What is Mergers and Acquisitions - M&A?
Mergers and acquisitions (M&A) is a general term that refers to the consolidation of companies or assets through various types of financial transactions. M&A can include a number of different transactions, such as mergers, acquisitions, consolidations, tender offers, purchase of assets and management acquisitions. In all cases, two companies are involved. The term M&A also refers to the department at financial institutions that deals with mergers and acquisitions. The following will review some of the different kinds of financial transactions that occur when companies engage in mergers and acquisitions activity.
What's an Acquisition?
Mergers & Acquisitions Overview
Merger: In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. After the merger, the acquired company ceases to exist and becomes part of the acquiring company. For example, in 2007 a merger deal occurred between Digital Computers and Compaq whereby Compaq absorbed Digital Computers.
Acquisition: In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or legal structure. An example of this transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, where both companies preserved their names and organizational structures.
Consolidation: A consolidation creates a new company. Stockholders of both companies must approve the consolidation, and, subsequent to the approval, they receive common equity shares in the new firm. For example, in 1998, Citicorp and Traveler's Insurance Group announced a consolidation, which resulted in Citigroup.
Tender Offer: In a tender offer, one company offers to purchase the outstanding stock of the other firm at a specific price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors. Example: Johnson & Johnson made a tender offer in 2008 to acquire Omrix Biopharmaceuticals for $438 million. While the acquiring company may continue to exist — especially if there are certain dissenting shareholders — most tender offers result in mergers.
Acquisition of Assets: In an acquisition of assets, one company acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders. The purchase of assets is typical during bankruptcy proceedings, where other companies bid for various assets of the bankrupt company, which is liquidated upon the final transfer of assets to the acquiring firm(s).
Management Acquisition: In a management acquisition, also known as a management-led buyout (MBO), the executives of a company purchase a controlling stake in another company, making it private. Often, these former executives partner with a financier or former corporate officers in order to help fund a transaction. Such an M&A transaction is typically financed disproportionately with debt, and the majority of shareholders must approve it. For example, in 2013, Dell Corporation announced that it was acquired by its chief executive manager, Michael Dell.
What is the Difference Between a Merger and an Acquisition?
Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition have slightly different definitions.
A merger occurs when two separate entities - usually of comparable size - combine forces to create a new, joint organization in which – theoretically – both are equal partners. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.
An acquisition refers to the purchase of one entity by another entity, usually a smaller firm by a larger firm. A new company does not emerge from an acquisition; rather, the acquired company, or target firm, is often consumed and ceases to exist, and its assets become part of the acquiring company. Acquisitions – sometimes called takeovers – generally carry a more negative connotation than mergers, especially if the target firm shows resistance to being bought. For this reason, many acquiring companies refer to an acquisition as a merger even when technically it is not.
Legally speaking, a merger requires two companies to consolidate into a new entity with a new ownership and management structure, ostensibly with members of each firm. An acquisition takes place when one company takes over all of the operational management decisions of another. The more common interpretive distinction rests on whether the transaction is friendly (merger) or hostile (acquisition).
In practice, friendly mergers of equals do not take place very frequently. It's uncommon that two companies would benefit from combining forces and two different CEOs would agree to give up some authority to realize those benefits. When this does happen, the stocks of both companies are surrendered, and new stocks are issued under the name of the new business identity.
Since mergers are so uncommon and takeovers are viewed in a derogatory light, the two terms have become increasingly conflated and used in conjunction with one another. Contemporary corporate restructurings are usually referred to as merger and acquisition (M&A) transactions, rather than simply a merger or acquisition. The practical differences between the two terms are slowly being eroded by the new definition of M&A deals. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders. The public relations backlash for hostile takeovers can be damaging to the acquiring company. The victims of hostile acquisitions are often forced to announce a merger to preserve the reputation of the acquiring entity.
Varieties of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:
- Horizontal merger: Two companies that are in direct competition and share the same product lines and markets.
- Vertical merger: A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
- Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company.
- Market-extension merger: Two companies that sell the same products in different markets.
- Product-extension merger: Two companies selling different but related products in the same market.
- Conglomeration: Two companies that have no common business areas. There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:
- Purchase Mergers: As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company.
- Consolidation Mergers: With this merger, a brand new company is formed, and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.
Details of Acquisitions
In an acquisition, as in some mergers, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.
Another type of acquisition is a reverse merger, a deal that enables a private company to become publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to acquire financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.
Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: Its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that it can.
There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:
- Comparative Ratios: The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio (P/E Ratio): With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
- Enterprise-Value-to-Sales Ratio (EV/Sales): With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
- Replacement Cost: In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets – people and ideas – are hard to value and develop.
- Discounted Cash Flow (DCF): A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.
It would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:
In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss later in this article, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.
What to Look for in Mergers and Acquisitions
It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:
- A reasonable purchase price: For example, a premium of 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires a synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests.
- Cash transactions: Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock or equity is used as the currency for acquisition, discipline can go by the wayside.
