MERGERS AND ACQUISITIONS

Different ways to Grow

Expansion & Diversification Buy existing businesses

Meaning of Strategy

Five meanings of strategy Plan, consciously elaborates direction of actions Pattern, clear basic line on the operation of an Organization Position, certain place or location in the markets or / and environment Perspective, point of view or certain way to examine the organization or its environment Plot, sequence of conducted activities which aim to

Corporate Strategic Planning

Define Corporate Mission Analyze, Evaluate Current Business Portfolio Identify New Business Arenas to Enter/ Business to exit

BCG Approach

Build: Objective is to increase the market share Hold: Objective is to preserve market share Harvest: Objective is to increase short term cash flow regardless of log term effect Divest: Objective is to sell / liquidate the business

BCG Matrix

BCG Matrix

Stars- Leaders in business Cash cows investments to be kept low because of lower growth rate Dogs- minimize the number of dogs, beware of expensive turnaround plans ????????????????

General Electric Approach

The Industry attractiveness index is made up of such factors as Market size, market growth Industry profit margin Amount of competition Seasonally and cyclically of demand Industry cost structure

General Electric Approach

Business strength is an index of factors like Relative market share Price, competitiveness Product quality Customer and market knowledge Sales effectiveness Geographic advantages

SWOT
Hold

SWOT ANALYSI S

Sell

Acquire

Strategy

Understand your objectives: Is it a defensive plan or to reach a specific growth objectives? Alignment is key: M&A strategy should align with the overall business strategy Evaluate the potential universe of opportunities: Define the parameters of an ideal deal Consider culture Consider a cultural fit between the two organizations Review structure and financing Determine the appropriate deal structure and identify financing vehicles at the outset

Strategy

Strategy facilitates proper positioning and move faster vis--vis competitors first-mover advantage A solid, well-articulated strategy acts as a guidepost for effective M &As Disciplines approach, better placed to integrate and operationalize deals to deliver shareholder value over the long term

Merger & Acquisitions in Developed and Developing Economies

In developed economies like Japan, USA & Europe, hundreds of acquisitions happen every year In India, 2005 has been referred as the year of mergers and acquisitions when $13b were struck as compared to $4.5b in 2004

Amalgamation

The terms mergers, acquisitions and takeovers are often used in common parlance, however there are differences Merger means unification of two entities into one Acquisition involves one entity buying out another and absorbing the same. In India, in legal sense merger is known as Amalgamation

Amalgamation

Amalgamation can be by merger of companies within the provisions of the Companies Act The shareholders of each amalgamating company becomes shareholders in the amalgamated company Accordingly, in a merger, two or more companies combine into a single unit or where one is merged with another or taken over by another The rights and liabilities of a company are amalgamated into another so that the transferee company becomes vested with all rights and liabilities of the transferor company

Merger v/s Consolidation

Merger results in the legal dissolution of one of the companies A consolidation dissolves both the parties and creates a new one into which the previous entities are merged. In a consolidation, entirely new firm is created, and the two previous entities cease to exist. Consolidated financial statements are prepared under the assumption that two or more corporate entities are in actuality only one. The consolidated statements are prepared by combining the account balances of the individual firms after certain adjustment and elimination of entries

Merger Waves
1897-1904 1916-1929 1965-1969 1981-?

The First Merger Wave--1897-1904

Mainly horizontal 300 major combinations involved 40% of U.S. manufacturing capital U.S. Steel combined 785 separate firms Era produced DuPont, Standard Oil, GE, Kodak Justice occupied with labor unions

The First Merger Wave-1897-1904

1903

1901 # mergers 1899

1897 0 500 1000 1500

The Second Merger Wave--19161929

First wave: merging for monopoly Second wave: merging for oligopoly Many vertical mergers

The Third Merger Wave-1965-1969

Law made horizontal & vertical mergers more difficult Conglomerates more prevalent

The Fourth Merger Wave-1981-?

Well-known for hostile mergers Many mega-mergers Deregulation Antitrust climate New forms of financing Defensive tactics Wave of consolidation in media business, telecom sector and financial service sector

Horizontal Merger

Two companies which have merged are in the same industry, normally the market share of the new consolidated company would be larger and it is possible that it may move closer to being a monopoly Horizontal merger take place where the two merging companies produce similar product in the same industry.

Vertical Merger

Vertical merger occur when two firms each working at different stages in the production of the same good combine. The merger of two companies which are in different field altogether

Market Extension & Product Extension Merger

Market Extension: Two companies that sell the same products in different markets. Product-extension merger: Two companies selling different but related products in the same market.

Conglomerate Merger

Firms engaged in unrelated type of business operations come together. The acquirer and the target are not related either horizontally or vertically In pure conglomerate there are no important common factors between the companies in production, marketing, research and development and technology The purpose remains utilization of financial resources, enlarged debt capacity ad also synergy of managerial functions

Reverse Merger

In order to avail the benefit of carry forward of losses which are available according to tax law only to the company which had incurred them, the profit making company is merged with company having accumulated losses

Congeneric Merger

The acquirer and target are related through basic technologies, production processes or markets. The acquired company represents an extension of product line, market participants or technologies of the acquirer. Outward movement by the acquirer from its current business scenario to other related business activities

Reasons and rationale for Mergers

Synergistic operating economics: Synergy may be defined as V(AB) > V(A) + V(B) The combined value of both firms shall be more than their individual value. This may be complementary services, economics of scale or both

Reasons and rationale for Mergers

E.g. Complementary services - One company may have good networking branches and the other an efficient production system. Both together would be more efficient Large scale production results in lower average cost of production i.e. reduction in overhead costs on account of sharing services like finance and accounting, office executives, top level management, legal, sales promotion and advertisement etc. These economics can be real arising out of reduction in factor input to output, or pecuniary realized from paying lower prices for factor inputs to bulk transactions

Reasons and rationale for Mergers

Diversification May lead to reduction in business risk which in turn would increase market value consequently discount rate / rate of return

