Mergers and Acquisitions

External growth and restructuring of firms. Jyoti Gupta

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Market for corporate control Mergers and acquisitions are part of the broader market for corporate control. It is not only acquisition of company by another, it includes spin-offs, divestitures, restructurings of capital structure, buy-outs and buy out of public companies by groups of private investors. The ordinary mergers involve combination of two established firms.
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Mergers
Horizontal mergers: between two firms in the same line of business. Acquisition by Altadis of Rgie des Tabacs du Maroc, Acquisition, TotalFina and Elf etc. Alcatel and Lucent which merged officially on the 1 December 2006. Vertical Mergers:companies at different stages of production; Disney and ABC television. Conglomerate merger: unrelated line of business; Vivendi and Seagram.
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Rationale of mergers The rationale behind any merger operation is to create value for the shareholders. This also supposes that all other stakeholders would be better-off if the merger operation is carried through. All other motives are secondary.

Motives for mergers (Efficiency gains)

Economies of scale. Increased revenues/ increased market share Improved productivity through cost cutting Surplus funds. Economies of scope. Reusability of information. Reputational spill over. Better product mix. Resource transfer by overcoming information asymmetry or by combining scarce resouces.
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Strategic reasons Increased competition Domino effect. Too big to fail. Empire building.

Value Drivers
Cost Savings Reduction in labour costs. Reduction in O/H costs, including costs related to marketing and distribution. Better recruitment strategy. Better HR management. Reduction in after sales service costs. Better and efficient IT services. Savings in purchasing costs (stronger purchasing power) Increase in revenues Better product mix Improvement in brand image. Better range of product and services. More effective pricing policy. Lower competition.

M&A process
Many firms have a pro-active approach to M & A operations as a source of growth, value creation and restructuring. They could be friendly or hostile. In case the firms are listed, the operations are subject to clearance from regulatory authorities. The authorities want to make sure that the operation will not lead to creation of a monopoly. The case Schnieder and Legrange, the European Commission refused the merger between the two.
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M&A process
In the case of listed companies, the acquiring company makes a take-over bid for the target company. An offer is made to the shareholders of the company (cash, exchange of shares, or a mix of the two). In a friendly bid, the Board of Directors of the two companies agree to the proposition. The Board recommends to shareholders to accept the offer by the acquiring company. The post merger strategy is jointly agreed upon. In a hostile bid, the target company board recommends to the shareholders to refuse the offer.

Hostile Takeover: game theory One can better understand and negotiate, if one considers a take-over as a game. It should include the following: 1. Gain the perspective of various players in the take over scenario, motives and behaviors. 2. Master important rules and defenses that constrain the players. 3. Anticipate the paths that the outcome might take.
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Players involved Bidder or the attackers: often viewed harshly. Target or the defender: considered to be a profitable opportunity; synergy, underutilized that could be sold, closing parts of the business which are under performing. Free riders, shareholders who are not well informed but are prepared to ride with the bidder. Groups within the target: Managers vs Directors. Senior managers are likely to loose jobs, whereas Directors are supposed to work for the shareholders (agency problems).
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Players
Insiders vs outside directors: Inside directors are usually also managers, outside directors may be friends of inside directors or independent. Large vs small shareholders. Their relative powers and voting rights can influence the outcome. Other potential buyers who have interest in acquiring the company but have not entered the bid. These are often called the white Knights. Arbitrageurs who make a living betting on price movements (Hedge Funds), they often absorb all the floating shares once the move is on, and can have a significant impact on the final outcome.
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M&A Process (A pro-active approach by Acquiring company)

Clear definition of objectives and goals. A preliminary analysis of possible target companies. Estimation of possible synergies, timing and probability. Valuation of the target company, stand alone and as a merged company. Preparation of an offer, including a due diligence report from the investment bank. Final offer. Negotiation and settlement.
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Role of the investment banks

