Mergers and Acquisitions (M&A) Explained
Corporate merger and acquisitions should be value-maximizing ventures
Corporations normally grow by internal expansion. The divisions of corporations undertake capital budgeting projects to increase the value of the corporation. A second way that a corporation can grow is through external expansion, which can occur through mergers and acquisitions (M&A). A merger happens when a new firm is created by a combination of two existing firms, while an acquisition occurs when one firm buys another firm.
In theory, a merger or acquisition is much like any other capital budgeting project. In order for it to be advisable, it has to maximize shareholder wealth or, in other words, increase the price of the stock owned by the firm's shareholders. In reality, mergers and acquisitions can be undertaken for a number of reasons. They are accomplished by several methods, come in different forms, and have both advantages and disadvantages.
What are some legitimate reasons that a company might decide on a merger or acquisition? It begins with knowing what each is and how and why they occur.
A merger creates a new, previously nonexistent business entity when two companies join forces. The two companies are usually similar in size, and they act as equal partners in the newly formed venture. An example is the CBS/Viacom merger in 2019. The same individual, Sumner Redstone, owned both companies and he had originally broken them apart in 2006. However, in 2019, he merged them back together in order to try to compete with media giants like Disney.
Mergers happen by joint agreement between the board of directors of each of the two companies with a vote taken by the shareholders of the two individual companies. After the merger takes place, shares of the stock of the new company are distributed to the shareholders of both the old firms.
Mergers are voluntary and generally take place because the boards of directors' valuation of the new entity. The two merging companies are usually similar not only in size but also in their customer base and the scale and scope of their operations.
Types of Mergers
There are five types of mergers that you should be aware of.
This type of merger occurs when two firms that produce the same or similar products or services combine. Since they involve two firms in the same line of business, horizontal mergers can be targeted by the U.S. Department of Justice as being in violation of antitrust laws. They may be anticompetitive. For example, the Department of Justice initially challenged about the largest merger AT&T and Time Warner in 2017, stating, among other things, that this transaction could harm competition.
When two firms within the same supply chain merge, it is considered a vertical merger. Vertical mergers involve two companies that produce a product or service along the same supply chain. They usually create value for their shareholders, but like other mergers, they are subject to antitrust laws through the US Department of Justice. One of the most notable vertical mergers was when eBay acquired Paypal in 2002 in order to facilitate online payment transactions.
A conglomerate merger occurs when two firms that have no related business activity or economic considerations merge. However, if you look closely at a conglomerate merger, you will often find some area of the two businesses that will be enhanced by the merger. In other cases, conglomerate mergers may be undertaken purely for economic and market power. The eBay/Paypal merger, usually seen as a vertical merger, has occasionally been characterized as a conglomerate merger.
This type of merger is also called a product extension merger. Two companies combine that serve the same market but sell different, but complimenting, products. A good example of a congeneric merger is when PepsiCo merged with Pizza Hut in 1977. PepsiCo realized that customers who went to Pizza Hut ordered soft drinks and through the merger, they could reach a broader market with their product.
Market Extension Merger
When two companies merge that sell the same product or service in different markets, that is called a market extension merger. A frequently cited example of a market extension merger was when RBC Centura merged with Eagle Bancshares in 2002. RBC Centura, a subsidiary of Royal Bank of Canada, was seeking growth in the North American market and the financial firm saw Atlanta-based Eagle Bancshares as a way to externally grow its business.
The terms "merger" and "acquisition" are often used interchangeably. That, however, is incorrect. A merger is a business combination that is agreed on by both companies involved in the transaction. A new company emerges from a merger. An acquisition, though, is something different.
An acquisition is an actual takeover of one company, called the target company, by another company, called the acquiring company.
The target company usually ceases to exist after being purchased by the acquiring company, although occasionally the target company is allowed to keep operating under its previous name.
In an acquisition, the acquiring company is larger and far more solvent than the target company. It buys the target company and either folds it into its operations or sets it up as a separate division of the company. Sometimes, acquisitions are friendly and the target company wants to be bought and become part of the larger company. There are also acquisitions that are hostile in which case the target company's management doesn't believe it would be better off as part of the acquiring company.
Types of Acquisitions
There are two basic types of acquisitions:
If a business wants to buy, or acquire, another business, the decision has to be approved by the acquiring firm's board of directors. After approval, if the acquiring firm has reason to believe that the target firm will look upon its financial offer kindly, the CEO of the acquiring firm may simply contact the CEO of the target company and discuss the acquisition process.
If the two company managers can come to an agreement regarding price and other factors, then a recommendation is made to the stockholders of the target firm that the acquisition go forward. The stockholders are asked to tender or send in, their existing shares of stock in exchange for the agreed-upon price. This is a friendly tender offer. Most acquisitions are friendly in nature.
