M&A and Accretion / Dilution
November 10, 2012
In partnership with the
Joshua Jia
Jules Koifman
Alexander Banh
| Instructor / CEO
| Instructor
| CSO
Table of Contents
1. Background
•
•
•
•
Types of M&A
Synergies
Transaction types
Role of investment banks
2. Process
•
•
Buy side process
Sell side process
3. Accretion / Dilution
•
•
•
Stock vs. cash acquisitions
Effects of an acquisition
Shortcuts
4. Merger Model
•
•
•
Steps
Excel examples
Goodwill
Background
1
Types of M&A
• Strategic vs. sponsor
• Strategic acquisition
 Purchase of an operating business that is in the same industry or
complements the buyers current business.
• Sponsor acquisition
 Purchase of a business by a financial sponsor (private equity firm)
 Typically through a leveraged buyout (LBO)
 We’ll cover this in greater detail next class
Background
Process
Accretion/Dilution
Merger Model
Background
2
Types of M&A
• Horizontal acquisition
 Acquirer and the target are in the same industry
• Vertical acquisition
 A cquirer and target are in the same value chain
 E.g. airline company acquiring a travel agency
• Conglomerate acquisition:
 The acquirer and the target are not related to each other
 Also known as diversification
Background
Process
Accretion/Dilution
Merger Model
Background
3
Why do mergers and acquisitions happen?
• Gain market share
 Market / monopoly power
• Fewer organic growth opportunities
• Too much cash on balance sheet
 Common issue for large tech companies
• Seller is undervalued
• Up-selling and cross-selling opportunities
Background
Process
Accretion/Dilution
Merger Model
Background
4
Why do mergers and acquisitions happen?
• Patents, critical technology
 E.g. Google buying Motorola Mobility
• Entering new market and / or new country
• Diversification
 Very common in the 1980s
 Japanese trading houses, “sogo shosas”, like Itochu and Marubeni
• Management is doing a poor job
 We can do better
• …And of course: “synergies”
Background
Process
Accretion/Dilution
Merger Model
Background
5
“Synergies”
• Perhaps the most overused business term of all time
• Synergies: 2+2=5
• Combining two firms will result in some strategic benefit above and beyond
their combined intrinsic values
• Two main categories: cost and revenue synergies
• Other synergies include: tax synergies, financing synergies
Background
Process
Accretion/Dilution
Merger Model
Background
6
Cost Synergies
• Easiest to understand and predict
• Only need one headquarters, can eliminate the other
• Can consolidate buildings, lay off redundant support and admin. staff
• Economies of scale
 Spread fixed overhead over a larger number of units
 More bargaining power against suppliers
• Vertical integration
 Disintermediation removes mark ups, delivery fees, bullwhip effect
• Target may have key competencies, technology or infrastructure that can
help reduce the costs of the acquirer
Background
Process
Accretion/Dilution
Merger Model
Background
7
Revenue Synergies
• Cross-sell products to new customers
• Up-sell new products to existing customers
• Expand into new geographies
• Network effect
• Market / monopoly power
• Since these are tough to predict, projected revenue synergies are not taken
as seriously
Background
Process
Accretion/Dilution
Merger Model
Background
8
Tax / Financing Synergies
• Net operating losses
 Bidding firm with past losses could acquired a profitable target and then
apply its NOLs
• Unused debt capacity
• A larger firm can sometimes get cheaper financing
• Write up purchased assets to fair market value, providing a larger
depreciation tax shield
• Used to be able to amortize goodwill (tax benefits), but no longer allowed
under IFRS
Background
Process
Accretion/Dilution
Merger Model
Background
9
Why do most mergers and acquisitions destroy value?
• About two thirds of mergers and acquisitions destroy value
• From 1980 to 2001, acquisitions resulted in an average of a 1-3% decline in
acquirer share price, or $218 billion of value transferred from acquirers to
sellers (McKinsey & Co.)
• Why?
Background
Process
Accretion/Dilution
Merger Model
Background
10
Why do most mergers and acquisitions destroy value?
