C4. Financing acquisitions and mergers Flashcards
The most common ways of paying for a target company’s shares are by offering:
- Cash. If the purchase consideration is in cash, the shareholders of the target company will simply be bought out.
- Paper ((shares, or possibly convertible bonds). A purchase of a target company’s shares with shares of the predator company is referred to as a share exchange.
- The choice will depend on: available cash, desired level of gearing, shareholders’ taxation position and change in control.
A cash offer can be financed from:
- Cash retained from earnings. This method is used when the predator company has accumulated profits over time and is appropriate when the acquisition involves a small company and the consideration is reasonably low. This method may be the cheapest option of finance.
- The proceeds of a debt issue. That is the company may raise money by issuing bonds. This is not an approach that is normally taken, because the act of issuing bonds will alert the markets to the intentions of the company to bid for another company and it may lead investors to buy the shares of potential targets, raising their prices.
- A loan facility from a bank. This can be done as a short-term funding strategy, until the bid is accepted and then the company is free to make a bond issue.
- Mezzanine finance. This may be the only route for companies that do not have access to the bond markets in order to issue bonds. Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an equity interest in the company in case of default, after venture capital companies and other senior lenders are paid. It is also used when the company has used all bank borrowing capacity and cannot also raise equity capital. It is of higher risk than normal forms of borrowing.
- Vendor placing. In a vendor placing the predator company issues its shares by placing the shares with institutional investors to raise the cash required to pay the target shareholders.
Purchases by share exchange.
One company can acquire another company by issuing shares to pay for the acquisition. The new shares might be issued:
• In exchange for shares in the target company. Thus, if A acquires B, A might issue shares which it gives to B’s shareholders in exchange for their shares. This is a takeover for a paper consideration.
• To raise cash on the stock market, which will then be used to buy the target company’s shares. To the target company shareholders, this is a cash bid.
Alternative forms of paper consideration
, including bonds, loan notes and preference shares are not commonly used, due to:
• Difficulties in establishing a rate of return that will be attractive to target shareholders
• The effects on the gearing levels of the acquiring company
• The change in the structure of the target shareholder’s portfolios
• The securities being potentially less marketable, and possibly lacking voting rights
Issuing convertible bonds will overcome some of these drawbacks, by offering the target shareholders the option of partaking in the future profits of the company if they wish.
Refinancing of the target’s debt.
Many debt arrangements carry a change of control clause which means that when a company completes an acquisition it may well have to refinance the target company’s debt. The acquiring company will need to ensure that it has factored this into its financial planning. This may require a short-term line of credit to act as a bridging loan while refinancing is being arranged.
Earn-out arrangements.
With any form of financing the acquirer can reduce risk by including deferred payments which are linked to future performance targets – these are referred to as earn-out arrangements. This is also a method of keeping previous owner-managers motivated post-acquisition, as they continue to benefit from good performance.
Leveraged buyouts (LBO)
is a takeover of a company by an investor (often private equity) using significant debt. Typically, the debt used to fund the takeover is secured on the assets of the target company. The cashflow generated by the target company is then used to service and repay the debt. The target company would normally need to have low existing debt, stable cashflows and good asset backing. This approach allows a private equity investor to acquire a large company with minimal cash or risk, since they are borrowing against the acquired company’s assets and earnings. A range of different debt is usually used, and any short-term debt instruments may need re-financing soon after the deal. The overall aim is to improve the running of the target over a 3-5-year period, generate additional profits, repay the debt and sell the company for a profit.
Impact of cash offer
Impact of cash offer (gearing decision as to how to obtain cash required).
• Value. Cash has a definite value; this will often be attractive to shareholders in the target company and may enhance the chances of a bid succeeding.
• Control. Less impact on the control exercised by the owners of the bidding company, although any new debt used may carry restrictive covenants.
• Gearing. Gearing may rise if cash is raised by borrowing, this may bring benefits in terms of tax savings on debt finance or may cause problems if it affects a company’s credit rating.
• Tax. Exposes a shareholder in the target company to capital gains tax (CGT), although this is not an issue for some investors.
• Risk. The risk of problems post-acquisition is borne by the acquirer – if the share price falls post-acquisition then this only affects the acquirer as the target company shareholders have received their definite cash payment.
Impact of paper offer.
Impact of paper offer.
• Value. Shares have an uncertain value, often a higher price will have to be offered if the bid is a paper bid than if it was a cash bid to compensate the target’s shareholders for this.
• Control. The percentage of the shares owned by the bidding company’s shareholders will be reduced as more shares are issued, so their control will be diluted.
• Gearing. Gearing will fall as more equity is issued.
• Tax. Gain is not realised for tax purposes until shares are sold – the timing of share sales can be staggered across different years to maximise the use of CGT allowances
• Risk. Post-acquisition risk is shared between the bidding company and the target – if the share price falls post-acquisition this affects both.
Mixed offer.
Mixed offer. Because cash might be preferred by some shareholders (e.g. due to certainty) and paper by others (e.g. wanting to share in anticipated gains from a takeover), it is not uncommon for an acquisition to be financed by a mixture of cash and shares.
Evaluating a cash offer.
A cash bid can simply be compared against the current market value of the target company or against an estimated value of an acquisition. While a significant premium above the market price is often expected (20-30% is not uncommon), it is important (to the buyer) that the amount paid is not greater than the value that will be generated from the target company under new ownership.
Evaluating the paper/mixed offer.
How much a paper bid or bid that is partly financed by the issue of paper, is worth can be assessed quickly by looking at the value of the shares of the bidding company before acquisition. However, a more accurate valuation would be based on the value of the shares post-acquisition. The value of the shares post-acquisition will be matter of concern for both the bidding and target company:
• The bidding company will not want to issue so many shares that its share price falls post-acquisition, and there may also be concerns about the effect of a paper bid on diluting the control of existing shareholders.
• The target company will want to estimate the likely post-acquisition value of the shares to assess the attractiveness of the takeover bid.
Post-acquisition value using earnings.
• Estimate the group’s post-acquisition earnings including synergies
• Use an appropriate P/E ratio to value these earnings
• If necessary:
o Deduct the cash element of the bid and then divide by the new number of shares in issue to calculate a post-acquisition share price (for bidding company to assess whether share price will fall or rise, for target company to estimate share value and attractiveness of bid).
o Deduct the value of the whole bid to see if value is created for the bidding company’s shareholders
Post-acquisition value using cash flows.
• Estimate the group’s post-acquisition cash flows including synergies
• Calculate an appropriate cost of capital and complete a cash flow valuation
• If necessary:
o Deduct the cash element of the bid and then divide by the new number of shares in issue to calculate a post-acquisition share price.
o Deduct the value of the whole bid to see if value is created for the bidding company’s shareholders
The impact of a given financial offer on the reported financial position and performance of the acquirer.
Place to start is to assess how the merger will affect earnings and earnings per share.
P/E ratios can be used as a rough indicator for assessing the impact on earnings. The higher the P/E ratio of the acquiring firm compared to the target company, the greater the increase in EPS to the acquiring firm.
Dilution of EPS occurs when the P/E ratio paid (price offered/EPS of the a target) for the target exceeds the P/E ratio of the acquiring company.
If there is the difference between the value of takeover bid and the net assets of the company being acquired is accounted for as goodwill in the consolidated statement of financial position. Consolidated statement of financial position may need to be analysed using ratio analysis.
