Mergers and Acquisitions

This article focuses on mergers and acquisitions (M&A). Mergers and acquisitions are common and in some cases necessary for a business to survive in the current global economy. There are a number of factors involved in mergers and acquisitions and they often require the involvement of various advisors, such as investment bankers, lawyers, accountants, and deal managers. Mergers and acquisitions can have far-reaching affects on the business community, the companies involved, and the companies’ employees, investors, and consumers. This article provides an overview of various factors involved in mergers and acquisitions and includes a discussion of the pros and cons of M&A activity.

Keywords Acquisition; Advisors; Consolidation; Contingent Liabilities; Due Diligence; Junk Bonds; Leveraged Buyout; Merger; Private Equity; Sarbanes-Oxley; Yield Curve

Finance > Mergers & Acquisitions

Overview

Mergers and acquisitions are a common strategy for growing a business. A merger occurs when two companies combine to form one entity, while an acquisition results from one business taking over and absorbing another. An acquisition can either be friendly where both parties want the deal to happen or can result in what is commonly known as a hostile takeover. In this scenario, a company that is not interested in making a deal becomes the target of another entity or group of investors (Ojala, 2005). These transactions are driven by many factors. For example, M&A activity can be the result of a business looking to form a strategic alliance with another company or vendor in the same industry.

Leveraged Buyouts

One potentially lucrative and increasingly popular strategy for M&A activity has emerged from large pools of private equity money being used for leveraged buyouts, or LBOs. Essentially, an LBO is the buyout of a company with borrowed money, where the target company's assets act as collateral (Barron's, 2006). In industry parlance, the term "leverage" refers to debt, and the borrowed money increases the buyer's purchasing power. In a private equity transaction, companies such as the Blackstone Group and Kohlberg, Kravis, Roberts & Co. (KKR) use their own money in addition to debt to finance the merger or acquisition of other companies. In many cases, these private equity buyers restructure the target company and then sell their holdings when the value of the merged company increases to a level where the buyer can make a large profit. In short, private equity buyers with vast financial resources have a major influence on merger activity.

Industry Consolidation

Another factor influencing M&A activity is the general trend toward consolidation in certain industries, such as the frenzy surrounding technology companies during the boom of the 1990s. "Consolidations are slightly different from mergers in that the resulting company is a new entity" (Ojala, 2005, p. 27). In the early 2000s, the banking industry saw a good deal of M&A activity. This was partly the result of the interest rate environment; long-term interest rates were producing lower yields than short-term rates. Because of this, banks were making less profit on long-term loans such as mortgages. Therefore, in order to grow in this type of interest rate environment, a bank will look to acquire another entity's assets, such as deposits. These deposits, or assets, can then be used for other investments. The ongoing M&A activity in this industry resulted in a great deal of consolidation, and many smaller community and regional banks no longer exist. Of note, there were three mergers in 2006 that accounted for $50 billion in deal value: Capital One's acquisition of North Fork Bank; Wachovia's acquisition of Golden West, and the Regions Financial acquisition of AmSouth Bancorp (McCune, 2006).

In regard to the energy sector, a contributing factor to M&A activity is the fact that the cost of buying a company is far less than starting new lines of production. According to the independent research firm Wall Street Access Corporation, large oil companies such as Marathon Oil and Hess can potentially make large gains in takeovers and will likely see lots of M&A activity. "Whether it's private equity players driving the deals or companies that see the virtue of joining together, the activity is likely to be bustling in lots of sectors" (Weber, 2006, p. 73).

Mergers and acquisitions can have far-reaching effects on a business sector as well as on the investors and shareholders of companies in a particular sector. While a number of studies have shown how M&A deals can "destroy shareholder value … companies with a strong history of deals earn higher returns than those who do few or none at all" (Corbett, 2005, p. 58). There are a number of ways that mergers and acquisitions can create value for shareholders. One key factor in this regard is for a company to enhance its core business by entering into transactions with entities in the same sector rather than buying ownership interests in target companies merely to expand the buyer's scope.

Logistics of M&A Activity

Due Diligence

Mergers do not occur overnight and sometimes take years to be fully implemented. Preliminary work involves a great deal of legal and other activity, and much of the effort in the early stages focuses on due diligence. This means that the buyer and the seller, as well as their advisors, need to do their homework. The buyer needs to learn as much as possible about the target company in order to adequately determine the appropriate purchase price. The buyer also needs to be familiar with the condition of the target company as well as any potentially bad financial situations, managerial problems, pending lawsuits, sales forecasts, and contingent liabilities (Parr, 2006). These are liabilities that will be incurred only when assets are sold, and these include costs for assets or income tax on capital gains realized through the sale of assets. In short, contingent liabilities are potential liabilities that are not listed on a company's balance sheet but recorded only as footnotes because they may never become due or payable (Barron's, 2006).

