MERGERS

& ACQUISITIONS

A view
Mergers are like marriage in the romantic
tradition. Usually there is a period of
courtship leading to the joining of two or
more entities into one, after which the
parties hope to live happily ever after.

Merger
Any transaction that forms one economic
unit from two or more previous ones.

Amalgamation
Consolidation : no original entity remains

New Co.

Target Co.

Acquire Co.

Amalgamation
absorption: only one entity remains

Acquire Co.

Target Co.

Acquisition
The purchase of the controlling interest or
ownership of another company. This can be
affected by:
Agreement with the persons having
majority of the stake
Purchase of shares in the open market
To make takeover offer to the general
body of share holders
Purchased of new shares by private
treaty
Acquisition of share capital

CFA Institute
Although M&A is often used as a generic term that refers to
any business combination, we can differentiate between mergers
and acquisitions. An acquisition refers to one company buying
only part of another company. A typical acquisition transaction
may involve the purchase of assets or a distinct business
segment(e.g., subsidiary) from another company. If the acquirer
absorbs the entire target company, the transaction is considered
a merger. Once a merger is completed, only one company will
remain, and the other will cease to exist. Whether a transaction
is called a merger or an acquisition, the initiator of the venture
is referred to as the bidder, or acquirer, while the opposite side
of the transaction is known as the target.

Takeover
This is similar to acquisition.

Merger Waves
Neoclassical explanation
A technological, regulatory or economic shock to an industrys
environment occurs,
Industry assets are reallocated through mergers and partial firm
acquisitions
Clusters in time and industry as managers simultaneously react and
then compete for the best combination of assets
Capital liquidity argument
modifies the neoclassical hypothesis of waves
only when sufficient capital liquidity exists to accommodate the
reallocation of assets, will an industry shock generate a merger wave.

Behavioral Hypothesis
In bull markets groups of bidders with overvalued stock to use the
stock to buy real assets of undervalued targets through mergers
Overvaluation in the aggregate, or in certain industries would lead
to wave like clustering in time

Merger Waves
First wave (1897-1904)
Mostly horizontal combinations- creation of large monopolies
Du Pont, GE, Standard Oil, Eastman Kodak

Second wave (1916-1929)

Merging for oligopoly- first large scale formation of conglomerates
GM, IBM, Union Carbide

Third wave (1965-1969)

Mostly conglomerate mergers

Fourth wave (1984-1989)

Significant role of hostile takeovers

Size of targets were much larger than in the past
Age of the corporate raider
Financed with large amounts of debt

Fifth wave (1992-2000)

Used equity rather than debt to finance acquisitions
A truly international merger wave- role of emerging market acquirers

Sixth wave (2003-2008)

Role of emerging economy firms expands
Fed by transactions delayed in previous period due to uncertainty following 9/11

Motives driving Mergers

Efficiency Theory
Operational synergies
Economies of scale
Vertical integration
More efficient production or
organizational technologyknowledge transfers

Financial synergies
Lower cost of capital- increase size,
lower risk, establish an internal
capital market
Access to unutilized tax shields
Increase leverage opportunities

Managerial synergies
Bidders management team may
have superior planning/ monitoring
abilities

Monopoly Theory
Mergers executed to achieve
market power
Firms can cross subsidize
products in different
markets
Limit competition in more
than one market- footholds

So What drives a company to

M&A

Well defined Objectives

Growth in Size
Synergistic benefits
New Geography
New line of business
New technology
Consolidation/ Monopoly
Tax saving
..

Not so well defined

Peer pressure
Should do something..
I want to be the largest
Survival
Have unutilised funds
Sentiment..
..

Example
Wockhardt sold its Nutrition business to Danone
because it needed money to settle its loans
Danone bought the business because it needs a
strong base in India on which12it can expand its own
product portfolio

Value
Creation

Real Value of a Merger

M&A involves many parties

Other parties to M&A

Existing Lenders
Shareholders
Employees
Independent Directors
Financiers
Regulators/ Govt.
Investment bankers
Lawyers
Taxmen
Auditors
Various suppliers/ contracts/
parties, etc

Other considerations
Availability of acquisition
finance
Listed company vs. unlisted
targets (auction guidelines)
Takeover code triggers
Competition Commission
Cross-country tax treaties
Tax-set offs available
Compatibility, etc..

