Mergers & Acquisitions Lecture 1

Question 1

What are the 8 motivations for M&A?

Answer 1

1. Buying growth
2. Economies of scale & scope
3. Increase market power
4. Increase bargaining power in supply chain
5. Diversification of revenue streams
6. Industry shocks & deregulation
7. Financial synergies
8. Overvaluation of equity

Question 2

Elaborate on ‘buying growth’ motive

Answer 2

• common when organic growth takes time
• typical in industries where R&D takes time to pay off (e.g., pharma)
• used to facilitate entry into new markets/product lines
• M&A does not only substitute organic growth, but also complements it
• firms in mature industries tend to be acquirers, while young/growth industries tend to be targets
  //
  Research shows that firms that grow via M&A have higher revenue growth IN THE SHORT TERM than companies that grow organically

Question 3

Elaborate on ‘economies of scale/scope’ motive

Answer 3

Economies of scale = cost savings due to overlap in physical infrastructure, R&D, marketing channels, other sharing of resources.
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Economies of scope = avg cost of producing different products together is lower than the cost when produced separately.
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Revenue stream enhancement is difficult to achieve

Question 4

Elaborate on ‘increase market power’ motive

Answer 4

> firms may merge horizontally to create monopolies which gives them higher market power and allows them to extract greater rents from customers.
firms may merge vertically to get exclusive access to intellectual property.
//
these deals may often face opposition from regulators!

Question 5

Elaborate on ‘increase bargaining power’ motive

Answer 5

> firms may undertake horizontal mergers to increase their bargaining power with their suppliers. They are able to hold-up the supplier and negotiate for better prices by threatening to walk away.
M&A usually creates lots of value, but mostly at the expense of upstream parties.
//
Academic evidence supports the idea horizontal takeovers increase the buyer power of the merging firms if suppliers are concentrated

Question 6

Elaborate on ‘diversification of revenue streams’ motive

Answer 6

• firms may diversify to have different revenue streams, which reduces the vola of their CFs (the coinsurance effect).
• this coinsurance effect from diversification can reduce the counter-cyclical deadweight costs of fin.distress, defections by important stakeholders (i.e., suppliers/customers/employees).
• it can also create an internal capital market to fund investment opportunities
  //
  This diversification can lead to a diversification premium or discount (evidence is mixed)

Question 7

Elaborate on ‘industry shocks & deregulation’ motive

Answer 7

Technological, regulatory and demand shocks to the industry could increase the need for consolidation. For example, when demand collapses, it might trigger a wave of mergers (i.e., consolidation).

Question 8

Elaborate on ‘financial synergies’ motive, and explicitly mention one example

Answer 8

• creating value by acquiring firms that are weighted down by debt, and refinancing the debt at a lower cost. Firms are able to do so because they have a better credit rating.
• similarly, over-levered firms may also acquire less levered firms (with equity) to shore up debt capacity
  //
  Tax inversions are a source of financial synergies!!

Question 9

Elaborate on ‘overvaluation of equity’ motive

Answer 9

If the firm’s equity is overvalued, managers acting in the interest of their shareholders would rationally use the overvalued equity as currency in mergers by paying for the targets using the firm’s shares.
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Academic evidence supports the idea of rational market timing by managers: firm-specific deviations from short-run industry pricing affects who buys whom as well as method of payment.

Question 10

Name 2 reasons to undertake M&A unrelated to the rational reasons

Answer 10

1. Managerial hubris: they believe the target will be worth more under their stewardship due to their superior management skills. It may follow periods of good performance at the firm. It may cause managers to overpay for targets (especially in bidding contests)
   //
2. Managerial overconfidence: similar, but it is more an internalised form of hubris. This is more related to their personality, and not whether their firm has performed well or not. Anyhow, it may cause them to overpay for targets and undertake value destroying mergers.

Question 11

Mention the motivations for M&A related to agency issues

Answer 11

Shareholders face costs as managers might not always act in their best interest (for example, the agency FCF problem = managers spend FCF on perks instead paying it out).
//
Although managers own <1% of equity in the firm, their wealth/compensation/job depends on firm performance, so there’s still scope for mischief. Hence, they may:
> overinvest via mergers to increase firm size
> take on high-risk mergers due to the convex payoff of their stock options
//
This might also lead to overpayment!

Question 12

What is the definition and characteristics of a merger?

Answer 12

• one party will give up their identity and become part of the acquirer
• both sides of the balance sheet will be consolidated
• both shareholder parties must agree on the deal with a majority vote. If the majority agrees, the deal goes through, and there’s nothing you can do

Question 13

What is the definition and characteristics of a consolidation?

Answer 13

It is essentially the same as a merger, however, both parties give up their identity and create a new entity, and become shareholder in the new firm.

Question 14

What is the definition and characteristics of an acquisition?

Answer 14

There are 2 types:
1. Purchase of assets
2. Purchase of stock
//
> The buyer purchases some or all of the assets or equity.
> The target may be liquidated or continue to operate as a subsidiary of the buyer.
> Approval of target shareholders is required, but can be avoided via a tender offer.
>Dissident (or minority) shareholders remain, but can be squeezed out.
The approval of acquiring shareholders is needed only in instances involving a substantial dilution of equity (i.e., more dan 20% issuance of shares)

Question 15

What kind of purchase does the seller/buyer prefer? Which one do you see more?

