Mergers and Acquisitions
Mergers and acquisitions (M&A) is the process of consolidating two or more businesses for competitive advantages. Mergers refer to the merger of two companies into one. Acquisitions are the acquisition of one company by another. M&A is a major aspect of corporate finance.
M&A is generally based on the fact that two companies create more value together than if they were in their own right. Companies continue to evaluate different options for wealth maximization through mergers and acquisitions.
M&A’s primary goal is to create value and expand market share for growth. M&A activity has the basic purpose of enabling the acquirer to create more value through acquisition than organic growth.
Nearly all M&A activity centers on the assumption that there is some type of synergy in the transaction. Simply put, synergy can be described as 1 + 1 = 3. The two firms together are more valuable than each firm individually.
M&A works on the basis that combined firms are worth more than each of them individually. The acquiring firm can pay a significant premium for the target company and still achieve a value increase. This is the theory. In practice, however, synergy doesn’t always work out and acquisitions don’t always succeed.
Differences Between Mergers and Acquisitions
The company that acquires another company usually keeps its business name, legal structure, and operations. The companies may choose to merge under a new name to better reflect the new company’s vision or may keep the brand identity and loyalty of one of their existing names.
Legally, the company that is acquired by another company ceases to exist as a separate legal entity and under its old name. It is taken over by the acquiring firm. Stocks that are sold or traded by the acquired company would then be owned and managed entirely by the acquiring firm.
Although these terms are frequently used interchangeably, some situations can be referred to as mergers while others are acquisitions depending on the terms of a business deal. This is known as a hostile takeover.
This is often due to differences in how the merger or acquisition will be presented to shareholders, employees, and the board of directors. Many mergers and acquisitions are mutually beneficial, allowing companies to expand their reach and grow their presence.
Types of Mergers
There are three types of mergers: horizontal, vertical, and conglomerate. This refers to the business relationship between two parties. Understanding the reasons behind mergers will give you an insight into their motivations.
Horizontal Mergers
Horizontal mergers are when a company acquires another firm within the same industry, with similar or compatible product lines. Horizontal mergers can often lead to a larger product range and greater coverage of the products in the combined company. Horizontal mergers may allow the combined firm to realize economies of scale, which is when output increases and costs per unit decrease.
Horizontal mergers are based on the assumption that companies producing nearly identical products can benefit from the scale gains that result from merging.
Horizontal mergers are often successful because they can generate more value at all levels of the company’s value chains. This includes the supply chain where larger companies can get bigger discounts and the customer where there is a greater customer base.
The principle behind a horizontal merger is to create value. The merger must create value that is greater than the sum of each company’s independent ownership. In horizontal mergers, 1 + 1 must be greater than 2 .
Vertical Mergers
Vertical mergers are when two companies merge that have previously bought or sold goods to each other. A manufacturer might merge with a supplier or producer of raw material, or with a retailer that sells its products.
Two companies can merge on equal terms. Vertical merger integration is more valuable than independent ownership because the businesses that merge together will be more valuable than their individual owners. This type of merger has two purposes: to create synergies and to be more efficient as one entity.
Vertical mergers are not designed to increase revenue or grow, but rather to reduce costs and achieve a higher profit margin. A vertical merger can also be used to make sure you have the necessary supplies for your production processes.
Conglomerate Mergers
Conglomerate mergers are when two businesses with totally unrelated businesses merge. A conglomerate merger serves two primary purposes: to diversify the company and reduce risk. One part of a business that is struggling may lead to another business that is doing well.
The earnings stream from the combined business will be stable if the profits of the different businesses aren’t highly correlated, that is, they don’t tend to move together.
A partnership with a dissimilar entity or one that is only slightly similar to your company provides instant access to other markets and possible product lines. Diversifying the company portfolio can increase revenue potential and reduce risk.
Motive Behind Mergers
While some reasons are sound and maximize the value of an entity for its owners, others are less convincing. We will be discussing a range of reasons for firms to merge with other firms here.
Synergy Effect
One + one = three is the definition of synergy. But how can you realize these synergies? A bank can acquire another bank to eliminate redundant branches in the same market. This allows it to retain the same customers while maintaining a lower cost structure.
This logic applies to mergers where the combined firm offers a more comprehensive product line. If two car companies merge, dealers can sell their vehicles and duplicate dealerships can be shut down. Or, if a soft drink producer merges with fast-food chains, the outlet for the product can be secured.
Fast Growth
It takes time and patience to grow organically. It is often faster and easier to invest in growth through acquisitions than to grow a company the hard way. Although a company might not be able to predict how successful it will become in organically growing a company, it can know exactly what it is buying in an acquisition.
Organic growth can be difficult in mature industries like the petroleum industry. In some industries, organic growth is difficult. Acquisitions may be the best option for rapid growth.
To Increase Market Value
Mergers may result in greater market power. A horizontal merger is a good example. Because there is less competition after the merger, the combined firm will have greater pricing power. Many horizontal mergers are subject to antitrust scrutiny for this reason. They can reduce competition. Vertical mergers have less supply-chain uncertainty and more control over their supplies.
