INVESTMENT BANKING
LESSON 4: MERGERS & ACQUISITIONS (M & A):
How IB is Used in Mergers & Acquisitions
Investment Banking (2nd edition) Beijing Language and Culture University
Press, 2013
Investment Banking for Dummies, Matthew Krantz, Robert R.
Johnson,Wiley & Sons, 2014
LESSON 3 REVIEW
1.WHAT ARE THE 3 MAIN POINTS THAT MAKES AN IPO
HAPPEN?
2. WHAT IS THE MAIN DOCUMENT THAT COMPANIES AND
INVESTMENT BANKERS MUST PRODUCE? CAN YOU NAME AND
GIVE A BRIEF DESCRIPTION OF 5 POINTS IN THE DOCUMENT?
3. WHAT ARE 2 THINGS IB DO NOT WANT TO HAVE HAPPEN
IN AN IPO?
4. WHAT ARE THE 2 PERIODS CALLED BEFORE AND AFTER
THE IPO AND WHY ARE THEY IMPORTANT?
LESSON 3 REVIEW
5. WHAT IS THE ROLE AND THE 3 GOALS OF THE
SELL-SIDE ANALYST?
6. WHAT IS THE PURPOSE OF THE RESEARCH
REPORT AND WHAT ARE SOME OF THE THINGS YOU
AS AN INVESTOR WANT TO KNOW ABOUT A
COMPANY?
INTRODUCTION – MERGERS & ACQUISITIONS
(M&A)
1. 3 KINDS OF MERGERS
2. WHY MERGE INSTEAD OF GROW?
3. THE MERGER: FRIENDLY OR HOSTILE?
4. TOOLS TO ANALYZE THE M & A DEAL
5. WHY MANY M & A DEALS GO WRONG?
LESSON 4 INTRODUCTION
In this lesson we will learn how IB create potential
business combinations and how a price tag is put
on company being acquired. In other words, if you
want to buy a company, how much do you want to
pay for it!
The basic goal of all M & A activity is value
creation and growth. Companies want to buy other
companies so they can grow faster and better than
if they just try to grow on their own. The term is
Synergy. Think 1+ 1 = 3. The idea is 2 companies
are worth more than either co. is worth alone.
LESSON 4 INTRODUCTION
The main idea is that a combined
firm is worth more than 2
separate firms that the buying
firm can pay the price and still
see an increase. But, this isn’t
always the case.
LESSON 4 1. KINDS OF MERGERS
Is there a difference between the terms merger
and acquisition?
A merger is a combination of equals. Both firms
are about the same size and agree to combine.
An acquisition is when a larger firm buys a much
smaller one or when the decision to combine is not
agreed upon an then it is called a takeover.
There are 3 basic kinds of mergers: horizontal,
vertical and conglomerate.
LESSON 4 1. KINDS OF MERGERS (cont)
1. In a horizontal merger a firm buys another firm
in the same industry and with similar product
lines. The combined company realizes economies
of scale which reduces costs.
An example would be like Alibaba merging with or
acquiring Jingdong. What could be a problem with
that?
2. A vertical merger takes place when 2
companies that sold or bought goods from each
other combine. Like maybe a parts producer.
Again, the purpose is to cut costs and have needed
supplies readily available.
LESSON 4 1. KINDS OF MERGERS (cont)
3. A conglomerate merger happens when 2
companies of different business combine. Why
might they want to merge?
To diversify the firm and decrease risk. The idea is
when one part of the business is not doing well the
other part is thriving and growing.
LESSON 4 2. Why Merge instead of Grow?
It would seem that merging is a lot of trouble and will
cost a lot of money. Why not just grow normally and
organically (think a garden)? What do you think are
some good reasons?
There are a lot of reasons:
A. Synergy - 1 + 1 = 3 Work together well
B. Speed – Grow faster. Growing organically is tough
and takes patience.
C. Increased market power – More pricing power, beat
the competition. But having a monopoly can cancel
the deal by government, antitrust violations.
LESSON 4 2. Why Merge instead of Grow? (cont)
D. Gain access to foreign markets – what are the
benefits and problems with this?
For: Access to a new market
Against: regulatory or laws that are different,
culture differences.
E. Management’s own interests – Best interests of
management but not necessarily the shareholders.
F. Diversification – Let’s look at this one a little
more closely. Conglomerate mergers are between
two different companies and can reduce risk, but..
