M&A

Mergers and Acquisitions (M&A) is a general term that refers to the consolidation of companies or assets through various types of financial transactions. M&A can include a number of different transactions, such as mergers, acquisitions, consolidations, tender offers, purchase of assets and management acquisitions. In all cases, two companies are involved.

Merger: In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. After the merger, the acquired company ceases to exist and becomes part of the acquiring company

Acquisition: In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or legal structure. – sometimes called takeovers 

Consolidation: A consolidation creates a new company. Stockholders of both companies must approve the consolidation, and, subsequent to the approval, they receive common equity shares in the new firm

Tender Offer: In a tender offer, one company offers to purchase the outstanding stock of the other firm at a specific price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors— most tender offers result in mergers.

The more common interpretive distinction between the tworests on whether the transaction is friendly (merger) or hostile (acquisition).

Regulatory oversight and litigation concerning M&A transactions.

Merger guidelines are a set of internal rules promulgated by the Antitrust Division of the United States Department of Justice (DOJ) in conjunction with the Federal Trade Commission (FTC). M&A deals are subject to DOJ approval.

For telecommunications companies, Mergers and acquisitions will also face scrutiny from the (FCC).

If the two biggest telecommunications companies in the U.S., AT&T and Verizon, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry.

The mission of the Antitrust Division of Department of Justiceis to promote economic competition through enforcing and providing guidance on antitrust laws and principles.

Antitrust Laws

The goal of the antitrust laws is to protect economic freedom and opportunity by promoting free and fair competition in the marketplace.

Federal antitrust laws apply to virtually all industries and to every level of business, including manufacturing, transportation, distribution, and marketing. They prohibit a variety of practices that restrain trade, such as price-fixing conspiracies, corporate mergers likely to reduce the competitive vigor of particular markets, and predatory acts designed to achieve or maintain monopoly power.

Serving as an Advocate for Competition

The Antitrust Division acts as an advocate for competition, seeking to promote competition in sectors of the economy that are or may be subject to government regulation.

A Current Dealnow under consideration by regulatory authorities:

FCC chair to recommend Sprint/T-Mobile approval

Update: FCC Chairman AjitPai tells Bloomberg: "In light of the significant commitments made by T-Mobile and Sprint as well as the facts in the record to date, I believe that this transaction is in the public interest and intend to recommend to my colleagues that the FCC approve it.”

T-Mobile/Sprint conditions might not satisfy DOJ

•        Throwing some cold water on Sprint (S +23.1%) and T-Mobile's (TMUS +4.9%) FCC-related positivity this morning, thatconditions that could get the companies an FCC OK may not win them Justice Dept. approval.

•        The companies appear likely to commit to 5G buildout with consumer price protection and to sell prepaid brand Boost Mobile to avoid dominance there.

•        While both the FCC and DOJ must sign off on the deal, the FCC has a slightly higher standard: While the DOJ is ensuring competition concerns, the FCC additionally can accept or reject a deal that otherwise would pass DOJ muster based on whether it's in the public interest.

Concessions expected to clear T-Mobile-Sprint deal

•        Following talks with the FCC, T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S) are planning to announce commitments to the U.S. government within days that include asset sales and rural-service guarantees to help secure regulatory approval for their $26.5B merger, Bloomberg reports.

•        Among them: The sale of one of their prepaid brands, a three-year buildout of their 5G network and a reiterated pledge not to raise prices while the network is being constructed.

The deal has stoked concerns of reduced competition in the wireless industry because the number of major players would fall from four to three.

Valuation Matters in M&A

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 it 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:

  • Comparative RatiosThe 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.
  • 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. It takes a long time to assemble good management, acquire property and purchase the right equipment. – people and ideas – are hard to value and develop. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost.
  • 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, butfew tools can rival this valuation method.

The Premium for Potential Success

The 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.

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.

Doing The Deal

1. The Opening Offer

When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company or building a position.

Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC

The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept or reject it.

letter of intent,or LOI, is used to set forth the terms of a proposed merger or acquisition. It provides a general overview of the proposed deal. The LOI may include the purchase price, whether it is a stock or cash deal and other elements of the proposed deal. There is a due diligence process that follows.

2. The Target's Response

Once the tender offer has been made, the target company can do one of several things:

  • Accept the Terms of the Offer: If the target firm's top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal.
  • Attempt to Negotiate: The tender offer price may not be high enough for the target company's shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target, particularly their jobs. If they're not satisfied with the terms laid out in the tender offer, the target's management may try to work out more agreeable terms.Highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation.
  • Execute a Takeover Defense or Find Another Acquirer: There are several strategies to fight off a potential.

3. Closing the Deal

Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company's shares with cash, stock or both.

A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company.

If stock instead of cash transaction, then it's not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions.

When a company is purchased with stock, new shares from the acquiring company's stock are issued directly to the target company's shareholdersWhen the deal is closed, investors usually receive a new stock in their portfolios – the acquiring company's expanded stock.

Merger and Acquisition Firms

Usually, step in to facilitate the process by taking on the responsibility for a fee. These firms guide their clients (companies) through these transformative, multifaceted corporate decisions.

Investment Banks

Investment banks perform a variety of specialized roles. They carry out transactions involving huge amounts of money, in areas such as underwriting. They also act as a financial advisor (and/or broker) for institutional clients, sometimes playing the role of an intermediary. They also facilitate corporate reorganizations, including mergers and acquisitions. They also prepare a list of prospective targets. Deal price expectations are analyzed.

