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A Practical Guide to Mergers, Acquisitions, and Divestitures
By Jae K Shim
Global Professional Publishing LtdCopyright © 2012 Jae K Shim
All rights reserved.
Mergers and Acquisitions
For years, academic studies maintained mergers and acquisition (M&A) deals destroyed shareholder value. Nonetheless, market consolidation is set to be high on the agenda in 2012, with delivering cost efficiency through economies of scale being a key driver in the absence of organic growth opportunities, particularly for those companies with a focus primarily on their domestic market. The renewables industry is a niche that could see large numbers of consolidatory M&A deals in the year to come, according to PricewaterhouseCoopers (PwC). M&A in the industry increased by 40 per cent last year and the trend is likely to carry on into 2012. Specifically, this current merger boom is characterized by
* Horizontal consolidation with significant potential for cost synergies.
* The use by acquirers of existing cash and borrowed money (after-tax cost) to purchase the (relatively higher cost) equity of acquired companies.
* Much lower acquisition premiums being initially paid.
Mergers and acquisitions can result in new organizations whose financial and strategic options are much improved. They are driven by globalization, a long-term market, various barriers to growth, which make M&As a valuable tool by which companies can quickly attempt to increase revenue.
This chapter discusses all facets of M&As including deciding on terms, key factors to consider, pros and cons of mergers, types of arrangements, evaluative criteria, valuation methods, financial effects of the merger, holding companies, takeover bids, SEC filing requirements, accounting and reporting requirements for business combinations, and financial analysis of combinations.
External growth occurs when a business purchases the existing assets of another entity through a merger. You are often required to appraise the suitability of a potential merger as well as participate in negotiations. Besides the growth aspect, a merger may reduce risk through diversification. The three common ways of joining two or more companies are a merger, consolidation, or a holding company.
In a merger, two or more companies are combined into one, where only the acquiring company retains its identity. Generally, the larger of the two companies is the acquirer. A merger is a business combination in which the acquiring firm absorbs a second firm, and the acquiring firm remains in business as a combination of the two merged firms. The acquiring firm usually maintains its name and identity. Mergers are legally straightforward because there is usually a single bidder and payment is made primarily with stock. The shareholders of each merging firm involved are required to vote to approve the merger. However, merger of the operations of two firms may ultimately result from an acquisition of stock.
With a consolidation, two or more companies combine to create a new company. None of the consolidation firms legally survive. For example, companies A and B give all their assets, liabilities, and stock to the new company, C, in return for C's stock, bonds, or cash.
A holding company possesses voting control of one or more other companies. The holding company comprises a group of businesses, each operating as a separate entity. By possessing more than 50% of the voting rights through common stock, the holding company has effective control of another company with a smaller percent of ownership.
Depending on the intent of the combination, there are three common ways in which businesses get together so as to obtain advantages in their markets. They are:
* Vertical merger. This occurs when a company combines with a supplier or customer. An example is when a wholesaler combines with retailers.
* Horizontal merger. This occurs when two companies in a similar business combine. An example is the combining of two airlines.
* Conglomerate merger. This occurs when two companies in unrelated industries combine, such as where an electronics company joins with an insurance company.
Outstanding planning and execution are essential for a successful merger. Integration is reached only after mapping the process and issues of the companies to be merged. Even then just 23% of all acquisitions earn their cost of capital. When M&A deals are announced, a company's stock price rises only 30% of the time. In acquired companies, 47% of executives leave within the first year, and 75% leave within the first three years. Synergies projected for M&A deals are not achieved 70% of the time. Productivity of merged companies can be affected by up to 50% in the first year and financial performance of newly merged companies is often lacking.
While there is no set formula to guarantee a successful merger, in order to minimize the negative impacts previously discussed, a map of M&A process and issues should be developed. The following steps describe the model of process and issues.
Step 1: Formulate
This stage involves the organization setting out its business objectives and growth strategy in a clear, rational, and data-oriented way. Companies should avoid vague and general objectives. Instead, a specific criteria should be formulated based on the objectives that have been determined and on a strategy of growth through acquisition. These criteria should be expressed in terms of goals like market share, geographic access, new products or technologies, and general amounts for financial synergy. The organization should evaluate the ideal target company based on factors such as the following:
* What type of cost structure does the ideal target have?
* What market channels would this target provide?
* What kinds of organizational competence and capabilities would provide maximum leverage and the greatest number of synergies?