Reasons and rationale for Mergers

Taxation There is a provision of set off and carry forward losses as per the Income Tax Act Thus Tax saving or reduction in tax liability of the merged of firm having substantial earnings Similarly, the losses of the target firm will be allowed to be set off against profits of the acquiring firm

Reasons and rationale for Mergers

Growth At a faster rate than other mode of expansion

Amalgamation is effected basically for growth and sometimes for image. Horizontal growth to achieve optimum size, to enlarge the market share, to curb competition or to use unutilized capacity Vertical combination with a view to economizing costs and eliminating avoidable sales tax and /or excise duty

Reasons and rationale for Mergers

Consolidation of Production Capacities and Increasing market power

Reasons and rationale for Mergers

Consolidation of Production Capacities and Increasing market power

Diversification of business Mobilizing financial resources by utilizing the idle funds lying with another company for the expansion of business Merging subsidiary company with the holding company with a view to improving cash flow Taking over a shell company which may have industrial licencing etc. but whose promoters do not wish to proceed with the project An amalgamation may also be resorted to for the purpose of nourishing a sick unit in the group and this is normally a merger keeping up the image of the group

Merger Wave in India

Acquisition through takeovers are regulated by SEBI An acquisition is when both the acquiring and acquired companies are still left standing as separate entities at the end of the transaction Corporate takeovers were started by Swaraj Paul when he tried to takeover Escorts Other major takeovers are: Ashok Leyland by Hindujas Saw Wallace, Dunlop and Falcon Tyres by the Chhabria Group Ceat Tyres by the Goenkas Consolidated Coffee by Tata Tea

Cement Sector

Early 1990s saw substantial expansion of cement capacity With recession setting in late 1990s, new and marginal players began to sell out to larger players Only larger players were able to withstand the downturn in demand due to economies of scale, operational efficiencies, centrally controlled distribution systems and geographical diversification

Future in Cement Sector

Realizing the growth potential in India, top international cement companies like Lafarge (France), Holcim (Switzerland), Italcementi (Italy) and Heidelberg (Germany) have entered the Indian market M&A would be the major focus area as green field projects require huge capital & considerable gestation period Due to the Cyclical nature of this industry only large players are able to withstand downturn in demand

Banking Sector

Majorly, M&A in Banking sector have been forced by RBI for rescuing ailing public sector banks with bigger public sector banks. Only few private sector banks have undertaken M&A activity like HDFC Banks takeover of Times Bank, merger of Anagram Finance, ITC Classic, Bank of Madura, ICICI and SCICI with ICICI Bank Mergers between Standard Chartered Bank and Grindlays Bank created the largest foreign bank

Banking Sector

Merger of ICICI Bank with ITC Classic increased its depositor base by 7lacs and added 10 branches and 12 franchisees With Anagram, it gained 50 branches and depositor base of 2.5lacs in Western Region. It also gained the retail portfolio of Anagram which was active in leasing and Hire purchase, car, truck & consumer finance With Bank of Madura, it gained 260 branches, 2500 personnel, Rs.37b deposit base and strong presence in Southern states With reverse merger with ICICI, it became a universal bank second largest in India

Banking Sector Foreign banks

International banks are keen to inorganically grow in India as it gives quicker access to management control & wide network of branches & customers but are restricted by 10% voting rights norms in the regulation They focus more on corporate banking and foreign exchange business and ignore retail finance Leading banks have established call centers, centralised global back office processing centers & research related work in India

Future in Banking Sector

Retail finance, mutual fund asset management, wealth management, structured finance, credit cards, consumer finance, mortgage finance are yet to take off in a big way Internationally, SIZE is increasingly the trend to accommodate thinner margins with sophisticated products and low cost technology to achieve substantial low cost per unit

Pharma Sector

Indian Pharma Sector is highly fragmented with severe price competition and governmental price control The leading 250 companies control 70% of the market share It meets 70% of the countrys need for bulk drugs, drug intermediaries, pharmaceutical formulations, chemical tablets, capsules, orals and injections

Pharma Sector

Indian pharmaceutical companies are focusing on global acquisitions to acquire new markets Dr Reddys Lab, Matrix Lab, Torrent Pharma, Ranbaxy have been making large acquisitions Research has become critical for survival in the Pharma Industry. It takes about 12 years for a new chemical entity to travel from the lab to the market. The requirement of high tech tools increases the cost of research Indian Pharma companies spends on an average 1.8% of its revenue on research against internationally 10-15% of revenue

Future in Pharma Sector

Due to strict regulatory norms mid sized pharma companies with strong manufacturing facility, production techniques are easy targets for acquisitions Stiff competition has brought margins under pressure

Food and Beverages Industry

Challenge is to create huge volumes with lowest possible cost Tata Tea acquisition of Tetley brought instant expansion of product line and served its globalisation drive Greater scope in fragmented liquor business. Distribution alliances have been created

Oil and Energy Sector

Oil industry continues to face volatile price swings. Companies with greater resources and lowest costs would remain in the battle In 2002, RPL merged with RIL creating fully integrated energy company with operations in oil and gas exploration and production, refining and marketing, petrochemicals, power and textiles for increasing scale, size, financial strength, flexibility and global competitiveness Tata Power Company is in consortium with Cairn Energy, Hardy Oil and Gas, ONGC, Hindustan Oil Exploration Company (HOEC) for gas and oil exploration and development projects

Oil and Energy Sector

IPCL merged in Reliance Tata Power was formed by merger of Andhra Power Supply company and Tata Hydro Electric Power Supply Company ONGC acquired Sakhalin Oil Gas for $1700m & Royal Dutch/ Shell for $660m Reliance acquired BSES and renamed Reliance Energy Parliamentary approval is required for government disinvestment of BPCL and HPCL

Media and Entertainment

Brutal advertising environment and radical changes in existing channels of distribution Vertical integrations bring scale and cost benefits Case of UTV

Telecommunication Sector

Birla Tata AT&T consortium Tata acquired VSNL for 32 earth stations, 12 international gateways, 5 submarine cables and assured traffic from BSNL & MTNL Reliance Infocomm bought Flag telecom to get access to the undersea cable network to enable them to connect to key regions like Asia, Europe and the US Hutchisons stake in Essar was acquired by Vodafone for $19b

