M&A Summary
Lecture 1:
Motivations for M&A
Buying growth
Economies of scale & scope
Increase market power
Increase bargaining power in supply chain
Diversification of revenue streams
Industry shocks & deregulation
Financial synergies
Overvaluation of equity
Buying growth
- Common among firms where organic growth or growth via internal expansion takes time.
- Typical in industries where R&D takes time to pay-off (e.g. pharma & tech)
- Used to facilitate entry into new markets or product lines.
- Acquisition can be used as complements (or substitute?) organic investments
- Firms in more mature industries are more likely to be net acquirers while firms in young/growth
industries are more likely to be targets.
Synergies – economies of scale and scope
- Cost savings due to overlap in physical infrastructure, R&D, marketing channels, other sharing of
resources (economies of scale)
- Average cost of producing different products together is lower than the cost when produced
separately (economies of scope)
- Revenue enhancement (difficult to achieve)
To increase power in one’s product markets
- Firms may merge horizontally to create monopolies which gives them higher market power and
allows them to extract greater (prices) rents from customers
- Firms may merge vertically to get exclusive access to intellectual property.
- Such deals may often face opposition from regulators such as the Federal Trade Commission (FTC) in
the U.S. or the European Commission in the E.U. or the Authority for Consumers and Markets (ACM)
in NL.
To Increase bargaining power in one’s supply chain
- Firms may undertake horizontal mergers to increase their bargaining power with their suppliers
- Suppose firm S sells 10% of its output to each firm A and B. By merging A and B to form a bigger
entity, they could hold-up the supplier and negotiate for better prices by threatening to walk-away.
- Academic evidence supports the idea that horizontal takeovers increase the buyer power of the
merging firms if suppliers are concentrated.
Diversification of revenue streams
- Firms may diversify to have different revenue streams which then reduces the volatility of their cash
flows (the coinsurance effect).
- The coinsurance effect from diversification can reduce the counter-cyclical deadweight costs of
financial distress, defections by important stakeholders (i.e. suppliers, customers and employees).
- E.g.: General Electric has grown via numerous acquisitions to include appliances, power & water, oil
& gas, energy management, aviation, healthcare, transportation & financial services.
,- Academic evidence is mixed: some argue that there is diversification discount while others argue
there is a premium.
Industry shocks and deregulation
- Technological, regulatory and demand shocks to the industry could increase the need for
consolidation.
- Demand shock: steel industry mergers in the late 90s in response to collapse in demand form Asia.
- Regulatory shocks: banking deregulation in the US in the late 90s, creation of the EU and Brexit.
Financial synergies
- Creating value by acquiring firms that are weighted down by debt cheaply and refinancing the debt
at a lower cost.
- Alternatively, over-levered firms may acquire less levered firms (with equity) to shore up debt
capacity.
- Tax inversions are another source of financial synergies.
Overvaluation of equity
- If the firm’s equity is overvalued managers acting in the interest of their shareholders would
rationally use the overvalued equity as currency in mergers by paying for the targets using the firm’s
shares.
- Academic evidence supports the idea of rational market timing by manager.
Motivation for M&A
Managers may pursue for reasons unrelated to the rational reasons. They may pursue deals purely
due to:
- Hubris: managers may pursue acquisitions because they believe that the target firm will be worth
more under their stewardship due to their superior management skills.
- Managerial hubris may follow periods of good performance at the firm:
- Managers driven by hubris overpay for the targets (especially in bidding contests).
- There is conflicting evidence on the role of hubris in mergers. Not surprising because it is quite
difficult to measure managerial hubris.
- Overconfidence.
Agency costs (Jensen & Meckling, AER, 1976) refer to costs faced by shareholders since the
managers (who are their agents) may not always act in their (shareholder’s) best interest.
Agency cost of free cash flow: Managers spending FCF on investments or perks rather than
returning it to shareholders.
Managers in a typical corporation own <1% of equity. Although their wealth (through
compensation) and their jobs depend on firm performance, there is stills cope for mischief.
Managers may:
- Overinvest via mergers to increase their firm size and their egos
- Take on high-risk mergers because of their convex pay-off structure of their compensation package
(through options).
Agency issues and M&A
Bottom-line: most deals are founded on strong economic rationale -> hubris/overconfidence/agency
factors may cause managers to pursue deals aggressively resulting in overpayment for the targets.
,Terminology.
Mergers
- In a (statutory) merger, the target company ceases to exist as a separate entity.
- All its assets and liabilities are assumed by the surviving entity.
Generally a merger:
- (typically) takes place between two companies of approximately the same size.
- Requires approval of at least 50% of shareholders of the target and the acquiring firm.
Consolidation
- In a (statutory) consolidation, stocks of both parties involved in the transaction are surrendered and
new stocks in the name of new company are issued to the acquiring and target firm shareholders. E.g.