The investment banks play an important role in the M&A operations. The aquiring company and the target company would normally appoint an investment bank (may be more than one) as advisers in the operation. They advise at all stages of the operations, which includes the valuation, synergy valuation, structure of the deal, carry out the due diligence, provide funding gurantee, funding and post merger support in putting the new business model in place. These operations represent a significant part of their revenues. Most investment banks have M&A departments, which are often divided in sectors (Telecommunications, agro, commodities etc). The investment banks often are at the source of operation, advising companies on the likely targets. These operations are called pitching; preparing the necessary documents to present to potential acquirers. They represent a significan part of the revenues.
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Due Diligence (an example)

Material Adverse Effect: This clause in the due diligence document can enable the Acquiring company to walk away from the deal even once the final offer is made. The Bank of America (BofA) purchase of Merrill Lynch, is a good example. The Bof A agreed to buy Merrill Lynch for $50 billion in stocks, or $29 share, in December 2008. Once the offer was made, the BA executives started having doubts, as ML started to show losses. By the end of the month, the losses exceeded $13 billion. Most of the losses were coming from trading department, ans also the wealth management unit. BofA executives discussed the possibility citing Material Adverse Effect clause to severe the contract.

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Merger gains and costs

Gain = PV(A+B) PV(A)-PV(B) PV(A), PV(B) and PV(A+B), being the values of the firms A , B stand alone and the two firms if they merge. Merger is justified only if there is a synergy gain. Cost to the acquiring firm A is given by cost=Cash paid- PV(B). The synergy gain is usually shared between the acquiring firm and the shareholders of the target firm.
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Estimating Merger Gains and Costs

The NPV of the gain to the bidder A of a merger with the target B is measured by the difference between the gain and the cost. NPV=Gain-Cost = (PV(A+B))-PV(A)PV(B))- (Cash Paid-PV(B)). The approach enables to analyze how the gains are shared between the two companies.
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An Example: Payment in cash

Bidder firm A is valued at 400 Target Firm B is valued at 200. The synergy gains (Present value of cost savings) is estimated to be 100. PV(A)=400, PV(B)=200, PV(A+B) =700 Price Paid for acquiring B = 260 Cost of acquisition =260-200 =60 The shareholders of B gain 60 The shareholders of A would gain 100-60=40. The maximum price that A should pay is 100, then the shareholders of A will get nothing out of the operation.
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Merger gains and stock prices If the investors do not anticipate the merger, the market capitalization of A should go up by 40 and the market capitalization should increase by 60. It is therefore important to analyze the reaction of the stock market after the announcement. If the stock price of A falls after the announcement, it means that the market feels that A is paying a too high a price. You only buy a whole company, you add value when you add additional economic rent.
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Market value and intrinsic value

One of the major problems in acquisitions of public companies is that the market capitalization of the target company often includes the anticipated merger gains. There are rumors of a possible merger by A of B, the investors already push the price of B up by some portion of the merger gains. In that case the cost of merger determined by the difference between the price paid and market value of B (determined by Share price of B x number of shares) is an underestimation. One should differentiate between Market Value and Intrinsic Value of a firm. If MV <PV MV =Share price after the rumors x Number of shares PV (Intrinsic value) =Share price stand alone x Number of shares.
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Mergers when paid in stocks of the acquiring company

When the target company are paid in shares, the cost depends on the price of shares of the new company. If the sellers receive N shares the cost = N x Share price of the new company- PV(B) One should ensure that the price per share after the announcement and its benefits are appreciated by the sellers. The cost can also be calculated by using the fraction of the total shares of the new company owned by the shareholders of A, if it is a Cost= a x PV(A+B) PV(B)

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Paid in stocks: example

Bidder or Acquiring company, share price 200, number of shares 200; PV(A) =40000 Target company B, share price 100, number of shares 100, PV(B) = 10000 New Company after merger (A+B), has 260 shares, shares are trading at 230, PV(A+B)= 59800. The synergy gains as estimated by the market is 9800. A pays the shareholders of B, 60 shares of A. An exchange ratio of 60/100 ,ie 0.6 shares of A for each share of B. Cost to the shareholders of A of the operation =60/260 x59800=13800-10000=3800.
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Gains for shareholders of A and B Gains

59800

A=200/260X59800 =46000

B=60/260 X59800 =13800

Gain=4600040000=6000

Total Gain=9800

Gain=1380010000= 3800

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Distinction between payment in cash and payment in stocks.

