<strong>Acquisitions</strong>: When an acquiring company buys a portion of a target company.

<strong>Merger</strong>: When an acquiring company buys all of a target company; the acquirer remains and the acquired no longer exists as an independent corporate entity.
<h2><strong>Integration Forms</strong></h2>
M&amp;A transactions can be segmented by the manners in which the acquired is integrated with the acquirer.
<ul>
	<li><strong>Subsidiary Merger</strong>: the target becomes a subsidiary of the acquiring company.  The acquiring company may use this form of integration in order to retain the brand recognition of the acquired entity.</li>
</ul>
<ul>
	<li><strong>Statutory Merger</strong>: the acquired no longer exists; it becomes part of the acquirer.</li>
</ul>
<ul>
	<li><strong>Consolidation</strong>: neither the acquired, nor the acquirer remain, rather both combine to form a new company.</li>
</ul>
<h2><strong>Merger Types</strong></h2>
<ul>
	<li>Mergers can also be described by the way the business operations of the acquirer and the target relate to one another.</li>
	<li><strong>Horizontal Mergers</strong>: the combination of two companies in the same business line.  For example, one beverage production company may decide to purchase another beverage production company.</li>
	<li><strong>Vertical Mergers</strong>: the purchase of a target company which performs an upstream or downstream function in the acquirer’s industry value chain.</li>
<ul>
	<li><strong>Backward Integration</strong>: the acquirer purchases a company closer to the raw material extraction phase of the industry value chain.  For example, a natural gas commercial distributer may decide to purchase a natural gas miner.</li>
	<li><strong>Forward Integration</strong>: the acquirer purchases a company closer to the market delivery phase of the industry value chain.  For example, a gold miner may decide to purchase a chain of retail jewelry stores.</li>
</ul>
	<li><strong>Conglomerate Merger</strong>: this is the case where an acquirer purchases a company in an unrelated line of business.  For example, an airplane manufacturer may decide to purchase a chain of hospitals.</li>
</ul>
<h2><strong>Reasons for M&amp;A</strong></h2>
Ideally, mergers are executed with the expectation that the target will increase the equity value of the acquirer.  Below some common merger motivations are described.
<ul>
	<li><strong>Cost Synergies</strong>: Mergers have the potential to lower costs for the combined companies, either through the elimination of redundant functions or by eliminating profits from “middle-man” points in the value chain.</li>
	<li><strong>Revenue Synergies</strong>: Mergers may provide the combined companies an opportunity to cross sell complementary products.</li>
	<li><strong>Growth</strong>: An acquisition might provide a company with more rapid growth potential than organic growth provided by reinvesting earnings.</li>
	<li><strong>Pricing Power</strong>: A horizontal merger can reduce competition and allow the acquirer to raise its prices.  A vertical merger can allow the acquirer to better control prices downstream or upstream in the value chain. When a merger has the potential to provide an acquirer with too much market power, government regulations may prevent the merger from taking place.</li>
	<li><strong>Increased Capability</strong>: An acquiring company may pursue a target for its in-house technical expertise.</li>
	<li><strong>Unlocking Value</strong>: An acquirer may view a target as underperforming financially and feel confident that it can facilitate the realization of the target’s full potential after taking control.</li>
	<li><strong>Diversification</strong>: Companies themselves are investors who seek to reduce risk and increase returns through the successful deployment of capital.</li>
	<li><strong>International M&amp;A Concerns</strong>: Companies may engage in M&amp;A beyond their domestic borders for multiple financial or strategic reasons.</li>
</ul>

Overview of Mergers & Acquisitions

<ul>
	<li>It can be possible, following a merger that the acquiring firm demonstrates earnings per share (EPS) growth, which is deceptive because no real synergies were ultimately realized.</li>
	<li>For example, an acquiring company may nominally show a 50% post merger growth to EPS, even though shares outstanding increased by only 25%.</li>
	<li>The illusion of economic value from gains to EPS growth is known as the “bootstrap” effect.  Well trained analysts will revise their price to earnings ratios in recognition of this valuation fallacy.</li>
	<li>Candidates may be required to interpret a bootstrap M&amp;A scenario on the exam, so it is advised to practice detailed problem examples to better understand the phenomenon.</li>
</ul>

M&A: Earnings Per Share & The “Bootsrap” Effect

M&amp;A activity can vary depending on the acquirer and/or target’s phase in the industry lifecycle.

