Mergers and Acquisitions
Chapter 19
Mergers and Acquisitions
• Corporations strive to increase their earnings
per share over time.
• Methods
– “Organic” approaches:
• Increase sales of existing divisions while maintaining level
operating margins
• Increase operating margins with constant sales
– Mergers and Acquisitions:
• Seek to merge or acquire another corporation, with resulting
corporation’s size and earnings enhanced by combination
A Brief History of Mergers and Acquisitions
• M&A transactions date back to 19th century
• Horizontal acquisitions: acquiring competitors
in the same industry and then systematically
reducing costs of acquired company by
integrating its operations into acquirer's
company
• Vertical acquisitions: acquiring companies in
own supply chain
• Enormous trusts, or business holding
companies
A Brief History of Mergers and Acquisitions
• In the 1920’s, 1960’s, and 1980’s, M&A
activity reached historic highs and
corresponded to positive performance of the
stock market.
– 1920’s: combinations of firms within industries
– 1960’s: conglomerate approach (e.g. LTV, ITT)
– 1980’s: use of large amounts of debt as the means
to finance acquisitions of companies with cheaply
priced assets through leveraged buyouts
A Brief History of Mergers and Acquisitions
• In the 2000’s, Wall Street declined due to lower asset
values and increased government regulation; strategic
horizontal mergers are becoming more common.
– Strong banks are absorbing weak ones before/after FDIC seizes
them.
– Chemical, pharmaceutical and commodities firms are merging in
order to increase global reach and reduce cost per unit of
production.
– Leveraged buyout firms (now private equity firms) have
decreased their activity due to losses from 2007/2008 vintage
investments and reduction in debt availability.
– Completed deals have lower levels of debt and therefore,
either a lower price or more equity.
How Companies Can Work Together
• Article 2 of the Uniform Commercial Code
(UCC): set of contractual rules for sale of
goods between companies
• Vendor-customer relationships are governed
by purchase orders (POs): short form of
contract, containing standard provisions and
blank spaces for price, quantity, and shipment
date of goods involved
How Companies Can Work Together
• Strategic alliance (or teaming agreement):
parties work together on a single project for a
finite period of time
– Do not exchange equity
– Do not create permanent entity to mark
relationship
– Written memorandum of understanding (MOU):
memorializes strategic alliance and sets forth how
parties plan to work together
How Companies Can Work Together
• Joint venture: parties work together for lengthy
or indeterminate period of time
– Form new, third entity
– Divide ownership and control of new entity,
determine who will contribute what resources
– Advantage: two entities can remain focused on their
core businesses while letting joint venture pursue the
new opportunity
– Downside: governance issues and economic fairness
issues create friction and eventual disbandment
How Companies Can Work Together
• Acquisition: acquired company becomes
subsidiary of purchasing company
– Most permanent
– Eliminates governance and economic fairness
issues
– Forms of acquisitions
• Merger
• Stock acquisition
• Asset acquisition
How Companies Can Work Together
• Merger: two companies legally become one
• All assets and liabilities being merged out of
existence become assets and liabilities of surviving
company
• Stock acquisition: acquired company becomes
subsidiary of acquiring company
• Asset acquisition: assets but not liabilities
become assets of acquiring firm
How and Why to do an Acquisition
• If acquisition will create positive present
value when weighing outflow (acquisition
price) versus future inflow (cash flow of
acquired company plus any synergies), then
transaction makes financial sense.
– Difficulty: determine what exactly are the
outflows, inflows, and synergies (both
revenue/cost synergies)
How and Why to do an Acquisition
• Common synergies
• Cost Savings:
–
–
–
–
One has lower existing costs due to efficiency, scale, etc.
