Download - Laurence Booth Sean Cleary. LEARNING OBJECTIVES Mergers and Acquisitions 15 15.1 Describe the different types of takeovers. 15.2 Explain securities legislation

Laurence Booth

Sean Cleary

LEARNING OBJECTIVES

Mergers and Acquisitions15

15.1 Describe the different types of takeovers.15.2 Explain securities legislation as it applies to takeovers.15.3 Differentiate between friendly and hostile acquisitions and describe

the process of a typical friendly acquisition.15.4 Explain the various motivations underlying mergers and

acquisitions.15.5 Identify the valuation issues involved in assessing mergers and

acquisitions.15.6 Identify the issues involved in accounting for mergers and

acquisitions.

15.1 TYPES OF TAKEOVERS• A takeover occurs when control is transferred from one

ownership group to another.• An acquisition occurs when one firm purchases another.• A merger combines two firms into a new legal entity and

shareholders in both firms must approve the transaction in order for the new firm to be created.

• An amalgamation, like a merger, requires shareholders in both firms to approve the transaction. Additionally, an amalgamation requires a fairness opinion by an independent expert on the true value of the firm’s shares when a public minority exists.

• A going private transaction or issuer bid occurs when the purchaser already owns a majority stake in the target company.

Booth • Cleary – 3rd Edition 3© John Wiley & Sons Canada, Ltd.

How the deal is financed:• Cash transactions– Shareholders of the target company receive cash in

exchange for their shares.• Share transactions– Shareholders of the target company receive shares, or a

combination of cash and shares, in the acquiring company in exchange for their shares

• Going private transactions (issuer bids)– An acquisition where the purchaser already owns a

majority stake in the target company


15.1 TYPES OF TAKEOVERS

15.2 SECURITIES LEGISLATIONGeneral Intent• Transparency and Information Disclosure

– To ensure complete and timely information is available to all parties, especially minority shareholders, throughout the process while at the same time not letting this requirement stall the process unduly

• Fair Treatment– To avoid oppression or coercion of minority shareholders– To permit competing bids during the process and not have the first

bidder have special rights. In this way, shareholders have the opportunity to get the greatest and fairest price for their shares

– To limit the ability of a minority to frustrate the will of a majority (minority squeeze-out provisions)


• Exempt Takeovers– Private firms are generally exempt from provincial securities legislation– Public firms that have few shareholders in one province may be subject

to takeover laws of another province where the majority of shareholders reside

• Exemption from Takeover Requirements for Control Blocks– Purchase of securities from five or fewer shareholders are permitted

without a tender offer requirement provided the premium over the market price is less than 15%

• The 5% Rule– Normal course tender offer is not required as long as no more than 5%

of the outstanding shares are purchased through the exchange over a one-year period of time

– This allows creeping takeovers where the company acquires the target over a long period of time


15.2 SECURITIES LEGISLATION

Critical Shareholder Percentages• Early Warning (10%)

– When a shareholder hits this point a report is sent to the OSC to alert other shareholders that a potential acquirer is accumulating a position in the firm

• Takeover Bid (20%)– No further open market purchases and must make a takeover

bid– Shareholders thus have an equal opportunity to tender shares

and receive equal treatment in receiving the same price through the bid

– The acquirer also must disclose intentions publicly before moving to full voting control of the firm



Critical Shareholder Percentages• Control (50.1%)

– Shareholder controls voting decisions under normal voting (simple majority) and can replace the board and control management

• Amalgamation (66.7%)– The acquirer can unilaterally approve amalgamation proposals

requiring a two-thirds majority vote (or a supermajority)• Minority Squeeze-Out (90%)

– Once the shareholder owns 90% or more of the outstanding stock, minority shareholders can be forced to tender their shares

– This provision prevents minority shareholders from frustrating the will of the majority



The Takeover Bid Process• Moving Beyond the 20% Threshold

– Takeover circular sent to all shareholders– Target has 15 days to circulate letter to shareholders with the

recommendation of the board of directors to accept or reject– Bid must be open for 35 days following the public announcement– Shareholders tender to the offer by signing authorizations– A competing bid automatically increases the takeover window by

