Merger Model Questions Flashcards
Covers questions found in IB guide overview on merger models (4 cards)
What determines the purchase price in an M&A deal? What is the premium based on? What about prices for private companies?
For public companies, a premium to their current share price (or average price over the past month, quarter, or year) is required. Otherwise, existing shareholders have no incentive to sell everything they own.
So, even if the valuation methodologies say that a company is worth $10.00 per share, if this company is currently trading at $12.00 per share, the Acquirer will have to pay a price greater than $12.00 per share to buy this company.
The deal can still work if there are enough Synergies to justify this higher price.
EXAMPLE: Let’s say that Company B has a Current Share Price of $33.00, Current Equity Value of $825 million, and Current Enterprise Value (TEV) of $1.025 billion.
The valuation methodologies say that the company’s Implied Share Price is $35.00 to $45.00.
The premiums paid for companies in this market have been between 15% and 30% over the past ~3 years.
Therefore, an Offer Price anywhere in this range of ~$38.00 (15% premium) to ~$43.00 (30% premium) might be reasonable.
However, if the valuation methodologies say that the company’s Implied Share Price is only $20.00 to $30.00, that doesn’t matter.
The Acquirer can’t just go to the Target and say, “Please sell for less than your Current Share Price – because we think you’re overvalued right now.”
The Acquirer still must pay a premium – more than $33.00 per share – to do this deal.
Since all deals with public Sellers include control premiums, assessing the potential Synergies is extremely important. If they’re high enough, these Synergies + the Seller’s Implied Value may still exceed the Purchase Price, justifying the deal financially.
For private companies, the purchase price is not based on a share-price premium but rather Revenue, EBITDA, or P / E multiples and the valuation.
For example, if similar companies in this market have been acquired at multiples of 8-12x EBITDA, then a 10x TEV / EBITDA might be appropriate for a Seller.
You could then back into the Purchase Equity Value once you have the Purchase Enterprise Value from this multiple.
How does the Acquirer decide on the amount of Cash, Debt, and Stock it should use to buy the Target? Is it based on simple percentages, or are there restrictions and guidelines?
You can base the mix of Cash, Debt, and Stock on simple percentages in a simple model, such as 1/3, 1/3, and 1/3, or 50%, 50%, and 0%.
In reality, though, Acquirers almost always prefer the cheapest purchase method, which is usually Cash.
If the Acquirer gives up only 1-2% interest on its Cash balance, then almost any M&A deal will look accretive if it’s completed with 100% Cash.
Once the Acquirer has used all the Cash it can, it will switch to Debt, the next cheapest acquisition method, up to a certain level, and then it will use Stock for anything past that.
The Cash Limit is usually based on a “minimum Cash balance” that the company needs to keep its operations running.
Depending on the Acquirer and Target’s sizes, this minimum Cash Balance could be based on just the Acquirer’s Cash balance or the Acquirer’s Cash + Target’s Cash.
The Debt Limit is usually based on a maximum desired Debt / EBITDA, Debt / Total Capital, or similar ratio.
For example, maybe the combined company wants to maintain an “investment grade” credit rating, so it aims to stay at or below 3x Debt / EBITDA.
This ratio should reflect both the Acquirer and Target’s numbers, but if the Acquirer is, say, 10x or 100x bigger, you might ignore the Target.
And the Stock Limit is murkier because a company could issue, in theory, an unlimited amount of new Stock… but most companies do not want to do that. Generally, Acquirers want to maintain control of the combined entity whenever it’s possible to do so.
For example, if the Acquirer is worth $1 billion, and the Target is worth $1.2 billion, the Acquirer would not want to issue $1.2 billion of Stock to buy the Target.
If it did that, it would own less than 50% of the combined entity.
Instead, it would use as much Cash and Debt as possible, and then it would switch to Stock for the remaining portion.
This limit could also be based on EPS accretion/dilution; if the deal turns dilutive with over $500 million of new Stock issued, for example, then maybe that’s the limit.
How much does an Acquirer “really pay” for a Target? Is it the Purchase Equity Value or the Purchase Enterprise Value? Something in between? Something else?
In short: The Acquirer pays neither the Purchase Equity Value nor the Purchase Enterprise Value, exactly; the amount paid is usually in between the two, depending on the terms of the deal. However, even this short answer differs based on whether the Target is a public or private company.
At the minimum, the Acquirer must pay for all the Target’s shares, so the Purchase Equity Value is always the starting point for the “real purchase price.”
Beyond that, the exact purchase price depends on the treatment of the Target’s Cash and Debt and the transaction fees (paid to the bankers, lawyers, and other professionals who advise on the deal).
