C1. Acquisitions and mergers versus other growth strategies

Question 1

To achieve its growth objectives, a company has 3 strategies it can use:

Answer 1

• Internal development (organic growth)
• Acquisitions/mergers
• Joint ventures

Question 2

Acquisitions vs internal development

Advantages of acquisitions

Answer 2

• Speed. An acquisition allows a company to reach a certain optimal level of production much quicker than through organic growth.
• Growth. Cheaper way of growing than internal expansion.
• Benefit of synergies. An acquisition may create synergies.
• Acquisition of intangible assets. A firm through acquisition will acquire not only tangible assets but also intangible assets (brand, reputation, customer loyalty etc) which are more difficult to achieve with organic growth.

Question 3

Acquisitions vs internal development

Disadvantages of acquisitions

Answer 3

• Acquisition premium. When a company acquires another company, it normally pays a premium over its present market value. Too large a premium may render the acquisition unprofitable.
• Lack of control over value chain. Assets or staff may prove to be lower quality than expected.
• Integration problems. Each company has its own culture, history and ways of operating, and there may exist aspects that have been kept hidden from outsiders.

Question 4

Acquisitions vs joint ventures
Advantages of acquisitions
Disadvantages of acquisitions

Answer 4

Advantages of acquisitions
• Reliability. Joint venture partners may prove to be unreliable or vulnerable to take-over by a rival.
• Managerial autonomy. Decision making may be restricted by the need to take account of the views of all the joint venture partners. There may be problems in agreeing on partners’ percentage ownership, transfer prices etc.
Disadvantages of acquisitions
• Cost and risk. Acquisitions will involve a higher capital outlay and will expose a company to higher risk as a result.
• Access to overseas markets. When a company wants to expand its operations in an overseas market, a joint venture may be the only option of breaking into the overseas market.

Question 5

Reasons for mergers and takeovers.

Answer 5

The main reasons why one company may wish to acquire the shares or the business of another may be categorised as follows:
• Operating economies. Elimination of duplicate facilities and many other ways.
• Management acquisition. Acquisition of competent and go-ahead team to compensate for lack of internal management abilities.
• Diversification. Securing long-term future by spreading risk through diversification.
• Asset backing. Company with high earnings: assets ratios reducing risk through acquiring company with substantial assets.
• Quality of earnings. Reducing risk by acquiring company with less risky earnings.
• Finance and liquidity. Improve liquidity/ability to raise finance through the acquisition of a more stable company.
• Tax factors. Tax efficient way of transferring cash out of the corporate sector. In some jurisdictions, it is a means of utilising tax losses by setting them against profits of acquired companies.
• Defensive merger. Stop competitors obtaining advantage.
• Strategic opportunities. Acquiring a company that provides a strategic fit.
• Asset stripping. Acquiring an undervalued company in order to sell off the assets to make a profit.

Question 6

Merger

Answer 6

A merger is the combining of two or more companies. Generally, by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock.

Question 7

An acquisition

Answer 7

An acquisition normally involves a larger company (a predator) acquiring a smaller company (a target).

Question 8

A demerger

Answer 8

A demerger involves splitting a company into two separate companies which would then operate independently of each other. The equity holders in the company would continue to have an equity stake in both companies.

Question 9

Types of mergers.

Answer 9

Mergers and acquisitions can be classified in terms of the company that is acquired or merged with, as horizontal, vertical or conglomerate. Each type of merger represents a different way of expansion with different benefits and risks.

Question 10

Horizontal merger

Answer 10

Horizontal merger is one in which company acquires another company in the same line of business. A horizontal merger happens between firms which were competitors and who produce products that are considered substitutes by their buyers. The main impact of a horizontal merger is therefore to reduce competition in the market in which both firms operate. The impact on market power is one of the most important aspects of an acquisition. By acquiring another firm, in a horizontal merger, the competition in the industry is reduced and the company may be able to charge higher prices for its products (although competition regulation may prevent this). To the extent that both companies purchase from the same supplier, the merged company will have greater bargaining power when it deals with its suppliers.

Question 11

Vertical mergers.

Answer 11

Vertical mergers are mergers between firms that operate at different stages of the same production chain, a between firms that produce complementary goods. Vertical mergers are either backward when the firm merges with a supplier (aim: control supply chain) or forward when the firm merges with customer (aim: control of distribution). Vertical mergers create the possibility of creating barriers to entry through vertical acquisition of production inputs.

Question 12

Conglomerate mergers.

Answer 12

Conglomerate mergers are mergers which are neither vertical nor horizontal. In a conglomerate merger a company acquires another company in a different, possibly unrelated, line of business (aim: diversification).

Question 13

Selecting an acquisition target

Answer 13

A company’s strategic planning should give focus for selecting an acquisition target. The strategic plan might be to diversify, or to find new geographical markets, or to find firms that have new skills/products/technology, or simply identify firms that are poorly managed and to turn them around and sell them on at a higher price. The criteria that should be used to assess whether a target is appropriate will depend on the motive for the acquisition.
Suppose a company decides to expand. Its directors will produce criteria (size, location, finances, products, expertise, management) against which targets can be judged. Directors and/or advisors then seek out prospective targets in the business sectors it is interested in. The team then examines each prospect closely from both a commercial and financial viewpoint against criteria. In general businesses are acquired as going concerns rather than the purchase of specific assets.

