m&a module 1

MODULE 1

MERGERS

Scheme of discussion…

Introduction to Corporate Restructuring Rationale behind Mergers and

acquisitions (M&A) and corporate restructuring

What is merger? Types of mergers Motives behind mergers Theories of mergers Efficiency theories Other theories

Introduction to Corporate Restructuring

Corporate restructuring implies

activities related to

expansion/contraction of a firm’s

operations or changes in its assets

or financial or ownership structure.

The "Corporate restructuring" is an

umbrella term that includes mergers

and consolidations, divestitures and

liquidations and various types of

battles for corporate control.

Introduction to Corporate Restructuring continued…. The essence of corporate

restructuring lies in achieving

the long run goal of

wealth maximization.

It helps us to know, if restructuring

generates value gains for shareholders

(both those who own the firm before the

restructuring and those who own the firm

after the restructuring), how these value

gains have be created and achieved or

failed.

Rationale behind Mergers and acquisitions (M&A) and corporate restructuring

Mergers and acquisitions (M&A) and

corporate restructuring are a big part of the

corporate finance world. One plus one makes

three: this equation is the special alchemy of

a merger or an acquisition.

The key principle behind buying a company is

to create shareholder value over and above

that of the sum of the two companies. Two

companies together are more valuable than

two separate companies.

Rationale behind Mergers and acquisitions (M&A) and corporate restructuring continued….

This rationale is particularly alluring to companies

when times are tough. Strong companies will act

to buy other companies to create a more

competitive, cost-efficient company.

The companies will come together hoping to gain

a greater market share or to achieve greater

efficiency. Because of these potential benefits,

target companies will often agree to be purchased

when they know they cannot survive alone.

What is Merger?

A Merger involves a combination of

two firms such that only one firm

survives.

Mergers tend top occur when one

firm is significantly larger than the

other and the survivor is usually

the larger of the two.

Types of Mergers

Horizontal Mergers

Vertical Mergers

Conglomerate Mergers

Horizontal mergers A Horizontal mergers involves

two firms operating and

competing in the same kind of

business activity.

Motives:

i. Elimination or reduction in

competition

ii. Putting an end to price-cutting

iii. Economies of scale in production

iv. R&D, marketing and management

Vertical Mergers Vertical mergers occur between firms in

different stages of production

operations

Upstream & Downstream Mergers

Motives :

i. Lower buying cost of materials

ii. Lower distribution costs

iii. Assured supplies and market

iv. Increasing or creating barriers to

entry for potential competitors

Conglomerate mergers

Conglomerate mergers involves firms

engaged in unrelated types of business

activity.

Product extension mergers

Market extension mergers

Pure Conglomerate mergers

Motive:

Diversification of risk.

Motives behind mergers Economies of scale

i. Production activity

ii. R&D/ technological activities

iii. Marketing and distribution activities

iv. Transport, storage ,inventories

Synergy

Fast growth

Tax benefits

Diversification

Theories of mergers

1. Efficiency theories

2. Information and signaling

3. Agency problems and managerialism

4. Free cash flow hypothesis

5. Market power

6. Taxes

7. Redistribution

Efficiency Theories

These theories hold that mergers and

other forms of asset redeployment

have potential for social benefits.

They generally involve improving the

performance of incumbent

management or achieving a form of

synergy.

Efficiency Theories

1. Differential managerial efficiency

2. Insufficient management

3. Operating synergy

4. Pure diversification

5. Strategic realignment to changing

environments

6. undervaluation

Differential managerial efficiency If the management of firm A is more efficient

than the management of firm B and if after

firm A acquires firm b, the efficiency of firm b

is brought up to the level of efficiency of firm

A, efficiency is increased by merger

Differential efficiency would be most likely to

be a factor in mergers between firms in

related industries where the need for

improvement could be more easily identified.

Insufficient management

May simply represent management that

is inept in an absolute sense. Almost

anyone could do better

The theory suggests that target

management is so incapable that

virtually any management could do

better, and thus could be an explanation

for mergers between firms in unrelated

industries.

Operating synergy

The theory is based on operating synergy assumes that economies of scale do exist in the industry and that prior to the merger, the firms are operating at levels of activity that fall short of achieving the potentials for economies of scale.

It includes the concept of complementarities of capabilities

Operating synergy continued…

For e.g.: one firm might be strong in

R&D but weak in marketing while

another has a strong marketing

department without the R&D

capability. Merging the two firms

would result in operating synergy.

Pure diversification The firm may simply lack internal

growth opportunities for lack of requisite resources or due potential excess capacity in the industry.

Pure diversification as a theory of mergers differs from share holders portfolio diversification.

Pure diversification continued… Therefore, firms may diversify to

encourage firm-specific human capital

investments which make their employees

more valuable and productive

and to increase the probability that the

organization and reputation of the firm

will be preserved by transfer to another

line of business owned by the firm in the

event its initial business declines.

