Module 3 Full Canvas

MODULE 3:
MERGERS AND ACQUISITIONS

DUE DILIGENCE
M&A PROCESS
Components:
the search process
the screening process
Due diligence
negotiation
the integration plan
closing
post-closing integration
post-closing evaluation
© Vlerick Business School

ACQUISITION INTEGRATION PROCESS TIMING

WHY DO WE NEED DUE DILIGENCE?
America Online and Time Warner (2001)  US$65 billion
Daimler-Benz and Chrysler (1998)  US$36 billion
Google and Motorola (2012)  US$12.5 billion
Microsoft and Nokia (2013)  US$7 billion
KMart and Sears (2005)  US$11 billion
eBay and Skype (2005)  US$2.6 billion
Bank of America and Countrywide (2008)  US$2 billion
Mattel and the Learning Company (1998)  US$3.8 billion

THREE ESSENTIAL COMPONENTS TO A MERGER
DEAL
Strategy
Post-M&A Valuation
Integration
6 © Vlerick Business School

COMPONENT 1: STRATEGY
Strategy:
Should we?
With whom?
Consider first the alternatives to M&A
Minority interest
Internal growth
Divest
JVs/Strategic alliances
‘Do nothing’
COMPONENT 1: STRATEGY
IF M&A is the best strategy:

M&A should be part of corporate strategy, helping to
promote strategic goals and objectives (LT view)
Strategic vs. Opportunistic deals
Develop a pipeline of potential acquisitions around a few
explicit strategic M&A themes

HOW TO BECOME A SUCCESSFULL (SERIAL)
ACQUIRER?

SCREENING POTENTIAL TARGETS
Other criteria to consider, next to the M&A strategy:
Geographic scope
Size
Strategic capabilities
Profitability
Other financials
Risk exposure
Asset type
Intellectual property
Management quality
Current ownership
Culture and organizational fit
ACQUISITIONS CAN GO WRONG FOR MANY
REASONS
Almost 70% of deals add no value

Reasons for failure?

ACQUISITIONS CAN GO WRONG FOR MANY
REASONS
Almost 70% of deals add no value

Overestimation of the target’s value
Overestimation of the expected synergies
Overbidding and overpaying
Insufficient due diligence/buying a fiction
Failure to deliver synergies
Value destruction
Not realizing the potential from complementarity

DUE DILIGENCE PROCESS
Needs to start before the deal is announced
But most active period is when the deal is public
Led from the top…
But needs to involve all divisions and staff at all levels
Outside experts
Issues of public versus non-public information
Assume that anything disclosed WILL be public
Non-disclosure agreements
Due diligence should be performed by both the bidder and target
Bidder: check external relationships as well as internal finances, operations,
and management
Target: check if bidder has the financial capacity to complete the transaction
DUE DILIGENCE
Risks:
Financial (cooked books? buying a fiction?)
Market: expectations for the future
HR
Legal
Contractual
Environmental
Regulatory
Etc
TYPES OF DUE DILIGENCE INFORMATION
Primary sources Secondary sources

Meetings Internet
Stakeholders Brokers’ reports
Customers Market reports
Competitors Filings/Accounts/Prospectuses
Employees Brochures
Academic publications
Statistics

1. TARGET VALUATION
“PRICE IS WHAT A DAMN
FOOL WILL PAY FOR IT…”
DO YOU REMEMBER THIS?

Acquirers gain 1%-1.5%
Targets gain 30%

OVERPAYMENT FOR TARGETS
“Facebook Massively Overpaid for WhatsApp” (Source: yahoo.finance)
“HP says that it overpaid for Autonomy ” (Source: thenextweb)
“Google bought mobile-phone pioneer Motorola Mobility Inc.

for $12.4 billion in part to get patents on technology. They
overpaid because they didn’t know what they were doing.”
(Source: Bloomberg)
“Did Amazon Overpay for Zappos?” (Source: Wall Street Journal)
“We estimate that Viacom, the winning bidder, overpaid for

Paramount by more than $2 billion.” (Source: Hietala et al., 2003)
“A major cause of acquisition failure is that the bidder pays to
much” (Weston et al., 2001)
REASON FOR OVERPAYMENT?
“The smell of the prey blinds the hunter”

“PRICE IS WHAT YOU PAY. VALUE IS WHAT YOU GET”
Warren Buffet
Value if you run the business
Negotiation range:
PRICE
Synergy - Competition
- Negotiation skills
- Alternatives?
- …
Value as is
VALUING M&A TARGETS
Vtarget = Vstand-alone + Vsynergies

!
How capturing synergies in valuation?

