Summary of:

MERGERS & ACQUISITIONS

PRIVATE EQUITY
 Mergers and Acquisitions and Private Equity
Lecture 1
Mergers:
- When two firms agree to forward as a single new company. The firms are often at the
same size.
Acquisitions:
- When one company swallows another company, and is the new owner.

Four different types of Mergers and Acquisitions

- 1 Horizontal:
o In the same industry and similar operations, for example Ahold acquiring
Delhaize
 To increase market share, market access and market power
 Improve performance of the target (Cost cutting)
 Realize economies of scale
 Eliminate a competitor
- 2 Vertical:
o The acquisition of one company by another across the value chain/supply
chain of the company. For example Volkswagen acquiring Battery producers
 To secure resources
 Assure markets
 Reduce transaction costs
 Control of the value/supply chain
- 3 Related:
o The acquisition of a company by another in a related industry. For example
CVS acquiring Aetna Insurance
 To acquire skills and technologies more quickly and at a lower cost
than it would be built in house
 Exploit cross sell opportunities
 To support an adaptive visionary or shaping strategy
- 4 Diversifying:
 o The acquisition of one company by another in an industry which it doesn’t
currently operate in.
 To exploit managerial capabilities
 Help targets develop their business
 Exploit financing synergies
 Increase firm size
Key drivers of M&A activity
1. Corporate clarity
a. Companies will continue to realize benefits of unlocking value and refocusing
on core assets through divestiture activity.
2. Ongoing tech disruption
a. The pace of technology is continuously increasing, it is expected that
companies get these kind of technology. But they have to buy the technology
instead of develop them in-house
3. Cheap access to financing
a. Low interest rates and high equity valuations, acquisitions is relatively cheap
4. Dry powder of private equity
a. PE Firms have enormously amounts of cash to spend
5. Capital allocation strategy
a. Most companies will engage in M&A to boost growth opportunities instead of
spending it on dividends or share repurchases
6. (Geo)political/macro economic/regulatory uncertainty
a. Uncertainties will remain in countries.
Neoclassical = Value combination > Value Acquirer + Value target
Redistribution = Value is extracted from their stakeholders, e.g. government, customers,
suppliers, employees due to market power and tax optimalization
- Tax gains
- Market power
- Debt impact on the bond holders of the company
- On labor, lower employee cost
- To pension funds
Behavioural = M&A is a consequence of overconfidence (hubris) benefitting from short term
market mispricing
- Hubris, Winner curse, paying too much
 - Stock market misevaluation
- Agency costs
- Integration problems

Key success factors in M&A

1. Sound due diligence process
2. Effective integration
3. Economic certainty
4. Accurate value of target
5. Stable regulatory and legislative environment
6. Proper target identification

Asset purchase
- You can amortize the goodwill for tax purpose
- Approval of the shareholders of the entity
Share purchase
-
Deal structuring
1. Cash offer
- Payment of cash from excess cash balance or raised via bridge financing
2. Share offer
- Payment to target shareholders in share of the acquirer
3. Deferred consideration/earn out:
- Payment of the consideration is deferred and may be contingent on the future
performance of the target
- Can be structured with call options for the buyer and put options for the seller
4. Combination of both cash and share offer with maybe deferred considerations

Value creation analysis on M&A transactions

How to assess the standalone value of the target?
We have a spectrum of valuation methodologies

DCF: The discounted cash flow is relatively easy. To determine the enterprise value, forecast
the free cash flow per year, discount this by the 1+WACC. For the continuation value, just
discount it by the 1+WACC
Multiples:
Is a valuation approach based on the prices paid for comparable assets where the valuation is
scaled to a value driver. For example 240K is paid for 80m2, this was your neighbour’s
house. Your house is 70m2. The price of your house will be 3k*70=210k.
Leveraged Buy out analysis:

Synergies
Synergies can be defined as the benefits that result from combining two standalone entities
into one combination taking into the cost related to combining the entities such as transaction
and integration costs.