IT & IT Related Services

Size, pricing pressure, building offshore capabilities, gain domain expertise and overseas clients Increasing geographic footprint, strengthening verticals or solution expertise, moving up the consulting value chain, acquiring skill and manpower, improve processes and access to niche markets

Chemical & Steel Sector

Increase scale of operations, reach new geographic areas, acquire international capabilities

Financial Services

Attain straits of scale in mutual fund business, improve revenue profile

Textile Sector

India is obviously being perceived as a good manufacturing destination, given its skill in the segment, cost of funds and government benevolence

Key drivers of M&A in India

Only way for companies with sick subsidiaries to seek a credible rehabilitation package Consolidate core business to gain balance sheet and net worth Promoters have proposed to merge investment subsidiaries with the parent to streamline their shareholding in other group companies Tax advantage setting off losses against profit, avoid paying sales tax at multiple stages in the production process or outright distress Changing role of financial institutions that help corporate to sell out their loss making businesses Presence of intermediaries like investment bankers has facilitated M&A activity by negotiating with the buyers and sellers

Problems of M&A in India

Indian corporate are largely promoter controlled. It is difficult for either of the two promoters of the merger to voluntarily relinquish management control un favor of the other In some cases the need for prior negotiations and concurrence of financial institutions and banks is an added rider, besides SEBIs rules and regulations The reluctance of financial institutions and banks to fund acquisitions directly The BIFR route, although tedious , is preferred for obtaining financial concessions Lack of Exit Policy for re-constructuring / downsizing Absence of efficient capital market system makes the Market Capitalization not fait in some cases Valuation is still evolving in India

M & A deals fall under Companies Act In cross border transactions, international tax considerations also arise What is BIFR? Board of Industrial and Financial Reconstruction

BIFR

The Board 2-14 qualified High Court judges or else to have at least fifteen years of relevant professional experience. The Board only handles large or medium sized sick industrial companies in which large amounts have been sunk Under the Sick Industrial Companies Act the Board of a sick industrial company is legally obliged to report it to the BIFR, and the BIFR has the power to make whatever inquiries are needed to determine if the company is in fact sick.

BIFR

BIFR can give the company reasonable time to regain health (bring total assets above total liabilities) or change management, amalgamation of the sick unit with a healthy one, sale or financial reconstruction. The Board can recommend a sick industrial company for winding up BIFR either turn companies around within six months or order closure

Mergers in Specific sectors

The Companies Act, 1956 and the SEBIs Takeover Code are the general source of guidelines governing mergers There are sector specific legislative provisions which to a limited extent empower the regulator to promote competition The Electric Regulatory Commission for Power Sector TRAI (Telecom Regulatory Authority of India) for Telecom sector RBI for banking sector

THEORIES OF MERGER

Monopoly Theory/ Empire Building Theory

This theory explains M&A as being planned and executed to achieve market share and market power. According to this theory M&A is primarily used as a growth strategy.
Monopoly theory works in three ways Market leaders trying to consolidate their position further Profitable and cash-rich companies trying to gain market leadership Market entry strategy

1.

2.

3.

Efficiency Arguments Theory

This theory explains M&A as being planned and executed to achieve synergies thereby adding to enterprise valuation.

a. b.

We can broadly classify synergies into two Revenue generating synergies Cost reduction synergies
Revenue generating synergies are far more difficult to achieve than cost reduction synergies.

Efficiency Arguments Theory

Differential Managerial Efficiency
Management of a more efficient acquiring firm can bring up the level of efficiency of the acquired firm, providing both social and private gain. Implies that firms in similar industries would be potential acquirers. Acquiring firms management complements the management of the acquired firm through its experience in the industry. Excess managerial talent by the acquiring firm can be put to use in the acquired firm (managerial synergy). This talent may be applied by direct entry into a new market. New entry may be expensive if the firm with excess managerial capacity does not have other non-managerial organizational capital relevant to that market. Such capital can be acquired through toehold acquisition

Efficiency Arguments Theory

Inefficient Management
In the case of totally inept management, mergers serve as a means of providing discipline to the managerial markets where the only way to get rid of inept management is through taking over the company
Problems: 1) Why arent managers replaced after mergers? 2) Why cant acquired firms be operated as subsidiaries??

Efficiency Arguments Theory

Operating Synergies
Economies of scale allow large firms to operate more efficiently than smaller firms due to indivisibility of resource inputs. Management and financial functions may also generate economies of scale. Vertical integration may also generate economies through more efficient co-ordination of the production process.

Efficiency Arguments Theory

Financial Synergies
Internal funds allow a less costly and more efficient means to finance expansion than reliance on external funds. This would allow cash-rich firms to provide financing for cashpoor companies. It might also allow for economies of scale in the financing of projects. The debt capacity of a combined company may exceed the debt capacity of its components because the variability of cash flow is reduced.

Efficiency Arguments Theory

Pure Diversification
For shareholders, diversification at the shareholder level is equivalent to diversification at the firm level, but should be cheaper, since acquisition costs are much less. For managers, firm diversification is much preferable since human capital is concentrated in a specific firm and depends on the fortunes of that firm. By diversifying, managers gain more job security and perhaps the firm gains lower labor costs. Firm diversification also allows protection of firmspecific information and the firms reputation capital against firm liquidation. Debt capacity can be raised by diversification.

Efficiency Arguments Theory

Strategic Realignment
Change can be effected more quickly by entry into a new product or market through merger than through direct entry. Where values are ephemeral (short lived), it may pay to acquire rather than to build. Problem: The price for timely acquisition may fully reflect value.

Efficiency Arguments Theory

Undervaluation The market may not fully reflect the true value of a potential acquisition, which may be known by competitors and managers in the industry with access to privileged information. Assets may be acquired more cheaply in the aftermarket than by building. The allows assets to be acquired whenever market values are less than their replacement cost.

Tobins q = market value/replacement cost A q value less than one implies negative NPV projects or assets that are worth less than their cost. Problem: Bringing up value of assets still requires greater efficiency by the acquirer.