Its an entire ecosystem that shakes

You can be working anywhere to be a part of it

What Investment Bankers do

Create Ideas
Evaluate a Group/Industry/company/.. and assess what options exist

Present Ideas and support with data

Present the idea to the relevant people, on both sides of table

Convince clients on the Idea and create a Deal

Convert an idea into a Deal by putting a name of counterparty to it

Advise on the Deal to earn fee

Typically represent one of the counterparty who pays to do the Deal keeping
in mind all aspects of a Deal

If the Idea is successful, Bankers get repeat business

 Search

The M&A Process

as per the primary selection criteria

Screening

Market segment
Product line
Profitability
Degree of leverage
Market share

Approaching the Target

Discretion
Clarity on time frame for completion of acquisition
Discuss value
Preliminary legal documents

Confidentiality agreement; Term Sheet- outlines the primary terms of the deal; LOI-formally states
the reasons for agreement and major terms and conditions

The M&A Process ...

Negotiation
Develop a negotiation strategy
Make concessions on deal breakers but with something in return
Resolve easier issues first

Refine valuation
Deal structuring
Acquisition vehicle/ post closing organization/ form of payment (stock
or assets)

Conduct Due Diligence

Strategic/Financial/ Legal/ Operational/ Marketing/ HR
Use of Data Room

Develop Financing Plan

Bridge financing/ Mezzanine financing/ VC funding (Road Show)

Select alternative financial structure

Cash/ stock/ Debt etc.

The M&A Process...

Develop Integration Plan
Choose an Integration Manager
Build a Post merger Integration Team
Multi functional
Comprising of members from both organizations

Earn trust
Get employees in both firms to work towards common goals
Based more on experience rather than slogans or pep talks
Design effective communication plan to keep off rumors

Closing the Deal

Gain necessary approvals
Compliance with laws: securities/ anti-trust/ state

Definitive agreement
Indicates all rights and obligations of both parties prior to closing the deal
Price; Payment mechanism; Assumption of liabilities; Representations
and warranties- ensure full disclosure of information

Covenants

The M&A Process...

Implementing PMI
Implement an effective communications plan
Management: Retain key managers
Bonuses; stock options; enhanced sales commissions etc.

Identify immediate operating cash flow requirements

Usually found to be higher than expected

Employ best practices in both companies

Realize operating synergies

Cultural issues
Organizational culture; National culture

Unions & Employees

Conduct Post Merger Evaluation

Current Learning on M&A

Usually low or even negative returns to acquiring firm, but significantly
positive returns to target firm
Expansionist vs. Transformative Deals
Scale benefit easier to accrue.

Friendly vs. Hostile

Hostile mergers less likely to succeed.

Large vs. Small

Target ~< 20% of acquirer create more value

Frequency of Deals
Frequent buyers more successful.

Timing of Synergies
Only 2 years to deliver synergies.

Experienced M&A Team [Mckinsey Study]

14 yrs at current employer vs. 4.7 yrs [M&A Teams at Successful vs. Unsuccessful
Acquirers]

General M&A Rules for Managers

Bidding Firm
Search for valuable & rare
economies of scope
Keep information away from
other bidders
Keep information away from
target
Avoid winning bidding wars/
multiple bidders
Evaluate targets carefully;
close the deal quickly
Operate in thinly traded
acquisition markets

Target Firm
Seek information from
bidders
Invite other bidders to join
the bidding competition
Delay, but do not stop the
acquisition

Other Restructurings
Divestitures

Selling part of the business

Need: Focus on core competence
Premise: Their value is higher with the buyer organization
Challenge: Valuing the business, negotiating price

Equity carve-out

Convert business into subsidiary

Sell a part (usually less than 20%) of the shares of a subsidiary
The parent still retains the remaining equity
Shares generally listed
Need: raising funds without losing control, Partnering

