets leaving nothing to the raider, thereby eliminating the raider's motive for acquiring thetarget.
(5) Golden Parachutes
Managers get pay-offs that may be substantial if the company istaken over. Although a golden parachute for one chief executive officer involved in a takeover battle in the USA was reportedly US $35 m, they are usually a low multiple of the most recent year's salary.
The targeted company acquires a large and/or under performing company in order to decrease its attractiveness to the raider.
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.
Created at 9/25/2012 10:38 AM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/1/2016 2:23 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
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