- Sensible appetite: An acquiring company should be targeting a company that is smaller and in business sectors that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers. Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.
Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergies that make the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.
Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:
- Becoming bigger: Many companies use M&A to grow in size and leapfrog their rivals. While it can take years or decades to double the size of a company through organic growth, this can be achieved much more rapidly through mergers or acquisitions.
- Preempted competition: This is a very powerful motivation for mergers and acquisitions and is the primary reason why M&A activity occurs in distinct cycles. The urge to snap up a company with an attractive portfolio of assets before a rival does so generally results in a feeding frenzy in hot markets. Some examples of frenetic M&A activity in specific sectors include dot-coms and telecoms in the late 1990s, commodity and energy producers in 2006-07, and biotechnology companies in 2012-14.
- Domination: Companies also engage in M&A to dominate their sector. However, since a combination of two behemoths would result in a potential monopoly, such a transaction would have to run the gauntlet of intense scrutiny from anti-competition watchdogs and regulatory authorities.
- Tax benefits: Companies also use M&A for tax purposes, although this may be an implicit rather than an explicit motive. For instance, since the U.S. has the highest corporate tax rate in the world, some of the best-known American companies have resorted to corporate “inversions.” This technique involves a U.S. company buying a smaller foreign competitor and moving the merged entity’s tax home overseas to a lower-tax jurisdiction, in order to substantially reduce its tax bill.
- Staff reductions: As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing, and other departments. Job cuts will also probably include the former CEO, who typically leaves with a compensation package.
- Economies of scale: Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies—when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
- Acquiring new technology: To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.
- Improved market reach and industry visibility: Companies buy companies to reach new markets and grow revenues and earnings. A merger may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community as bigger firms often have an easier time raising capital than smaller ones.
Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers – who have much to gain from a successful M&A deal – will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price.
Mergers and Acquisitions-Prone Industries
Mergers and acquisitions are most common in the health care, technology, financial services, retail and, lately, the utilities sectors.
In health care, many small and medium-sized companies find it difficult to compete in the marketplace with the handful of behemoths in the field. A rapidly changing landscape in the health-care industry, with government legislation leading the way, has posed difficulties for small and medium companies that lack the capital to keep up with these changes. Moreover, as health-care costs continue to skyrocket, despite efforts from the government to reign them in, many of these companies find it nearly impossible to compete in the market and resort to being absorbed by larger, better-capitalized companies.
The technology industry moves so rapidly that, like health care, it takes a massive presence and huge financial backing for companies to remain relevant. When a new idea or product hits the scene, industry giants such as Google, Facebook and Microsoft have the money to perfect it and bring it to market. Many smaller companies, instead of unsuccessfully trying to compete, join forces with the big industry players. These firms often find it more lucrative to be acquired by one of the giants for a huge payday.
Throughout the 21st century, particularly during the late 2000s, merger and acquisition activity has been constant in the financial services industry. Many companies that were unable to withstand the downturn brought on by the financial crisis of 2007-2008 were acquired by competitors, in some cases with the government overseeing and assisting in the process. As the industry and the economy as a whole have stabilized in the 2010s, mergers and acquisitions by necessity have decreased. However, the 30 largest companies in the industry have a market capitalization totaling over $27.5 trillion as of 2017, giving them much leverage to acquire regional banks and trusts.
The retail sector is highly cyclical in nature. General economic conditions maintain a high level of influence on how well retail companies perform. When times are good, consumers shop more, and these firms do well. During hard times, however, retail suffers as people count pennies and limit their spending to necessities. In the retail sector, much of the merger and acquisition activity takes place during these downturns. Companies able to maintain good cash flow when the economy dips find themselves in a position to acquire competitors unable to stay afloat amid reduced revenues.
Since 2000, M&As have picked up in the utilities sector. After a brief downturn in the immediate wake of the financial crisis of 2008, the pace of acquisitions has risen, especially between 2012 and 2015, driven primarily by a basic focus on operational efficiency and resulting profitability. The fallout from the 2008 financial crisis saw a number of weaker firms, but ones with significant assets, become ripe as takeover targets, especially in Europe. Utility companies in many of the developed markets became busy supplementing or realigning their portfolios. Low wholesale prices, resulting from dramatic declines in the prices of oil and natural gas, and new regulatory frameworks to deal with, have both been factors as firms seek to align themselves in the most advantageous position. Some companies have undertaken significant divestitures, looking to rid themselves of less-profitable divisions or subsidiaries. Regulatory changes and the simple recognition that renewable energy sources will be an increasing portion of the utilities business moving forward have been the impetus for several firms to acquire promising wind power companies.
The rapid economic growth in emerging market economies, especially the rapid expansion of utility infrastructure and tens of millions of brand-new customers, has kept many utility companies focused on acquisitions in China, India, and Brazil.
Doing The Deal
1. The Opening Offer
When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company or building a position. Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the company must formally declare how many shares it owns and whether it intends to buy the company or keep the shares purely as an investment.
Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it's willing to pay for its target in cash, shares or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept or reject it.
A letter of intent, or LOI, is used to set forth the terms of a proposed merger or acquisition. It provides a general overview of the proposed deal. The LOI may include the purchase price, whether it is a stock or cash deal and other elements of the proposed deal. After the LOI is submitted, the buyer performs significant due diligence on the seller’s business.
An LOI does not have to be legally binding upon the parties unless the terms of the LOI specifically states it is, or it may include both binding and non-binding provisions. There may be provisions stating the buyer agrees to keep all confidential information it sees during due diligence secret.
2. The Target's Response
Once the tender offer has been made, the target company can do one of several things:
- Accept the Terms of the Offer: If the target firm's top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal.
- Attempt to Negotiate: The tender offer price may not be high enough for the target company's shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target, particularly their jobs. If they're not satisfied with the terms laid out in the tender offer, the target's management may try to work out more agreeable terms that let them keep their jobs or, even better, send them off with a nice, big compensation package. Not surprisingly, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger's future success.
- Execute a Takeover Defense or Find Another Acquirer: There are several strategies to fight off a potential acquirer (see Defensive Maneuvers, below).
Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest telecommunications companies in the U.S., AT&T and Verizon, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry.
3. Closing the Deal
Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company's shares with cash, stock or both.
A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company.
If the transaction is made with stock instead of cash, then it's not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions.
When a company is purchased with stock, new shares from the acquiring company's stock are issued directly to the target company's shareholders, or the new shares are sent to a broker who manages them for target company shareholders. The shareholders of the target company are only taxed when they sell their new shares.
When the deal is closed, investors usually receive a new stock in their portfolios – the acquiring company's expanded stock. Sometimes investors will receive new stock identifying a new corporate entity that is created by the M&A deal.
What Merger And Acquisition Firms Do
The merger or acquisition deal process can be intimidating, and this is where merger and acquisition firms step in to facilitate the process by taking on the responsibility for a fee. These firms guide their clients (companies) through these transformative, multifaceted corporate decisions. The various types of merger and acquisition firms are discussed below. The role of each type of firm is to successful seal a deal for its clients, but each does differ in its approach and duties.
Investment banks perform a variety of specialized roles. They carry out transactions involving huge amounts of money, in areas such as underwriting. They act as a financial advisor (and/or broker) for institutional clients, sometimes playing the role of an intermediary. They also facilitate corporate reorganizations, including mergers and acquisitions. The finance division of investment banks manages the merger and acquisition work, right from the negotiation stage until the deal's closure. The work related to the legal and accounting issues is outsourced to affiliate companies or impaneled experts.
The role of an investment bank in the procedure typically involves vital market intelligence, in addition to preparing a list of prospective targets. Once the client is sure of the targeted deal, an assessment of the current valuation is done to know the price expectations. All of the documentation, management meetings, negotiation terms and closing documents are handled by the representatives of the investment bank. In cases where the investment bank is handling the selling side, an auction process is conducted with several rounds of bids to determine the buyer. Some of the major investment banks are Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), JPMorgan Chase (NYSE: JPM), Bank of America Merrill Lynch (NYSE: BAC), Barclays Capital, Citigroup (NYSE: C), and Credit Suisse Group (NYSE: CS).
Corporate law firms are popular among companies looking to expand externally through a merger or acquisition, especially companies with international borders. Such deals are more complex as they involve different laws governed by different jurisdictions, thus requiring very specialized legal handling. The international law firms are best suited for this job with their expertise on multi-jurisdiction matters. Some of the leading law firms engaging in mergers and acquisitions are Wachtell, Lipton, Rosen & Katz; Skadden, Arps, Slate, Meagher & Flom LLP; Cravath, Swaine & Moore LLP; Sullivan & Cromwell LLP; Simpson Thacher & Bartlett LLP; and Davis Polk & Wardwell LLP.
Audit & Accounting Firms
Audit and accounting firms also handle merger and acquisition deals with obvious specialization in auditing, accounting, and taxation. These companies are experts in evaluating assets, conducting audits and advising on taxation aspects. In cases where cross-border merger or acquisition is involved, the understanding of the taxation part becomes critical, and these companies fit well in such situations. In addition to auditing and accounting experts, these companies have other experts on the panel to manage any aspect of the deal well. Some of the well-known firms from this category with specialized services in mergers and acquisitions are KPMG, Deloitte, PricewaterhouseCoopers (PwC) and Ernst & Young (EY); these companies together are tagged as the Big Four.
Consulting & Advisory Firms
The leading management consulting and advisory firms guide clients through all stages of a merger or acquisition process – cross-industry or cross-border deals. These firms have a team of experts who work towards the success of the deal right from the initial phase to the successful closure of the deal. The bigger companies in this business have a global footprint which helps in identifying targets based on suitability in all aspects. The firms work on the acquisition strategy followed by screening to due diligence and advising on price valuations, making sure that the clients are not overpaying. Some of the well-known names in the business are AT Kearney, Bain and Company, The Boston Consulting Group (BCG), McKinsey and L.E.K. Consulting.
