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Mergers and Acquisitions. Chapter 19. Mergers and Acquisitions. Corporations strive to increase their earnings per share over time. Methods “Organic” approaches : Increase sales of existing divisions while maintaining level operating margins Increase operating margins with constant sales

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mergers and acquisitions2
Mergers and Acquisitions
  • Corporations strive to increase their earnings per share over time.
  • Methods
    • “Organic” approaches:
      • Increase sales of existing divisions while maintaining level operating margins
      • Increase operating margins with constant sales
    • Mergers and Acquisitions:
      • Seek to merge or acquire another corporation, with resulting corporation’s size and earnings enhanced by combination
a brief history of mergers and acquisitions
A Brief History of Mergers and Acquisitions
  • M&A transactions date back to 19th century
  • Horizontal acquisitions: acquiring competitors in the same industry and then systematically reducing costs of acquired company by integrating its operations into acquirer\'s company
  • Vertical acquisitions: acquiring companies in own supply chain
  • Enormous trusts, or business holding companies
a brief history of mergers and acquisitions4
A Brief History of Mergers and Acquisitions
  • In the 1920’s, 1960’s, and 1980’s, M&A activity reached historic highs and corresponded to positive performance of the stock market.
    • 1920’s: combinations of firms within industries
    • 1960’s: conglomerate approach (e.g. LTV, ITT)
    • 1980’s: use of large amounts of debt as the means to finance acquisitions of companies with cheaply priced assets through leveraged buyouts
a brief history of mergers and acquisitions5
A Brief History of Mergers and Acquisitions
  • In the 2000’s, Wall Street declined due to lower asset values and increased government regulation; strategic horizontal mergers are becoming more common.
    • Strong banks are absorbing weak ones before/after FDIC seizes them.
    • Chemical, pharmaceutical and commodities firms are merging in order to increase global reach and reduce cost per unit of production.
    • Leveraged buyout firms (now private equity firms) have decreased their activity due to losses from 2007/2008 vintage investments and reduction in debt availability.
    • Completed deals have lower levels of debt and therefore, either a lower price or more equity.
how companies can work together
How Companies Can Work Together
  • Article 2 of the Uniform Commercial Code (UCC): set of contractual rules for sale of goods between companies
  • Vendor-customer relationships are governed by purchase orders (POs): short form of contract, containing standard provisions and blank spaces for price, quantity, and shipment date of goods involved
how companies can work together7
How Companies Can Work Together
  • Strategic alliance (or teaming agreement): parties work together on a single project for a finite period of time
    • Do not exchange equity
    • Do not create permanent entity to mark relationship
    • Written memorandum of understanding (MOU): memorializes strategic alliance and sets forth how parties plan to work together
how companies can work together8
How Companies Can Work Together
  • Joint venture: parties work together for lengthy or indeterminate period of time
    • Form new, third entity
    • Divide ownership and control of new entity, determine who will contribute what resources
    • Advantage: two entities can remain focused on their core businesses while letting joint venture pursue the new opportunity
    • Downside: governance issues and economic fairness issues create friction and eventual disbandment
how companies can work together9
How Companies Can Work Together
  • Acquisition: acquired company becomes subsidiary of purchasing company
    • Most permanent
    • Eliminates governance and economic fairness issues
    • Forms of acquisitions
      • Merger
      • Stock acquisition
      • Asset acquisition
how companies can work together10
How Companies Can Work Together
  • Merger: two companies legally become one
      • All assets and liabilities being merged out of existence become assets and liabilities of surviving company
  • Stock acquisition: acquired company becomes subsidiary of acquiring company
  • Asset acquisition: assets but not liabilities become assets of acquiring firm
how and why to do an acquisition
How and Why to do an Acquisition
  • If acquisition will create positive present value when weighing outflow (acquisition price) versus future inflow (cash flow of acquired company plus any synergies), then transaction makes financial sense.
    • Difficulty: determine what exactly are the outflows, inflows, and synergies (both revenue/cost synergies)
how and why to do an acquisition12
How and Why to do an Acquisition
  • Common synergies
  • Cost Savings:
    • One has lower existing costs due to efficiency, scale, etc.
    • One has better cost management
    • Combined company has greater economies of scale
    • One has better credit rating/balance sheet and therefore cheaper financing costs
    • Transactions costs eliminated in vertical merger
    • Reduction in employee costs (layoffs)
    • Reduction in taxes if acquirer has NOLs and is not limited by Section 382 of IRC
how and why to do an acquisition13
How and Why to do an Acquisition
  • Common synergies (continued)
  • Revenue enhancements:
    • Use of each other’s distributors and other channels
    • “Bundling” opportunities from combined product offering makes company more attractive
