Giddy | Introduction to Mergers

& Acquisitions
Briefing
Mergers & Acquisitions: An Introduction

Prof. Ian Giddy, New York University

INTRODUCTION

This is an introduction to the subject of mergers, acquisitions, buyouts and

divestitures as covered in my Mergers & Acquisitions course. The purpose
is to delineate how and why a merger decision should be made. The course
focuses on mergers and acquisitions in the context of private as well as
publicly traded companies. Acquisitions of private companies account for
the majority of transactions. To properly assess a potential merger we need
to perform fundamental strategic and financial analysis, but remain aware
of the idiosyncrasies that each potential merger contains.

A merger is a pivotal event for the companies involved. Both parties hope
to benefit from the greater efficiency and competitive strength found in the
combined company. Strategies are altered and as a result product lines are
broadened, strengthened, or refocused; management systems and
personnel are changed; and levels and growth rates of profits are shifted.
In many instances, however, one side or the other (or both) lose
substantial sums of money. Merger costs, including the direct costs of
attorneys, accountants, investment bankers, and consultants, are
substantial even though they are not a large percentage of the value of the
merger. There is also substantial cost in terms of time required by key
employees to evaluate, complete, and implement the merger. Perhaps half
of all mergers and acquisitions fail or do not achieve the desired results.
Many mergers fail because projected synergies do not materialize, often
due to human obstacles. If a merger is not well received by the employees
of the new entity, then its chances of success are greatly diminished. It is
critical that the parties involved in a merger become skilled in managing
change. Sometimes acquisitions fail for the acquiring company simply
because it pays too much for the acquired company. An understanding of
pre- and post-merger valuation analysis is required to avoid this pitfall.

Because an entire company is acquired in a merger, determining the

advisability of a potential merger requires a much broader analysis of the
factors involved than most other areas of financial management. In
addition to the usual tax, legal, cash flow, and cash outlay considerations,
competitive positions and strategies are important.

The occurrence of a merger often raises concerns in antitrust circles.

Devices such as the Herfindahl index can analyze the impact of a merger
on a market and what, if any, action could prevent it. Regulatory bodies
such as the European Commission and the United States Department of
Justice may investigate anti-trust cases for monopolies dangers, and have
the power to block mergers.

The remainder of this article will discuss several topics important to

understanding the basic nature of and issues surrounding mergers and
acquisitions. These include methods of business combinations, motives for
mergers and acquisitions, accounting for mergers, and before-and-after
financial analysis.

METHODS OF BUSINESS COMBINATION

There are several methods for achieving a business combination. It is

useful to have an understanding of these different methods. Hereafter, the
term acquisitions will be used to refer to any type of business combination.

Acquisition

An acquisition usually refers to the purchase of the assets of a company.

However, in the remainder of this course, the term will be used in a much
broader sense to indicate the purchase of shares, assets, or companies in
the merger process. Thus, the narrow, distinct meaning of the term will not
be used.

An acquisition can take the form of a purchase of the stock or other equity
interests of the target entity, or the acquisition of all or a substantial
amount of its assets.

Share purchases - in a share purchase the buyer buys the shares of

the target company from the shareholders of the target company. The
buyer will take on the company with all its assets and liabilities.
Asset purchases - in an asset purchase the buyer buys the assets of
the target company from the target company. In simplest form this
leaves the target company as an empty shell, and the cash it receives
from the acquisition is then paid back to its shareholders by dividend
or through liquidation. However, one of the advantages of an asset
purchase for the buyer is that it can "cherry-pick" the assets that it
wants and leave the assets - and liabilities - that it does not.

Merger

In a merger, two separate companies combine and only one of them

survives. In other words, the merged (acquired) company goes out of
existence, leaving its assets and liabilities to the acquiring company.
Usually when two companies of significantly different sizes merge, the
smaller company will merge into the larger one, leaving the larger
company intact.

