Chapter 2: Mergers and Acquisitions

Major Finance and Accounting -Dr. Manara Abdelaziz Toukabri-Fall 2021-part2

In practice, many of the terms used to describe various types of transactions are used loosely such
that the distinctions between them are blurred.

 For example, the term “consolidation” is often applied to transactions where the entities are
about the same size, even if the transaction is technically a statutory merger.
 Similarly, mergers are often described more generally as takeovers, although that term is
often reserved to describe hostile transactions, which are attempts to acquire a company
against the wishes of its managers and board of directors.

Major differences of stock versus asset purchases:

There are two basic forms of acquisition: An acquirer can purchase the target’s stock or its assets

Stock purchase Asset purchase

Payment Target shareholders receive
compensation in exchange for
their shares.
Approval Shareholder approval required
Tax: corporate No corporate-level taxes
Tax: shareholder Target company’s shareholders
are taxed on their capital gain
Liabilities Acquirer assumes the target’s
liabilities.
Payment is made to the selling
company rather than directly to
the shareholders.
Shareholder approval might not be
required.
Target company pays taxes on any
capital gains.
No direct tax consequence for
target company’s shareholders.
Acquirer generally avoids the
assumption of liabilities

REGULATION :
Even when a merger has been accepted by the target company’s senior managers, the board of
directors, and shareholders, the combination must still be approved by regulatory authorities.

This section provides an overview of the key rules and issues that arise from M&A activity.

The two major bodies of jurisprudence relating to mergers are antitrust law and securities law.

Antitrust :
Most countries have antitrust laws, which prohibit mergers and acquisitions that impede
competition.

Antitrust legislation began in the United States with the Sherman Antitrust Act of 1890, which made
contracts, combinations, and conspiracies in restraint of trade or attempts to monopolize an
industry illegal. The Sherman Antitrust Act was not effective at deterring antitrust activity partly
because the US Department of Justice at the time lacked the resources necessary to enforce the law
rigorously.

The last major piece of US antitrust legislation was the Hart–Scott–Rodino Antitrust Improvements
Act of 1976, which required that the FTC (Federal trade commission) and Department of Justice have
the opportunity to review and approve mergers in advance. A key benefit of the Hart–Scott–Rodino
Act is that it gives regulators an opportunity to halt a merger prior to its completion rather than
having to disassemble a company after a merger is later deemed to be anticompetitive.

Just as US transactions are reviewed by the FTC and the Department of Justice, the European
Commission (EC) has the authority to review the antitrust implications of transactions among
companies that generate significant revenues within the European Union. Although the European
Commission’s member states have jurisdiction on mergers within their respective national borders,
mergers with significant cross-border effects are subject to EC review. Similar to the requirements in
the United States, pre-merger notification is required.

Prior to 1982, the FTC and Department of Justice used market share as a measure of market
power when determining potential antitrust violations among peer competitors in an industry

In 1982, the agencies shifted toward using a new measure of market power called the Herfindahl–
Hirschman Index (HHI).

By summing the squares of the market shares for each company in an industry, the HHI does
a better job of modeling market concentration while remaining relatively easy to calculate and
interpret. To calculate the HHI, the market shares for competing companies are squared and then
summed:

𝑠𝑎𝑙𝑒𝑠 𝑜𝑟 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑖

𝑯𝑯𝑰 = ( × 100)𝟐
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑜𝑟 𝑜𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡

 Regulators initially calculate the HHI based on post-merger market shares.

 If postmerger market shares result in an HHI of less than 1,000, the market is not considered
to be concentrated and a challenge is unlikely unless other anticompetitive issues arise.
 A moderately concentrated HHI measure of between 1,000 and 1,800, or a highly
concentrated measure of more than 1,800, requires a comparison of post-merger and pre-
merger HHI.
Securities Laws
In the United States individual states regulate M&A activities to varying degrees. But companies must
also comply with federal US securities regulations.