10 days and shareholders can withdraw authorization and accept the competing offer during this time



The Takeover Bid Process• Prorated Settlement and Price

– Takeover bid does not have to be for 100% of the shares– Tender offer price cannot be for less than the average price that

the acquirer bought shares in the previous 90 days (prohibits coercive bids)

– If more shares are tendered than required under the tender, everyone who tendered shares will get a prorated number purchased



15.3 FRIENDLY VERSUS HOSTILE TAKEOVERS

Friendly Takeovers• A friendly acquisition occur when the target company is

willing to be acquired. Usually, the target will accommodate overtures and provide access to confidential information to facilitate the scoping and due diligence processes.


Friendly Takeovers• The target company normally uses an investment bank to prepare an

offering memorandum• A friendly overture for information necessary for the valuation process can

also be made by a company seeking to acquire• The target company may set up a data room and use confidentiality

agreements to permit access to interested parties practising due diligence• A signed letter of intent signals the willingness of the parties to move to

the next step, which usually includes a no-shop clause and a termination or break fee

• A legal team checks documents, while an accounting team may seek an advance tax ruling from the CRA

• Final sale may require negotiations over the structure of the deal, including tax planning and legal structures



Structuring a Friendly Takeover• In friendly takeovers, both parties have the opportunity to structure the

deal to their mutual satisfaction including:1. Taxation issues, where cash for share purchases trigger capital gains

so share exchanges may be a viable alternative2. Asset purchases, rather than share purchases, that may

• Give the target firm cash to retire debt and restructure financing• Give the acquiring firm a new asset base to maximize CCA

deductions• Permit escape from some contingent liabilities, usually excluding

claims resulting from environmental lawsuits and control orders that cannot be severed from the involved assets

3. Earn-outs, where there is an agreement for an initial purchase price with conditional later payments depending on the performance of the target after acquisition



• Hostile takeovers occur when the target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide any confidential information.

• The acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) and this preemptive investment indicates the strength of the acquirer’s resolve.



• The Typical Hostile Takeover Process:1. Slowly acquire a toehold (beach head) by open market

purchase of shares at market prices without attracting attention

2. File a statement with the securities commission at the 10% early warning stage while not trying to attract too much attention

3. Accumulate 20% of the outstanding shares through open market purchase over a longer period of time

4. Make a tender offer to bring ownership percentage to the desired level (either control, 50.1%, or amalgamation, 67%); the offer contains a provision requiring the acquisition of a certain minimum percentage



Hostile Takeovers Defensive Tactics• During a hostile takeover, the acquirer will try to monitor management

and board reactions and fight attempts by them to put into effect shareholder rights plans or to launch other defensive tactics.

• Shareholder rights plans are known as poison pills or deal killers, and can take different forms. They often give non-acquiring shareholders the right to buy 50% more shares at a discounted price in the event of a takeover.

• Selling the crown jewels refers to defensive tactics where the target company sells its assets in which the acquiring company is most interested in order to make it less attractive for takeover. This can involve a large cash dividend to remove excess cash from the balance sheet.

• White knights are other potential and friendly acquirers that the target company active seeks to make counter-offers and thereby rescue the target from a hostile takeover.



• Market clues to the potential outcome of a hostile takeover attempt:1. The market price jumps above the offer price, meaning that a

competing offer is likely or the bid price is too low2. The market price stays close to the offer price, which suggests

the offer is fair and the deal will likely go through3. There is little trading in the shares as a result of the offer,

which indicates that shareholders may be reluctant to sell and can be a bad sign for the acquirer

4. There is a high volume of trading in the shares as a result of the offer, which suggests that normal investors may be selling large numbers of shares to arbitrageurs (arbs) who are themselves building a position to negotiate for an even bigger premium by coordinating a response to the tender offer



15.4 MOTIVATIONS FOR MERGERS AND ACQUISITIONS

Classifications of Mergers and Acquisitions1. Horizontal

– A merger in which two firms in the same industry combine– Often an attempt to achieve economics of scale and scope

2. Vertical– A merger where one firm acquires a supplier or another firm that is

closer to its existing customers– Often an attempt to control supply or distribution channels

3. Conglomerate– A merger in which two firms in unrelated businesses combine– Often an attempt to diversify by combining uncorrelated assets and

income streams4. Cross-Border or International

– A merger or acquisition involving a Canadian and a foreign firm


• M&A activity generally occurs in “waves” in response to domestic economic cycles or globalization issues such as the formation of trading zones (e.g., NAFTA), deregulation and booms in sectors of the economy



• Creation of Synergy Motive for M&A– The primary motive for M&A is the creation of synergy.– Synergy value is created from economics of integrating a target and

acquiring company; the amount by which the value of the combined firm exceeds the sum value of the two individual firms.