Question 14

Having identified the general type of target, two areas of particular importance are:

Answer 14

• Are there potential synergies with the target?

* Is there a likelihood of a good working relationship with the target?

Question 15

Working relationship.

Answer 15

Possible issues that impede good working relationship between the acquired company and its new owner include language, culture and strategic values. These issues should be examined as part of a due diligence investigation prior to a takeover being finalised.

Question 16

Assessing the target

Answer 16

Prior to takeover bid, investigations should be undertaken to assess the target, three types are common:
• Legal due diligence: checks for any legal concerns (pending litigation) and are there concerns about the costs of complying with the local regulatory environment
• Financial due diligence focuses on verifying the financial information provided (financial forecasts)
• Commercial due diligence: consider competitors and fuller analysis of the assumptions that lie behind the business plan.

Question 17

Potential reasons for failure of acquisitions:

Answer 17

Potential reasons for failure of acquisitions:
• Clash of cultures. Especially if the two firms follow different business strategies
• Uncertainty among staff. Lay-offs expected, the best staff often leave
• Uncertainty among customers. Customers fear post-acquisition problems and sales fall
• Unanticipated problems. Information systems may be more difficult to integrate than expected, assets and staff may prove to be lower quality than expected
• Paying too high a price for the target. Managers’ desire to grow may stem less from a desire to benefit shareholders and more from a desire to empire-build or to make the company less of a takeover target; so they may overpay to acquire the target.

Question 18

Post-integration strategy.

Answer 18

To minimize the risks of acquisition failure a firm should have a clear post-integration strategy. This should include:
• Control of key factors – e.g. new capex approval centralized
• Reporting relationships – appoint new management and establish reporting lines quickly
• Objectives and plans – to reassure staff and customers
• Organization structure – integrating business processes to maximise synergies
• Position audit of the acquired company – build understanding of the issues faced by the target via regular online employee surveys and strategy discussion forums with front line staff and managers.

Question 19

Synergies and types

Answer 19

Synergies: extra benefits resulting from an acquisition either from higher cash inflows and/or lower risk.
Synergies can be separated into three types: revenue, cost and financial.

Question 20

Revenue synergy:

Answer 20

Revenue synergy:
• which result in higher revenues for the combined entity,
• higher return on equity and
• a longer period when the company is able to maintain competitive advantage
May be due to sharing customer contacts and distribution networks or increased market power.

Question 21

Cost synergy:

Answer 21

Cost synergy:
• which result mainly from reducing duplication of functions and related costs, and from taking advantage of economies of scale; Sources of which include:
o Economies of scale (arising from e.g. larger production volumes and bulk buying);
o Economies of scope (which may arise from reduced advertising and distribution costs where combining companies have duplicated activities);
o Elimination of inefficiency;
o More effective use of existing managerial talent.

Question 22

Financial synergy:

Answer 22

Financial synergy:
• which result from financing aspects such as the transfer of funds between group companies to where it can be utilised best, or from increasing debt capacity. Sources of which include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made available to the other party in the business combination;
o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less bankruptcy risk and therefore cheaper borrowing;
o Diversification reduces risk (however this is a suspect argument, since it only reduces total risk not systematic risk for well diversified shareholders);
o High PE ratio companies can impose their multiples on low PE ratio companies (however this argument, known as “bootstrapping”, is rather suspect).

Question 23

Reverse takeover:

Answer 23

Reverse takeover: a situation where a smaller quoted company (S) takes over a larger unquoted company (L) by a share-for-share exchange. To acquire L, a larger number of S shares will have to be issued to L’s shareholders. This will mean that L will hold the majority of shares and will therefore have control of the company. The company will often be renamed, and it is normal for the larger company to impose its own name on the new entity.
A reverse takeover is a route to a company obtaining a stock market listing. Compared to an initial public offering (IPO), a reverse takeover has a number of potential advantages and disadvantages.

Question 24

Advantages of reverse takeovers

Answer 24

Advantages of reverse takeovers, it will obtain all the benefits IPO provides and also:
• Speed. An IPO typically takes between 1-2 years. By contrast, a reverse takeover can be completed in a matter of months.
• Cost. Unlike an IPO, a reverse takeover will not incur advertising and underwriting costs. In addition, a reverse takeover results in two companies combining together, with the possibility of synergies resulting from this combination.
• Availability. In downturn, it may be difficult to stimulate investor appetite for an IPO. This is not an issue for a reverse takeover.

Question 25

Disadvantages of reverse takeovers

Answer 25

Disadvantages of reverse takeovers
• Risk. There is a risk that the listed company being used to facilitate a reverse takeover may have some liabilities that are not clear from its financial statements
• Lack of expertise. Running a listed company requires an understanding of the regulatory procedures required to comply with stock market rules. There is the risk that the unlisted company that is engineering the reverse takeover does not have a full understanding of these requirements.
• Share price decrease. If the shareholders in the listed company sell their shares after the reverse takeover then this could lead to a sharp drop in the share price.