There are six different synergies that can be identified at value driver level:
- Revenue synergies (31%)
- Cost synergies (50% buyer will pay for)
 - CAPEX / Net Working Capital (10%)
- Tax Synergies (9%)
- Financial Synergies

Overall fun facts

Article 1, The good, the Bas, and the Ugly

As in the slide:
Neoclassical = Value combination > Value Acquirer + Value target
Redistribution = Value is extracted from their stakeholders, e.g. government, customers, suppliers, employees due to market power and tax
optimalization
Behavioural = M&A is a consequence of overconfidence (hubris) benefitting from short term market mispricing

The Neoclassical Theory of M&A is that the business rationale for mergers is that they can be
positive net present value investments. Mergers increase value when the two individual
firms’ value is smaller than the two firms’ combined. M&A Activity is influenced by a lot of
different things in the past. There are different return numbers in different industries. This is
because of the change forces that affects different industries.
There are different types of M&A forms. Firms choose this on the type of synergies and
needs they want. In summary, the neoclassical theory posits that unexpected change forces
leads firms to reorganize assets more efficiently. The nature of the change force dictates the
type of synergy that may be realized and hence best form of M&A to be employed. Empirical
evidence suggests that firms respond to these change forces by using various M&A activities.

Article 2 European market for corporate control

9.13% for target firms
0.53% for bidder firms
Systematic variation in the valuation effects of different types of takeovers.
Hostile takeovers have higher returns for target and lower for bidder
Negative impact if the acquisition is paid with equity to target and bidder stock
Also when the bidder had a low M&A activity, the stock of both bidder and target are lower

Article 3
M&A deals create more value to acquiring firms after 2009 then ever before.
This is because the quality of corporate governance among acquiring firms in the aftermath of
2008.
- Better efficient investment strategies, lower degree of over and under investment.
 -

Lecture 2
Chapter 9, McKinsey
To prepare the financial statements for analyzing economic performance, you need to
reorganize the items on the balance sheet, income statement, and statement of cashflows into
three categories: operation and nonoperating items. The balance sheet mixes together the
operating assets, nonoperating assets, and sources of financing.

ROIC = NOPLAT / Invested Capital

FCF = NOPLAT + Noncash Operating Expenses – Investment in Invested Capital
FCF = NOPLAT – Net Increase in Invested Capital
Invested capital
Operating assets – Operating liabilities = invested capital
Debt + Equity = invested capital
This is too easy for most companies, most companies consist of nonoperating assets too.

NOPLAT
NOPLAT is the after-tax profit generated from core operation, excluding any income from
nonoperating assets or financing expenses, such as interest. To calculate NOPLAT, we
reorganize the accounting incoming statements in three ways.
1. Interest is not subtracted from operating profit, interest is a payment to the company’s
investors, not an operating expense.
2. When calculating after-tax operating profit, exclude any nonoperating income
generated from assets that were excluded from invested capital.
3. Exclude nonoperating taxes
Free cashflow
FCF is independent of financing and nonoperating items.
FCF = NOPLAT + Noncash operating expenses – investments in invested capital
Reorganizing the accounting statements
- Operating working capital
o Operating current assets – operating current liabilities
 Lecture 3
Chapter 3 DCF Analysis
To determine the discounted cash flow analysis we need to fulfil five steps:
1. Study the target and determine key performance drivers
a. Sales growth, profitability, FCF generation, market trends, working capital
efficiency, new products)
2. Project free cash flow
a. To determine the free cash flow we have to start with the EBIT. This EBIT
needs to be adjust with tax, so EBIT x (1-25%). Then we have the EBIAT.
This EBIAT we need to add the D&A, less CAPES, and less increase/decrease
in NWC. At the end of this process we have the FCF. Future CAPEX will be
stable, same as change in NWC. NWC can be calculated by adding (AR+
Inventory + prepaid expenses and other current assets) minus (-) (AP +
Accrued liabilities + other current liabilities). This is learned in MFM
b. DSO = AR/Sales *365
c. DIH= Inventory/COGS * 365
d. Inventory turns = COGS/Inventory
e. DPO = AP/COGS *365
3. Calculate the WACC
a. WACC = (After-tax Cost of Debt * % of debt) + (Cost of Equity * % of
equity)
b. WACC = (Rd *(1-t)) * D/D+E) + (Re * E/E+D)
c. Four steps for calculating the WACC
i. Determine target capital structure
1. D/D+E or E/E+D
ii. Estimate cots of debt
1. Probably given
iii. Estimate cost of equity
1. Capital Asset Pricing Model (CAPM)
2. Cost of Equity = Risk free rate + Levered Beta*Market risk
Premium
3. Rf + beta * (Rm-Rf)
 4. Sometimes the Size Premium is added because it is empirical
proven that smaller firms are riskier, and therefore should have
a higher cost of equity.
iv. Calculate WACC
4. Determine the Terminal Value
a. Exit multiple method
i. Terminal value = EBITDA x Exit Multiple
ii. Multiple is aprox. The market
b. Perpetuity Growth method
i. Terminal value = (FCFn * (1+g)) / (r-g)
ii. n = terminal year of the projection period
iii. g = perpetuity growth rate
iv. r = WACC
c. You can control these caluclations with the Implied perpetuity growth rate
5. Calculate present value and determine valuation
a. Discount factor = 1/((1+WACC)^n)
b. Discount factor mid year = 1/((1+WACC)^n-0.5)
c. FCF1/(1+WACC)^0.5
 d.
Slides lecture 3
Discounted Cash Flow
Operating fixed assets and operating working capital generate free cash flows. The debt and
equity holders want a return of their investments, primarily driven by the risk of the assets
(WACC).
Derive every cashflow with the 1+WACC tot de macht with the given year of that cashflow.
Then for the continuation value, use the last cashflow and derive this with de 1+WACC.

