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Thursday, January 3, 2013



Mergers and acquisitions and corporate restructuring - or M&A for short - are a big part of the corporate finance. One plus one makes three: this equation is the special alchemy of a merger or 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 -at least, that’s the reasoning behind M&A. This idea is particularly attractive 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 achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.
A corporate merger is essentially a combination of the assets and liabilities of two firms to form a single business entity. Although they are used synonymously, there is a slight distinction between the terms ‘merger’ and ‘acquisition’. Strictly speaking, only a corporate combination in which one of the companies survives as a legal entity is called a merger. In a merger of firms that are approximate equals, there is often an exchange of stock in which one firm issues new shares to the shareholders of the other firm at a certain ratio. In other words, a merger happens when two firms, often about the same size, agree to unite as a new single company rather than remain as separate units. This kind of action is more precisely referred to as a “merger of equals.” Both companies’ stocks are surrendered, and new company stock is issued in its place. When a company takes over another to become the new owner of the target company, the purchase is called an acquisition. From the legal angle, the ‘target company’ ceases to exist and the buyer “gulps down” the business and stock of the buyer continues to be traded.
 In summary, “acquisition” is generally used when a larger firm absorbs a smaller firm and “merger” is used when the combination is portrayed to be between equals. For the sake of discussion, the firm whose shares continue to exist (possibly under a different company name) will be referred to as the acquiring firm and the firm’s whose shares are being replaced by the acquiring firm will be referred to as the target firm. However, a merger of equals doesn’t happen very often in practice. Frequently, a company buying another allows the acquired firm to proclaim that it is a merger of equals, even though it is technically an acquisition. This is done to overcome some legal restrictions on acquisitions. 

Synergy is the main reason cited for many M&As. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit through staff reductions, economies of scale, acquisition of technology, improved market reach and industry visibility. Having said that, achieving synergy is easier said than done-synergy is not routinely realized once two companies merge. Obviously, when two businesses are combined, it should results in improved economies of scale, but sometimes it works in reverse. In many cases, one and one add up to less than two.
Excluding any synergies resulting from the merger, the total post-merger value of the two firms is equal to the pre-merger value, if the ‘synergistic values’ of the merger activity are not measured. However, the post-merger value of each individual firm is likely to be different from the pre-merger value because the exchange ratio of the shares will not exactly reflect the firms’ values compared to each other. The exchange ratio is distorted because the target firm’s shareholders are paid a premium for their shares. Synergy takes the form of revenue enhancement and cost savings. When two companies in the same industry merge, the revenue will decline to the extent that the businesses overlap. Hence, for the merger to make sense for the acquiring firm’s shareholders, the synergies resulting from the merger must be more than the value lost initially.
Different forms of Mergers 
There are a whole host of different mergers depending on the relationship between the two companies that are merging. These are:
1)   Horizontal Merger: Merger of two companies that are in direct competition in the same product categories and markets.
2)   Vertical Merger: Merger of two companies which are in different stages of the supply chain. This is also referred to as vertical integration. A company taking over its supplier’s firm or a company taking control of its distribution by acquiring the business of its distributors or channel partners are examples of this type of merger.
3)   Market-extension Merger: Merger of two companies that sell the same products in different markets.
4)   Product-extension Merger: Merger of two companies selling different but related products in the same market.
5)   Conglomeration: Merger of two companies that have no common business areas. 
From the finance standpoint, there are three types of mergers: pooling of interests, purchase mergers and consolidation mergers. Each has certain implications for the companies and investors involved: 
Pooling of Interests: A pooling of interests is generally accomplished by a common stock swap at a specified ratio. This is sometimes called a tax-free merger. Such mergers are only allowed if they meet certain legal requirements. A pooling of interests is generally accomplished by a common stock swap at a specified ratio. Pooling of interests is less common than purchase acquisitions. 
Purchase Mergers: As the name suggests, this kind of merger occurs when one company purchases another one. The purchase is made by cash or through the issue of some kind of debt investment, and the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be “written up” to the actual purchase price, and the difference between book value and purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. Purchase acquisitions involve one company purchasing the common stock or assets of another company. In a purchase acquisition, one company decides to acquire another, and offers to purchase the acquisition target’s stock at a given price in cash, securities or both. This offer is called a tender offer because the acquiring company offers to pay a certain price if the target’s shareholders will surrender or tender their shares of stock. Typically, this tender offer is higher than the stock’s current price to encourage the shareholders to tender the stock. The difference between the share price and the tender price is called the acquisition premium. These premiums can sometimes be quite high.
