A guide to mergers and acquisitions: M&A explained
We explain mergers and acquisitions, how they work, and the opportunity they present for investors and traders.
What is M&A and what’s the difference between a merger and an acquisition?
The term M&A stands for mergers and acquisitions. The two words are commonly used interchangeably to describe two companies joining forces, but there is a difference between the two.
What is a merger?
Technically, a merger is when two companies decide to combine forces by merging two separate entities into one new joint organisation made up of both businesses. A merger is usually pursued when two companies of a similar size and stature join forces, with both companies being broadly treated as equals. However, the term merger is often used when one large company buys another, even if the buyer absorbs the target company into its existing business – although, this is not technically correct.
For two publicly-listed businesses to merge, both companies would have to replace their existing shares with new shares in the new enlarged business.
What is an acquisition?
Most deals that are referred to as ‘M&A’ are, in fact, acquisitions. This is when one company buys another, with the target company being absorbed into the bidding company. Technically, the target company that is being acquired – and therefore its shares - cease to exist when the deal is completed while the buyer’s shares continue to trade as normal.
Acquisitions do not have to involve entire businesses. Sometimes, a buyer only buys the assets of a company. This can be all the assets of a business or can carve out certain assets such as a single division. Either way, this means the company that sells the assets continues to exist – either as a shell company with no assets at all, or as a smaller business with whatever assets it has left.
An example of M&A
The story of three companies in the oilfield services industry helps demonstrate both mergers and acquisitions. In 2014, two major players - UK-based AMEC and Swiss peer Foster Wheeler – agreed to merge together in a £1.9 billion deal. This combined both companies into a new entity named Amec Foster Wheeler, which replaced the two separate entities.
Fast-forward three years, to 2017, and Amec Foster Wheeler found itself being acquired by rival Wood Group for around £2.2 billion. Amec Foster Wheeler was folded into its rival and ceased to exist, while Wood Group retained its name and listing.
What is a joint venture?
Joint ventures are not a type of M&A but are worth mentioning. A joint venture is when two (or more) companies work together but retain their individual businesses. For example, Sony and Ericsson launched a joint venture named Sony Ericsson Mobile Communications in 2001. The pair set up the new company and held a 50% stake each. Both of them contributed assets and resources to the joint venture because they believed they had a better chance in the mobile phone market by working together.
Interestingly, the pair described this as a ‘merger’ at the time. This was because a new company was established and the relevant assets, including staff, were transferred to Sony Ericsson Mobile Communications. However, this was widely treated as a joint venture because both Sony and Ericsson both continued to exist as separate companies, and although they transferred assets they still owned them and secured the returns the joint venture generated.
The main reason we mention joint ventures is because they can often act as a precursor to M&A. In 2011, Sony agreed to buy Ericsson’s 50% stake in the joint venture, giving the Japanese firm full control. Similarly, Pfizer and Hisun Pharmaceuticals launched a joint venture in 2012 to make branded generic pharmaceutical products for the global market, particularly in China. In 2017, Pfizer bought out Hisun’s stake in the venture to take full control. A joint venture is a lower-risk and cheaper way of entering a new market or developing a new product. If it proves successful, it is unsurprising that one (or more) partners want to take control to reap the benefits.
Reasons for M&A: why do companies merge or acquire each other?
There are numerous reasons why companies seek to merge with or acquire another business. It can be motivated by growth or used as a defensive manoeuvre. For example, Alphabet saw the growth prospects of Android when it purchased it in 2005 for around $50 million – which has ended up being a huge bargain. An example of a more defensive move was Facebook acquisition of messaging service WhatsApp and image social platform Instagram. The firm was willing to pay big bucks for two services that weren’t generating any money because it saw the threat they could pose to its core social media platform in the long run.
Some pursue M&A to take advantage of a target’s weakness, such as a huge slump in its share price or a rough period of trading, because they see an opportunity to buy an asset on the cheap even though its long-term prospects remain strong. For example, CK Asset, owned by the richest man in Hong Kong, announced earlier this year that it was acquiring UK pub chain Greene King. This was driven by the weakness in Greene King shares (its market cap, which is determined by the share price, was lower than the book value) plus the Brexit-induced weakness in the pound, which made the deal even better value for the foreign buyer.
