Mergers & Acquisitions (M&A)

Mergers and Acquisitions (M&A) is a general term that describes all types of financial transactions related to the transfer or consolidation of ownership and assets of a company.

These two terms are often used interchangeably, but they have different meanings.

In a merger, two companies combine to form a new entity. For example, in 1999, Exxon and Mobil merged to create a superpower in the energy industry.

On the other hand, acquisition refers to the act of buying another company by acquiring more than 50% stake in it. For example, Walt Disney Co. acquired Pixar in 2006 for $7.4 billion and has since had tremendous success with films like Finding Dory and Toy Story 3.

Understanding Mergers and Acquisitions (M&A)

As discussed above, the terms "mergers" and "acquisitions" are often substituted for each other, but they differ in meaning.

Euphemistically, a deal is regarded as a merger when both CEOs mutually decide that joining together is the best strategy for both companies. For example, Meta (Facebook) acquired the mobile messaging service Whatsapp for $19 billion.

Hostile takeovers (in which the target firm opposes the deal but is forcefully acquired) are often regarded as acquisitions. The key difference is choice. For example, Vodafone acquired the German firm, Mannesmann AG, for $202.8 billion in 1999.

When two firms of the same size think that it is in the best interest of both to join hands, then such a deal is called a merger of equals. 

One of the most popular examples of this is the merger between AOL and Time Warner, which later came to be known as AOL Time Warner.

The company that aspires to take over another is called the acquirer. The business that is being considered by the acquirer is called the target.

An M&A is executed for a variety of reasons. Firstly, they increase efficiency by reducing the unnecessary cost of operations and overheads. It helps overcome competition, achieve economies of scale, and increase profits.

However, due to the high cost of M&A, it carries a high level of risk and uncertainty. It can have an unfavorable impact on stock prices too. Various studies have proven that 50% of acquisitions were unsuccessful. 

Types of Mergers and Acquisitions (M&A) Transactions

The transactions that are covered under the M&A category are as follows:

1. Mergers

When two or more firms mutually decide to combine their resources to create a new legit firm, it is called a merger. 

For example, in 2015, Dow Chemical and DuPont merged to form the largest chemical company in the world. 

In 2018, the business was generating a revenue of $86 billion per year. But shortly after, in 2019, the enterprise was divided into three different companies, each with a different focus.

2. Acquisitions

When one company acquires a major stake in another, called the target company, it is referred to as an acquisition. 

For instance, in 2021, Salesforce acquired Slack for $27.7 billion. It is the second-biggest deal of all time for a software company.

3. Consolidations

When two or more companies combine to form an entirely new company, it is known as consolidation. It is a type of merger, but a new legal entity is created.

For example, Sandoz and Ciba Geigy, two Swiss pharmaceutical companies, consolidated to become Novartis.

4. Tender Offers

In a tender offer, a person or organization gives an offer or invitation to all shareholders of the target firm to sell their shares at a predetermined price, which is usually more than the market price, generally subject to a minimum and a maximum number of shares. 

Tender offers in which securities are offered as consideration are known as "exchange offers."

5. Acquisition of Assets

In an asset acquisition, a company directly purchases the assets of another company instead of its shares. It may also involve the assumption of certain liabilities.

As the first party (purchaser) gets to pick what assets to invest in, it gives more flexibility and involves less risk.

This is usually used during bankruptcy proceedings during the liquidation process.

6. Management Acquisitions

It is also known as Management Buyout (MBO). In this type of M&A, the management of the firm acquires a major stake in it, making it private and thus enabling it to take advantage of fewer regulations and reduced listing and regulation costs. 

Since the firm becomes private, the management streamlines its operations, increases profitability away from publicity, and goes public eventually at a much higher valuation.

For instance, former PricewaterhouseCooper director Michael Line led an MBO backed by two private equity firms of PwC's fintech division, which was then known as eBAM. The company was then rebranded as LikeZero.

How are Mergers Structured

A company chooses the type of M&A it wants to get into based on the goals of the company. 

These are far more complicated than just two companies coming together. The process however depends on the companies involved, the industry they are in, and also the type of merger they are getting into.

An M&A has a huge impact on the companies involved and even the market. They can either increase the Earnings Per Share (EPS) or decrease it.

They are not always successful. A lot of them fail if the managers have not done proper research or are not able to combine both companies, particularly their cultures.

Mergers can be between competitors, industry partners, corporations with an input-output relationship like suppliers, etc. 

Based on the relationship between the two companies, mergers can be structured in the following ways:

Horizontal Merger

It is a type of merger that happens between companies that operate in the same or similar industry. It helps to gain a competitive advantage.

