Mergers and Acquisitions

INTRODUCTION

 When an organisation decides on expansion the choice is between organic growth or acquisition.  Organic growth is internal growth by expansion of the existing business (e.g. opening more outlets, major marketing/sales campaign, reduce prices to achieve additional sales etc.)  or investment in new projects.  The alternative is to acquire a competitor (thus reducing competition), or other companies in related or non-related lines of business.  Acquisition achieves the objective more quickly and avoids the risk of start-up.  However, it is generally more expensive than organic growth.

Merger – this is generally where two companies unite to form a single entity.

Acquisition/Takeover – generally where one company purchases a controlling interest in another company.

TYPES OF COMBINATIONS

Generally, the combinations can be categorised as follows:

• Vertical Integration – combination of two firms in the same industry but at different levels – e.g. a production company acquires its supplier of raw materials.
• Horizontal Integration – combination of two firms in the same industry and at the same level – e.g. the acquisition of a direct competitor.
• Conglomerate Merger/Takeover – combination of two firms in unrelated/indirectly related industries – e.g. a tobacco company acquires an insurance company.                                                                                                                                                                                               REASONS FOR ACQUISITION

There are many reasons why one company may wish to acquire another.  The following list is not in any particular order as priorities may vary from one acquisition to another:

• Synergy => 2 + 2 = 5 (benefits accrue due to increased earnings or reduction in costs

e.g. reduced advertising & distribution costs; disposal of one H.O. etc.)

• Economies of Scale – Fixed operating costs spread over larger production volume; equipment used more efficiently; bulk purchasing (production, marketing, administration, R & D, finance etc).
• New Market – quick entry
• Management Acquisition – a company with a weak management team acquires a company with a strong team.
• Diversification – reduction of risk. This may not be beneficial to shareholders who already hold diversified portfolios.  Can be beneficial if the acquired company is one in which the shareholder could not previously invest.
• Increased Market Share & Market Power – gain some monopoly power which may increase profitability (e.g. price leadership). In some markets to operate effectively requires the achievement of a “critical mass” size.  Beware of Monopolies legislation.
• Bolster Asset Backing – a company with a high level of earnings relative to its assets may wish to improve the overall risk profile by acquiring a company with substantial assets.
• Growth – growth through acquisition may be cheaper and quicker than internal expansion.
• Taxation – a company with unused tax allowances may wish to combine with a company with large taxable profits. Similarly, a company with accumulated tax losses may be acquired so that the losses can be offset against the taxable profits of the acquiring company.
• Reduction of Competition – consider Monopolies legislation and attitude of Competition Authority
• Asset Stripping – company broken up and assets sold off.
• Use of Surplus Cash – acquire “earnings enhancing” company.
• Lower Costs Of Financing – improved credit-rating following reduced variability of returns may make it easier/cheaper to raise finance.
• Improvement In Gearing – highly geared company links up with “cash-rich” company.
• Purchase of Patents/Brands
• Note: Evidence suggests that many acquisitions are financially unsuccessful.  There is often some abnormal return for the shareholders of the target (premium paid for their shares) but very little for the bidding company shareholders.  Also, acquisitions often experience difficulties in integrating the operations of the companies.  Research by the London Business School indicates that 75% fail to reach their financial targets and 50% of acquiring companies fail to recoup the premium they pay above market value.

IMPACT OF ACQUISITION

On Shareholders in Bidding Company

Approval may not be forthcoming if the shareholders regard the bid as unattractive because:

• It might reduce EPS
• The target company is in a risky business It might reduce the net asset backing per share
• It might dilute their control.

On Directors & Shareholders in Target Company

The Board and/or shareholders in the target company may regard the bid as unattractive because:

• They regard the terms of the offer as poor The takeover has no obvious advantages
• The employees are strongly opposed to it.

 

PURCHASE CONSIDERATION

There are a number of ways that the acquiring company can pay for the target.  Briefly, these are:

• Cash
• Share Exchange – e.g. three shares in company A for every five shares in company B Loan Stock – e.g. RWF100k of 10% Loan Stock for forty shares in company B
• Combination – some cash plus some shares etc.
• Deferred Expenditure – Performance Related.

