The mysterious world of Mergers&Acquisitions

As a student of Financial Engineering and having followed the summer course “Finance in London”  at ESCP London, I am fascinated by the mysterious world of M&A.

When two companies decide to combine forces in a merger, the papers are shouting about it. Why are companies in industries ranging from telecommunications to financial services to retail looking to merge?  What is meant by the term M&A, Mergers and Acquisitions? And is a successful M&A more of a fairy tale than reality?

M&A is generic term that can be broken down and defined more technically.
We talk about merger if an agreement between equals is made to combine their operations. However consolidation would mean that a new firm is created after a merger, and both acquiring firm and target firm shareholders receive shares in this firm. The merger of Royal Haskoning and DHV is one of the many examples of the far reaching consolidation in the engineering sector.
Acquisition takes place when one company uses its capital resources (cash and/or shares) to purchase another in order to develop resources and competences. Think of the recent buy of by Ahold, this would be a typical example of acquisition. If one firm acquires the assets of another, through a formal vote by shareholders of the firm being acquired, one would speak of purchase of assets. And finally when a firm is acquired by its own management or by a group of investors, we speak of a buyout. After such transaction, the acquired firm can cease to exist as a publicly traded firm and becomes a private business.

The players
The buyers of companies can be put in two groups, strategic and financial. As the name already suggests strategic buyers are corporations who want to acquire another company for strategic business reasons. Financial buyers however are buyers who want to acquire another company purely as a financial investment. Financial buyers are typically Leveraged Buyout Funds or other private equity funds.

Already have an idea who will pay more for a company? Nine times out of ten, a strategic buyer will pay more than a financial buyer.  Strategic buyers take into consideration that they can grow company’s cash flows by expanding into complementary markets, reducing overlapping costs etc. As a result, the strategic buyer incorporates in his valuation of the company the post-acquisition cash flows, which he hopes will be higher than are currently expected to be, thus ending up valuing company higher. Such buyer will typically assume faster revenue growth and reduction of certain costs because the acquiring company will be able to derive the strategic efficiencies from the acquired company.  In contrast to this, financial buyer will not pay attention to the possible synergies while valuing the company.

Identification of the potential target
To determine whether a company can be a suitable acquisition target, the acquirer will consider the strategic aspects from 5 different motives. They include firm specific, industry specific, strategic, financial or personal motives.

  • Firm specific:
    • Achieving economies of scale (Removal of central functions such as HR, finance and IT)
    • Reducing transaction costs (Heidelberg and Hanson)
    • Attaining economies of scope (Citibank and traveler)
  • Industry specific:
    • Managing industry rivalry  (Heineken and Gruppo Petropolis)
    • Increasing bargain power (car makers)
    • Building barriers to enter (IBM and proprietary technology firms)
    • Capturing last opportunities (Morrison and Safeway)
  • Strategic capabilities:
    • Adding new resources (Geely and Volvo)
    • Increasing value of products (Virgin and NTL)
    • Entering new markets (DHV and Royal Haskoning)
    • Protecting product quality (Ryanair and Aer Lingus)
  • Financial advantages:
    • Exercising corporate finance (Vodafone and Mannesmann)
    • Diversifying risk (Bowater)
    • Increasing debt capacity (Carlyle and Virgin Media)

And finally the last motive, not to be forgotten,

  • Personal gains
    • Building empire (ITT under CEO Harold Geneen)
    • Obtaining better benefits

I invite you to look up yourself all the mentioned companies between the brackets to get an idea of what companies they are!
Next time I will talk about the reasons for M&A to fail.  The valuation of firms by discounted cash flows and multiples will be covered also in this blog theme, but that will be done in third and fourth part. Stay tuned!

To be continued!