Funding the Takeovers – “The
Investment Banking
Perspective”
BIPIN K DIXIT
ASSISTANT PROFESSOR
(FINANCE AND ACCOUNTING)
INDIAN INSTITUTE OF MANAGEMENT TRICHY
Role of Investment Bankers in M&A
 Investment bankers put together merger models to analyze
the financial profile of two combined companies
 The primary goal of the investment banker is to figure out
whether
the
buyer’s
earnings
per
share
will increase or decrease as a result of the merger
(EPS)
 An increase in expected EPS from a merger is called
Accretion (and such an acquisition is called an Accretive
Acquisition)
 A
decrease in expected EPS from a merger is
called Dilution (and such an acquisition is called a Dilutive
Acquisition).
Merger Model Steps
Starting
 Who is the Seller?
 Publicly traded stock, or privately held?
 Insider ownership or sizable public float (i.e., is a large portion of the
company’s shares available for sale in the open market)?
 Who are the potential Buyers?
 Strategic Buyer (an existing company able to gain from potential
synergies)?
 Financial Sponsor (a Private Equity firm looking to generate an
attractive return via a Leveraged Buyout)?
 What is the context of the transaction?
 Privately negotiated sale or auction?
 Hostile or friendly takeover?
 What are the market conditions?
 Acquisition currency (Cash or Equity)?
 Historical premiums paid for Comparable Transactions?
Mergers Consequences Analysis
 A Merger Consequences Analysis consists of the following
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key valuation outputs:
Analysis of Accretion/Dilution and balance sheet impact
based on pro forma acquisition results
Analysis of Synergies
Type of Consideration offered and how this will impact
results (i.e., Cash vs. Stock)
Goodwill creation and other Balance Sheet adjustments
Transaction fees
Type of synergies
 Increase and diversify sources of revenue by the acquisition of
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new and complementary product and service offerings
(Revenue Synergies)
Increase production capacity through acquisition of workforce
and facilities (Operational Synergies)
Increase market share and economies of scale (Revenue
Synergies/Cost Synergies)
Reduction of financial risk and potentially lower borrowing costs
(Financial Synergies)
Increase operational efficiency and expertise (Operational
Synergies/Cost Synergies)
Increase Research & Development expertise and programs
(Operational Synergies/Cost Synergies)
Valuation Methods
 A critical component to evaluating an M&A transaction is to
determine the Purchase Price for the Target company.
 In particular, how much of a Control Premium should be
paid for the Target (relative to the current valuation of the
target)?
 One very important method is to look at recent Comparable
(Precedent) Transactions to determine how much of a
premium has been paid for ownership of other, similar
companies in recent M&A transactions.
 Other methods used to establish a fair value for a target
company in an M&A transaction include:
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Comparable Company Analysis
Discounted Cash Flow Analysis
Accretion/Dilution Analysis
Valuation Methods
 Typically, all of these valuation methods will be used to
value the equity of the target company
 These methods will hopefully lead to a reasonable, narrow
range of Purchase Prices and Control Premiums for the
Target
 It will then be up to the management of both the Buyer and
Target (along with their respective M&A investment
banking advisors) to argue for and agree upon a precise
price/premium.
TRANSACTION ASSUMPTIONS
 Make assumptions about important parameters affecting
the deal
 a vital step in determining a feasible range for the
Purchase Price/Control Premium:
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Current Share Price & Number of Shares Outstanding for the Buyer
Current valuation information for the Seller
Expected Purchase Price/Control Premium for the Seller in the
proposed transaction
Portion of consideration arising from Equity/Cash
M&A transaction fees
Financing Fees from new Equity and/or Debt issuance
Expected interest rate on new Debt
Method of payment
 Important issue is the type of consideration being offered to the Seller’s
shareholders.
 Buyer can offer Cash, Equity (shares of the Buyer’s common stock) or a
combination of both as the consideration for the Purchase Price.
 Which should the Buyer use? –
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Typically, if the Buyer’s current stock price is considered undervalued relative to its peers,
the Buyer may decide to not use Equity as consideration, because it would have to give the
stockholders of the Target a relatively large number of shares to acquire the company.
On the flip side, the Target shareholders may want to receive Equity consideration in this
case, because they might feel it is more valuable than receiving Cash.
If the Buyer feels that its current stock price is trading at high levels, the Buyer will likely
want to use Equity for the consideration of the Purchase Price, because issuing new stock for
the transaction is relatively inexpensive (i.e., the stock has a high value in rupee terms).
