Inbound Mergers And

Acquisitions Financing:
Challenges And
Opportunities
A report by:
Sukesh &
Sushant
Abstract

Mergers and acquisitions (M&A) have been an important element of corporate strategies all
over the world for several decades. These have been used to gain or increase the margin of
profits or revenue of the buying company by merging with or acquiring the target company.
They are different ways of mergers and acquisitions that can be followed depending on the
buying company's strategy. The different aspects that are associated with any merger and
acquisition process are the choice of merger and acquisition, target company business
valuation, financing M&A, choosing specialist M&A advisory firms, motives behind M&A,
effect on management and market placed difficulties.

Inbound M&A are mergers or acquisitions where a foreign company merges with or acquires
an inbound company. Our studies focus mainly on inbound mergers and acquisitions in India
in last five years and it’s financing. We have carried out statistical analysis of financial data
pertaining to the inbound mergers and detailed studies of challenges faced by the acquiring
company in financing. The opportunities are also defined clearly.

The studies shows that the predominate method of payment for acquired firm is stock and in
almost half of the M&A corporate control shift took place, where as one fourth of the
acquired firms were sick and were referred to the BIFR (Board for Industrial and financial
reconstruction) at the time of their mergers and acquisitions. The studies also shows that the
opportunities for inbound M&A’s in India are better than most of the other economies in the
world and merged or acquired firm demonstrate improvement in long term financial period. It
is found that the merged firms demonstrate improvement in long-term financial
Performance after controlling for pre- merger performance, with increasing cash flow returns
post merger. The wealth gains to acquired firm shareholders on announcement of a merger
are positively influenced by the relative size and the pre- merger performance of the acquired
firm. The transfer of corporate control from the acquired firm to the acquiring firm is
negatively associated with these abnormal share price returns. The level of industry-
relatedness of the acquired and the acquiring firms, the method of payment for the acquired
firm and the business health of the acquired firm do not appear to be playing a role in
affecting the share price returns to the acquired firm shareholders, on announcement of a
merger.

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CONTENTS

1. Introduction 4
2. An overview of the inbound mergers and
acquisitions 5-7
3. Financing M&A’s 8
4. Challenges in financing M&A’s 9-17
5. Opportunities in financing M&A’s 18-19
6. Conclusion 19-20
7. Bibliography 21

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 1.

Introduction
In recent years, worldwide, mergers and acquisitions (M&A) volume has been averaging US
$ 2 trillion. Deals running into several billion dollars are not uncommon. This report takes
special interest in financing process of inbound mergers and acquisitions and the associated
challenges and opportunities. The market for inbound M&A is a market in which foreign
bidders compete for the rights to manage inbound companies. The shareholders of the target
companies can exercise of the choice of selling their shares to the highest bidder or the
acquisition can be a hostile one.

Acquisitions are often viewed as convenient means to growth. Many economist and industrial
organisation and theorist allege that managers pursue acquisition at an unfair cost to the
shareholders. According to this view, it is the shareholder, and not the manager, who is better
placed at investing capital in alternative businesses. These theorists argue that reckless
managers aggrandize themselves with extravagant acquisitions a result of breakdown of the
agency trust that shareholders repose in their managers.

While there is some merit in this argument, there is no evidence to prove that managers of the
bidding company are systematically harming shareholders to build empires. These all results
are associated with the factor that how the financing of the M&A’s is done. The process of
M&A’s financing is an exhaustive one and consists of many steps. We will be discussing in
this report internal and external factors that come up as challenges and opportunities for
financing an inbound M&A’s.

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An overview of the inbound mergers and
acquisitions

Inbound merger

In business or economics an inbound me rger is a combination of two companies into one

larger company. The company is a foreign company. Such actions are commonly voluntary
and involve stock swap or cash payment to the target. Stock swap is often used as it allows
the shareholders of the two companies to share the risk involved in the deal. A merger can
resemble a takeover but result in a new company name (often combining the names of the
original companies) and in new branding; in some cases, terming the combination a "merger"
rather than an acquisition is done purely for political or marketing reasons.

Classifications of mergers

Horizontal merge r - Two companies that are in direct competition and share similar product
lines and markets.

Vertical me rger - A customer and company or a supplier and company. (e.g.: an ice cream
maker merges with the dairy farm that they previously purchased milk from; now, the milk is
'free')

Market-extension merge r - Two companies that sell the same products in different markets
(e.g.: GTE and Bell Atlantic into Verizon)

Categories of mergers

Mergers may be broadly classified in (i) Cogeneric and (ii) Conglomerate.