ESTIMATE THE EXPECTED SYNERGY GAINS
“The easiest way to lose the acquisition game is

by failing to define synergy in terms of real,
measurable improvements in competitive
advantage” Sirower, A. (Boston Consulting Group)
 Estimate the impact of the expected synergies

in terms of free cash flows!  DCF
 What WACC should be used?
ESTIMATE THE EXPECTED SYNERGY GAINS
 Consider all types of synergy sources
 Revenu increasing
 Cost decreasing
 Tax savings
 Capital expenditure decreases (+tax implications)
 What WACC should be used?

 Acquirer current WACC
 Potential WACC after integration

WHAT IS THE PREFERRED VALUATION
METHODOLOGY IN ACQUISITIONS?
Multiple of revenue
Multiple of EBIT
Other
Discounted cash flow
Revalued book value
Multiple of EBITDA
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
The insights are based on survey responses of 97 Belgian companies in their growth phase (joint research with EY).

WHAT IS THE PREFERRED VALUATION
METHODOLOGY IN ACQUISITIONS?
Multiple of revenue 3%
Multiple of EBIT 3%
Other 7%
Discounted cash flow 27%
Revalued book value 40%
Multiple of EBITDA 47%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
The insights are based on survey responses of 97 Belgian companies in their growth phase.

MULTIPLE COMPARISON
No need to make assumptions

Challenge is to find good comparable
companies/transactions!
Most commonly used multiples?
P/E; P/S
EV/EBITDA; EV/EBIT; EV/S
Nonfinancial (operational) data

MULTIPLES OF QUOTED COMPANIES (GLOBAL)
Industry EV/EBITDA Industry EV/EBITDA
Coal & Related Energy 5,59 Chemical (Diversified) 12,96
Oil/Gas (Production and Exploration) 6,11 Transportation 13,2
Rubber& Tires 8,39 Chemical (Basic) 13,32
Steel 8,96 Food Processing 14,14
Retail (Grocery and Food) 9,05 Drugs (Pharmaceutical) 15,07
Oil/Gas Distribution 9,22 Chemical (Specialty) 15,89
Homebuilding 9,93 Electronics (General) 16,69
Power 10,02 Machinery 17,09
Trucking 10,05 Semiconductor 17,81
Metals & Mining 10,2 Drugs (Biotechnology) 18,61
Advertising 12,74 R.E.I.T. 23,08
Retail (General) 12,76 Software (Entertainment) 25,76
Utility (Water) 12,78 Software (System & Application) 30,92
Oilfield Svcs/Equip. 12,81 Retail (Online) 36,23
Food Wholesalers 12,84 Software (Internet) 44,21
Size/illiquidity discount for
Source: Damodoran, January 2021 (NYU)
http://pages.stern.nyu.edu/~adamodar/
private firms: 20%-30%
ENTERPRISE VALUE VERSUS EQUITY VALUE
Equity value = value of all shares
Enterprise value
= Value of entire business (all assets and operations, excl. cash)
= Value of shares if the company would not have debt nor cash
(debt and cash free)
= Value that is available to equity and debt holders

EQUITY VERSUS ENTERPRISE VALUE
Equity
Enterprise
Value
Financial
Debt
Cash
Equity = Enterprise Value + Cash – Financial Debt

Enterprise Value = Equity + Financial Debt - Cash
HOW TO CALCULATE VALUE OF SHARES?
EV/EBITDAPEERS x EBITDACOMPANY= EVCOMPANY
Enterprise
Equity - FINANCIAL DEBT
Value + CASH
Financial
Debt
Cash
Value of shares

HOW TO CALCULATE VALUE OF SHARES?
EV/EBITDAPEERS x EBITDACOMPANY= EVCOMPANY
- FINANCIAL DEBT
+ CASH
Value of shares
• EV/EBITDAPEERS = 5,68
• EBITDACOMPANY= € 144 million
• EVCOMPANY = € 818 million
Cashof the shares = € 818 - € 478 + € 420 + € 400

• Value
• Value of the shares = € 1.16 billion
Offer price valued the
company at € 1,36 billion

IMPORTANT EXTRA ADJUSTMENTS
Undervaluation of working capital

Non-operating assets (private jets, yachts, a
second home in the Bahamas) are cash like assets
Quality of assets
Off-balance sheet items
What about EBITDA?