Target might be hesitant to receive the Equity as consideration in this case
depending on the terms of the deal, the Seller’s shareholders may end up suffering a loss on
the sale relative to Cash consideration in the event that the Buyer’s stock price falls between
the time that the deal is announced and the time that the acquisition is completed (usually
several months, but in some cases closing can take as long as a year)
 As you can see, finding a combination of consideration that is agreeable to
both the Buyer and the Seller is an important part of structuring the deal.
Method of payment
 Note that if a Buyer with a relatively low Price/Earnings Ratio acquires a Target
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company with a relatively high Price/Earnings Ratio, the transaction will
generally be dilutive to the Acquirer on a pro forma basis.
This is because for each rupee of Price used to acquire the Target company, the
Buyer is receiving fewer rupees of Earnings.
If the Buyer has an Earnings Yield ([Earnings Per Share ÷ Share Price], or
simply [1 ÷ Price/Earnings Ratio]) lower than the expected Cost of Debt (the
interest rate on new Debt, after accounting for the tax shield from the Debt)
then using Equity as consideration will be more accretive (less dilutive) than
using Cash
Reason: a lower Earnings Ratio necessarily implies a high Price/Earnings
Ratio.
As a result, the higher the Price/Earnings Ratio of a company, it is more likely
that company will want to
pursue an acquisition strategy, and
use Equity as consideration for the deal (all other things being equal, of course)
Funding through debt
 In one of the acquisition funding was secured by the assets
and future cashflows of the company to be acquired
 Acquirer wanted to retain BBB+ credit rating
 Need to think carefully about how you could raise as much
debt as possible while not breaching the rating agencies’
criteria for a BBB+ rated company
BUILDING ―SOURCES & USES‖ TABLE
 The Sources & Uses section of an M&A Model contains the
information regarding flow of funds in an M&A transaction—
specifically, where the money is coming from and where it is
going.
 Sources of Funds: An investment banker determines the
amount of money raised through various equity and debt
instruments, as well as from Cash on Hand (i.e., existing
Cash owned by the Buyer to help pay for the transaction) to
fund the purchase of the Target.
 Uses of Funds: cash that is going out to purchase the Target,
as well as various fees needed to complete the transaction.
 Importantly, the total Sources of Funds must always balance
with the total Uses of Funds
Example
Sources of Funds
 Assume that Company X, the Buyer, will raise $30 million in New
Senior Debt and $60 million in new Equity in order to raise
money to purchase the Company Y, the Target company. This will
trigger fees for the financing of this Debt and Equity, and these
figures are located in the boxes on the left.
Uses of Funds
 the buyer will purchase the Equity of the target business, which is
approximately $91.2 million.
 M&A transaction fees are 2.0% of the Purchase Price
(approximately $1.8 million)
 Financing fees include 4.0% of the $30 million in new Senior
Debt raised and 6.0% of the $60 million in new Equity raised
 Note that the total capital raised is only $90 million. The rest of
the money used to pay for the transaction will have to come from
Cash on Hand
Example
 To get the Sources of Funds to equal the Uses of Funds, we build
the following ―plug‖ formula for Cash on Hand:
 Cash on Hand = Total Uses of Funds – Total Sources of
Funds excluding Cash on Hand
= (Purchase of Equity + Transaction Fees + Financing
Fees) – (Newly Raised Equity + Newly Raised Debt)
 Thus, approximately:
 Cash on Hand = [$91.2 million + $1.8 million + ($1.2
million + $3.6 million)] – [$30 million + $60 million]
= ($91.2 million + $1.8 million + $4.8 million) – ($30
million + $60 million)
= $97.8 million – $90 million = $7.8 million
 In this scenario Company X will need to use approximately $7.8
million of Cash from its own Balance Sheet to complete the
transaction.
Accretion/Dilution Analysis
 After the transaction has closed, the Buyer will own all of
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the assets, as well as the financial performance
(Profit/Loss), of the Target company
Accretion/Dilution Analysis is used to determine how the
Target’s financial performance will affect the Buyer’s
Earnings Per Share
a transaction is accretive if the buyer’s expected future
EPS increases as a result of the acquisition
the transaction is dilutive if the buyer’s expected future
EPS declines as a result of the acquisition.
Thus it is important to estimate the Accretion/Dilution
potential from a deal before the Buyer can agree to the
proposed transaction.
Accretion/Dilution Analysis
 If the consideration used for the acquisition of the Target company
is the Buyer’s common stock, the transaction will often be dilutive to
the buyer’s EPS due to the fact that the new shares issued to buy the
Target will increase the number of outstanding shares of the Buyer
 In this case, a combination of Equity and Cash may be used to for
the consideration of a Purchase Price to minimize the effect of
dilution on EPS.
