Merger and Acquisitions

Mergers and acquisitions (M&A) are defined as consolidation of companies. Differentiating the two terms, Mergers is the combination of two companies to form one, while Acquisitions is one company taken over by the other. M&A is one of the major aspects of corporate finance world. The reasoning behind M&A generally given is that two separate companies together create more value compared to being on an individual stand. With the objective of wealth maximization, companies keep evaluating different opportunities through the route of merger or acquisition.

Mergers & Acquisitions can take place:

• By purchasing assets
• By purchasing common shares
• By exchange of shares for assets
• By exchanging shares for shares

Types of Mergers and Acquisitions:

Merger or amalgamation may take two forms: merger through absorption or merger through consolidation. Mergers can also be classified into three types from an economic perspective depending on the business combinations, whether in the same industry or not, into horizontal ( two firms are in the same industry), vertical (at different production stages or value chain) and conglomerate (unrelated industries). From a legal perspective, there are different types of mergers like short form merger, statutory merger, subsidiary merger and merger of equals.

Reasons for Mergers and Acquisitions:

• Financial synergy for lower cost of capital
• Improving company's performance and accelerate growth
• Economies of scale
• Diversification for higher growth products or markets
• To increase market share and positioning giving broader market access
• Strategic realignment and technological change
• Tax considerations
• Under valued target
• Diversification of risk

Principle behind any M&A is 2+2=5

There is always synergy value created by the joining or merger of two companies. The synergy value can be seen either through the Revenues (higher revenues), Expenses (lowering of expenses) or the cost of capital (lowering of overall cost of capital).

Three important considerations should be taken into account:

• The company must be willing to take the risk and vigilantly make investments to benefit fully from the merger as the competitors and the industry take heed quickly

• To reduce and diversify risk, multiple bets must be made, in order to narrow down to the one that will prove fruitful

• The management of the acquiring firm must learn to be resilient, patient and be able to adopt to the change owing to ever-changing business dynamics in the industry

Stages involved in any M&A:

Phase 1: Pre-acquisition review: this would include self assessment of the acquiring company with regards to the need for M&A, ascertain the valuation (undervalued is the key) and chalk out the growth plan through the target.

Phase 2: Search and screen targets: This would include searching for the possible apt takeover candidates. This process is mainly to scan for a good strategic fit for the acquiring company.

Phase 3: Investigate and valuation of the target: Once the appropriate company is shortlisted through primary screening, detailed analysis of the target company has to be done. This is also referred to as due diligence. 

Phase 4: Acquire the target through negotiations: Once the target company is selected, the next step is to start negotiations to come to consensus for a negotiated merger or a bear hug. This brings both the companies to agree mutually to the deal for the long term working of the M&A. 

Phase 5: Post merger integration: If all the above steps fall in place, there is a formal announcement of the agreement of merger by both the participating companies. 

Reasons for the failure of M&A - Analyzed during the stages of M&A:

Poor strategic fit: Wide difference in objectives and strategies of the company

Poorly managed Integration: Integration is often poorly managed without planning and design. This leads to failure of implementation

Incomplete due diligence: Inadequate due diligence can lead to failure of M&A as it is the crux of the entire strategy

Overly optimistic: Too optimistic projections about the target company leads to bad decisions and failure of the M&A

Example: Breakdown in merger discussions between IBM and Sun Microsystems happened due to disagreement over price and other terms.  

Recent Mergers and Acquisitions
Mergers and Acquisitions Case Study:

Case Study 1: Sun Pharmaceuticals acquires Ranbaxy: 

The deal has been completed: The companies have got the approval of merger from different authorities.

This is a classic example of a share swap deal. As per the deal, Ranbaxy shareholders will get four shares of Sun Pharma for every five shares held by them, leading to 16.4% dilution in the equity capital of Sun Pharma (total equity value is USD3.2bn and the deal size is USD4bn (valuing Ranbaxy at 2.2 times last 12 months sales).

Reason for the acquisition: This is a good acquisition for Sun Pharma as it will help the company to fill in its therapeutic gaps in the US, get better access to emerging markets and also strengthen its presence in the domestic market. Sun Pharma will also become the number one generic company in the dermatology space. (currently in the third position in US) through this merger.

Objectives of the M&A:

• Sun Pharma enters into newer markets by filling in the gaps in the offerings of the company, through the acquired company

• Boosting of products offering of Sun Pharma creating more visibility and market share in the industry

• Turnaround of a distressed business from the perspective of Ranbaxy

This acquisition although will take time to consolidate, it should in due course start showing results through overall growth depicted in Sun Pharma's top-line and bottom-line reporting.

