The Three Phases of Merger Activity
There are three phases in merger management. It is surprising how often the first and third are neglected while the second is given great amounts of managerial attention. The three stages are a) preparation, b) negotiation and transaction, and c) integration.
In the preparation stage, strategic planning predominates. Targets need to be searched for and selected with a clear purpose – shareholders wealth in the long run.
There must be a thorough analysis of the potential value to flow from the combination and the effort that is devoted to such plan of action is anticipated to lead to the successful integration of the target.
The negotiation and transaction stage comprises two crucial aspects to be taken into consideration. They are,
Financial Analysis and Target Evaluation
This evaluation needs to go beyond mere quantitative analysis and it is also likely to venture into other important fields such as human resources, competitive positioning etc.
Negotiating Strategy and Tactics
It is in the area of negotiating strategy and tactics that the specialist advisers are particularly useful.
The integration stage is where so many mergers come apart. It is in this stage that the management needs to consider the organizational and cultural similarities and differences between the firms. They also need to create a plan of action to obtain the best post merger integration. Too often the emphasis in managing mergers is firmly on the ‘hard’ world of identifiable and quantifiable data. Here economics, finance and accounting come to the fore.
There is a worrying tendency to see the merger process as a series of logical and mechanical steps, each with obvious rationale and a clear and describable set of costs and benefits. This approach all but ignores the potential for problems caused by non–quantifiable elements, for instance, human reactions and inter–relationships.
Matters such as potential conflict, discord, alienation, and disloyalty are given little attention. There is also a failure to make clear that the nature of decision making in this area relies as much on informed guesses, best estimates and hunches as on cold facts and figures.
Broad Classification of Merger Deals
Mergers and Takeovers may be Broadly Classified into Three Categories
Horizontal – A horizontal takeover or merger is one that takes place between companies which are essentially catering to the same market segment. Their products may or may not be identical. For example, merger of Tata Oil Mills Company Ltd [TOMCO] with Hindustan Lever Ltd [HLL] is a horizontal merger. Both the companies have similar products. A TV manufacturing company taking over a company manufacturing washing machines will also be a horizontal takeover because both the companies are in the consumer durables market.
Vertical – A vertical takeover or merger is one in which the company expands backwards by takeover of or merger with a company supplying raw materials or expands forward in the direction of the ultimate consumer. Thus, in a vertical merger, there is a merging of companies engaged at different stages of the production cycle within the same industry. For example, the merger of Reliance Petrochemicals Ltd [RPCL] with Reliance Industries Ltd [RIL] is an example of vertical merger with backward linkage as far as RIL is concerned. Similarly, if a cement manufacturing company acquires a company engaged in civil construction, it will be a case of vertical takeover with forward linkage.
Conglomerate – In a conglomerate takeover or merger, the concerned companies are in totally unrelated lines of business. For example, Mohta Steel Industries Ltd merged with Vardhaman Spinning Mills Ltd. Conglomerate mergers/takeovers are expected to bring about stability of revenues, cash flows and profits, since the two units belong to different industries. Adverse fluctuations in sales, cash flows and profits arising due to trade cycles may not hit all the industries at the same time.
Crude Definitions
[But it aids in swift communication of the underlying concept.]
| The Term/Phrase | Crude Way of Defining the Term/Phrase | Remarks |
| Synergy | 2 + 3 = 6 | Essentially described as the primary motivator of all M & A deals. |
| Anergy | 5 – 2 = 4 | The word ‘anergy’ [sometimes referred to as reverse synergy] does not even appear in an English dictionary despite the fact that it is a very popular jargon in commercial circuit all over the globe. Essentially described as the primary motivator of all sell-off deals. |
Introducing the World Of
CORPORATE RESTRUCTURING
(Various Facets & Dimensions)
Broadly, corporate restructuring deals may be categorized as under,
-
- Expansion Deals
- Sell Off Deals
- Deals in the nature of “Changes in Ownership & Controls”
Expansion Deals
Expansion deals may be further subdivided into
-
- Merger Deals (includes both Absorption Deals & Consolidation Deals)
- Deals in the nature of “Purchase of Units”
- Takeover / Acquisition Deals
Supporting write up is provided below for your ready reference.