Investors will often see the terms ‘synergies’ as part of the rationale behind M&A deals. There are two sides to these synergies. The first essentially cuts out the costs that are duplicated across the two businesses that are merging, such as IT, labour or back-office functions (often referred to as ‘cost synergies’). The second is how sales can increase by merging the two companies (sometimes called ‘revenue synergies’). For example, if a broadband provider merged with a cable TV provider, they might believe they can sell more contracts by offering the services together.
It is also worth mentioning reverse takeovers, which private companies use as a quicker route to go public. Instead of going through the costly endeavour of conducting an initial public offering (IPO), a private business can buy shell companies that are already publicly listed. Instead of folding the shell company into the private business, it is done the other way around (hence the term reverse), so that the private business becomes publicly-listed on completion. Some companies are specifically set up as shell companies and listed in the hope of either acquiring assets themselves or being bought through a reverse takeover. Reverse takeovers are a cheaper and quicker way of going public than a traditional IPO, and the owners of the private business can retain greater ownership over the company. Warren Buffet’s Berkshire Hathaway is one example of a firm using a reverse takeover to go public in the past.
Types of M&A
- Horizontal: When one company acquires or merges with another direct competitor, like Facebook’s purchase of Instagram or the 1998 merger between Exxon and Mobil (to create Exxon Mobil).
- Vertical: When a company acquires or merges with a company that operates in a different part of the same supply chain. AT&T’s purchase of Time Warner was classed as vertical integration as it combined a cable provider with a content producer.
- Market extension: When a company acquires or merges with another company that sells the same products or services but in a different geographical market. Amazon and Alibaba offer similar services but one is rooted in western markets while the other is in the east, so if they joined forces then this would be seen as market extension as it would allow one another to tap into each other’s markets. China is a good place to look for market extension M&A as the country’s laws on foreign businesses mean many look to partner or invest in local companies for a smoother entry into the country.
- Product extension: When a company acquires or merges with another that sells different products but to the same customers. Coca-Cola’s acquisition of Costa Coffee is an example as each individual business sold different products to the same consumer base.
- Conglomerate: When two companies merge that each operate completely different and unrelated businesses. This is when a conglomerate – a group of diverse companies operating under one umbrella – buys a business that offers something completely unelated to what it currently does. Companies like Samsung, Alphabet and General Electric are all conglomerates with fingers in many different pies.
How is M&A valued and priced?
The priority for investors boils down to value of any M&A deal that is proposed, but it is important to stress that there are two sides to this. The company that is subject to a takeover bid and its investors will try to secure the highest valuation possible. The company that is making the bid, and its investors, will try to get the best deal possible and secure the lowest valuation possible. Therefore, the value of most M&A deals lands somewhere in the middle.
It can be difficult to negotiate. It is easy to slap a value on hard assets, but harder to value the likes of growth prospects or intangible intellectual property. There are many different models used to value a business. This includes comparing previous M&A deals involving similar companies. For example, if one media company was bought for a price equal to 4x annual revenue and 12x annual earnings, then this could help set a range for the bidder to operate in. The price of a recent fundraising may be used to value the company. Some will simply start with the book value and then evaluate the opportunities versus the risks. The ‘discounted cash flow’ model, also known as DCF, is a popular method of evaluating a company’s current worth based on its ability to deliver cash flow in the future.
M&A: premiums and discounts
Fortunately, there is an obvious measure to use as a starting point for any M&A deals involving publicly-listed companies: the share price. Any offer that is made for a publicly-listed company will be made on a per-share basis, which can then be easily compared to the current share price. The difference between the offer and the share price is known either as a ‘premium’ or a ‘discount’. If the target company’s share price was trading at 100p before a takeover offer of 110p per share was made, then this would be a 10% premium. Similarly, if it traded at 100p but an offer of 90p was made, then this would be a 10% discount. Most premiums and discounts are calculated using the most recent share price before the offer was made, but some choose to use other dates – so read the specifics carefully.
How is M&A funded: cash, shares or a bit of both
The company that makes an offer to merge with or acquire another business must demonstrate it can fund and afford the deal early-on in the process. Most companies will make sure they already have access to the funding they need before they bid, but some will launch a fundraise in tandem with the offer (which may be contingent on the deal being completed).
Ultimately, there are only a few ways that M&A can be funded - using cash resources, equity, or debt - and these dictate what type of offer is made:
All-share acquisition and mergers
These deals see the bidding company offer shares in the business in return for the shares they already own in the target company. For example, the bidding company could offer one share in the enlarged business for every two shares they hold in the target company. This means investors in the target company end up owning a stake in the enlarged company, but they won’t receive any cash unless they decide to sell-up. All-share deals have more volatile valuations as it is based on the moving share prices of both businesses. For the bidding company, this type of deal will dilute existing shareholders but it won’t have to raise cash or debt to fund the deal.
