University Of Tunis Fin 440 : Advanced Corporate Finance

Tunis Business School Dr: Manara Abdelaziz Toukabri

Chapter 3: Mergers and Acquisitions

(M&A))

Chapter Outline

Introduction

Merger and Acquisition definitions

MOTIVES FOR MERGER

TRANSACTION CHARACTERISTICS

Takeovers

Valuation

Regulation

other clasifications
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
Introduction:
Companies enter into merger and acquisition activities for a variety of reasons.

Many companies use mergers as a means to achieve growth. Others seek to diversify their
businesses.

In all cases, it is important for corporate executives and analysts to understand both the
motives for mergers and their financial and operational consequences.

I. Mergers and Acquisitions: definitions

Mergers and acquisitions (M&As) are best understood in the context of corporate
restructuring strategies.
Business combinations come in different forms.
A distinction can be made between acquisitions and mergers.
In the context of M&A, an acquisition is the purchase of some portion of one company by
another. An acquisition might refer to the purchase of assets from another company, the
purchase of a definable segment of another entity, such as a subsidiary, or the purchase of an
entire company, in which case the acquisition would be known as a merger.
A merger represents the absorption of one company by another. That is, one of the companies
remains and the other ceases to exist as a separate entity.

Typically, the smaller of the two entities is merged into the larger, but that is not always the case.

Mergers classification:

Mergers can be classified by the form of integration

❖ In a statutory merger: one of the companies ceases to exist as an identifiable entity

and all its assets and liabilities become part of the purchasing company.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
❖ In a subsidiary merger: the company being purchased becomes a subsidiary of the
purchaser, which is often done in cases where the company being purchased has a strong
brand or good image among consumers that the acquiring company wants to retain

❖ A consolidation : is similar to a statutory merger except that in a consolidation, both

companies terminate their previous legal existence and become part of a newly formed
company. A consolidation is common in mergers where both companies are
approximately the same size.

Mergers can be classified by the intention of the offer

❖ hostile transactions: which are attempts to acquire a company against the wishes of
its managers and board of directors
❖ A friendly transaction: in contrast, describes a potential business combination that is
endorsed by the managers of both companies, although that is certainly no guarantee
that the merger will ultimately occur.

Mergers classification can be based on the relatedness of the merging companies’ business
activities.

❖ A horizontal merger : is one in which the merging companies are in the same kind of
business, usually as competitors
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri

❖ A vertical merger: the acquirer buys another company in the same production chain,
for example, a supplier or a distributor. In addition to cost savings, a vertical merger
may provide greater control over the production process in terms of quality or
procurement of resources or greater control over the distribution of the acquirer’s
finished goods.

❖ A conglomerate merger: When an acquirer purchases another company that is

unrelated to its core business. The acquiring firm and the acquired firm are not related
to each other.
“General Electric is an example of a conglomerate, having purchased companies in a
wide range of industries, including media, finance, home appliances, aircraft parts, and
medical equipment.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
II. MOTIVES FOR MERGER
There are typically several motives, both recognized and tacit, behind any given merger.

❖ Synergy: Among the most common motivations for a merger is the creation of synergy,
in which the whole of the combined company will be worth more than the sum of its
parts. Generally speaking, synergies created through a merger will either reduce costs
or enhance revenues. Cost synergies are typically achieved through economies of scale
in research and development, manufacturing, sales and marketing, distribution,
administration…

❖ Growth: Growth through M&A activity is common when a company is in a mature

industry

❖ Increasing Market Power: When a company increases its market power through
horizontal mergers, it may have a greater ability to influence market prices. ―Taken to
an extreme, horizontal integration results in a monopoly.‖ Vertical integration may
also result in increased market power. Vertical mergers can lock in a company’s
sources of critical supplies or create attractive markets for its products/services.
❖ Diversification: The idea behind company-level diversification is that the company can
be treated as a portfolio of investments in other companies. Like a large portfolio, large
firms bear less unsystematic risk, so often mergers are justified on the basis that the
combined firm is less risky.
❖ Managers’ Personal Incentives: Managerialism theories posit that because executive
compensation is highly correlated with company size, corporate executives are
motivated to engage in mergers to maximize the size of their company rather than
shareholder value. Additionally, corporate executives may be motivated by self
aggrandizement. For example, being the senior executive of a large company conveys
greater power and more prestige: conflict of interest, over confidence…
❖ Tax Considerations: It is possible for a profitable acquirer to benefit from merging with
a target that has accumulated a large amount of tax losses. Instead of carrying the tax
losses forward, the merged company would use the tax losses to immediately lower
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
its tax liability. A conglomerate may have a tax advantage over a single-product firm
because losses in one division can offset profits in another division.

WHY DO M&AS HAPPEN?