<img class="aligncenter size-full wp-image-5833" title="Industry Lifecycle" src="https://financetrain.com/wp-content/uploads/life_cycle.gif" alt="" />
<ul>
	<li><strong>Pioneering Phase</strong>: start-up founders may opt to “cash out” of their promising ventures by selling to larger companies that are seeking growth opportunities.  Horizontal and conglomerate mergers.</li>
	<li><strong>Accelerating Growth Phase</strong>: highly profitable and fast growing companies in new industries may sell themselves to more established companies in order to access capital for business expansion.  Horizontal and conglomerate mergers.</li>
	<li><strong>Mature Growth Phase</strong>: larger companies with slowing growth rates may look for targets with value potential or targets that can facilitate economies of scale.  Horizontal and vertical mergers.</li>
	<li><strong>Industry Maturity Phase</strong>: an acquiring company is now growing around the same pace as that of the economy; it will look for targets that can increase economies of scale or invest in small growing concerns that provide return opportunities for shareholders.  Horizontal mergers.</li>
	<li><strong>Decline Phase</strong>: overall industry is shrinking; an acquirer may look for synergies, to buy profitability of younger firms, or to simply survive.  Horizontal, conglomerate, and/or vertical mergers.</li>
</ul>

Industry Lifecycle Phase and M&A

A company may set up preemptive defense mechanisms in order to help ensure that it remains independent or to increase its purchase price.

<strong>Rights Based Defenses</strong>: These are shareholder actions that can be taken to make the company less attractive to a would-be acquirer.
<ul>
	<li><strong>Poison Pills</strong>: Trigger the issuance of target company stock at a discounted price to dilute earnings.</li>
<ul>
	<li><strong>Flip-in Pill</strong>: Target company shareholders can buy stock at a discount, once one share owner crosses a specific ownership threshold.</li>
	<li><strong>Flip-over Pill</strong>: Target company shareholders can buy the acquirer’s stock at a discount from the market price.</li>
</ul>
	<li><strong>Shark Repellants</strong>: Can change the target’s corporate charter with no action from shareholders, in order to fend off a hostile acquirer.</li>
<ul>
	<li><strong>Strategic Incorporation Location</strong>: In some jurisdictions it may be easier to resist hostile takeovers, so companies may select one of these locales for incorporation.</li>
	<li><strong>Staggering Board Terms</strong>: While considered less than optimal from a corporate governance standpoint, staggered board elections can increase the amount of time takes a would-be acquirer to get board representation.</li>
	<li><strong>Golden Parachutes</strong>: Offer payouts to pre-merger executives if they depart following the change in control.  Arguably a weak defense, given that the acquiring firm may be fully prepared to pay up in order to remove the existing management team.</li>
	<li><strong>Fair Price Amendments</strong>: Sets a price floor for the would be acquired firm’s shares.</li>
	<li><strong>Supermajority Provisions</strong>: Requires a shareholder vote approving the merger well above a 51% simple majority in order for the takeover to be allowed.</li>
	<li><strong>Voting Rights Restrictions</strong>: Requires a large shareholder to obtain board permission to vote once a certain ownership threshold has been crossed.</li>
</ul>
</ul>

Pre-Offer Defense Takeover Mechanisms

<ul>
	<li><strong>Just Say No</strong>: Management can decline an acquirer’s offer and attempt to convince the board that a takeover is not best for the firm.</li>
	<li><strong>Greenmail</strong>: The target reaches an agreement to repurchase shares from a would be acquirer at a premium.</li>
	<li><strong>Litigation</strong>: Most effective as a delay tactic, a target can use the court system to contend that a takeover would materially harm the competitive structure of the industry.</li>
	<li><strong>Leveraged Share Repurchase</strong>: A target may borrow in order to buy shares on the market; this can drive up the price for the acquirer and also increase the risk of the target’s balance sheet.  In its extreme form, target company management may use debt to buy all of the shares and take the target company private; this would be a leveraged buyout.</li>
	<li><strong>Leveraged Recapitalization</strong>: Similar to the leveraged share repurchase, but will leave some equity to trade in the public stock exchange.</li>
	<li><strong>White Knight</strong>: Target seeks a third party to make the purchase, in order drive the hostile acquirer out of the picture.</li>
	<li><strong>White Squire</strong>: Target seeks a third party to purchase enough shares in order to prevent full acquisition by a hostile buyer.</li>
	<li><strong>Crown Jewel</strong>: Target sells off one its top assets in order to make purchase by an acquirer less attractive.</li>
	<li><strong>Pac Man</strong>: Target flips the script as the target responds by attempting to buy the would be acquirer.</li>
</ul>