Valuation Theory

This theory explains M&A as being planned and executed by the acquirer who has better information about the valuation of the target company than the stock market as a whole and who estimates the real intrinsic value to be much higher than the present market capitalisation of the company. Therefore such an acquirer is ready to pay premium over the present market price to acquire control over the target company.

The acquire may have the same information about the company as the stock market but has a different view on future cash flows based on his own reading of the future course of the economy or the company . Companies that have substantial off balance sheet assets or substantially undervalued non-operating assets, which are not being encashed by the present management, the acquirer may have a game plan to encash upon these assets and hence he would put more value to the companys assets than the stock market. Cyclical pattern of economies and stock market.

Agency Problem, Managerialism & Free Cash Flow Theory

Agency problems in relationships arise whenever the two parties do not have exactly the same objective function. Then, benefits to one of the parties can come at the expense of another party. In the context of the differences between objectives of management and shareholders, agency problems can lead to inefficiencies, which inefficiencies may be resolve by means of the markets discipline of managers through takeovers or the threat of takeovers.

Examples: Manager/employees vs. stockholder/owners Inefficiency is a form of managerial perk Stockholders vs. bondholders

Agency Problem, Managerialism & Free Cash Flow Theory

Mergers as a solution to agency problems If managers have created inefficiencies, then the stock price will not be as high as possible had such inefficiencies not existed. The presence of inefficiencies opens the opportunity for an outsider to buy assets at a discount, resolve the inefficiencies, and bring the assets up to full value

Agency Problem, Managerialism & Free Cash Flow Theory

Mergers as an outcome of managerialism Managers may have incentives to maximize the size of assets managed rather than maximizing shareholder wealth if their incomes or economic power is more related to the size of their managerial scope. They are incented to add assets for their own purposes rather than to make shareholders better off. The discipline of a merger would strip inefficient or un-needed assets and reduce the firm to its proper size.

Agency Problem, Managerialism & Free Cash Flow Theory

Conflicts over the distribution of cash flow Managers and shareholders may have different objectives represented in preferences for use of the firms internally generated cash, with managers wanting the firm to become larger while shareholders would prefer to obtain cash through dividends or share repurchases.

Agency Problem, Managerialism & Free Cash Flow Theory

The rationale for the use of debt.

Interest and principal payments provide discipline for managers in running a tighter ship to assure that cash is available for fixed financial charges. Financing associated with Leveraged buyouts or management buyouts can impose such discipline.

Agency Problem, Managerialism & Free Cash Flow Theory

The Free Cash Flow problem.

Agency problems are heightened when management has financial flexibility at its disposal in the form of the ability to generate cash from operations or in pools of liquid assets built up. Buildup of free cash flow in a) current assets b) pension fund c) borrowing capability can be used by managers to benefit themselves directly (higher salary) or indirectly (poor investments) at the expense of shareholders. Firms with good investment opportunities have greater need for financial slack (free cash flow) and are less likely to waste free cash. Firms with poor investment opportunities may be inclined to invest anyway simply because ample cash is available. Example: Cash-rich oil companies with poor investment opportunities being the subject of and the subject of takeover battles in the 1980s. Takeovers prevented oil companies from wasting cash in negative NPV investment because of managerialism.

Information and signaling arguments

Information is not shared equally between parties in a transaction. Sellers and job applicants know more about the item offered or skills available than buyers or employers. Managers know more abut the condition of the firm than investors or the managers of an acquiring firm.

Information and signaling arguments

Pooling Equilibrium
When individual characteristics are unknown then group characteristics are assigned rather than individual characteristics. Example: All used cars are classified as lemons. Graduates of prestigious universities are considered smarter and harder-working

Resolution
Costless signaling is worth what it costs. Costly signaling is difficult to signal falsely.

Information and signaling arguments

Information implications of merger activity.

Investors learn information about a company when it goes in play as a takeover target. Its value is revised upward. The revision may be due to a combination of two explanations.
Explanation #1. - Sitting on a gold mine The target shares and assets may be undervalued because of their higher value for an alternative owner who may place assets at a higher and better use. If one outsider can add value, then other potential new owners may also add value. Explanation #2 - "Kick in the pants" When managers learn of the potential for the discipline of a merger, they institute pre-emptive steps to initiate the discipline by themselves.

Information and signaling arguments

Signaling implications The form of mergers can be used to glean information about bidders and targets. A bidder that uses common stock rather than cash may signal that the bidders own stock may be overvalued, or it may signal that the bidder is unsure of the target value and wishes target shareholders to share in the risk of potential misestimation of the targets value.

Wealth Redistribution
1.

Shareholders versus bondholders. Mergers are often, but not necessarily, accompanied by opportunities to change capital structure in a manner that disciplines management. Substitution of debt for equity applies such discipline, but also provides shareholders with an opportunity to transfer bondholder wealth to themselves. Losses by bondholders will increase the wealth of shareholders, even with no change in the value of assets.

Viewing the equity as an option on underlying firm assets produces the same implications. Sale of assets to generate cash also undercuts the value of bonds since fewer assets reduces the cash flow available for paying interest and principal. Examples: In the KKR takeover of RJR assets sales of $5 billion and sale of junk bonds that produced a net loss after interest of $976 million.

In Phillips Petroleum defense against takeover, the leveraged refinancing hurt the value of existing bonds. Equity was reduced from $6.6 billion in 1984 to $1.6 billion in 1985, while long-term debt increased from $2.8 billion in 1984 to $6.5 billion in 1985. (Notice that takeover was averted by management pre-emption of takeover strategies).

Wealth Redistribution
Shareholders versus other stakeholders.
A. Employees In a merger, the acquiring firm and its new management may not feel as responsible for the welfare of employees or other stockholders. The result can be much of the efficiencies of mergers. Example: Acquisition of TWA by Icahn produced cost savings of $200 million per year by means of wage reductions forced on employees. It can be argued whether this is the result of a breach of trust or an end to regulation. B. Government Greater leverage and reduced tax payments may transfer wealth from society to shareholders.

