Introduction
A merger can be said to be a combination of two or more equally strong firms to form a completely new entity. The firms lose their original identity after the merger and no firm dominate the other.
An acquisition is described a as situation where one company known as predator or acquirer takes over another company known as the target. In some cases, the target company disappears completely while the predator/acquirer retains the original identity.
Corporate restructuring refers to the changes in ownership, business mix, asset mix and alliances undertaken with a view to enhance shareholders value.
An absorption is a take over of two or more companies by an existing company. The company taken over loses its identity.
Consolidation is the combination of two or more companies to form a new company. In this type of merger, all companies are legally dissolved and a new entity is created.
FORMS OF MERGER
Vertical merger
This is combination of two or more firm involved in different stages of production or distribution. E.g where a manufacturing company combines with a distribution company. The purpose appears to provide supply of raw materials and to eliminate problems associated with coordination and negotiation with suppliers
Horizontal merger
A combination of two or more firms in a similar line of business with a main purpose of achieving economies of scale and increase market share. Eg A merger of two banks.
Conglomerate merger
A combination of firms engaged in unrelated lines of business activity with the main aim appearing to be risk diversification
Motives for mergers
Synergy
This implies a situation where the combined firm is more valuable than the sum of the individual combining firms. i.e, 1+1=3 phenomenon. These are additional benefits associated with economies of scale after mergers and acquisitions. The performance of the combined firms is higher than its previous separate firms.
Revenues: By combining the two companies, we will realize higher revenues than if the two companies operate separately.
Expenses: By combining the two companies, we will realize lower expenses than if the two companies operate separately.
Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.
For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the need to cut costs. Cost savings often come from the elimination of redundant services, such as Human Resources, Accounting, Information Technology, etc. However, the best mergers seem to have strategic reasons for the business combination. These strategic reasons include:
Positioning – Taking advantage of future opportunities that can be exploited when the two companies are combined. For example, a telecommunications company might improve its position for the future if it were to own a broad band service company. Companies need to position themselves to take advantage of emerging trends in the marketplace.
Gap Filling – One company may have a major weakness (such as poor distribution) whereas the other company has some significant strength. By combining the two companies, each company fills-in strategic gaps that are essential for long-term survival.
Organizational Competencies – Acquiring human resources and intellectual capital can help improve innovative thinking and development within the company.
Broader Market Access – Acquiring a foreign company can give a company quick access to emerging global markets.
Risk diversification
A merger may have its primary objective the diversification of risk. The motive remains questionable since in most empirical studies, individual shareholders are able to diversify risk than companies. Risk diversification is normally achieved through conglomerate mergers especially where the results of the two firms are negatively correlated
Tax savings
A company paying high taxes due to high income can acquire another company with accumulated losses which after the merger or acquisition can gain more by reducing the overall taxable income thus reducing the tax liability of the company.
Increased market power
A merger can increase the market share and bargaining power of the merged firm due to its size
Empire building
Were a merger is motivated by personal and selfish reasoning of the managers to acquire more power, remuneration, control and influence.
Asset backing
A merger may be driven by the need of a company seeking another with substantial asset value. This is particularly so for risky companies in the service industry such as IT
Reasons for global mega mergers
- The increasing level of deregulation in the financial markets has made it easier to organize the finance for large deals.
- The increasing trend towards globalization of both operations and financing has made the concept of the ‘mega company’ more attractive.
- There is some evidence that there has been a trend towards getting bigger, becoming a defence against being taken over as the number of key players in the different market sectors has gradually declined.
- In some sectors. Eg vehicle manufacturing and mobile subscribers, there is a trend towards bigger companies as the market becomes increasingly concentrated in the hands of declining number of large companies
- Large companies see the opportunity for achieving significant economies of scale and thereby becoming more competitive. These economies are no longer primarily in the field of operations, but rather in the overhead areas such as the head office costs
- Sometimes the merger may be the quickest and cheapest way to achieving the growth in the earnings that is demanded by the investors, and the increasing size of leading companies means that some of these mergers will fall into ‘mega merger’ category.
Problems associated with ‘mega mergers’
- The creation of very large companies may lead to unforeseen diseconomies of scale. Eg there may be problems of communication and control within the organization which means that large and costly new IT solutions are required that were not originally envisaged.