Tim Hortons and Burger King Worldwide merged to form Restaurant Brands International. Following
the consolidation, Tim Horton and Burger King operate as separate brands owned by Brands
International.
Acquisition
In an Acquisition:
- The buyer purchases some or all of the assets or the equity (i.e. the stock) of the selling firm.
- The target may be liquidated or continue to operate as a subsidiary of the buyer.
- Approval of target shareholders is required (but can be avoided via a tender offer); dissident (or
minority) shareholders remain. If minority squeeze out is possible, the minority/dissident shareholder
will be forced to accept the same price offered to the other shareholders
- (Typically) the approval of acquiring shareholders is needed only in instances involving a substantial
dilution of equity interest (i.e. issuance of 20% or more in shares to the target shareholders).
So you can acquire the assets or stocks using cash or stock of yourself.
Buyout
, A buyout is the acquisition of stocks and delisting of an entire company or a division, financed
primarily with debt. Hence, called “leverage buyout” (LBO).
- Buyer: typically a PE fund managed by an LBO sponsor(or a consortium of funds). E.g. Blackstone,
Carlyle, KKR.
- Sponsor raises debt to finance most of the purchase price and contributes an equity investment
from the fund.
-Objective: improve operating efficiency and grow revenue before divesting the firms within 3-5
years.
- Debt is paid down over time and all excess returns accrue to the equity holders.
- Exit: IPO, sale to a strategic buyer, or sale to another LBO fund.
- LBO’s always involve payment with cash.
- The cash is borrowed using the target’s assets and expected cashflows.
- Large increase in financial leverage: average leverage increases from 20% to 70% following an LBO.
- Financing the buyout premium
> Get as much (as little) as possible from the senior lenders (equity investors).
> Tailor the terms of the mezzanine to be serviced from the expected cashflows.
The results of an LBO is that the target becomes a private company.
Drivers to LBO activity: Access to cheap credit is necessary but not sufficient. And LBO activity is
higher when the equity risk premium is lower.
The M&A Process
Initiating a deal: Sell-side
1. Preparation
Evaluate alternatives (recapitalization, IPO, selling part of whole business).
Perform advisory due diligence
Conduct valuation for different perspectives (strategic, financial).
Set seller expectations about the expected price (based on merger consequences analysis for
potential buyers – i.e. synergies, accretion/dilution, control).
Decide on the sale process (broad/targeted auction, negotiated sale) based on seller’s priorities
(speed, confidentiality, certainty of completion, value maximization).
Lecture 1:
Motivations for M&A
Buying growth
Economies of scale & scope
Increase market power
Increase bargaining power in supply chain
Diversification of revenue streams
Industry shocks & deregulation
Financial synergies
Overvaluation of equity
Buying growth
- Common among firms where organic growth or growth via internal expansion takes time.
- Typical in industries where R&D takes time to pay-off (e.g. pharma & tech)
- Used to facilitate entry into new markets or product lines.
- Acquisition can be used as complements (or substitute?) organic investments
- Firms in more mature industries are more likely to be net acquirers while firms in young/growth
industries are more likely to be targets.
Synergies – economies of scale and scope
- Cost savings due to overlap in physical infrastructure, R&D, marketing channels, other sharing of
resources (economies of scale)
- Average cost of producing different products together is lower than the cost when produced
separately (economies of scope)
- Revenue enhancement (difficult to achieve)
To increase power in one’s product markets
- Firms may merge horizontally to create monopolies which gives them higher market power and
allows them to extract greater (prices) rents from customers
- Firms may merge vertically to get exclusive access to intellectual property.
- Such deals may often face opposition from regulators such as the Federal Trade Commission (FTC) in
the U.S. or the European Commission in the E.U. or the Authority for Consumers and Markets (ACM)
in NL.
To Increase bargaining power in one’s supply chain
- Firms may undertake horizontal mergers to increase their bargaining power with their suppliers
- Suppose firm S sells 10% of its output to each firm A and B. By merging A and B to form a bigger
entity, they could hold-up the supplier and negotiate for better prices by threatening to walk-away.
- Academic evidence supports the idea that horizontal takeovers increase the buyer power of the
merging firms if suppliers are concentrated.
Diversification of revenue streams
- Firms may diversify to have different revenue streams which then reduces the volatility of their cash
flows (the coinsurance effect).
- The coinsurance effect from diversification can reduce the counter-cyclical deadweight costs of
financial distress, defections by important stakeholders (i.e. suppliers, customers and employees).
- E.g.: General Electric has grown via numerous acquisitions to include appliances, power & water, oil
& gas, energy management, aviation, healthcare, transportation & financial services.
,- Academic evidence is mixed: some argue that there is diversification discount while others argue
there is a premium.
Industry shocks and deregulation
- Technological, regulatory and demand shocks to the industry could increase the need for
consolidation.
- Demand shock: steel industry mergers in the late 90s in response to collapse in demand form Asia.