Raider Theory

The acquirer acquires controlling stake in cash needy companies at much lower valuation than potential valuation or even present valuation just to transfer the wealth from existing shareholders to themselves without any strategic intent of running these companies themselves.

GAINS FROM MERGER

Gains from Mergers or Synergy

1st step Identify the economic gains from the merger Combined Value > (Value of acquirer + Standalone value of target) Synergy = Combined Value Sum of the Values of Individual Companies Value of acquirer + Value of target + Value of Synergy = Combined Value There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid over the market value plus other costs of integration Therefore, net gain = value of synergy premium paid

Gains from Mergers or Synergy

Gains from Mergers or Synergy

Gains from Mergers or Synergy

Operating improvement are also a big source of value creation than monetary synergy. Better post merger integration could lead super-normal returns even when the acquired company is in unrelated business Managerial talent is the single most important instrument in creating value by cutting down costs, improving revenues and operating profit margin, cash flow etc.

Gains from Mergers or Synergy

Executive compensation tied to the performance in the post merger period induces them to think and behave like shareholders

5 principle steps in a Successful Merger

1) 2) 3)

4)
5)

Manage the pre acquisition process / Competitive Stage Search and Screen candidates Eliminate those who do not meet the criteria and value the rest / Strategy development calls Negotiate Post merger integration

The acquirer should maintain secrecy about its intentions. Otherwise, the resulting price increase due to rumors kill the deal

5 principle steps in a Successful Merger

The competitive stage is to identify your own objective of having a merger or an acquisition and also synergistic inter relationship between the buyer and the targets business opportunities In search and screen stage, a list of good acquisition / merger candidates is developed. While the screening process involves identifying a few of the best candidates that meet the established criteria once best apparent candidates have been identified, more detailed analysis for each will be initiated The strategy development calls for the development of a blueprint for the exploitation of apparent operational synergies The negotiation stage is following up with structuring and paying for the deal The more an acquisition depends upon synergistic inter relationship, the greater is the need to develop an post merger integration blueprint beforehand

Financial evaluation of the acquisition / merger process

Central issues are: 1) What is the maximum price that should be for the target company? 2) What are the principle areas of risk? 3) What the cash flow and balance sheet implications of the acquisition / merger? 4) What is the best way of structuring the acquisition In the negotiation stage, negotiations will depend to a large extent on the quality of he homework done in the earlier stages

Scheme of Amalgamation or Merger

Scheme of the proposal is the heart of the process and has to be drafted with care No prescribed scheme but should take care of any special feature peculiar to the arrangement An essential component is the provision for vesting all assets and liabilities of the transferor company in its transferee company. If the transferee company does not want to take over any asset or liability, the transferor company before finalizing the draft scheme should dispose it off or settle, Otherwise, the scheme would be considered defective and incomplete and the court would not sanction it. It is also important to define the effective date from which the scheme is intended to come into operation,. This would save time and labor in explaining to the court the intention behind using several descriptions on the scheme. According to the order of the Central Government under Section 396 of the Companies Act, the entire business and undertaking of a transferor company shall be transferred to and vest with the transferee company on the day when it is notified in the Official Gazette, for accounting purposes, the amalgamation shall be effected with reference to the audited accounts and balance sheets as on a particular date (which precedes the date of notification) of the two companies and the transactions thereafter shall be pooled into a common account

Scheme of Amalgamation : Valuation of Shares

Objections have been raised as to the method of valuation even in cases where the scheme had been approved by a large majority of shareholders and the financial institutions as lenders. In Hindustan Lever case, the Supreme Court held that it would not interfere with the valuation of shares when more than 99% of the shareholders have approved the scheme an the valuations having been perused by the financial institutions.

Scheme of Amalgamation: Position of employees

The position of employee should be clearly set out. The scheme should provide for the transfer of all employees to the transferee company on the same terms and conditions of service without any break in service. In the event of the transferee company not willing to absorb any of the employees through the merger, the transferor company should settle those employees with applicable law before the scheme is put through

ACQUISITIONS AND TAKEOVERS

Acquisition

1.

2.

Purchasing a controlling interest by one company in the share capital of an existing company When a company is acquired by another company, the acquiring company has 2 options: Either to merge the companies into one and function as a single entity (Acquisition) Operate the takeover company as an independent entity with change management and policies (Takeover)

Acquisition or Takeover may be by way of

Acquisition of Company shares Acquisition of Business Assets Acquisition of Brand Acquisition of Companies by Friendly or Hostile takeover Reverse Acquisition

Value creation in Acquisitions

Simple Acquisition

Acquisition of one of the business of a company as a going concern not necessarily be routed through court, if the transfer of business is to be accomplished without allotting shares in the transferee company to the shareholders of the transferor company. This would tantamount to a simple acquisition In this case the transferor company continue to exist and no change in shareholding is expected

Slump Sales

If the sale takes place for a lump-sum consideration without attributing any individual values to any class of assets, such sales are called slump sales. The capital gains arising on slump sales were being exempt from income tax based on a decision of the Supreme Court of India

Purchase of Voting Stock

Another way to acquire a firm is to buy the voting stock. This can be done by agreement of management or by tender offer. In a tender offer, the acquiring firm makes the offer to buy stock directly to the shareholders, thereby bypassing management. In contrast to a merger, a stock acquisition requires no stockholder voting. Shareholders wishing to keep their stock can simply do so. Also, a minority of shareholders may hold out in a tender offer.

Purchase of Voting Stock

A bidding firm can also buy another simply by purchasing all its assets. This involves a costly legal transfer of title and must be approved by the shareholders of the selling firm. A takeover is the transfer of control from one group to another. Normally, the acquiring firm (the bidder) makes an offer for the target firm. In a proxy contest, a group of dissident (rebel) shareholders will seek to obtain enough votes to gain control of the board of directors.

