AIBC 2021 Research
An Introduction to Mergers & Acquisitions
By Jamie Ho
What is M&A?
Mergers and Acquisitions (M&A) refer to the joining of companies and assets.
A merger is the typically friendly joining of two or more similar sized companies, hence the term “merger of equals”. Post-merger, the company doing the takeover may continue to exist, while the absorbed company ceases to. Alternatively, if consolidation also occurs, then all the original companies involved would dissolve, joining to create one new operating entity.
An acquisition is the (sometimes) hostile purchasing of a smaller target firm by a larger acquirer. The acquired (or target) firm and its stock ceases to exist: the ownership, operational and management power is transferred to the acquiring company.
Why do Companies pursue M&A?
M&A can provide a whole host of benefits to the companies involved. The ultimate goal of M&A is to increase shareholder value. Common deal rationales include the capturing of operational and financial synergies, expedited expansion and diversification of a firm’s business, and curbing of competition.
1. To Capture Synergies
Synergies is the concept that ‘the whole is greater than the sum of its parts’. When two compatible companies combine their business activities, their joint performance and value increase. This is because the combined company is able to leverage each firm’s strengths to create operational and financial synergies.
a. Operational Synergies
Operational synergies are created through increased efficiencies in operating activities. There are two types of operational synergies–revenue synergies and cost synergies.
Revenue synergies come about when the combined company is able to generate greater total sales than the two companies were able to individually. Revenue synergies are traditionally derived from cross selling, increased access to new markets, and reduced competition. Despite increasing in significance as a deal rationale over the last few years, revenue synergies can be difficult to capture and often take longer than cost synergies to manifest.
Cost synergies arise when the combined company is able to reduce operating costs further than the two companies were able to individually, thanks to economies of scale and increased efficiencies.
Companies reap economies of scale when costs are spread over a larger production base, and through an increase in supply chain pricing power which they can use to bargain with suppliers and distributors. In the case of a vertical merger where the acquirer buys one of its suppliers or distributors, the combined company can also improve on its profit margins, which were previously eroded from the lack of bargaining power.
Increased efficiencies can be achieved by restructuring the combined company, eliminating redundancies (e.g. trimming duplicate operations) and increasing access to R&D. Total cost synergies targets tend to take 2 years to capture, and are generally easier and quicker to capture than revenue synergies. However, it can also be painful for employees. For example, reducing headcount is one of the most common tactics to achieve cost synergies post-merger. In fact, it is estimated that approximately 30% of all employees are deemed redundant after a merger or acquisition between companies in the same industry.
b. Financial Synergies
Financial synergies are created through increased efficiencies in financing activities. A much larger company can enjoy greater tax benefits, increased debt capacity leading to reduced cost of capital, as well as diversification–which leads to a lower risk perception and reduced cost of equity. As companies do not wish to be seen seeking benefits that carry negative connotations like tax reductions, financial synergies are often implicitly understood rather than explicitly stated.
2. To Expand and Diversify
Expansion and diversification in product range and geographical scope are important elements of a company’s strategy. They can help companies defend against competition, downturns, and business risk, boost brand image, gain access to new markets and talent, and contribute to their long-term revenue growth.
M&A deals can help companies expedite that process. By acquiring an existing business from a distinct industry or market, companies can springboard themselves into higher-growth, less-penetrated markets much more quickly than if they were to attempt it organically. For example, ride-hailing firm Uber announced in 2020 the takeover of AutoCab, a firm which sells Software-as-a-Service to the taxi and private hire vehicle industry. This will increase Uber’s market access from 40 towns to 170 towns across the UK.
3. To Increase Market Share and Eliminate Competition
The horizontal integration of companies is one of the quickest ways to secure market share and curb competition. Horizontal integration of companies refers to the acquisition or merger with competitors on the same part of the supply chain. By identifying and acquiring small but fast-growing competitors, market leaders can further increase their market share relative to current key competitors, while also eliminating future potential threats. Similarly, by merging with their smaller-sized competitors, firms with low market shares can also stop competing with each other and increase their combined market share to a more competitive level.