Consolidation

A consolidation is a combination of two or more companies in which an

entirely new corporation is formed and all merging companies cease to
exist. Shares of the new company are exchanged for shares of the merging
ones. Two similarly sized companies usually consolidate rather than
merge. Although the distinction between merger and consolidation is
important, the terms are often used interchangeably, with either used to
refer generally to a joining of the assets and liabilities of two companies.
Leveraged Buyout

A leveraged buyout (LBO) is a type of acquisition that occurs when a group

of investors, sometimes led by the management of a company
(management buyout or MBO), borrows funds to purchase the company.
The assets and future earnings of the company are used to secure the
financing required to purchase the company. Sometimes employees are
allowed to participate through an employee stock ownership plan, which
may provide tax advantages and improve employee productivity by giving
employees an equity stake in the company.

Holding Company

A holding company is a company that owns sufficient voting stock to have

a controlling interest in one or more companies called subsidiaries.
Effective working control or substantial influence can be gained through
ownership of as little as 5 percent to as much as 51 percent of the
outstanding shares, depending on how widely the shares are distributed. A
holding company that engages in the management of the subsidiaries is
called a parent company.

Divestitures

While divestitures do not represent a business combination, they are a

means of facilitating the acquisition of part of a company. Sometimes
divestitures are used by companies as a means to improve earnings and
shareholder value, or as a means of raising capital. A divestiture involves
the sale of a portion of a company. Two popular means of divestiture are
spin-offs and equity carve-outs.

In a spin-off, a company distributes all of its shares in a subsidiary to the

company's shareholders as a tax-free exchange. The reorganization of
AT&T is an example of a spin-off. AT&T was reorganized into three
separate publicly traded corporations, and a fourth business was sold.
What remained was AT&T, comprised of long distance and wireless phone
businesses, a credit card business, and two other companies that were
formed and spun off to shareholders by giving them stock in the two
companies. One of these companies, now Lucent Technologies, was an
equipment producer and research company. It was spun-off to avoid
conflicts with customers of other AT&T products. The other company was
NCR, a computer company. This was spun-off to remove the effects of a
poor-performing business from AT&T's results. An equity carve-out is
similar to a spin-off. It occurs when a company sells some of its shares in a
subsidiary to the public. This raises additional capital for the company.

Hostile versus Friendly Combinations

Acquisitions may be hostile or friendly. In a hostile acquisition, the

acquiring, or bidder, company makes an offer to purchase the acquired or
target company, but the management of the target company resists the
offer. At that point, the bidder often tries to take control of the target
through a tender offer, whereby the bidder offers to purchase a majority of
the target's stock at a predetermined price, set sufficiently higher than the
current market price to attract the shareholders' attention. Hostile
acquisitions are typically more expensive for both parties since they
involve more time and negotiations, fees to experts such as attorneys and
investment bankers, and may result in a bidding war where multiple
bidders enter the contest for control. The large number of hostile
acquisitions in the 1980s led to the coining of the term "market for
corporate control." This terminology reflects the view that acquisitions are
really market-based contests whereby corporate managers bid to control
corporate assets, with the highest bidder receiving control.

Even though hostile acquisitions receive much of the media attention

surrounding acquisitions, the great majority of acquisitions are; friendly.
In a friendly acquisition, the management of both companies come to an
agreement over the terms of the acquisition. Many acquisitions that begin
as hostile end up being completed on a friendly basis.

MOTIVES FOR ACQUISITIONS

The overriding motive for any acquisition should be to maximize

shareholder value. There has been increasing emphasis on maximizing
shareholder value and managers are under more and more pressure to do
so. The threat of a hostile takeover places pressure on all corporate
managers to manage their companies to maximize value, or risk being
taken over and restructured by another management. Increasingly
competitive global capital markets, active institutional investors, active
and independent boards of directors, and better informed market
participants have all led to an increased focus by shareholders on
shareholder value, and have placed increased pressure on corporate
managers to maximize shareholder value.

Acquisitions are a means of creating shareholder value by exploiting

synergies, increasing growth, replacing inefficient managers, gaining
market power, and extracting benefits from financial and operational
restructuring. However, for value to be created, the benefits of these
motives must exceed the costs.

