CH11 – Financial and strategic

F3 – Financial Strategy
implications of M&A

Chapter 11
Financial and strategic
implications of mergers and
acquisitions

Chapter learning objectives:

Lead Component Indicative syllabus content

D.1 Discuss the Discuss: • Reasons for M&A and divestments

context of valuation.
(a) Listing of firms • Taxation implications
(b) Mergers and • Process and implications of management
acquisitions (M&A) buy-outs
(c) Demergers and • Acquisition by private equity and venture
divestments capitalist

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 CH11 – Financial and strategic
F3 – Financial Strategy
implications of M&A

1. Mergers and acquisitions

Merger: A merger usually occurs when two or more companies combine to form a new
separate entity.
Acquisition: An acquisition or takeover occurs when a company acquires a majority
shareholding in another company.
Takeover: the acquisition by a company of a controlling interest in the voting share capital
of another company, usually achieved by the purchase of a majority of the voting shares.
(CIMA official terminology)
Horizontal Integration: when an entity acquires or merges its business with an entity
operating in the same line of business and at the same level of the supply chain.
Vertical Integration occurs when an entity diversifies by acquiring another entity that is
operating at a different level of the supply chain.
A conglomerate is the result of two entities in totally different, unrelated businesses
combining to become one entity.
Synergy results from two or more companies joining their businesses together, thus bringing
about greater value for the combined company than could have been achieved as separate
entities.

2. Reasons for merger/acquisition

Synergies
An acquisition or merger should increase shareholder wealth via:
1. Acquiring the target company at an undervalue
Or:
2. Synergistic benefits [Market Value (MV) of the combined company (AB) > MV of A + MV
of B]
- Economic efficiency gains
§ Economies of scale (volume-related savings, horizontal combinations)
§ Economies of vertical integration (e.g. manufacturer buys a supplier – cutting
out the middleman)
§ Complementary resources (combining companies specialising in different
fields)
§ Elimination of inefficiency: highly skilled management can take over and
eliminate efficiencies

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F3 – Financial Strategy
implications of M&A

- Financial synergy
§ Diversification and financing: reduced total risk will not benefit well-diversified
shareholders (the systematic risk is not reduced by diversification), but reducing
total risk may reduce insolvency risks and hence borrowing costs
§ The “bootstrap” or P/E game – companies with higher P/E acquiring a company
can project that P/E onto the acquired company
§ Exploiting tax losses sooner
- Market power
§ Acquiring monopolistic powers (e.g. eliminate competition)
§ Acquisition of a scarce resource
§ Dynamic management
§ Innovative product
§ Cash surplus
§ To enter a new market quickly
§ To exploit big data opportunities

Acquisitions and mergers can be classified as either:

• Horizontal integration – acquisition of a company in the same industry
• Vertical integration – acquisition by a company of a company before or after it in the
supply chain
• Conglomerate – acquisition of a company in a different line of business

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F3 – Financial Strategy
implications of M&A

Problems with acquisitions and mergers

• Cultural clashes may arise.
• There may be a lack of goal congruence between the two companies, leading to disputes.
• Before making an offer, the acquiring company should consider not only the purchase
cost but also the expenses and management time needed to turn the acquired company
around.
• There may be certain areas of the acquired company that the acquirer may only come to
know of fully after the acquisition. It could be that the acquired company does not have
the resources or industrial position anticipated by the acquirer.
• The premium paid by the acquirer may be too high and may not be realised after the
takeover.
• The integration should be well planned out in advance and negotiated with the target
company before making the offer. If the integration is not properly thought-out and
negotiated before acquisition, it can cause difficulties after acquisition and result in
possible failure. The plan should consider the areas of the acquiring company that will be
most affected by the acquisition.
• The acquirer should be prepared and willing to embrace change, which will be necessary
for integration to be effective.

3. Tax implications of M&A

Tax issues affecting mergers and acquisitions:
• Members of a group can surrender losses to another group member, so the acquired
company can surrender or relieve losses. However, pre-acquisition losses cannot be
relived, nor can any losses be set off against pre-acquisition profits.
• If a company acquires another company based in a different country, the tax rates
applicable to the two companies will be different.
• There may be a double-taxation treaty operating between the two countries. The main
aim of the treaty is to avoid double taxation, so only one of the countries gets to tax the
income.
• Withholding taxes will need to be paid on payments made to companies within the group
(withholding tax is tax deducted from the payment and paid to the government).