Before deciding on the method of consideration there are a number of factors to consider:

• Factors – Bidding Company & Shareholders
  • Dilution in EPS – may occur in certain circumstances when the consideration is equity (if the target company is bought on a higher P/E Ratio than the bidder).
  • Cost – may be less with loan stock as the interest is allowable for Corporation Tax. Also, dilution of EPS may be avoided.
  • Gearing – a highly geared company may find it difficult to issue additional loan stock.
  • Control – may be diluted if a large number of shares is issued. Cash causes less dilution of ownership.
  • Cash Resources – use of equity conserves cash resources and may be the only real alternative when the target company is large in relation to the bidding company. The issue of Loan Stock will also conserve liquidity but will increase gearing.
  • Price – if equity is offered the value of the bid is dependent upon the share price – fluctuations causing the attractiveness of the bid to alter. The cost of the bid is more precise when cash is the consideration.  Where shares are offered the bidding company will be concerned that the market value of their shares should not fall before the target company’s shareholders have accepted.

 

• Factors – Shareholders in Target Company
  • Taxation – if cash is offered an immediate C.G.T./Income Tax liability arises. If paper (shares/stock etc.) is offered the tax liability is deferred.
  • Income – if paper is offered, the bidding company should generally ensure that the shareholders’ income is at least maintained.
  • Future Investment – shareholders may prefer equity to maintain a continued interest in their company, albeit as part of a larger group, without incurring transaction costs of purchasing in the new group. Unless Loan Stock is issued as “convertibles” or with warrants attached the shareholders will not maintain an equity interest in the group.
  • Cash – if cash is offered the value is certain and the shareholder is free to invest elsewhere, without incurring transaction costs of selling shares.
  • Value – evidence suggests that the consideration is higher when equity rather than cash is used as consideration.
  • Risk – the receipt of fixed interest stock will change the risk of the shareholders’ portfolios which they may not wish.                         DEFENCE TACTICS

Where an unwelcome or hostile bid is received a number of steps can be taken to thwart it:

• Reject the bid on the basis that the terms are not good enough.
• Issue a forecast of attractive future profits and dividends to persuade shareholders to hold onto their shares.
• Revalue any undervalued assets.
• Attempt to have the offer referred under Monopolies legislation – at minimum this will delay the bid.
• Mount an effective advertising and P.R. campaign.
• Find a “White Knight” that is more acceptable – where a company finds a more suitable acquirer and deals with them rather than the original bidder.
• Make a counter bid – only possible if the companies are of a similar size.
• Arrange a Management Buyout.
• Attack the credibility of the offer or the offeror itself, particularly if shares are offered – e.g. commercial logic of the takeover, dispute any claimed synergies, criticize the track record, ethics, future prospects etc. of the offeror.
• Appeal to the loyalty of the shareholders.
• Encourage employees to express opposition to the merger
• Persuade institutions to buy shares.

Note: In fighting the bid, the company may be restricted by a Rwandan Stock Exchange (RSE) Code on Takeovers and Mergers.

MANAGEMENT BUYOUT (MBO)

• This is the purchase of all or part of a business by one or more of its executive management. The main factors to consider are the riskiness and the problems which may arise when the new company becomes independent (e.g. loss of H.O. support; customers may go elsewhere if they regard the firm as too risky.
• Management put up some of the capital themselves and obtain the remainder from other sources (e.g. Venture Capital organisations). Equity from external investors will often be in a form other than ordinary shares e.g. convertible redeemable preference shares.

They will also require board representation and options on future share issues.  Management will to keep effective control by ceding <50% of voting rights to external equity holders.

• External investors will need some potential exit route e.g. future listing, refinancing, sale of entire business to another company or the management team.
• Originally used to dispose of poor performing subsidiaries at a discount but nowadays, mostly used to dispose of successful operations which do not fit the “core” business.
• An MBO may also arise where a company or subsidiary is threatened with closure.
• There are usually three parties to an MBO:
  • The management team who must possess the necessary skills and ability.
  • The directors/owners who are willing to dispose of the entity.
  • The financial backers (possibly more than one) who will usually require an equity stake. They will review strategic business plans & cash flow projections and assess the personal commitment and quality of the management team.
• The main reasons for an MBO are:
  • The subsidiary no longer fits the group’s overall strategy.
  • The parent’s desire to sell a loss-maker (MBO possibly cheaper than liquidation).
  • The parent needs cash urgently.
  • The subsidiary is too small for the level of time involved in managing it. Management is unable to devote the time/capital necessary to develop the subsidiary. Rather than run it down or sell it to a competitor it may arrange an MBO (possibly on generous terms) in order to retain trading contacts with the subsidiary in the future.
  • A new parent wishes to sell unwanted parts, following acquisition.
  • The best offer may come from the management team.
  • There will generally be better co-operation in an MBO.
• The main advantages of an MBO are:
  • Although high-risk, the potential for rewards is high
  • Less risky than starting from scratch
  • MBO firms tend to operate at a higher level of efficiency

 

Management Buy-In (MBI)

• This is a variation on the MBO theme and occurs when a team of outside managers mounts a takeover bid and then assumes the executive responsibilities for running the business themselves.

