Mergers and Acquisitions: What, Why, How & When!
Driven by the desire for power and competition, business entities often resort to mergers and acquisitions. That’s one reason, mergers have become a common practice in every other industry. On the brighter side, they result in generating jobs for M&A specialists. If you want to expand your knowledge base in correlation with this, stick on! We will discover the in-depth topics related to mergers and acquisitions and by the end of the article, you will have a clear conception of what mergers and acquisitions are and how they work. Dive in!
Are Mergers and Acquisitions the same thing?
Do you ever wonder if mergers and acquisitions are the same things? The answer is NO. In reality, they are two different things. Mergers, on one hand, are the coming together of two business entities or companies; acquisitions, on the other hand, refer to the takeover of a smaller business company. See, two different things, right?
But then, why are they always glued together- be it spoken or written form? Firstly, that’s because the purpose behind both mergers and acquisitions is usually the same. It could be to eliminate competition, increase growth revenue, market expansion, etc. Secondly, the roles and responsibilities of managing and handling both mergers and acquisitions are put in the hands of one person- an M&A specialist. That’s what echoes the essence of their inseparable bond.
What are Mergers?
When two companies (of usually small or similar size) find a middle ground to join hands to turn into a new entity, it is described as a merger. A notable thing that backs up this merger decision is that both entities believe that the synergy is in the best interests of both parties involved. These mergers can be between two organizations of one single industry or two organizations belonging to two different industries.
Let’s have a look at an example of a merger.
Have you heard about the popular merger between Vodafone and Idea that turned into VI mobile operations? Of course, you have. In the month of March 2017, Vodafone and Idea vowed to collaborate to form India’s most lucrative telecom brand. The merger of these fierce competitors came soon after the launch of Reliance Jio Infocomm Limited (Jio) by Mukesh Ambani in September 2016.
What are Acquisitions?
When one company takes over another company and establishes itself as the new owner, such a transactional purchase is termed an acquisition. An acquisition can be an amicable or a hostile takeover, as per the approval of the target company’s board of directors.
A well-known example of an acquisition can be traced back to the year 2000 when the U.K.-based Vodafone acquired German company Mannesmann. As a result, Vodafone turned into the largest mobile network operator in the world, paving the way for future telecom mergers and acquisitions. It was one of the chief acquisitions in history.
Substantially, an acquisition can be an absolute 100% acquisition, a minority acquisition, or a majority acquisition. The difference lies in the number of shares and assets bought by the leading company:
- Complete Acquisition: When the leading company buys all the shares and stocks of the target company.
- Minority Acquisition: When the leading company buys a few shares (say10-15%) of the target company.
- Majority Acquisition: When the leading company buys most of the shares and assets of the target company.
How are the Acquisitions Financed?
Markedly, there are three ways to make happen a deal. It can be in the form of cash, stock, or assumptions of debts. All three of them can be used individually or conjointly.
Why do we need Mergers and Acquisitions?
Growth and competition are the key pilots of mergers and acquisitions. However, if you think these are the only two reasons, then you are wrong. There is a lot more to the story behind mergers and acquisitions.
Following are the major reasons, why companies intermittently indulge in mergers and acquisitions:
Synergies are oft-times the common rationale for mergers and acquisitions. In synergies, the integrated worth of the company is far greater than the individualistic wealth of the companies involved. Combining business pursuits leads to enhanced performance, cost reductions, and high revenue generation. This way synergy ventures are a win-win for both the parties of the complementary businesses.
Extensive Growth and Expansion
In a world driven by a thirst for growth and power, every company aims for evolution. For that very purpose, many companies merge and associate with other crucial firms either to embrace new technologies or eradicate costs for buying raw materials.
In sharp contrast to organic growth, inorganic growth channeled through mergers and acquisitions is a faster way to generate more sales. Apparently, a firm can increase profit share by mingling with the firms having cutting-edge technologies. Additionally, it lowers the risk of developing those new technologies in their firm.
The run-of-the-mill reason for chasing mergers and acquisitions is eliminating competition. It is as obvious as saying, competition divides the market, and profit share dwindles. To combat the competitive market, companies often indulge in mergers and acquisitions.
