Laurence Booth
Sean Cleary
15
Mergers and Acquisitions
LEARNING OBJECTIVES
15.1 Describe the different types of takeovers.
15.2 Explain securities legislation as it applies to takeovers.
15.3 Differentiate between friendly and hostile acquisitions and describe
the process of a typical friendly acquisition.
15.4 Explain the various motivations underlying mergers and
acquisitions.
15.5 Identify the valuation issues involved in assessing mergers and
acquisitions.
15.6 Identify the issues involved in accounting for mergers and
acquisitions.
15.1 TYPES OF TAKEOVERS
• A takeover occurs when control is transferred from one
ownership group to another.
• An acquisition occurs when one firm purchases another.
• A merger combines two firms into a new legal entity and
shareholders in both firms must approve the transaction in
order for the new firm to be created.
• An amalgamation, like a merger, requires shareholders in both
firms to approve the transaction. Additionally, an
amalgamation requires a fairness opinion by an independent
expert on the true value of the firm’s shares when a public
minority exists.
• A going private transaction or issuer bid occurs when the
purchaser already owns a majority stake in the target company.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.1 TYPES OF TAKEOVERS
How the deal is financed:
• Cash transactions
– Shareholders of the target company receive cash in
exchange for their shares.
• Share transactions
– Shareholders of the target company receive shares, or a
combination of cash and shares, in the acquiring company
in exchange for their shares
• Going private transactions (issuer bids)
– An acquisition where the purchaser already owns a
majority stake in the target company
Booth • Cleary – 3rd Edition
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15.2 SECURITIES LEGISLATION
General Intent
• Transparency and Information Disclosure
– To ensure complete and timely information is available to all
parties, especially minority shareholders, throughout the process
while at the same time not letting this requirement stall the
process unduly
• Fair Treatment
– To avoid oppression or coercion of minority shareholders
– To permit competing bids during the process and not have the
first bidder have special rights. In this way, shareholders have the
opportunity to get the greatest and fairest price for their shares
– To limit the ability of a minority to frustrate the will of a majority
(minority squeeze-out provisions)
Booth • Cleary – 3rd Edition
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15.2 SECURITIES LEGISLATION
• Exempt Takeovers
– Private firms are generally exempt from provincial securities legislation
– Public firms that have few shareholders in one province may be subject
to takeover laws of another province where the majority of shareholders
reside
• Exemption from Takeover Requirements for Control Blocks
– Purchase of securities from five or fewer shareholders are permitted
without a tender offer requirement provided the premium over the
market price is less than 15%
• The 5% Rule
– Normal course tender offer is not required as long as no more than 5%
of the outstanding shares are purchased through the exchange over a
one-year period of time
– This allows creeping takeovers where the company acquires the target
over a long period of time
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.2 SECURITIES LEGISLATION
Critical Shareholder Percentages
• Early Warning (10%)
– When a shareholder hits this point a report is sent to the OSC
to alert other shareholders that a potential acquirer is
accumulating a position in the firm
• Takeover Bid (20%)
– No further open market purchases and must make a takeover
bid
– Shareholders thus have an equal opportunity to tender shares
and receive equal treatment in receiving the same price
through the bid
– The acquirer also must disclose intentions publicly before
moving to full voting control of the firm
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.2 SECURITIES LEGISLATION
Critical Shareholder Percentages
• Control (50.1%)
– Shareholder controls voting decisions under normal voting
(simple majority) and can replace the board and control
management
• Amalgamation (66.7%)
– The acquirer can unilaterally approve amalgamation proposals
requiring a two-thirds majority vote (or a supermajority)
• Minority Squeeze-Out (90%)
– Once the shareholder owns 90% or more of the outstanding
stock, minority shareholders can be forced to tender their
shares
– This provision prevents minority shareholders from frustrating
the will of the majority
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.2 SECURITIES LEGISLATION
The Takeover Bid Process
• Moving Beyond the 20% Threshold
– Takeover circular sent to all shareholders
– Target has 15 days to circulate letter to shareholders with the
recommendation of the board of directors to accept or reject
– Bid must be open for 35 days following the public announcement
– Shareholders tender to the offer by signing authorizations
– A competing bid automatically increases the takeover window by
10 days and shareholders can withdraw authorization and accept
the competing offer during this time
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.2 SECURITIES LEGISLATION
The Takeover Bid Process
• Prorated Settlement and Price
– Takeover bid does not have to be for 100% of the shares
– Tender offer price cannot be for less than the average price that
the acquirer bought shares in the previous 90 days (prohibits
coercive bids)
– If more shares are tendered than required under the tender,
everyone who tendered shares will get a prorated number
purchased
Booth • Cleary – 3rd Edition
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
Friendly Takeovers
• A friendly acquisition occur when the target company is
willing to be acquired. Usually, the target will accommodate
overtures and provide access to confidential information to
facilitate the scoping and due diligence processes.