* Are there strategic customer accounts or market segments to be gained?
* In what global regions or countries can we build additional capacity through this target?
* What is the optimum capital structure?
* What are the sources for new acquisitions?
* Will the ideal targets be operated as independent holdings, or does the organization intend to integrate the business partly or fully into its operations?
* If joint venture structures are to be used what level of involvement is desired by the parent company?
Step 2: Locate
After the strategic template has been set in Step 1, the search for desirable target companies should become more focused on financing an operational analysis. These initial parameters, terms, and conditions are defined and ultimately submitted as part of a letter of intent. These letters describe the desired objectives and give an overview of the proposed financial and operational aspects of the transaction. They also include specific details on items like the assets and business units involved, the equity positions of the parent companies, the assumption-of-debt requirements, inter-company supply agreements, employee liabilities, taxes, technology transfer, indemnification, public announcements, and other essential terms and conditions. Additional agreements outside the letter of intent should be made about the following issues. In the case of a joint venture arrangement, the governance structure of the partnership and specific issues for approval need to be agreed upon. The overall process to be used for determining top-level organizational structure and staffing decisions should also be agreed upon. Agreement on the integration process to be used, including mutual participation, formation of key task forces, planning phases, and leadership roles should take place at this point. Another additional agreement that should be made at this point is high-level reconciliation of major discrepancies regarding executive compensation, employee benefits, and incentive compensation plans. Once a consensus is made regarding these agreements, companies can move to Step 3.
Step 3: Investigate
The third step in the model relies on exploring all facets of the target company before finalizing a definitive agreement. Due diligence must be exercised in the financial, operational, legal, environmental, cultural, and strategic areas. Key findings should be summarized for executive review, and all potential merger problems should be identified. Due diligence findings are used to set negotiating parameters, determine bid prices, and provide the basis for initial integration recommendations.
Due diligence is particularly important in light of recent felonious accounting practices. Had Enron or WorldCom been acquired without due diligence, the newly formed company would probably not have uncovered accounting irregularities until months after the acquisition. This could cost billions in market capitalization. There are other areas where due diligence is helpful with assessing risk. The following are key areas to focus due diligence.
* Market. How large is the target's market? How fast are specific segments growing? Are there threats from substitute technologies or products? To what extent is the market influenced or controlled by governments?
* Customers. Who are the target's major customers? What are their purchase criteria: price? Quality? Reliability? Do buyers of product X also buy product Y, and do they buy both through similar channels? Are there unmet needs? Are changes in buying behavior to be expected?
* Competitors. Who are the target's major competitors? What is the degree of rivalry? What are the competitor's strengths and weaknesses? What barriers to entry exist for new competitors? How will the competitors try to exploit the merger or integration issues to their own advantage?
Culture and human resources. Which key people must be kept, which core areas of competence should be retained, and how possible is it to do either? Are there major cultural discrepancies with the target? If they could cause major defections or other losses of productivity, is the organization willing to resolve them? If so, at what cost?
To be uninformed on any of these issues can prove to be just as costly as the discovery of fraudulent accounting practices. This level of detailed evaluation must be conducted before an executive team can properly recognize the level of integration that will be appropriate to support the deal.
Exhibit 1 provides a checklist for due diligence.
Step 4: Negotiate
This step includes requirements for successfully reaching a definitive agreement. Deal teams should be briefed by due diligence teams, who together with executives should formulate the final negotiating strategy for all terms and conditions of the deal. Considerations include price, performance, people, legal protection, and governance.
Step 5: Integrate
The last step of the model should be customized to each organization and adapted to each specific deal. This is the actual process of planning and implementing the newly formed organization with its processes, people, technology, and systems. In determining how to resolve the issues that arise at this stage, the merging organizations must carefully consider such questions as how fast to integrate, how much disruption will be created, how disruption can be minimized, how people can be helped to continue focusing on customers, safety, and day-to-day operations, and how to best communicate with all the stakeholder groups of the company.
Exhibit 2 outlines the previously discussed Watson Wyatt Deal Flow and the processes and issues involved.
Pros and Cons of a Merger
There are many reasons why your company may prefer external growth through mergers instead of internal growth.
Advantages of a Merger
* Increases corporate power and improves market share and product lines.
* Aids in diversification, such as reducing cyclical and operational effects.
* Helps the company's ability to raise financing when it merges with another entity having significant liquid assets and low debt.
