OE - M&A Flashcards
Why do firms merge?
Some of the most common reasons include: cost synergies (e.g., R&D, marketing, firing employees), revenue diversification, and ability to increase influence over the five forces affecting the industry. Revenue synergies (e.g. cross-selling) are another reason, however they are much more difficult to prove than cost synergies and usually not included in the merger model.
Speak in detail about the main reasons for a firm to acquire another firm.
Synergies:
- Two businesses functioning together to produce a result not independently obtainable (i.e., if companies A and B are combined, the result is greater than the expected arithmetic sum A+B)
- Revenues: By combining the two companies, we will realize higher revenues than if the two companies operate separately.
- Expenses: By combining the two companies, we will realize lower expenses than if the two companies operate separately.
- Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.
- For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the need to cut costs. Cost savings often come from the elimination of redundant services, such as human resources, accounting, information technology, etc.
Strategic Reasons:
- Strategic positioning in markets that take advantage of future opportunities that can be exploited when the two companies merge.
- Fills in strategic gaps that are essential for long-term survival.
- Organizational competencies: Acquiring human resources and intellectual capital can help improve innovative thinking and development within the company.
- Broader Market Access: Acquiring a foreign company can give a company quick access to emerging global markets.
Business Reasons:
- Bargain Purchase: It may be cheaper to acquire another company than to invest internally. For example, suppose a company is considering expansion of manufacturing facilities. Another company has very similar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities than to go out and build new facilities on your own.
- Diversification: It may be necessary to smooth out earnings and achieve more consistent long-term growth and profitability. This is particularly true for companies in very mature industries where future growth is unlikely. It should be noted that traditional financial management does not always support diversification through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the management of companies, since managing a steel company is not the same as running a software company.
- Short-Term Growth: Management may be under pressure to turn around sluggish growth and profitability. Consequently, a merger and acquisition is made to boost poor performance.
- Undervalued Target: The target company may be undervalued and thus it represents a good investment. Some mergers are executed for “financial” reasons and not strategic reasons. For example, a financial sponsor (KKR, Blackstone, etc.) acquires poorly performing companies and replaced the management team in hopes of increasing depressed values.
What is a control premium?
The control premium is an amount that a buyer is willing to pay above the current market price of a publicly traded company. This premium is often necessary to compensate existing shareholders to relinquish control of the firm. Moreover, it is often justified by the expected synergies achievable in the transaction. Control premiums can vary widely but are often 20% or more of the target firm’s unaffected stock price.
What is a typical premium paid for an acquisition?
The typical premium paid for an acquisition changes depending on the economic environment and industry but is typically about 20-30% above the unaffected stock price of the target firm.
What does it mean if a deal is “accretive”?
Accretive means that the acquiring company’s earnings per share (EPS) is increased by the acquisition. If the acquiring firm’s P/E is less than the P/E of the target firm in an all-stock transaction, then the deal is dilutive. Otherwise, if the acquirer’s P/E is greater, then the deal is accretive.
Explain accretion / dilution.
The purpose of an accretion / dilution model is to assess the impact of an acquisition on the acquirer’s earning per share (EPS). An acquisition is accretive when the combined (pro forma) EPS is greater than the acquirer’s standalone EPS. It is dilutive if the combined EPS is less than the acquirer’s standalone EPS.
To complete the analysis, you need to project the combined company’s net income and the combined company’s new shares outstanding. Pro forma net income will be the sum of the buyer’s and target’s projected net income plus/minus transaction adjustments (i.e., synergies, increased interest expense if debt is used to finance the purchase, decreased interest income if cash is used, and any new intangible asset amortization resulting from the transaction). Pro forma shares outstanding reflects the acquirer’s share count plus the number of shares to be created and used to finance the purchase in a stock deal.
A 100% stock deal will always be dilutive when the target’s P/E ratio is higher than the acquirer’s. A 100% stock deal will always be accretive when the acquirer’s P/E ratio is higher than the target’s.
The full formula for determining if the deal is accretive or dilutive is:
New EPS = (Net Income of Company A + Net Income of Company B - Post-Tax Cost of Restructuring and Merging + Post-Tax Synergies)/ Total New Number of Shares
What factors contribute to making an acquisition accretive?
An accretive transaction is dependent on a number of factors. One is the consideration mix of stock and cash. Another is the relative P/Es of the acquirer and target if stock is being used. If cash is being used to finance the transaction, the cost of debt is important. Many deals are done to generate cost or revenue synergies, and these levels play an important role in determining how accretive a transaction is.
If a company with a high P/E ratio acquires a company with a low P/E ratio, will the deal be accretive or dilutive?
This question depends on the structure of the deal. In an all-cash deal, the deal is accretive regardless of the P/E ratio (assuming additional earnings more than offset the cost of debt issued). Once stock enters the consideration mix, then the relative P/Es matter. If the acquiring firm’s P/E is less than the P/E of a target firm, then the deal is dilutive. Otherwise, if the acquirer’s P/E is greater than the target’s, the deal is accretive.
You have $1bn of cash on the balance sheet and your target has a P/E of 10. How do you structure an acquisition to be accretive.
A deal will likely be accretive when the acquirer’s P/E ratio is higher than the target’s. We could use the cash on our balance sheet to buy shares of the target.
Give me the factors that affect the decision why a company would pay cash, stock, or both when acquiring a company?
One consideration is how accretive the transaction will be. Different consideration mixes impact accretion: 1) Tradeoff between additional earnings and the cost of additional debt in a cash deal; 2) Tradeoff between additional earnings and the dilution from additional shares issued in a stock deal.
Another consideration is ownership in the new firm. The greater the stock mix, the more ownership the acquiring firm has “given up.” The acquiring firm will also be sensitive to using stock if they feel that their stock is currently undervalued.
In a cash transaction, acquiring shareholders take all the risk that the expected synergy value embedded in the acquisition premium will not materialize. When stock is involved, the risk is spread and shared with the acquired shareholders as well.
Which is more accretive, a cash or stock deal?
It is hard to say without additional information. This depends on a number of factors, including the additional earnings from the target firm, the cost of debt, and the additional shares that would be issued in an all-stock deal. Generally, all-cash deals are more accretive than all-stock deals.
What are synergies?
Synergies are the idea that the value of a combined entity will be greater than the value of the individual parts. Typically these are either revenue or cost synergies. Revenue synergies mean the firm can generate more revenue as a single entity, often by providing additional products or services to each firm’s customer base (cross-selling). Cost synergies mean the firm can decrease expenses as a single entity, usually by cutting redundancies between the two or by achieving economies of scale. Cost synergies are typically highlighted in a transaction presentation as they are considered more “concrete”.
Your MD comes to you and tells you to look at Company X as an acquisition candidate. What do you look at?
- The intrinsic value of the firm
- Price to be paid, whether this is high or low relative to historic prices
- Synergies and other gains from the acquisition
- Competitive advantage gained from the acquisition
- Management and current owner’s incentive or willingness to sell
- Cultural fit of the two firms
- Industry convergence or other action
- Areas of risk for the acquisition
What is due diligence? What are you looking for?
Due diligence is a process to uncover any risks, issues, and opportunities associated with the target / deal. In general, you will examine all official statements (i.e., registration statements), executives, financial projections, etc. You will attempt to substantiate all claims that are material to the transaction (i.e., growth estimates, market advantages, potential litigations, etc.). You will attempt to discover any risks that would materially affect the transaction.
What other incentives do you offer to a seller of a company when you want to acquire it, besides paying a premium?
Some possibilities are employment contracts, significant management roles for seller, earnouts, and bonuses.
