MERGERS AND ACQUISITIONS:
THEORY MEETS PRACTICE
Sergey Barabanov and Mufaddal Baxamusa
University of St Thomas
Fundamentals
4-step
process
Agenda
Valuation
Mini
Case
Fundamentals
Mergers occur in waves
Waves caused by liquidity in
capital markets
Not by overvaluations
Do M&As create value?
◦ It depends
Some industry experts believe
80 % of mergers fail - most companies undergoing
mergers typically erode shareholder wealth; create
years of chaos, fear and turmoil for employees; and end
up taking missteps that leave them perfectly positioned
to lose the battle against their competition.
Lamb and Grubb (2000)
Creation
Acquirer’s wealth
Medium
and small
firms.
repeat
acquirers
Destruction
Warning: As an acquirer be careful !!!
Large
firms and
Target’s wealth
•Generally beneficial
Combined (Acquirer + target) wealth
•Generally beneficial
Why do M&A occur?
% of Total
Acquisitions
Unrelated
Horizontal
Vertical
42.57
31.80
25.62
Vertical acquisitions
Business
reasons
Academic
verdict
• Supply chains
• Does not facilitate shipment of
goods
• Only 0.4% of goods are
transferred vertically in firms
Horizontal acquisitions …
Academic
infatuation
Business
pushback
• Market power and pricing
• IBM: market power would only
come if we were “buying
everyone”
… Horizontal acquisitions
Business
reasons
Academic
support
•Technology
•Complementary products
•Technology and product similarity
independently lead to better
acquisitions
•However, simultaneous presence of
technology and product
complementarity leads to poorer
outcomes
Unrelated acquisitions
Business
reasons
Academic
support
• Strategic reasons
• Internal cash flows
• Talent
• Diversification
• Product bundling
The 4 step process
Step 1: Make a plan
◦ Compare your objectives to academic reasons
◦ Make sure to go beyond generalities like strategic fit and
growth.
◦ Acquirers
◦ Make sure your reasons are for increasing the owners wealth
◦ Not for resume building, hubris, or personal glory
◦ Subject your plan to a healthy dose of skepticism
Potential sources of synergy
◦ Increased productivity of capital and labor in target
◦ Decrease investments, wages, employment in target
◦ Output is unchanged
◦ Product switching
Step 2: Search and screening
process
List firms that:
cite your patents.
or, spend heavily on R&D but do not yet have patents.
or, are in the similar product space.
or, your directors know about.
Screen out firms with bad quality accounting
data
Do quick valuation
Quick valuation
First find Free cash Flows
•Use comps, only if data is not available
Find NPV
•Remember to use real option valuations
Should we hire an M&A banker?
Experienced advise
Help in selecting target
Is an execution house i.e. follows instructions and
no value added
Increases acquirer returns by 1.26%
Little dispersion if bank does more than 10 M&As
in a year
What should we look for in a banker?
Ivy league education
Multiple industry experience
Number of deals
Better deal performance
Shorter time to completion
Higher completion rates
Step 3: Due diligence, negotiation
and deal structure
Premiums
High for growth firms
Lower: If CEO is planning
to stay, or has good
severance package.
Each female director on the
acquirers board:
Fairness opinions: Do they matter?
Acquirer opinions have + valuation errors
Target opinions have – valuation errors
Top tier advisors are more accurate
Protects in litigations
As necessary to valuation analysis as the appendix to human digestive system, Elson (1992)
Litigation generally by target
shareholders
Single bidder, friendly acquisitions
Low premiums, however after the litigation the premium rises
Lower completion rate
Material-Adverse-Clauses are
important
Material-Adverse-Events
• 69% of terminations
• 80% of renegotiations
Fewer Material-Adverse-Events
• Higher premiums
• Larger arbitrage spreads
Termination fees
Lesser than 5%
• Increases completion
• Does not remove competing bids
Greater than 5%
• Lower premiums
• Poorer target corporate governance
Step 4: Post-merger impact on firm
Quality converges across products
Prices fall relative to industry
Prices do not fall if entering new industry
Effects are stronger in mature, slow growth industries
3 Years from acquisition
27% of target’s plants are sold
19% of target’s plants will be closed
Remaining target’s plants show increased productivity
An afterthought: trading strategy
Buy target stocks with high probability of deal completing
Sell target stocks with high probability of failure
1% abnormal monthly return
Valuation
Valid Reasons
•If company A wants to buy company B, then NPV of
purchase must be > 0.