Despite decades of research, there is little consensus about what are the determinants of
M&As
Much of this research has focused on examining aggregate data which may conceal
important size, sector, and geographic differences. Different perspectives often reflect
different underlying assumptions.

Table 1: Common Theories of What Causes Mergers and Acquisitions

Theory Motivation
Operating synergy : Improve operating efficiency through economies

✓ Economies of scale of scale or scope by acquiring a customer,

✓ Economies of scope supplier, or competitor or to enhance technical

or innovative skills
✓ Complementary technical assets and
skills
Financial synergy Lower cost of capital

Diversification Position the firm in higher growth products or

✓ New products/current markets
✓ New products/new markets
✓ Current products/new markets
Strategic realignment
✓ Technological change
markets
Acquire capabilities to adapt more rapidly to
environmental changes than could be achieved

✓ Regulatory and political change if they were developed internally

University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
Hubris1 (managerial over confidence) Acquirers believe their valuation of the target is
more accurate than the market’s, causing them
to overpay by overestimating synergy
Managerialism (agency problems) Increase the size of a company to increase the
power and pay of managers
Tax considerations2 Obtain unused net operating losses and tax
credits and asset write ups, and substitute
capital gains for ordinary income
Market power Actions taken to boost selling prices above
competitive levels by affecting either supply or
demand

III. TRANSACTION CHARACTERISTICS

M&A transactions can differ along many dimensions, such as the form of acquisition,
financing, timing, control and governance, accounting choices, and numerous details ranging
from the post-merger board composition to the location of the new headquarters.

1. The Form of acquisition :

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

❖ Stock purchases: are the most common form of acquisition. A stock

purchase occurs when the acquirer gives the target company’s
shareholders some combination of cash and securities in exchange for
shares of the target company’s stock. For a stock purchase to proceed,

1
Arrogance
2
Taxes may be an important factor motivating firms to move their corporate headquarters to low cost
countries.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
it must be approved by at least 50 percent of the target company’s
shareholders and sometimes more depending on the legal jurisdiction.
❖ Asset purchase: the acquirer purchases the target company’s assets and
payment is made directly to the target company. One advantage of this
type of transaction is that it can be conducted more quickly and easily
than a stock purchase because shareholder approval is not normally
required unless a substantial proportion of the assets are being sold,
usually more than 50 percent..

2. Method of Payment

The acquirer can pay for the merger with cash, securities, or some combination of the
two in what is called a mixed offering. In a cash offering, the cash might come from
the acquiring company’s existing assets or from a debt issue. In the most general case
of a securities offering, the target shareholders receive shares of the acquirer’s
common stock as compensation. Instead of common stock, however, the acquirer
might offer other securities, such as preferred shares or even debt securities. In a stock
offering, the exchange ratio determines the number of shares that stockholders in the
target company receive in exchange for each of their shares in the target company.

3. Mind-Set of Target Management :

Mergers are referred to as either friendly or hostile depending on how the target
company’s senior managers and board of directors view the offer. The distinction is
not trivial because a huge amount of time and resources can be expended by both
acquirer and target when the takeover is hostile.

❖ Friendly Mergers :the acquirer will generally start the process by approaching
target management directly. If both management teams are agreed to a
potential deal, then the two companies enter into merger discussions. The
negotiations revolve around the consideration to be received by the target
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
company’s shareholders and the terms of the transaction as well as other
aspects, such as the post-merger management structure.
Before negotiations can culminate in a formal deal, each of the parties
examines the others’ books and records in a process called due diligence.
The purpose of due diligence is to protect the companies’ respective
shareholders by attempting to confirm the accuracy of representations made
during negotiations. Any deficiencies or problems uncovered during the due
diligence process could have an impact on negotiations, resulting in
adjustments to the terms or price of the deal. If the issue is large enough, the
business combination might be called off entirely. Once due diligence and
negotiations have been completed, the companies enter into a definitive
merger agreement.
The definitive merger agreement is a contract written by both companies’
attorneys and is ultimately signed by each party to the transaction. The
agreement contains the details of the transaction, including the terms,
warranties, conditions, termination details, and the rights of all parties.
Common industry practice has evolved such that companies typically discuss
potential transactions in private and maintain secrecy until the definitive
merger agreement is reached. This trend may have been influenced
by shifts in securities laws toward more stringent rules related to the disclosure
of material developments to the public. Additionally, news of a merger can
cause dramatic changes in the stock prices of the parties to the transaction.
Premature announcement of a deal can cause volatile swings in the stock prices
of the companies as they proceed through negotiations. After the definitive
merger agreement has been signed, the transaction is generally announced to
the public through a joint press release by the companies. In a friendly merger,
the target company’s management endorses the merger and recommends that
its stockholders approve the transaction.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
In cases where a shareholder vote is needed, whether it is the target
shareholders approving the stock purchase or the acquirer shareholders
approving the issuance of a significant number of new shares, the material facts
are provided to the appropriate shareholders in a public document called a
proxy statement, which is given to shareholders in anticipation of their vote.
After all the necessary approvals have been obtained—from shareholders as
well as any other parties, such as regulatory bodies—the attorneys file the
required documentation with securities regulators and the merger is officially
completed. Target shareholders receive the consideration agreed upon under
the terms of the transaction, and the companies are officially and legally
combined.