Gain Access to Foreign Markets
Many businesses find it difficult to cross borders. One way a company can quickly and efficiently access foreign markets is by merging with another firm. Crossing borders can be difficult for many reasons, including cultural and regulatory concerns. However, merging with an established firm can help to avoid many of these issues.
Management’s Self-interest
One of the secrets to merger activity is the fact that not all mergers are in shareholders’ best interest, but rather in the best interests of the management. It is a fact that CEOs in larger organizations are paid more than those of smaller companies.
When it comes to CEO compensation, the size of the company really matters. It’s not just the CEO’s pay that matters, it’s the entire executive team’s pay. It’s not surprising that CEOs want to increase their influence and compensation by creating a larger empire.
To Diversify
Diversification and lowering risk are the main motivations for conglomerate mergers. For example, a firm that is cyclical might acquire a counter-cyclical company. The combined firm’s profit stream should be more stable.
While diversification can be a motivator for management, it’s not always a good motive for owners and shareholders. Conglomerate mergers actually make it harder for investors to choose between firms.
Tax Considerations
Sometimes mergers are made because they make sense tax-wise. A firm that has suffered significant tax losses may be a good target for an acquisition. The combined firm will have lower taxes than the separate firms. A firm that can increase its depreciation costs after an acquisition will be able to save taxes. These tax savings should lead to an increase in firm valuation.
Better Control
Many acquirers believe there is hidden value in acquired companies that can be unlocked by gaining control. The company is being mismanaged, and the new management team will be able to turn it around. If the company is truly being mismanaged, it is not maximizing the value of its assets.
If the assets can easily be purchased at a price that is less than the current value and the acquirer can make better use of them, then the hidden worth of the assets can be realized by a change of control.
To Increase Borrowing Ability
We all know the expression “Capital is King”, so anyone who has access to capital must also be part of the royal family. Unutilized borrowing capacity is an example of hidden value. If a firm has very little or no debt, it may be a good candidate for acquisition.
A buyer could purchase the assets and use the untapped borrowing capacity to obtain much-needed capital and expand further. The firm that can borrow more money than it costs will be able to increase its value and add to the total firm’s return of equity. This will make both shareholders and management happy.
Why Many M&A Deals Go Wrong
M&A deals are not always a good deal, even though there are many highly intelligent people involved.
Misplaced Incentives
Some mergers or acquisitions shouldn’t be allowed to proceed because they are bad ideas. There are many incentives to make a deal happen. Many people get paid for a successful M&A deal. Others, including the management of the acquirer, build a larger empire.
Sometimes M&A deals don’t materialize as they should. The deal can become attractive if an assumption is changed. Many investment bankers and their teams remind us of the old joke about accountants.
Management teams and boards of firms are often so concerned about their personal lives and livelihoods that they will fight for the best interests of potential suitors. Many investors are supportive of management owning large stakes in the equity of their firms. This equity stake is intended to align management’s incentives with shareholders.
Faulty Analysis
Investment banking firms use two types of financial models: relative valuation and discounted cash-flow models. The incorrect models rarely cause analysis to be flawed. Simple adjustments to an assumption can make a transaction profitable or unprofitable.
Because the modeling is so complicated, there is an illusion of precision. Companies are often so eager to make a deal that they will accept deals that have very little margin for error. This is magnified when there is lots of M&A activity.
Overstated Synergies
Shareholders may be disappointed by the outcome of a merger/acquisition because they are too optimistic. The benefits that are described on paper may not be realized in the real world. Sometimes mergers and acquisitions end in failure because investment bankers or management teams are too optimistic.
Culture Wars
Mergers and acquisitions that combine companies with different cultures are often unsuccessful. It is more than just merging assets and liabilities on a balance sheet. It also requires bringing people together to collaborate productively.
The company’s culture is the company’s personality. It often manifests in a “that’s how we do things here” mentality. While some firms have cultures that are more bureaucratic and hierarchically focused, others encourage teamwork and greater worker autonomy. Integrating companies with different corporate cultures can lead to problems and a failure to realize the potential synergies.
Drawbacks of Mergers and Acquisitions
Less Selection Options
Consumers may have less choice if there is a merger. This is especially important in industries like retail/clothing/food, where choice is just as important as the price.
Stress and Conflicts Among Employees
Invariably, the M&A process consolidates positions within companies that have been duplicated. There is always a possibility of layoffs, which could result in people being out of work for an indefinite time. Many people find themselves in higher levels of uncertainty due to the fact that none of this potential is definite until the M&A process is completed.
Job Loss
Mergers can result in job losses. This is especially true if the merger is aggressively done by an ‘asset-stripping company. A company that seeks to merge with underperforming segments of its target firm.
Prevents Economies-of-scale
It may prove difficult to create synergies when there are very few commonalities between companies. A larger company might not be able to motivate its employees or have the same level of control. The new company might not be able to achieve economies of scale.
High Cost
The acquirer will often pay a price that is significantly higher than the target’s fair value in a hostile takeover. The goal is to persuade shareholders of the target and get them to give up their shares.