Strategic realignment to changing environments

It says that mergers take place in response to environmental changes. External acquisitions of needed capabilities allow firms to adapt more quickly and with less risk than developing capabilities internally

Rationale is that by mergers the firm

acquires management skills for needed

augmentation of its present

capabilities.

Undervaluation

It states that mergers occur when the

market value of target firm stock for

some reason does not reflect its true

or potential value in the hands of an

alternative management.

One possibility of undervaluation may

be that management is not operating

the company up to its potential.

Undervaluation continued…

A second possibility is that the

acquirers have inside information.

It is not much different from the

inefficient management or differential

efficiency theory. it cannot stand

alone and requires an efficiency

rationale.

Information and signaling

This theory attempts to explain why

target shares seem to be permanently

revalued upward even if the offer

turns out to be unsuccessful.

The merger offer disseminated

information that the target shares are

undervalued and the offer prompts

the market to revalue those shares.

Information and signaling continued

No particular action by the target firm or any

others is necessary to cause the revaluation.

This is called “sitting on a gold mine”

explanation (Bradley, Desai and Kim, 1983)

The other hypothesis is that the offer inspires

target firm management to implement a more

efficient business strategy on its own.

No outside input other that the merger offer

itself is required for the upward revaluation.

This is called “kick in the pants” explanation.

Agency problems

Agency problems arise basically

because contracts between managers

(decision or control agents) and owners

(risk bearers) cannot be enforced.

May result from conflict of

interest between managers

and shareholders or between

shareholders and debt holders

Agency problems continued… An agency problem arises when managers

own only a fraction of the ownership shares

of the firm. This may cause managers to

work less vigorously than otherwise and

consume more perquisites

In large corporations with widely dispersed

ownership, there is not sufficient resources

to monitor the behavior of managers.

Takeovers as a solution to agency problems

(Fama & Jensen, 1983)

Managerialism (Mueller 1969)

Free cash flow hypothesis

Jensen’s Free cash flow hypothesis says

that takeovers takes place because of

the conflicts between managers and

shareholders over the payout of free

cash flows.

He defines free cash flow as cash flow in

excess of the amounts required to fund

all the projects that have positive NPVs.

Free cash flow hypothesiscontinued…

He states that such free cash flow

must be paid out to shareholders if

the firm is to be efficient and to

maximize share price

The payout of free cash flow reduces

the amount of resources under the

control of managers and reduces

their power resulting in agency costs.

Market power

Market power advocates claim that

merger gains are the result of increased

concentration leading to collusion and

monopoly effects.

The theory posts that mergers take place

to increase their market share, means

increasing the size of the firm relative to

other firms in an industry.

Market power continued..

An objection is often raised against

permitting a firm to increase its market

share by merger is that the result will be

“undue concentration” in the industry.

On contrary, some economists hold that

increased concentration is generally the

result of active and intense competition.

Tax effects

Tax implications may be important to

mergers , although they do not play a

major role. Carry over of net operating

losses and tax credits, substitution of

capital gains for ordinary incomes are

among the tax motivation for mergers

Carry over of net operating losses and tax

credits: a firm with accumulated tax losses

and tax credits can give positive earnings

of another firm with which it is joined

Tax effects continued…

2 conditions to be met:

Majority of the target corporation

should be acquired in exchange for the

stock of the acquiring firm.

Secondly, the acquisition should have

legitimate motives/ business purposes

net operating losses: can be carried

back 3 years and forward 15 years

Tax effects continued…

Substitution of capital gains for ordinary

income: a mature firm with few internal

investment opportunities can acquire a

growth firm in order to substitute capital

gains taxes for ordinary income taxes.

The acquiring firm provides the necessary

funds which otherwise would have to be

paid out as dividends taxable as ordinary

incomes.

Redistribution hypothesis

Value increases in mergers by

redistribution among the

stakeholders of the firm. Possible

shifts are from debt holders to stock

holders and from labor to

stockholders.

Next discussion… A presentation on Hubris hypothesis (agency

problems) A presentation on Framework for analysis of

mergers- 1. Organization learning and organization

capital 2. Investment opportunities Herfindahl index (H – index) Redistribution benefit calculation Operating , financial and managerial synergy of

mergers Value creation Merrill Lynch

Herfindahl index

The Herfindahl index, also known as Herfindahl-

Hirschman Index or HHI, is a measure of the size

of firms in relation to the industry and an

indicator of the amount of competition among

them.

It is an economic concept widely applied in

competition law, antitrust and also technology

management

The theory behind the use of the H-index is that

if one or more firms have relatively high market

shares, there is of even greater concern than the

share of the largest four firms

E.g.1:

In one market four firms each hold

15% market share and the remaining

40% is held by 40 firms, each with 1%

market share. Its HHI would be:

H = 4(15)2 + 40(1)2 = 940

E.g.2:

In another market 1 firm has 57%

market share and the remaining 43%

is held by 43 firms, each with 1%

market share. What would be the H-

index?