EBITDA
- Depreciation & Amortization & Impairment
EBIT
- Operating tax expense
NOPLAT
+ Depreciation & Amortization & Impairment
- CAPEX
 + Change in operating provisions
+ Change in Deferred Taxes
- Investments in Operating Working Capital
Free Cash Flow

Terminal Value
For cyclical business, calibrate explicit forecast period to the mid-cycle
There are several different terminal value methodologies

Perpetuity method
o Assuming an infinite cash flow of the firm growing at a constant rate
o Highly dependent on cash flow in last year and infinite growth rate
Continuing value = Free cash flow in the last year of the cash flows / (WACC-Growth)
Growth = Long term reinvestment rate in continuing value * Long term nominal return on
new investments in operating capital
G = RI * RONIC
This (Growth) should be lower than the nominal growth rate of the economy or the industry
- Real GDP growth + Inflation
- Real industry growth + Inflation
The reinvestment rate shows the proportion of NOPLAT being reinvested in the business for
growing the business. The difference between NOPLAT and FCF is equal to reinvestments.
RI = New investments / NOPLAT
RI + (NOPLAT-FCF) / NOPLAT
RONIC = Change in NOPLAT / New investments
- In a competitive industry, in the long term the RONIC should be equal to WACC. The
company will make only zero NPV
- When a firm has a sustainable competitive advantage it is possible to have RONIC
above WACC. NPV > 0

Is the McKinsey value driver model correctly specified?

- Quite some critique on the value driver model, see Bradley & Jarrel
- Is the Growth rate reflecting inflation properly?
 - When RI is 0, no expansions in the capex, the growth is zero. However, under
positive inflation levels, the FCF and Firm value decreases

Multiples
o Continuing value based on EV-Multiple
o Used by financial buyers
Liquidation approach
o Assuming liquidation at the end of the forecast period
o Determine the liquidation value of the tangible assets

Risk
Can be diversified away:
Project risk
Competitive risk
Industry risk
International risk
CANNOT:
Market risk, investors demand a reward for bearing this risk
This can be evaluated by using the sensitivity analysis, scenario analysis or simulation
analysis. Possible models are CAPM, Fama French, Arbitrage Pricing Theory

WACC = Ke * E/TV + Kd(1-Tax) * D/TV

CAPM is used to determine the cost of equity Ke

Rf Risk free rate

- Return on asset where we know the expected return with certainty
- It should capture the Real interest rate and inflation
- Estimate cash flow and risk free rate with the same currency
- Default free zero-coupnn government bond or 20/30 years triple AAA government
bond
Beta of the stock
 - Beta captures the systematic risk of a stock that cannot be diversified away by the
investors. It shows whether a stock is more or less risky than the market
Market risk premium
- Is the market risk the investors want a return on
- MRP = E(Rm) – Rf
- Historical method : Take the average of the difference between Rf and return on
market portfolio
- Survey method: Expected market return -Long term Rf
- Implied method: IRR of the market with DCF model for the market as a whole
- You always take the median
Cost of debt is Rf+credit spread