These motives are considered to add shareholder value:

Economies of scale: This refers to the fact that the combined company
can often reduce duplicate departments or operations, lowering the
costs of the company relative to theoretically the same revenue
stream, thus increasing profit.
Increased revenue/Increased Market Share: This motive assumes that
the company will be absorbing a major competitor and dtjdf its power
(by capturing increased market share) to set prices.
Cross selling: For example, a bank buying a stock broker could then
sell its banking products to the stock broker's customers, while the
broker can sign up the bank's customers for brokerage accounts. Or, a
manufacturer can acquire and sell complementary products.
Synergy: Better use of complementary resources.
Taxes: A profitable company can buy a loss maker to use the target's
tax write-offs. In the United States and many other countries, rules
are in place to limit the ability of profitable companies to "shop" for
loss making companies, limiting the tax motive of an acquiring
 company.
Geographical or other diversification: This is designed to smooth the
earnings results of a company, which over the long term smoothens
the stock price of a company, giving conservative investors more
confidence in investing in the company. However, this does not
always deliver value to shareholders (see below).
Resource transfer: resources are unevenly distributed across firms
and the interaction of target and acquiring firm resources can create
value through either overcoming information asymmetry or by
combining scarce resources.
Financial restructuring: a change in control can lead to a more cost-
effective or safer capital structure, and more efficient use of financial
assets.
Business mix restructuring: the acquirer may divest non-core
businesses.

The following motives are considered to not add shareholder value:

Diversification: While this may hedge a company against a downturn

in an individual industry it fails to deliver value, since it is possible for
individual shareholders to achieve the same hedge by diversifying
their portfolios at a much lower cost than those associated with a
merger.
Overextension: Tend to make the organization fuzzy and
unmanageable.
Manager's hubris: manager's overconfidence about expected synergies
from M&A which results in overpayment for the target company.
Empire Building: Managers have larger companies to manage and
hence more power.
Manager's Compensation: In the past, certain executive management
teams had their payout based on the total amount of profit of the
company, instead of the profit per share, which would give the team a
perverse incentive to buy companies to increase the total profit while
decreasing the profit per share (which hurts the owners of the
company, the shareholders); although some empirical studies show
 that compensation is rather linked to profitability and not mere
profits of the company.
Bootstrapping: Example: how ITT executed its merger.
Vertical integration: Companies acquire part of a supply chain and
benefit from the resources.

WHY GROW THROUGH ACQUISITIONS?

There are numerous reasons for a company to want to grow. Growth is

often considered vital to the health of a company. A stagnating company
may have difficulty attracting high-quality management. Furthermore,
larger companies may pay higher salaries to top management than smaller
companies. In some industries, size itself may bring competitive
advantages. For example, marketing dominance may be strengthened
through improved access to advertising. In addition, a large company may
have significantly higher production or distribution efficiencies than a
smaller one. Sometimes growth is a means of survival. For example,
companies in the telecommunications industry have grown through
acquisition in an effort to compete to control phone lines, cable systems,
and content. The merger of Viacom, Blockbuster, and Paramount created a
conglomeration of television and movie production, video distribution and
publishing, and cable channels in an industry where many companies are
merging to compete to become comprehensive media powerhouses. Firms
in the defense industry have merged to survive in a declining market.
Finally, tax laws may encourage merger growth.

Despite these reasons to grow, growth by itself does not necessarily benefit
either the stockholders or the managers of a company. Growth is not
something that must be achieved regardless of its price. Throughout this
course, emphasis will be placed on an acquisition's impact on value.
Careful comparisons between benefits and costs will be made. A good
acquisition will be defined as one that can be expected to increase the stock
price (other things being equal) of the acquiring company.

Furthermore, a merger is not always the best way to grow. A company can
achieve internal expansion through investment in projects generated
within the company itself. By doing so, efficiency may be improved,
existing activities may be expanded, and new products may be introduced.

External expansion takes place through an acquisition. Because of the

similarities between the acquisition and the capital budgeting process, the
same approval and review forms, control procedures, and post-audit
examinations commonly used for analyzing capital expenditures can be
applied to an acquisition analysis as well. In addition, consideration should
be given at the highest levels of the business to how the proposed
acquisition fits in with the needs and strategic thrust of the company. With
a good fit, even at a relatively high price, the company being considered
may be viewed as a good investment. Without a good fit, the acquisition
may not be a good deal at almost any price.