EXERCISE
2019 2020 2021 What would you be willing to

PPE 120 132 145 pay for 100% of the shares of
ART COLLECTION 20 20 20
INV 40 44 48 this construction company if
ACCOUNTS RECEIVABLE 30 33 10 you know that the industry
CASH 30 33 85
TOTAL 240 262 308
EV/EBITDA equals 6?
EQUITY 120 130 140

FIN DEBT 100 110 120
ACCOUNTS PAYABLE 20 22 48
TOTAL 240 262 308
SALES 100 110 120

- OP CASH COSTS 50 55 60
- DEP 10 11 12
EBIT 40 44 48

Hint: Remember Covid
EXERCISE - SOLUTION
2021
EBIT 48
+ DEP 12
EBITDA 60
* EV/EBITDA 6
= EV 360 EV = EQ + FIN D - CASH
+ Cash 85
+ Art collection 20 = similar to cash
- Financial debt -120
- Correction AR -26 Normally 30% sales
- Correction AP -24 Normally 20% sales
= Value equity 295 EQ = EV - FIN D + CASH
Not only look at the last

year  observe a trend

2. FINANCING AND PAYMENT
FINANCING VERSUS PAYMENT
Immediate payment
Postponed payments: Earnout vs vendor loan

EARNOUTS
Payment contingent upon future performance of

the target
Often used in service or high-tech sectors
Performance level may be determined in terms of
sales, profits or cash flow
Earn-out element may be paid in shares, loan
notes or cash

IMPACT OF PAYMENT METHOD ON BIDDER RETURNS:
CASH IS KING!

RISK MANAGEMENT IN EQUITY OFFERS
Types of shares exchange offers

Fixed stock exchange ratio: e.g. 1 acquirer share for 3 target shares
Fixed value offers: e.g. acquire all the shares for $5 bio
How to mitigate the risk of price fluctuations?

Collars can be introduced in the deal terms
bands or collars are set around the announced price
a range around the target price  as long as you are within that range, the
agreed upon price stands, as soon as the price exceeds the bands, however,
the deal terms begin to adjust

FACTORS DETERMINING FINANCING CHOICE
a) Risk and valuation considerations
b) Maximizing tax benefits
c) Corporate control considerations
d) Deal execution considerations
e) Financial market conditions
- Stock prices
- Private equity
- Interest rates
- Cash reserves
- Confidence

3.BUYOUTS
WHAT DO YOU THINK ABOUT ELON’S
ACQUISITION OF TWITTER?

ELON MUSK ACQUIRES TWITTER
Some facts:
Acquirer: Elon Musk
Target: Twitter
Take private transaction of $44 billion

Deal value: $ 44 billion

Financing structure?
Existing stake in Twitter worth $ 4 billion
$ 7.1 billion other equity investors
$ 20 billion in cash (sold part of stake in Tesla)
$ 13 billion in debt financing (incl. Morgan Stanley & Bank of America)


WHAT ARE BUYOUTS?
Acquisition of a company (listed or private) or

division
Investment horizon of 3-7 years  Exit!
Financial buyer (Private Equity)

Significant amount of leverage (i.e., debt or
mezzanine)  LBO

SPECIFIC TYPES OF BUYOUTS
Going private transaction: If the company is quoted

Reverse LBO (RLBO): A transaction in which a firm that
was previously taken private reobtains public status
through a secondary initial public offering (SIPO)
Management Buyout (MBO): LBO with crucial role for
existing management
Management Buy-in (MBI): takeover led by new managers
Secondary Buyout (SBO): second round LBO, new financial
buyer

LBO: MOTIVATIONS & VALUE CREATION
Tax advantages (deductability of interest payments,
depreciation, etc.)
The larger the potential advantages, the larger the premium
Tax advantages crucial in 1980s
Tax advantages more important in SBO than first time LBO
SBOs are riskier and higher priced
Takeover defense
Primarily important for buyouts (MBO) of 1980s
High debt burden + Mgmt fights against the hostile acquirer
Undervaluation
Evidence mixed, sensitive to takeover waves
Management incentives, reduced agency costs and

control
Increased managerial ownership and ownership concentration
Better alignment of the interests of managers and shareholders:
more incentives for management to spend effort, lower agency
costs
Fewer free cash flow problems thanks to high leverage &
monitoring by banks  reduces agency costs
Empirical evidence is mixed

Operational improvements and efficiency

Most LBO companies have extensive management
incentive plans
Sales and profits grow
Resource efficiencies: e.g. working capital requirements
Limited evidence on operational improvements compared
to industry peers
Operational improvements are more important for ‘first time
buyouts; more difficult in SBO: ‘low hanging fruit’ has been taken
before

DELL BUYOUT
25 bio USD (increased offer with 10c

from 13.65 to 13.75 per share)
 Michael Dell: 16% + 700 mio USD
 Silver Lake (PE): 1 bio USD
 Microsoft: 2 bio USD subordinated loan
 Syndicated bank loan: 19 bio USD

