Mergers

Question 1

How do you evaluate whether a client should do M&A deal?

Answer 1

1. Shareholder Value
   - If NPV > 0
2. Financial considerations
   - Accretion/ Dilution Analysis
   - Capital structure & financing
   - Tax implications
3. Strategic considerations
   - Strategic sense?
   - Improving competitiveness?
   - Growth in market share?
   - Regulation change?

Question 2

Company A wants to buy company B for $500m, the maximum they think it is worth. Under what circumstances might company A agree to pay $530m in a stock transaction rather than a cash one?

Answer 2

1. Why is Company A paying $30m more?
   - Company A uncovers additional synergies which will lead to a present value in excess of $30m.
   - Company has a deferred tax asset with a present value higher than $30m
2. Company A agrees to pay $30m more but to convert the deal to a stock one
   - Because it believes its stock price is currently overvalued

Question 3

What are some common hostile takeover defense?

Answer 3

1. Poison pill
2. Acquisitions to dilute shareholders
3. White Knight
4. Increase leverage, spend all cash

Question 4

Company has 4 divisions, stock price is depressed because of the underperformance of one of the divisions. What could you do to improve the stock price?

Answer 4

1. Improve performance (restructuring)
2. Spin-off
3. Divesture
4. Shut-down

Question 5

What advantage do financial buyers have?

Answer 5

1. Move faster, leaner decision process
2. Offer incentive packages to management

Question 6

Conditions and advantages for buyer of asset deals?

Answer 6

1. Conditions
   - Remaining entity must keep ongoing business open
2. Advantages for buyer
   - Can depreciate the price paid and therefore have tax shield
   - Allows acquirer to pick and choose assets it wants

Question 7

What is the breakeven price on an all-stock transaction

Answer 7

P/E target = P/E Buyer

=> EPS target * P/E Buyer = Breakeven Price

Question 8

You are given 2 companies. A and B. B is 5x bigger than A. You own 30% of A. A and B are merging. What would your diluted stake in A be post transaction?

Question 9

Studies have repeatedly shown a high percentage of deals destroy shareholder value. If that’s the
case, why do companies still engage in M&A?

Answer 9

M&A is often a defensive response to structural sector disruption that presents a threat to an existing business model

Question 10

What is a teaser and its purpose?

Answer 10

1. Two page document, first marketing document for potential buyers
2. Generate interest to sign NDA and receive CIM
3. Name of company usually not revealed
4. Investment highlights + summary financials (Revenue, operating income, EBITDA, etc.)

Question 11

What is a CIM?

Answer 11

1. In depth overview of business over 20-50 pages
2. Company profile, market overview, industry trends, investment highlights, business segments, “management case” (projections)

Question 12

What can be found in LOI

Answer 12

1. Buyer provides seller with Letter of Intent
2. Provides initial terms (purchase price, form of consideration, planned financing sourcing)
3. Usually non-binding, room for negotiation

Question 13

What is MAC?

Answer 13

1. Material Adverse Conditions
2. Legal clauses that list out conditions that would allow buyer to walk away
3. E.g. Anti-trust, failure to meet financial targets

Question 14

What is the difference between a subsidiary and an affiliate company?

Answer 14

1. Subsidiary: A subsidiary is when the parent company remains the majority shareholder (50%+).
2. Affiliate Company: An affiliate company is when the parent company has only taken a minority stake

Question 15

Walk me through a simple M&A model.
An M&A model takes two companies and combines them into one entity.

Answer 15

1. First, assumptions need to be made about the purchase price and other uses of funds such as refinancing target debt and paying transaction and financing fees.
2. Then, assumptions about the sources of funds need to be made. The question being answered here is: “Will the acquirer pay for the acquisition using cash, take on additional debt, issue equity, or a combination?”
3. With those assumptions in place, the acquirer’s balance sheet is adjusted to reflect the consolidation of the target.
   Certain line items such as working capital can be added together, while others require further analysis.
   The major adjustment to the combined balance sheet involves calculating the incremental goodwill created in the transaction, which involves making assumptions regarding asset write-ups and deferred taxes created (or eliminated).
4. Next, deal-related borrowing and paydown, cash used in the transaction, and the elimination of target
   equity all need to be reflected.
5. Lastly, the income statements are combined to determine the combined, pro forma accretion/dilution in EPS – which is ultimately the question being answered: “Will this deal be accretive or dilutive?”

Question 16

What are two ways to determine the accretive/dilutive impact to EPS?

Answer 16

1. Bottom-Up Analysis:
   When the post-transaction EPS calculation is done as a bottom -up analysis, this involves starting from the buyer ’s and seller’s standalone EPS and adjusting to reflect the incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write-ups.
2. Top-Down Analysis: Alternatively, the accretion/dilution analysis can be done top-down, whereby the two income statements are combined, starting with revenue and then moving down to expenses while making the deal-related adjustments

Question 17

Would you expect an all-cash or all-stock deal to result in a higher valuation?

Answer 17

In most cases, an all-stock deal will result in a lower valuation than an all-cash deal since the target’s
shareholders get to participate in the potential upside of owning equity in the new entity.

If the deal were all-cash, the proceeds from the sale would be a fixed amount (and be capped), but an all-stock deal comes with the possibility of higher returns if the combined entity performs well and the market has a favorable view of the acquisition, leading to share price appreciation.

Question 18

What are the most common balance sheet adjustments in an M&A model?

Answer 18

Question 19

What are the most common income statement adjustments in an M&A model?

Answer 19

1. Revenue: Increase consolidated revenue by any revenue synergies.
2. Operating Expenses: Reduce consolidated expenses by any expected cost
   synergies.
3. Incremental D&A: Asset write-ups often result in more non-cash D&A. Thus, incremental D&A expenses from write-ups need to be added to consolidated D&A.
4. Other Expenses: Transaction fees are expensed on the income statement.
5. Interest Expense: Acquirer interest expense is adjusted up when debt financing is used to fund the deal.
6. Target interest expense is eliminated when target debt is refinanced.
7. Financing Fees: Financing fees related to raising debt are amortized over the term of the debt, and the
   non-cash expense is recognized within interest expense.
8. Interest Income: Reduce interest income by the impact of excess cash used to fund the deal.
9. Taxes: All the adjustments above need to be tax-affected at the acquirer’s tax rate.
10. Pro Forma EPS: Use the acquirer’s pre-deal share count and then add the number of acquirer shares
    issued in the transaction

Question 20

Would an acquirer prefer $100 in revenue synergies or $100 in cost synergies?

Answer 20

An acquirer would prefer $100 in cost synergies because all those cost savings (after accounting for tax) flow through to the bottom line, while revenue synergies have associated costs that reduce the bottom-line benefit.

For example, $100 in revenue synergies for a company with 40% pre-tax profit margins and a 25% tax rate would see $100 x 40% x (1 - 25%) = $30 flow to the bottom line, while the same company with $100 in cost synergies would see $100 x (1 - 25%) = $75 flow to the bottom line.

Question 21

What happens to a target’s existing NOLs in transactions?

Answer 21

The treatment of existing target NOLs depends on the structure of the deal:

1. Asset Sales: NOLs can be used up by the target to offset any gain on sale on the corporate level. The
   acquirer doesn’t get any remaining unused NOLs as they’re permanently lost.
2. Stock Sales: NOLs can be used by the acquirer in the future but are subject to an annual “IRC 382
   limitation,” which limits the annual carryforward to a regularly published “long term tax-exempt rate”
   times the equity purchase price