4. Competition authorities
• Competition authorities monitor all takeovers and mergers to ensure none is going
against the laws and regulations.

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implications of M&A

• The competition authorities will investigate a merger/acquisition if they believe it to be

anti-competitive or going against public interest and can reject the proposal, accept the
proposal or accept it subject to certain conditions.
• The investigations can be time-consuming, and the acquirer may just decide to withdraw
their proposal.

5. Divestment
Divestment: disposal of by an entity of part of its activities. (CIMA official terminology, 2005)
Divestment could be in the form of:
1) Sell-off (trade sale): a part of the entity is sold off to a third party in return for cash
Reasons for sell-offs could be to:
• generate cash in times of crisis
• dispose of unprofitable or unwanted business units
• protect the rest of the business from a takeover by selling off the part wanted by the
buyer

2) Spin-off (demerger): this is the creation of a new entity by transferring some of the
assets. The shares are held by the original shareholders.
Reasons for spin-offs could be to:
• help investors identify the true value of the underlying operations
• achieve a clearer management structure
• reduce the risk of takeover

6. Management buyouts (MBOs)

Management buyout is the purchase of the business (or part of the business) by members of
the existing management team.

Reasons for MBO

A buyout can be looked at from both the buyout team’s point of view and the seller’s point of
view, as each will have differing reasons for wishing to proceed with the buyout.
• From the buyout team’s point of view:
- To obtain ownership of the business rather than remain as employees, which allows
better management of the business.
- To avoid redundancy when the business is threatened with closure.

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F3 – Financial Strategy
implications of M&A

• From the seller’s point of view:

- To dispose of part of the company that does not fit in with the overall company
strategy whilst raising cash.
- To dispose of a loss-making segment of the business that the directors do not have
the time or inclination to turn around.
- It is often easier to arrange a management buyout than to try to sell off parts of a
business in the open market.
It may well avoid redundancy costs strike action if closure is the only alternative.
Why do MBOs work? Potential issues

• Personal motivation of the • Lack of experience of the management team in

buyout team certain areas of the business
• A more hands-on approach • Lack of resources needed to run the business
to management
• The price paid may be too high
• Keener decision-making on
• Difficulty in convincing employees to change
such areas as pricing and
working practices
debt collection
• Maintaining relationships with suppliers and
• Savings in head office
customers
overheads
• Loss of key staff

Financing
In a buyout, some finance will be provided by the managers, but most of the finance will be
provided by other financiers including:
• Venture capitalists – they usually provide funds for five to ten years and require high
returns
• Banks
• Private equity firms
• Other financial institutions

Factors to be considered
• by the buyout team:
- the potential of the business being bought out
- support services will be lost
- the quality of the management team
- the valuation of the business and the price to be paid

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implications of M&A

- whether the owners are willing to sell

• by the divesting company:
- a way to sell loss-making segments
- a way of asset-stripping
- often easier to arrange a management buyout than to sell in the open market
- the segment may no longer fit in with the overall strategy of the company
- loss of key staff
- members of the buyout team being in possession of detailed and confidential
information on the vendor’s other areas of business

7. Exit strategies
Exit strategy is the means of terminating ownership of a company.

Motives for exit strategies

• Raising cash – to ease liquidity problems or to reduce gearing.
• Disposal of non-core business - may allow the company to focus on key strategic
initiatives.
• Takeover defence – selling off underperforming division(s) may deter a takeover bid that
aims to add value by unbundling the company.
• Synergy – other owners may make better use of a division.

Exit routes available to investors

• Trade sale: Sell off all the shares to a bidding company.
• Initial public offering (IPO): the flotation of the shares on the stock market after it gets
listed on the stock exchange. A company will have to meet certain criteria to join the stock
exchange.
• Independent sale of shares to another shareholder.

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F3 – Financial Strategy
implications of M&A

9. Chapter summary

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