For e.g.:

Two cases in which the six largest firms

produce 90 % of the output:

Case 1: All six firms produce 15% each,

and

Case 2: One firm produces 80 % while the

five others produce 2 % each.

Assuming that the remaining 10% of

output is divided among 10 equally

sized producers.

A HHI index below 0.01 (or 100) indicates

a highly competitive index.

A HHI index below 0.1 (or 1,000) indicates

an unconcentrated index.

A HHI index between 0.1 to 0.18 (or 1,000

to 1,800) indicates moderate

concentration.

A HHI index above 0.18 (above 1,800)

indicates high concentration

Synergy WHAT IS IT?

Popular definition: 1 + 1 = 3

Roundabout definition: If am I willing to

pay 6 for the business market-valued at 5

there has to be the Synergy justifying

that

More technical definition: Synergy is

ability of merged company to generate

higher shareholders wealth than the

standalone entities

Drivers of SynergyINITIAL FACTORS INTERNAL FACTORS

SYNERGY

Strategy

Operations

Contested

vs.

Uncontested

Acquisition Premium

System Integration

Strategic Relatedness

Managerial Risk Taking

Relative Size

Method of

Payment

Control and Culture

Time

The Synergy Matrix

Managerial Synergy Improve management or

replace inefficient one

Financial Synergy Redeploy capital

Increase RoI

Operating Synergy Scale Economies Improve margins

Market Valuation Release “value”

Company-specific Risk Cost-of-capital reduction

VALUE CREATION

Operating synergy

Economies of scale Economies of scope Vertical integration economies Managerial economies

Financial synergies Complementarities between merging firms

in matching the availability of investment

opportunities and internal cash flows

Lower cost of internal financing —

redeployment of capital from acquiring to

acquired firm's industry

Increase in debt capacity which provides for

greater tax savings

Economies of scale in flotation of new issues

and lower transaction costs of financing

Managerial synergy If a firm has an efficient management team

whose capacity is in excess of its current

managerial input demand, the firm may be

able to utilize the extra managerial

resources by acquiring a firm that is

inefficiently managed due to shortages of

such resources.

Managerial Synergy hypothesis can be

formulated more vigorously and may be

called as differential efficiency theory

Transaction SupportEnsuring Value Creation at all stages

Transaction Business

Scope


Scope

Consideration

Consideration

Transaction StructureTransaction Structure

Management

Management

Funding StructureFunding Structure WarrantiesWarranties

Closing Arrangement

s

Closing Arrangement

s

Strategic Business

Need

Strategic Business

Need

Target SearchTarget Search

Target Cultivation

Target Cultivation

Business EvaluationBusiness

Evaluation

Financial EvaluationFinancial

Evaluation

Preliminary Offer

Preliminary Offer

Process

Transaction Elements



Scope


Scope

Consideration

Consideration


Management

Management


Closing Arrangement

s

Closing Arrangement

s

MoUMoU

Due Diligence

Due Diligence

Risk Assessment

Risk Assessment

Definitive AgreementDefinitive

Agreement

ImplementImplement

NegotiationsNegotiations


Process

What is the fair EV; “Walk-Away”

What is the fair EV; “Walk-Away”



Scope


Scope

Consideration

Consideration


Management

Management


Closing Arrangement

s

Closing Arrangement

s

Strategic Business

Need

Strategic Business

Need

Target SearchTarget Search

Target Cultivation

Target Cultivation

Business EvaluationBusiness

Evaluation

Financial EvaluationFinancial

Evaluation

Preliminary Offer

Preliminary Offer

Regulatory compliance

check / solutions

Regulatory compliance

check / solutions

Mitigating contingent

risks

Mitigating contingent

risks

LBO vs Equity

LBO vs Equity

Process


Presenting the Story

right

Presenting the Story

right

Circumstances favoring merger

over internal growth

Lack of opportunities for internal growth

Lack of managerial capabilities and

other resources

Potential excess capacity in industry

Timing may be important — mergers can

achieve growth and development of new

areas more quickly

Other firms may be competing for

investments in traditional product lines

Roles of M&AsStrengthen existing product line by adding capabilities or extending geographic markets

Add new product lineForeign acquisitions to obtain new capabilities or needed presence in local markets

Obtain key scientists for development of particular R&D programs

Roles of M&As continued…Reduce costs by eliminating

duplicate activities and shrinking

capacity to improve sales to capacity

relationships

Divest activities not performing well

Harvest successful operations in

advance of competitor programs to

expand capacity and output

Round out product lines

Roles of M&As continued…

Strengthen distribution systems

Move firm into new growth areas

Attain critical mass required for

effective utilization of large

investment outlays

Create broader technology platforms

Achieve vertical integration

Revise and refresh strategic vision

Disadvantages of M&As Buyer may not have full information of

acquired assets

Implementation may be difficult

•Considerable executive talent and

time commitments

•Different organization cultures

Wide use of joint ventures and

strategic alliances

Combine different expertise and

capabilities of different companies

Reduce size of investments and risks

m&a module 1

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