* Provides a good return on investment when the market value of the acquired business is significantly less than its replacement cost. Studies suggest that the shareholders of target firms that are acquired receive the greatest benefit.
* Improves the market price of stock in some cases, resulting in a higher P/E ratio. For example, the stock of a larger company may be viewed as more marketable, secure, and stable.
* Provides a missed attribute; that is, a company gains something it lacked. For instance, superior management quality or research capability may be obtained.
* Aids the company in financing an acquisition that would not otherwise be possible to obtain, such as where acquiring a company by exchanging stock is less costly than building new capital facilities, which would require an enormous cash outlay. For instance, a company may be unable to finance significant internal expansion but can achieve it by purchasing a business already possessing such capital facilities.
* Achieves a synergistic effect, which means that the results of the combination are greater than the sum of the parts. For instance, greater profit may result from the combined entity that would occur from each individual company due to increased efficiency (e.g., economies of scale)and cost savings (e.g., eliminating overlapping administrative functions, volume discounts on purchases). There is better use of people and resources. A greater probability of synergy exists with a horizontal merger since duplicate facilities are eliminated. Operational synergy arises because the combined firm may be able to increase its revenues and reduce its costs. For example, the new firm created by a horizontal merger may have a more balanced product line and a stronger distribution system. Furthermore, costs may be decreased because of economies of scale in production, marketing, purchasing, and management. Financial synergy may also result from the combination. The cost of capital for both firms may be decreased because the cost of issuing both debt and equity securities is lower for larger firms. Moreover, uncorrelated cash flow streams will provide for increased liquidity and a lower probability of bankruptcy. Still another benefit is the availability of additional internal capital. The acquired company is often able to exploit new investment opportunities because the acquiring company has excess cash flows. Note: Synnergy equals the value of the combined firm minus the sum of the values of the separate firms. These values can be calculated using the capital budgeting technique of discounted cash flow analysis. The difference between the cash flows of the combined firm and the sum of the cash flows of the separate firms is discounted at the appropriate rate, usually the cost of equity of the acquired firm. The components of the incremental cash flows are the incremental revenues, costs, taxes, and capital needs.
* Obtains a tax loss carryforward benefit if the acquired company has been losing money. The acquirer may utilize the tax loss carryforward benefit to offset its own profitability, thus reducing its taxes. Note, however, that Section 382 of the IRC sets the limit as to how much net operation losses an organization that has just undergone an ownership change can deduct from its income. The maximum deductible amount is derived by multiplying the value of the old loss corporation's stock prior to the change in ownership by the long term tax exempt rate. It's usually 4-7% of the actual loss that is able to be utilized.
* Use surplus cash from a tax perspective. Dividends received by individual shareholders are fully taxable, whereas the capital gains from a combination are not taxed until the shares are sold. In addition, amounts remitted from the acquired to the acquiring firm are not taxable. The combined firm's capital structure also may allow for increased use of debt financing, which results in tax savings from greater interest reductions.
Disadvantages of a Merger
* Reverse synergies which reduce the net value of the combined entity (e.g., adjustments of pay scales, costs of servicing acquisition debt, defections of key acquired company staff).
* Adverse financial effects because the anticipated benefits did not materialize; for example, expected cost reductions were not forthcoming.
* Antitrust action delaying or preventing the proposed merger.
* Problems caused by dissenting minority stockholders.
Note: A proxy fight is an attempt by dissident shareholders to gain control of the corporation, or at least gain influence, by electing directors. A proxy is a power of attorney given by a shareholder that authorizes the holder to exercise the voting rights of the shareholder. The proxy is limited in its duration, usually for a specific occasion like the annual shareholders' meeting. The issuer of a proxy statement must file a copy with SEC ten days prior to mailing it to shareholders all material information concerning the issues. A form that indicates the shareholder's agreement or disagreement must be provided. Also, if the purpose is for voting for directors, proxies must be accompanied by an annual report.
In evaluating a potential merger, you have to consider its possible effect upon the financial performance of the company, including:
* Earnings per share. The merger should result in higher earnings or improved stability.
* Dividends per share. The dividends before and after the merger should be maintained to stabilize the market price of the stock.
* Market price of stock. The market price of the stock should be higher or at least the same after the merger.
* Risk. The merged business should have less financial and operating risk than before.
Excerpted from A Practical Guide to Mergers, Acquisitions, and Divestitures by Jae K Shim. Copyright © 2012 Jae K Shim. Excerpted by permission of Global Professional Publishing Ltd.
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