Booth • Cleary – 3rd Edition
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
Friendly Takeovers
• The target company normally uses an investment bank to prepare an
offering memorandum
• A friendly overture for information necessary for the valuation process can
also be made by a company seeking to acquire
• The target company may set up a data room and use confidentiality
agreements to permit access to interested parties practising due diligence
• A signed letter of intent signals the willingness of the parties to move to
the next step, which usually includes a no-shop clause and a termination
or break fee
• A legal team checks documents, while an accounting team may seek an
advance tax ruling from the CRA
• Final sale may require negotiations over the structure of the deal,
including tax planning and legal structures
Booth • Cleary – 3rd Edition
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
Structuring a Friendly Takeover
• In friendly takeovers, both parties have the opportunity to structure the
deal to their mutual satisfaction including:
1. Taxation issues, where cash for share purchases trigger capital gains
so share exchanges may be a viable alternative
2. Asset purchases, rather than share purchases, that may
•
Give the target firm cash to retire debt and restructure financing
•
Give the acquiring firm a new asset base to maximize CCA
deductions
•
Permit escape from some contingent liabilities, usually excluding
claims resulting from environmental lawsuits and control orders
that cannot be severed from the involved assets
3. Earn-outs, where there is an agreement for an initial purchase price
with conditional later payments depending on the performance of
the target after acquisition
Booth • Cleary – 3rd Edition
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
• Hostile takeovers occur when the target has no desire to be
acquired and actively rebuffs the acquirer and refuses to
provide any confidential information.
• The acquirer usually has already accumulated an interest in
the target (20% of the outstanding shares) and this
preemptive investment indicates the strength of the
acquirer’s resolve.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
• The Typical Hostile Takeover Process:
1.
2.
3.
4.
Slowly acquire a toehold (beach head) by open market
purchase of shares at market prices without attracting
attention
File a statement with the securities commission at the 10%
early warning stage while not trying to attract too much
attention
Accumulate 20% of the outstanding shares through open
market purchase over a longer period of time
Make a tender offer to bring ownership percentage to the
desired level (either control, 50.1%, or amalgamation, 67%);
the offer contains a provision requiring the acquisition of a
certain minimum percentage
Booth • Cleary – 3rd Edition
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
Hostile Takeovers Defensive Tactics
• During a hostile takeover, the acquirer will try to monitor management
and board reactions and fight attempts by them to put into effect
shareholder rights plans or to launch other defensive tactics.
• Shareholder rights plans are known as poison pills or deal killers, and can
take different forms. They often give non-acquiring shareholders the right
to buy 50% more shares at a discounted price in the event of a takeover.
• Selling the crown jewels refers to defensive tactics where the target
company sells its assets in which the acquiring company is most interested
in order to make it less attractive for takeover. This can involve a large
cash dividend to remove excess cash from the balance sheet.
• White knights are other potential and friendly acquirers that the target
company active seeks to make counter-offers and thereby rescue the
target from a hostile takeover.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.3 FRIENDLY VERSUS HOSTILE
TAKEOVERS
• Market clues to the potential outcome of a hostile takeover
attempt:
1.
2.
3.
4.
The market price jumps above the offer price, meaning that a
competing offer is likely or the bid price is too low
The market price stays close to the offer price, which suggests
the offer is fair and the deal will likely go through
There is little trading in the shares as a result of the offer,
which indicates that shareholders may be reluctant to sell and
can be a bad sign for the acquirer
There is a high volume of trading in the shares as a result of
the offer, which suggests that normal investors may be selling
large numbers of shares to arbitrageurs (arbs) who are
themselves building a position to negotiate for an even bigger
premium by coordinating a response to the tender offer
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
Classifications of Mergers and Acquisitions
1. Horizontal
–
–
2.
Vertical
–
–
3.
A merger where one firm acquires a supplier or another firm that is
closer to its existing customers
Often an attempt to control supply or distribution channels
Conglomerate
–
–
4.