When one firm acquires a competitor, the market share of that particular firm multiplies outrightly. In simpler terms, when one company takes over a competitor, its market share automatically increases. Why? Because now the target audience will not have two options to choose from but only one. As a result, they will fall directly into your sales gamut.
Another big reason for mergers and acquisitions is diversification. Businesses have a tendency to shoot up and crash in one fell swoop. It may be raining money one season, and money-drought another season. Under such circumstances, businesses alternatively look out for diversifying businesses to acquire wholesome year-round cash flows.
Put it differently, companies operating in cyclical industries are compelled to diversify their cash flow statements to certainly avoid losses during a downturn. By leveraging diversification in a non-cyclical industry, such businesses can reduce bankruptcy risks.
Practicing Strong Control Over Market Power
When a corporation buys out one of its suppliers, it can save money on the margins that the supplier used to add to its final costs. Take, for example, if there is a company that manufactures clothes, and they buy another company that supplies yarns. Then, the costs for yarn and additional charges can be adjusted in one company only, resulting in cost reductions. More so, it gives them an upper hand over the supply chain and lets them prevent external supply disruptions.
Having a strong authority over the market share, the parent company can thus influence the market price as well, which is again a huge plus. However, all of these are calculated risks that companies have to take to enhance profit-sharing.
In this section, we will walk you through the advantages of M&A. The benefits of M&A are as follows:
- M&A is a tried and proven technique for expansion in terms of market share, geographical footprint, and technology.
- M&A makes room for buying out competitors and assimilating newer talents, assets, and skills.
- Through M&A, two companies can save money on duplicating roles, systems, and licenses.
- Business mergers induced synergies can provide more value than the corporations working individually. In other words, when two companies form a synergy, the combined benefits far outweigh their individual potential.
Flipping on the other side of the coin, M&A does come up with certain disadvantages, which are enumerated below:
- M&A falls into a gray area with risks involved. Due diligence is a prerequisite to ensure that the acquiring firm has a complete understanding of the target company. That is why it is a common practice among business entities to outsource consultants to assess the risk of the transaction.
- M&A is a time-consuming task demanding a long haul. Being a lengthy process, M&A might take months to years to fix a deal. The larger point to be noted here is that it takes away key players from their day jobs, thus negatively impacting the productivity and outputs of the companies involved.
- As per Harvard, most studies show that the failure rate for M&A is as high as 70-90%. Why? Inadequate due diligence and high expectations for quick execution are some of the underlying reasons for a high failure rate.
- A significant challenge is posed in M&A between two corporations coming up from different backgrounds, work cultures, and visions. Evidently, such deals face immense problems at the integration stage if the strategy has not been considered beforehand.
Read more: Financial Modeling Courses in India
Types of Mergers and Acquisitions (7 types with examples)
There are different categories for mergers and acquisitions. Each type has its own requirements, uses, and conclusions that reap the best benefits for the involved organizations. Here, in this section, we will dig into the depths of each type of M&A along with examples to get a clear-cut idea of how things operate.
When two companies belonging to the same industry collaborate to form a merger, it is termed horizontal M&A. In other words, a conglomeration between two competitive companies that share the same market and product lines comes under the horizontal merger. Such mergers are beneficial as they eradicate competition to develop one authoritative company, instead of two competitors. Moreover, they give widespread reach on the market, rendering enormous revenue.
The formerly mentioned merger between Vodafone and Idea is an excellent example of a horizontal merger. Both Vodafone and Idea belong to the telecommunication network industry and they collaborated to form a merger called VI against the potent JIO networks.
Another example of such type of M&A could be when Zomato acquired UberEATS. As we know, both Zomato and UberEATS operate in the online-food delivery industry. In the year 2020, Zomato conquered the Indian team of UberEATS in a non-cash deal to standalone as a robust competitor to Swiggy (another online-delivery business).
To comprehend vertical M&A, we must have a little knowledge about the supply chain. Fundamentally, the supply chain is a term coined for the product journey from the supplier to the final consumer. Look at the image below to understand the chain of events from the supplier to the end customer.
