Chapter 14 - Pricing and post-transaction issues

Question 1

Managing the financing of the bid

Answer 1

• How to obtain cash for a cash bid is a gearing decision – a cash bid does not necessarily mean the gearing will rise, although this will often be the case

Question 2

What is a share exchange?

Answer 2

One company acquires another company by issuing shares to pay for the acquisition

Question 3

Financing Cash Offers:

Answer 3

1. Cash from retentions:
   * Common when the firm to be acquired is small in relation to the acquiring firm, but not very common when the firm to be acquired is large
   * A company may occasionally divest some of its assets to accumulate cash prior to bidding for another company
2. Proceeds of a debt issue (bond issue):
   * Not normally taken because the act will alert the markets of its intentions to bid for another company and may lead to investors buying shares of the potential target, raising their prices
3. Loan facility from a bank:
   * Done as a short-term strategy until the bid is accepted and then the company is free to make a bond issue

Question 4

Financing by Paper Issues:

Answer 4

Shares are issued to finance the acquisition

Shares might be issued:

1. In exchange for shares in the target company
   * Takeover for a paper consideration
   * May often be accompanied by a cash alternative
   * Paper bid could also include issue of bonds to target shareholders
2. To raise cash on the stock market
   * Cash will be used to buy target companies shares
   * To the target company, this is a cash offer

• Both arrangements will end in an increase in issued share capital of the predator company

Question 5

The choice between a cash offer and a paper issue:

Answer 5

• The choice will depend on how the different methods are viewed by the company and its existing shareholders and the shareholders of the target company
• The acquisition will often be financed by a mixture of cash and shares

Question 6

The choice between a cash offer and a paper offer - factors to be considered by the directors of the bidding company

Answer 6

• Cost to the company = use of bonds to back a cash offer will attract tax relief and is cheaper than equity
• Gearing = highly geared companies may not be able to issue further bonds to obtain cash
• Taxation = if consideration is in cash, many investors may suffer immediate liability to tax on capital gains
• Dilution of EPS = may occur if purchase consideration is in equity shares
• Control = control could change considerably if a large number of new shares are issued
• Future investments = shareholders who want to retain stake in target business may prefer shares
• Share price = if consideration is shares, recipients will want to be sure that their shares retain their value

Question 7

Other issues to consider:

Answer 7

1. Convertibles:
   * Allow the target shareholders the possibility of sharing the benefit of any gains from the acquisition
   * Use is fairly rare, but more commonly used by a company to raise finance for a cash bid
2. Earn-out arrangements:
   * Earn-out arrangement = procedure whereby the owners selling the entity receive a portion of their consideration linked to financial performance of the business during a specific period after a sale
   * The arrangement gives a measure of security to the new owners, who pass some of the financial risk to the sellers

Question 8

Earn-out arrangement considerations may be structured as follow:

Answer 8

• An initial amount payable at the time of acquisition
• A guaranteed minimum amount of deferred consideration payable in a period of time
• An additional amount of deferred consideration payable if a specific target performance is achieved over a period of time

Question 9

Managing the refinancing of the target’s debt:

Answer 9

• Some debt agreements carry a change of control clause that states when a company completes an acquisition it may have to refinance the target company’s debt
• This may require a short-term line of credit to act as a bridging loan while refinancing is arranged
• A bidding company will have to ensure that sufficient funds are available to purchase the shares of the target company and to repay the debt in the target entity

Question 10

Assessing the post-acquisition value of the shares

Answer 10

• How much a paper is worth depends on the value of the shares post-acquisition
• Acquiring company = will issuing more shares result in a fall in the share price post-acquisition?
• Target company = what will the value of the shares being offered be post-acquisition?

Question 11

Evaluating a paper bid:

Answer 11

General approach for estimating the post-acquisition share price:

1. Value the target company (Main approaches are cash flow or earnings valuation methods)
2. Add this to the value of the company making the bid
3. Include the value of the synergy
4. Divide by the new number of shares in issue to get the estimated post-acquisition share value

Question 12

Describe the P/E ratio post-acquisition

Answer 12

1. If a high growth company acquires a low growth company in the same sector, the market may assume that the low growth company will be turned around by the high growth company
   * Low growth company after acquisition would be assumed the have a high P/E ratio
   * As long as the paper bid is not over-generous, the acquisition of a low growth company should increase the EPS of the acquiring company (bootstrapping)
2. If the acquisition is in a different sector or if the market does not believe the target company will be turned around, the P/E ratio will remain low alongside low growth

Question 13

Impact of synergies:

Answer 13

The post-acquisition value should rise (assuming an efficient stock market) by the value of expected synergies

Question 14

The directors of a company may choose to contest a bid on the following grounds:

Answer 14

• The offer may be unacceptable because the terms are poor – rejection of the offer may lead to an improved bid
• The merger/takeover may have no obvious advantage
• Employees may be strongly opposed to the bid
• Founding members may oppose the bid and appeal to the loyalty of other shareholders

Question 15

Post-bid defences:

Answer 15

• Attacking the logic of the bid
• Attacking the track record of the bidder
• Searching for an alternative bidder
• Launching a share buyback scheme
• Considering an MBO
• Lobbying for investigation of the bid by the competition authorities

Question 16

Pre-bid defences:

Answer 16

• Best defence is to have an efficiently run company with no underutilised assets – will contribute to excellent relationships with shareholders and will help to maximise share price which help deter takeover bids
  1. Poison Pills
  2. Golden Parachutes
  3. Competition authorities

Question 17

Poison pills:

Answer 17

• Triggered if a hostile bid is made or stake by key shareholder rises above a certain level key level
• E.g. new shares are issued to existing shareholders at a discount or convertibles can be exchanged into ordinary shares on favourable terms
• Controversial because they hinder an active market for corporate control
• By giving directors the power to deter takeovers they put directors in positions to enrich themselves as they will be compensated for the price of consenting to a takeover

Question 18

Golden parachutes:

Answer 18

• Massive pay-outs for existing members of the board

* Frowned upon and may be illegal or non-compliant with certain codes

Question 19

Competition authorities:

Answer 19

• Any acquisition that will lead to a substantial lessening of competition will be investigated by competition authorities
• A detailed investigation may take 6 months to complete and can result in a block to the bid or requirement that the acquiring company disposes of parts of the acquired business

Question 20

What is an exit strategy?