A merger in which two firms in the same industry combine
Often an attempt to achieve economics of scale and scope
A merger in which two firms in unrelated businesses combine
Often an attempt to diversify by combining uncorrelated assets and
income streams
Cross-Border or International
–
A merger or acquisition involving a Canadian and a foreign firm
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• M&A activity
generally occurs in
“waves” in response
to domestic
economic cycles or
globalization issues
such as the
formation of trading
zones (e.g., NAFTA),
deregulation and
booms in sectors of
the economy
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Creation of Synergy Motive for M&A
– The primary motive for M&A is the creation of synergy.
– Synergy value is created from economics of integrating a target and
acquiring company; the amount by which the value of the combined firm
exceeds the sum value of the two individual firms.
– Additional value created = post-merger firm value less the sum of the premerger firm values of the acquiring and target firms (Equation 15-1)
V  VAT  (VA  VT )
• Operating Synergies
– Economies of Scale, such as reducing capacity, spreading fixed costs, and
geographic synergies
– Economies of Scope, where the combination of two activities reduces costs
– Complementary strengths, where combining the different relative strengths
of the two firms creates a firm with both strengths that are complementary
to one another
Booth • Cleary – 3rd Edition
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Efficiency Increases
– New management team will be more efficient and add
more value than what the target now has
– The combined firm can make use of unused production,
sales or marketing channel capacity
• Financing Synergies
– Reduced cash flow variability
– Increase in debt capacity
– Reduction in average issuing costs
– Fewer information problems
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Tax Benefits
– Make better use of tax deductions and credits
– Merged firms can use these before they expire (e.g., loss carry-back or
carry-forward provisions)
– Merged firms can use a deduction in a higher tax bracket to obtain a
large tax shield
– Merged firms can use deductions to offset taxable income (nonoperating capital losses offsetting taxable capital gains that the target
firm was unable to use)
– Merged firm will have operating income to make use of available CCA
• Strategic Realignments
– Permits new strategies that were not feasible prior to the acquisition
because of the acquisition of new management skills, connections to
markets or people, and new products or services
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Managerial Motivations for M&A
– Increased firm size
• Managers are often more highly rewarded financially for building a
bigger business with compensation tied to assets under
administration, for example
• Many associate power and prestige with the size of the firm
– Reduced firm risk through diversification
• Managers have an undiversified stake in the business (unlike
shareholders who hold a diversified portfolio of investments and
do not need the firm to be diversified) and so they tend to dislike
risk (volatility of sales and profits)
• M&As can be used to diversify the company and reduce risk that
might concern managers
– These motivations may not be in the best interest of
shareholders, but do address common needs of managers
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Gains Resulting from Mergers: Empirical Evidence
– Target shareholders gain the most through premiums paid to
them to acquire their shares
• 15 to 20% for stock-financed acquisitions
• 25 to 30% for cash-financed acquisitions (trigger capital
gains)
• Gains may be greater for shareholders will wait for “arbs” to
negotiate higher offers or bidding wars to develop between
multiple acquirers
– Between 1995 and 2001, 302 deals were completed
• 61% lost value over the following year
• The biggest losers were deals financed through shares which
lost an average 8%
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.4 MOTIVATIONS FOR MERGERS AND
ACQUISITIONS
• Shareholder Value at Risk (SVAR) is the potential that M&A
synergies will not be realized or that the premium paid will be
greater than the synergies that are realized.
• When using cash, the acquirer bears all of the risk
• When using shares swaps, the risk is borne by shareholders in
both the acquiring and target companies
• SVAR supports the argument that firms making cash deals are
much more careful about the acquisition price
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
• Fair market value (FMV) is the highest obtainable price in an open and
unrestricted market between knowledgeable, informed and prudent
parties acting at arm’s length with neither party being under any
compulsion to transact.