Let’s get the chain of events with an example. In the fashion industry, there is a supplier of raw material, then there is a manufacturer who weaves cloth, followed by the distributor who distributes the clothes to the retailers, from where the consumers finally buy the product.
Based on the supply chain, there are two different types of mergers and acquisitions.
- Forward Integration
When the acquiring company (say the manufacturer) targets the retailer and acquires the same, it is called forward integration. Put differently, when the acquiring company moves a step toward the consumer in the supply chain, it is labeled as the forward integration.
- Backward Integration
Backward integration occurs when the acquiring company takes a step backward toward the supplier in the supply chain. In other terms, when the acquiring company (the manufacturer) targets the supplier of raw material, it is labeled as backward integration.
Vertical mergers of both types profit the manufacturer in manifold ways. It reduces the cost of transportation and saves the additional cost imposed by the supplier. At the same time, it enlarges the market share, thus putting the acquiring company in a better place to influence the market price.
Conglomerates are usually coined for the big group of companies with diversified interests. A conglomerate merger happens when two companies from totally different industries come together to form a corporation. The notable thing here is that there is essentially no link between the two involved companies. It could be a car manufacturing company merging with a telecom network company- with no particular common ground.
Some of the big groups that are examples of conglomerate M&A are:
- The Tata Group
- The Aditya Birla Group
- Reliance Industries Ltd.
Let’s get more clarity while bifurcating the multi-faceted group of reliance industries.
Reliance Industries Ltd is an Indian multinational conglomerate entity. RIL has miscellaneous business ventures in petrochemicals, energy, natural gas, telecommunications, retail, textiles, and mass media. If we scrutinize the ventures, we come to the point that there is no relation between petrochemical and retail business or telecom business. Right? That’s what a conglomerate is and the idea behind a conglomerate entity is usually to diversify and expand.
For companies working in the cyclical industries, it becomes difficult to survive in the off-season. It could even lead to a point of stagnation coercing the company to shut down. That’s one major reason that businesses diversify and promote ventures in non-cyclical industries for a steady income.
As the name suggests, concentric M&A has a central common point, which is the target audience. The business entities may be belonging to different industries, yet they have the same target audience. For instance, a car manufacturer and a car insurance company. Both have different functionality areas, nevertheless, they have a common audience base. A person who buys a car will also buy car insurance, so they have a middle ground to work out mergers and acquisitions.
Take, for example, in 2015, Heinz and Kraft merged to form a concentric merger bond. At the given point in time, Heinz was the global leader in sauce, pasta sauce, & frozen appetizers. On the other hand, Kraft was a leading manufacturer of mayonnaise, cottage cheese, salad dressing, etc. It is believably one of the largest concentric mergers in history.
Market Extension M&A
Market Extension M&A applies to the companies indulged in producing and selling similar types of products but having completely different markets. Or else, it can be said that Market M&A marks the bond between two companies with similar products and distinct markets.
This can be better understood with a hypothetical example. Let’s say there is a pizza company A selling normal pizza and another pizza company B that sells only healthy pizza. As it is clearly decipherable, products (pizza) are the same for both A & B companies, but the market is quite different. While company A has a market of junkie lovers, health-conscious people fill the market of company B.
Provided the given circumstances, when A and B merge to widen their market size and correspondingly extend their customer reach, it is remarkedly known as Market Extensions M&A. Since A and B have tied hands, they can maximize their scope and attract more customers (pizza lovers- be it scrumptious cheesy pizza lovers or the healthy pizza lovers.
Product Extension M&A
The next type of merger and acquisition is the product extension M&A, which typically applies to companies working in the same market. In the situation of a product M&A, the products are not identical but they are most likely consumed together. When two such companies with co-consumed products and the same market decide to come together, they get the benefit of producing a meta product from their individual products, which can be further used to delight a bigger market. More so, by pooling resources, they can lower their operating costs while increasing earnings.