Such consolidations help in achieving economies of scale more efficiently and thus, reduce the cost of operations.

These types of mergers usually happen between competitors and are often reviewed by competition authorities to ensure that the new firm does not acquire a monopoly in the market and increases prices.

The new company usually exercises better control over prices. It is usually better to acquire an already excelling business than to develop the products and services from scratch.

However, sometimes merging two different corporate cultures can be difficult. This becomes even more challenging if the two companies have differing managerial styles.

The integration of Facebook, Whatsapp, Instagram, and Messenger is an example of a horizontal merger.

Vertical Merger

It is a type of merger that happens between two or more companies operating at different stages of the production process. It helps in increasing synergies, reducing costs, ensuring quality control, and realizing higher profits.

Operational synergy leads to better coordination and management along the supply chain. It also leads to financial synergy by increasing the borrowing capacity, reducing the cost of capital, and achieving better creditworthiness. 

A poor-performing management team is replaced with a more effective one. Cost is also reduced across different parts of the production process.

This leads to tighter quality control of the raw material used. Due to rea duction in costs and increase in productivity and efficiency, profits of the firm increase.

A vertical merger can be used to block competitors from accessing raw materials, thus reducing market competition.

The terms "vertical merger" and "vertical integration", although often used interchangeably, differ in meanings. 

In vertical integration, the company decides to produce its raw material instead of purchasing it from suppliers while in a vertical merger, a company decides to integrate with its supplier.

The merger between Google and Android is an example of a vertical merger.

Congeneric Mergers

It is a type of merger that happens between two or more companies that belong to the same industry but do not produce the same product. 

If a bank and an insurance company merge, then it is an example of a congeneric merger as they both belong to the same industry but produce different products.

It helps in expanding the product line, increasing the customer base, and combining technologies. Both the companies may have similar technology, distribution channels, or production systems that produce synergy.

It is an important growth strategy and can be used for boosting revenue through product diversification. Diversification also carries less risk as the two companies belong to the same industry.

The sharing of production processes, technology, and distribution channels reduces costs and leads to economies of scale.

The combined synergy of the companies is greater than the individual companies themselves. An example of this is the acquisition of Mobilink Telecom by Broadcom in 2002.

Market-Extension Merger

This type of merger takes place between companies that deal in the same product but separate markets.

If one food chain operates on the outskirts and another in the main town, then the merger between the two will be an example of a market-extension merger as the new firm will get access to both markets.

It is done when a business feels that its reach is limited or wants to expand its products to other markets.

It helps in getting a greater customer base, a bigger market, and also in improving the products.

It is helpful when you want to expand your reach to other markets, and also provides an opportunity to relocate and get better access to the customers of the new market with a focus on segmentation.

When the product reaches new customers, the firm also comes to know about its shortcomings and weaknesses to generate improvements and strengthen its market share.

The most famous example of this is the acquisition of the American-based Eagle Bancshares Inc. by RBC Centura Inc. in 2002.  This deal provided a chance for RBC to deal in the financial markets of Atlanta and hence build itself in the North American market.

Product-Extension Merger

Unlike a market-extension merger, a product-extension merger takes place between companies that deal in related products in the same market.

It expands the product line and customer base of both entities increases the market share and gives a competitive advantage.

Since the products are generally similar, they can share technology and workforce post-merger and can thus reduce costs. Pooling resources will help increase profits.

Customer satisfaction is also increased as customers get the complete set of products or services and they don't have to go to multiple vendors for it. This helps to gain customer confidence.

The company also stands out among its competitors as it now offers augmented products to an increased customer base.

The merger of Pizza Hut and PepsiCo. in 1977 is an example of a product-extension merger.

Conglomeration

A conglomerate is a multi-industry company that is created when a parent company acquires subsidiaries. The resultant company is usually large and multinational. It takes place between totally unrelated companies.

The risks involved in operating in a single market are mitigated as cyclical companies can be balanced by non-cyclical or counter-cyclical companies. It also provides immunity to the parent company against potential takeovers as it increases in size.

The parent company can diversify and reach new customers. However, from an investor's point of view, diversification is realized at a far cheaper price as mutual funds are becoming common in investment portfolios.

Conglomerate mergers are of two types: pure conglomerate mergers and mixed conglomerate mergers. 

In pure conglomerate mergers, two companies that have nothing in common and operate in different markets come together, while in mixed conglomerate mergers, two companies that want to diversify their product or market line combine.
Some examples of conglomerates include Alphabet, AT&T, Thomson Reuters Corporation, 3M, etc.