Consolidation Mergers: In a consolidation, the existing companies are dissolved, a new company is formed to combine the assets of the combining companies and the stock of the consolidated company is issued to the shareholders of both companies. The tax terms are the same as those of a purchase merger. The Exxon merger with Mobil Oil Company is technically a consolidation.
As stated earlier, an acquisition is only slightly different from a merger. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies, and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another—there is no exchanging of stock or consolidating as a new company. In an acquisition, a company can buy another company with cash, stock, or a combination of the two. In smaller deals, it is common for one company to acquire all the assets of another company. Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise finance buys a publicly listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company and together they become an entirely new public corporation with tradable shares. Regardless of the type of combination, all mergers and acquisitions have one thing in common: they are all meant to create synergy and the success of a merger or acquisition hinges on how well this synergy is achieved.
The attributes leading to successful acquisition suggested by various studies are that the:
1.   Acquired firm has assets or resources that are complimentary to the acquiring firm’s core business.
2.   Acquisition is friendly.
3.   Acquiring firm selects target firms and conducts negotiation carefully and methodically.
4.   Acquiring firm has adequate cash and favourable debt position.
5.   Merged firms maintains low to moderate debt position.
6.   Acquiring firm has experience with change and is flexible and adaptable.
7.   Acquiring firm maintains sustained and consistent emphasis on R&D and innovation
Case Study of Acquisition:
Ispat International: Building a Muscle of Steel 
Steel magnate Lakhmi N. Mittal’s Ispat International announced the acquisition of LNM Holdings and a merger with the US based International Steel Group Inc (ISG) in a deal worth $ 17.8 billion to form the world’s largest steel firm, Mittal Steel Co. Mittal Steel, with operations in 14 countries in Europe, Africa, Asia and the United States and 165,000 employees will have pro forma revenues of $30 billion in 2004 and an annual production capacity of 70 million tonnes, according to a statement from Ispat International. The Netherlands-based Ispat International, 77-percent owned by Mr.Mittal, will issue 525 million new shares, valued at $ 13.3 billion to the shareholder of LNM Holdings. The Mittal Steel Co. will then pay $42 a share in cash and stock-or about $4.5 billion- depending on Mr.Mittal’s share price, to the ISG shareholders. 
These transactions dramatically change the landscape of the global steel industry. The coming together of Ispat International, LNM Holdings and ISG, one of the largest steel producers in America, will create global powerhouse. This combination also provides Mittal Steel with a more significant presence in important industrialized economies such as those in North America and Europe and in economies that are expected to experience above average in steel consumption, including Asia and Africa. According to Mr.Aditya Mittal, President and CEO of the new combined entity, Mittal Steel will be a leader not only in terms of its global reach and operational excellence but also among the most profitable steel producers in the world. LNM Holdings earned $ 9.9 billion revenue and had an operating income of $3.2 billion in the first nine months of 2004, and was also one of the largest steel companies. (Source: The Hindu, October 26, 2004)
There are a number of reasons that mergers and acquisitions take place. These issues generally relate to business concerns such as competition, efficiency, marketing, product, resource and tax issues. They can also occur because of some very personal reasons such as retirement and family concerns. Some people are of the opinion that mergers and acquisitions also occur because of corporate greed to acquire everything. Various reasons for M&A include: 
Reduce Competition: One major reason for companies to combine is to eliminate competition. Acquiring a competitor is an excellent way to improve a firm’s position in the marketplace. It reduces competition and allows the acquiring firm to use the target firm’s resources and expertise. However, combining for this purpose is as such not legal and under the Antitrust Acts it is considered a predatory practice. Therefore, whenever a merger is proposed, firms make an effort to explain that the merger is not anti-competitive and is being done solely to better serve the consumer. Even if the merger is not for the stated purpose of eliminating competition, regulatory agencies may conclude that a merger is anti-competitive. However, there are a number of acceptable reasons for combining firms. 