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Cogeneric : in same industries and taking place at the same level of economic activity-
exploration, production or manufacturing wholesale distribution or retail distribution to the
ultimate consumer. Conglomerate: between unrelated business.

(i) Co generic mergers are of two types (a) Horizontal merger (b) Vertical merger (Take
over)(e.g.: an ice cream maker in the United States merges with an ice cream maker in
Canada)

Product-extension me rger - Two companies selling different but related products in the
same market (e.g.: a cone supplier merging with an ice cream maker).

Conglomeration - Two companies that have no common business areas.

Co generic merger/concentric mergers occur where two merging firms are in the same
general industry, but they have no mutual buyer/customer or supplier relationship, such as
a merger between a bank and a leasing company. Example: Prudential's acquisition of
Bache & Company.

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. The purchase is made with cash or through the issue of some k ind 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 me rgers - 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.

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 Inbound acquisition

An inbound acquisition, also known as a takeover or a buyout, is the buying of one

company (the ‘target’) by another. The acquiring company is a foreign company. An
acquisition may be friendly or hostile. In the former case, the companies cooperate in
negotiations; in the latter case, the takeover target is unwilling to be bought or the target's
board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a
smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management
control of a larger or longer established company and keep its name for the combined entity.
This is known as a reverse takeover. Another type of acquisition is reverse merger. A deal
that enables a private company to get publicly listed in a short time period. A reverse merger
occurs when a private company that has strong prospects and is eager to raise financing buys
a publicly listed shell company, usually one with no business and limited assets. Achieving
acquisition success has proven to be very difficult, while various studies have showed that
50% of acquisitions were unsuccessful. The acquisition process is very complex, with many
dimensions influencing its outcome.

The buyer buys the shares, and therefore control, of the target company being purchased.
Ownership control of the company in turn conveys effective control over the assets of the
company, but since the company is acquired intact as a going concern, this form of
transaction carries with it all of the liabilities accrued by that business o ver its past and all
of the risks that company faces in its commercial environment.

The buyer buys the assets of the target company. The cash the target receives from the
sell-off is paid back to its shareholders by dividend or through liquidation. This type of
transaction leaves the target company as an empty shell, if the buyer buys out the entire
asset
s. A buyer often structures the transaction as an asset purchase to "cherry-pick" the assets
that it wants and leave out the assets and liabilities that it does not. This can be

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 particularly important where foreseeable liabilities may include future, unquantified
damage awards such as those that could arise from litigation over defective products,
employee benefits or terminations, or environmental damage. A disadvantage of this
structure is the tax that many jurisdictions, particularly outside the United States, impose
on transfers of the individual assets, whereas stock transactions can frequently be
structured as like-kind exchanges or other arrangements that are tax- free or tax- neutral,
both to the buyer and to the seller's shareholders.

The financing aspects that are associated with inbound mergers and acquisitions are searching
an acquisition candidate, choice of the type of financing, valuation of business, effects on
management, market place difficulties.

Businesses now operate in global economy, where national borders mean a little, to
multinationals employing worldwide personnel and financial strategies to suit their strategic
objectives. Inbound M&A are driven by many factors like strength of the currency and stock
market, tax, regulatory changes, and level of interest rate.

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

Cash

Payment is done by 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.

A cash deal would make more sense during a downward trend in the interest rates. Another
advantage of using cash for an acquisition is that there tends to lesser chances of EPS dilution
for the acquiring company. But a caveat in using cash is that it places constraints on the cash
flow of the company.

Financing

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Financing capital may be borrowed from a bank, or raised by an issue of bonds.
Alternatively, the acquirer's stock may be offered as consideration. Acquisitions financed
through debt are known as leveraged buyouts if they take the target private, and the debt will
often be moved down onto the balance sheet of the acquired company.

Hybrids

An acquisition can involve a combination of cash and debt or of cash and stock of the
purchasing entity.

Factoring

Factoring can provide the extra to make a merger or sale work. Hybrid can work as ad e-
denit.

Challenges in inbound merger and

acquisition

Searching an acquisition candidate

The market of corporate control or the takeover market is the market in which alternative
bidders compete for the rights to manage or gain control of underperforming companies. A
study by McKinsey indicates that 61% of the 116 acquisition studies were failure. Yet
another study suggests that than half the deals amounting to US $ 1.5 trillion fall short of
value creation target. Despite such statistic, the question is,

Why do companies acquire?

What should manager do to ensure success in acquisition?