LESSON 4 2. Why Merge instead of Grow? (cont)
How might this not be so good for shareholders.
What do you think if you were a shareholder of a
company that has 2 completely different product
lines?
G. Tax Considerations – A company with a high
tax bill might buy a company with large tax losses.
Rarely happens for this reason alone.
H. Greater Control – The target company may be
mismanaged and with a new management team
the combined company can realize greater profits.
LESSON 4 2. Why Merge instead of Grow? (cont)
I. Make use of untapped borrowing capacity – If
the target company has little or no debt it can be
an attractive takeover candidate. The buying
company can expand it’s capital using debt as a
leverage. Similar to an LBO (leveraged buyout).
In summary, the most attractive acquisition target
would be a
with unused debt
, or at a loss with
unused tax credits.
LESSON 4 3. The Merger: Friendly or Hostile?
In a friendly merger, the two firms
work together and the combination
is approved by the board of directors
of both companies and the
shareholders agree as well.
No surprise here! Research proves
that when there is synergy and
people want to work together, they
will be more successful.
LESSON 4 3. The Merger: Friendly or Hostile? (cont)
In a hostile takeover, the deal is opposed by the
target firms board of directors and management, as
they might become unemployed. So, for the buying
company it must gain control of the target firm to get
it to agree to the transaction. They do this by:
A. Making a tender offer, which is simply an offer to
buy the shares of the firm at a fixed price that it
better than the current market price of the target
firm. The offer is only good if 51% of shareholders
agree or tender their shares. This can be good raising
the share price of the target company. This can lead
to a bidding war!
LESSON 4 3. The Merger: Friendly or Hostile? (cont)
The other way to acquire a company in a hostile
takeover is:
B. Engage in a proxy fight – In this way of the
buying company gaining control, a shareholder of
the target firm gives up her vote (proxy) to
someone who is authorized to vote and agrees
with the merger. This way the buying firm is able
to replace the directors of the target company
with it’s own people and then approve the merger.
LESSON 4 4. Tools Used to Analyze the M & A Deal
A separate team from different IB’s
work on opposite sides of any
acquisition deal. One bank
represents the seller and the other
the buyer. This is an important
source of fee income for IB’s and M
& A activity is very profitable for
IB’s.
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
THE ROLE OF THE BUY-SIDE M & A ADVISOR for a
firm seeking to buy (acquire) another company.
A. Helps the company identify acquisition targets.
B. Performs due diligence 尽职调查 (Jìnzhí
diàochá) on proposed targets
C. Valuing (putting a price) the benefits of the
acquisition
D. Negotiating the terms of the deal
E. Closing the deal
Let’s look at these one at a time!
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
A. IDENTIFYING TARGETS – This must be confidential
information (kept quiet). If even a rumor starts that a
deal is happening, market would bid up the value of
the firm making it more costly to buy.
B. DUE DILIGENCE – This is doing an in-depth analysis
of the firm, strengths and weaknesses. This is
gathering lots of information, analyzing it in order to
determine if it is a good deal. This involves financial
modeling, creating pro forma financial statements,
such as balance sheets, income & cash flow
statements.
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
B. DUE DILIGENCE (cont) – This process should detail
the strengths and weaknesses and highlight any risks
to the buyer.
REAL WORLD EXAMPLE OF FAILED DUE DILIGENCE:
Wachovia Bank (the bank I worked for) failed to do
adequate due diligence on an acquisition to buy a
bank in a totally new but lucrative (wealthy) market
in California. The bank was selling at a high price but
also had a lot of bad loans in it’s portfolio. As a
primary result, Wachovia bank was sold at a cheap
price to Wells Fargo during the 2008 crisis.
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
C. VALUING THE COMPANY – The goal of due diligence
is to come to an accurate estimate of the true value
of the target firm to the buyer. The primary method
involves a discounted cash-flow analysis. The
earnings of the target firm are discounted back in
present value terms. If the net present value of the
acquisition is positive it should add value to the
parent or buying firm.
Another valuation tool is the accretion/dilution
analysis. This determines if the EPS (earnings per
share) will increase or decrease after the deal is done.
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
D. NEGOTIATING THE TERMS OF THE DEAL – This
includes such things as, who is on the Board of
Directors and management team as well as
employment contracts. This will involve a lot of
give and take before closing the deal.
E. CLOSING THE DEAL – Both the acquiring and the
acquired firm’s boards meet to approve the deal.
The banks deliver a fairness opinion to their
clients. Finally, the shareholders must approve the
deal.