Mergers can also be differentiated based on the financing method followed:

A. Purchase Mergers: When one company purchases another company, it is called a purchase merger. The consideration can be in the form of cash or some debt instrument.

B. Consolidation Mergers: In this kind of merger, both companies are combined, and a new entity is formed.

How are Acquisitions Financed

An M&A deal can be financed with stock, cash, assumption of debt, or by acquiring another business's assets.

In stock swaps, the buying company exchanges its stock for shares of the seller's company.

An obvious alternative to this is cash transactions. These are instantaneous and involve huge costs for some companies.

The buying company can also assume the selling company's debt instead of paying in cash or stock. This type of deal usually takes place when the selling company is having difficulty repaying its debt. This is usually considered a cost-effective way to acquire assets.

In smaller deals, company A buys all assets of company B, and company B only remains with cash and debt and reduces to a shell. It either liquidates or enters a new business.

A reverse merger is another type of deal that enables a private firm to become publicly listed by skipping the lengthy and complex process. In this process, a private company acquires a relatively small public company.

Diginex, a Hong Kong-based cryptocurrency firm, closed a reverse merger deal with 8i Enterprises Acquisitions Corp., and the name was changed to Diginex Ltd.

How are Mergers and Acquisitions Valued

Valuation is conducted by both the acquirer and the target of the acquisition. The aims of both parties are different as the acquirer will want to purchase at the lowest price, while the target will want to get the highest price.

The major methods used for valuation are:

1. Price-to-Earnings Ratio (P/E Ratio)

This ratio measures the current price of the share with Earnings Per Share (EPS). With the help of this ratio, the acquiring concern gives an offer that is a multiple of the earnings of the target firm. 

It analyzes the stocks of other companies within the same industry and gets an idea of what the target's P/E multiple should be.

2. Enterprise-Value-to-Sales Ratio (EV/Sales)

Enterprise value compares the value of the company to its sales. The target organization is valued as a multiple of its sales.

3. Discounted Cash Flow (DCF)

The DCF model is used to calculate the present value of an enterprise based on the expected future cash flows. 

The free cash flows are discounted using the Weighted Average Cost of Capital (WACC) to its present value.

Free cash flow= Net income + Depreciation/ Amortisation - Capital expenditures - Change in working capital

4. Replacement Cost

Replacement cost is the amount of money that the acquirer must spend to replace the target company at present, according to its current worth. However, this method cannot be used to value a service company as human resources are difficult to value.

5. Comparable Transaction Analysis

Similar M&A transactions are examined and compared in this method to determine the target's value.

Reasons for Mergers and Acquisitions (M&A) Activity

M&A is conducted for the following reasons:

1. Unlocking Synergies

Synergy means that the combined value of the two companies is greater than that of the individual firms.

This happens due to many factors, including staff reduction, which leads to a reduction in the cost of operation, economies of scale, new technology, improved market reach, and increased industry visibility.

2. Higher Growth

Mergers and Acquisitions lead to faster growth as they lead to higher revenues. A firm can acquire another enterprise with the latest technology without undertaking the risk of developing the same.

3. Stronger Market Power

Horizontal mergers generate greater monopoly power by combining industry rivals. Vertical mergers are more shielded from supply chain shocks and are more in control.

4. Diversification

Cyclical companies can diversify by acquiring a non-cyclical or counter-cyclical to reduce market risk.

5. Tax Benefits

The tax liability of one enterprise can be set off against the tax losses of another in M&A.

Brand Considerations

Deciding what the new firm will be called is one of the key factors for the success of an M&A.

There are four choices, each with its pros and cons:

1. Keeping one name and discontinuing the other- The strongest brand name among the two is chosen in this strategy. The merger of NationsBank Charlotte and BankAmerica Corp. is an example of this, as the new entity adopted the name "Bank of America".

2. Keeping one name and demoting the other- The stronger brand name among the two is chosen as the company name, and the weaker one is demoted to a product or division brand name. Caterpillar Inc. keeping the Bucyrus International name is an example of this. 

3. Keeping both names and using them together- Some companies merge both names to create a new brand name. JP Morgan Chase is an example of fusing both brand names.

4. Discarding both names and adopting a new one- The most aggressive strategy is to create a new brand name, which is helpful if the new entity is going for a transformational change. The most famous example of this strategy is the merger between Bell Atlantic and GTE. "Verizon Communications" was adopted as the new brand name.

Researched and authored by Harveen Kaur Ahluwalia | LinkedIn

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