If cash payment is made, the cost is unaffected by the merger gains. If shares are offered the cost is determined by the merger gains which are reflected in the share prices. Stock payment also mitigates any over or under evaluation. The shareholders of the target company would often like to protect themselves against any unfavorable movement of the merged company. The contingency value rights (CVR) have been used to protect the shareholders of the target companies. The CVRs are derivative type instruments, which stipulates an additional payment if the share price of the merged company trades below a certain level after a certain period of time. The maximum payment is also often limited.

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Right Price: Key to a good transaction To obtain a reasonable price based on intrinsic value it is important to understand the valuation model used. Determining the Free cash flows, appropriate discount rate, and how they impact the value. One should take into account the position from which the valuation is being made.
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Example Consider the case of a company B is an acquisition target by another company A. The value of the company B depend on the why, for whom and circumstances (majority, cash payment or exchange) which can bring significant differences in the valuation and the price that A should pay for B. Generally a premium needs to be paid for absolute majority. Tables give the possible scenarios.
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Scenario 1: Maximum value for B

FCF Synergies in B Synergies in A Discount rate What do get Those generated by B when run by A Included Included Bs Rate when run by A Maximum intrinsic value of B for A To determine for A, the maximum price to be paid for B
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What it is used for

Scenario 2: Bs continuity value

Free Cash Flows Synergies in A Synergies in B Discount rate What is obtained What it is used for Those generated by B without transaction Not Included Not Included Bs rate without transaction Bs intrinsic value To determine Bs minimum value
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Scenario 3: As continuity value

Free cash flows Synergies in A Synergies in B Discount rate What is obtained What it is used for Those generated by A without transaction Not included Not included As rate without transaction As intrinsic value To determine possible A and B exchange ratio
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Merger Accounting How does the merged companies financial statements are affected after the acquisition? Since 2001, FASB( Financial Accounting Standards Board) introduced new rules. All companies are required to to use the purchase method. This method introduces an asset which is called the Goodwill.
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Merger accounting, an example

We look at two companies A and B Company A is the acquirer and the company B is the target. The balance sheets are given. The Shareholders equity of the target company B is 1000. Company A pays a premium of 500 to the shareholders of B. The purchase price is 1500. It might be paying for the intangible assets, which are not in the balance sheet. Under the purchase method, the accountant takes of this by creating a new asset called goodwill and assigns 500 to it in the balance sheet of the merged company. The shareholders equity of the merged company = 2800 + 1000 + 500 = 4300. The equity of the merged company goes by the value of the premium paid.
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Merger accounting, an example: the balance sheet of the acquiring company A

Balance Sheet Firm A

Assets Liabilities

OWC

800

Debts

1200

FA

3200

Equity

2800

Total

4000

Total

4000

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Balance Sheet Target Company B

Balance Sheet Firm B Assets Liabilities

OWC

100

Debt

FA

900

Equity

1000

Total

1000

Total

1000

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Balance sheet, Merged company AB