Uber’s $2.65 billion acquisition of Postmates is a good example of how horizontal integration can lead to an enlarged market share. Post-acquisition, Uber and Postmates would have a combined 37% of market share, becoming the 2nd largest food delivery service in the U.S., just behind Door Dash’s 45%. However, it is important to note that these strategies often draw antitrust regulatory attention, due to the risk of forming monopolies.
What are the Different Types of M&A?
Deal rationale and the type of M&A pursued are interconnected, and there are many different types of deals and buyers. For example, deals can generally be classified as either friendly or hostile, and as vertical integrations, horizontal integrations, conglomerate mergers or reverse takeovers. Buyers can also be split into either strategic or financial. These categories are not mutually exclusive.
Types of deals
1. Friendly takeover vs Hostile takeover
Friendly and hostile takeovers differ over the presence of shareholder, directorial board, and management approval. After a takeover proposal is filed by the acquirer, the target company’s board and management can either approve the proposal and advise shareholders to vote in favour of the takeover (friendly takeover), or they can reject the proposal and advise shareholders to vote against it (hostile takeover). This is because for decisions as significant as the sale of an entire company, majority shareholder approval is necessary for the transaction to go through. Board and management approval is not enough.
In the case of a friendly takeover, the acquiring and the acquired work together to see through the takeover process. The acquiring company will either offer a share conversion, cash, or a combination of the two. They can also offer a share price premium.
The acquiring company offers ‘x’ shares of the acquiring company for each share of the target company.
The acquiring company offers ‘$x’ per share of the target company.
Share price premium:
The acquiring company offers a % premium on the most recent closing share price of the target company.
In hostile takeovers, the acquiring company will employ a range of strategies to try and proceed with the purchase without the target company’s approval. Popular strategies include tender offers and proxy fights.
The hostile acquirer directly contacts the target company’s shareholders and bids for their shares at an attractive price premium, with the aim of obtaining a majority stake in the company themselves.
The hostile acquirer directly contacts the target company’s shareholders and persuades them to vote out their current board, replacing them with directors that are more receptive to the takeover and who would approve the transaction.
In the case of a hostile takeover, the target company may also mount a takeover defence and employ a range of defense strategies. Popular defense strategies include the poison pill, the crown-jewel defense, and the Pac-Man defense. As a result of these strategies, hostile takeovers are typically more complex and drawn-out.
The target firm allows existing shareholders (other than the hostile acquirer) the right to purchase additional shares at a discount. This dilutes the ownership interest of the hostile acquirer’s already-purchased shares, making it more expensive for them to acquire the needed majority and raising the cost of acquisition. As a result, acquisition attempts are disincentivised. For example, over-the-top content platform Netflix implemented a poison pill in its 2012 shareholder rights plan in response to investor Carl Icahn acquiring a threatening 10% stake. The poison pill stipulated that new acquisitions of and over 10%, as well as transfers of over 50% of assets will trigger the right for existing shareholders to purchase 2 shares for the price of 1.
Crown jewels refer to the most valuable or profitable unit or asset of a business. As a last-resort, the target firm sells its ‘crown jewels’ to reduce its attractiveness to the hostile acquirer.
The target company counters the hostile acquirer’s bid by buying back its own shares from them and even purchasing the shares of the acquiring company. This not only allows the target firm to regain financial control, it can also help scare off the hostile acquirer.
2. Vertical Integration
A vertical integration is the merger between two or more companies operating at different points along the same supply chain. This allows companies to control the supply chain more comprehensively. Vertical integrations can be effective at creating cost synergies–they reduce transportation costs and delays, capture upstream and downstream profits, and grant access to new distribution channels. There are two types of vertical integrations: backward integration and forward integration.
Backward integration occurs when the acquirer takes over a target company operating in an earlier stage of the supply chain. For example, when Apple Inc. purchased chip supplier Dialog for $600 million in 2018, allowing Apple to bring chip design in-house.