Additional risk premium

For the Weightings in WACC you can use historical or current capital structures of peer
group or look at the multiple approach.
Article Bradley

When a firm makes no investments or invests only in zero NPV projects is mis specified if
inflation is rather positive. The FCF decreases
Lecture 4
Multiples:
Is a valuation approach based on the prices paid for comparable assets where the valuation is
scaled to a value driver. For example 240K is paid for 80m2, this was your neighbour’s
house. Your house is 70m2. The price of your house will be 3k*70=210k.

Popular because of:

- Reflect the market
- Increased valuation efficiency
- Easy, simple
- Overcomes challenges inherent to DCF
- Cross-check
- May be mandatory in court

Typology of multiples
Trading versus transaction
- Trading: Based on market cap of lister peers
- Transaction: Based on pricing in past M&A transactions

Warnings in using multiples

- Are the prices good indications, maybe over/under-pricing in the market
- Good standalone value but not including synergies
- Transaction multiples give good expected selling price, but not the value of the
company to the current owner
- No proper cleaning of financial
- Heavy reliance on database
- Neglecting differences in fundamentals

Steps to use in multiple analysis

- Identification of comparable
- Selection of multiples
- Research of information
- Multiples calculation
- Multiples applications
Best is 5 to 10 companies for your benchmarking.

There are several multiples that can be used

- Earning
o Most used
- Sales
o Does not consider profitability
- Market to book
o Does not consider ROE, ROA
- Industry specific
o Are related to sales

Enterprise value versus equity value multiples

- Enterprise value multiples generally perform better than equity multiples, as they
undo net debt disortions
- Price to Earning multiple changes with the capital structure
- For large companies, PE does good because of the similar capital structures
EC/EBITDA versus EV/EBIT(A)

Forward looking versus historical multiples

- Forward looking multiples do better than historic multiples
o Value is forward looking
o Mitigates non-recurring items in the past
- Empirical research shows that two year forward outperforms one year and three years
forward outperforms two years forward
- Caveats: Forecasting enter the analysis, so you can be subjective
- Caveats: does not consider value impact of difference between peers

Asset based multiples are better in capital intense industries (real estate, shipping) and
financial institutions (bank, lease companies.
For big peer groups, use the median and harmonic mean, small use the simple mean and
remove the outliers.
How to calculate the market capitalization of equity?
- Calculate the basic shares outstanding
o Use latest number available for shares outstanding
When a firm or sector reaches maturity, multiples generally decline as a result of lower
growth.

Pros and cons of trading multiples

Pros:
- Market based, reflecting expectations
- Requires no assumptions, objectivity
- Easy to use
- Updated continuously with little effort
Cons:
- Market pricing not always rational (Gamestop)
- Hard to find good peers
- Pricing is based on one share
- Comparability, may not capture specifics of target
- Is a stand-alone value (no synergies)
Transaction multiples
- Uses similar companies that are sold
- Includes acquisition premium
- Multiples are calculated at the time of the deal
- A lot of information sources (news, clients, inhouse, databases, investor presentation)

Caveats:
- Data can be difficult to obtain
- Transactions are rarely comparable due to different deal structures
- Timing of the transaction vs valuation date of the target
Trading multiples pros and cons
Pros
- Market based
- Objectivity
- Easy
- Value based on majority perspective
Cons
- Winners curse
- Pricing may include premium or synergies

