Mergers and Acquisitions (M&A)

What Are Mergers and Acquisitions (M&A)?

Mergers and acquisitions (M&A) is a general term that describes the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.

The term M&A also refers to the desks at financial institutions that deal in such activity.

Understanding Mergers and Acquisitions

The terms mergers and acquisitions are often used interchangeably, however, they have slightly different meanings.

When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition.

Then again, a merger describes two firms, of approximately the same size, that combine efforts to move forward as a single new entity, rather than remain separately owned and operated. This action is known as a merger of equals. Case in point: Both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created. The two companies' stocks were surrendered, and new company stock was issued in its place. In a brand refresh, the company underwent another name and ticker change as the Mercedes-Benz Group AG (MBG) in February 2022.

A purchase deal will also be called a merger when the two CEOs agree that alliance is to the greatest advantage of both of their companies.

Unfriendly or hostile takeover deals, in which target companies don't wish to be purchased, are always regarded as acquisitions. A deal can be classified as a merger or an acquisition based on whether the acquisition is friendly or hostile and the way things are announced. In other words, the difference lies in how the deal is communicated to the target company's board of directors, employees, and shareholders.

M&A deals generate sizable profits for the investment banking industry, yet not all mergers or acquisition deals close.

Types of Mergers and Acquisitions

Coming up next are some common transactions that fall under the M&A umbrella:

Mergers

In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. For example, in 1998, a merger deal occurred between the Digital Equipment Corporation and Compaq, whereby Compaq absorbed the Digital Equipment Corporation. Compaq later merged with Hewlett-Packard in 2002. Compaq's pre-merger ticker symbol was CPQ. This was combined with Hewlett-Packard's ticker symbol (HWP) to create the current ticker symbol (HPQ).

Acquisitions

In a simple acquisition, the gaining company obtains the majority stake in the acquired firm, which does not change its name or alter its organizational structure. An example of this type of transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, wherein the two companies preserved their names and organizational structures.

Consolidations

Consolidation creates a new company by joining core businesses and leaving the old corporate structures. Stockholders of the two companies must approve the consolidation, and subsequent to the approval, receive common equity shares in the new firm. For example, in 1998, Citicorp and Travelers Insurance Group announced a consolidation, which resulted in Citigroup.

Tender Offers

In a tender offer, one company offers to purchase the outstanding stock of the other firm at a specific price rather than the market price. The securing company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors. For example, in 2008, Johnson and Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. The company agreed to the tender offer and the deal was settled toward the end of December 2008.

Acquisition of Assets

In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must get approval from its shareholders. The purchase of assets is typical during bankruptcy proceedings, wherein other companies bid for various assets of the bankrupt company, which is liquidated upon the last transfer of assets to the getting firms.

Management Acquisitions

In a management acquisition, also known as a management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a financier or former corporate officers in an effort to help fund a transaction. Such M&A transactions are typically financed disproportionately with debt, and the majority of shareholders must approve it. For example, in 2013, Dell Corporation announced that it was acquired by its founder, Michael Dell.

How Mergers Are Structured

Mergers can be structured in a number of different ways, based on the relationship between the two companies involved in the deal:

• Horizontal merger: Two companies that are in direct competition and share the same product lines and markets.
• Vertical merger: A customer and company or a supplier and company. Think of an ice cream maker merging with a cone supplier.
• Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company.
• Market-extension merger: Two companies that sell the same products in different markets.
• Product-extension merger: Two companies selling different yet related products in the same market.
• Conglomeration: Two companies that have no common business areas.

Mergers may also be distinguished by following two financing methods, each with its own ramifications for investors.

Purchase Mergers

As the name suggests, this sort of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some sort of debt instrument. The sale is taxable, which attracts the gaining companies, who enjoy the tax benefits. Acquired assets can be written up to the real purchase price, and the difference between the book value
what's more, the purchase price of the assets can depreciate every year, reducing taxes payable by the obtaining company.

Consolidation Mergers

With this merger, a brand new company is formed, and the two companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

How Acquisitions Are Financed

A company can buy another company with cash, stock, assumption of debt, or a combination of some or the entirety of the three. In smaller deals, it is also common for one company to acquire another company's all's assets. Company X buys Company Y's all's assets for cash, and that means that Company Y will have just cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business.

Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time period. Reverse mergers happen when a private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets. The private company reverses merges into the public company, and together they become an entirely new public corporation with tradable shares.

How Mergers and Acquisitions Are Valued

The two companies involved on either side of a M&A deal will value the target company differently. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it at the lowest cost possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the accompanying metrics:

Price-to-Earnings Ratio (P/E Ratio)

With the use of a price-to-earnings ratio (P/E ratio), an obtaining company makes an offer that is a multiple of the earnings of the target company. Examining the P/E for every one of the stocks inside the same industry group will give the obtaining company great guidance for what the target's P/E multiple should be.

Enterprise-Value-to-Sales Ratio (EV/Sales)

With a enterprise-value-to-sales ratio (EV/sales), the obtaining company makes an offer as a multiple of the revenues while being aware of the price-to-sales (P/S ratio) of other companies in the industry.

Discounted Cash Flow (DCF)

A key valuation tool in M&A, a discounted cash flow (DFC) analysis determines a company's current value, as per 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 cost of capital (WACC). Admittedly, DCF is precarious to get right, however few tools can rival this valuation method.

Replacement Cost

In a few cases, acquisitions are based on the cost of replacing the target company. For the good of simplicity, suppose the value of a company is simply the sum of all its equipment and staffing costs. The procuring company can literally order the target to sell costing that much, or it will create a competitor for the same cost. Normally, it requires a long investment to assemble great management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make a lot of sense in a service industry wherein the key assets (people and ideas) are difficult to value and develop.

Highlights

• In an acquisition, one company purchases another outright.
• A merger is the combination of two firms, which subsequently form a new legal entity under the banner of one corporate name.
• A company can be objectively valued by studying comparable companies in an industry and using metrics.
• The terms "mergers" and "acquisitions" are often used interchangeably, yet they differ in meaning.

FAQ

How Does M&A Activity Affect Shareholders?

Generally speaking, in the days leading up to a merger or acquisition, shareholders of the gaining firm will see a temporary drop in share value. At the same time, shares in the target firm typically experience a rise in value. This is often due to the way that the obtaining firm should spend capital to acquire the target firm at a premium to the pre-takeover share prices. After a merger or acquisition formally takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends.Note that the shareholders of the two companies might experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-upon conversion rate. Shareholders of the procuring company experience a marginal loss of voting power, while shareholders of a smaller target company might see a significant erosion of their voting powers in the relatively larger pool of stakeholders.

For what reason Do Companies Keep Acquiring Other Companies Through M&A?

Two of the key drivers of capitalism are competition and growth. When a company faces competition, it must both cut costs and innovate at the same time. One solution is to acquire competitors so that they are at this point not a threat. Companies also complete M&A to develop by gaining new product lines, intellectual property, human capital, and customer bases. Companies may also search for synergies. By consolidating business activities, overall performance efficiency tends to increase, and across-the-board costs tend to drop as each company leverages off of the other company's strengths.

How Do Mergers Differ From Acquisitions?

In general, "acquisition" describes a transaction, wherein one firm absorbs another firm through a takeover. The term "merger" is used when the purchasing and target companies mutually combine to form a completely new entity. Because each combination is a unique case with its own peculiarities and reasons for undertaking the transaction, use of these terms tends to overlap.

What Is a Hostile Takeover?

Friendly acquisitions are most common and happen when the target firm agrees to be acquired; its board of directors and shareholders approve of the acquisition, and these combinations often work for the mutual benefit of the securing and target companies. Unfriendly acquisitions, commonly known as hostile takeovers, happen when the target company does not consent to the acquisition. Hostile acquisitions don't have the same agreement from the target firm, thus the getting firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition.

What Is the Difference Between a Vertical and Horizontal Merger or Acquisition?

Horizontal integration and vertical integration are competitive strategies that companies use to consolidate their position among competitors. Horizontal integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level of the value chain in an industry — for instance when Marriott International, Inc. acquired Starwood Hotels and Resorts Worldwide, Inc.Vertical integration refers to the process of securing business operations inside the same production vertical. A company that opts for vertical integration takes complete control over one or more stages in the production or distribution of a product. Apple, for example, acquired AuthenTec, which makes the touch ID fingerprint sensor technology that goes into its iPhones.