❖ Hostile Mergers : In a hostile merger, which is a merger that is opposed by

the target company’s management, the acquirer may decide to circumvent the
target management’s objections by submitting a merger proposal directly to
the target company’s board of directors and bypassing the CEO. This tactic is
known as a bear hug.
Because bear hugs are not formal offers and have not been mutually agreed
upon, there are no standard procedures in these cases. If the offer is high
enough to warrant serious consideration, then the board may appoint a special
committee to negotiate a sale of the target.
Although unlikely in practice, it is possible that target management will
capitulate after a bear hug and enter into negotiations, which may ultimately
lead to a friendly merger. If the bear hug is not successful, then the hopeful
acquirer will attempt to appeal more directly to the target company’s
shareholders.
One method for taking a merger appeal directly to shareholders is through a
tender offer, whereby the acquirer invites target shareholders to submit
(―tender‖) their shares in return for the proposed payment. It is up to the
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
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..
Another method of taking over a target company involves the use of a proxy
fight.
In a proxy fight, a 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. If the acquirer’s
slate is elected to the target’s board, then it is able to replace the target
company’s management. At this point, the transaction may evolve into a
friendly merger.

IV. TAKEOVERS
When a target company is faced with a hostile tender offer (takeover) attempt, the target
managers and board of directors face a basic choice. They can decide to negotiate and sell the
company, either to the hostile bidder or a third party, or they can attempt to remain
independent.

1. Pre-Offer Takeover Defense Mechanisms

❖ Poison Pills : is a legal device that makes it costly for an acquirer to take control
of a target without the prior approval of the target’s board of directors.
Most poison pills make the target company less attractive by creating rights
that allow for the issuance of shares of the target company’s stock at a
substantial discount to market value

❖ Incorporation in a State with Restrictive Takeover Laws (United States): In the

United States, many states have adopted laws that specifically address
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
unfriendly takeover attempts. These laws are designed to provide target
companies with flexibility in dealing with unwanted suitors. Some states have
designed their laws to give the company maximum protection and leeway in
defending against an offer.

❖ Staggered Board of Directors: Instead of electing the entire board of directors

each year at the company’s annual meeting, a company may arrange to stagger
the terms for board members so that only a portion of the board seats are due
for election each year. For example, if the company has a board consisting of
nine directors, members could be elected for three year terms with only three
directors coming up for election each year.
The effect of this staggered board is that it would take at least two years to
elect enough directors to take control of the board

❖ Golden Parachutes: are compensation agreements between the target

company and its senior managers. These employment contracts allow the
executives to receive lucrative payouts, usually several years’ worth of
salary, if they leave the target company following a change in corporate
control

2. Post-Offer Takeover Defense Mechanisms

A target also has several defensive mechanisms that can be used once a takeover has already been
initiated.

❖ Just Say No” Defense

❖ White Knight Defense: Often the best outcome for target shareholders is
for the target company’s board to seek a third party to purchase the
company i of the hostile bidder. This third party is called a white knight
because it is coming to the aid of the target. A target usually initiates this
technique by seeking out another company that has a strategic fit with the
target.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
❖ Litigation : A popular technique used by many target companies is to file a
lawsuit against the acquiring company based on alleged violations of
securities or antitrust laws. In the United States, these suits may be filed in
either state or federal courts. Unless there is a serious antitrust violation,
these suits rarely stop a takeover bid. Instead, lawsuits often serve as a
delaying tactic to create additional time for target management to develop
other responses to the unwanted offer

V. Valuation
In this part we will enumerate the most used valuation methods for the target company and
the merger value

1. 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
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Discounted Cash Flow Analysis
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.
Fin 440 : Advanced Corporate Finance
Dr: Manara Abdelaziz Toukabri
Comparable Company Comparable Transaction Analysis
Analysis
In this approach, the analyst first This approach is closely related to
defines a set of other companies comparable company analysis except
that are similar to the target that the analyst uses details from
company under review. This set recent takeover transactions for
may include companies within the comparable companies to make direct
target’s primary industry as well as estimates of the target company’s
companies in similar industries. takeover value
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.