• Management egos
 Bigger company = bigger bonus
• Diversification results in loss of management focus
• Clashing cultures
• The transition phase is often underestimated
• Easy to overestimate synergies
 Synergies often not enough to overcome control premiums and
financing / transaction fees
• Winner’s curse
 When an attractive target is put into play, competing bidders often enter
Background
Process
Accretion/Dilution
Merger Model
Background
11
Strategic M&A Advisory
• Investment banks can add a great deal of strategic value compared to more
transaction oriented situations like equity or debt issuances
• Host of key issues which bankers must decide
• How do we structure the transaction?
 Plan of Arrangement, Takeover Bid, Amalgamation
• Consideration?
 Cash, shares, preferred shares, warrants, special warrants
Background
Process
Accretion/Dilution
Merger Model
Background
12
Strategic M&A Advisory
• Price?
• Deal terms?
 Break fee, reverse break fee
 Go-shop clause
 Right to match
 Are options assumed by buyer, cashed out, or ignored?
 Locking up management, BoD, large shareholders
• Tax consequences?
 Creation of goodwill
 Transaction structure and consideration will affect taxes
 E.g. can defer capital gains with amalgamation or stock purchase
Background
Process
Accretion/Dilution
Merger Model
Background
13
Strategic M&A Advisory
• Special situations
 Buying firm after bankruptcy or restructuring
 Insider bids (requires protection of minority shareholders)
 Reverse mergers
 Three-way mergers
• Cross-border transactions are more complex
 Government intervention
 Different regulations
Background
Process
Accretion/Dilution
Merger Model
Background
14
Strategic M&A Advisory
• Execution
 M&A process can be lengthy
 Many legal procedures need to be followed
 Due diligence
• Regulation
 Certain deals must be carefully structured to maintain compliance with
anti-trust, national interests, and other legal issues
 Many large deals get blocked by the government
Background
Process
Accretion/Dilution
Merger Model
Background
15
Buy side vs. sell side
• Investment banks can advise on the buy side or sell side
• Buy side: advising the buyer
 Helps buyer determine the right bid and deal terms
 Can be complex with multiple bidders or with hostile takeover
 Takes 16 – 36 weeks
 Takes another 3 – 4 months to close after announcement
• Sell side: advising the sell side
• Which advisory role do investment banks typically prefer?
Background
Process
Accretion/Dilution
Merger Model
Background
16
Sell side…strong side?
• Sell side advisory roles have much higher chance of closing then buy side
advisory roles
 Transaction and financing fees are based on the transaction closing
• Most companies can be sold for some price
• However, if there are multiple bidders, then the buyer may not get the deal
Background
Process
Accretion/Dilution
Merger Model
Background
17
Other roles
• Acquisitions after restructuring require special expertise
 E.g. Deloitte buying Monitor
• Spinoffs / divestitures
• Fairness opinion
 Independent valuation to determine if offer price is fair
 Most Board of Directors require a fairness opinion before selling their
company
 Fees tend to be lower than advisory role
Background
Process
Accretion/Dilution
Merger Model
Background
18
Other roles
• “Strategic review”
 Means a firm has hired an investment bank to assess strategic
alternatives, including finding buyers for the company
• Hostile defense
 Is our company undervalued?
 Are we vulnerable to a raider?
Background
Process
Accretion/Dilution
Merger Model
Background
19
Why choose X bank as an advisor?
• How does a firm choose an investment bank?