| Merger | When two or more companies merge into one company or a new company altogether. |
| Absorption | Combination of two or more companies into an existing company. All companies except one lose their separate identities in such deals. |
| Consolidation | Combination of two or more companies into a new company. In this case, all companies are legally dissolved and a new entity is created. |
| Purchase of Units | An existing company purchasing one or more units of another existing company. |
| Takeover/Acquisitions | Generally involves the acquisition of a certain block of equity capital of a company, which enables the acquirer to exercise control over the affairs of the company. |
| Concept of Control | Theoretically control may not be exercised unless 50% of equity capital is acquired. In practice, however, effective control can be exercised with a much smaller holding [say, 20% to 30%] |
Sell Off Deals
Sell Off deals may be further subdivided into
-
- Divestiture Deals
- Spin Off Deals
- Split Up Deals
Supporting write up is provided below for your ready reference.
| Divestiture | Involves sale of a division or a unit to another company. The general rationale of divestiture are fund raising, reducing losses, strategic realignment and anergy. |
| Spin Off | A division or a business unit is spun off to form an independent company. After such spin off, the parent company and the spun off entity are separate corporate entities. This arrangement may facilitate sharper business focus and may also strengthen managerial efficiency. |
| Split Up | A company is simply broken into two or more independent companies. The parent company disappears as a corporate entity and in its place two or more separate companies emerge. It may be noted that the specific advantages of such arrangement is identical to that of a spin off arrangement. |
Deals in the nature of “Changes in Ownership & Controls”
Such deals may be further subdivided into
-
- Going Public
- Privatization
- Leveraged Buy Out
- Buy Back of Shares
Supporting write up is provided below for your ready reference.
| Going Public | Firms and small private limited companies may decide on going public after achieving considerable size and stature. However, they need to carefully weigh the advantages and disadvantages involved therein and hence a trade off should be considered before contemplating such decisions. The merits include access to public money, respectability, ability to attract talent and sometimes even foreign alliances; whereas demerits will include dilution of ownership stake, loss of flexibility due to comprehensive regulations, adherence to stricter disclosure norms and hence increased accountability to stakeholders, etc. |
| Privatization | A number of countries |
[including India]
have taken steps in the direction of privatization. Privatization essentially refers to transfer to ownership [partial or total] of public enterprises from government to individuals and non–government entities. The advantages of privatization includes, generation of resources and improving efficiency and productivity.
Leverages Buy–out Deals [LBO Deals]
[An Overview Only]
A leveraged buy out [LBO] is an acquisition of a company in which the acquisition is substantially financed through debt. Debt typically forms 70% to 90% of the purchase price. Actually, this portion of debt is obtained on the possible strength of the company’s future earning potential.
An example to explain the modus operandi
Company X desires to dispose off its unit C for a price of Rs.100 lakhs [say]. Three or four executives of Unit C are keen on acquiring it through an LBO operation and they are willing to invest Rs.8 lakhs [say]. On the basis of projections made by them, a finance company feels that the proposal is potentially viable and they are willing to invest to the tune of Rs.85 lakhs. The above executives also locate a private investor who is ready to invest another Rs.7 lakhs in the project. Once such an operation comes through, the Unit C of the Company X is acquired by an independent company run by the above executives, which is financed to the tune of 85% through debt, equity participation being 15% only.
Specific features of this form of corporate restructuring
The sponsors of a leveraged buy out operation are encouraged by the prospect of owning a company or division thereof with the aid of substantial debt financing. They assume considerable risks with the hope of reaping handsome rewards. The success of the entire operation depends on their ability to improve the performance of the unit, contain its business risk, exercise cost control measures, etc. If they fail to do so, the high fixed financial costs [due to bulk debt finance] may jeopardize the venture.
Buy Back of Shares [Stock Repurchases Deal]
[An Overview Only]
Under this arrangement, a company can buy back its own shares with the objective of self discipline utilizing the surplus cash available with them. Through buy backs, management demonstrates the commitment to enhance the value of the shareholders in the forthcoming future rather than to expand their empire.
Stock prices seem to fluctuate a great deal in response to changing market sentiments. If a company buys back its shares when the prices look depressed to the management [who are probably better equipped to assess its true worth], such repurchase action of the management tends to have a positive effect on the stock market.
WHY MERGE?
The deals of Mergers and Acquisitions take place in the global market due to a variety of reasons, like, gaining market power, achieving economies of scale and efficient coordination, entering new markets and locations, ensuring diversification of risks, replacing inefficient management by a more efficient one – to mention a few. These motivators promoting merger deals are essentially in the domain of various strategic considerations for M & A deals. However, financially, perhaps the most common rationale that promotes merger deals has something to do with “undervalued firms” as explained hereunder.