Takeover

1)

2)

An acquisition by purchase of a continuing interest in the share capital of another existing company is takeover Two types: Friendly takeover: Takeover through negotiations and with willingness and consent of the acquired companys Board of director Hostile takeover: An acquirer company may not offer to target company the proposal to acquire its undertaking but silently and unilaterally pursue efforts to gain control in it against the wishes of the management

Tender Offer

Tender offer is a type of takeover bid. The tender offer is a public, open offer or invitation (usually announced in a newspaper advertisement) by a prospective acquirer to all stockholders of a publicly traded corporation (the target corporation) to tender their stock for sale at a specified price during a specified time, subject to the tendering of a minimum and maximum number of shares. In a tender offer, the bidder contacts shareholders directly; the directors of the company may or may not have endorsed the tender offer proposal. To induce the shareholders of the target company to sell, the acquirer's offer price usually includes a premium over the current market price of the target company's shares. For example, if a target corporation's stock were trading at $10 per share, an acquirer might offer $11.50 per share to shareholders on the condition that 51% of shareholders agree. Cash or securities may be offered to the target company's shareholders, although a tender offer in which securities are offered as consideration is generally referred to as an exchange offer.

Take Over Strategies

Other than tender offer the acquiring company can also use the following techniques: Street Sweep: acquiring company accumulates larger number of shares in a target before making an open offer. The target company is left with no choice but to agree to the proposal of acquirer for takeover Bear Hug: When the acquirer threatens the target to make an open offer, the board of target company agrees for a settlement with the acquirer for change of control

Take Over Strategies

Strategic Alliance: Disarming the acquirer by offering a partnership rather than a buyout. The acquirer asserts from within and takes over the target company Brand Power: entering into an alliance with powerful brands to displace the targets brands and as a result, buyout the weakened company

Takeover by Reverse Bid / Merger

In ordinary case, the company taken over is the smaller company; in a reverse takeover a smaller company gains control of a larger one. a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares. Its is not the amalgamation of a sick unit with a healthy and prosperous company but is a case whereby the entire undertaking of the healthy and prosperous company is to be merged and vested in the sick company which is non-viable

Asset Stripping

The process of buying an undervalued company with the intent to sell off its assets for a profit The individual assets of the company, such as its equipment and property, may be more valuable than the company as a whole due to such factors as poor management or poor economic conditions Seeking a profit by buying a company, when the market price is below the value of the assets, and then selling off all or some of the assets

Dawn Raid

During a dawn raid, a firm or investor aims to buy a substantial holding in the takeover-target companys equity by instructing brokers to buy the shares as soon as the stock markets open By getting the brokers to conduct the buying of share s I the target company (the victim), the acquirer (the predator) masks its identity and thus its intent The acquirer then builds up a substantial stake in its target at the current stock market price Because this is done early in the morning, the target firm usually doesnt get informed about the purchases until its too late, and the acquirer now has controlling interest

Sell-off

When a company sells part of its business to a 3rd party, it is called sell-off This is a usual practice to divest unprofitable or less profitable businesses to avoid further drain on its resources Sometimes, even non-core profitable business if sold to ease liquidity problem or generate funds for investing in the core business

Demerger of Spin off

L&T engineering L&T L&T Cement Division Ultratech Cement Company

Spin-offs

When a company creates a new company from the existing single entity, it is called spinoff After spin-off shareholders hold shares of 2 companies, able to value business separately, know which business is poorly performing and take corrective action Concentrated attention results in operating efficiencies Reduces attractiveness for acquisition

Takeover by Reverse Bid / Merger

1)

2)

3)

The 3 tests are: The assets of the transferor company are greater than the transferee company Equity capital to be issued by the transferee company pursuant to the acquisition exceeds its original issued capital the change of control in the transferee company through the introduction of a minority holder or group of holders

Equity Carve Out

Sometimes known as a partial spinoff, a carve out occurs when a parent company sells a stake in a subsidiary for an IPO or rights offering. Diluting the ownership rights of original or existing shareholders by issuing new ordinary shares of a firm to new investors.

M&A Terminologies

Black Knight: It is the company which makes a hostile takeover bid on the target company White Knight: It is the potential acquirer which is sought out by a target companys management to take over the company to avoid hostile takeover by an undesirable black knight Grey Knight: is a third firm that is not welcomed by the victim, seeking to exploit the situation to their own advantage

M&A Terminologies

Yellow Knight: A firm who originally seeks to launch a hostile takeover bid but then moderates its stance and negotiates on the basis if a mergerthe yellow being used to imply some element of cowardice in the behavior of the bidding firm who may begin to appreciate that it will not be able to bully its victim into submission White Squire: Such a firm may not be big enough to be able to take control of another firm but may well seek to buy in to the victim firm to prevent the black knight from being able to achieve its takeover plans

M&A Terminologies

Crown Jewels: The precious assets in the Company are called as Crown Jewels to depict the greed of the acquirer under the takeover bid. These precious assets attract the raider to bid for the Companys control Saturday Night Special: This is a sudden attempt by one company to take over another. The name comes from the fact that these maneuvers used to e done over the weekends

M&A Terminologies

Break-up Fee: A fee that is payable to the seller or buyer if the other party backs out of a transaction after signing a letter of intent. Penalty for causing due diligence without closing the deal Window Shopper: Likes to look, but rarely buys Bottom Fisher: Constantly hunting for bargains, active buyer Market Share / Product Line Extender: most common buyer category because fewer operating risks are involved Strategic Buyer: seeking to diversify and redeploy assets Leveraged Buyout: Very active sector. Financially oriented buyers

DEFENSIVE TACTICS OF TARGET COMPANIES IN HOSTILE TAKEOVERS

Anti-takeover Defenses
Pre-offer

defenses company is not in play Post-offer defenses

Antitakeover Defenses-Pre-Offer
Staggered board Supermajority Fair price Shareholder rights plan Dual class recapitalization

Antitakeover Defenses-Post-Offer Pacman defense Targeted share repurchase Standstill agreement Asset restructuring Liability restructuring