A significant historical example of this type of merger was when Pepsi Co acquired Pizza Hut in 1977. Pepsi analyzed this thing that many people went to Pizza hut and by forwarding this merger deal, they could actually enhance their market reach. It was a huge success as Pizza Hut became a division of Pepsi Co, which meant anyone who bought a pie from Pizza Hut would also purchase a Pepsi.
As opposed to the conventional initial public offering (IPOs), reverse M&A or reverse takeovers is an excellent method for a private limited company to go public. It is a strategically appealing alternative for private companies to obtain a public company status. Besides, it is a time-effective method and less costly in sharp contrast to IPOs. If you want to know why companies want to go public, it’s simply because reverse merger increases the value of a company’s stock and liquidity.
In an IPO, private companies have to hire an investment banker to underwrite and issue statements of the soon-to-be-public entity. However, a reverse merger is a quite simpler, shorter, and more reasonable process. In a reverse merger, private firm investors purchase a majority of shares of a public shell company, which is then added to the acquiring entity. To complete the transaction, the private firm trades shares with the public shell in exchange for stock in the shell, thus, effectively turning the acquirer into a public corporation.
A perfect example of this reverse merger could be when Warren Buffett bought Berkshire Hathaway by buying stocks in the company and turning it into a huge success.
As obvious as it sounds, any company would evaluate the prospects before dipping its hands in mergers and acquisitions. Let us learn more about how these M&A are valued.
How Are Mergers and Acquisitions Valued?
When two companies A & B are involved in a merger, both will evaluate the deal differently. If company A is the selling company, it would value the maximum price for the deal. Vice-a-verse, company B (the buying company) will value a minimum price for the deal. On common grounds, company value can be measured using comparable company analysis, which operates on the following metrics:
- P/E ratio
P/E ratio, also called the price-to-earnings ratio, is a valuation ratio that compares a company’s current share price to its earnings per share (EPS). While evaluating P/E ratios, the acquiring company makes a reasonable offer, which is the multiple of the earnings of the target company.
- EV sales
EV sales, or Enterprise-to-value-sales, is a valuation method that measures and compares the enterprise value of the company to its annual sales. The EV/sales multiple provides investors with a quantitative tool for valuing a company based on its sales while considering both equity and debt. With an EV sales value, the acquiring company puts up an offer as a multiple of revenue.
- Discounted Cash flow
Another nifty metric for financial valuation is the discounted cash flow or DCF method. A DCF analysis takes into account the forecasted cash flows, which are then discounted back to find the current cash flow value. The weighted average cost of capital (WACC) is an important element used to tighten up the accuracy of the DCF cash flow results.
Examples of Successful Mergers and Acquisitions
The first on the cards for successful M&A is the mass media conglomerate Disney, which firstly acquired Pixar and then Marvel Entertainment. In 2006, Walt Disney Co. acquired Pixar, an animation company for $7.4billion. The collaboration resulted in the stellar success of movies like WALL-E, Toy Story 3, Finding Dory, etc- which proved to cultivate high returns on investments.
Within a short span of 3 years, in 2009, Disney Co. acquired Marvel Entertainment for $4billion. Since then, Marvel and Disney’s movies have had a string of supernova hits, bringing back more money than the initial investment. Clearly, a big WIN!
How can one forget the classy acquisition of Android by Google, when it comes to successful M&A? In 2005, Google made a deal to buy a moderately known mobile startup- Android. With Android, Google unleashed the powers of the mobile operating system (OS) required to compete with the popular mobile operating systems like Apple and Microsoft. That led to the expansion of Google beyond the laptop screens. See for yourself, today there is no second-guessing that Android Google is all over the place with a whopping market share of 85%.
Examples of Failure Mergers and Acquisitions
The biggest failure comes from Vodafone Group’s acquisitions of German telecom leader Mannesmann AG for $180.95 billion. The unsuccessful acquisition actually occurred in the year 2000, which could count for $280 billion worth of value today, only if it were adjusted for inflation. Although Vodafone Group had high hopes to get an upper hand in the telecom industry, the merger eventually turned into a failure, forcing Vodafone to pay back billions of dollars.