While the buyer needs to rely on the information being provided by the seller and any other information that might be otherwise available, sellers also need to perform due diligence before they provide information to prospective buyers and "the seller should control the information flow" (Parr, 2006, p. 232). In order to do so, the seller needs to know as much as possible about the target company so that there are no surprises during the negotiation and to ensure that material information is not concealed from the buyer. If a buyer uncovers onerous information about a target that was not provided by the seller, a potential merger transaction can quickly unravel (Parr, 2006).

Confidentiality

A deal can also unravel if confidential information finds its way to the public. In the course of performing due diligence, a great deal of information is exchanged and it is often the case that this information is confidential and may not be available to the public. Moreover, the parties involved in an M&A transaction need to be mindful that M&A activity can trigger the buying and selling of stock on the various exchanges. In such cases, the buyer and seller need to agree that the terms of a pending M&A transaction will remain confidential and that the parties involved will not share information disclosed in the course of due diligence to the public or with other parties not directly involved in the transaction. Finally, successful deal-making also requires the merging companies to share the same core values and this is as important as their desire for a strategic alliance. While the merger might make sense in terms of products, technologies, and numbers, companies that do not share the same values ultimately will be not be able to survive a merger. Finally, a successful merger is one that is priced correctly. This requires that a buyer avoid the "negotiating frenzy" that sometimes arises in a competitive merger market and this ultimately rests on a buyer having performed sufficient due diligence (Welch, 2006).

According to Alistair Corbett, a partner of Bain and Company, an example of a dealmaker that has been successful in creating shareholder value is Power Financial. The company has frequently made M&A deals but has selected companies that are close to its core business, performed extensive due diligence, and, through its experience, has been able to integrate quickly. In the end, a company looking to grow its business has a greater chance for success by pursuing deals that expand a company's base "by adding new customers, products, markets or channels" (Corbett, 2005, p.58).

Applications

Advisement for M&A Activity

While there are many factors that shape M&A activity, these transactions often require merging companies to rely on various advisors such as deal managers, investment banks, lawyers, and accountants. Such advisors have a network of contacts that can make the M&A process more efficient. Further, advisors have knowledge of various dynamics affecting a particular merger market, and they are familiar with techniques that contribute to structuring the finance and determining the correct price of a transaction (Holliday, 2006).

While companies like the Blackstone Group and KKR act as private equity buyers in some merger transactions, these outfits also act as deal managers on other M&A transactions. In this capacity, their role is to lend their expertise to pricing and structuring a proposed transaction as well as to act as an intermediary in the negotiating process. Today, the role of deal managers continues to evolve in response to technological advancements, globalization, and the growing complexity of corporate transactions. Companies that rely on investment banks as advisors in a merger transaction often have a greater chance for a successful outcome. This was the case for the Winetasting Network, a company located in Napa, California, that sells wine to consumers through catalogs, membership clubs, and the Internet. In July 2004, the company was looking to grow its business by finding a strategic investor. Instead, the company received a number of attractive offers to sell the business entirely. According to Laura Rich, the company was successful, in part, because they adhered to a number of requirements mandated by the merger market:

• Purchases must have strict controls in place;
• Target companies must have clear accounting procedures; and
• A minimum of three years of financials must be available for review (Rich, 2005).

Moreover, relying on an investment bank, particularly one that was already an investor in the company, enabled the Winetasting Network to find a buyer. By the fall of 2004, the company was sold to 1800Flowers.com for about $9 million. The deal provided the company's founder with an opportunity to continue running the company without a lot of managerial oversight by the new parent. More important, the Winetasting Network earned the potential to distribute its products to a prospective customer base of more than fifteen million people (Rich, 2005).

While the expertise of advisors such as investment bankers and deal managers often provides merging companies with an effective intermediary for negotiating, deals also require buyers and sellers to be aware of various legal and regulatory issues. Selling a company can be a difficult process and has become even more so partially as a result of stricter corporate governance standards of the Sarbanes-Oxley Act of 2002. This act became law after a number of corporate accounting scandals in the 1990s, most notably the Enron, Adelphia, and WorldCom scandals. Sarbanes-Oxley provides for greater accountability concerning the accuracy of accounting books, records, and financial statements of publicly traded companies. Although this law does not apply to privately held entities, it has affected the broader merger market and this can be seen by the strict price controls and accounting requirements. In short, government regulations necessitate the advice of lawyers and accountants (Rich, 2005).