To answer this question it is important to understand, why firms acquire and who the sellers
are. Many companies realize that disciplined acquisition search is the key to success for

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example, aligned signal corporation, identified 550 attractive potential business to be
acquired 1996-97. Of these 190 targets were selected. Further screening reduced the sample
size to 52 firms from which the company made an offer on 28. Detailed due – diligence
research was conducted on 17; allied signal consummated 10 of these deals. Perhaps the all
time record for acquisition search was Siba-Geigy’s acquisition of Airwick industries in
1974, this was preceded by a review more than 18000 companies. The internet is a useful
source of such information. Valuation criteria include a company asset, industry position,
financial status, reputation, management, trade secret, technology, name recognition and so
on. There are web sites developed exclusively for companies wishing to buy and sell their
businesses.

Frame work for decision making

Size of the target: Companies often have a range of sizes in mind. The target size depends
on the investment budget of the acquirer. Large acquire can afford to pay large amount of
money, whereas mid market companies cannot, usually, cannot afford to purchase bid
companies.
Target companies competence: Prahalad and Hamel(1990) defined core competencies as
the collective learning in the organization especially on how to coordinate diverse
production skill and integrate multiple streams of technologies.
Profitability/solvency: it is not enough for the company to meet the size requirement; it
should also be sufficiently profitable. Buying a big but bankrupt company is obviously
not a good idea unless the acquirer a vulture investor who specializes in turn around
Asset composition: companies derive their value from two sources; assets in place and
future growth opportunities. Some acquires look for research capabilities and patent s
whereas others may look for liquidity of assets for example biotechnology,
pharmaceutical and production business respectively
Nature of the industries and companies position: companies and industries go through a
life cycle just like products. The future growth rate of the company depends on the state
of the industries and the company’s competitive position. A typical industry life cycle is
shown below.

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 Financial analysis : The financial analysis involves the analysis of the income
statement, balance sheet, and cash flow statement to gauge how the company has
been performing in the recent years. More specifically, one can answers such
questions as :

 How did the company finance its operations?

 Does the company pay too much or too little as dividend?
 If the company generating enough cash to support its operations?
 Is the company adequately liquid?

This is both an ex-post analysis of the past performance and a rough estimate of how the
company is likely to perform

Strategic analysis : the strategic analysis, in contrast with the financial analysis is
supposed to through the light on the current state of strategy and what is wrong with
it. The analysis leads to the new strategies for repositioning and new segmentations
opportunities.
Due diligence : it includes assimilating and prospecting quantitative information like
sales cash flow and other financial data, and qualitative information like location,
quality of management, internal control systems and so on. Due diligence involve the
analysis of public and proprietary information related to the assets and liabilities of

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 the company being purchased. The information encompasses legal, tax and financial
matters.

Valuation of target

Companies acquire for a variety of reason, gaining synergies, increasing sales, acquiring
undervalued assets, increasing market shares and adding new products. Despite the good
intentions various studies show that only a few mergers and acquisitions become very
successful. A well designed financial evaluation program is necessary to avoid costly
mistakes. The leverage is created when the NPV of the strategies is positive at the time of
the implementation.

Value created by strategies =PV of incremental cash flows due to new investment – PV of
investment in fixed asset and working capital+ PV of residual value

NPV is a function of valuation parameters are or value drivers like sales growth rate.
Operating profit margin, tax rate, fixes capital investment, Working capital investment
and duration of the project. The value of the strategy or NPV is decided by

Acceleration of cash flows lead into higher NPV

Entries in the levels of cash flows
A reduction in the risk associate with the cash flows (volatility) and hence,
indirectly, firms cost of capital.
Increasing the residual value of the business

One of the essential steps in M&A is determining the value of the target company. There
are several approaches for measuring the value of the target firms. One of the popular
methods is DCF (discounted cash flow) methodology. In the DCF approach, the value of
the business is future expected cash flow discounted at a rate that reflects the riskiness if
the projected cash flow. This is used to value companies, since firms are essentially
collection of projects.

The steps involved in the valuation are

Step 1: determine free cash flow

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Free cash flow = NOPAT + depreciation – capital expenditure -/+ (increases or decreases
in working capital)

CFt (cash in a year t) = St-1(1+Gt)(Pt)(1- T)-(St-St-1)(Ct+Wt)

Where

S= sales

P= profit margin

T = income tax rate’

C=capital investment per dollar of the sales increase

W= net working capital per dollar of sales increase

G= growth rate

Step 2: Estimate a suitable a discount rate for the acquisition

The acquiring company can use its weighted average cost of capital based on its target
capital structure only if the acquisition do not affect the riskiness of the acquirer

Step 3.calculate the present value of cash flow

Since the life of a going concern by definition is infinite the value of the company =

PV of Cash flow during the forecast period + terminal value

Step 4 Estimate the terminal value

The terminal value is the present value of cash flows occurring after the forecast period
the

Terminal value = [CFt (1+g)]/k- g

Where

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 CFt= cash flow in the last year

g= constant growth rate

k= discount rate

Step 5: add present value of terminal value

Step 6: deduct the value of debt and other obligations

The other approaches for valuation of the company are

Adjusted present value (APV) = value of project – equity financed + interest tax shields,
bankruptcy cost financed.