Another flop M&A occurred when the e-commerce giant eBay bought Skype for $2.6billion promulgating an initiative for video communication between buyers and sellers. The giant e-commerce player failed to consider the fact that nobody would want to video chat with a complete stranger. While they did try every other possible move to salvage the acquisitions, they ultimately sold off the company shares in 2009.
What are M&A models?
As obvious as it sounds, M&A models are computed for the companies involved in mergers and acquisitions. The M&A model represents the simulation of two companies coming together as a merger, or one company acquiring the other. The model thus puts forward the assessment and impact of the merger on both parties involved.
Every merger and acquisition deal calls for due diligence to steer a fair deal. Thus, a long valuation and modeling process goes into practice to predict an effective deal. That’s what echoes the essential nature of M&A models.
The key elements that form the basis of an M&A are model inputs, assumptions, valuation inputs, model analysis, and model outputs. Based on the accumulated comparable company data of the industry and other assumptions, M&A models are constructed.
Why do we make M&A models?
M&A models are created to solve the following purposes:
- To simulate M&A of business entities
- To show clients the impact of the M&A on the prospective earnings per share (EPS) of the companies and how the new EPS compares to the present EPS.
- To valuate the targeted company
- To estimate the amount, one must pay for an acquisition
- To evaluate and contrast different types of acquisitions, such as cash and stock.
- To forecast the overall impact of the acquisitions on the acquirer.
How to Create an M&A model?
Building an M&A model is an active 5-step process. Let us break down each step and move forward in a comprehensible step-by-step manner.
A lot of assumptions go into setting the ground for a lucrative merger deal. Whether the deal must be liquidated in cash, equity, or shares is one of the foremost concerns. In cases, where the buyer’s stock has low value, the entity may opt for cash rather than equity to compensate for the deal. On the flip side, the target company may demand equity as it holds more value than cash. Coming up with an agreement that is acceptable to both parties is one of the critical parts.
What are the key assumptive factors here?
- Purchase price of the target company
- Bunch of shares to be issued to target company
- Cash value to be paid to the target company
- Evaluation of resulting synergies (cost savings)
- Financial adjustments (related to accounts)
- Financial forecast for both parties- the buyer and the seller
To make projections, a financial analyst will make assumptions pertinent to revenue growth, fixed costs, variable costs, margins, capital expenditures, and other accounts as per the company’s financial statement. Basically, this process is nothing more than curating a three-statement model that encompasses- linking together the income statement, balance sheet, and cash flow statement.
After crunching the forecast numbers, it is time to execute the business valuation for both the business entities. Business valuation is done with the help of the DCF model, which is afterward compared to comparable company analyses and former transactions.
Business valuations are highly based on assumptions, for this simple reason, this process is explicitly subjective. As a result, companies could use a maven financial analyst with the benefit of experience to make a significant difference in rendering accurate numbers for the valuation.
The key steps of performing business valuations begin with comparable company analysis, followed by the DCF model, WACC, and terminal value of the business entity.
Combining the Business Conduit Financial Statements
The next step involves combining the financials of two businesses by adding up their balance sheets. To combine the finances, several accounting adjustments like the determination of goodwill value, the value of stock shares, cash equivalents, and other options is necessitated.
Goodwill ensues when a buyer buys a target for more than the Fair Market Value of Net Tangible Assets on the seller’s balance sheet. If the purchased entity’s book value is less than what the acquirer paid, an impairment charge will be incurred. As a result, the value of the acquired net assets will be written down to the amount paid in consideration.
What are the key assumptive factors here?
- Form of consideration- cash or share
- Goodwill computation
- Purchase Price Allocation (PPA)
- Changes in accounting practices
- Calculation of Synergies
Any type of merger or acquisition deal is centered around financial performance, which is calculated in the form of Earning per share (EPS). Accretion/Dilution analysis determines the same thing- the possible outcome of acquisition on buyer’s Pro Forma Earnings per Share (EPS). If the buyer company’s EPS increases, it is estimated to be accretive. On the other hand, if the EPS decreases, the deal is said to be dilutive.