DELL BUYOUT
25 bio USD (increased offer with 10c
from 13.65 to 13.75 per share)
 Michael Dell: 16% + 700 mio USD
 Silver Lake: 1 bio USD
 Microsoft: 2 bio USD subordinated loan
 Syndicated bank loan: 19 bio USD

SOURCES OF VALUE CREATION IN BUYOUTS?
Increase in operating
Leverage Multiple expansion
value
• Increase equity stake • Company is valued at • Increase in EBITDA

a higher multiple upon through:
exit than at purchase - Top-line growth
• Huge potential but - Margin improvement
risky
• Working capital
management
Source: Bain & Company

VALUE CREATION PRINCIPLES IN BUY-OUTS
Bank debt Y0
Bank debt
EBITDA 30
130
Multiple 6.0x
Enterprise Value 180
Debt 130
Equity Equity 50
50
EV=180

EBITDA Debt Multiple

Y0 Y4 Y4 Y4
EBITDA 30 40 30 30
Multiple 6 6 6 6,5
EV 180 240 180 195
Debt 130 130 80 130
Equity 50 110 100 65
irr 22% 19% 7%
multiple 2,2 2,0 1,3


Y0 Y4 Y4 Y4
EBITDA 30 40 30 30
Multiple 6 6 6 6,5
EV 180 240 180 195
Debt 130 130 80 130
Equity 50 110 100 65
irr 22% 19% 7%
Money multiple:
110/50=2.2

Y0 Y4 Y4 Y4
EBITDA 30 40 30 30
Multiple 6 6 6 6,5
EV 180 240 180 195
Debt 130 130 80 130
Equity 50 110 100 65
irr 22% 19% 7%


Y0 Y4 Y4 Y4
EBITDA 30 40 30 30
Multiple 6 6 6 6,5
EV 180 240 180 195
Debt 130 130 80 130
Equity 50 110 100 65
irr 22% 19% 7%

EV=260
Growth in value through:
EV=180 80
Bank debt
1. Increased profits/EBITDA
130
Bank debt
180 – Sales growth, margin
50
Equity
expansion, M&A
Time of Investment Time of Exit
Equity 2. Repayment of bank debt
– Focus on cash flow, financial

Y0 Y4 engineering
EBITDA 30 40
1
Multiple 6.0x 6.5x
3 3. Multiple uplift
Enterprise
value
180 260
– Arbitrage, M&A, industry
cycle, professionalization
Debt 130 80 2
Equity 50 180

Growth in value through:

Bank debt
1. Increased profits/EBITDA
Bank debt
– Sales growth, margin
Equity
expansion, M&A
Equity 2. Repayment of bank debt
– Focus on cash flow, financial

Y0 Y4 engineering
EBITDA 30 40
1
Multiple 6.0x 6.5x
3 3. Multiple uplift
Enterprise
value
180 260
– Arbitrage, M&A, industry
cycle, professionalization
Debt 130 80 2
Equity 50 180
Combined effect?
EV=260
EV=180 80
Bank debt
130
IRR (Equity) = ? 38%

180
Bank debt
50
Time of Investment Time of Exit

Equity Money multiple = ? 3.6x
Equity
Y0 Y4
EBITDA 30 40
Multiple 6.0x 6.5x
Enterprise 180 260

value
Debt 130 80
Equity 50 180

ATTRACTIVE LBO TARGETS
Industry characteristics:
Basic, non-regulated industry – stable earnings,
predictable/low financing requirements
High-tech industry less appropriate – more risk, no track
record, fewer assets, high P/Es
Half of LBOs in 5 industries – retail, textiles, food, apparel,
soft drinks (Lehn, Poulsen, 1988)

Target characteristics:
Capable management – willing to bet personal wealth on
success
Strong market position within industry
Liquid balance sheet (with undervalued assets)
Strong asset base, with tangible assets that can serve as
collateral
Clean balance sheet (i.e., limited amounts of debt)

Target characteristics:
Stable and predictable cash flows
Low capital expenditure (capex) requirements, and
preferably limited working capital investments
Low rate of technological change/R&D expenses
Growth opportunities
Efficiency enhancement opportunities
Low or (under-) stock market valuation
Good exit options
LBO/MBO EXAMPLE: WAVELL CORPORATION
Small, quoted glassware manufacturer
Stable cash flows (EBIT = $650,000), very low leverage ratio
Parent company dissatisfied: Wavell’s activity is non-core to group and
growth opportunities are low
Management has negotiated a takeover price of $2 million
Typical financing:
5 year bank loan: $1.2 million (interest rate 13%)
5 year subordinated loan from financing partner (insurance company): $0.6
million (interest rate 16%)
Equity investment by insurance company: $0.1 million (shares can be
repurchased after 5 years for an annual r = 40%)
Equity investment by management team: $0.1 million
Management assumes they can generate sufficient CF to repay loans
Bank loan repayment schedule: Annuity factor:PVAF(t;r%) = [1 – 1/(1+r)t]/r
PVAF(5;13%) = (1 – 1/1.135)/0.13
= 3.51723
Loan/PVAF(5;13%) = 341 177
Loan $1.200.000
Interest Rate 13%
Payments $341.177
Year 1 Year 2 Year 3 Year 4 Year 5