2. The Net present value of a merge

Firm typically use the NPV analysis when making acquisition (Myres, 1976).

The analysis is relatively straightforward when using cash. The analysis become more complex
when the consideration is stock.

Cash:
Suppose a firm (A) and (B) have values as separate entities of $500 and $100 respective.
If firm (A) acquires firm (B), the merged firm (AB) will have a combined value of $700 due to
synergies of $100.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
The board of directors of firm (B) has indicated that it will sell firm (B) if it is offered $150 in
cash. Should firm (A) acquire (B)?

Value of the firm (A) after the merger= value of the combined firm-cash
=700-150=550$

NPV of merge to the acquirer= synergy-premium

3. 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.

Short term Long term

The empirical evidence suggests that merger Empirical evidence shows that acquirers
transactions create value for target tend to underperform comparable
company shareholders in the short run: companies during the three years following
an acquisition.
‘’on average, both the acquirer and target tend
to see higher stock returns surrounding cash
acquisition offers than around share offers “ This implies a general post-merger operational
failure to capture synergies.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
VI. 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
✓ Securities law.

1. Antitrust Laws
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.
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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 𝑜𝑓 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.
Post Merger HHI Concentration Change in HHI Government action
Less than 1000 Not concentrated Any amount No action
Between 1000 and Moderately 100 or more Possible challenge
1800 concentrated
More than 1800 Highly concentrated 50 or more Challenge

2. 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.
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
VII. Other classifications

Workforce
reduction/Reali
gnment
joint venture
/strategic
alliance
Operational Hostile
restructuring divestiture, Hostile
spin-off or takeover Tender offer
carve-out
Statutory
Takeover
Merger
corporate
restructuring Subsidary
Friendly
Acquisition
Leveraged takeover
management
bayout Inside
Bankruptcy
Consolidation
Reorganization/
Liquidation
Financial Outside
restructuring Bankruptcy
stock buyback

Figure 1Figure 1 The corporate restructuring process (Donald M.DePamphilis, Mergers,

Acquisitions, and Other Restructuring Activities (Ninth Edition)
An Integrated Approach to Process, Tools, Cases, and Solutions; 2018, Pages 5-45)

Carve out: is a partial divestiture of a business unit in which a parent company sells a
minority interest of a subsidiary to outside investors. (Investopedia)
The sale through an IPO of a portion of the shares of a subsidiary to new public market shareholders
in exchange for cash is called a carve-out. This type of transaction leaves the parent with ongoing
ownership in a portion of the former subsidiary. In practice, since a large sale might flood the market
with too many shares, thereby depressing the share price, usually less than 20% of the subsidiary is
sold in a carve-out. Selling a minority position of the subsidiary also enables the parent to continue
having control over the business and, importantly, makes it possible to complete a potentially tax-
University Of Tunis Fin 440 : Advanced Corporate Finance
Tunis Business School Dr: Manara Abdelaziz Toukabri
free transaction if less than 20% of the shares are sold. . One consideration of a carve-out is the
potential conflict of interest between the parent and the separated company. For example, if the
separated company is vertically integrated with the parent company (i.e., a supplier), potential
conflicts may arise if the former subsidiary pursues business with the parent company’s competitors.
(Stowell, Investment banks, Hedge funds and private Equity, Third Edition 2018 (Academic press))
Spinoff : when a company creates a new independent company by selling or distributing
new shares of its existing business. A parent company will spin off part of its business if it
expects that it will be lucrative. The spinoff will have a separate management structure and
a new name, but it will retain the same assets, (Investopedia)

In a spin-off, the parent gives up control over the subsidiary by distributing subsidiary shares to
parent company shareholders on a pro rata basis. This full separation avoids conflicts of interest
between the parent and the separated company (unlike in a carve-out).
No cash is received by the parent company since a spin-off is essentially redistributing assets owned
by parent company shareholders to those same shareholders. A spin-off may be accomplished in a
two-step process. First, a carve-out is completed on a fraction of the shares to minimize downside
pressure on the stock. It also allows the subsidiary to pick up equity research coverage and market
making in the stock prior to delivery of the remaining shares to the original parent company
shareholders. The carve-out sale is usually on less than 20% of the subsidiary’s shares to preserve
tax benefits. A spin-off provides the new company with its own acquisition currency, enables the
new company management to receive incentive compensation, and unlocks the value of the
business if comparable companies trade at higher multiples than the parent company multiple.
(Stowell, Investment banks, Hedge funds and private Equity, Third Edition 2018 (Academic press))
Example: American express and the Lehman Brothers in 1994.
Divestiture : is a partial or full disposal of a business unit through sale, exchange, bankruptcy.
(Investopedia)
Divestiture or divestment is the disposal of company’s assets or a business unit through sale,
exchange…