Forward integration occurs when the acquirer takes over a target company operating in a later stage of the supply chain. This allows the acquirer to offer their products in a more direct manner to the consumer. For example, when e-commerce company Amazon purchased supermarket chain Whole Foods in 2017 for $13.7 billion, Amazon moved further down the supply chain into brick and mortar outlets.
3. Horizontal Integration
A horizontal integration is the merger between two or more companies operating in the same industry, at the same level of the supply chain. Horizontal integrations are very useful for companies looking to increase market access, diversify their product offerings, grow market share, or reduce competition. Additionally, the economies of scale derived from the increased size and ability to share technology, marketing, distribution, and R&D costs create cost synergies. For example, luxury fashion company Moncler’s announcement to acquire streetwear brand Stone Island in December 2020 will help Moncler gain access to both Stone Island’s younger consumer base and digital branding expertise.
4. Conglomerate Merger
A conglomerate merger is a merger between companies operating in unrelated industries or markets. The resulting diversification in product and/or geography should theoretically reduce the combined company’s business risk. This is because if one subsidiary suffers a downturn, another subsidiary's stability or even expansion can help counterbalance it. As a result, conglomerates are believed to be better able to cope with seasonal patterns, business cycles, and market shocks.
Conglomerate mergers were very popular in the 1960s, and the conglomerate business model is still going strong in emerging markets. However, investors in the West have since become skeptical of conglomerates, even applying what has become known as a conglomerate discount. This is because the financial benefits of conglomerates have proven to be incredibly limited. The Walt Disney Company’s (world’s largest media conglomerate) $2.58 billion acquisition of streaming media company BAMtech in 2017 is a limited example of how diversification can reduce risk. While most of Disney’s theme parks were temporarily closed due to the Covid-19 pandemic, the purchase of BAMtech led to the launch of Disney+ (Disney’s over-the-top streaming service), which witnessed record high subscriptions amidst global lockdowns.
5. Reverse Takeover
A reverse takeover (RTO) occurs when a private company acquires a public company. It is done for the purposes of getting the private company to go public without having to take on the added risk, oversight, and expense of going through an Initial Public Offering (IPO). In a reverse takeover, the private company purchases a majority share in the publicly-traded company. The private and public company’s shareholders then exchange shares, resulting in the formation of one publicly-traded company. Reverse takeovers are common amongst foreign investors looking to gain quick entry into the US stock market. However, due to lower regulatory oversight, RTOs are risky and can easily hide fraudulent financial reporting. For example, in the series of scandals surrounding US-listed Chinese companies that came to light in 2011, many of the companies involved had been listed via reverse takeovers.
Types of Buyers
1. Strategic Buyers (Corporate Acquisition)
M&A is typically associated with strategic buyers–companies with business activities in industries and markets similar to their targets. Strategic buyers identify and pursue M&A opportunities with the purpose of integrating the companies, capturing their synergies, and generating long-term shareholder value. For example, apparel company Lululemon is a strategic buyer in its 2020 acquisition of Mirror. This is because Lululemon purchased virtual workout start-up Mirror for strategic purposes–to expand their content creating partnership and reach more customers.
2. Financial Buyers (Private Equity Buyout)
Financial buyers are private equity firms who pursue M&A for the sole purpose of making financial returns. Using their investor’s funds (dry powder), private equity firms provide the working capital to buy, restructure, and develop private companies. They do this with the aim of making a profit within the short investment time horizon of around 5-7 years, at which point they will resell the company at a higher price or carry out an IPO.
Due to their business model, financial buyers do not focus on synergies or integration capabilities like strategic buyers. Instead, they focus on evaluating the potential of the target company’s general industry, capacity for earnings growth, quality of back-office infrastructure, and general desirability as a long-term, actively managed investment. Due to the short investment time horizon, financial buyers are also much more sensitive to M&A timings, business cycles and its effect on price than strategic buyers.
Jamie is a first year International Relations undergraduate at the London School of Economics. Her articles cover mainly markets and M&A, with a particular interest in political risk.
Disclaimer: This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. You are advised to perform your own independent checks, research or study.