Case Study 2: Vodafone with hutch Essar

• Acquisition of a Controlling Interest in Hutch Essar

•Vodafone announces it has agreed to acquire companies that control a 67% interest in Hutch Essar from Hutchison Telecom International Limited ('HTIL') for a cash consideration of US$11.1 billion (£5.7 billion)

• Vodafone will assume net debt of approximately US$2.0 billion (£1.0 billion)

• The transaction implies an enterprise value of US$18.8 billion (£9.6 billion) for Hutch Essar

• The acquisition meets Vodafone's stated financial investment criteria Infrastructure sharing MOU with Bharti

• Whilst Hutch Essar and Bharti will continue to compete independently, Vodafone and Bharti have entered into a MOU relating to a comprehensive range of infrastructure sharing options in India between Hutch Essar and Bharti

• Infrastructure sharing is expected to reduce the total cost of delivering telecommunication services, especially in rural areas, enabling both parties to expand network coverage more quickly and to offer more affordable services to a broader base of the Indian population

• Local partners

• The Essar Group ('Essar') currently holds a 33% interest in Hutch Essar and Vodafone will make an offer to buy this stake at the equivalent price per share it has agreed with HTIL

• Vodafone's arrangements with the other existing minority partners will result in a shareholder structure post acquisition that meets the requirements of India's foreign ownership rules

• 10% economic interest in Bharti

• Vodafone has granted a Bharti group company an option, subject to completion of the Hutch Essar acquisition, to buy its

• 5.6% listed direct interest in Bharti for US$1.6 billion (£0.8 billion) which compares with the acquisition price of US$0.8 billion (£0.5 billion)

• If the option is not exercised, Vodafone would be able to sell this 5.6% interest

• Vodafone will retain its 4.4% indirect interest in Bharti, underpinning its ongoing relationship

• Commenting on the transaction, Arun Sarin, Chief Executive of Vodafone, said: 'We are delighted to be deepening our involvement in the Indian mobile market with the full range of Vodafone's products, services and brand. This announcement is clear evidence of how we are executing our strategy of developing our presence in emerging markets. We have concluded this transaction within our stated financial investment criteria and we are confident that this will prove to be an excellent investment for our shareholders. Hutch Essar is an impressive, well run company that will fit well into the Vodafone Group.'

The Principal Benefits to Vodafone of the Transaction Are:

• Accelerates Vodafone's move to a controlling position in a leading operator in the attractive and fast growing Indian mobile market

• India is the world's 2nd most populated country with over 1.1 billion inhabitants

• India is the fastest growing major mobile market in the world, with around 6.5 million monthly net adds in the last quarter

• India benefits from strong economic fundamentals with expected real GDP growth in high single digits

• Hutch Essar delivers a strong existing platform in India

• Nationwide presence with recent expansion to 22 out of 23 license areas ('circles')

• 23.3 million customers as at 31 December 2006, equivalent to a 16.4% nationwide market share

• Year-on-year revenue growth of 51% and an ebitda margin of 33% in the six months to 30 June 2006

• Experienced and highly respected management team

Key Strategic Objectives

• In the context of penetration that is expected to exceed 40% by FY2012, Vodafone is targeting a 20-25% market share within the same timeframe. The operational plan focuses on the following objectives:

• Expanding distribution and network coverage

• Lowering the total cost of network ownership

• Growing market share

• Driving a customer focused approach

• Site sharing

• The MOU outlines a process for achieving a more extensive level of site sharing and covers both new and existing sites.

Around one third of Hutch Essar's current sites are already shared with other Indian mobile operators and Vodafone is planning that around two thirds of total sites will be shared in the longer term.

• The MOU recognizes the potential for achieving further efficiencies by sharing infrastructure with other mobile operators in India.

• The MOU envisages the potential, subject to regulatory approval and commercial development, to extend the agreement to sharing of active infrastructure such as radio access network and access transmission.

VALUATION MATTERS

Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: Its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.

There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:

1. Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:

• Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
• Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.

2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.

3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

The Premium for Potential Success

For the most part, acquiring companies nearly always pay a substantial premium on the  stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.

Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy.

In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.

What to Look For

It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:

• A reasonable purchase price.  A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests.
• Cash transactions. Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside.
• Sensible appetite. An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers. Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.

Why Merger?

Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.

Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:

• Becoming bigger: Many companies use M&A to grow in size and leapfrog their rivals. While it can take years or decades to double the size of a company through organic growth, this can be achieved much more rapidly through mergers or acquisitions.
• Preempted competition: This is a very powerful motivation for mergers and acquisitions, and is the primary reason why M&A activity occurs in distinct cycles. The urge to snap up a company with an attractive portfolio of assets before a rival does so generally results in a feeding frenzy in hot markets. Some examples of frenetic M&A activity in specific sectors include dot-coms and telecoms in the late 1990s, commodity and energy producers in 2006-07, and biotechnology companies in 2012-14.
• Domination: Companies also engage in M&A to dominate their sector. However, since a combination of two behemoths would result in a potential monopoly, such a transaction would have to run the gauntlet of intense scrutiny from anti-competition watchdogs and regulatory authorities.
• Tax benefits: Companies also use M&A for tax purposes, although this may be an implicit rather than an explicit motive. For instance, since the U.S. has the highest corporate tax rate in the world, some of the best-known American companies have resorted to corporate 'inversions.' This technique involves a U.S. company buying a smaller foreign competitor and moving the merged entity's tax home overseas to a lower-tax jurisdiction, in order to substantially reduce its tax bill.
• Staff reductions: As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also probably include the former CEO, who typically leaves with a compensation package.
• Economies of scale: Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
• Acquiring new technology: To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.
• Improved market reach and industry visibility: Companies buy companies to reach new markets and grow revenues and earnings. A merger may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price.

Steps followed by companies 

1. Prepare to integrate

The integration phase of a deal really determines whether an acquisition is a success or not. With increased scrutiny from boards, shareholders and regulators, integration planning ahead of deal-signing has moved from being a best practice to a minimum requirement.

When planning for day one and the first 100 days post-closing, the key priority is ensuring operational stability in the business acquired. The majority of banks and insurers involved in buying a business from another organization point to the importance of transitional service agreements (TSA) as they can help the deal move towards closing.

• 95% of bankers say they start integration planning before signing.
• 78% of insurers had a synergy case in place before signing.
• 69% of asset managers say operational stability is a priority from day one

2. Target operating model design

When it comes to the target's operating model, many acquirers merge it into their own organization. However, there are those that use integration as an opportunity to broaden their vision and transform their business.

Although it may feel easier to leave systems in place, it makes sense to decommission and eradicate as much legacy technology as possible, as legacy IT systems often stand in the way of innovation and customer experience.

• 42% of banks created new best of-breed operating models instead of absorbing the target.
• 48% of insurers see between 25-50% of their target's IT systems remaining in place in their end-state operating model.
• 52% of wealth managers leave the target operating on a stand-alone basis.

As new business models and new entrants enabled by technology emerge, more financial services companies seek to make acquisitions to execute their ambitions for technology transformation.

3. Manage the integration

Our survey reveals that integration has had a positive effect on the client and customer experience. The ability to retain customers and deliver on their growth objectives is a primary focus for most acquirers. They now include a customer experience workstream in their integration programs.

However, banks and asset managers need to watch target employee retention closely. The management team of the target business must be fully involved and represented in the integration process.

• 29% of banks say at least a quarter of employees departed, including 5% who lost more than half the target's staff.
• 70% of insurers claim the client experience improved during the integration process.
• 67% of asset managers have integration teams numbering between 11-25 employees, with a further 30% having greater numbers.

The in-house resources dedicated to integration are quite substantial, and financial services firms also hire contractors to advise them on integration. Experience, leadership, dedication and communications are the characteristics required from a high-performing integration team, according to the majority of financial services respondents.

4. Realize value

Synergies are the essence of value creation, and financial services companies feel that financial synergies (capital, tax) created the most value. However, they were also the hardest to realize according to respondents in the asset management and insurance sectors. Although there may be opportunities to improve sales productivity or leverage combined distribution channels, revenue synergies are seen as tougher to deliver in the banking industry.

• 60% of banking and insurance respondents believe product and service innovation accelerated during their post-deal integration work.
• 63% of asset managers say that they make sure that every synergy is linked to a trigger point in the integration plan that can be tracked.

With product and service innovation often being accelerated during the integration process following a deal, integration offers a great opportunity for business transformation if that is made a priority during the process. Many acquisitions are all about acquiring new capabilities - to improve distribution, for example, so leveraging these capabilities for innovation and growth will be vital for many industry players.

5. Look ahead

The most successful acquirers learn from each transaction they manage to secure greater value from subsequent deals, and many respondents say they have a deal 'playbook' that sets out the methodologies to be followed during integration work. 

However, integration playbooks and similar models will need to be flexible as the trends having the biggest impact during the integration stage of transaction are changing. That will require dedicated integration teams to shift their approach in future transactions in a way that is appropriate to the prevailing themes.

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