During the 1960s, tender offers became a popular means to execute hostile takeovers. Acquirers
often announced tender offers that expired in short time frames or threatened lower bids and less
desirable terms for those shareholders who waited to tender.

 Tender offer: acquirer invites target shareholders to submit (―tender‖) their

shares in return for the proposed payment. It is up to the individual shareholders
to physically tender shares to the acquiring company’s agent in order to receive
payment. A tender offer can be made with cash, shares of the acquirer’s own
stock, other securities, or some combination of securities and cash..

 Proxy fight : company or individual seeks to take control of a company through

a shareholder vote. Proxy solicitation is approved by regulators and then mailed
directly to target company shareholders. The shareholders are asked to vote for
the acquirer’s proposed slate of directors.

In addition to 
giving shareholders little time to evaluate the fairness of an offer, it gave
target management little time to respond.

The Williams Act sought to remedy these problems in two keys ways: disclosure requirements and a
formal process for tender offers.

Target Company Valuation:

The three basic valuation techniques that companies and their advisers use to value companies in an
M&A context are:

 Discounted cash flow analysis

 Comparable company analysis
 comparable transaction analysis

Discounted Cash Flow Analysis :

Discounted cash flow (DCF) analysis, as it is generally applied in this context, discounts the company’s
expected future free cash flows to the present in order to derive an estimate for the value of the
company. Free cash flow (FCF) is the relevant measure in this context because it represents the
actual cash that would be available to the company’s investors after making all investments
necessary to maintain the company as an ongoing enterprise.Free cash flows are the internally
generated funds that can be distributed to the company’s investors (e.g., shareholders and
bondholders) without impairing the value of the company.

Comparable Company Analysis:

A second approach that investment bankers use to estimate acquisition values is called “comparable
company analysis.”

In this approach, the analyst first defines a set of other companies that are similar to the target
company under review. This set may include companies within the target’s primary industry as well
as companies in similar industries.

The sample should be formed to include as many companies as possible that have similar size and
capital structure to the target. Once a set of comparable companies is defined, the next step is to
calculate various relative value measures based on the current market prices of the comparable
companies in the sample.

Such valuation is often based on enterprise multiples. A company’s enterprise value is the market
value of its debt and equity minus the value of its cash and investments.

In order to calculate an acquisition value, the analyst must also estimate a takeover premium.

The takeover premium: is the amount by which the takeover price for each share of stock must
exceed the current stock price in order to entice shareholders to relinquish control of the company
to an acquirer. This premium is usually expressed as a percentage of the stock price and is
calculated as:

𝑫𝑷 − 𝑺𝑷
𝑷𝑹𝑴 =
𝑺𝑷

Where:

 PRM: takeover premium

 DP: deal price per share of the target company
 SP: stock price of the target company
To calculate the relevant takeover premium for a transaction, analysts usually
compile a list of the takeover premiums paid for companies similar to the target.
Comparable Transaction Analysis
A third common approach to value target companies is known as “comparable transaction analysis.”
This approach is closely related to comparable company analysis except that the analyst uses details
from recent takeover transactions for comparable companies to make direct estimates of the target
company’s takeover value

WHO BENEFITS FROM MERGERS?

What does the empirical evidence say about who actually gains in business combinations?

Studies on the performance of mergers fall into two categories: short-term performance studies,
which examine stock returns surrounding merger announcement dates, and long-term performance
studies of post-merger companies.