Precedent Transaction Analysis Overview
 Precedent Transaction Analysis, also known as ―M&A Comps,‖
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―Comparable Transactions,‖ or ―Deal Comps,‖ uses previously completed
mergers and acquisitions deals involving similar companies to value a
business.
Precedent Transaction Analysis typically uses the same multiples as
Comparable Companies’ Analysis (or ―Comps‖)
In particular, Enterprise Value/Sales, Enterprise Value/EBITDA and
Earnings/Earnings Per Share (EPS) are the most commonly used
metrics.
However, unlike in Comparable Company Analysis, the basis for value
comparison is the price paid by the purchaser for a business, rather
than the traded market values of the company’s securities.
These prices can be different because there is a control premium
Thus, Precedent Transaction Analysis will typically result in valuations
that are higher than standard Comparable Company Analysis.
Precedent Transaction Analysis Overview
 Precedent Transaction Analysis tends to focus on the value
of a business as of the time an acquisition of the business
can be completed, rather than today
 This is because deals take time to close, whereas current
market values for a business can be assessed on any day
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 Sometimes, deals can take as long as a year (or more!) to
close, so the Precedent Transaction Analysis should reflect
that fact
WHY USE PRECEDENT TRANSACTIONS?
 To value a private business that does not have public trading
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comparables
To evaluate the market demand for acquiring a company, based
on the total dollar volume and number of recent transactions in a
certain industry.
To provide data analytics in assessing M&A activity and
consolidation trends.
To identify potential bidders if the company is looking to be
acquired or identify potential sellers if a company is looking to
buy a business.
To provide a fairness opinion to a Board of Directors when a
company is acquiring or selling all or part of a business, or is
being acquired
Sources of Information
 Previous valuation analyses: A great source for previous transactions
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is presentation material that has previously been compiled in a certain
industry. This can be a great way to save time, so be sure to check whether
such analyses have recently been conducted at your bank—chances are high
that they have.
Public tender documents and merger proxy statements: Fairness
opinions disclosed in public tender documents and merger proxy
statements can provide a wealth of information about other closed
transactions.
SDC database: Securities Data Corporation compiles a database of all
completed M&A transactions and can be used to search for relevant
transactions.
Capital IQ or Factset: This database is a widely used internet-access
financial database that has a search feature for M&A transactions that can
be filtered by many factors including target company geography, size, etc.
News internet searches: Try a Google search for industry M&A news.
Equity research: Typically transaction information can be found in
initiation reports.
Finding Right Precedent
 The best Precedent Transactions to use are those in
which the target companies and the company one is
valuing have the most similar business and financial
characteristics.
 These characteristics include the following:
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Same business & industry
Similar business size
Similar sales growth rates and profitability margins
Similar capital structure
Similar reasons for transaction (e.g. fire sale, bankruptcy, or
strategic motive).
Same geographic location of operations
ADVANTAGES AND DISADVANTAGES
PROs and CONs of Using Precedent Transactions
PROs
CONs
•Typically based on publicly
•Public data is based on past transactions
available information
that may not be indicative of current market
•Multiples reflect actual payments
conditions
for real-life deals, rather than
•Information available from industry and
traded multiples that are subject to
news sources can be misleading
supply and demand pressure
•Precedent transaction dynamics are rarely
•Useful in M&A negotiations and
perfectly comparable
discussions
•Values and multiples obtained may vary
•Provide guidance to assess what a
over a wide range and the summary metrics
buyer may be willing to pay for a
may be of limited usefulness
business
•Other factors may affect the multiples such
•Can reveal valuable information
as governance issues, specific agreements,
such as industry consolidation
synergies, and intangible values (such as
trends, and potential buyers and
patents and other intellectual property)
sellers
Pitfalls To Avoid in Precedent Transactions
 Be sure to review this checklist of pitfalls to avoid
before completing the analysis:
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INCONSISTENT ANNOUNCEMENT DATE OR EFFECTIVE
TRANSACTION DATE
INCLUDING EXTRAORDINARY ITEMS
INCLUDING MINORITY INTERESTS IN FINANCIAL
RESULTS
TAKING THE NUMBERS STRAIGHT FROM AN ONLINE
FINANCIAL DATABASE
FAILING TO CALCULATE THE PREMIUM OVER MARKET
VALUE
Always footnote any exclusion
THANK YOU