•NPV = Gain – Cost > 0
•Gain = PV AB – (PV A + PV B) = Value of Synergy
•i.e. PV of combined company AB must be greater
than PV of each separate
Dubious Reasons
•Diversification
•Ambitions (e.g., Agency Problem)
Positive NPV
Cash Acquisition Example (company A buys company B)
• Cost = cash – PV B; thus, NPV = gain – cost
• NPV = [ PV AB – (PV A + PV B)] – [(COST – PV B)]
• Example:
• Given: PV A = $100, PV B = 50. B is bought for $65.
• Suppose there are $35 in synergies, i.e., PV AB = $185.
• Solution:
• Gain =PV AB – (PV A + PV B) =Cost savings = $35
• Cost = cash – PV B = 65 – 50 = 15
• Therefore, NPV = gain-cost = 35 – 15 = 20
Real Options!!!
NPV
Real
Options
Call options: Product switching, growth
Put option: Sell the plants, close the plants,
layoffs.
Value
Valuation: Sources of Cash Flows
Increased Revenues
• Gains from better marketing efforts
• Strategic benefits – leader in new markets
Decreased costs
• Economies of scale, scope
• Elimination of inefficiencies
Taxes
• Transfer of net operating losses
• Unused debt capacity
Reduced investment needs
• Use of excess capacity
Valuation is not that straight-forward
Status-Quo Valuation
• Estimate FCFF, FCFE, Growth Rates, Terminal Value,
Cost of Capital, Debt Ratios
• All are varying over time
Value of control =
Value of firm optimally managed – Value of firm with current
management
Value of Corporate Control
Mini Case Study
Value of Digital Equipment to Compaq was more
than twice its status-quo valuation in 1997/98
acquisition (Damodaran)
• Value of firm (optimally managed)= $4,531.59 million
• Value of firm (status quo)
= $2,110.41 million
• Value of control
= $2,421.18 million
Typical Merger Valuation Biases
Selection Bias for Comparable Firms / Multiples
Mismatching Cash Flows and Discount Rates
• Use the target’s cost of equity (not bidding firm’s)
• Use the cost of equity to discount FCFE (not the cost of
capital)
• Do not transfer acquirer’s low cost of debt or debt
capacity to the target’s firm valuation
Subjective Adjustments – any valuation you want it to be!
Additional Valuation Considerations
Excess reserves for restructuring
• Shift earnings from the present to the future and create an
illusion of “financial turnaround”
• Debit restructuring reserve (liability on the Balance Sheet)
and credit earnings
Unintended transfer of wealth from
stockholders to bondholders
• If the cash flows of new firm are less volatile the debt of the
new firm will be less risky and its value will be higher and
equity value will be smaller
CASH VS COMMON STOCK
Sharing Gains
• If cash is used, then target firm’s shareholders will not
participate in the potential gains of the merger. If it is
not successful, the shareholders of the acquiring
company will be worse off.
Is your stock overvalued?
Exchange Ratio (fair/max/min)
Control
• No dilution with cash acquisitions.
So… You make a Monday morning
announcement!
What to disclose?
•Aggregate vs. detailed financial projections
•Large complex valuations
•Stocks may be over- or under-valued
•Competitors may gain information
•Criticized for not meeting the sub-target
•Additional focus on non-financial targets to track merger
progress (e.g., headcount, market share, etc.)
Thank You!
Mufaddal Baxamusa, Ph.D.
Sergey S. Barabanov, Ph.D.
Associate Professor
Associate Professor
Department of Finance
Department of Finance
Opus College of Business
Opus College of Business
University of St. Thomas
University of St. Thomas
mufaddalb@stthomas.edu
ssbarabanov@stthomas.edu
612-623-7984
651-962-5042