Cost Efficiency: Due to technology and market conditions, firms may benefit from economies of scale. The general assumption is that larger firms are more cost effective than are smaller firms. It is, however, not always cost effective to grow. In spite of the stated reason that merging will improve cost efficiency, larger companies are not necessarily more efficient than smaller companies. Further, some large firms exhibit diseconomies of scale, which means that the average cost per unit increases, as total assets grow too large. Some industry analysts even suggest that the top management go in for mergers to increase its own prestige. Certainly, managing a big company is more prestigious than managing a small company. 
Avoid Being a Takeover Target: This is another reason that companies merge. If a firm has a large quantity of liquid assets, it becomes an attractive takeover target because the acquiring firm can use the liquid assets to expand the business, pay off shareholders, etc. If the targeted firm invests existing funds in a takeover, it has the effect of discouraging other firms from targeting it because it is now larger in size, and will, therefore, require a larger tender offer. Thus, the company has found a use for its excess liquid assets, and made itself more difficult to acquire. Often firms will state that acquiring a company is the best investment the company can find for its excess cash. This is the reason given for many conglomerate mergers. 
Improve Earnings and Reduce Sales Variability: Improving earnings and sales stability can reduce corporate risk. If a firm has earnings or sales instability, merging with another company may reduce or eliminate this provided the latter company is more stable. If companies are approximately the same size and have approximately the same revenues, then by merging, they can eliminate the seasonal instability. This is, however, not a very inefficient way of eliminating instability in strict economic terms. 
Market and Product Line Issues: Often mergers occur simply because one firm is in a market that the other company wants to enter. All of the target firm’s experience and resources are readily available of immediate use. This is a very common reason for acquisitions. Whatever may be the explanation offered for acquisition, the dominant reason for a merger is always quick market entry or expansion. Product line issues also exert powerful influence in merger decisions. A firm may wish to expand, balance, fill out or diversify its product lines. For example, acquisition of Modern Foods by Hindustan Lever Limited is primarily related product line. 
Acquire Resources: Firms wish to purchase the resources of other firms or to combine the resources of the two firms. These may be tangible resources such as plant and equipment, or they may be intangible resources such as trade secrets, patents, copyrights, leases, management and technical skills of target company’s employees, etc. This only proves that the reasons for mergers and acquisitions are quite similar to the reasons for buying any asset: to purchase an asset for its utility.  
Synergy: Synergy popularly stated, as “two plus two equals five,” is similar to the concept of economies of scope. Economies of scope would occur if two companies combine and the combined company was more cost efficient at both activities because each requires the same resources and competencies. Although synergy is often cited as the reason for conglomerate mergers, cost efficiencies due to synergy are difficult to document. 
Tax Savings: Although tax savings is not a primary motive for a combination, it can certainly “sweeten” the deal. When a purchase of either the assets or common stock of a company takes place, the tender offer less the stock’s purchase price represents a gain to the target company’s shareholders. Consequently, the target firm’s shareholders will usually gain tax benefits. However, the acquiring company may reap tax savings depending on the market value of the target company’s assets when  compared to the purchase price. Also, depending on the method of corporate combination, further tax savings may accrue to the owners of the target company. 
Cashing Out: For a family-owned business, when the owners wish to retire, or otherwise leave the business and the next generation is uninterested in the business, the owners may decide to sell to another firm. For purposes of retirement or cashing out, if the deal is structured correctly, there can be significant tax savings. 
To summarize, firms take the M&A route to seize the opportunities for growth, accelerate the growth of the firm, access capital and brands, gain complementary strengths, acquire new customers, expand into new product- market domains, widen their portfolios and become a one-stop-shop or end-to end solution provider of products and services. 
A firm that intends to take over another one must determine whether the purchase will be beneficial to the firm. To do so, it must evaluate the real worth of being acquired. Logically speaking, both sides of an M&A deal will have different ideas about the worth of a target company: the seller will tend to value the company as high as possible, while the buyer will try to get the lowest price possible. There are, however, many ways to assess the value of companies. The most common method is to look at comparable companies in an industry, but a variety of other methods and tools are used to value a target company. A few of them are listed below: 
1) Comparative Ratios
The following are two examples of the many comparative measures on which acquirers may base their offers:
P/E (price-to-earnings) Ratio: With the use of this ratio, an acquirer makes an offer as a multiple of the earnings the target company is producing. Looking at the P/E for all the stocks within the same industry group will give the acquirer good guidance for what the target’s P/E multiple should be. 