– Additional value created = post-merger firm value less the sum of the pre-merger firm values of the acquiring and target firms (Equation 15-1)

• Operating Synergies– Economies of Scale, such as reducing capacity, spreading fixed costs, and

geographic synergies– Economies of Scope, where the combination of two activities reduces costs– Complementary strengths, where combining the different relative strengths

of the two firms creates a firm with both strengths that are complementary to one another


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• Efficiency Increases– New management team will be more efficient and add

more value than what the target now has– The combined firm can make use of unused production,

sales or marketing channel capacity• Financing Synergies– Reduced cash flow variability– Increase in debt capacity– Reduction in average issuing costs– Fewer information problems



• Tax Benefits– Make better use of tax deductions and credits– Merged firms can use these before they expire (e.g., loss carry-back or

carry-forward provisions)– Merged firms can use a deduction in a higher tax bracket to obtain a

large tax shield– Merged firms can use deductions to offset taxable income (non-

operating capital losses offsetting taxable capital gains that the target firm was unable to use)

– Merged firm will have operating income to make use of available CCA

• Strategic Realignments– Permits new strategies that were not feasible prior to the acquisition

because of the acquisition of new management skills, connections to markets or people, and new products or services



• Managerial Motivations for M&A– Increased firm size

• Managers are often more highly rewarded financially for building a bigger business with compensation tied to assets under administration, for example

• Many associate power and prestige with the size of the firm– Reduced firm risk through diversification

• Managers have an undiversified stake in the business (unlike shareholders who hold a diversified portfolio of investments and do not need the firm to be diversified) and so they tend to dislike risk (volatility of sales and profits)

• M&As can be used to diversify the company and reduce risk that might concern managers

– These motivations may not be in the best interest of shareholders, but do address common needs of managers



• Gains Resulting from Mergers: Empirical Evidence– Target shareholders gain the most through premiums paid to

them to acquire their shares• 15 to 20% for stock-financed acquisitions• 25 to 30% for cash-financed acquisitions (trigger capital

gains)• Gains may be greater for shareholders will wait for “arbs” to

negotiate higher offers or bidding wars to develop between multiple acquirers

– Between 1995 and 2001, 302 deals were completed• 61% lost value over the following year• The biggest losers were deals financed through shares which

lost an average 8%Booth • Cleary – 3rd Edition 24© John Wiley & Sons Canada, Ltd.


• Shareholder Value at Risk (SVAR) is the potential that M&A synergies will not be realized or that the premium paid will be greater than the synergies that are realized.

• When using cash, the acquirer bears all of the risk• When using shares swaps, the risk is borne by shareholders in

both the acquiring and target companies• SVAR supports the argument that firms making cash deals are

much more careful about the acquisition price



15.5 VALUATION ISSUES• Fair market value (FMV) is the highest obtainable price in an open and

unrestricted market between knowledgeable, informed and prudent parties acting at arm’s length with neither party being under any compulsion to transact.