Other Restructurings
Spin-Off
Giving up 100% ownership of a BU (spin-off is an independent
company)
Often follows equity carve-out
Shareholders initially common (e.g. dividend as new companys share)
Ensures focus both for parent and subsidiary

Tracking Stock
Parent creates a new class of stock but focussed on a unique business
Tracking stock is still a common stock of parent (e.g. with voting rights
etc)
Ensures focus but within the same board control like a new subsidiary
which happens to be listed.
Applications: Leveraging internet valuations, Management evaluation

Other Restructurings
Split-Offs
Rare form where shares of the subsidiary are offered to shareholders of
parent firm
Shareholders of parent now directly own the subsidiary, but cease to own
parent
Ensures equity base of parent goes down proportionally without an inflow
of cash

Ex-ante Returns to Shareholders

Friendly
Acquired co.

20%

Acquiring co.

2-3% (a)

Hostile
Acquired co.

35%

Acquiring co.

3-5%

(a) Statistically insignificant

Success and Failure of

Acquisitions
Unknown
Success
23%

16%

Failure
61%

Acquisition Program -- by Type

of Program
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

55%
73%

45%
27%
RelatedSmall

RelatedLarge

62%
86%

38%
14%
UnrelatedSmall

UnrelatedLarge

Failure
Success

How Core Businesses Performed

Prior to Acquisition
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

52%
Strong Core Business
Weak Core Business
48%
92%
8%
Success

Failure

Impediments to M&A in India

Bureaucratic Delays
High transaction costs
stamp duties, sales tax, income tax, court fees
Hostile by overseas companies prohibited
no uniform taxes/ duties
stamp duty, sales tax, ULCS, Rent Act

Regulatory Framework
Indal--Sterlite; India Cement -- Raasi

Sentiment of promoter

Reasons for Failure

Overoptimistic Appraisal
Overestimation of synergies
Overbidding
Poor post-acquisition integration

Valuation for M&A

Maximum Value of target firm to buyer
=
Value to seller
+
Value added by buyer
+
Change in value to Buyer if target firm
acquired by competitor

Some more definitions

Synergy = Value of Combined Business
less Sum of Value of Individual Businesses
Premium = Price paid - (Market Value of
Business + Transaction costs)

Value add by buyer

Synergies
New strategy
PV of sale of redundant assets

Valuing Synergy
The key to the existence of synergy is that the target firm controls a
specialized resource that becomes more valuable if combined with the
bidding firm's resources. The specialized resource will vary depending
upon the merger:
In horizontal mergers: economies of scale, which reduce costs, or
from increased market power, which increases profit margins and
sales. (Examples: Bank of America and Security Pacific, Chase
and Chemical)
In vertical integration: Primary source of synergy here comes
from controlling the chain of production much more completely.
In functional integration: When a firm with strengths in one
functional area acquires another firm with strengths in a different
functional area, the potential synergy gains arise from exploiting
the strengths in these areas.

Valuing operating synergy

(a) What form is the synergy expected to take? Will
it reduce costs as a percentage of sales and
increase profit margins (as is the case when there
are economies of scale)? Will it increase future
growth (as is the case when there is increased
market power)? )
(b) When can the synergy be reasonably expected
to start affecting cashflows? (Will the gains from
synergy show up instantaneously after the
takeover? If it will take time, when can the gains
be expected to start showing up? )

Sources of Synergy
Synergy is created when two firms are combined and can be
either financial or operating

Operating Synergy accrues to the combined firm as

Strategic Advantages

Higher returns on
new investments

More new
Investments

Higher ROC

Higher Reinvestment

Higher Growth
Rate

Higher Growth Rate

Financial Synergy

Economies of Scale

More sustainable
excess returns

Cost Savings in
current operations

Longer Growth
Period

Higher Margin
Higher Baseyear EBIT

Tax Benefits

Lower taxes on
earnings due to
- higher
depreciaiton
- operating loss
carryforwards

Added Debt
Capacity

Higher debt
raito and lower
cost of capital

Diversification?