- There is an increasing climate of job uncertainty within the companies concerned as staff anticipates possible redundancies as part of the post merger rationalization. This may translate into a reduced level of commitment to the new organization, a higher level of staff turnover with a loss of key staff, and a corresponding decline in performance
- The cultures of the two organizations may be so different as to make integration very difficult. This is less important where a small company is taken over by a large one since in this situation there will be greater expectation of change. In the mega merger, change will be required by all staff within both companies and if cultural divergence is too great, this may be difficult to achieve successfully.
- Very large organizations may lose their flexibility and ability to provide a good quality of local customers service as managers become increasingly distanced from their customers. This in turn may mean that they lose some of their competitive advantage.
- The two companies have strategies and objectives that are too different and they conflict with one another.
- Poorly Managed Integration – The integration of two companies requires a very high level of quality management. Integration is often poorly managed with little planning and design. As a result, implementation fails.
Note:
A survey carried out I 1992, through the interviewing of senior executives of the UK’s top 100 companies covering 50 deals, revealed some common factors contributing to the failure of mergers in order of decreasing rate of incidence:
Cultural differences and poor attitude of target management
Little or no post acquisition planning
Lack of knowledge of industry or Target Company Little or o experience of acquisitions
We should also recognize some cold hard facts about mergers and acquisitions. In the book The Complete Guide to Mergers and Acquisitions, the authors Timothy J. Galpin and Mark Herndon point out the following:
- Synergies projected for M & A’s are not achieved in 70% of cases.
- Just 23% of all M & A’s will earn their cost of capital.
- In the first six months of a merger, productivity may fall by as much as 50%.
- The average financial performance of a newly merged company is graded as C – by the respective managers
In acquired companies, 47% of the executives will leave the first year and 75% will leave within the first three years of the merger.
Merger analysis
The Merger & Acquisition Process can be broken down into five phases:
Phase 1 – Pre Acquisition Review:
The first step is to assess your own situation and determine if a merger and acquisition strategy should be implemented. If a company expects difficulty in the future when it comes to maintaining core competencies, market share, return on capital, or other key performance drivers, then a merger and acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to protect its valuation, it may find itself the target of a merger. Therefore, the pre-acquisition phase will often include a valuation of the company – Are we undervalued? Would an M & A Program improve our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth targets (such as 10% market growth over the next 3 years) can be achieved internally. If not, an M & A Team should be formed to establish a set of criteria whereby the company can grow through acquisition. A complete rough plan should be developed on how growth will occur through M & A, including responsibilities within the company, how information will be gathered, etc.
Phase 2 – Search & Screen Targets:
The second phase within the M & A Process is to search for possible takeover candidates. Target companies must fulfill a set of criteria so that the Target Company is a good strategic fit with the acquiring company. For example, the target’s drivers of performance should compliment the acquiring company. Compatibility and fit should be assessed across a range of criteria – relative size, type of business, capital structure, organizational strengths, core competencies, market channels, etc.
It is worth noting that the search and screening process is performed in-house by the Acquiring Company. Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must be highly guarded and independent.
Phase 3 – Investigate & Value the Target:
The third phase of M & A is to perform a more detail analysis of the target company. You want to confirm that the Target Company is truly a good fit with the acquiring company. This will require a more thorough review of operations, strategies, financials, and other aspects of the Target Company. This detail review is called “due diligence.” Specifically, Phase I Due Diligence is initiated once a target company has been selected. The main objective is to identify various synergy values that can be realized through an M & A of the Target Company. Investment Bankers now enter into the M & A process to assist with this evaluation.
A key part of due diligence is the valuation of the target company. In the preliminary phases of M & A, we will calculate a total value for the combined company. We have already calculated a value for our company (acquiring company). We now want to calculate a value for the target as well as all other costs associated with the M & A.
Phase 4 – Acquire through Negotiation:
Now that we have selected our target company, it’s time to start the process of negotiating a M & A. We need to develop a negotiation plan based on several key questions:
- How much resistance will we encounter from the Target Company?
- What are the benefits of the M & A for the Target Company?
- What will be our bidding strategy?