FINANCIAL ANALYSIS

An acquisition is essentially as an investment decision. An initial outlay is

invested to obtain expected future benefits. A good acquisition will
generate greater benefits, in present value terms, than its costs. The likely
effect of a good acquisition will be to increase the stock value of the
acquiring company. To properly conduct this type of acquisition analysis,
some strategic concepts and many valuation tools are required. The
discipline of corporate finance shapes both the strategic and the financial
analysis necessary to identify and evaluate acquisition candidates and
assess the impact of acquisitions on company value.

Acquisitions are financial decisions that should be consistent with the

company's goal of shareholder wealth maximization. Sound and thorough
financial analysis should be a part of any acquisition. Many acquisitions
that fail, in the sense that they do not add value to the acquiring company,
do so because they were motivated by wishful thinking rather than sound
and thorough financial analysis. This discipline starts with the methods for
analyzing a company's financial statements. The next step is is an
understanding of lenders' and investors' required returns and corporate
valuation analysis. Through this framework, the financial analyst will be
better able to view the acquisition process as a competition with other
stock purchasers, all of whom are looking for good buys.

Acquisitions are also strategic decisions that should be consistent with the
mission of the acquiring company and fit into its overall strategic plan. The
reasons for an acquisition must be understood in the context of a
company's strategic analysis. Acquisitions can be justified in terms of the
competitive advantages they produce (for example, marketing positions
may be strengthened or production costs reduced). Other motives include
improved management, tax benefits, or defensive maneuvers to prevent
takeover by other companies. Finally, many acquisitions produce benefits
purely from the financial and business restructuring that follows a change
in control -- as illustrated by the value increases following leveraged
buyouts.

ACCOUNTING FOR MERGERS

Two methods of accounting for acquisitions -- purchase and pooling of

interests -- are often discussed. Financial statements that record the results
of an acquisition must follow one of these two techniques. Financial
managers must be aware of the accounting requirements as merger
negotiations near completion.

Under the purchase method, the acquired company is treated by the

acquiring company as an investment, analogous to a capital budgeting
expenditure. A totally new ownership is assumed. Asset values are
reappraised in light of estimates of their current market values, and the
balance sheet is restated to the new levels. As a result of these adjustments,
goodwill often results. Goodwill is the amount by which the price paid for a
company exceeds the company's estimated net worth at market value.
Goodwill must be written off against future net income over a reasonable
period. Such deductions against income aret deductible for tax purposes in
most countries.

Under the pooling of interests method, the assets and liabilities of the two
combining companies are simply added together. Since only the book
values of the assets and liabilities are considered, no goodwill results. In
most countries, there are severe restrictions on a company's use of the
pooling of interests method. As a result of these restrictions, the pooling of
interests method is used much less today than it was in the past.

MERGER NEGOTIATION AND DUE DILIGENCE

Negotiating the merger can be difficult. The simple answer to making it

work is: hire the best advisors. Thier job is to manage the negotiation
process in such a way that it reaches a satisfactory conclusion -- both
parties must see a gain, and both parties must be proteced -- and it does
not run afoul of legal and regulatory constraints. The goal is to reach an
agreement that is embodied in the "sale and purchase agreement" -- which
includes all the key terms of the deal, such as price, payment method,
adjustments, constraints on the seller, etc as well as accounting definitions,
accounting and tax warranties and indemnities, etc.

Quite often, a proposed merger or acquisition gets canned or valued down

following conflicts over intellectual property rights, personnel, accounting
discrepancies or incompatibilities in integrating information technology
systems. The process of researching, understanding and, in some cases,
avoiding these risks is known as due diligence.

"Due diligence is going in and digging a hole in the ground and seeing if
there's oil, instead of taking someone's word on it," says Joseph Bankoff, a
lawyer. "If you don't do a sufficient amount of due diligence, you don't
really know what questions to ask."

Due diligence for mergers and acquisitions requires broad and deep data
analysis of assets and liabilities, including large balance sheet items such
as accounts receivable, inventory, and accounts payable to establish fair
market value. It also means analyzing
collections of receivables and inventory to identify doubtful accounts or
obsolete stock, and analyzing cash receipts and billing files using historical
trends to assess the reliability and adequacy of projected cash flows. The
due diligence team must sift through press reports and regulatory filings to
uncover any actual or potential legal, environmental, or other problems. In
the case of a technology acquisition, a due diligence investigation should
answer pertinent questions such as whether an application is too bulky to
run on the mobile devices the marketing plan calls for or whether
customers are right when they complain about a lack of scalability for a
high-end system.