Balance Sheet AB Assets OWC FA 900 4100 Liabilities Debt Equity 1200 4300

Goodwill 500 Total 5500 Total 5500

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Goodwill and Taxation

Goodwill are not allowed to be amortized. Suppose the goodwill (premium paid over the book value) is 10 million. As long as the goodwill is estimated to be at least 10 million, it stays on the balance sheet and it has no impact on the companys earnings. The company is obliged each year to estimate the fair value of the goodwill. If the estimated value falls below the 10 million, the amount shown in the balance sheet must be adjusted downward and the write-off deducted from the years earnings. The example of AOL, write-off $54 billion.
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Tax Considerations
An acquisition may be either taxable or tax-free. In general, if the payment is in cash, the acquisition is considered as taxable. Investors pay capital gains tax. If payment is essentially in shares, the operation is considered to be tax free, as they are simply exchanging shares. The tax status of the acquisition also effects the tax paid by the merged firm afterwards. In the case of a taxable acquisition, the assets of the selling firm are revalued, the write-up or write-down is treated as taxable gain or taxable loss. The depreciation is calculated on the basis of the restated asset values.
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Tax considerations: an example The Norman Shipping Company buys a tanker for $20 million.This is the only asset owned by the company. It is depreciated over 20 years linearly; yearly depreciation = $1 million. The Norman was acquired by Pat Shipping corporation after 10 years for $15 million. What would be tax liabilities if it was a taxable merger or a tax-free merger?
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Example
Taxable merger Tax-free merger

Impact on N

N must recognize $5 million as capital gains

Capital gains can be deferred until N sells the Pat Shares

Impact on P

Tanker is revalued at $15 Tanker tax million. Depreciation is depreciation remains increased to $1.5 million from at $1.0 million. 1.0 million.

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Takeover defenses
Given the increasing number of firms which are likely to be target, management team try to develop tactics and weapons of defense. These are used in the case of hostile take-over bids. Increasingly, govenments are intervening to stop foreign companies taking over national companies ( Sanofi Synthelabo, Danone, Arcelor). Major motivation being, firstly managers believe their jobs will be at risk, secondly they would like to obtain a higher price from the bidders.
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Takeover defenses (preoffer)

Type of defense Description

Staggered Board

Board is classified into several groups. Only one group is elected each year. Therefore the bidder cannot gain control of the target immediately. Mergers are only allowed if the bidder offers a fair price. The fair price is determined by a formula.

Fair Price

Multiple voting rights

The shareholders are classified into different groups with different voting rights. Some shareholders who own multiple voting rights can block the takeover.
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Takeover defense (preoffer defense)

Type of defense Restricted voting rights Description Shareholders who acquire more tha a certain number of shares lose their voting rights unless approved by the board.

Waiting period Unwelcome acquirers must wait for a specified period before they can complete the merger. Poison pill Poison put Golden parachute Rights issue to friendly shareholders at a bargain exercise price. Sale of crown jewels. Existing bond holders can demand repayment if there is a change of control due to hostile takeover. General payoffs if the existing managers loose their jobs as a result of takeover.
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Takeover defense (Postoffer)

Type of defense Description

Legal recourse File suit against the bidder for violating the anti-trust laws or securities laws

Liability restructuring

Issue shares to friendly third party or increase the number of shares. Repurchase shares from the existing shareholders at a premium. By shares that the bidder will not like or create antitrust problems.

Asset restrucuring

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Merger and antitrust law

Most countries have antitrust laws, which forbids acquisitions if it leads to the lessening of competition and creation of monopolies. In the US, the Clayton Act (1914), forbids an acquisition whenever the effect may limit and restrict competition. The European Community has strict antitrust laws. An acquisition is forbidden if it leads to the creation of a company which holds more than 50 percent of market in any one European country or more 30 % of the Euopean market. The proposed merger between GDF and Suez is being scrutinized by the European Antitrust commission on the question of monopoly. The investment banks should ensure that the merger will not be prohibited as part of the due diligence.

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M&A:General observations
The analysis of the M&A operations in the past gives some interesting results: The sellers generally do better than buyers. The average gain of the shareholders of the target company was around 16 percent. The shareprices of the acquiring company decline on average. Studies show that a significant proportion of M&A operations destroy value. The question is why ? This is explained by behavioral finance. The managers of acquiring companies may be driven by hubris or overconfidence in their ability to run the target company than the existing managers. Another explanation is based on signalling effect of an merger announcement; the firm can grow by greenfield investment or acquisition. The acquisition is justified when the overall market is not growing. Therefore the firm value might drop simply because the market interprets that the sector growth is limited.