M&A Effects – Capital Structure and Financial Position
M&A activity obviously has longer-term ramifications for the acquiring company or the dominant entity than it does for the target company in an acquisition or the firm that is subsumed in a merger.
For the target company, an M&A transaction gives its shareholders the opportunity to cash out at a significant premium, especially if the transaction is an all-cash deal. If the acquirer pays partly in cash and partly in its own stock, the target company’s shareholders would hold a stake in the acquirer and thus have a vested interest in its long-term success.
For the acquirer, the impact of an M&A transaction depends on the deal size relative to the company’s size. The larger the potential target, the bigger the risk to the acquirer. A company may be able to withstand the failure of a small-sized acquisition, but the failure of a huge purchase may severely jeopardize its long-term success.
Once an M&A transaction has closed, the impact upon the acquirer would typically be significant (again depending on the deal size). The acquirer’s capital structure will change, depending on how the M&A deal was designed. An all-cash deal will substantially deplete the acquirer’s cash holdings. However, as many companies seldom have the cash hoard available to make full payment for a target firm in cash, all-cash deals are often financed through debt. While this additional debt increases a company’s indebtedness, the higher debt load may be justified by the additional cash flows contributed by the target firm.
Many M&A transactions are also financed through the acquirer’s stock. For an acquirer to use its stock as currency for an acquisition, its shares must often be premium-priced to begin with or else making purchases would be needlessly dilutive. As well, management of the target company also has to be convinced that accepting the acquirer’s stock rather than hard cash is a good idea. Support from the target company for such an M&A transaction is much more likely to be forthcoming if the acquirer is a Fortune 500 company than if it is ABC Widget Co.
M&A Effects – Market Reaction and Future Growth
Market reaction to news of an M&A transaction may be favorable or unfavorable, depending on the perception of market participants about the merits of the deal. In most cases, the target company’s shares will rise to a level close to that of the acquirer’s offer, assuming of course that the offer represents a significant premium to the target’s previous stock price. In fact, the target’s shares may trade above the offer price if the perception is either that the acquirer has submitted a below-market offer for the target and may be forced to raise it, or that the target company is coveted enough to attract a rival bid.
There are situations in which the target company may trade below the announced offer price. This generally occurs when part of the purchase consideration is to be made in the acquirer’s shares, and the stock plummets when the deal is announced. For example, assume the purchase price of $25 per share of TargetedXYZCo consists of two shares of an acquirer valued at $10 each and $5 in cash. If the acquirer’s shares are now only worth $8, TargetedXYZCo would most likely be trading at $21 rather than $25.
There are many reasons why an acquirer’s shares may decline when it announces an M&A deal. Perhaps market participants think that the price tag for the purchase is too steep, or the deal is perceived as not being accretive to EPS (earnings per share). Another possibility is that perhaps investors believe that the acquirer is taking on too much debt to finance the acquisition.
An acquirer’s future growth prospects and profitability should ideally be enhanced by the acquisitions it makes. Since a series of acquisitions can mask a company’s deteriorating core business, analysts and investors often focus on the “organic” growth rate of revenue and operating margins – which excludes the impact of M&A – for such a company.
In cases where the acquirer has made a hostile bid for a target company, the latter’s management may recommend that its shareholders reject the deal. One of the most common reasons cited for such rejection is that the target’s management believes the acquirer’s offer substantially undervalues it. Such rejection of an unsolicited offer can sometimes backfire, as demonstrated by the famous Yahoo-Microsoft case.
On February 1, 2008, Microsoft unveiled a hostile offer for Yahoo, Inc. (YHOO) of $44.6 billion. Microsoft Corp’s (MSFT) offer of $31 per Yahoo share consisted of one-half cash and one-half Microsoft shares and represented a 62% premium to Yahoo’s closing price on the previous day. However, Yahoo’s board of directors – led by co-founder Jerry Yang – rejected Microsoft’s offer, saying that it substantially undervalued the company. Unfortunately, the credit crisis that gripped the world later that year also took its toll on Yahoo shares, resulting in the stock trading below $10 by November 2008. Yahoo’s subsequent road to recovery was a long one, and the stock only exceeded Microsoft’s original $31 offer five and a half years later in September 2013.
M&A Effects – The Workforce
Historically, mergers tend to result in job losses, as operations and departments become redundant. The most consistently threatened jobs are the target company's CEO and other senior management, who often are offered a severance package. However, there can also be risk for all of the target company's employees, especially since those who had hired them are likely no longer making critical labor decisions. In some circumstances, the employees of the newly created entity receive new stock options, such as an employee stock ownership plan, or other benefits as a reward and incentive.
The Impact of Foreign Exchange
Foreign currency exchange rates can have a major impact on the flow of cross-border M&A deals – that is, when the target company and the acquiring company are in different countries. Studies show that companies in countries whose currencies have appreciated substantially are more likely to target acquisitions in countries whose currencies have not appreciated as much. Since the acquiring company has a stronger currency relative to the country of the acquisition, the transaction is more affordable on a relative basis.