May reduce
cost of equity
for private or
closely held
firm

A procedure for valuing synergy

(1) the firms involved in the merger are valued
independently, by discounting expected cash flows to
each firm at the weighted average cost of capital for that
firm.
(2) the value of the combined firm, with no synergy, is
obtained by adding the values obtained for each firm in the
first step.
(3) The effects of synergy are built into expected growth
rates and cashflows, and the combined firm is re-valued
with synergy.
Value of Synergy = Value of the combined firm, with
synergy - Value of the combined firm, without synergy

Synergy Effects in Valuation

Inputs
If synergy is
Valuation Inputs that will be affected are
Economies of Scale Operating Margin of combined firm
will be greater than the revenueweighted operating margin of
individual firms.
Growth Synergy More projects:Higher Reinvestment Rate
(Retention)
Better projects: Higher Return on Capital
(ROE)
Longer Growth Period
Again, these inputs will be estimated for the
combined firm.

Who gets the benefits of

synergy?
In theory: The sharing of the benefits of synergy among the two
players will depend in large part on whether the bidding firm's
contribution to the creation of the synergy is unique or easily
replaced. If it can be easily replaced, the bulk of the synergy
benefits will accrue to the target firm. It is unique, the sharing of
benefits will be much more equitable.
In practice: Target company stockholders walk away with the
bulk of the gains. Bradley, Desai and Kim (1988) conclude that
the benefits of synergy accrue primarily to the target firms when
there are multiple bidders involved in the takeover. They
estimate that the market-adjusted stock returns around the
announcement of the takeover for the successful bidder to be
2%, in single bidder takeovers, and -1.33%, in contested
takeovers.

Why is it so difficult to get

synergy?
Synergy is often used as a plug variable in acquisitions: it is the
difference between the price paid and the estimated value.
Even when synergy is valued, the valuations are incomplete and
cursory. Some common manifestations include:
Valuing just the target company for synergy (You have to
value the combined firm)
Not thinking about the costs of delivering synergy and the
timing of gains.
Underestimating the difficulty of getting two organizaitons
(with different cultures) to work together.
Failure to plan for synergy. Synergy does not show up by
accident.
Failure to hold anyone responsible for delivering the synergy.

Thoughts on Synergy
If an acquisition is motivated by synergy, make a realistic estimate of
the value of the synergy, taking into account the difficulties associated
with combining the two organizations and other costs.
Do not pay this value as a premium on the acquisition. Your objective
is to pay less and share in the gains. If you get into a bidding war and
find you have to pay more, drop out.
Have a detailed plan for how the synergy will actually be created and
hold someone responsible for it.
Follow up the merger to ensure that the promised gains actually get
delivered.
Do not trust your investment bankers or anyone else in the deal to look
out for your interests; they have their own. That is your job.

Synergies: Drivers
Across all value drivers/elements of the P&L

Volume
Pricing
Distributor Costs
Cost of Goods
SG&A
Marketing Expenses
Tax
Asset Efficiency
Cost of Capital
Etc

Volume
Evaluate Volume building proposals/initiatives
Distribution Gains
New customers, expanded reach/channels

Co-promotions
Leveraging consumer base of similar product

In-store support
Stronger First moment of Truth

New products
Leveraging technology of one company with the
brand name of the other

Pricing
Are there realistic price up opportunities?
Oligopoly giving pricing power
Generally faces regulatory hurdles

Leveraging existing equity/product

Through better total consumer experience
after integration

Distributor Costs
Compare distributor costs of both
companies
Change in business models
Eliminating distributors by bringing work in
house

Scale benefit lower customer margins

Power shifts to the company
Distributors still make higher $ profits

Cost of Goods
Detailed benchmarking of costs
Unutilized capacity
Especially in common RM/PM.

Scale benefit on purchasing

On non-commoditized supplies

Logistic Cost
Higher utilization of warehouses, delivery van etc.

Cross learning
Best practices in production, packaging etc.

Vertical integration
Ability to do work in house and eliminate supplier profits.

SG&A
Design the new organization structure and then
look at positions eliminated
Leadership Layer
Generally contributing to the majority of savings.