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Observations Why sellers get higher returns:

Premium paid because of competition Get a share of the estimated synergy Target management may put obstacles, white knight, antitrust law, poison pill to push the price up. The other major winners are of course the investment banks, lawyers, accountants, arbitrageurs etc.
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The case of Sanofi-Synthelabo and Aventis. Sanofi-Synthlabo: Created in December 1998, after the merger between Sanofi and Synthlabo. Sales (2003): 5350 million euros Sector: Pharmaceutical products. Employees: 32500 globally. Major shareholders: TotalFinaElf (26%), LOreal (19.5%).
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Sanofi-synthlabo
Major products: Plavix, Aprovel, Stilnox. Specialization: Cardiovasculaire, Thrombosis, Nervous system, Oncology. R&D budget: 1316 million in 2003. Market capitalization (Early 2004) 43751 million . Among the top 20 internationally, 7 in Europe. Major risk: a significant number of licenses will fall in the public domain in 2006.
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Aventis
Sales: 17815 million euros. Sector: Pharmaceutical products. Employees: 71000 globally. R&D budget: 2863 million euros. Created by the merger of Rhone-Poulenc and Hoecst. Joint venture in veternary medicine with merck &Co (50/50). Major products: Allegra/Telfast, Lovenox/ Clexane, Taxotere.
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Take-over bid by Sanofi-Synthlbo for Aventis (25 January 2004)

Objective: Strategic project for a sustainable strong growth and profitability. The details were as follows: An offer based on exchange of shares and cash payment: 5 SS shares + 69 for 6 Aventis shares. A supplementary offer (cash or exchange) cash offer: purchase of Aventis share for 60.43. Exchange offer: Exchange 35 SS shares for 34 shares of Aventis. Shareholders were given the possibility to choose a mix of the above two possibilities. The overall offer was based on 81 % of exchange of shares and 19 % in cash.
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Reasons for the bid

Value creation for the shareholders in excess of what they can get if stayed separately. Respond to the needs of patients globally. Given the larger number of molecules. Better positioning in USA. Significant R&D budget (>4 billion) Synergy gains due to cost cutting estimated at 1.6 billion /year. The culture of the two companies are fairly similar. A significant number of managers in SS come from Aventis.
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Post merger proposition by SS Reorganization of the Board of Directors after the Take over (Equal numbers). Head office in Paris. Major investment in USA, Germany and Japan. Merger in due time. No redundancy for the Aventis employees. Reorganization of R&D, production and promotion.
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Financial implications of the take-over bid. Financing: the cash requirement is estimated to be around 9168 million . The BNP Paribas and Merill Lynch agreed to a credit line of 12000 million to finance the bid.

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Valuation of Aventis shares by SS based on the figures 2000/01/02 Share prices PER of comparable companies. Benchmarking of premiums paid in the case of similar operations. Earnings per share. Dividend paid share.

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Exchange ratio
Mixed offer: 5 SS shares + 69 for one Aventis share= (5*58,72 + 69)/6 = 60.43 Supplementary offer : 1 Aventis share = 1.02917 SS shares;(5*58,72+ 69)/6*58.72) =1,02917 SS shares. This is equivalent to 34 Aventis shares for 35 SS shares. SS took as base the SS share price of 58,72 (before the rumeurs were started). The offer valued the Aventis company at 47 billion . Aventis had 777.8 million shares outstanding.

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Refusal of the offer by the Aventis Board.