• Relationship business
• Strategic expertise can play a role
 Certain banks are strong in certain sectors
• Rarely decided on fees
 Most banks have similar fee structures
• On the buy side, financing offered by banks will vary
 Important decision criteria for companies
• Sometimes there is a “stapled financing package,” meaning sell side advisor
provides financing for buyers
 Buyers no longer need to scramble for last-minute financing
Background
Process
Accretion/Dilution
Merger Model
Background
20
Types of Transactions
• Plan of Arrangement
 An actual “plan” is prepared, showing the steps needed to close deal
 No direct offer to shareholders
 Requires shareholder approval of two-thirds
 Provides maximum flexibility for structuring (e.g. three way mergers)
 Useful when there are multiple classes of shares
 Useful for buying a subsidiary of a publically-traded target
 Costs more and takes longer
 Requires court approval
 Must be friendly
Background
Process
Accretion/Dilution
Merger Model
Background
21
Types of Transactions
• Take-Over Bid
 Offer to acquire outstanding voting or equity securities
 Bid must be made to all holders of the class with identical consideration
 If bidder increases price, everybody who tendered gets the benefit of
the increased price
 If 90% tender, then compulsory acquisition of the remaining 10%
 If only two-thirds tender, then move into second stage process
Background
Process
Accretion/Dilution
Merger Model
Background
22
Types of Transactions
• One stage process
 If 90% tender, then compulsory acquisition of the remaining 10%
 This is the fastest
• Two stage process
• If more than two-thirds tender, but less than 90%
 Company must call a shareholder meeting
 Shareholders will vote to merge / amalgamate, which requires two-thirds
approval
 Minority shareholders are squeezed-out
Background
Process
Accretion/Dilution
Merger Model
Background
23
Types of Transactions
• Stock purchase
 By far the most common
 Purchase of the entire entity by buying up all equity ownership (stock)
• Asset purchase
 Seller retains ownership of equity
 Buyer simply buys up the assets from seller (and sometimes associated
liabilities)
 Buyer creates a new entity or uses another existing entity
Background
Process
Accretion/Dilution
Merger Model
Process
24
Buy Side Process
• Four stages:
1. Assessment
2. Contacting targets and valuation
3. Pursuing the deal and due diligence
4. Definitive agreement and closing
Background
Process
Accretion/Dilution
Merger Model
Process
25
Preliminary Assessment (4 – 8 weeks)
• Analyze competitive landscape
• Identify potential targets
• Find key issues to address
 Pensions
 Contingent liabilities
 Off balance sheet items
 Inside ownership
 Unusual equity structures (special warrants)
• Build out acquisition timetable
 Tendency to be optimistic
Background
Process
Accretion/Dilution
Merger Model
Process
26
Contacting Targets and Valuation (4 – 8 weeks)
• Contact candidates
• Negotiate Confidentiality Agreement (CA)
• Perform preliminary valuation on target
 Trading comparables
 Precedent transactions
 DCF
 Accretion / Dilution
 LBO
Background
Process
Accretion/Dilution
Merger Model
Process
27
Pursuing the Deal, Due Diligence (4 – 10 weeks)
• Send letter of intent (LOI) with details of initial offer
• Conduct due diligence
 Create data room
 Analyze products and services
 Analyze the company and industry
 Assess the company’s financials
 Identify contingent liabilities
 Conferences with management, auditors, lawyers
 Site visits
• Finish valuation
Background
Process
Accretion/Dilution
Merger Model
Process
28
Definitive Agreement and Announcement (4 – 10 weeks)
• Finish due diligence
• Arrange, negotiate and execute definite agreement
 Board must approve for it to be a friendly acquisition
• Provide financing, unless stapled financing package in place
• Conduct any required filings and announce deal
• Seek shareholder approval
• Seek regulator approval
• Deal may take another 3 to 4 months before it is officially closed
Background
Process
Accretion/Dilution
Merger Model
Process
29
Sell Side Process
• When a firm wishes to sell itself, it will usually either:
 Contact investment bank which it has a strong relationship with
 Contact investment bank which has strategic expertise in its sector
 Invite multiple investment banks to a “beauty contest”
• During a beauty contest, multiple investment banks will present their
qualifications, expertise, proposed strategy, key issues, and universe of
buyers to the firm
 Firm picks the “best” bank
Background
Process
Accretion/Dilution
Merger Model
Process
30
Preliminary Assessment (2 – 4 weeks)
• Identify seller’s objectives and determine appropriate sale process
 Broad or narrow auction?