One has better cost management
Combined company has greater economies of scale
One has better credit rating/balance sheet and therefore
cheaper financing costs
– Transactions costs eliminated in vertical merger
– Reduction in employee costs (layoffs)
– Reduction in taxes if acquirer has NOLs and is not limited
by Section 382 of IRC
How and Why to do an Acquisition
• Common synergies (continued)
• Revenue enhancements:
– Use of each other’s distributors and other
channels
– “Bundling” opportunities from combined product
offering makes company more attractive
– Combined company can raise prices (greater
market power)
How and Why to do an Acquisition
• Companies will hire a group of advisors to
assist in evaluating and consummating
transaction  investment bank, law firm with
expertise in mergers and acquisitions,
accounting firm, valuation firm
How and Why to do an Acquisition
• Investment bank
• Primary financial advisor
• Puts together financial model to analyze cash
flows of combined company on pro forma basis
• Evaluates comparable transaction in order to
render advice on price
• Offers advice on tax and accounting structure for
transaction
• Helps raise capital needed to complete transaction
How and Why to do an Acquisition
• Law firm
– Responsible for drafting and negotiation of
transaction documents
– Reviews appropriate tax, employment,
environmental, corporate governance, securities,
real property, and other applicable international,
federal, state and local laws
– Advise Board of Directors on fulfilling its fiduciary
duties of care and loyalty to shareholders
How and Why to do an Acquisition
• Accounting firm
– Advise company on proper tax and accounting
treatment of transaction
– Assist in valuing certain specific assets
– “Comfort letter” on certain accounting issues
– Consent letter needed if publicly registered
securities offering is made in connection with
transaction
The Politics and Economics of Acquisitions
• Key political elements of a transaction
1. Which entity will survive or be parent company
2. What will new company’s board of directors look
like
3. Who will manage company day-to-day
The Politics and Economics of an
Acquisition
• Smaller company will typically become
subsidiary of larger company
– Smaller company may have token representation
on Board of Directors of parent
– Management of smaller company will typically
either remain at subsidiary or exit
The Politics and Economics of an
Acquisition – Merger of Equals
• Board positions often allocated 50/50
• “Office of the Chairman” or “Office of CEO”:
formed to share management authority
• Murky lines of authority or shared power can
lead to difficulty and conflict
The Politics and Economics of an
Acquisition
• Buyer will offer price based on whether
transaction will be accretive: increases
earnings per share of acquiring company
• Seller will seek premium over its existing stock
price (if public) or price in line with public
traded comparables or recent public disclosed
M&A transaction multiples based on price to
earnings, price to EBITDA or price to sales (if
private)
LBOs, Hostile Takeovers and Reverse M&A
• Leveraged Buy Outs (LBOs): purchases of stock of
company where a significant percentage of
purchase price is paid for with proceeds of debt
– Became prominent in 1970’s and 1980’s with rise of
LBO shop
– Debt financing to fund:
• High yield (junk) bonds
• Hostile takeovers: acquisition in which “target’s” board of
directors does not consent to transaction
– Tender offer: Potential buyer or “raider” makes cash offer directly
to shareholders, thereby bypassing board of directors
LBOs, Hostile Takeovers and Reverse M&A
• Three major events altered landscape to reduce
incidence of hostile takeovers:
1. Creation of poison pills: companies issued convertible
preferred stock to exiting shareholders with provisions
which made a potential tender offer prohibitively
expensive
2. State of Delaware passed new provision of Delaware
General Corporate Law, Section 203: requires hostile
buyer to acquire at least 85% of target company in order
to consummate hostile takeover
3. U.S. Congress passed revision of tax code: limited tax
deductibility of certain high yield debt (HYDO rules), thus
reducing attractiveness of junk bonds as means of
financing acquisitions
LBOs, Hostile Takeovers and Reverse M&A
Reverse M&A (add value through divestiture)
• Four forms of reverse M&A:
1.Simple sale of division or subsidiary: asset
sale, stock sale, or merger
LBOs, Hostile Takeovers and Reverse M&A
2. Spin-off: corporation issues dividend of shares of
subsidiary to be spun-off corporation’s
shareholders
– Shareholders of parent participate in spin-off on pro
rata based on their ownership percentage in parent
– Prior to spin-off, parent may extract cash from
subsidiary
• “19.9% IPO”: subsidiary is taken public and all or large
portion of proceeds are then allocated to parent
• Transfer certain debts to subsidiary so that parent ends up
with less leveraged balance sheet post spin-off
• Parent has subsidiary dividend to parent a portion of
subsidiary’s cash
LBOs, Hostile Takeovers and Reverse M&A
3. Split-off: shareholder in parent corporation
elects to take shares in subsidiary being splitoff, but ends up with fewer shares of parent
corporation
4. Split-up: shareholder elects to take shares in
one part of split company or other
– Less common than spin-offs and split-offs
because most shareholders like having parts of
both parent and entity divested