- Regulatory shocks: banking deregulation in the US in the late 90s, creation of the EU and Brexit.
Financial synergies
- Creating value by acquiring firms that are weighted down by debt cheaply and refinancing the debt
at a lower cost.
- Alternatively, over-levered firms may acquire less levered firms (with equity) to shore up debt
capacity.
- Tax inversions are another source of financial synergies.
Overvaluation of equity
- If the firm’s equity is overvalued managers acting in the interest of their shareholders would
rationally use the overvalued equity as currency in mergers by paying for the targets using the firm’s
shares.
- Academic evidence supports the idea of rational market timing by manager.
Motivation for M&A
Managers may pursue for reasons unrelated to the rational reasons. They may pursue deals purely
due to:
- Hubris: managers may pursue acquisitions because they believe that the target firm will be worth
more under their stewardship due to their superior management skills.
- Managerial hubris may follow periods of good performance at the firm:
- Managers driven by hubris overpay for the targets (especially in bidding contests).
- There is conflicting evidence on the role of hubris in mergers. Not surprising because it is quite
difficult to measure managerial hubris.
- Overconfidence.
Agency costs (Jensen & Meckling, AER, 1976) refer to costs faced by shareholders since the
managers (who are their agents) may not always act in their (shareholder’s) best interest.
Agency cost of free cash flow: Managers spending FCF on investments or perks rather than
returning it to shareholders.
Managers in a typical corporation own <1% of equity. Although their wealth (through
compensation) and their jobs depend on firm performance, there is stills cope for mischief.
Managers may:
- Overinvest via mergers to increase their firm size and their egos
- Take on high-risk mergers because of their convex pay-off structure of their compensation package
(through options).
Agency issues and M&A
Bottom-line: most deals are founded on strong economic rationale -> hubris/overconfidence/agency
factors may cause managers to pursue deals aggressively resulting in overpayment for the targets.
,Terminology.
Mergers
- In a (statutory) merger, the target company ceases to exist as a separate entity.
- All its assets and liabilities are assumed by the surviving entity.
Generally a merger:
- (typically) takes place between two companies of approximately the same size.
- Requires approval of at least 50% of shareholders of the target and the acquiring firm.
Consolidation
- In a (statutory) consolidation, stocks of both parties involved in the transaction are surrendered and
new stocks in the name of new company are issued to the acquiring and target firm shareholders. E.g.
Tim Hortons and Burger King Worldwide merged to form Restaurant Brands International. Following
the consolidation, Tim Horton and Burger King operate as separate brands owned by Brands
International.
Acquisition
In an Acquisition:
- The buyer purchases some or all of the assets or the equity (i.e. the stock) of the selling firm.
- The target may be liquidated or continue to operate as a subsidiary of the buyer.
- Approval of target shareholders is required (but can be avoided via a tender offer); dissident (or
minority) shareholders remain. If minority squeeze out is possible, the minority/dissident shareholder
will be forced to accept the same price offered to the other shareholders
- (Typically) the approval of acquiring shareholders is needed only in instances involving a substantial
dilution of equity interest (i.e. issuance of 20% or more in shares to the target shareholders).
So you can acquire the assets or stocks using cash or stock of yourself.
Buyout
, A buyout is the acquisition of stocks and delisting of an entire company or a division, financed
primarily with debt. Hence, called “leverage buyout” (LBO).
- Buyer: typically a PE fund managed by an LBO sponsor(or a consortium of funds). E.g. Blackstone,
Carlyle, KKR.
- Sponsor raises debt to finance most of the purchase price and contributes an equity investment
from the fund.
-Objective: improve operating efficiency and grow revenue before divesting the firms within 3-5
years.
- Debt is paid down over time and all excess returns accrue to the equity holders.
- Exit: IPO, sale to a strategic buyer, or sale to another LBO fund.
- LBO’s always involve payment with cash.
- The cash is borrowed using the target’s assets and expected cashflows.
- Large increase in financial leverage: average leverage increases from 20% to 70% following an LBO.
- Financing the buyout premium
> Get as much (as little) as possible from the senior lenders (equity investors).
> Tailor the terms of the mezzanine to be serviced from the expected cashflows.
The results of an LBO is that the target becomes a private company.
Drivers to LBO activity: Access to cheap credit is necessary but not sufficient. And LBO activity is
higher when the equity risk premium is lower.
The M&A Process
Initiating a deal: Sell-side
1. Preparation
Evaluate alternatives (recapitalization, IPO, selling part of whole business).
Perform advisory due diligence
Conduct valuation for different perspectives (strategic, financial).
Set seller expectations about the expected price (based on merger consequences analysis for
potential buyers – i.e. synergies, accretion/dilution, control).
Decide on the sale process (broad/targeted auction, negotiated sale) based on seller’s priorities
(speed, confidentiality, certainty of completion, value maximization).