Defensive Tactics from Hostile Takeover

e.g.: the acquiring company may issue substantial amount of convertible debentures to its existing shareholders to be converted at a future date when it faces a takeover threat. The task of the bidder would become difficult since the number of shares to having voting control of the company increases substantially Poison Put: Target company issue bonds that encourage holder to cash in at a higher prices. The resultant cash drainage would make the target unattractive Greenmail: An incentive offered by management of the target company to the potential bidder for not pursuing the takeover. The management of the target company may offer the acquirer for its shares a price higher than the market price. This is where a large block of shares is held by the unfriendly company, which forces the target company to repurchase the stock at a substantial premium to prevent the takeover. In a takeover bid this could prove to be an expensive defense mechanism

Defensive Tactics from Hostile Takeover

White Knight: Target company offers to be acquired by a friendly company to escape from a hostile takeover. The possible motive for the management of the target company to do so is not lose the management of the company. The hostile acquirer may change the management White squire: Sell out the shares of the company to a company that is not interested in the takeover. As a consequence the management of the target company retains its control over the company Golden parachutes: When a company offers hefty compensations to its managers if they get ousted due to takeover, the company is said to offer golden parachutes. This reduces their resistance to takeover Pac-man defense: This strategy aims at the target company making a counter bid for the acquirer company. This would force the acquirer to defend itself and consequently may call off its proposal for takeover.

Defensive Tactics from Hostile Takeover

Macaroni Defense: A tactic by which the target company issues a large number of debt instruments with a guarantee to redeem at a higher price in case of a takeover. Redemption price increases- kind of like macaroni in a pot! A highly useful tactic- need to be careful in issuing too much of debt difficult in interest payments People Pill: The management team threatens to resign at the same time en masse. Losing a good management team could seriously harm the company and make the bidder think twice. The effectiveness of people pill defense really depends on the situation

Defensive Tactics from Hostile Takeover

Divesture: Target company divests or spins off some of its businesses in the form of an independent, subsidiary company thus reducing the attractiveness of the existing business to the acquirer Crown jewels: When a target company uses the tactic of divestiture it is said to sell the crow jewels Poison pill: Sometimes an acquiring company itself becomes a target when it is bidding for another company. The tactics used by the acquiring company to major itself unattractive to a potential bidder is called poison pills.

So, what next? When the cat is idle, the mice will play ....

When managers do not fear stockholders, they will often put their interests over stockholder interests

No stockholder approval needed.. Stockholdr Approval needed

Greenmail: The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement. Golden Parachutes: Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover. When a company offers healthy compensation to its managers if they get ousted due to takeover, the company is said to offer golden parachutes. This reduces their resistance to takeover Poison Pills: A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill. It is a strategy to make the company unattractive to the acquirer. One of the strategy is to increase the debt component in the capital structure of the Company i.e. increasing the Debt Equity Ratio Shark Repellents: The company change and amend their bye-laws and regulations to be less attractive for the corporate raider company. Anti-takeover amendments are also aimed at dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted. Overpaying on takeovers: Acquisitions often are driven by management interests rather than stockholder interests.

Maximise stockholder wealth, $20 more than the market price Hostile, replaces the management, loose your job Either loose your job or maximise stockholder wealth Stand still agreement Extra money to go away, used the shareholder money, to make sure that stockholder do not get extra $20 per share Aggregious way to protect

1980 revlon Golden parachutes, pay the manager if hostile acquisitions take place. So that the acquiring company needs to keep money aside to pay the manager and do not have enough money to pay for the acquisition Poison pills: harmless if you run the company but someone tries to take over the company, it will kill them and probably you with them Rights plan to buy, flip over rights plan Share =$10, offer $5 Additional rights at $100, if acquisition takes place rights plan at $1

Poison pills spitting on the fries, managers are spitting on fries but the stockholder Need share holder approval

Overpaying on takeovers

The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time. Many mergers do not work, as evidenced by a number of measures.

The profitability of merged firms relative to their peer groups, does not increase significantly after mergers. An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work.

A case study in value destruction: Eastman Kodak & Sterling Drugs

Kodak enters bidding war

Kodak wins!!!!

In late 1987, Eastman Kodak entered into a bidding war with Hoffman La Roche for Sterling Drugs, a pharmaceutical company. The bidding war started with Sterling Drugs trading at about $40/share. At $72/share, Hoffman dropped out of the bidding war, but Kodak kept bidding. At $89.50/share, Kodak won and claimed potential synergies explained the premium.

Earnings and Revenues at Sterling Drugs

Sterling Drug under Eastman Kodak: Where is the synergy? 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1988 1989 Revenue 1990 1991 Operating Earnings 1992

Kodak Says Drug Unit Is Not for Sale but

An article in the NY Times in August of 1993 suggested that Kodak was eager to shed its drug unit.

In response, Eastman Kodak officials say they have no plans to sell Kodaks Sterling Winthrop drug unit. Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as massive speculation, which flies in the face of the stated intent of Kodak that it is committed to be in the health business.

A few months laterTaking a stride out of the drug business, Eastman Kodak said that the Sanofi Group, a French pharmaceutical company, agreed to buy the prescription drug business of Sterling Winthrop for $1.68 billion.

Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock Exchange. Samuel D. Isaly an analyst , said the announcement was very good for Sanofi and very good for Kodak. When the divestitures are complete, Kodak will be entirely focused on imaging, said George M. C. Fisher, the company's chief executive. The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.

Defending a Company in a Takeover Bid

The speed with which a hostile takeover is attempted puts the target Company at a disadvantage One of the observations on the prevailing regulations pertaining to takeover is that, there is very little scope for a target company to defend itself in a takeover battle. Due to the prevailing guidelines, the target company without the approval of the shareholder cannot resort to any issuance of fresh capital or sale of assets etc., and also due to the necessity of getting approvals from various authorities. In the past, most companies who wanted to resist a takeover, did so, either by getting a White Knight support the Company or by refusing to transfer shares acquired by the Acquirer, followed by long protracted legal battle. Now under the guidelines, the target company cannot refuse transfer of shares without the consent of shareholders in a general meeting.

Distinction between a Merger and Acquisition

When a company takes over another one and clearly becomes the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist and the buyer swallows the business, and stock of the buyer continues to be traded. In the pure sense of the term, a merger happens when two firms, often about the same size, agree to go forward as a new single company rather than remain separately owned and operated. This kind of action is more precisely referred to as a merger of equals. Both companies stocks are surrendered, and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.