 The empirical evidence suggests that merger transactions create value for target
company shareholders in the short run: “On average, target shareholders reap
30 percent premiums over the stock’s pre-announcement market price, and the
acquirer’s stock price falls, on average, between 1 and 3 percent”. Moreover, on
average, both the acquirer and target tend to see higher stock returns surrounding
cash acquisition offers than around share offers
 The high average premiums paid to target shareholders may be attributed, at least
partly, to the winner’s curse—the tendency for competitive bidding to result in
overpayment. Even if the average bidding company accurately estimates the target
company’s value, some bidders will overestimate the target’s value and other
potential buyers will underestimate its value. Unless the winner can exploit some
strong synergies that are not available to other bidders, the winning bidder is likely
to be the one who most overestimates the value.
 When examining a longer period, empirical evidence shows that acquirers tend to
underperform comparable companies during the three years following an
acquisition.
o This implies a general post-merger operational failure to capture synergies.
Average returns to acquiring companies subsequent to merger transactions
are negative 4.3 percent with about 61 percent of acquirers lagging their
industry peers.27 This finding suggests that financial analysts would be well
served to thoroughly scrutinize estimates of synergy and post-merger value
creation.

Summary
Mergers and acquisitions are complex transactions. The process often involves not only the acquiring
and target companies but also a variety of other stakeholders, including securities antitrust
regulatory agencies. To fully evaluate a merger, analysts must ask two fundamental questions: First,
will the transaction create value; and second, does the acquisition price outweigh the potential
benefit?

 An acquisition is the purchase of some portion of one company by another. A merger

represents the absorption of one company by another such that only one entity survives
following the transaction.
 Mergers can be categorized by the form of integration. In a statutory merger, one company
is merged into another; in a subsidiary merger, the target becomes a subsidiary of the
acquirer; and in a consolidation, both the acquirer and target become part of a newly formed
company.
 Horizontal mergers occur among peer companies engaged in the same kind of business.
Vertical mergers occur among companies along a given value chain. Conglomerates are
formed by companies in unrelated businesses.
 The motives for M&A activity include synergy, growth, market power, the acquisition of
unique capabilities and resources, diversification, increased earnings, management’s
personal incentives, tax considerations, and the possibilities of uncovering hidden value.
Cross-border motivations may involve technology transfer, product differentiation,
government policy, and the opportunities to serve existing clients abroad.
 A merger transaction may take the form of a stock purchase (when the acquirer gives the
target company’s shareholders some combination of cash or securities in exchange for
shares of the target company’s stock) or an asset purchase (when the acquirer purchases the
target company’s assets and payment is made directly to the target company). The decision
of which approach to take will affect other aspects of the transaction, such as how approval
is obtained, which laws apply, how the liabilities are treated, and how the shareholders and
the company are taxed.
 The method of payment for a merger can be cash, securities, or a mixed offering with some
of both. The exchange ratio in a stock or mixed offering determines the number of shares
that stockholders in the target company will receive in exchange for each of their shares in
the target company.
 Hostile transactions are those opposed by target managers, whereas friendly transactions
are endorsed by the target company’s managers. There are a variety of both pre- and post-
offer defenses a target can use to ward off an unwanted takeover bid.
o Examples of pre-offer defense mechanisms include poison pills, incorporation in a
jurisdiction with restrictive takeover laws, staggered boards of directors, restricted
 voting rights, supermajority voting provisions, fair price amendments, and golden
parachutes.

o Examples of post-offer defenses include “just say no” defense, litigation, or finding
a white knight…

 Antitrust legislation prohibits mergers and acquisitions that impede competition. Major US
antitrust legislation includes the Sherman Antitrust Act, the Clayton Act..
 The Federal Trade Commission and Department of Justice review mergers for antitrust
concerns in the United States. The European Commission reviews transactions in the
European Union.
 The Herfindahl–Hirschman Index (HHI) is a measure of market power based on the sum of
the squared market shares for each company in an industry. Higher index values or
combinations that result in a large jump in the index are more likely to meet regulatory
challenges.
 The Williams Act is the cornerstone of securities legislation for M&A activities in the United
States. The Williams Act ensures a fair tender offer process through the establishment of
disclosure requirements and formal tender offer procedures.
 The empirical evidence suggests that merger transactions create value for target company
shareholders. Acquirers, in contrast, tend to accrue value in the years following a merger.
This finding suggests that synergies are often overestimated or difficult to achieve.
(Discussion!!!!!)