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
THE ROLE OF THE SELL-SIDE M & A ADVISOR
performs many of the same things as the buy-side
advisor.
A. PREPARING THE COMPANY FOR SALE – Many
companies who were acquired were looking to be
acquired. The dream of many entrepreneurs is to
found a company, make it successful and then sell
for a major profit. So, the sell-side advisor gets
the company ready for sell. Like the buy-side
advisor, they will prepare an analysis and
recommend steps the company needs to take to
get the best price. Maybe selling off only part of
LESSON 4 4. Tools Used to Analyze the M & A Deal (cont)
B. MARKETING THE FIRM – The big
difference between buy and sell side is
that the sell-side focuses on marketing
the firm. They focus on a business plan
that makes the firm look good to
potential buyers.
So, the sell-side buyer focuses on
connecting the buyer and seller
LESSON 4 5. Why Many M & A Deals Go Wrong
Even though many smart people, who know how to
do financial modeling, work on M & A deals they
can go wrong. There are 5 main reasons.
A. MISPLACED INCENTIVES – Some deals are just
bad from the start. Investment bankers remind us
of good joke about accountants. “When asked
what 2 +2 is, the accountant replies, What do you
want it to be?”
But this reason is why many investors support
management having a large personal stake in the
equity of the firm.
LESSON 4 5. Why Many M & A Deals Go Wrong (cont)
B. FAULTY ANALYSIS – Even though most
analysis is fairly standard, as someone
once said, “It’s tough to make
predictions, especially about the
future”. Bankers do just that – predict
the future. But the analysis isn’t always
perfect so successful investors demand a
margin of safety (or margin of error)
before they invest funds.
LESSON 4 5. Why Many M & A Deals Go Wrong (cont)
C. OVERSTATED SYNERGIES – Some M & A
deals fall through simply because the
bankers and the management team are
overly optimistic that the deal can work.
REAL WORLD EXAMPLE: Quaker Oats
(breakfast food co.) bought Snapple
Beverage corp for $1.7 billion in 1994.
On paper it seemed like a great deal
but 3 years later Snapple was sold for
$300 million.
LESSON 4 5. Why Many M & A Deals Go Wrong (cont)
D. CULTURE WARS – Combining companies because people
can’t work together is a main reason for failed deals. Just
like people have personalities so do companies and that is
called corporate culture
REAL WORLD EXAMPLE – German-based Daimler-Benz and
US-based Chrysler had synergy but because their cultures
were so different it failed. Daimler paid a big price for
this merger misstep, paying $38 billion for Chrysler in
1998. Nine years later they only received $7.4 billion
when sold to another company.
LESSON 4 5. Why Many M & A Deals Go Wrong (cont)
E. THE WINNER’S CURSE: OVERPAYING – Just like in an
auction you say, “I’ll pay no more than $500, not a penny
more!” If a company is set on “winning the deal”, if there
is a bidding war with another potential buyer, it can cost a
lot! This is why acquisitions can be great for the target
firm and bad for the shareholders of the acquiring firm.
This is probably the reason that most M & A deals fall
through and history has a lot of these kind of failures.
CHINA’S INFLATION RATE 2008-2018?
WHAT IS A CREDIT DEFAULT SWAP? AIG AND THE 2008
FINANCIAL CRISIS – MOVIE, TOO BIG TO FAIL
A credit default swap (CDS) is akin to an insurance policy. It's a financial derivative that a debt
holder can use to hedge against the default by a debtor corporation or a sovereign entity. But a
CDS can also be used to speculate.
A subsidiary of AIG wrote insurance in the form of credit default swaps, meaning it offered
buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447
billion. But the mix was toxic. They also sold insurance on esoteric asset-backed security pools –
securities like collateralized debt obligations (CDOs), pools of subprime mortgages, pools of AltA mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary collected
a lot of premium income and its earnings were robust.
When the housing market collapsed, imploding home prices resulted in precipitously rising
foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit
crisis began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had
insured. In 2007, the company was starting to feel serious heat.
LESSON 4 COVERED IN YOUR TEXTBOOK
CHAPTER 8 PAGES 131-148
Citi Corp and Travelers as a real world example – Page
132. 8.1
Motivations of Buyers and Sellers – Pages 132-134.
Valuation and Financing – pages 136-141
Takeovers – Pages 144-146
example China page 146.
8.5
8.6 and 8.7 real world
8.2