Answer 20

Way to terminate ownership of a company/ part of company

Question 21

Motives for exit strategies

Answer 21

1. Raising cash = selling of a division for cash could help ease the group’s liquidity problems or improve groups gearing
2. Disposal of non-core businesses = if there is no synergy, it may be better to sell off neglected divisions that is seen as not being core to the group’s future strategy
3. Takeover defence = selling off underperforming divisions may deter a takeover bid that aims to add value by debundling the company

Question 22

Types of exit Strategy:

Answer 22

1. Divestment (or sell off)
2. Demerger (or spin-off)
3. Management buy-out (MBO)

Question 23

Divestment (or sell-off):

Answer 23

• Sale of part of a company to a third party – method of raising cash
• Sale of a division will add value is the estimated sales price exceeds the present value of lost cash flows
• Buyer may be prepared to pay more than present value of cash flows because under their ownership the business is worth more (synergies)
• To value a division, a cost of capital that reflects the risk of the division will be required

Question 24

Demerger (or spin-off):

Answer 24

1. Involves splitting up the business into two or more companies without raising cash
2. Aims of demerger is to create a clearer management structure and to allow faster decision making
3. May facilitate a future merger/ takeover
4. Risks losing synergies between different parts of the group
5. It is also expensive and time consuming process
6. Assets & liabilities will have to be clearly segregated
7. To value a demerger, a cost of capital reflecting the risk of the division will be required

Question 25

Management buy-out (MBO):

Answer 25

1. Form of divestment involving selling part of the business to its management team
2. Raises cash, allows disposals of non-core business and a possible takeover defence
3. May be preferred to a sell-off because:
   * It allows a division to be sold with the co-operation of divisional management, and a lower risk of redundancies
   * Less likely to attract the attention of competition authorities
   * In a similar way to demergers, management-owned operations may be able to achieve better performance because of greater personnel motivation, quicker decision making and savings in overheads

Question 26

Financing issues of MBO:

Answer 26

• Mainly financed by a venture capitalist/ private equity provider
  1. Venture capitalists:
• Will usually want to see that managers are financially committed to the venture as well
• Venture capitalists can also be a source of strategic advice and business contacts
  2. Private Equity company
• Type of finance offered will not only be in the form of an injection of equity it may also invest via convertibles (mezzanine finance – both equity & debt) or bank loans
• If the PEC is concerned about the risk of an MBO, it will increase the proportion of its investment that is non-equity or involve banks by using the assets as security for the loans (leveraged buy-out)
• Venture capitalists and PEC will normally expect to exit their investment through floatation or sale to another firm

Question 27

Post-acquisition integration:

Answer 27

• Failures of takeovers often result from inadequate integration of the companies after takeover
• There is a tendency for senior management to devote their energies to the next acquisition rather than the newly acquired firm
• The particular approach adopted will depend on the culture and nature of the company acquired and how it fits into the amalgamated organisation

Question 28

Drucker’s Golden Rules for post-acquisition integration (MARCH):

Answer 28

1. Management – within one year the acquiring company should put top management with relevant skills in place
2. Add value – acquiring company must ensure it adds value to the target (ensure targets are set, communicated to customers and synergies are realised)
3. Respect – acquiring company must show respect to products, management and track record of the target
4. Common core – ensure there is a common core of unity (take actions to ensure systems are compatible)
5. Holding on – strategies should be developed for holding on to existing staff (e.g. Loyalty bonusses)

Question 29

Service contracts for key personnel:

Answer 29

• The predator company might want to ensure that key personnel, on whom the success of the company has been based, do not leave after takeover occurs
• Might be necessary to insist as a condition of the offer that the key personnel should agree to sign service contracts to tie them to the company for a certain time
• Service contracts should be attractive to the employees (offering a high salary or other benefits such as share options in the predator company)
• Where key personnel are shareholders, they might be bound not to sell shares for a period

Question 30

Merging systems:

Answer 30

1. Complete absorption of the firm
   * Cultures, operational procedures and organisational structures are fused together
   * Most suitable where significant cost reductions are expected to be achieved through economies of scale and combining marketing and distribution efforts to enhance revenues
   * Might be best to use the systems already in place and initially supplemented by requests for additional reports for adequate info and control flows between two management bodies
   * As the integration process proceeds, the best aspects of each company’s systems will be identified and a common system developed
2. Preservation approach
   * Target company is to become independent subsidiary of the holding company
   * Most beneficial for the merger of companies with very different products, markets and cultures
   * Some changes will be needed to financial control procedures
   * Target company’s management may continue with their own cultures, operations and systems

Question 31

Post-audit:

Answer 31

• Post-audit should examine whether the acquisition achieved its aims (e.g. if synergies were achieved)
• Should be independent and used to learn from mistakes
• Existence of post-auditing process should ensure that the original synergy forecasts are not wildly optimistic