Chapter 8: Mergers and Acquisitions

Fundamental Concepts about M&As

From the perspective of business finance, mergers and acquisitions can be seen as a strategic tool to use for creating a value for shareholders, or stakeholders –in a broader sense. Value creation here refers to a long-term consequence, rather than a short-term outcome of which you would see the instant results. Before defining a merger and an acquisition, a broader business approach to ground our understanding should be made: resource-based view of the firm. Briefly, resource-based view focuses on the competitive advantage concept. According to this view, external business opportunities can be exploited and created by company managers best by using the existing resources of the company, rather than acquiring new skills. Building on resource-based view, firms need to seek opportunities to grow by using their own resources in order to survive domestic and global competition. And to do that, there are some activities and definitions of these activities are:

• Corporate restructuring refers to activities of firms that significantly change their business operations and/or financial structure.
• Business alliance is a term that refers to different forms of combining business activities of two or more firms.
• Merger is a combination of two firms in a way that only one firm survives after combining.
• Consolidation is joining of two or more firms in order to form a new firm.
• Acquisition is taking a controlling ownership in another firm, subsidiary of another firm, or business unit of another firm by an acquirer firm.
• Divestiture is a sale of all of a company or all of a business/product line to another party in exchange for cash or securities.
• Business combination : A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes refer to as “mergers of equals” are also business combinations. (IFRS 3)
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Forms of M&As M&As

are identified in horizontal and vertical dimensions as well as congeneric and conglomerate forms. They are also identified in a cross-border type of forms.

• Horizontal dimension is about the industry. If M&A is between two firms in the same industry, then it is a horizontal combination.
• Vertical dimension on the other hand, is about the position in the value chain. If M&A occurs between two firms of which one is a supplier, or a customer to another, then it is a vertical combination. The idea is to expand in the value chain either towards customers forward, or towards production factors backward.
• Congeneric M&A is between related firms in very similar industries, but merging firms are not in any horizontal or vertical relationship.
• Conglomerate M&A is between unrelated firms in different industries.
• Cross-border M&A is a form of business combination between two firms in two different countries.

Host country is the country in which business enterprises from other countries come in to invest. Psychic distance between the home country and the host country refers to differences in institutions, ease of doing business, corporate governance, and in other areas, which are not related to spatial distance between the two countries. Institutional context refers to economic, socio-cultural, and political forces that shape the way businesses are managed in an economy.

Motivation for M&As

There has to be a good motivation for making such a big, strategic, risky, and complex decision like M&A. Some of the reasons for M&A are down to earth reasons like cost reduction or knowledge transfer. These motivations are:

1. Synergy : Synergy refers to the added value created by joining two separate firms, enabling a greater return to be achieved than by their individual contributions as separate entities. “Although synergy is often optimistically sought, it can be hard to achieve in practice owing to resistance to change, particularly after a contested takeover. The corporate culture that each participant may have built up over many years of separate existence may prove too inflexible to enable a productive merger to be achieved without friction. The condition that arises when, far from adding value, a merger produces an outcome that is less than the sum of the parts is known as anergy” (A Dictionary of Business and Management, 2016). Anergy refers to a condition of joining two separate firms producing an outcome that is less than the sum of separate entities.
2. Diversification : Diversification refers to a movement by a manufacturer or trader into a wider field of products.
3. Tax Considerations : Tax may be one of the motivations for engaging in M&A activity. Depending on whether the payment for M&A is in the form of cash or in the form of shares, an acquisition may be taxable, or tax-free for shareholders. The M&A activity has effects on the merged firm’s taxes after the deal is closed. The merged firm is taxed as if the merged firms had always been together when the payment for M&A is in the form of shares.
4. Managers ’ personal preferences: Sometimes managers of firms (generally acquiring firms) prefer engaging in M&A activity because of their personal incentives. Their motivation might be related to earning high bonuses, or it may stem from overconfidence or hubris. They might be over optimistic over the value of an investment opportunity just because … they think so.
5. Purchase of undervalued assets: Buying undervalued assets may be considered as a good investment opportunity especially when the investment is closely related to the acquiring firm’s business area. Expectation may be selling these assets when their value increases.

Process of M&As

DePamphilis (2003) describes M&A process in 10 phases which are:

• Phase 1: Building the business plan
• Phase 2: Building the merger/acquisition implementation plan
• Phase 3: The search process
• Phase 4: The screening process
• Phase 5: First Contact
• Phase 6: Negotiation
• Phase 7: Developing the integration plan
• Phase 8: Closing
• Phase 9: Implementing postclosing integration
• Phase 10: Conducting a postclosing evaluation

Two of these phases should be focused in detail. These are:

• Negotiation in M&A activity is the process of bargaining between the acquiring firm and the target firm aimed at coming to an agreement over the terms, needs and aims of both parties. During negotiation, various takeovers can occur. Friendly takeover occurs when managements of both the acquiring firm and target firm approves the terms of merger or acquisition, and state it to stockholders. Hostile takeover occurs when the management of the target firm resists the merger or acquisition. The acquiring firm then needs to make a direct appeal on stockholders of the target firm. Tender offer is the direct offer of the acquiring firm to stockholders of the target firm, to buy their stocks. Due diligence refers to the current state of firms.
• Integration in M&A activity refers to the degree of how well merged companies integrate their activities, operations, culture, etc. after the acquisition deal is closed. Angwin (2007) introduces four different post-acquisition integration styles of “isolate, maintain, subjugate, and collaborate.” Three dimensions are used for explaining the four different styles: 1. Speed of integration between the acquirer and the acquired is characterized as rapid or slow. 2. The importance of keeping the acquired firm’s organizational configuration is characterized as dissolved or retained. 3. The need for integrating in order to benefit from synergy is characterized as low or high. There are also four different styles: in isolation style, the acquirer company keeps the acquired company at a distance, in maintenance style, generally the acquired company is a well-performing company in a different business, in subjugation style, acquired and the acquirer companies are usually in the same industry, in collaboration style, the acquired company usually is in a good shape, and valuable for the acquirer.