Post-Offer Defense Takeover Mechanisms

<ul>
	<li>HHI measures market concentration and is a metric used by government oversight bodies in the U.S. to determine if a merger should be allowed or blocked.</li>
	<li>HHI calculates the sum of squared market shares for competing companies.</li>
</ul>
<div class="formula1">HHI = ∑ ((Sales <sub>firm i</sub> / Sales <sub>Market</sub>) * 100)) <sup>2</sup></div>
<ul>
	<li>For an individual firm, HHI is calculated once; for a merger of two companies the HHI of the combined entity will be the sum of their individual market share HHI values.</li>
	<li>When HHI crosses a certain threshold, the government may legally challenge the proposed merger.</li>
</ul>
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">COMBINED ENTITY HHI</th>
<th scope="colspan">HHI CHANGE</th>
<th scope="colspan">GOVERNMENT RESPONSE</th>
</tr>
<tr>
<th class="spec" scope="row">&lt; 1,000</th>
<td>Irrelevant</td>
<td>None.</td>
</tr>
<tr>
<th class="specalt" scope="row">1,000 - 1,800</th>
<td class="alt">≥ 100</td>
<td class="alt">Potential legal challenge to merger.</td>
</tr>
<tr>
<th class="spec" scope="row">1,800+</th>
<td>≥ 50</td>
<td>Definite government challenge to merger.</td>
</tr>
</tbody>
</table>
<ul>
	<li>Note that a small change to HHI in a heavily concentrated industry may be more scrutinized than a large change to HHI in a highly competitive industry.</li>
	<li>In the U.S., the Justice Department will consider other factors that just the HHI, when determining whether or not to attempt to block a merger.</li>
</ul>

Herfindahl-Hirschman Index (HHI)

There are several widely employed methods for valuing a potential M&amp;A target; it is not uncommon for acquirers and investment banks to employ all of them when evaluating the attractiveness of a merger.
<ul class="list2">
	<li>Discounted Cash Flow (DCF) Analysis</li>
	<li>Comparable Company Analysis</li>
	<li>Comparable Transaction Analysis</li>
</ul>
<h2>Discounted Cash Flow (DCF) Analysis</h2>
This is a derivative of the Gordon Growth approach to valuing a company, where an acquirer may discount free cash flows to the firm (FCFF) to value a potential target.
<ul class="list2">
	<li>FCFF is important because it incorporates contributions of all suppliers of capital - both debt and equity.</li>
	<li>DCF analysis attempts to determine the intrinsic value of the firm (i.e. the net present value of expected future cash flows).</li>
	<li>By breaking down the cash flows, DCF analysis allows for an analyst to estimate the potential value created by synergies.</li>
	<li>DCF analysis can be challenging because valuation relies on a number of estimates and assumptions that might not be fully known.</li>
	<li>Candidates should review the steps of a DCF valuation and practice them in preparation for the exam. This is also relevant to the Equity sessions.</li>
</ul>
<h2>Comparable Company Analysis</h2>
The analyst will evaluate a target within the context of a group of relevant peer firms.
<ol>
	<li>The analyst must compile a list of comparable companies; the list may go beyond just firms in the target's industry, but include other companies of similar size and similar capital structure.</li>
	<li>The analyst must then select the appropriate equity and/or enterprise valuation metrics (note: enterprise metrics sum the value of debt and equity less cash and marketable securities).</li>
	<li>The analyst will then apply the selected valuation metrics to the target and its "comps."</li>
	<li>The analyst will then calculate the takeover premium (per share), which is the excess of the merger price per share over the pre-merger market price per share of equity divided by the pre-merger price per share.</li>
	<li>The analyst will then evaluate the takeover premium within the context of the comparable company valuations to determine a possible acquisition price.</li>
</ol>
<h2>Comparable Transaction Analysis</h2>
This method allows for the direct estimation of a target's value by observing prices from recent acquisitions.
<ol>
	<li>The analyst identifies transactions that are comparable for the target in question. In this method, industry similar transactions are preferred.</li>
<ul class="list2">
	<li>For example, if an analyst is looking at a potential software company merger, he/she would not review recent bank acquisition prices.</li>
</ul>
	<li>Just like in a comparable company analysis, the analyst will identify valuation metrics.</li>
	<li>The analyst will then apply the valuation metrics to the target firm.</li>
<ul class="list2">
	<li>For example, if an analyst is looking at a potential software company merger, he/she would not review recent bank acquisition prices.</li>
</ul>
</ol>
This method is very attractive for evaluating M&amp;A actions, but it can be very difficult to find truly comparable transactions and a number of adjustments may need to be made to the "comparable" transactions used in the analysis to make them relevant to the target in question.