Scale benefit on organization

Especially in back room functions.

Cheaper purchasing (e.g. travel, data etc.)

Scale benefit with suppliers.

Cross learning
Best practices on managing overheads.

Vertical integration
Bringing work in house

Marketing Cost
Benchmark key costs of the two companies (e.g. media
buying costs)
More clout with agencies
Lower media buying cost
Co-promotion is cheaper
Pay at cost vs. selling price
Various revenue synergies
Cross-ruffs
Leveraging each other's userbase
Cross-learnings
Best-in-class trial builders, consumer understanding,
marketing mix etc.

Tax
Thorough study of tax position
Carried Forward Losses/Tax Credits
If unused/unusable in target company

Change in Asset Base

Higher Depreciation

Change in Business Models

Lower overall tax rate in new model

Cross learnings/reapplications
Impact on Personal Taxes of Shareholders
Deal Structuring Deferring tax liability

Caution: Tax Planning vs. Avoidance!

Asset Efficiency
Capacity planning exercise including future
requirement
Low Tobin ratio (market value/replacement
value of assets)
Cheaper to buy company vs. asset

Unutilized assets
Use or Sell (Corporate Jets!)

Scale benefit
Lower overheads behind higher utilization

Reapplications

Cost of Capital
Benchmark current sources/cost of cash and
future requirements/ size
Ability to use existing cash
Valuation does not measure idle cash

Internal Funds maximization

Higher ROI projects across the 2 firms

Ability to take more loan

Leverage as market cap goes up

Reduce Beta
More diversification, hence lower risk

Synergies: Process
Estimates based on central analysis
Identify Baselines per organization
Ensure no lost people
Ensure no double counting
Do global due diligence with some countries as input,
plus benchmarks
Use simplifying assumptions
E.g. 5% savings on global media costs

Process very similar to strategic planning/budgeting

Allocate as targets to regional/ functional teams

To develop specific plans
To ensure sell-in and execution

Tracking
Build the final number in annual targets/budgets

Dis-synergy: Often
forgotten!
Hurts coming behind integration
Revenue Dis-synergy
Disruption/Loss of focus
Business Model change
Competitive Challenges

One time costs

Severances
Relocations
Asset write-offs
Penalties
Poison Pills
Integration Costs
Investment Bankers cost
Regulatory costs (incl. need to spin-off)
Others

Factors that make a Firm

Vulnerable to Takeover
A low stock price in relation to replacement cost
of assets or their potential earning power.
A highly liquid balance sheet with large amounts
of excess cash, a valuable securities portfolio, and
significant unused debt capacity.
Good cash flows relative to current stock prices

Factors that make a Firm

Vulnerable to Takeover
Subsidiaries or properties which could be
sold off without significantly impairing cash
flows
Relatively small stockholdings under the
control of incumbent management

What steps?
Increase debt with borrowed funds used to
repurchase equity
Increase dividends on remaining equity
Securities portfolios should be liquidated and
excess cash drawn out to invest in positive NPV
projects or returned to shareholders
Use excess cash to invest in firms that raiders
might be disinterested in.

What steps?
Eliminate subsidiaries through spin-offs
True value of undervalued assets should be
realised by selling them off or restructuring.

Cash or Stock Deal

Stock
When acquirer overvalued
Sharing synergies with target
Problems of cash availability
No immediate capital gains for shareholders of
target. So no immediate capital gains tax

Cash
No sharing synergies

Defense against Takeover

Golden Parachutes
Refer to separation provisions of an
employment contract that compensates
managers for the loss of their jobs under a
change of control clause.
The provision usually calls for a lump-sum
payment or payment over a specified period
at full or partial rates of normal
compensation.

Rewards for Failure?

Beatrice: $23.5 mn compensation to six
officers in connection with an LBO
$2.7 mn compensation though he had been
with company for only 13 months
$7 mn after having been recalled from
retirement just six months earlier

Poison Puts
Corporate bond quality usually deteriorates
following an leveraged recapitalisation,
LBO or other forms of corporate control.
Poison Puts in covenants to reduce risk of
takeover related credit deterioration
Exercise of put option is usually set at
100% or 101% of bonds face amount.