Capital cash flow valuation (CCV) = net income + depreciation – capital expenditure- ∆
working capital+ interest tax shields

Choosing type of financing

The acquirer can pay the target company in cash or exchange sha res in consideration 45.6
percent of 4256 deals done in the US between 1973 and 98 where paid in cash. The
percentage of stock deals is increasing.

The analysis for shares as opposed to acquisition for cash is slightly different. The steps
involved in the analysis are:

Estimate the value of acquirers equity

Estimate the value of the target company equity.
Calculate the maximum number of shares that can be exchanged with the target
companies shares
Conduct the analysis for pessimistic and optimistic scenario

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Under and overvaluation

Due to information asymmetry between managers and investors, it is possible for shares
to be over or undervalued. The symmetric information theory hypothesis, that due to
information asymmetry between managers and investors shares could be over or under
valued. Managers acting in the interest of existing shareholders, have an incentive to issue
shares if they are overvalued. If this theory were right they suspect managers to pay in
stock rather than cash on the context of acquisitions.

The method of payment has tax consequences also, shareholders in the selling company
will encounter tax bill for capital gains if they accept cash. The tax treatment for stock
financed acquisitions favors the selling shareholders because they allow them to receive
the acquirer’s stock tax free.

Effects on management

The effects of mergers and acquisitions on, the management of the targeted firm depends, on
the type of the merger or acquisition it has been through. In case of a merger the synergies of
the merger helps the total value of the firm to increase, but in case of an acquisition it is not
the same always.

If the acquisition is a friendly acquisition, the management shows positive trend a nd

confidence in the management. Same time if the acquisition is a hostile one, the management
and the workforce of the targeted company behaves in a different way and the productivity is
affected. To overcome this problem management can introduce some kind of introduction
program for the targeted company employees to, make them comfortable.

Market place difficulties

In many states, no marketplace currently exists for the mergers and acquisitions of privately
owned small to mid-sized companies. Market participants often wish to maintain a level of
secrecy about their efforts to buy or sell such companies. Their concern for secrecy usually
arises from the possible negative reactions a company's employees, bankers, suppliers,
customers and others might have if the effort or interest to seek a transaction were to beco me
known. This need for secrecy has thus far thwarted the emergence of a public forum or

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marketplace to serve as a clearinghouse for this large volume of business. In some states, a
Multiple Listing Service (MLS) of small businesses for sale is maintained by organizations
such as Business Brokers of Florida (BBF). Another MLS is maintained by International
Business Brokers Association (IBBA).

At present, the process by which a company is bought or sold can prove difficult, slow and
expensive. A transaction typically requires six to nine months and involves many steps.
Locating parties with whom to conduct a transaction forms one step in the overall process
and perhaps the most difficult one. Qualified and interested buyers of multimillion dollar
corporations are hard to find. Even more difficulties attend bringing a number of potential
buyers forward simultaneously during negotiations. Potential acquirers in an industry simply
cannot effectively "monitor" the economy at large for acquisition opportunities eve n though
some may fit well within their company's operations or plans.

An industry of professional "middlemen" (known variously as intermediaries, business

brokers, and investment bankers) exists to facilitate M&A transactions. These professionals
do not provide their services cheaply and generally resort to previously-established personal
contacts, direct-calling campaigns, and placing advertisements in various media. In servicing
their clients they attempt to create a one-time market for a one-time transaction. Stock
purchase or merger transactions involve securities and require that these "middlemen" be
licensed broker dealers under FINRA (SEC) in order to be compensated as a % of the deal.
Generally speaking, an unlicensed middleman may be compensated on an asset purchase
without being licensed. Many, but not all, transactions use intermediaries on one or both
sides. Despite best intentions, intermediaries can operate inefficiently because of the slow and
limiting nature of having to rely heavily on telephone communications. Many phone calls fail
to contact with the intended party. Busy executives tend to be impatient when dealing with
sales calls concerning opportunities in which they have no interest. These marketing
problems typify any private negotiated markets. Due to these problems and other problems
like these, brokers who deal with small to mid-sized companies often deal with much more
strenuous conditions than other business brokers. Mid-sized business brokers have an average
life-span of only 12–18 months and usually never grow beyond 1 or 2 employees. Exceptions
to this are few and far between. Some of these exceptions include The Sundial Group,
Geneva Business Services, Corporate Finance Associates and Robbinex.