• Key phrases in this definition:1. Open and unrestricted market – where supply and demand can freely

operate, as in Figure 15-22. Knowledgeable, informed and prudent parties3. Neither party under any compulsion to transact4. Arm’s length


Types of Purchasers• Determining fair market value depends on the perspective of

the acquirer. Some acquirers are more likely to be able to realize synergies than others and those with the greatest ability to generate synergies are the ones who can justify higher prices

• Market pricing will reflect these different buyers and their importance at different stages of the business cycle


15.5 VALUATION ISSUES

Types of Purchasers• Types of Acquirers and Impact on Valuation

1. Passive investors: use estimated cash flows currently present

2. Strategic investors: use estimated synergies and changes that are forecast to arise through integration of operations with their own

3. Financials: valued on the basis of reorganized and refinanced operations

4. Managers: value the firm based on their own job potential and ability to motivate staff and reorganize the firm’s operations; useful for MBOs and LBOs



• Reactive methods are models that react to general rules of thumb and price relative to other securities. – Examples: multiples or relative valuation, liquidation

values.• Proactive methods are valuation methods that determine

what a target firm’s value should be based on future values of cash flow and earnings. – Example: discounted cash flow (DCF) models.



Multiples Valuation1. Find individual firms that are comparable to the target

and/or use industry averages2. Adjust or normalize the financial statement data for

differences between the target and comparable firms to account for any material accounting policy differences or capital structure differences

3. Calculate a variety of ratios for both the target and comparable firms, including:– Trailing price-earnings – Value/EBITDA– Price-book value– Return on equity

4. Obtain a range of justifiable values based on the ratiosBooth • Cleary – 3rd Edition 30© John Wiley & Sons Canada, Ltd.


Liquidation Valuation1. Estimate the liquidation value of current assets2. Estimate the present value of tangible assets3. Subtract the value of the firm’s liabilities from the estimated

liquidation value of all of the firm’s assets to obtain the liquidation value of the firm

• This approach values the firm based on existing assets and is not forward looking.



Discounted Cash Flow (DCF) Analysis• The key to using the DCF approach to price a target firm is to

obtain good forecasts of free cash flow.• Free cash flows to equity holders represent cash flows left

over after all obligations, including interest payments, have been paid

• DCF valuation takes the following steps:1. Forecast free cash flows2. Obtain a relevant discount rate3. Discount the forecast cash flows and sum to estimate the value

of the target



Discounted Cash Flow (DCF) Analysis• Equation 15-3 is the generalized DCF model.

• Equation 15-4 is the DCF model for a firm where the free cash flows are expected to grow at a constant rate for the foreseeable future.



Discounted Cash Flow (DCF) Analysis• Since many firms are high growth firms, a multi-stage model

may be more appropriate• The multi-stage DCF model can be amended to include

numerous stages of growth in the forecast period



The Acquisition Decision• Once the value to the acquirer has been determined, the

acquisition will only make sense if the target firm can be acquired at a price that is less than that amount

• As the acquirer enters the buying/tender process, the outcome is not certain:– Competing bids may occur– Arbs may buy up outstanding stock and force price concessions

and lengthen the acquisition process– Forecast synergies may not be realized after the merger

• The acquirer can attempt to mitigate some of these risks through advance tax rulings from the CRA, entering a friendly takeover and through due diligence



The Effect of an Acquisition on Earnings per Share• Generally, an acquiring firm can increase its EPS if it

acquires a firm that has a P/E ratio lower than its own.



15.6 ACCOUNTING FOR ACQUISITIONS

• Historically, firms could use one of two approaches to account for business combinations: the purchase method, or the pooling-of-interests method (which is no longer allowed)

• While more popular in other countries, the pooling of interests method is no longer allowed by the CICA (Canada), FASB (USA) and IASB (International).



• The Purchase Method– The acquiring firm assumes all assets, liabilities and future

operating results of the target firm– All assets and liabilities are expressed at their fair market

value as of the acquisition date– If the fair market value exceeds the target firm’s equity, the

excess amount is goodwill and reported as an intangible asset

– Goodwill is no longer amortized, but must be tested annually for impairment in which case it will be written down


• Goodwill in Subsequent Years– Goodwill is subject to an impairment test each year– The impairment test requires an estimate of fair market

value, which is usually done using a discounted cash flow approach

– Goodwill is changed only if it is impaired in subsequent years, resulting in a write down and a charge against earnings in the year impairment is recognized



© John Wiley & Sons Canada, Ltd.

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Booth • Cleary – 3rd Edition 40

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Download - Laurence Booth Sean Cleary. LEARNING OBJECTIVES Mergers and Acquisitions 15 15.1 Describe the different types of takeovers. 15.2 Explain securities legislation

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