• Broad auction
 Contact many potential buyers
 More bidders = higher price (usually)
 Risks leaking competitive information
 Higher chance that process will be leaked, which will interfere with the
deal process and morale of employees
 Often best option if the public is expecting sale
 When companies announce they are performing a “strategic review,”
this often means a broad auction
Background
Process
Accretion/Dilution
Merger Model
Process
31
Preliminary Assessment (2 – 4 weeks)
• Narrow auction
 Contact a few strategic buyers
 Prevents leaking competitive information
 Often best option if the public is expecting sale
 When companies announce they are performing a “strategic review,”
this often means a broad auction
Background
Process
Accretion/Dilution
Merger Model
Process
32
First Round
• Contact potential buyers
• Negotiate and execute CAs
• Send out Confidential Information Memorandum and initial bid procedures
letter
• Prepare management presentation
• Build data room
• Negotiate stapled financing package if there is one
• Receive initial bids, and filter buyers to second round
Background
Process
Accretion/Dilution
Merger Model
Process
33
Second Round
• Facilitate management presentations
 Management brings bankers to presentations to add legitimacy
• Facilitate due diligence
 Site visits
 Open up data room to buyers
• Send out final bid procedures letter and create a draft of the definitive
agreement
• Buyers make their final bids
Background
Process
Accretion/Dilution
Merger Model
Process
34
Negotiations
• Evaluate final bids
• Negotiate with top bidders
• Select winning bidder
 Not always the highest bidder
 Other factors like deal terms, type of consideration, future plans, if buyer
is willing to cooperate with existing management’s vision
• Arrange for fairness opinion (if needed)
• Receive board approval and execute definitive agreement
• Transaction is announced
Background
Process
Accretion/Dilution
Merger Model
Process
35
Closing
• Shareholder approval
• Regulatory approval
• Financing and closing
• May take 3 to 4 months for acquisition to officially close
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
36
Benefits of acquiring with cash
• Cash is generally cheaper than equity
 Opportunity cost of balance sheet cash is forgone interest in cash
 Typically 1%, while cost of equity is usually double digits
 Debt is also generally cheaper than stock
• Good for confident buyers
 With cash, buyer retains 100% of the benefit since acquiring
shareholders own all of the entity’s shares
 Target shareholders will receive the acquirer’s shares in exchange for
their own
 Stock transactions distribute benefit / loss between acquiring
shareholders and target shareholders
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
37
Benefits of acquiring with cash
• Less uncertainty
 Stock offers are usually made with an exchange ratio, no fixed value
 Stock price could fluctuate before tendering of shares
 Cash is a fixed value (assuming no currency risk)
• Better if stock of acquirer is weak
 Cash is more common in economic downturns
• Will result in better profitability ratios
 However, liquidity ratios will decline
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
38
Benefits of acquiring with stock
• Good if acquirer’s stock is doing well
 Many stock acquisitions by tech companies before tech bubble burst
• Better for tax
 With cash acquisition, capital gain is immediately taxable
 With stock, these capital gains can be deferred
• Acquirer may not have access to cash
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
39
Accretion / Dilution
• What is accretion?
 If pro forma (combined) EPS > Acquirer’s EPS
• What is dilution?
 When pro forma (combined) EPS < Acquirer’s EPS
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
40
What are the effects of an acquisition?
• Foregone interest on cash
 Opportunity cost of balance sheet cash is lost interest income
• Interest on debt
 If buyer uses debt
• Additional shares outstanding
 If buyer pays with stock, it issues additional shares
• Combined financial statements
• Creation of goodwill and other intangibles
 Write up target’s assets from historical cost to fair value
 Goodwill represents the premium over this amount (approximately)
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
41
Acquirer, P / E of 10. Target, P / E of 5. Accretive?
• What’s the consideration?
 Assume all stock
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
42
Acquirer, P / E of 10. Target, P / E of 5. Accretive?
