Chapter 5- M&A Advisory – Part I Flashcards
- Mergers & Acquisitions (M&A) is a general term used to refer to a wide range of corporate transactions
Acquisition
Merger-of-Equals
Sale or Divestiture
Take-Over Defense / Proxy Contests
Strategic Partnership
Leveraged Buyout
Restructuring
Review of Strategic Alternatives
Special Committee Assignment
Why Do Companies Pursue M&A Transactions?
- Companies pursue M&A transactions to create shareholder value
- The guiding principle of value creation is that companies create value by investing capital at rates of return exceeding the cost of that capital
Buyer Rationale for M&A
- Accelerate growth
- Strong strategic fit
- Competitive positioning
- Economies of scale / synergies
- Diversification
- Excess cash to deploy
- Shareholder value creation
Seller Rationale for M&A
- Value maximization
- Wealth planning / liquidity
- Non-core assets or division
- Redeployment of capital
- Shareholder pressure
- Inability to compete
Idea Generation and Deal Sourcing
- Idea generation involves identifying and pitching potential acquisition targets, merger opportunities or other strategic transactions to a client
- A typical “acquisition opportunities” or “M&A brainstorming” presentation includes:
- Market / Company Update
- Summary of Potential Acquisition Targets
- Strategic Rationale for Each Target
- Qualitative Analysis for Each Target
- Actionability
- Market Implications
- Approach Strategy
- Financing Alternatives and Considerations
- If a client expresses interest in a particular idea:
the investment banker can focus their attention on building or strengthening the relationship with the target in an attempt to facilitate a deal
– It can take several years before an identified idea becomes “actionable”, however if a client decides to pursue an opportunity they will typically hire the bank that raised the idea with them
- An investment banker’s ability to maintain a pulse on
both the market and the competitive landscape in a particular sector: are critical to getting hired as an advisor
Buy-Side Advisory Responsibilities: * The typical buy-side mandate includes the following responsibilities:
– Evaluating the potential target and its industry to identify key opportunities and risks
– Assessing the strategic fit of the target and identifying potential synergies
– Construction of a financial model that reflects the anticipated results going forward
– Establishing a baseline view on value and sensitizing for upside and downside scenarios
– Providing analysis on the financial implications of the deal under various financing structures
– Providing general financial advice (market impact, communication strategy, etc.)
– Developing a view on the competitive bidding universe (ie. who else is bidding? what can they afford to pay?)
– Coordinating due diligence, including commercial, financial, environmental, legal, HR, IT and other
– Identifying potential red flags in the due diligence process and following up accordingly
– Formulating a bidding strategy and helping negotiate the final terms of the deal
The M&A Toolkit–>
- Investment banks rely on various valuation methodologies and financial analyses to assess the merits of an M&A deal, including the following:
Valuation Methodologies:
– Trading comps
– Precedent transactions
– Discounted cash flow analysis
– Leveraged buy-out analysis
– Sum-of-the-partsanalysis
Supporting Analyses (Not a Basis for Valuation)
– Accretion/dilution analysis
– Ability-to-pay analysis
– Cash vs. stock consideration
– Synergy assessment
– Future share price analysis
– Analysisofprecedentpremiums
Accretion/Dilution Analysis (Public Company Metric)
- Accretion/dilution analysis is used to evaluate the impact a potential transaction will have on the acquirer’s earnings per share or free cash flow per share
A deal is considered “accretive” if:
it results in an increase in earnings per share or free cash flow per share
Accretion is often a:
prerequisite for a public company to pursue an acquisition
Key assumptions in an accretion/dilution analysis include:
purchase price, financing mix and estimated synergies
Accretion/Dilution Rules of Thumb
- EPS accretion/dilution in a transaction is determined by the “value” of the target’s share price per dollar of earnings (ie. Price / Earnings ratio) relative to the value of the acquisition currency being used by the acquirer
In an all-stock financed deal:
if the acquirer’s P/E ratio is greater than the target’s P/E ratio at the acquisition price (ie. 15.0x vs. 10.0x), the deal will be accretive to the acquirer’s earnings
– The acquirer’s stock is more valuable – the market is paying more for a dollar of the acquirer’s earnings
* Because debt is cheaper than equity, using more debt as consideration will always make a transaction more
accretive
In an all-debt financed deal:
the acquirer’s P/E ratio is irrelevant as the equity value of the acquirer is no longer the acquisition currency we are using to finance the deal
– To determine the value of the acquirer’s currency in an all-debt financed deal you need to calculate the inverse of the acquirer’s after-tax cost of debt (ie. debt yield). The deal will be accretive if:
* 1 / [(Cost of Acquirer Debt) * (1 – Acquirer Tax Rate)] > Target P/E
Example:
* After-tax cost of debt = 4.0%
* 1 / 4% = 25.0x (the acquirer can pay 25.0x EPS and generate neutral accretion)
* To determine the breakeven after-tax cost of debt at a given purchase price, you use the inverse calculation: 1 / 10.0x = 10.0%