<> Due diligence entails taking all the "reasonable steps" to ensure that
both buyer and seller get what they expect "and not a lot of other things
that you did not count on or expect," Bankoff explains. The process
involves everything from reading the fine print in corporate legal and
financial documents such as equity vesting plans and patents to
interviewing customers, corporate officers and key developers. It helps to
identify potential risks and red flags.

FINANCING THE DEAL

Mergers are generally differentiated from acquisitions partly by the way in

which they are financed and partly by the relative size of the companies.
Various methods of financing an M&A deal exist:

A company acquiring another will frequently pay for the other company
with cash. Such transactions are usually termed acquisitions rather than
mergers because the shareholders of the target company are removed from
the picture and the target comes under the (indirect) control of the bidder's
shareholders alone. An acquisition can involve a cash and debt
combination, or a combination of cash and stock of the purchasing entity,
or just stock.

A "merger" or "merger of equals" is often financed by an all stock deal (a

stock swap), known in the UK as an all share deal. Such deals are
considered a mergers rather than acquisitions because neither company
pays money, and the shareholders of each company end up as the
combined shareholders of the merged company. There are two methods of
merging companies in this way:

one company takes ownership of the other, issuing new shares in itself
 to the shareholders of the company being acquired as payment, or
a third company is created which takes ownership of both companies
(or their assets) in exchange for shares in itself issued to the
shareholders of the two merging companies.

Where one company is notably larger than the other, people may
nevertheless may be wary of calling the deal a merger, as the shareholders
of the larger company will still dominate the merged company

If cash is paid, the cash can be raised in a number of ways. The company
may have sufficient cash available in its account, but this is unlikely. More
often the cash will be borrowed from a bank, or raised by an issue of bonds,
or of equity. Acquisitions financed through debt are known as leveraged
buyouts, and the debt will typically be moved down onto the balance sheet
of the acquired company. Many leveraged acquisitions include a
component of mezzanine debt, which falls between senior secured bank
debt and equity.

POST-MERGER INTEGRATION

Some problems must inevitably occur when two companies combine;

however, these problems can be anticipated and minimized. Managers of
the acquired company will feel some loss of autonomy since their decisions
must now be meshed with the policies of the merged company. Once-
simple procedures become complicated by a new control system.
Furthermore, the acquired company's managers are often concerned about
personal recognition, advancement, and job security in the new company.
Historically, many managers of acquired companies have lost their jobs
following an acquisition.

Problems in the acquiring company will emerge as well. Its strengths and
weaknesses and the skills and potential of its personnel will not be
immediately apparent in the combined company. In addition, the staff of
the acquiring company may lack the expertise to understand completely
the production processes of the acquired company and may therefore be
unable to make appropriate decisions about them. Disciplines, procedures,
and controls that have been well established over time may not work as
well in the new environment. There may be a clash of corporate cultures.

Solutions to these problems cover too broad an area for satisfactory

coverage in this brief introduction. Several suggestions can be given.
Immediate arrangements should be made for orientation of the new staff,
for discussing procedures with operational personnel, and for making
shifts in assignments where necessary. Teams who are responsible for
preventing the imposition of inappropriate controls on the new division,
and for educating top management about the characteristics of the
unfamiliar company, can be appointed during the merger planning
process. Furthermore, the increased opportunities for advancement in the
larger, merged company can be communicated to lower-level employees.
Finally, a special effort can be made to listen to what is happening during
the initial period of difficulty.

Questions:

If your company is considering growth through acquisition, consider the

following questions:

1. Why is growth through acquisition a better option than internal

expansion? Will the growth be profitable for the owners of the
company?
2. Do we have the expertise to carry out this acquisition? Where will we
turn for the necessary strategic, legal, and financial advice?
3. Do we have the people in our organization to plan and value and
execute an acquisition? If not, where will we get them?
4. How will we screen for appropriate acquisition candidates?
5. How will we negotiate the terms of the acquisition?
6. Who will help us finance it? With what methods?
7. How will we handle integrating the two companies?
8. How will we assess the success or failure of the acquisition after it is
completed and implemented?