According to Karen Kahler Holliday, even though the M&A market is focused on numbers, it is essentially a highly personalized business endeavour and there are some key qualities for buyers and sellers to look for in advisors. The most important of these qualities is trust, since an advisor needs to earn the parties' confidence. In so doing, advisors need to be objective, need to know the parties involved in a transaction, and need to focus on executing a deal according to a stated game plan (Holliday, 2006).

Integration

One important question that advisors can help to resolve is how to integrate the two entities. "It is critical to move quickly and ensure that the majority of employees stay focused on running the business" (Corbett, 2006, p. 232). However, bringing two companies together often results in people losing their jobs or remaining employees being asked to take on additional responsibilities. At times, the merging entities might have very different corporate cultures and this does not lend itself to a smooth transition.

According to Jack Welch, the former chair and chief executive of General Electric, a successful merger requires boldness when it comes to integrating the merging companies. In this regard, Welch echoes the ideas of Corbett that the process should be completed quickly. More important, integration requires business leaders to choose the best team even if that means letting people go. One potential stumbling block in the integration process is the response of surviving employees. At times, companies must be able to deal with a behavior pattern that some have termed "tribalism."

Effects of M&A Activity on Employees

After two companies merge, it is common for employees who have been with one company for a long time to mistrust new employees who, in turn, may be impatient or unfamiliar with old ways of doing business. But tribalism is common because people have a natural tendency to join others and these groups can develop an "us against them" mentality. This mindset arises because mergers and acquisitions make people insecure about the future and forming tribes can provide a sense of security. In the long run, however, this is detrimental not only to the success of a merged enterprise but also to the success of individual employees. These incidents are not only common but probably inevitable and handling them effectively requires leaders to help employees to develop a new perspective that will ensure their success and the viability of the new organization (Mc-Gee Cooper, 2005).

While M&A activity can result in job losses and "tribalism" by the surviving employees, employees can also be provided with opportunities to grow. For Welch, there are a number of important considerations employees need to make if they decide to stay with a merged entity. First, they need to like the company, the product, and the people. If that is the case, employees are responsible for creating a balance in their life and must be able to manage the increased demands of work arising from a merger while maintaining a family life (Welch, 2006).

The Clayton Act

An overriding issue in any large merger or acquisition is to ensure that a proposed transaction will adhere to US antitrust laws, in particular, the Clayton Act. This law regulates mergers, and some of the prohibited practices under the act include price discrimination, exclusive dealings, and "predatory pricing, a practice by which a firm temporarily reduces its prices below cost to eliminate weaker rivals" (Peake, 1999, p. 5). Antitrust laws are essentially aimed at preventing merging companies from monopolizing industry, protecting consumers from being overcharged for goods and services, ensuring that economic power is dispersed, and encouraging competition in the marketplace. A transaction that leads to less competition or that is anti-competitive could be deemed to be in violation of the Clayton Act (Peake, 1999).

Viewpoints

Successes & Failures

Even though M&A activity is common, this does not mean that mergers and acquisitions are always successful. Further, the effect that M&A activity can have on a business sector and the labor market can sometimes be detrimental. For example, consolidation in the banking industry has resulted in job losses, as positions that had become redundant in the merged entities were eliminated. In addition, in order to reduce business costs and to effectively compete in the global economy, many merged banking entities have outsourced a variety of back office positions to offshore companies.

M&A activity can also affect the financial well-being of an organization as well as its creditors and investors because merging entities frequently rely on debt to finance these transactions. In industry parlance, the type of debt used has often been junk bonds. A junk bond is one that has a low rating by one or more of the bond rating agencies. Junk bonds are also issued by companies without long credit histories as well as by businesses that have weak credit histories. The benefit of junk bonds is that they offer bondholders high yields because the interest being charged to the borrower is higher than other types of credit. At the same time, increased reliance on junk bonds to finance M&A activity can result in companies not being able to meet their payment obligations and some may even default on their debt. This is not a good scenario for creditors and investors (Rosenbush, 2006).

While mergers and acquisitions are a very lucrative sector of finance, there are times when deals falter. For example, in January of 2000, the Internet service provider America Online merged with the entertainment conglomerate Time Warner Corp. At the time, the deal made sense as the companies were looking to capitalize on the technological advances of the Internet and the telecommunications sector. However, the entities were not successful in expediently integrating, in part because they each had very different corporate cultures. In time, the value of AOL Time Warner's stock fell dramatically triggering the selloff of a number of the company's divisions and the ouster of key executives.

On the other hand, mergers can result in the formation of new entities that thrive. One example of a successful merger was a deal in the 1980s that was the largest corporate transaction of its time. In 1985, the tobacco company Reynolds Industries was looking to diversify so it acquired Nabisco Brands to form RJR Nabisco (RJR). Three years later, RJR entered into a merger agreement with the aforementioned deal maker KKR. The deal was structured as an LBO. Eventually, KKR sold off all of its holdings in RJR and this proved to be quite lucrative for KKR.