EV/Sales (price-to-sales) Ratio: With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the P/S ratio of other companies in the industry. 
2) Replacement Cost
In a few cases, acquisitions are based on the cost of replacing the target company. The value of a company is simply assessed based on the sum of all its equipment and staffing costs without considering the intangible aspects such as goodwill, management skills, etc. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. This method of establishing a price certainly wouldn’t make much sense in a service industry where the key Assets- people and ideas - are hard to value and develop. 
3) Discounted Cash Flow
An important valuation tool in M&A, the discounted cash flow analysis, determines a company’s current value according to its estimated future cash flows. Future cash flows are discounted to a present value using the company’s weighted average cost of capital. Though this method is a little difficult to use, very few tools can rival this valuation method. 
4) Synergy
Quite often, acquiring companies pay a substantial premium on the stock value of the companies they acquire. The justification for this is the synergy factor: a merger benefits shareholders when a company’s post-merger share price increases by the value of potential synergy. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation solves for the minimum required synergy and offers a good way to think about synergy and how to determine if a deal makes sense. In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action.  
The equation:
Here the pre-merger stock price refers to the price of the acquiring firm. Increase in the value of the acquiring firm is a test of success of the merger. However, the practical aspects of mergers often prevent the anticipated benefits from being fully realized and the expected synergy quite often falls short of expectations. 
Some more criteria to consider for valuation include: 
1.   A reasonable purchase price - A small premium of, say, 10% above the market price is reasonable.
2.   Cash transactions- Companies that pay in cash tend to be more careful when calculating bids, and valuations come closer to target. When stock is used for acquisition, discipline can be a casualty.
3.   Sensible appetite - An acquirer should target a company that is smaller and in a business that the acquirer knows intimately. Synergy is hard to create from disparate and unrelated businesses. And, sadly, companies have a bad habit of biting off more than they can chew in mergers.
1) Initial Offer by the Intending Buyer 
When a company decides to go for a merger or an acquisition, it starts with a tender offer. Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it’s willing to pay for its target in cash, shares, or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it. 
2) Response from Target Company 
Once the tender offer has been made, the target company can do one of the several things listed below:
Accept the Terms of the Offer: If the target firm’s management and shareholders are happy with the terms of the transaction, they can go ahead with the deal. 
Attempt to Negotiate: The tender offer price may not be high enough for the target company’s shareholders to accept, or the specific terms of the deal may not be attractive. If target firm is not satisfied with the terms laid out in the tender offer, the target’s management may try to work out more agreeable terms. Naturally, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Therefore, managers have more negotiating power if they can show that they are crucial to the merger’s future success.
Execute a Poison pill or some other Hostile Takeover Defence: A target company can trigger a poison pill scheme when a hostile suitor acquires a predetermined percentage of company stock. To execute its defence, the target company grants all shareholders—except the acquirer—options to buy additional stock at a hefty discount. This dilutes the acquirer’s share and stops its control of the company. It can also call in government regulators to initiate an antitrust suit.
Find a White Knight: As an alternative, the target company’s management may seek out a friendly potential acquirer, or white knight. If a white knight is found, it will offer an equal or higher price for the shares than the hostile bidder. 
3) Closing the Deal 
Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquirer will pay for the target company’s shares with cash, stock, or both. A cash-for-stock transaction is fairly straightforward: target-company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company. If the transaction is made with stock instead of cash, then it’s not taxable. There is simply an exchange of share certificates. The desire to steer clear of the taxman explains why so many M&A deals are carried out as cash-for-stock transactions. When a company is purchased with stock, new shares from the acquirer’s stock are issued directly to the target company’s shareholders, or the new shares are sent to a broker who manages them for target-company shareholders. Only when the shareholders of the target company sell their new shares are they taxed. When the deal is closed, investors usually receive a new stock in their portfolio - the acquiring company’s expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal.


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