- How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both companies to reach agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes called a “bear hug.” The negotiated merger or bear hug is the preferred approach to a M & A since having both sides agree to the deal will go a long way to making the M & A work. In cases where resistance is expected from the target, the acquiring firm will acquire a partial interest in the target; sometimes referred to as a “toehold position.” This toehold position puts pressure on the target to negotiate without sending the target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the acquiring company will make a tender offer directly to the shareholders of the target, bypassing the target’s management. Tender offers are characterized by the following:
- The price offered is above the target’s prevailing market price.
- The offer applies to a substantial, if not all, outstanding shares of stock.
- The offer is open for a limited period of time.
- The offer is made to the public shareholders of the target.
Phase 5 – Post Merger Integration:
If all goes well, the two companies will announce an agreement to merge the two companies. The deal is finalized in a formal merger and acquisition agreement. This leads us to the fifth and final phase within the M & A Process, the integration of the two companies.
Every company is different – differences in culture, differences in information systems, differences in strategies, etc. As a result, the Post Merger Integration Phase is the most difficult phase within the M & A Process. Now all of a sudden we have to bring these two companies together and make the whole thing work. This requires extensive planning and design throughout the entire organization. The integration process can take place at three levels:
Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into one new company. The new company will use the “best practices” between the two companies.
Moderate: Certain key functions or processes (such as production) will be merged together. Strategic decisions will be centralized within one company, but day to day operating decisions will remain autonomous.
Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both strategic and operating decisions will remain decentralized and autonomous.
If post merger integration is successful, then we should generate synergy values. However, before we embark on a formal merger and acquisition program, perhaps we need to understand the realities of mergers and acquisitions.
Defensive tactics against a merger
As much as mergers and acquisitions are a good way of restructuring corporate entities, sometimes entities adopt hostile takeovers. The target company may undertake a number of tactics to defend itself from a hostile takeover. These tactics include
Crown jewels
This is where the target sells off the most attractive part of its business that the predator is interested in or highly valued assets which in turn makes the company un attractive.
Poisson pill
This is where the target undertakes an act that will make it less attractive and that can interfere with its going concern. E.g Borrowing heavily or declaring very high dividends.
White knight
The target gets a more friendly predator to acquire it instead. The strategy should however be used as a last result since it results I loss of independence and again, the white knight may not be as elegant as initially thought. Usually, the Target Company will enlist the services of an investment banker to locate a “white knight.” The White Knight Company comes in and rescues the Target Company from the hostile takeover attempt. In order to stop the hostile merger, the White Knight will pay a price more favorable than the price offered by the hostile bidder.
Litigation:
One of the more common approaches to stopping a merger is to legally challenge the merger. The Target Company will seek an injunction to stop the takeover from proceeding. This gives the target company time to mount a defense. For example, the Target Company will routinely challenge the acquiring company as failing to give proper notice of the merger and failing to disclose all relevant information to shareholders.
Pac Man Defense:
As a last resort, the target company can make a tender offer to acquire the stock of the hostile bidder. This is a very extreme type of anti-takeover defense and usually signals desperation. It is based o the rationale that the best defensive strategy is to attack
Green mail
This is where the target makes a counter offer to acquire the predator such that the target becomes the predator and the predator the target. It is possible where the two companies are almost equally strong.
Golden Parachutes
Another popular anti-takeover defense is the Golden Parachute. Golden parachutes are large compensation payments to executive management, payable if they depart unexpectedly. Lump sum payments are made upon termination of employment. The amount of compensation is usually based on annual compensation and years of service. Golden parachutes are narrowly applied to only the most elite executives and thus, they are sometimes viewed negatively by shareholders and others. In relation to other types of takeover defenses, golden parachutes are not very effective.
Others
- Leveraged buyout (LBO) – sell the company to its own management using a large amount of borrowed funds
- Persuasion by the management that the offer is not in the best interest of the shareholders
- Conversion of the company into a private one. Eg. By delisting
- Selling shares to friendly parties. Eg. Employees through an employee share option scheme with the objective of increasing the proportion of shareholders likely to resist the merger.
Merger valuation methods
Asset basis method
In this the net assets of the company are valued either at the net realizable value or book
value and this value is divided by the number of shares to find the value of a share.
Dividend basis
This follows the fundamental theory of valuation which states that the value of a share is the PV of all cash flows expected from the share and in this case present value of all dividends payments.
The method assumes a constant growth rate in earnings of the company and a constant dividend payout ratio.