• This is accretive
• In an all-stock deal, accretive if P / E of Target < P / E of Acquirer
• Think of it as a more expensive company acquiring a cheaper company, in
terms of stock price to earnings
• You are paying for a company that is generating more earnings than you are
per dollar of stock price
 Your EPS will go up if you buy their relatively underpriced stock with
your own relatively overpriced stock
• Note: we have not accounted for financing fees, transaction fees, or
synergies
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
43
All-Cash Acquisition
• If a deal is finance only through cash and debt, there is a shortcut for
calculating accretion / dilution
• If: interest expense for debt + foregone interest on cash < target’s pre-tax
income, then acquisition is accretive
• Think of it as: pre-tax cost of the capital being used < pre-tax income being
consolidated with your own
• Assumes no synergies, transaction fees, financing fees
• Complete equation:
 If transaction fees + financing fees + interest expense for debt +
foregone interest on cash < target’s pre-tax income + synergies, then
acquisition is accretive
Background
Process
Accretion/Dilution
Merger Model
Accretion / Dilution
44
Accretion / Dilution Analysis
• No shortcuts for finding accretion / dilution for acquisitions that use a mix of
cash or stock
 Must build merger model
• Advantages of using a merger model:
 Intrinsic valuation allows you to understand break-even synergies, key
variables, as well as bull, base and bear case scenarios
• Disadvantages:
 Using precedents transactions may provide a more objective view, since
there is less room for manipulation
 Difficult to model out synergies, transition costs, effect on corporate
culture and employee morale
Background
Process
Accretion/Dilution
Merger Model
Merger Model
45
Accretion / Dilution Analysis Steps
1. Input purchase price assumptions (% cash / stock / debt)
2. Build standalone income statement and balance sheet for acquirer / target
3. Allocate purchase price to the writing-up of assets to fair value, the creation
of new goodwill, and transaction fees
4. Build a sources & uses table to calculate amount of cash / stock / debt
5. Make adjustments to the target’s balance sheet based on step 3
6. Create pro-forma post-merger balance sheet and income statement, making
adjustments for any synergies or new debt / interest expense
7. Calculate post-merger fully diluted shares outstanding
8. Did EPS increase? Sensitize analysis to purchase price, % stock / cash /
debt, revenue synergies and expense synergies
Background
Process
Accretion/Dilution
Merger Model
Merger Model
46
Allocation of Purchase Price
Allocation of Purchase Price
Book value (A-L)
Less: Old Goodwill
Tangible Book Value
Plus: Option proceeds (increases bv)
Tangible Book Value (trans. Adj.)
Plus: Write up of Inventory
Plus: Write up of PP&E
Plus: Write up of Amortizable Intagible Assets
Less: Deferred taxes
Target FMV
Non-financing transaction expenses
Goodwill
Purchase price (offer value + transaction fees)
Sources & Uses of Funds
Sources of Funds
Acquisition Debt
Stock Issued
Total Sources
Uses of Funds
Cash to Target
Stock to Target
Transaction Fees
Financing Fees
Total Uses
Background
Process
0.2%
0.3%
0.2%
2,457.0
1,024.0
1,433.0
0.0
1,433.0
75.0
150.0
100.0
99.8
1,658.2
458.7
44,668.6
$46,326.8
break circularity? (y/n)
n
24,116.2
22,934.1
$47,050.3
$22,934.1
22,934.1
458.7
723.5
$47,050.3
Accretion/Dilution
Merger Model
Merger Model
47
Adjusting Target’s Balance Sheet
Pro Forma Balance Sheet Adjustments
Prior to Merger
Acquirer
Target
PG
Gillette