Answer 15

A buyer prefers acquisition of assets due to:
> he is not responsible for the liabilities, as he only buys the assets
> he can step up his tax basis, which leads to lower taxable income (tax shields)
> the scope of a DD is much smaller. In an equity purchase it is more intensive
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A seller prefers acquisition of stock due to:
> in an asset sale, you have to pay ordinary income taxes, and its tax rate is higher than the capital gains tax rate. In an equity sale, this is taxes more favourably. So an asset sale leads to higher taxes.
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You see equity acquisitions more often, due to the fact that asset sales have double taxation, and equity sales just single taxation.

Question 16

What are 2 forms of payment in an acquisition, and what are the implications?

Answer 16

1. Cash: the target can continue operating. They can buy new assets, or pay a liquidation dividend and close the company.
2. Stock: if you pay with stock, the target automatically stops operating and existing

Question 17

What is a buyout? What is a special form of a buyout?

Answer 17

A buyout is the acquisition of stock and delisting of an entire company or a division, financed primarily with debt.
> the buyer is typically a PE fund managed by an LBO sponsor
> typical exits: IPO, sale to strategic buyer, sale to other LBO fund
> LBOs always involve payment with cash
//
Management buy-out is a special form of buyouts. The management can perform a buyout when it thinks the market is valuing its shares wrongly.

Question 18

What are the drivers of LBO activity?

Answer 18

1. Access to cheap credit
2. LBO activity is higher when the ERP is lower

Question 19

What are 2 selling strategies? Discuss the level of Competition, Structure, Likelihood of sale, Goals and control, Confidentiality, Speed, Asset specificity

Answer 19

Negotiation // Auction
–––––––––––––––––––-
low // high
few rules // clear rules
uncertain // strong probability
controlled by target (social issues important) // independent directors control (price important)
high // low
slow // fast
high // low

Question 20

Is there a difference in premium received in a negotiated deal vs auction?

Answer 20

No, one would expect a lower premium in negotiations as there’s less competition, but this is not the case!
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However, it is not fair to compare the two, as they both are fundamentally different!

Question 21

What is a standstill agreement?

Answer 21

It is a contract that contains provisions that govern how a bidder of a company can purchase, dispose of, or vote stock of the target. It can effectively stop or stall the process of a hostile takeover, as the contract usually prohibits the acquirer from making a hostile offer.
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In exchange, the target provides access to do a DD. The target is not allowed to make major financing decisions, such as paying dividends!
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Also known as non-disclosure/non-solicitation agreement

Question 22

What is a letter-of-intent

Answer 22

= non-binding offer = a way to show that you’re interested. If the acquirer walks away afterwards, he has to pay a break-up fee, but so is the target if he dips out
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The LOI clearly outlines what is being acquired, for how much, by whom, in what timeframe, and under what terms and conditions.

Question 23

What is a withdrawal class?

Answer 23

It refers to a group of shareholders who have the right to withdraw from a transaction, and receive a payout or a consideration. It is typically given to minority shareholders, and may only be triggered if certain condition are met, such as in the case of a change in control.

Question 24

What is a negotiated deal?

Answer 24

Going to the target’s management and expressing interest. After negotiations, seek approval of target shareholders by convening a special shareholder meeting. If the board refuses to negotiate, the buyer can then also make a tender offer. In a negotiated deal, the target has more control over the deal.

Question 25

What is hostile tender offer? And what are the requirements?

Answer 25

A tender offer is a hostile takeover bid made directly to the target shareholders, and no approval is needed. In a hostile takeover, the target has less control over the deal.
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Note that in a tender offer you cannot do a proper DD
//
> minimum 50% of shares have to be tendered
> within 6-7 weeks
> deal has also to be withdrawn if not cleared by the anti-trust regulator

Question 26

What are the 3 forms of a hostile takeover?

Answer 26

1. Tender offer
2. Proxy fight = convince existing shareholders to vote out their own management, and put in place a management that’s willing to accept the deal.
3. Buy necessary shares in the market

Question 27

Explain the steps in a two-tier tender offer

Answer 27

Step 1: make tender offer to purchase some/all shares
Step 2: back-end merger to acquire shares not tendered (i.e., this is a squeeze out of minority shareholders). It can be done by the buyer alone, without target board or stockholder vote, if the buyer owns the requisite portion of target shares (this portion varies by country).

Question 28

What is a negotiated tender offer? What is the advantage?

Answer 28

It is made under a written agreement with the target’s management. After a merger agreement is reached, instead of calling a shareholder meeting, the target announces the merger agreement and their assessment of the fairness of the offer. The acquirer then makes a tender offer directly to the target shareholders. After this, the tender offer is executed just like the 2-tier tender offer.
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Advantages:
>avoid going through a lengthly shareholder approval process (and sometimes to reduce the likelihood of entry of competing bidders!)
> they are less hostile, which gives the target’s management the opportunity to control the deal. It could be a way for them to make sure the shareholders receive a fair price. Target shareholders may then view the offer as more friendly.

Question 29

What’s the difference between a merger and an acquisition?

Answer 29

1. In a merger, both sides of the balance sheet are consolidated, whereas in an acquisition, that does not have to be the case.
2. In a merger, both shareholders have to agree, whereas in an acquisition, that does not have to be the case. This also means that there cannot be dissident shareholders in a merger, but in an acquisition there can be.

Question 30

Which firms often make use of an auction sale?

Answer 30

1. Distressed firms
2. Firms with low asset specificity

Question 31

What are the pros and cons of a tender offer?

Answer 31

+ quick, low disclosure requirements, impede competition entry
–lack of target’s management cooperation post-deal