While there are downsides to M&A activity and there are inherent risks involved, mergers and acquisitions can provide benefits and opportunities to businesses seeking to maintain a competitive edge. In the end, mergers and acquisitions will continue to be a strategy employed by businesses to ensure their growth and, quite possibly, their survival in the global market place. Many sectors of business have become increasingly competitive and this will often lead to strategic alliances not only between companies that are based in the United States but in overseas markets as well. The implications of these trends are far reaching and the effects will be seen in how businesses evolve, how readily adaptable employees are to changing work situations and priorities, how consumers respond to the manner in which goods and services are provided by new entities, and the extent to which mergers and acquisitions continue to create value for investors.

Terms & Concepts

Acquisition: The takeover of one business entity by another.

Advisors: Investment banks, deals managers, lawyers, and accountants that play various roles in advising and negotiating M&A.

Contingent Liabilities: Liabilities that will be incurred only when assets are sold and these include costs for assets or income tax on capital gains realized through the sale of assets. Contingent liabilities are not listed on a company's balance sheet but are recorded only as footnotes because they may never become due and payable.

Consolidation: The concentration of a business sector into fewer enterprises resulting from M&A.

Due Diligence: The analysis of various information about a target company by buyers and sellers.

Junk Bonds: Debt used to finance M&A that has a low rating but offers a high yield.

Leveraged Buyout: A takeover of a company or a controlling interest in a company where a significant amount of borrowed money is relied on to finance the transaction and the target company's assets serve as collateral for the borrowed money.

Merger: The combination of two companies to form one entity.

Private Equity: An investment in an asset in which the equity is not freely tradable on a public stock market; this includes leveraged buyouts.

Sarbanes-Oxley Act: Federal law enacted in 2002 that enhances financial reporting requirements of publicly traded companies and makes executives accountable for their accuracy.

Yield Curve: A graph that shows the difference between short-term and long-term interest rates on bonds of the same quality.

Bibliography

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Ferris, S. P., Jayaraman, N., & Sabherwal, S. (2013). CEO overconfidence and international merger and acquisition activity. Journal of Financial and Quantitative Analysis, 48, 137–164. Retrieved November 20, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=87775048

Holliday, K. K. (2006). What should you expect from a merger advisor? ABA Banking Journal, 98, 42-47. Retrieved on March 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23430321&site=ehost-live

McCune, J. (2006). M&A outlook: Will a catalyst emerge in '07? ABA Banking Journal, 98, 8-12. Retrieved March 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23430135&site=ehost-live

McGee-Cooper, A. (2005). Tribalism: Culture wars at work. The Journal for Quality and Participation, 28, 12-15. Retrieved March 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=17153329&site=ehost-live

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Parr, C. (2006). Due diligence: Worth a look? Business Law Review, 27, 232-233. Retrieved March 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23105169&site=ehost-live

Peake, C.F. (1999). Strategic behavior and competition in the information age: The Microsoft case. National Forum, 79, 5-6. Retrieved March 23, 2007 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=2288337&site=ehost-live

Rich, L. (2005). Seller's market. Inc., 27, 39-42. Retrieved March 9, 2007 from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=16846981&site=ehost-live

Rosenbush, S. (2006). The dark side of the M&A boom. Business Week Online, 5. Retrieved March 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=23087120&site=ehost-live

Serdar Dinc, I., & Erel, I. (2013). Economic nationalism in mergers and acquisition. Journal of Finance, 68. 2471–2514. Retrieved November 20, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=91929435

Weber, J. (2006). An irresistible urge to merge. Business Week, 4015, 72-73. Retrieved March 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=23461430&site=ehost-live

Welch, J. & Welch, S. (2006). The six sins of M&A. Business Week, 4006, 148. Retrieved March 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=22725852&site=ehost-live

Suggested Reading

Cartwright, S. & Schoenberg, R. (2006, Mar.). Thirty years of Mergers and Acquisitions research: Recent advances and future opportunities. British Journal of Management, 17, S1-S5 Retrieved March 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19892963&site=ehost-live

Erel, I., Liao, R. C., & Weisbach, M. S. (2012). Determinants of cross-border mergers and acquisitions. Journal of Finance, 67, 1045–1082. Retrieved November 20, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=75369038

Mayer-Sommer, A.P., Sweeney, S. & Walker, D.A. (2006, Mar.). Impact of community bank mergers on acquiring shareholder returns. Journal of Performance Management, 19, 3-25. Retrieved March 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=20831400&site=ehost-live

Moore, S. (2005) George Bush's antitrust tax. American Spectator, 38, 16-20. Retrieved March 9, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=17135329&site=ehost-live