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The market inefficiencies can prove detrimental for this important sector of the economy.
Beyond the intermediaries' high fees, the current process for mergers and acquisitions has the
effect of causing private companies to initially sell their shares at a significant discount
relative to what the same company might sell for where it already publicly traded. An
important and large sector of the entire economy is held back by the difficulty in conducting
corporate M&A (and also in raising equity or debt capital). Furthermore, it is likely that since
privately held companies are so difficult to sell they are not sold as often as they might or
should be.

Previous attempts to streamline the M&A process through computers have failed to succeed
on a large scale because they have provided mere "bulletin boards" - static information that
advertises one firm's opportunities. Users must still seek other sources for opportunities just
as if the bulletin board were not electronic. A multiple listings service concept was previously
not used due to the need for confidentiality but there are currently several in operations. The
most significant of these are run by the California Association of Business Brokers (CABB)
and the International Business Brokers Association (IBBA) these organizations have
effectively created a type of virtual market without compromising the confidentiality of
parties involved and without the unauthorized release of information.

One part of the M&A process which can be improved significantly using networked
computers is the improved access to "data rooms" during the due diligence process however
only for larger transactions. For the purposes of small- medium sized business, these data
rooms serve no purpose and are generally not used.

Opportunities

Synergy

According to many researchers the notion of synergy offers the explanation. It captures the
creation of additional value, through a cooperative process between two entities over and
above the value that existed prior to such or process.

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Components of synergy

The flowing are the synergy types

a. Economies of scale
b. Economies of scope
c. Economies due to competitive positioning
d. Economies due to corporate positioning
e. Economies due to financial strategy

Economies of scale:

A major benefit of M&A’s is the economies of scale. Economies of scale come from 2
sources. The first source, in over sized production facility; the excess capacity permits a
reduction in average cost when fixed overhead cost is spread over additional units. The
second source appears when the capacity of the production unit is expanded in such a say that
the larger one is more efficient then the smaller one

Economies of scope:

Another form of benefit or opportunities the combined form of corporation may potentially
enjoy is grouped under the category of economies of scope. Cost advantage occurs to the firm
when it is cheaper to produce a number of different products together rather than separately
by different firms.

Economies due to competitive positioning:

M&A’s can be an effectible means of competitive positioning. The firm in the market place,
following porter (1980), there are three major players, buyers suppliers and competitors in the
market. M&A’s may also enhance the combine firm’s position with respect to any of these
players. These are likely to be collusive and may be concentric.

Economies due to competitive [positioning ca\n lead to greater bargaining power to make
more favorable decision on production level; [pricing leading to highetr profits,

Economies due to corporate positioning

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Corporate positioning may involve attempts to reduce environmental uncertainties by
including them within the organization boundaries. The traditional form of corporate
positioning is vertical integration. The acquiring firm widens itself, so to subsume a formal
environmental element. This kind of control would be beneficial where the market exchanges
are inefficient or involve transaction cost,

Economies due to financial strategy

Economies due to financial strategy do not quite fit into the continuum that can be observed
in the synergy levels develop so far. However, this is an important element of diversification
strategy in its quest for synergies.

The individual businesses are considered stand alone units that can be traded in the market
for corporate control. This market providers an arena where those SBUs with liquid assets
quality could be shuffled around for maximum cash returns following an acquisitions
therefore not only there is a possible lowering of the cost of capital due to reduce monitoring
cost but also there is a chance of greater availability of capital for one of the merging firms
from the other firm.

Some other opportunities are:

Tax saving
New market
Diversification

Conclusion
Great managerial skills

Mergers and acquisition requires great amount of managerial skills to be successful.

The process is very complex and involves a lot of quantitative skills and calculations.
The forecasting and valuation of the targeted business are two major aspects of M &

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 A process. It demands a lot of awareness and information about the market. A good
manager and proper implementation will ensure that the M & A will be successful.

Accurate valuation

Accurate evaluation of the target company will increase the sells growth and the
market share it will also reduce the cost of M & A and will ensure the increme nt in
the combined value of the M & A.

Correct forecasting

Forecasting of the synergy and other profit is very important as it will ensure
profitability in the long run.

Bibliography
The sites and books referred are:

Wikipedia
Mergers, acquisitions and corporate restructuring:
krishmurthi&viswanath
www.livemint.com
www.investopedia.com

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