Foreign currency traders may even take advantage of major international M&As for profitable trade setups. A large cross-border M&A often requires a large currency transaction. This transaction can have an impact on the relative exchange rates between the two countries for large deals.
A 2000 study by Francis Breedon and Francesca Fornasari of Lehman Brothers entitled "FX impact of cross-border M&A" found that large M&A deals can result in an increase in the domestic currency of the target of 1% relative to the currency of the acquiring company. The study further found that for every deal in excess of $1 billion, the currency of the target corporation increased in value by around 0.5%. These currency movements are most pronounced in the days after the announcement of the deals.
The structure of the M&A deal is important to gauge the extent of any impact on currency rates. The larger the cash portion of the deal, the greater the impact on the currency exchange rates between the countries.
The Biggest Mergers & Acquisitions in the U.S.
In recent decades, the late 1990s were a high point for mergers and acquisitions. In the 21st century, activity slowed at first, but has gradually increased: 2015 was a record-breaking year, with approximately $4.7 trillion in global deals signed. Some of the biggest deals over the last few years in the United States (in no specific order) have been:
One of the biggest deals in recent times has been the 2014 acquisition of Vodafone Group PLC’s (NASDAQ: VOD) 45% stake in Verizon Wireless by Verizon Communications Inc. (NYSE: VZ) in a transaction worth $130 billion. Verizon Wireless, which was founded in 2000 as a joint venture of Verizon Communications and Vodafone, is now wholly owned by Verizon Communications Inc. Verizon Wireless is a close second as the largest and most profitable wireless telecommunications company serving 116.3 million retail connections, operating in more than 7,400 retail locations in the United States. The company reported annual revenue of $128 billion in 2018.
Two of the fastest growing companies from the pharmaceutical space joined hands in 2000 as Pfizer Inc (NYSE: PFE) acquired Warner-Lambert (WLA) in a $90 billion deal. The deal had some background drama to it as merger plans were originally announced by Warner-Lambert and American Home Products in November 1999 for approximately $70 billion. In the next few hours, Pfizer attempted the largest hostile takeover in the pharmaceutical business by announcing an unsolicited $82 billion offer for Warner-Lambert. Warner-Lambert's cholesterol drug Lipitor was said to be the point of focus for the merger as the drug was jointly marketed by Warner-Lambert and Pfizer since its launch in 1997. The merger finally went through after three months of tussle as American Home Products agreed to walk away with a breakup fee of around $1.8 billion.
ExxonMobil Corporation (XOM), the largest company in the oil and gas sector, was created in 1998 by bringing together the fragments of Standard oil monopoly (Exxon Corporation and Mobil Corporation) in an $80 billion deal. At the time of the deal, Exxon and Mobil were the largest and second-largest oil producers in the U.S. with a combined market capitalization of $237.53 billion. The company is now a multinational giant headquartered in Irving, Texas.
In January, 2008, the Board of Directors of Altria Group Inc (NYSE: MO) approved the spin-off of Philip Morris International Inc, a wholly owned subsidiary of Altria, with a vision of making it the most profitable publicly traded tobacco company and to build long-term shareholder value. As per the laid down terms, each Altria shareholder received one share of Philip Morris International for every share of Altria held on March 19, 2008 (record date) and involved approximately $107 billion.
In 2006, the largest telecommunication giant AT&T (NYSE: T) acquired BellSouth (BLS), another large telecommunications company, in a $67 billion deal. The acquisition resulted in giving AT&T a local customer base of 70 million across 22 states, further strengthening its dominance in the industry. The two companies were already joint owners of Cingular Wireless with 60% ownership with AT&T and 40% with BellSouth. Cingular Wireless was brought under the brand and consolidated ownership of AT&T after the acquisition of BellSouth.
The 1998 merger of the banking giant Citicorp and Travelers Group estimated at $70 billion changed the landscape of the financial-services industry. The merger created Citigroup, Inc. (NYSE: C), one of the biggest companies in the financial services space. Citigroup had a market capitalization of approximately $135 billion at that time and offered services like banking, insurance and investment in over 100 countries. Citigroup operates in around 160 countries and has a market capitalization of approximately $159 billion as of February 2019.
Why Mergers Don't Go Through
While they seem to constantly grow in size and scope, mergers and acquisitions don't always happen – or, if they do happen, the results are not happy ones. For every deal that goes through, there are plenty that fail to launch or fail to thrive.
The three main reasons for a merger or acquisition deal to fail are a lack of funding by the acquirer to close the deal, the difference in valuation estimates by the two parties, and government intervention due to regulations.
Adequate funding is necessary for a successful merger. In late 2008, for example, automotive giants General Motors and Chrysler, two of the so-called Big Three of the U.S. auto industry, were deep in talks to merge. Before the year ended, the merger talks collapsed after GM admitted it was running out of money following a huge $4.2 billion quarterly loss.