Discounted cash flow method
Here the firm is first valued by discounting all its post tax and post interest cash flows at the cost of equity of the target company to perpetuity. Once the value has been obtained the same is divided among all the shares of the organization.
Earnings basis of valuation
Here the market value of a share is calculated as the company’s price earnings ratio multiplied by its earnings per share (forecasted) i.e P/E x EPS = MPS
Forms of consideration
This is the price to pay for the merger or acquisition The consideration can take different forms such as:
Payment in cash
This is where the predator pays cash to acquire shares or assets of the target it has the following implications
- there is no dilution of ownership and control for the predator company
- the predator has to consider its liquidity position
- the shareholders of the target company will dispose off their shares and lose ownership in the predator company
- shareholders of the target company will realize capital gains which may not be taxable
- shareholders of the target company are able to dispose of their shares without incurring transaction costs
Share for share exchange
I this case, there is no cash outflow but the shareholders of the target company surrender a given number of their shares to acquire a given umber of shares in the predator company. This is known as exchange ratio.
It has the following implications
- conserves the cash for the predator company
- the shareholders of the target company gain control ad ownership of the predator company
- There will be increase in the equity capital of the predator company after the issue of new shares.
- There will be dilution of ownership ad control of the predator company including the possibility of dilution of the future earnings per share.
Use of convertible securities
This is where the predator company will issue convertible securities to the shareholders of the target company to surrender their shares to become debenture holders or preference shareholders in the predator company after acquisition.
It has the following implications
- it conserves cash in the predator company
- there is no dilution of ownership and control
- it increases the gearing level of the predator company resulting into the increase in the financial risk
- in case the predator company issues debentures, it will enjoy the interest tax shield benefit
A combination of any of the above
The impact of mergers and takeover on stakeholders
- Acquiring company shareholders
At least half of mergers studied have shown a decline in profitability compared with industry averages. Returns to equity can often be poor relative to the market in the early years, particularly for equity financed bids and first time players.
Costs of mergers frequently outweigh the gains
- Target company shareholders
In the majority of cases, it is the target shareholders who benefit the greatest from a takeover. Bidding companies invariably have to offer a significant premium over the market price prevailing prior to the bid in order to achieve the purchase.
- Target company management
The management of the newly enlarged organization will often enjoy increased status and influence as well as increased salary and benefits.
- Target company management
Whilst some key personnel may be kept on for some time after the takeover, a significant number of managers will find themselves out of a job. However, a ‘golden handshake’ and the prospect of equally remunerative employment elsewhere may lessen the blow of this somewhat
- Other employees
Commonly the economy of scale cost savings anticipated in a merger will be largely achieved by the loss of jobs, as duplicated service operations are eliminated and loss making divisions closed down. However, in some instances, the increased competitive strength of the new enlarged enterprise can lead to expansion of operations and the need for an increased workforce.
(d) Financial institutions
These are perhaps the outright winners. The more complex the deal, the longer the battle and the more legal and financial problems encountered, the greater their fee income regardless of the end result.
Price earnings game theory
The fundamental principle of this theory is that a firm with a high P/E ratio can acquire any firm with a lower P/E ratio without dilution of EPS irrespective of whether the acquisition has synergistic effects or not.
This is sometimes explained as the firm with the higher P/E ratio being considered less risky and hence more attractive to investors.
According to this theory the maximum price that an acquiring firm should pay for the ordinary shares of the acquiring firm should the product of the P/E ratio of the acquiring firm and EPS of the target firm i.e the maximum price a company should pay to acquire another company’s earnings is the acquiring company’s P/E ratio.
Exchange ratio
This is the number of common shares of the acquiring company given to acquire a specified number of common shares of a target company
Maximum exchange ratio
The ratio of exchange of common shares that ensures there is no dilution in post merger EPS. It is calculated as follows
Illustration
Mr. Upendo, a director of Yote Limited met Mr. Mapenzi, a director of Toa Limited during a conference in Mombasa. They had some discussion about their various companies. After flying back to Nairobi, Mr. Upendo proposed to his board of directors acquisition of Toa Limited.
During his presentation to the board he stated that: “As a result of this takeover we will diversify our operations and our earnings per share will rise by 13%, bringing great benefits to our shareholders”.
A bid would be based on an exchange of shares between the two companies which would be one Yote share for every six Toa shares. Financial data for the two companies include the following:
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