DEMERGERS

• A demerger results in the splitting up of a firm into smaller legally separate firms.
• A demerger may arise:
  • Where one part of a firm is of an unusual level of risk.
  • Where one part of a firm has unusual financing requirements.
  • Where a firm has grown too large for its management structure.
• Among the financial advantages are:
  • Ensures the continued survival and viability of the profitable parts of a firm whose existence could otherwise be threatened by a loss-making division.
  • Enables management to have a direct investment in their activities and to observe their performance as evidenced by the share price behaviour for their part of the firm.
  • May enable the separate and smaller firms to take advantage of lower tax rates, government subsidies etc. applicable only to smaller firms.
  • May enable risky but worthwhile activities to be separated from the rest of the less risky firm. This will enable shareholders to choose the level of risk of their investments.
• Among the financial disadvantages are:
  • Any economies of scale may be lost.
  • Total overheads may be greater.
  • Total borrowing capacity may be reduced. Before demerger the portfolio effect of many activities will help to smooth cash flows and, therefore, will assist in boosting borrowing capacity.                                                                                                                                  MEZZANINE FINANCE

• This is a layer of funding between senior debt and equity.
• It ranks behind senior debt and usually has little or no asset backing.
• To compensate for the higher risk it normally carries an enhanced coupon rate together with some participation in the equity of the business.
• In an MBO this allows the percentage of true equity in the total package to be smaller and control of the company can be left in the hands of the management group.
• The major characteristics are:
  • Floating interest rate, normally higher than senior debt.
  • Equity participation, either by way of warrants or initial subscription, to give a total return somewhere below straight equity but above straight debt.
  • Repayment terms of eight to ten years or more.
  • Security on the basis of second fixed and floating charges behind similar charges in favour of senior lenders.                                             DUE DILIGENCE

The main objective of Due Diligence is to confirm the reliability of the information which has been provided and has been used in making an investment decision.  Changes in these primary assumptions may have a significant impact on the price to be paid and possibly even raise questions on the wisdom of proceeding with the transaction.  This is a very useful process and at minimum will provide additional information on the potential target.

The following should be considered:

• Earnings – audited financial statements are prepared to comply with statutory/tax requirements. To assess the true quality of earnings an in-depth review of the business and detailed management accounts must be performed.  Adjustments may need to be made for one-off events, lost customers, discontinued products, changes in cost structure etc.  Also, evaluate non-financial information e.g. quality of risk management, quality of management, corporate governance etc.
• Forecasts – may be prepared on a high-level basis with oversimplified assumptions. The assumptions may be difficult to reconcile with historical performance.
• Assets – write-offs for aged debtors, obsolete stock, idle assets, capitalised costs etc.

may need to be made.  Also, clarify which assets are to be included in the transfer and agree valuations.

• Undisclosed Liabilities – substantial hidden tax liabilities, penalties and exposures may subsequently arise. Evaluate and possibly, seek protection by obtaining warranties or indemnities against future potential tax issues.
• Trading Performance – related party transactions are often conducted under special pricing terms (e.g. business support services not charged by parent company). The impact on the business of a change in ownership should be assessed to reflect normal commercial arrangements.
• Controls – additional investment in new reporting systems may be required to obtain the quality of information needed to properly monitor performance. Also, ensure the necessary staff are locked-in for an appropriate period.
• Balanced View – issues should be weighed against the upside potential in a balanced way. Examples of the upside might include, synergies, optimal financing structure, access to new markets, new management team etc.
• Tax Structure – effective tax planning is a key component in delivering value as quickly as possible.

 POST-ACQUISITION ISSUES

When one company successfully acquires another company it is very important to consider the issues which may arise following the acquisition.  Amongst these are:

• Organisation Structure
• Change Management
• Key Employees
• Major Customers
• Cultural Issues
• Technology
• Control

ETHICAL CONSIDERATIONS

When a company receives a bid from another company it is important that the board of the target company take account of any ethical considerations.  Examples might include:

• Any Issues which might be Illegal
• Any Issues which may Distort the Markets (price-manipulation)
• Insider Dealing
• Use of Price-Sensitive Information
• Terms of Confidentiality Agreements
• Any Incentives Offered to Ensure the Bid is Accepted (e.g. seats on the board of the bidding company; enhanced salaries, bonuses)
• Impact on Shareholders and Other Stakeholders
• Impact on Employees