One year after the failed merger between GM and Chrysler, social media sites Facebook and Twitter were in discussions to join forces, with the former attempting to acquire the latter for $500 million. Disagreements over Facebook’s valuation could not be overcome by the two camps, resulting in the end of what could have been the single most dominant player in global social media.
- Dawn Raid: This is a corporate action more common in the United Kingdom, though it has also occurred in the Unites States. During a dawn raid, a firm or investor aims to buy a substantial holding in the takeover-target company's equity by instructing brokers to buy the shares as soon as the stock markets open. By getting the brokers to conduct the buying of shares in the target company (the "victim"), the acquirer (the "predator") masks its identity and thus its intent. The acquirer then builds up a substantial stake in its target at the current stock market price. Because this is done early in the morning, the target firm usually doesn't get informed about the purchases until it is too late, and the acquirer now has controlling interest. In the U.K., there are now restrictions on this practice.
- Saturday Night Special: A Saturday night special is a sudden attempt by one company to take over another by making a public tender offer. The name comes from the fact that these maneuvers used to be done over the weekends. This too has been restricted by the Williams Act in the United States, whereby acquisitions of 5% or more of equity must be disclosed to the Securities Exchange Commission.
If a company doesn't want to be taken over, there are many strategies that management can use. Almost all of these strategies are aimed at affecting the value of the target's stock in some way. Let's take a look at some more popular methods – known in the M&A world as "shark repellents" – that companies can use to protect themselves from a predator.
A golden parachute measure discourages an unwanted takeover by offering lucrative benefits to the current top executives, who may lose their jobs if their company is taken over by another firm. Benefits written into the executives' contracts include items such as stock options, bonuses, liberal severance pay and so on. Golden parachutes can be worth millions of dollars and can cost the acquiring firm a lot of money, therefore becoming a strong deterrent to proceeding with their takeover bid.
A spin-off of the term "blackmail," greenmail occurs when a large block of stock is held by an unfriendly company or raider, who then forces the target company to repurchase the stock at a substantial premium to destroy any takeover attempt. This is also known as a "bon voyage bonus" or a "goodbye kiss."
In this tactic, the target company issues a large number of bonds that come with the guarantee that they will be redeemed at a higher price if the company is taken over. It's called a macaroni defense because the redemption price of the bonds expands, like macaroni in a pot of boiling water. It's a highly useful strategy but the target company must be careful it doesn't issue so much debt that it cannot make the interest payments. Takeover-target companies can also use leveraged recapitalization to make themselves less attractive to the bidding firm.
in a people pill, management threatens that, in the event of a takeover, the management team will resign at the same time en masse. This is especially useful if they are a good management team; losing them could seriously harm the company and make the bidder think twice. On the other hand, hostile takeovers often result in the management being fired anyway, so the effectiveness of a people pill defense really depends on the situation.
With this strategy, the target company aims at making its own stock less attractive to the acquirer. There are two types of poison pills. The 'flip-in' poison pill allows existing shareholders (except the bidding company) to buy more shares at a discount. This type of poison pill is usually written into the company's shareholder-rights plan. The goal of the flip-in poison pill is to dilute the shares held by the bidder and make the takeover bid more difficult and expensive.
The 'flip-over' poison pill allows stockholders to buy the acquirer's shares at a discounted price in the event of a merger. If investors fail to take part in the poison pill by purchasing stock at the discounted price, the outstanding shares will not be diluted enough to ward off a takeover.
An extreme version of the poison pill is the "suicide pill" whereby the takeover-target company may take action that could lead to its ultimate destruction.
With the sandbag tactic, the target company stalls with the hope that another, more favorable company (like "a white knight," see below) will make a takeover attempt. If management sandbags too long, however, they may be become distracted from their responsibilities of running the company.
A white knight is a company (the "good guy") that gallops in to make a friendly takeover offer to a target company that is facing a hostile takeover from another party (a "black knight"). The white knight offers the target firm a way out; although it will still be acquired, it will be on more favorable terms – or at least, terms more to its liking.
Why Mergers Fail
It's no secret that plenty of mergers don't work. Those who advocate mergers will argue that the merger will cut costs or boost revenues by more than enough to justify the price premium. It can sound so simple: just combine computer systems, merge a few departments, use sheer size to force down the price of supplies, and the merged giant should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice, the situation can go awry. Different systems and processes, dilution of a company's brand, overestimation of synergies, and lack of understanding of the target firm's business can all occur, destroying shareholder value and decreasing the company's stock price after the transaction.
For starters, a booming stock market encourages mergers, which can spell trouble. Deals done with highly rated stock as currency are easy and cheap, but the strategic thinking behind them may be easy and cheap too. Additionally, mergers are often attempt to imitate: somebody else has done a big merger, which prompts other top executives to follow suit.
A merger may often have more to do with glory-seeking than business strategy. The executive ego, which is boosted by buying the competition, is a major force in M&A, especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives receive a large bonus for merger deals, no matter what happens to the share price later.