Lease accounting before implementation IFRS 16

A lease is an agreement where the owner of the asset conveys the right to use the asset to
lessee for the lease term and gets in return a series of payments
- Financial lease
o A lease that transfers substantial all the risks and rewards of an asset to the
lessee
 Lease term close to economic life, cannot cancel
 Lessee can buy the assets at the end
 Lessee must buy the asset
 Present value of lease payment is close to the fair value of the leased
asset
 Lessee has an option to extend lease at a rate below market rent
- Operating lease
o Any lease other than financial (rental)
BEFORE IFRS 16
Implementation of IFRS 16
Finance lease has no changes
Operating lease has changes
- Balance sheet
o Right of use asset
o Lease liability
- Income statement
o Amortization
o Interest expense
- Leases lower than 5k euro is exemption
 Lecture 5
The sell side process of M&A
- Preparation
- Targeting, Marketing, Structuring
- Term sheets and Due Diligence
- Sale & Purchase agreement
- Completion

There are different types of sales processes

- Bilateral negotiations
- Targeted solicitations
- Managed auction
- Broad public auction
 Buy-side process

Valuating synergies
Value (A+B) – Standalone A – standalone B – Related costs

The synergies you pay for:

Cost synergy, Revenue synergy, tax synergy, balance sheet synergy
90% of the transaction realized more than 70& of cost synergy
50% of the transactions realized more than 70% of revenue synergy

Deal structuring
Cash offer, Share offer, Deferred considerations, and combinations of cash, share
Example of full cash offer:
EXAMPLE
 Lecture 6&7
What is private equity?
It is an asset class consisting of equity securities in companies that are not publicly traded on
a stock exchange
Different forms of private equity
Venture capital
- Investments in startup companies, for the launch of early development.
- Roi >40%
Growth capital
- Fast growing companies looking for capital to expand operations, enter new markets
or finance a major acquisition.
- Roi 15-30%
Leveraged buyouts
- Making equity investments as part of a transaction in which a company is acquired
from the current shareholders typically with the use of financial leverage.
- 17,5-25%
Distressed capital
- Investment in equity or debt securities of financially stressed companies

Private equity fund structure

Definition of a leveraged buyout

 - Purchase of a company by a small group of investors with a limited investment
horizon, where the purchase price of the target is financed with high levels of debt
that will be repaid from the target’s future cash flows as quickly as possible and
equity participation of management is relatively high.
3 elements of LBO
- Investors acquire the target with existing/new management/
- High debt will induce management to curb wasteful investment and improve
operations
- Mitigating agency costs

A LBO targets must be:

- High and stable cashflow
- Good assets, for collateral
- A fat cost base to reduce
- Experienced management
- Appropriate size
- Unlocking break up value
- Visible exit in 5 years

LBO Debt financing

- Bullet
o One installment at the end of redemption year
- Split bullet
o Two semi installments
- Equal annual amortization
- Not equal annual amortization

Senior debt instruments

- First to be repaid after bankruptcy
 - Lowest risk
Mezzanine financing
- Paying between 12 and 20% per year
- Highest risk of debt/unsecured
- For growth projects
High yield bond/notes
- Third priority, secured/unsecured
- Large transactions
- For startups with high debt
- High interest rates for investors because of risk
- Much liker to default and volatile

Different types of covenants

- Financial covenants
o Financial requirements for the borrower
o Net debt/ebitda
o DSCR
o Solvency
- Positive covenants
o Refer to actions that a borrower must take
- Negative covenants
o Refer to actions prohibited for borrower

LBO equity financing

- Ordinary shares
o Held by financial buyer and management
o Management invest 1-2x annual salary
- Preferred shares
o Dividends on ordinary stocks will not be paid until all the past dividends on
the preferred stock have been paid
o Higher return than ordinary shares
o For investors
- Shareholder loan
o Unsecured loan provided by the shareholder
Exit strategies
- IPO
- Sale to other PE
- Sale to Management
- Liquidation
- Trade sale

LBO exit value calculations are multiple driven

- Based on performance at the exit date
- A higher entry does not mean higher exit multiple

EBITDA * exit multiple = Enterprise value

Enterprise value – net debt = equity value
Equity value – shareholder loan, preferred equity = value ordinary shares

Money multiple
- Reflects the ratio between the total proceeds that accrue to the equity investors and
their initial investment. It is a measure for the absolute return made on the initial
investment.

Money multiple:

Why use money multiple?

RR is biased to short holding periods rather than absolute return

Management/employees are more interested in absolute return and often don’t understand IRR