    • Combined company can raise prices (greater market power)
how and why to do an acquisition14
How and Why to do an Acquisition
  • Companies will hire a group of advisors to assist in evaluating and consummating transaction  investment bank, law firm with expertise in mergers and acquisitions, accounting firm, valuation firm
how and why to do an acquisition15
How and Why to do an Acquisition
  • Investment bank
    • Primary financial advisor
    • Puts together financial model to analyze cash flows of combined company on pro forma basis
    • Evaluates comparable transaction in order to render advice on price
    • Offers advice on tax and accounting structure for transaction
    • Helps raise capital needed to complete transaction
how and why to do an acquisition16
How and Why to do an Acquisition
  • Law firm
    • Responsible for drafting and negotiation of transaction documents
    • Reviews appropriate tax, employment, environmental, corporate governance, securities, real property, and other applicable international, federal, state and local laws
    • Advise Board of Directors on fulfilling its fiduciary duties of care and loyalty to shareholders
how and why to do an acquisition17
How and Why to do an Acquisition
  • Accounting firm
    • Advise company on proper tax and accounting treatment of transaction
    • Assist in valuing certain specific assets
    • “Comfort letter” on certain accounting issues
    • Consent letter needed if publicly registered securities offering is made in connection with transaction
the politics and economics of acquisitions
The Politics and Economics of Acquisitions
  • Key political elements of a transaction
    • Which entity will survive or be parent company
    • What will new company’s board of directors look like
    • Who will manage company day-to-day
the politics and economics of an acquisition
The Politics and Economics of an Acquisition
  • Smaller company will typically become subsidiary of larger company
    • Smaller company may have token representation on Board of Directors of parent
    • Management of smaller company will typically either remain at subsidiary or exit
the politics and economics of an acquisition merger of equals
The Politics and Economics of an Acquisition – Merger of Equals
  • Board positions often allocated 50/50
  • “Office of the Chairman” or “Office of CEO”: formed to share management authority
  • Murky lines of authority or shared power can lead to difficulty and conflict
the politics and economics of an acquisition21
The Politics and Economics of an Acquisition
  • Buyer will offer price based on whether transaction will be accretive: increases earnings per share of acquiring company
  • Seller will seek premium over its existing stock price (if public) or price in line with public traded comparables or recent public disclosed M&A transaction multiples based on price to earnings, price to EBITDA or price to sales (if private)
lbos hostile takeovers and reverse m a
LBOs, Hostile Takeovers and Reverse M&A
  • Leveraged Buy Outs (LBOs): purchases of stock of company where a significant percentage of purchase price is paid for with proceeds of debt
    • Became prominent in 1970’s and 1980’s with rise of LBO shop
    • Debt financing to fund:
      • High yield (junk) bonds
      • Hostile takeovers: acquisition in which “target’s” board of directors does not consent to transaction
        • Tender offer: Potential buyer or “raider” makes cash offer directly to shareholders, thereby bypassing board of directors
lbos hostile takeovers and reverse m a23
LBOs, Hostile Takeovers and Reverse M&A
  • Three major events altered landscape to reduce incidence of hostile takeovers:
    • Creation of poison pills: companies issued convertible preferred stock to exiting shareholders with provisions which made a potential tender offer prohibitively expensive
    • State of Delaware passed new provision of Delaware General Corporate Law, Section 203: requires hostile buyer to acquire at least 85% of target company in order to consummate hostile takeover
    • U.S. Congress passed revision of tax code: limited tax deductibility of certain high yield debt (HYDO rules), thus reducing attractiveness of junk bonds as means of financing acquisitions
lbos hostile takeovers and reverse m a24
LBOs, Hostile Takeovers and Reverse M&A

Reverse M&A (add value through divestiture)

  • Four forms of reverse M&A:
  • Simple sale of division or subsidiary: asset sale, stock sale, or merger
lbos hostile takeovers and reverse m a25
LBOs, Hostile Takeovers and Reverse M&A

2. Spin-off: corporation issues dividend of shares of subsidiary to be spun-off corporation’s shareholders

  • Shareholders of parent participate in spin-off on pro rata based on their ownership percentage in parent
  • Prior to spin-off, parent may extract cash from subsidiary
    • “19.9% IPO”: subsidiary is taken public and all or large portion of proceeds are then allocated to parent
    • Transfer certain debts to subsidiary so that parent ends up with less leveraged balance sheet post spin-off
    • Parent has subsidiary dividend to parent a portion of subsidiary’s cash
lbos hostile takeovers and reverse m a26
LBOs, Hostile Takeovers and Reverse M&A
  • Split-off: shareholder in parent corporation elects to take shares in subsidiary being split-off, but ends up with fewer shares of parent corporation
  • Split-up: shareholder elects to take shares in one part of split company or other
    • Less common than spin-offs and split-offs because most shareholders like having parts of both parent and entity divested
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