$5,892.0
$644.0
4,062.0
1,216.0
4,400.0
1,407.0
958.0
302.0
1,803.0
190.0
14,108.0
3,524.0
19,610.0
1,024.0
4,290.0
570.0
1,925.0
1,082.0
Cash and equivalents
Accounts Receivable
Inventories
Deferred Tax Assets
Other Current Assets
PP&E
Goodwill
Intagibles
Other Assets
Deferred Financing Fees
Total Assets
0.0
75.0
(1,024.0)
150.0
44,668.6
100.0
723.5
Accounts Payable
Other Current Liabilities
Deferred Tax Liabilities
Total Debt (ex. Convertible)
Convertible Debt
Other Liabilities
Minority Interest
Convertible Preferred Stock
Common Equity
Total Liabilities + SE
Balance Check
Background
Adjustments
$57,048.0
$9,959.0
3,617.0
10,243.0
2,261.0
20,841.0
598.0
2,139.0
652.0
3,112.0
99.8
24,116.2
0.0
2,808.0
1,526.0
15,752.0
57,048.0
0.0
Process
932.0
69.0
2,457.0
9,959.0
0.0
Accretion/Dilution
0.0
(2,457.0)
22,934.1
Merger Model
Pro Forma
6,536.0
5,278.0
5,882.0
1,260.0
1,993.0
17,782.0
64,278.6
4,960.0
3,007.0
723.5
111,700.1
4,215.0
12,382.0
3,012.8
48,069.2
0.0
3,740.0
69.0
1,526.0
38,686.1
111,700.1
0.0
Merger Model
48
Pro Forma Income Statement
Pro Forma Income Statement Adjustments
Transaction Year
Date
6/30/05
% of transaction year post-deal date
79.2%
Acquirer
FY EPS
$2.56
Diluted Shares Outstanding
2,597.5
Net Income
6,649.7
Target
FY EPS
$1.72
Diluted Shares Outstanding
1,017.3
Net Income
Converted in consensus EPS? (y/n)
1,385.3
Plus: Pref. dividends saved on conversion of converts
y
0.0
Plus: Interest exp. saved on conversion of converts
y
0.0
Net Income (adj. for convertible securities)
1,385.3
Pro Forma Net Income (pre adjustments)
8,035.0
Plus: Planned Synergies
Plus: Interest income from option proceeds
Less: Addtl. Interest Expense
Less: Amort. Financing Costs
Less: Addtl. Depreciation
Less: Amort. of ID'd Intangibles
Total Pretax Adjustments (Taxable)
Tax Impact of adjustments at acquirer's 30.7% tax rate
Total Adjustments
Pro Forma Net Income (post adjustments)
Diluted Shares Outstanding
Pro Forma EPS
Accretion/Dilution -- per share
Accretion/Dilution -- %
Additional Synergies Requiried to Breakeven ($MM)
Background
Process
Accretion/Dilution
100.0
0.0
(763.7)
(71.6)
(7.9)
(6.3)
(749.5)
230.1
(519.4)
Yr 1
6/30/06
Yr 2
6/30/07
$2.82
2,597.5
7,325.1
$3.14
2,597.5
8,156.3
$1.93
1,017.3
1,963.4
0.0
0.0
1,963.4
$2.13
1,017.3
2,168.7
0.0
0.0
2,168.7
9,288.5
10,325.0
200.0
0.0
(964.6)
(90.4)
(10.0)
(8.0)
(873.1)
268.0
(605.0)
300.0
0.0
(964.6)
(90.4)
(10.0)
(8.0)
(773.1)
237.3
(535.7)
7,515.5
2,923.7
$2.57
8,683.5
3,009.5
$2.89
9,789.3
3,009.5
$3.25
$0.01
0.4%
-
$0.07
2.3%
-
$0.11
3.6%
-
Merger Model
Merger Model
49
Deferred tax liabilities
• Writing up target’s assets to fair values creates deferred tax liabilities (DTLs)
• On your books, it seems like you don’t have to pay as much tax, since you
are writing up your assets up and increasing your depreciation base
• In reality, you still have to pay the same amount of tax
 Naturally, government does not let you reduce taxes by writing up the
target’s assets after an acquisition
• There will be a discrepancy between your books and the taxes you actually
pay
• This discrepancy creates a DTL
 DTL = asset write-up x tax rate
Background
Process
Accretion/Dilution
Merger Model
Merger Model
50
Goodwill
• We write up the target’s assets from historical cost to fair market value
• We then have to account for any DTLs created
• Goodwill = equity purchase price – seller book value + seller’s existing
goodwill – asset write-ups – seller’s existing deferred tax liability + writedown of seller’s existing deferred tax asset + newly created deferred tax
liability
Background
Process
Accretion/Dilution
Merger Model