If the managers of a target business firm do not want the business to be bought and resist the acquisition, it is considered a hostile takeover. The acquiring firm must appeal directly to the target firm's shareholders, pointing out to them the benefits of the acquisition, if they tender their shares of stock. Firm management will try to talk the shareholders out of accepting the tender offer.
Hostile takeover bids are sometimes, but not always, successful. An example of one of the most successful hostile takeovers was pharmaceutical giant Sanofi-Aventis's $20 billion acquisition of Genzyme in 2011. After the Genzyme board of directors turned down the initial bid by Sanofi-Aventis, the latter had to considerably increase its bid to present to the stockholders and complete its acquisition.
Reasons for Mergers and Acquisitions
In a capitalist society, the goal of the business firm is the maximization of shareholder wealth, which simply means that the firm's management should take actions to increase its stock price. When undertaking a merger or acquisition, it is usually the case that the only legitimate reason for this type of external expansion is if the two business firms are worth more together than the sum of their value when apart. This is called synergy. There are four sources from which firms that have combined through merger and acquisition achieve synergy:
Synergy is the concept of 2 + 2 = 5. In other words, the sum of the whole is greater than the sum of the two parts.
- Operating economies: If two companies merge that are in the same general line of business and industry, operating economies can result. Duplication of functions such as accounting, purchasing, and marketing efforts within each firm can be eliminated to the benefit of the combined firm. It is sometimes particularly beneficial when two relatively small firms merge. The combined business entity would be better able to afford the necessary activities of a going concern, but operating economies can be achieved by larger M&A as well. Economies of scale often come into play to increase operational efficiency. The cost of doing business generally decreases, especially in manufacturing industries, when materials and other purchases are scaled up.
- Financial economies: Two smaller companies may receive better coverage by security analysts if they combine. Their transactions costs may also be lower. Improved financing is another motive for mergers and acquisitions. Larger businesses might have better access to sources of financing in the capital markets than smaller firms. The expansion that results from a merger might enable the recently enlarged business to access debt and equity financing that had previously been out of reach. A company might look for another company to acquire it if it's in financial trouble. The alternative could be going out of business or going into bankruptcy.
- Tax effects: The combination of two firms, if one is subject to a lower tax rate, might minimize taxes for the combined firm.
- Management efficiencies: If one firm in a merger or acquisition has weak management, the combined firm's assets may perform better after that management is replaced.
Other Reasons for Mergers
There are other reasons for merger and acquisition that may not be synergistic and they may not maximize the wealth of the shareholders.
Increased Market Power
The thirst for market power is not a legitimate reason for merger or acquisition. In fact, if a combined firm has too much market share, that firm will be deemed monopolistic and a deterrent to competition. This violates U.S. antitrust laws.
Firm managers often say that diversification is a good reason for merger or acquisition. There is considerable evidence that they are wrong. The combined firm's value may drop unless it merges or acquires with synergy in mind. Investors are capable of diversifying their own portfolios. They don't need firm managers to do it for them.
Advantages of Mergers and Acquisitions
In order to determine the advantages and disadvantages of M&A, we have to keep one thing in mind: It is only deemed beneficial if there is synergy involved. Here are some important advantages:
- Increased ability to capture synergies: A merger or acquisition should only happen if both firms can see the synergistic effects of combining the two firms.
- Intellectual property: The business combination might give both firms access to intellectual property that they don't already have.
- Personnel: There may be valuable talent for the acquiring firm that exists in the target company.
- Economies of scale: The combined firm may become more efficient at utilizing its assets due to the merger or acquisition.
- Economies of scope: The acquiring firm may be able to use similar production processes for the products manufactured by the target firm.
- Research and development: The combined firm may gain efficiencies through the synergy between the two firms that free up money for increased research and development.
Remember that diversification is not an advantage of mergers or acquisitions since investors can diversify their own portfolios.
Risks of Mergers and Acquisitions
While M&A offers a fair share of advantages for the parties involved, it can also come with its own set of risks, which includes:
- Corporate governance: There is the potential for clashes between the management of the acquiring and target companies unless terms are completely spelled out.
- Corporate cultures: There is always the chance that the cultures of the two firms may not be compatible. If this is the case, day-to-day operations would be difficult.
- Monopolistic behavior: If the merger or acquisition is too large, market efficiency and competitiveness may be reduced and charges of monopolistic behavior may ensue.
- Overestimating synergies: Many times, the acquirer overestimates the synergies between the two companies. Determining the synergies should be approached with caution and with full knowledge of the target firm.
- Paying too much: Over-valuation of the target firm occurs often. If the acquiring firm pays too much for the target firm, the maximization of shareholder wealth did not occur with regard to the business combination.