Undervalued Shares
Many people believe that stock market occasionally underestimates the true value of shares. It may well be that the potential target firm is being operated in the most efficient manner possible and productivity could not be raised even if the most able managerial team in the world takes it over. Such a firm might be valued low by the stock markets because the existing management is not very aware of the importance of a good stock market image. Perhaps they provide little information beyond the statutory minimum and in this way endanger suspicion and uncertainty. Investors (as a general rule) hate uncertainty and would tend to avoid such a firm. On the other hand, the acquiring firm might be very conscious of its stock market image and hence, puts considerable effort in cultivating good relationships with the investment community.
In many of these situations the acquiring firm has knowledge which goes beyond that which is available to the general public. The acquirer may be intimately acquainted with the product markets or the technology of the target firm and hence, they may be in a better position to assess the value of the target more accurately. A small example (as given below) would clarify this point of view, Moreover, the same example (as provided below) would also aid us in appreciating as to why majority of merger deals get financed by share swaps in preference to cash settlement despite the fact that cash as a consideration for merger otherwise enjoys some inherent advantages from the point of view of both parties involved in such a deal.
An Example
The financial numbers pertaining to two firms A & B are tabulated in the nest page. As the figures suggest – fundamentally, both firms had performed reasonably well although there are some significant differences between the two. Such difference is in the domain of perception of the investors so far these two companies are concerned. Such differential perception has been reflected in the price earnings ratio whose impact gets translated in the stock prices as well. This has happened because – since company A has concentrated a lot in building good stock market image, the investors perceive firm A as a dynamic firm where the management is trying in all cylinders to improve their performance whereas the firm B, traditionally, did not concentrate much on developing and nurturing such stock market image.
| Details | Firm A | Firm B |
| Profit After Tax (Rs Crores) | 1.00 | 1.00 |
| Number of Shares | 10. 00 | 10.00 |
| Earnings per share (in paisa) | 10 | 10 |
| Price Earning Ratio (PER) | 20 | 10 |
| Ruling Share Price (in Rs) | 2.00 | 1.00 |
With the aid of the above information, you are required to explain the impact of stock market image on merger decision making process and also clarify the advantages of financing merger through share swaps under such situations.
| We are aware that a substantial chunk of real life merger deals actually translate into failure stories. There are certainly a number of reasons for occurrence of such phenomenon, out of which a few may be identified as follows. |
Managerial Motives
One group which seems to do well out of merger activity is the management team of the acquiring firm. When all the dust settles after a merger they end up controlling a larger enterprise. Having responsibility for larger business means that managers have to be paid a lot more money. Not only higher monthly pay to induce them to give their best but also in terms of higher pension contribution and myriad perks. Being in charge of a larger business and receiving a higher salary also brings increased status. Some feel more successful and important and the people they rub shoulders with tend to be in a more influential class.
If these incentives to grow rapidly through mergers were not enough, some people simply enjoy putting together an empire – creating something grand and imposing gives them a sense of achievement and satisfaction. To have controls over larger numbers of individuals appeals to the basic instincts (some even measure their social position and their stature by counting the number of employees reporting to them).
Quoting Warren Buffet, “CEOs the world over possess an abundance of animal spirit and ego, which initiates merger and acquisition activities in a number of real world situations.”
Hubris
Another reason, namely hubris is also very important in explaining merger activity. It may help explain why mergers tend to occur in greatest numbers when the economy and companies have had a few years of good growth and management are feeling rather pleased with themselves.
Richard Roll in 1986 spelt out his hubris hypothesis for merger activity. Hubris means over-weaning self-confidence, or less kindly arrogance. Managers commit errors of over optimism in evaluating merger opportunities due to excessive pride or faith in their own abilities. The suggestion is that some acquirers do not learn from their mistakes and may be convinced that they can see an undervalued firm when others cannot. They may also think that they have talent, experience and entrepreneurial flair to shake up a business and generate improved performance.
Note that the hubris hypothesis does not require the conscious pursuit of self-interest by managers. They may have worthy intentions but can mistakes in judgment.
Third Party Motives
Advisors charge fees to the bidding company to advise on such matters as identifying targets, the rules of the takeover game, regulations, monopoly references, finances, bidding tactics, stock market announcements, so on and so forth. Other groups with a keen eye on merger market include accountants and lawyers. There is also the Press, ranging from tabloids to specialist publications. Even a cursory examination of these documents gives the distinct impression that they tend to have a statistical bias of articles, which emphasize the positive aspects of mergers. It is difficult to find negative articles, especially at the time of takeover. They like the excitement of the merger event and rarely follow up with considered assessment of the final outcome. Also the Press reports generally portray acquirers as dynamic, forward looking and entrepreneurial.