On the other side of the coin, mergers can be driven by generalized fear. Globalization, the arrival of new technological developments, or a fast-changing economic landscape that makes the outlook uncertain are all factors that can create a strong incentive for defensive mergers. Sometimes the management team feels they have no choice and must acquire a rival before being acquired. The idea is that only big players will survive a more competitive world.
The Obstacles to Making it Work
Even if the rationale for a merger or acquisition is sound, executives face major stumbling blocks after the deal is consummated. Potential operational difficulties may seem trivial to managers caught up in the thrill of the big deal; but in many cases, integrating the operations of two companies proves to be a much more difficult task in practice than it seemed in theory.
The chances for success are further hampered if the corporate cultures of the companies are very different. When a company is acquired, the decision is typically based on product or market synergies, but cultural differences are often ignored. It's a mistake to assume that personnel issues are easily overcome. For example, employees at a target company might be accustomed to easy access to top management, flexible work schedules or even a relaxed dress code. These aspects of a working environment may not seem significant, but, if new management removes them, the result can be resentment and shrinking productivity.
Cultural clashes between the two entities often mean that employees do not execute post-integration plans well. Since the merger of two workforces often creates redundant functions, which in turn often result in layoffs, scared employees will act to protect their own jobs, as opposed to helping their employers realize synergies.
Furthermore, sometimes, the expected advantages of acquiring a rival don't prove worth the price paid. As an example, pharmaceutical company A is unduly bullish about pharmaceutical company B’s prospects – and wants to forestall a possible bid for B from a rival – so it offers a very substantial premium for B. Once it has acquired company B, the best-case scenario that A had anticipated doesn't materialize: A key drug being developed by B may turn out to have unexpectedly severe side-effects, significantly curtailing its market potential. Company A’s management (and shareholders) may then be left to rue the fact that it paid much more for B than what it was worth.
More insight into the failure of mergers is found in a highly acclaimed study from McKinsey, a global consultancy firm. The study concludes that companies often focus too intently on cutting costs following mergers, while revenues, and ultimately profits, suffer. Merging companies can focus on integration and cost-cutting so much that they neglect day-to-day business, thereby prompting nervous customers to flee. This loss of revenue momentum is one reason so many mergers fail to create value for shareholders.
Biggest Merger and Acquisition Disasters
Historical trends show that roughly two-thirds of big mergers will disappoint on their own terms, which means the combined new company, or the acquiring company, will lose value on the stock market. Here are a few examples of deals that ended up being disasters.
New York Central and Pennsylvania Railroad
In 1968, the New York Central and Pennsylvania railroads merged to form Penn Central, which became the sixth largest corporation in America. However, just two years later, the company shocked Wall Street by filing for bankruptcy protection, making it the largest corporate bankruptcy in American history at the time.
The railroads, which were bitter industry rivals, both traced their roots back to the early- to mid-nineteenth century. Management pushed for a merger in a somewhat desperate attempt to adjust to disadvantageous trends in the industry. Railroads operating outside of the northeastern U.S. generally enjoyed stable business from long-distance shipments of commodities, but the densely-populated Northeast, with its concentration of heavy industries and various waterway shipping points, created a more diverse and dynamic revenue stream. Local railroads catered to daily commuters, longer-distance passengers, express freight service and bulk freight service. These offerings provided transportation at shorter distances and resulted in less predictable, higher-risk cash flow for the Northeast-based railroads.
Short-distance transportation also involved more personnel hours - thus incurring higher labor costs - and strict government regulation restricted railroad companies' ability to adjust rates charged to shippers and passengers, making cost-cutting seemingly the only way to positively impact the bottom line. Furthermore, an increasing number of consumers and businesses began to favor newly constructed wide-lane highways.
The Penn Central case presents a classic case of post-merger cost-cutting as "the only way out" in a constrained industry, but this was not the only factor contributing to Penn Central's demise. Other problems included poor foresight and long-term planning on behalf of both companies' management and boards, overly optimistic expectations for positive changes after the combination, culture clash, territorialism, and poor execution of plans to integrate the companies' differing processes and systems.
Quaker Oats Company and Snapple Beverage Company
Quaker Oats successfully managed the widely popular Gatorade drink and thought it could do the same with Snapple. In 1994, despite warnings from Wall Street that the company was paying $1 billion too much, the company acquired Snapple for a purchase price of $1.7 billion. In addition to overpaying, management broke a fundamental law in mergers and acquisitions: make sure you know how to run the company and bring specific value-added skills sets and expertise to the operation. In just 27 months, Quaker Oats sold Snapple to a holding company for a mere $300 million, or a loss of $1.6 million for each day that the company owned Snapple. By the time the divestiture took place, Snapple had revenues of approximately $500 million, down from $700 million at the time that the acquisition took place.