Distinction between a Merger and Acquisition

In practice, however, actual mergers of equals dont happen very often. Often, one company will buy another and, as part of the deals terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if its technically an acquisition. Being bought out often carries negative connotations. By using the term merger, dealmakers and top managers try to make the takeover more palatable. A purchase deal will also be called a merger when both CEOs agree that joining together in business is in the best interests of both their companies. But when the deal is unfriendlythat is, when the target company does not want to be purchasedit is always regarded as an acquisition

Distinction between a Merger and Acquisition

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target companys board of directors, employees and shareholders.

DUE DILIGENCE
Due Diligence is an analysis and appraisal of an entity in preparation for establishing a relationship with that entity which involves business risk
.

Due Diligence

It is the process of examining all aspects of a company including manufacturing, financial, legal, IT systems, labor issues, regulatory issues as well as understanding issues relating environment and other factors It is done to evaluate and assess a company for acquisition purposes It helps the acquiring company to determine if it is worth pursuing a target and at what price Inadequate evaluation is considered the major reason for failure in M&A

Objectives of Due Diligence

To look for over valued assets or unrecorded or under recorded liabilities. To look at the quality of management of the target company. To look at the tax position/ structure and its impact. Review projected cash flows.

Aspects covered by Due Diligence

The organizational structure and management style The operational aspects, which include production technology, processes and systems The financial aspects which include operating performance information and potential tax liabilities The human resource environment Various legal aspects The information system

Process of Due Diligence

Appointment of the team

Expertise

available inhouse and from retained consultants and advisors

Skills/expertise

Team involves Financial & legal personnel, economic consultant, environment experts, engineers

Clear and definite mandate Costs Confidentiality agreements

Process of Due Diligence

Data room and access to the room Due Diligence Questionnaire and Checklist One on one interviews with management from the target company Investigative mode of enquiry

TYPES OF DUE DILIGENCE

Financial

Tax

Legal

Operations & IT

HR

Market

Financial Aspects

Return on assets per employee Economic value added Percentage of profits and revenues from new businesses Quantification of lost business opportunities (due to competition and new product failures)

Financial Aspects
Annual and quarterly financial information for the past three years

Income statements, balance sheets, cash flows Planned versus actual results Management financial reports Breakdown of sales and gross profits by: Product Type Geography

Financial Aspects
Capital Structure 1. Current shares outstanding 2. List of all stockholders with shareholdings, options, warrants or notes 3. Schedule of all options, warrants, rights, and any other potentially dilutive securities with exercise prices and vesting provisions. 4. Summary of all debt instruments/bank lines with key terms and conditions

Financial Aspects

Details of Assets / Liabilities and their recoverability / impairment Fixed Assets (including leased assets and IPRs) Title and any encumbrances; Inventories; Receivables (including Credit Policy/ Collection Period) and other Assets; Liabilities (including Retirement benefits and other employee liabilities). Gross Margins and EBITDA analysis. Management & Employees and their Relationship.

Tax Aspects

Analyze the impact of unpaid taxes/contingent liability against the target. Assess the impact of likely results of current and potentially pending litigation. Liabilities towards deferred tax Future tax implications in respect to the potential acquisition.

Legal Aspects

Legal structures in cross border acquisitions Accounting practices Environmental Laws

Legal Aspects

Pending lawsuits against the Company (detail on claimant, claimed damages, brief history, status, anticipated outcome, and name of the Companys counsel) Pending lawsuits initiated by Company (detail on defendant, claimed damages, brief history, status, anticipated outcome, and name of Companys counsel)

Legal Aspects

Description of environmental and employee safety issues and liabilities 1. Safety precautions 2. New regulations and their consequences List of material patents, copyrights, licenses, and trademarks (issued and pending) Summary of insurance coverage/any material exposures

Production Aspects

Manufacturing or service process Measurement of cycle time Improvement of overtime Achievement of quality goals Assessment of effectiveness of management IT and administration expenses per employee

Human Aspects

Assessment of people, team and organizational networks Evaluation of management capabilities Indices on leadership and motivation Investment in human resources Employee empowerment

Customer and Marketing Aspects

Customer satisfaction Index Customer relationship analysis Market share vis--vis competition

Accounting Aspects

Differences in Accounting Standards, US GAAP, IAS, Indian GAAP, IFRS, which impact historical and combined financials Differences in Accounting Policies, Revenue Recognition, contracts, Inventory valuation, provisioning, depreciation etc. Off Balance Sheet Items and contingent liabilities Goodwill Accounting Policy, Fair Value Accounting, Accounting System Integration

Due Diligence Challenges

If a wrong firm is selected the due diligence process may not have much value Managerial Hubris Examples: Quaker Oats acquisition of Snapple Chrysler acquisition of American Motors Chrysler acquisition attempt of Nissan Motors Company Sony acquisition of Columbia Studios Union Pacific acquisition of Southern Pacific

Checklist for Due Diligence to be reviewed by attorneys and consultants

Check out corporate details, trade names, service marks and trade registrations Check Articles of Incorporation Check Intra company transactions, subcontracts, transfer of assets, cash and credit Check documents relating to organizational legal structure & incorporation, insurance coverage, personnel policies & structure, finance and fund raising, capital and real estate, licences, contracts, marketing materials, any current or potential legal liabilities

Asset Appraisal and Cultural Due Diligence

Asset appraisal of saleable assets like machinery, real property or inventories is mandatory Cultural components corporate policies, compensation plans, leadership styles, communication and work environment Maximise the value of human capital including retention of expert existing employees and incentive plans Essential to get staff remuneration data and understand labor market position Also essential to understand staff transfer, redundancies, leave obligations, employee agreement entitlements, trade union agreements, health & safety, contractual commitments with HR related suppliers & history of legal action

Obstacles in Due Diligence Process & Challenges to Due Diligence in the Indian Market

Lack of Quality Information Lack of Adequate Information Insufficient Disclosure Lack of Corporate Governance Dilution of Control

Limitations of Due Diligence

Limited scope Limited time frame