Cash acquisitions and mergers
A more straightforward way of funding a deal is in cash. This sees the bidding company offer a cash value for each share in the target company, which is paid on completion. The bidding company has to source the cash needed: if it doesn’t have cash at hand then it may decide to raise it by either issuing equity or securing debt.
Cash and share acquisitions and mergers
Some M&A involves an element of both. For example, the bidding company may offer half a share in the enlarged business and 100p in cash for each share already held in the target company. This can be beneficial to shareholders in the target company as they not only receive a cash sum but also a stake in the new enlarged business, giving them the best of both worlds. Again, the valuation can be volatile between the offer being made and the deal being completed as it is predicated on the share prices of both companies.
Recommended offers vs hostile bids
M&A usually involves two companies, but it is not always a two-way street. Ideally, bidding companies want the target company to agree to the offer and recommend it to shareholders as it has a better chance of going through and less likely to face objection. If the directors of the target company believe the offer is acceptable, then they will recommend shareholders to accept it and argue that it is in the interest of the company and shareholders.
However, this is not always the case. Bidding companies are not always able to convince directors of the target company that the offer is good enough. However, this is not a necessity and the bidding company can go over the head of management of the target company. This is known as a ‘hostile bid’ or an ‘unsolicited offer’. Under this scenario, the bidding company appeals directly to the shareholders of the target company and tries to convince them to accept the offer, while the directors of the target company try to convince shareholders to reject the offer and argue why the deal is not in the best interests of shareholders. Some bids may start-off as hostile but eventually secure the recommendation of the target company later on.
Understanding whether the M&A is hostile or not is key because it will decide what process is used and possibly how long it will take.
M&A: scheme of arrangement
The bidding company must secure acceptances from shareholders in the target company that collectively own a minimum of 75% of the issued share capital. Because the threshold is so high, a scheme of arrangement is most commonly used in recommended offers. The biggest benefit of a scheme of arrangement is that all shareholders in the target company are bound by the outcome. For example, if shareholders owning 80% of the share capital accept the deal then the remaining 20% have no choice but to do the same. However, it must also be approved in the courts, which makes the schedule less flexible.
M&A: contractual offers
A contractual offer needs a lower minimum threshold to be accepted. It only needs to secure acceptances from shareholders in the target company that collectively own 50% of the issued share capital – but many bidding companies choose to set a higher threshold. This is because not all shareholders will be tied to the outcome: a bidding company would need to receive acceptances of at least 90% to be able to squeeze out the remaining 10%. Hostile bidders tend to favour contractual offers because the threshold is lower than that required by a scheme of arrangement.
How to trade M&A
Trading M&A can be difficult but very rewarding, and, like other types of trading and investing, requires a bit of foresight. There is always plenty of stocks tipped to be subject to major M&A in the future, and this can form a large part of the investment case. Because the majority of M&A deals are priced at a premium rather than a discount, the share price of the target company tends to rise once a bid has been made. For example, IBM agreed to buy Red Hat for $190 per share when Red Hat shares were only trading at around $116. Unsurprisingly, Red Hat shares soared toward the offer price after the bid was made – so anyone who already held Red Hat shares, or were quick enough to buy them (or go long) once the bid was announced, made a sizeable profit rather quickly. Similarly, if an offer has been made but you believe it won’t be accepted or cleared by regulators, then there may be an opportunity to short shares in either the bidding or target company in anticipation of shares being hit if the deal falls through.
If you own shares in the target company then you have a few options. You can accept the offer being made, or sell the stock after the offer has been made public and lifted the share price.
One example of a possible takeover target is Morrisons. The UK supermarket has been building a strong relationship with Amazon. It has long been expected that the ecommerce giant will one day make a move into the UK supermarket sector (fuelled by its purchase of Whole Foods in the US), and if it does then Morrisons is the logical target. However, it is important to stress that there is no guarantee this will happen, or if it does, when. It is also worth looking for sectors that are ripe for consolidation, such as the European telecoms sector or automotive industry.
There are also companies that make M&A their business, such as Melrose, which buys failing companies on the cheap and then tries to turn them around so they can sell them off for a profit in the future. This has seen it pounce of the weakness of firms like GKN and Nortek.
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