Quaker Oats' management thought it could leverage its relationships with supermarkets and large retailers; however, about half of Snapple's sales came from smaller channels, such as convenience stores, gas stations and related independent distributors. The acquiring management also fumbled on Snapple's advertising campaign, and the differing cultures translated into a disastrous marketing campaign for Snapple that was championed by managers not attuned to its branding sensitivities. Snapple's previously popular advertisements became diluted with inappropriate marketing signals to customers. While these challenges befuddled Quaker Oats, gargantuan rivals Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP) launched a barrage of competing new products that ate away at Snapple's positioning in the beverage market.
Oddly, there is a positive aspect to this flopped deal (as in most flopped deals): the acquirer was able to offset its capital gains elsewhere with losses generated from the bad transaction. In this case, Quaker Oats was able to recoup $250 million in capital gains taxes it paid on prior deals thanks to losses from the Snapple deal. This still left a huge chunk of destroyed equity value, however.
America Online and Time Warner
The consolidation of AOL Time Warner is perhaps the most prominent merger failure ever. In 2001, America Online acquired Time Warner in a mega-merger for $165 billion— the largest business combination up until that time. Respected executives at both companies sought to capitalize on the convergence of mass media and the Internet.
Shortly after the mega-merger, however, the dot-com bubble burst, which caused a significant reduction in the value of the company's AOL division. In 2002, the company reported an astonishing loss of $99 billion, the largest annual net loss ever reported by a company, attributable to the goodwill write-off of AOL. Around this time, the race to capture revenue from Internet search-based advertising was heating up. AOL missed out on these and other opportunities, such as the emergence of higher-bandwidth connections due to financial constraints within the company. At the time, AOL was the leader in dial-up Internet access; thus, the company pursued Time Warner for its cable division as high-speed broadband connection became the wave of the future. However, as its dial-up subscribers dwindled, Time Warner stuck to its Road Runner Internet service provider rather than market AOL.
With their consolidated channels and business units, the combined company also did not execute on the converged content of mass media and the Internet. Additionally, AOL executives realized that their know-how in the Internet sector did not translate to capabilities in running a media conglomerate with 90,000 employees. Finally, the politicized and turf-protecting culture of Time Warner made realizing anticipated synergies that much more difficult. In 2003, amidst internal animosity and external embarrassment, the company dropped "AOL" from its name and simply became known as Time Warner.
Sprint and Nextel Communications
In August 2005, Sprint acquired a majority stake in Nextel Communications in a $35 billion stock purchase. The two companies combined to become - at that time - the third largest telecommunications provider, behind AT&T (NYSE:T) and Verizon (NYSE:VZ). Prior to the merger, Sprint catered to the traditional consumer market, providing long-distance and local phone connections and wireless offerings. Nextel had a strong following from businesses, infrastructure employees and the transportation and logistics markets, primarily due to the press-and-talk features of its phones. By gaining access to each other's customer bases, both companies hoped to grow by cross-selling their product and service offerings.
Soon after the merger, multitudes of Nextel executives and mid-level managers left the company, citing cultural differences and incompatibility. Sprint was bureaucratic; Nextel was more entrepreneurial. Nextel was attuned to customer concerns; Sprint had a horrendous reputation in customer service, experiencing the highest churn rate in the industry. In such a commoditized business, the company did not deliver on this critical success factor and lost market share. Further, a macroeconomic downturn led customers to expect more from their dollars.
Cultural concerns exacerbated integration problems between the various business functions. Nextel employees often had to seek approval from Sprint's higher-ups in implementing corrective actions, and the lack of trust and rapport meant many such measures were not approved or executed properly. Early in the merger, the two companies maintained separate headquarters, making coordination more difficult between executives at both camps.
Sprint Nextel's (NYSE:S) managers and employees diverted attention and resources toward attempts at making the combination work at a time of operational and competitive challenges. Technological dynamics of the wireless and Internet connections required smooth integration between the two businesses and excellent execution amid fast change. Nextel was simply too big and too different for a successful combination with Sprint.
Sprint saw stiff competitive pressures from AT&T (which acquired Cingular), Verizon, and Apple's (NASDAQ:AAPL) wildly popular iPhone. With the decline of cash from operations and with high capital-expenditure requirements, the company undertook cost-cutting measures and laid off employees. In 2008, the company wrote off an astonishing $30 billion in one-time charges due to impairment to goodwill, and its stock was given a junk status rating. With a $35 billion price tag, the merger clearly did not pay off.
The idea of becoming smaller might seem counter-intuitive, but corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders.
The rationale behind a spinoff, tracking stock or carve-out is that "the parts are greater than the whole." These corporate restructuring techniques, which involve the separation of a business unit or subsidiary from the parent, can help a company raise additional equity funds. A break-up can also boost a company's valuation by providing powerful incentives to the people who work in the separating unit and help the parent's management to focus on core operations.
That said, de-merged firms are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies. Additionally, the smaller size of the firm may mean it has less representation on major indexes, making it more difficult to attract interest from institutional investors.
Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm divides itself into smaller units, it may be losing the synergy that it had as a larger entity. For instance, the division of expenses such as marketing, administration and research and development (R&D) into different business units may cause redundant costs without increasing overall revenues.