• Key phrases in this definition:
1. Open and unrestricted market – where supply and demand can freely
operate, as in Figure 15-2
2. Knowledgeable, informed and prudent parties
3. Neither party under any compulsion to transact
4. Arm’s length
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.5 VALUATION ISSUES
Types of Purchasers
• Determining fair market value depends on the perspective of
the acquirer. Some acquirers are more likely to be able to
realize synergies than others and those with the greatest
ability to generate synergies are the ones who can justify
higher prices
• Market pricing will reflect these different buyers and their
importance at different stages of the business cycle
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.5 VALUATION ISSUES
Types of Purchasers
• Types of Acquirers and Impact on Valuation
1. Passive investors: use estimated cash flows currently
present
2. Strategic investors: use estimated synergies and changes
that are forecast to arise through integration of
operations with their own
3. Financials: valued on the basis of reorganized and
refinanced operations
4. Managers: value the firm based on their own job
potential and ability to motivate staff and reorganize the
firm’s operations; useful for MBOs and LBOs
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
• Reactive methods are models that react to general rules of
thumb and price relative to other securities.
– Examples: multiples or relative valuation, liquidation
values.
• Proactive methods are valuation methods that determine
what a target firm’s value should be based on future values of
cash flow and earnings.
– Example: discounted cash flow (DCF) models.
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
Multiples Valuation
1. Find individual firms that are comparable to the target
and/or use industry averages
2. Adjust or normalize the financial statement data for
differences between the target and comparable firms to
account for any material accounting policy differences or
capital structure differences
3. Calculate a variety of ratios for both the target and
comparable firms, including:
–
–
–
–
Trailing price-earnings
Value/EBITDA
Price-book value
Return on equity
4. Obtain a range of justifiable values based on the ratios
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
Liquidation Valuation
1. Estimate the liquidation value of current assets
2. Estimate the present value of tangible assets
3. Subtract the value of the firm’s liabilities from the estimated
liquidation value of all of the firm’s assets to obtain the
liquidation value of the firm
• This approach values the firm based on existing assets and is
not forward looking.
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
Discounted Cash Flow (DCF) Analysis
• The key to using the DCF approach to price a target firm is to
obtain good forecasts of free cash flow.
• Free cash flows to equity holders represent cash flows left
over after all obligations, including interest payments, have
been paid
• DCF valuation takes the following steps:
1. Forecast free cash flows
2. Obtain a relevant discount rate
3. Discount the forecast cash flows and sum to estimate the value
of the target
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.5 VALUATION ISSUES
Discounted Cash Flow (DCF) Analysis
• Equation 15-3 is the generalized DCF model.
• Equation 15-4 is the DCF model for a firm where the free cash
flows are expected to grow at a constant rate for the
foreseeable future.
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
Discounted Cash Flow (DCF) Analysis
• Since many firms are high growth firms, a multi-stage model
may be more appropriate
• The multi-stage DCF model can be amended to include
numerous stages of growth in the forecast period
Booth • Cleary – 3rd Edition
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15.5 VALUATION ISSUES
The Acquisition Decision
• Once the value to the acquirer has been determined, the
acquisition will only make sense if the target firm can be
acquired at a price that is less than that amount
• As the acquirer enters the buying/tender process, the
outcome is not certain:
– Competing bids may occur
– Arbs may buy up outstanding stock and force price concessions
and lengthen the acquisition process
– Forecast synergies may not be realized after the merger
• The acquirer can attempt to mitigate some of these risks
through advance tax rulings from the CRA, entering a friendly
takeover and through due diligence
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.5 VALUATION ISSUES
The Effect of an Acquisition on Earnings per Share
• Generally, an acquiring firm can increase its EPS if it
acquires a firm that has a P/E ratio lower than its own.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.6 ACCOUNTING FOR ACQUISITIONS
• Historically, firms could use one of two approaches to account
for business combinations: the purchase method, or the
pooling-of-interests method (which is no longer allowed)
• While more popular in other countries, the pooling of
interests method is no longer allowed by the CICA (Canada),
FASB (USA) and IASB (International).
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.6 ACCOUNTING FOR ACQUISITIONS
• The Purchase Method
– The acquiring firm assumes all assets, liabilities and future
operating results of the target firm
– All assets and liabilities are expressed at their fair market
value as of the acquisition date
– If the fair market value exceeds the target firm’s equity, the
excess amount is goodwill and reported as an intangible
asset
– Goodwill is no longer amortized, but must be tested
annually for impairment in which case it will be written
down
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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15.6 ACCOUNTING FOR ACQUISITIONS
• Goodwill in Subsequent Years
– Goodwill is subject to an impairment test each year
– The impairment test requires an estimate of fair market
value, which is usually done using a discounted cash flow
approach
– Goodwill is changed only if it is impaired in subsequent
years, resulting in a write down and a charge against
earnings in the year impairment is recognized
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