Anti-takeover Amendments
Supermajority Amendments
Classified Boards
Authorization or preferred stock

Poison Pills

Targeted Share Repurchases and

Standstill Agreement
In a targeted repurchase, often called greenmail, a
target firm repurchases through a private
negotiation a large block of its tock from
individual shareholders or a subset of shareholders
at a premium
Standstill Agreement is a voluntary contract in
which the stockholders who is bought out is agrees
not to make further investments in the target
company during a specified period of time.

Other Measures

Greenmail
White Knight
White Squire
Capital Restructuring
Litigation
Pac-Man Defense

Accounting for Merger

Accounting Methods
Pooling-of-interests method: retains historical
basis
Purchase method: requires determination of
new basis
Rules regarding treatment of goodwill

Pooling of Interests Accounting

Logic for when to use pooling:
Acquisitions are mainly by stock and nontaxable
Acquiring firm and target firm approximately the same
size
Consolidated income statement is a summation of each
account
Accounting treatment reflected in prior year financial data

WhyPooling is to be eliminated
Caused similar transactions to have different
accounting methods
Pooling provides less information
Ignores the values exchanged
Difficult to compare companies
Artificially boosts earnings
Transaction should be recorded based on
value that is given up in exchange

Purchase Accounting
One company is buyer records target at price
paid
Identifiable assets and liabilities assigned
portion of the cost (usually FMV)
Excess of price paid over acquired book net
worth assigned to

Tangible depreciable assets at FMV

Identifiable intangible assets with definite lives
Intangible assets with indefinite lives
Goodwill

Before Amalgamation
Gamma

Lambda

7000

3000

11000

4000

18000

7000

Share Capital (fv

Rs. 10 each)
Reserves and
Surplus
Share Premium

4000

1000

8000

2000

Debt

6000

4000

18000

7000

Fixed Assets (net)

Current Assets
Goodwill
Total Assets

Total Liabilities

Additional Information
For each share held in Lambda Company one
share of Gamma Company was given in exchange.
The issue price was fixed at Rs. 60 per share (Rs
10 face value; Rs 50 premium).
The fair market value of fixed assets and current
assets of Lambda Company was assessed at Rs.
5000 and Rs. 4500 respectively.

Pooling Method

After Amalgamation--Pooling
Gamma

Lambda

7000

3000

Gamma
Lambda
Company
10000

11000

4000

15000

18000

7000

25000

Share Capital (fv

Rs. 10 each)
Reserves and
Surplus
Share Premium

4000

1000

5000

8000

2000

10000

Debt

6000

4000

10000

18000

7000

25000

Fixed Assets (net)

Current Assets
Goodwill
Total Assets

Total Liabilities

Purchase Method

After Amalgamation--Purchase
G am m a
L am bda
G am m a
7000

3000

L am bda
C om pany
12000

11000

4000

15500

500

18000

7000

28000

S h a re C a p ita l (fv
R s. 1 0 each )
R e s e rv e s a n d
S u rp lu s
S h a re P re m iu m

4000

1000

5000

8000

2000

8000

5000

D ebt

6000

4000

10000

18000

7000

28000

F ix e d A s s e ts (n e t)
C u rre n t A s s e ts
G o o d w ill
T o ta l A s s e ts

T o ta l L ia b ilitie s

Accounting of Merger

Purchase Price Method (Pooling-of-interest no longer allowed

under FAS141).
Price paid over and above identifiable assets is goodwill.
Opening Balance Sheet combines the 2 balance sheets at their
net value (assets/liabilities at fair market value, using external
valuation if need).
All adjustments increase/decrease goodwill.

Separately, an acquisition reserve is setup for integration related

liabilities related to acquired company only.
Reduces overall book value, hence increase goodwill

12 months window to establish all adjustments, and a further 12

months to charge all costs against reserve.

Goodwill is no longer amortized (FAS 142) annual evaluation

and impairment, only if warranted at a BU level.