What are the key assumptive factors here?
- Profits acquired from the target
- Synergy impact
Division of Processes Involved in M&A.
- Pre-merger Actions
The bedrock of an M&A deal is set with the contract between a client and an investment banker. In the client-investment banker meeting, fundamentals terms & conditions plus fee structure are fixated. Once done, the investment banker begins his pursuit of due diligence activities involving lawyers, auditors, and analysts and sets up a team to work. Considering all the financial, technical, tax-related, patent, copyright, and other intellectual activities, they muster relevant data. With all the assumptions, research, and historical data, they prepare financial models to estimate valuations and deal size.
- Deal Negotiation Actions
Once the stage is set, deal negotiation activities commence. Involved parties negotiate a deal and simultaneously decide the pay-out structure. One of the crucial parts of the deal is to come up with a common point of how the buyer and seller are going to pay or receive the money: it can be an all-cash deal, an all-equity deal, or a blended cash-equity deal.
After seeing eye to eye with the payment methods, both parties sign a contract. All there is left to be done is to apply for approval from regulatory bodies like SEBI, RBI, ROC, etc.
- Post-merger Actions
For a successful transaction to happen, it is essential to define and manage post-merger integration activities. Once the post-merger integration plan is in place, select the self-motivated and skilled employees and divide them as per functional activities like sales, human resources, manufacturing, services, legal, finance, IT, and facilities management. Set clear goals, and objectives, and communicate well about risks and chances. The success key here is to start early and stay focussed on the strategic integration plan.
Even after succeeding in all the activities related to a merger deal, there are still certain unpredictable circumstances that could lead to the failure of the merger. Let us have a look at some of such volatile influences:
- Political Instability: If there is a single government, there may be a lack of growth. Or worst-case scenario, a new government could bring up entirely different laws that goes against the favorable environment of your merger deal. Thus, shaking up the dynamics of the deal.
- Cross-border Deal: In the case of a cross-border deal between two countries, currency fluctuations can cause unforeseen damages to the acquisitional deal.
- Diverse-culture management: Different cultures have different working capacities and dynamics. For instance, in a deal between Japan and India, the work cultures are quite unmatched. In Japan, there are 15 hours of work, and 9 hours of other activities; in India, there are 11 hours of work and the remaining 13 for other tasks. Under dire circumstances, if Indians are compelled to work 15 hours, their productivity will wane.
In any of the above-mentioned predicaments, the merger deal can downturn incurring heavy losses to the buyer company.
Frequently Asked Questions
Q1. What is meant by merger and acquisition?
A merger is a transaction deal where two companies align their operations to work as a single operative business entity. An acquisition refers to the purchase deal when one company takes over another company. It can be done in an amicable or hostile manner.
Q2. Why do companies do M&A?
Companies indulge in M&A deals to stimulate growth opportunities, acquire competitive advantages, influence supply chains, or expand market share.
Q3. What are the 5 stages of a merger?
The 5 stages of a merger are as follows:
- Pre-merger acquisitions strategy evolution
- Organizing acquisition
- Deal negotiation and structuring
- Post-acquisition integration
- Post-acquisition audit.
Q4. What does an M&A analyst do?
M&A analysts do the majority of the preliminary due diligence for potential merger and acquisition deals. They do most of the research and muster data on growing revenue, competitors, and market share opportunities. Besides, they dig into the depths of company fundamentals and financial statements to analyze the deal from all angles.
Q5. Why do mergers and acquisitions fail?
The reasons behind the failure of M&A could be:
- a lack of focus on the desirable objectives
- inability to devise a concrete merger plan covering all aspects
- lack of vital integration processes
- lack of market and competitor research
- political instability
In this comprehensive article, we have covered the most crucial aspects of mergers and acquisitions. We hope you had all your doubts clear, if there is anything unclear, do comment in the comment section. We will surely answer your query.
With all this information, if you developed an inclination toward becoming an M&A analyst, then do check out our holistic Financial Modeling Course that covers different types of financial models and their operative measures with a complete focus on practical training. There is an option for a FREE demo if you want to try it before you buy it.