Interest 156.000 131.927 104.724 73.985 39.251
Principal 185.177 209.251 236.453 267.192 301.927
Balance 1.014.823 805.572 569.119 301.927 0
= 1 200 000 * 0.13 = 156 000

= 1 014 823 * 0.13 = 131 927
Insurance company loan (subordinated loan)

repayment schedule:
Annuity factor:PVAF(t;r%) = [1 – 1/(1+r)t]/r
PVAF(5;16%) = (1 – 1/1.165)/0.16
= 3.274294
Loan/PVAF(5;16%) = 183 246
Loan $600.000
Interest Rate 16%
Payments $183.246
Year 1 Year 2 Year 3 Year 4 Year 5

Interest 96.000 82.041 65.848 47.064 25.275
Principal 87.246 101.205 117.398 136.181 157.970
Balance 512.754 411.549 294.152 157.970 0

= 156 000 + 96 000 >0

78 © Vlerick Business School = 185 177 + 87 246

Guaranteed return on the insurance company’s equity investment = 40%
Can buy back shares for $100.000 × (1.40) 5 = $537.824
Managers get the rest of the equity value = $1,656,731 – $537.824
= $1.118.907
Expected return of LBO for managers = ($1.118.907/$100.000) 1/5 – 1=
62.09% (at book value!)
+ Debt free company that can be sold or return to the stock exchange
in short time (SIPO)
Return depends highly upon the equity stake
Risk is especially high in the first years following the LBO, risk
reduces later
 In some cases: refinancing of deal is needed
EXIT STRATEGIES
EXIT STRATEGIES
Private equity investors need to recover their investment

(typically in 5-10 years after the deal)
Which exit routes do you know?

(Secondary) Initial public offering = (S)IPO
= take the company (back) to the stock exchange
Sell to other company in the industry (“strategic buyer”)
Secondary buyout (SBO) = sell it to other buyout firm

EXIT STRATEGIES

THANK YOU FOR YOUR ATTENTION!
Questions?

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MODULE 3:

MERGERS AND ACQUISITIONS

© Vlerick Business School

© Vlerick Business School

© Vlerick Business School

6 © Vlerick Business School

IF M&A is the best strategy:

8 © Vlerick Business School

9 © Vlerick Business School

Almost 70% of deals add no value

11 © Vlerick Business School

Almost 70% of deals add no value

12 © Vlerick Business School

Primary sources Secondary sources

15 © Vlerick Business School

© Vlerick Business School

Targets gain 30%

“HP says that it overpaid for Autonomy ” (Source: thenextweb)

“Google bought mobile-phone pioneer Motorola Mobility Inc.

“Did Amazon Overpay for Zappos?” (Source: Wall Street Journal)

“We estimate that Viacom, the winning bidder, overpaid for

“The smell of the prey blinds the hunter”

22 © Vlerick Business School

Value if you run the business

Vtarget = Vstand-alone + Vsynergies

© Vlerick Business School

“The easiest way to lose the acquisition game is

 Estimate the impact of the expected synergies

 Consider all types of synergy sources

 Capital expenditure decreases (+tax implications)

 What WACC should be used?

 Potential WACC after integration

Discounted cash flow

Revalued book value

27 © Vlerick Business School

Discounted cash flow 27%

Revalued book value 40%

Multiple of EBITDA 47%

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

28 © Vlerick Business School

No need to make assumptions

© Vlerick Business School

Equity value = value of all shares

© Vlerick Business School

Equity = Enterprise Value + Cash – Financial Debt

EV/EBITDAPEERS x EBITDACOMPANY= EVCOMPANY

33 © Vlerick Business School

Cashof the shares = € 818 - € 478 + € 420 + € 400

35 © Vlerick Business School

Undervaluation of working capital

What about EBITDA?

37 © Vlerick Business School

2019 2020 2021 What would you be willing to

EQUITY 120 130 140

SALES 100 110 120

39 © Vlerick Business School

Not only look at the last

40 © Vlerick Business School

Postponed payments: Earnout vs vendor loan