Success and Failure in M&As

Scholars assess performance of mergers and acquisitions with several different approaches. In The Handbook of M&As (2011), these approaches are classified as i) shortterm financial performance, ii) accounting-based performance, iii) long-term financial performance, iv) key informants’ retrospective assessments of performance, v) divestiture performance, vi) integration process performance, vii) innovation performance. Nevertheless, it would not be wrong to say that there are a substantial number of mergers and acquisitions, which are viewed as a not successful deal, or as a failure. There are number of reasons to explain why mergers and acquisitions fail. Starting from building a plan and going to post acquisition stage, in every phase of the process it is possible to find a reason. Poor consequences of mergers and acquisitions are linked to: “inaccurate valuations, inflated prices, poor due diligence, excessive optimism, exaggerated synergies, and failed integration” by Schweiger and Very (2003).

Financing of M&As

One of the most important aspects of M&As is financing. iIt is assumed that financial managers’ prior objective, as of with all kinds of financial decisions, is maximizing shareholders’ wealth. In order to contribute shareholder wealth maximization as much as possible, when financial managers find the right target, their offer price should be not too high and not too low. Owners or/and managers of an acquiring firm have very important two decisions to make: i) how the payment will be made, ii) how it will be financed. Baker and Martin (2011) suggest that these two decisions may be relevant to the value of the acquiring firm through capital structure (which is the outcome of long-term financing decisions of a firm, reflecting a balance between debt and equity).

Method of Payment

Payment to the target firm’s shareholders should be regarded as some kind of a negotiation, or a bargain between two parties, which are decision makers in the target firm and the acquiring firm. Bargaining power of negotiating parties determines the difference between what a party demands and what it gets in the end. Bargaining power refers to capability of a negotiating party to change the deal in accordance with their request, or affect the outcome of negotiation. An acquiring firm may choose to offer making payment either by cash or by stocks. Payment with cash and payment with stocks are two different options having totally different outcomes resulting from pricing effects and governance effects (Baker and Martin, 2011). Pricing effect is about risk and return tradeoff between cash and stocks. Governance effect is about allocation of control rights. With ownership and control issues, it is crucial whether the target firm is privately, publicly, or state owned.

Financing Alternatives

Acquiring company may use internal financing or external financing in order to finance M&A. Each alternative has its benefits and costs to consider and compare. An advantage of using internally generated funds to finance M&A is to avoid costs of external financing. However, it brings the disadvantage of increasing risks resulting from abstinence of creditors and shareholders as control mechanisms over managers’ decisions regarding the deal. On the other hand, financing M&A externally brings advantage of control mechanism of creditors and shareholders over actions of management. Disadvantage is its costs.

Firm Valuation in M&As

For mergers and acquisitions, valuation is crucial because it is one of the important factors to determine whether the deal is successful or not. If the valuation is done correctly, then acquisition premium is set correctly, that reflects the expected synergies and benefits from the acquisition. Acquisition premium is the “price paid for a target firm that exceeds its pre-acquisition market value” (The Handbook of M&As, 2011). It is paid in the hope of realizing the synergies that may exist in the merged organization. Valuation approaches can be grouped in three categories of income-based, market-based, and assetbased valuation.

1. Income-based valuation : Income-based valuation focuses on finding the fair value of the company, depending on the future cash flows. The key of income-based valuation is future cash flows that a company will generate.
2. Market-based valuation : Market-based valuation techniques use “market multiples” to calculate the value of the target company. This approach is related to market equilibrium for company assets.
3. Asset-based valuation : Asset-based valuation focus on company assets’ acquisition costs reflected in records. Under this approach, value of a business equals the sum of its components. Net asset value is the value of assets minus value of liabilities of a firm. Book value is the value of assets that are recorded at a date, at a value, by accounting records. Liquidation value is the value that could be realized if a company were sold individually and not as part of a going concern.

Among all valuation methods, two methods of valuation are commonly used in mergers and acquisitions. These are:

1. Discounted Cash Flow (DCF) Approach to Firm Valuation in M&As : One of the most widely used methodologies to value target firms in M&As is the discounted cash flow (DCF) approach. The idea is to discount projected post-period (after the merger or acquisition) cash flows by using the estimated discount rate (which is cost of equity).
2. Market Multiples Approach to Firm Valuation in M&As: Market multiples approach is another widely used methodology to value target firms in M&As. Either market price or enterprise value (the value of the entire business including debt and other obligations) is divided to a measure in order to find the value of the target company. This measure is generally from financial statements. Most common ones are earnings, book value, sales, cash flow, dividends, and EBITDA (earnings before interest expenses, tax, depreciation and amortization). The three most commonly used market multiples in M&As are:
   • Price to Earnings Ratio
   • Price to Book Value Ratio
   • Price to Cash Flow Ratio