This is a part of my CFA Level 2 notes series. I will try and jot down the important points and ideas in each of the CFA readings, both for my reference as well as for my fellow aspirants who may benefit from it.
Being in Investment Banking for around 20 months now, I thought M&A would be a good way to start the Corp Fin section. Let’s start with the definitions.
Acquisition: The purchase of some portion (asset,definable segment, entire company) of another company.
Merger: Absorption of 1 company into the other.
Classification of mergers:
1.a Statutory merger: One company ceases to exist and all its assets become a part of the purchasing company
b. Subsidiary merger: Purchased company becomes a subsidiary.(Good if target as a good brand image)
c:Consolidation: Both companies terminate previous legal existence and become a part of a new company.
2.a.Horizontal mergers: Between companies in the same business, usually competitors(Exxon-Mobil)-Offers economies of scale. May face anti-trust issues.
b. Vertical mergers: Buys company in production chain(Types-forward: Producer buying distributor; backward: steel producer buying iron ore mining co.)
c. Conglomerate merger: Unrelated companies.(Generally frowned upon by shareholders.)
So now that we are done with the classification of mergers, let’s look at the
Motives for merger:
1.Synergy: Cost saving(economies of scale) and revenue enhancing(cross-selling of products).
2.Increasing market power: In horizontal by moving towards a monopoly, in vertical by reigning in atleast 1 of Porter’s forces.
3.Inorganic growth. 4.Acquire unique capabilities and resources. 5.Diversification 6. Managerial incentives
7.Bootstrap earnings: If target P/E is lower than acquirer P/E, and post merger P/E remains unchanged, then there are gains known as bootstrapped earnings.
8.Tax considerations(Buy companies with large tax losses) 9. Cross border motivations(Overcoming adverse govt policy, tech transfer etc)
Now that we have a broad idea about why a company may want to acquire, let’s dive into the nitty gritties of deal making, and the potential road blocks.
1.Form of acquisition: Can either be an asset purchase[ Payment to selling company, generally no shareholder approval, Target pays tax on capital gains] or stock purchase[Shareholder approval required, get payout and are taxed as individuals on any capital gains.]-Note: In the US, acquisition of target losses is not allowed for asset level sales.
2.Method of payment: Cash, securities or mixed.[If the acquirer is confident in its ability to derive value from the deal, a cash payment is advisable(Target S/H don’t get potential upside. On the other hand in cases where the acquirer’s shares are over valued, a securities payment would be advisable.)
3.Mindset: In case of friendly mergers, the acquirer will generally approach the target[Negotiations, due diligence and definitive merger agreement]. Hostile takeover on the other hand resort to a variety of methods like the bear-hug(Approaching target board directly, bypassing the CEO or a tender-offer(asking shareholders to sell at a given price) to acquire the target.
As you might have predicted, companies have many novel ways designed to hinder such unwanted advances, many of which are designed by I-bankers themselves! 😀
1.Pre-offer defence:1. Poison pill: This legal tool gives the right to the normal target share holders to buy shares of either the target or the acquirer at a discount to market once a certain level of ownership is reached leading to considerable dilution for the acquirer.The board generally has a provision to redeem this pill(nullify) in cases of friendly mergers.[Flip-in: Target shareholders have right to buy target shares at a discount. Flip-over:Target shareholders have right to purchase shares of acquring firm at a discount] To make matters tighter firms also have dead hand provisions that allow for redemption only by a vote of continuing directors.(i.e directors before takeover attempt).2.Poison put This allows the target bondholders to redeem their shares at a price typically above par.3.Staggered board of directors. 4. Incorporation in target friendly states 5.Golden parachutes(Large payouts to management post a change in corporate control.)6. Restricted voting rights(Board can deny voting rights if a certain percentage ownership is exceeded.)and supermajority voting provisions(eg 80%+ for merger approval) 7.Fair price amendment(Set floor for offer value)
2. Post-offer defence(We can have direct questions based on these strategies so remember the highlighted names):
1.Crown jewel defence(Sell off most lucrative subsidiary or asset to third party. 2.Pacman defence(If of similar size, make a counter offer to acquire the acquirer)
3. Litigation(Based on antitrust law) 4.White knight defence(A third party with a strategic fit buys target) 5. White squire defence(Friendly party buys out minority stake in target to block acquirer) 6. Greenmail: Pay substantial premium to acquirer to stop takeover attempt(also known as goodbye kiss!) 7. Share repurchase or leveraged buyout.
Mergers and acquisitions can alter the market dynamics drastically as a result of which certain external oversight is required. 1.Antitrust(Prohibits mergers that impede competition) 2. Securities laws(Better disclosures and formal tender offers)
This index was developed to judge the market concentration and take action according to the change in it.
HHI=∑(Sales of firm/Total market sales*100)^2
(<1000 Not con, no action, 1000-1500 Moderate-Action if change exceeds 100 points, >1800 concentrated, Action if change exceeds 50 points.)
We will now look into the three methods to value target companies:
1.DCF( Future FCFs discounted using WACC).
FCF= Netincome-Int(1-t)+ΔDTL+D&A-ΔWorking capital-Capex
2.Comparable company analysis [Peer multiples(P/E,EV/EBITDA etc) applied to target to get value range]3. Comparable transaction analysis[Multiples from recent takeover transactions used]
It is helpful to also keep in mind the gains that each of the parties get. A lot of the numerical questions are based on these two simple equations.
Acquirer=Synergies-Premium. [In actual analysis we will consider a lot of other factors like the interest saved on div, cost of financing, but they are all accounted for under a single heading for the purpose of the exam]
More CFA notes here: https://ganeshnagarsekar.wordpress.com/cfa-notes/