Some of the major investment banks are Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), JPMorgan Chase (NYSE: JPM), Bank of America Merrill Lynch (NYSE: BAC), Barclays Capital, Citigroup (NYSE: C), and Credit Suisse Group (NYSE: CS).

Law Firms

Corporate law firms are popular among companies looking to expand externally through a merger or acquisition, especially companies with international borders.

Audit & Accounting Firms

Audit and accounting firms also handle merger and acquisition deals with obvious specialization in auditing, accounting, and taxation. These companies are experts in evaluating assets, conducting audits and advising on taxation aspects.

Consulting & Advisory Firms

The leading management consulting and advisory firms guide clients through all stages of a merger or acquisition process – cross-industry or cross-border deals. These firms have a team of experts who work towards the success of the deal right from the initial phase to the successful closure of the deal.

The firms work on the acquisition strategy followed by screening to due diligence and advising on price valuations, making sure that the clients are not overpaying.

M&A Effects – Capital Structure and Financial Position

M&A activity obviously has longer-term ramifications for the acquiring company or the dominant entity than it does for the target company in an acquisition or the firm that is subsumed in a merger.

Historical Perspective

Throughout the 21st century, particularly during the late 2000s, merger and acquisition activity has been constant in the financial services industry. The 30 largest companies in the industry have a market capitalization totaling over $27.5 trillion as of 2017, giving them much leverage to acquire regional banks and trusts.

The retail sector is highly cyclical in nature. General economic conditions maintain a high level of influence on how well retail companies perform.

In the retail sector, much of the merger and acquisition activity takes place during these downturns. Companies able to maintain good cash flow when the economy dips find themselves in a position to acquire competitors unable to stay afloat amid reduced revenues.

Since 2000, M&As have picked up in the utilities sector.

A number of weaker firms, but ones with significant assets, become ripe as takeover targets, especially in Europe as firms seek to align themselves in the most advantageous position. Renewable energy sources will be an increasing portion of the utilities business moving forward have been the impetus for several firms to acquire promising wind power companies.

The rapid economic growth in emerging market economies, especially the rapid expansion of utility infrastructure and tens of millions of brand-new customers, has kept many utility companies focused on acquisitions in China, India, and Brazil.

Two big deals:

AT&T/Bell South

In 2006, the largest telecommunication giant AT&T (NYSE: T) acquired BellSouth (BLS), another large telecommunications company, in a $67 billion deal. The acquisition resulted in giving AT&T a local customer base of 70 million across 22 states, further strengthening its dominance in the industry. The two companies were already joint owners of Cingular Wireless with 60% ownership with AT&T and 40% with BellSouth. Cingular Wireless was brought under the brand and consolidated ownership of AT&T after the acquisition of BellSouth.

Travelers Group/Citicorp

The 1998 merger of the banking giant Citicorp and Travelers Group estimated at $70 billion changed the landscape of the financial-services industry. The merger created Citigroup, Inc. (NYSE: C), one of the biggest companies in the financial services space. Citigroup had a market capitalization of approximately $135 billion at that time and offered services like banking, insurance and investment in over 100 countries. Citigroup operates in around 160 countries and has a market capitalization of approximately $159 billion as of February 2019.

And;
The Famous “Bad Deal”
The America Online and Time Warner Deal

The consolidation of AOL Time Warner is perhaps the most prominent merger failure ever. Warner Communications merged with Time, Inc. in 1990. In 2001, America Online acquired Time Warner in a mega-merger for $165 billion – the largest business combination up until that time. Respected executives at both companies sought to capitalize on the convergence of mass media and the internet.

Shortly after the mega-merger, however, the dot-com bubble burst, which caused a significant reduction in the value of the company's AOL division. In 2002, the company reported an astonishing loss of $99 billion, the largest annual net loss ever reported, attributable to the goodwill write-off of AOL. (Read more in "Impairment Charges: The Good, the Bad and the Ugly" and "Can You Count on Goodwill?")

M&A Arbitrage

What Is Merger Arbitrage?

Merger arbitrage, often considered a hedge fund strategy, involves simultaneously purchasing and selling the stocks of two merging companies to create "riskless" profits. A merger arbitrageur reviews the probability of a merger not closing on time or at all.

Because of uncertainty, the stock price of the target company typically sells at a price below the acquisition price. The arbitrageur purchases the stock before the acquisition, expecting to make a profit when the merger or acquisition completes.

Merger arbitrage, also known as risk arbitrage, is a subset of event-driven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. A regular portfolio manager often focuses on the profitability of the merged entity.

By contrast, merger arbitrageurs focus on the probability of the deal being approved and how long it will take to finalize the deal. Since there is a probability the deal may not be approved, merger arbitrage carries some risk. 

Merger arbitrage is a strategy that focuses on the merger event rather than the overall performance of the stock market.

If a merger arbitrageur expects a merger deal to break, the arbitrageur may short shares of the target company's stock. If a merger deal breaks, the target company's share price typically falls to its share price prior to the deal announcement. Mergers may break due to a multitude of reasons, such as regulations, financial instability, or unfavorable tax implications.

KEY TAKEAWAYS

  • Merger arbitrage is an investment strategy whereby an investor simultaneously purchases the stock of merging companies.
  • A merger arbitrage takes advantage of market inefficiencies surrounding mergers and acquisitions.

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