Limitations of Accretion/Dilution Analysis
- Accretion analysis assumes that the acquirer will retain its existing P/E multiple after the deal, which results in value creation (ie. constant P/E multiple * Higher EPS)
- In reality, P/E multiples reflect the market’s perception of the quality and growth of earnings and transactions that are accretive in the short-term are not necessarily accretive to value in the long-term
- In a perfect market, the acquirer’s pro-forma P/E multiple should reflect a blend of its pre-deal P/E and the target’s P/E proportional to the earnings contribution of each business
– If Company A has a P/E multiple of 10.0x and acquires Company B at 15.0x, an all-stock deal will be dilutive – However, Company A’s P/E multiple should expand to reflect the addition of Company B’s higher quality or
higher growth earnings - Accretion should always be examined within the context of the market’s perception of the price paid compared to the intrinsic value of the target (including potential synergies)
Ability-to-Pay Analysis (for Competing Bidders)
- Involves identifying potential competing strategic bidders and assessing their ability-to-pay with an accretion/dilution model (for publicly-traded strategic buyers) or LBO model (for financial buyers)
- Ability-to-pay is not a basis for valuation, but it can provide an indication of the price that competing bidders may be willing to pay in a competitive auction
- There are several factors that may increase or decrease a competing bidders relative ability or willingness to pay:
factors that may increase a competing bidders relative ability or willingness to pay:
- Significant synergy potential
- Very strong balance sheet (ie. debt capacity)
- Trade at a higher multiple than the target
- Viewed as a must-have asset / defensive play
factors that may decrease a competing bidders relative ability or willingness to pay:
- Minimal synergies
- Limited debt capacity (ie. requires equity)
- Trade at a lower multiple than the target
- Not viewed as a must-have asset
- As mentioned previously, an acquisition by a public company will always be viewed in the context of
the market’s perception of the price paid relative to the intrinsic value of the target (including potential synergies)
Cash vs. Stock Consideration
- Cash and common equity are the two primary types of consideration that companies use to complete acquisitions
– Sources of Cash: On the acquirer’s balance sheet, the target’s balance sheet or by borrowing new debt
– Sources of Common Equity: Issue new shares directly to the target or to the market - The financing mix needs to be carefully considered as buyer and seller preferences often vary
(Cash vs Stock Consideration) Buyer’s Perspective:
- Debt is cheaper than equity
- Debt financing capacity may be limited by the acquirer’s balance sheet objectives or limitations imposed by lenders (ie. leverage covenant)
- Equity is costly and dilutes the ownership of existing shareholders
– However it may be perceived positively by the market if the acquirer’s stock is overvalued or if it is viewed as prudent balance sheet management
Cash vs Stock Consideration:
Seller’s Perspective
- Cash is the most liquid form of consideration and its value is certain, however it triggers a tax event
- Equity is typically treated as a tax-free rollover
- Equity provides value upside if the seller believes in the prospects of the combined company (including its synergy potential)
Transaction Synergies
- A synergy is a common M&A term used to describe a financial benefit as a result of the combination of two companies
- The expectation of revenue and/or cost synergies is often the driving force behind M&A transactions
Revenue Synergies
- Cross-selling customers
- New product/market development
- Increased scale/pricing power
Cost Synergies
- Economies of scale create cost efficiencies
- Elimination of redundant facilities or people
- Increased purchasing power with suppliers
____ synergies are typically easier to identify, quantify and execute on
Cost
- To form a preliminary view on synergies, investment bankers typically:
– Review the cost structures and operating footprints of both companies to identify potential redundancies
– Review historical transactions in the sector for both announced and realized synergies
– Take guidance from company management
- Public stakeholders (ie. politicians, unions, communities) may scrutinize synergies if they are:
concerned about potential job losses while regulatory bodies and consumer groups will closely examine the competitive impact on the market (ie. too much pricing power)
Future Share Price Analysis:
- Future share price analysis provides an illustrative view of a public company’s potential share price trajectory by applying an EBITDA or earnings multiple to its forecast EBITDA or earnings
- For comparability, the projected share price needs to be discounted to present day at the cost of equity
Analysis of Historical Offer Premiums Paid in M&A Deals
- Analysis of historical premiums paid involves reviewing the offer premiums on precedent public transactions
- Transactions can be categorized by size, geography and sector depending on the deal under review
- Premiums across North America have generally ranged between 30% - 40% over the last five years
Premiums to Unaffected Share Prices (1-Day Prior to Announcement)1 – Deals >C$500 million (Last Five Years)
Canadian Premia: 27%
Canadian Industrials : 38%
U.S. Industrials : 32%
Offer Being Reviewed: 34%
