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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 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


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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


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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


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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.


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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


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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


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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


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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


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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


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    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)


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    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


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    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)


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    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


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    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


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    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


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    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


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    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


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    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


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    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


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    The Politics and Economics of an Acquisition Equals

    • 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)


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    LBOs, Hostile Takeovers and Reverse M&A Equals

    • 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


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    LBOs, Hostile Takeovers and Reverse M&A Equals

    • 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


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    LBOs, Hostile Takeovers and Reverse M&A Equals

    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


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    LBOs, Hostile Takeovers and Reverse M&A Equals

    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


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    LBOs, Hostile Takeovers and Reverse M&A Equals

    • 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