Valuing Target Companies

<h2>Merger Gains to Shareholders</h2>
<strong>Shareholders of the Target:</strong> The value paid for the target’s shares in excess of the pre-merger market price is the takeover premium. The amount of the takeover premium is a gain for the target’s shareholders.

<strong>Shareholders of the Acquirer</strong>: The shareholders of the acquiring company are assuming greater risk in the merger because their gains hinge on the ability of management to create synergy value that exceeds the takeover premium.
<div class="formula1">Gains for Shareholders <sub>acquirer</sub> = Synergies – Takeover Premium</div>
If synergies do not exceed the takeover premium, then value for shareholders of the acquirer will be negative (i.e. a decline in share price).
<h2>Post Merger Valuation</h2>
Assuming that the acquiring firm has made correct estimates in the valuation process, the following formula will calculate the post merger value of the acquirer:
<div class="formula1">V <sub>Acq. Post-merge</sub> = V <sub>Acq. Pre-merge</sub> + V <sub>Target pre-merge</sub> + Synergies – Cash <sub>paid to target firm shareholders</sub></div>
 

Merger Gains to Shareholders & Post Merger Valuation

Strategic decisions made by corporations are not limited to expansion; sometimes the decision to downsize can benefit the company’s valuation. In this article, we will discuss the various forms of restructuring.

<strong>Divesture</strong>

This action is the sale of a business unit to an outside company (note that divestures are sometimes forced upon companies under antitrust law).  Below are some reasons for divestures:
<ul>
	<li>Sometimes a firm may divest a business unit to raise cash.</li>
	<li>Sometimes a subsidiary no longer falls within the firm’s strategic plans.</li>
	<li>Sometimes a reverse synergy is created when business units are worth more separately than combined under the firm.</li>
	<li>Sometimes a firm simply cannot earn an appropriate rate of return on a business unit and will sell to a buyer with better capabilities in that specific area.</li>
</ul>
<strong>Spin-offs</strong>

In this restructuring instance, a company will establish a new legal entity from one of its business units.  Spin-offs can also be forced by law.
<ul>
	<li>Shareholders at the time of the spin-off will get a proportional amount of shares in the spun-off entity.</li>
	<li>While a divesture infuses cash into the company, a spin-off does not.</li>
	<li>A spin-off may be undertaken to allow company management to focus on “core” operations.</li>
</ul>
<strong>Equity Carve Out</strong>

The company sells a business unit in the form of public offering.
<ul>
	<li>A carve out may be done to reduce exposure to a high risk business unit.</li>
	<li>Carve outs create cash for the company; spin offs do not.</li>
	<li>Carve outs are more expensive than spin offs because of the transactions costs associated with a new public offering.</li>
	<li>While shareholders of the parent may buy shares in a carve out, a new shareholder base is created.  In a spin off, initially the existing shareholder base is intact.</li>
</ul>
<strong>Split-off</strong>

Hybrid of the spin off and carve out, where the parent will give shareholders an equity stake in the isolated business unit, but in return the company receives back some of its outstanding shares.  A split-off does not provide a cash infusion, but does reduce the parent’s shares outstanding.

<strong>Liquidation</strong>

This involves the selling of the business in pieces and is commonly associated with bankruptcy proceedings.

Types of Restructuring

Mergers & Acquisitions

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COURSE

Mergers & Acquisitions

Lessons

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