The first offer of SS was rejected by Aventis. They considered it to be insufficient. The offer was based on a PER of 16.2, which was below the average of the sector estimated at 21.2. Aventis looked for an alternative to SS offer, they approached Novartis to act as the white knight. Novartis was interested as they considered that Aventis was worth 53 billion . Aventis agreed to a friendly take over if given the green light by the Government. Novartis had the financial capacity to go ahead rapidly. But they did not want to go against the wishes of the French Government, given that the state was the biggest customer.
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Second friendly take over bid by SS (26/04/04).

The bid revalued the original offer by around 6,7 billion . The mixed offer: 5 SS shares +120 cash for 6 Aventis shares. Supplementary offer: Exchange 1,1739 SS shares for 1 Aventis share or 68.93 cash for each Aventis share. This meant 71 % of the offer in shares and 29 % in cash. The offer was accepted. The new group Sanofi-Aventis was created. At this offer price Aventis was valued at 53.6 billion.

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Sanofi- Aventis
The name of the company would be SanofiAventis. Board of Directors will be made up of 17 members, CEO will be Jean-Franois Dehecq, 8 members will be from Aventis including the Vice President. The board will create 4 committees: Strategic committee, committee for salaries and nomination of directors, Audit and Scientific committees. 2 will be headed by person designated by SS, 2 others by Aventis.
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Spin off
The spin off are used by companies as part of the strategy to restructure the business of the company, often as a response to the investors concern. This is often used as a means of raising the returns to the shareholders. The spin off consists of floating a segment of the business as an independent company through an IPO. In most cases the parent company keeps a significant shareholding in the new company.
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Spin off: The example of Anglo American

Anglo American is a London based mining group. It is the worlds third largest mining group. Its main concentration is on Platinum, gold and Diamond. These were seen to be its strength. Investors feared that the firm was missing out on recent surge (2005-2006) in bulk commodities largely driven by the demand from China and India. Since 2002, Anglo has under performed the FTSE world mining index by 20.5 per cent and BHP Billiton by more than 30 per cent. Anglo American turnover in 2005 was $34.5 bn. An increase of 8 percent essentially as a result of commodity prices. Pre-tax profits rose to $ 5.2bn in 2005 from $4.9bn 2004 The base metal division was the greatest contributor.

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Anglo American
In February 2006, Anglo American announced that they would spin off Mondi, its paper and packaging business estimated to be worth $6bn-$8bn. The group plans to go for an Initial Public Offering of Mondi on the London Stock Exchange. Initially 20-25 percent stake will be sold to the public. Offering price will depend upon the level of debt which is transferred from the parent company. Goldmam Sachs and UBS felt that the new company will go straight to FTSE 100 index, and the new company would be the biggest paper and packaging business on the London market.
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Anglo American
This operation is part of an overall restructuring process, which includes sales of 51 per cent stake Anglo Gold (intends to keep the majority). It is also raising its planned return to shareholders by $500m to 1.5bn, through share buy-back and a special dividend of 33 cents per share. The announcement led to an increase of Anglo American shares by 2.7 per cent. The announcement of the restructuring operation was made February 22, 2006.
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Example-Total
In year 2005 Total products were divided into three segments
Upstream, includes Exploration and production and Gas & Power activities. Downstream, includes refining and marketing. Chemicals, includes petrochemicals, specialities chemicals and industrial chemicals.

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Total
Sales 143,168 m Net operating Income 11,902 m Net Income 12,003 m Total Assets 106,144 m Earnings per share (EPS) = 20.33 Dividend per share (DPS) = 6.48 Market Capitalization (130.5 bn )
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Total
The company has announced as part of their strategy to focus on petrol and petroleum products to create a new decentralized entity encompassing the Vinyl products, industrial chemicals and performance product activities. This entity, named Arkema, was officially created on October 1, 2004. This entity will become a stand alone entity, and it is proposed to spin-off. The objective is to focus its chemical activities on petrochemicals and speciality chemicals.
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Total
The ROACE (Return on Average Capital Employed) is currently lower in the Chemicals division.
Upstream 40% Downstream 28% Chemicals 11%.

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