a Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES MERGERS, ACQUISITIONS AND DIVESTITURES axon Tass, Growth eee yea ow neal rene Introducing new products, TET intemal growth is that the company continues to do business locations ‘The importank “oP gning itself with any other company, acquiring another company o ao To creating any other company: toa situation where a company goes out and either buys another eral Growth company or becomes Par af ante compay. nay. ‘ten takes the FO" any) Spore combinations L. {WO OF more companies come aniey ayo in eae Qwmership and contfoh RM COMBINATIONS im fake the form ofa takeover, FORMS OF Phyations can Sea Business © 331Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES oe eo mn Sepa comet Hien eerie trample if Wadd Co. Ld. buys Sig or ofa caulty shares of Niki Lt, the former company wil ave taken over the later compere Inte ce both Wadd Co. Ltd and Nikki Ltd will continue to exist and do business under their res $Pectivg firm names, However, Wadd Co. Lid will now exercise control over the management of Nida ne? ‘A company that owns more than half of the share capital of another corPany (6-8, Wadd Co, Leg in Suhedlaty. On the other hand, ifa holding company owns move na 50% but less than 100% or rapatY company’s equity shares, the subsidiary ts knowe Partly-owned subsidiary. The holding company plus its subsidiary companies arc together known as a Group, Hes wna net be A¥alabe to the buyer. Howeven the wees oe useful if the goodwill lies with the Products (brand names) of the company, rather than the produces EH The buyer company can then ne) ot Use the brand names ofthe Products without any serious loss ‘Of corporate goodwill nd pulls the three terms (acquisition, Imerger and amalgamation) have different meanings # fonnotation, in general sense they ore ‘commonly used interchangeably. DIODES OF BUSINESS COMBINATIONS Directionally, companies may eombion ith ‘other companies along any of the following lines: 332Chapter 15 MERGERS, ACQUISITIONS & DiVestiTURES Jerteal Integration inthis arrangement, a company combines with anothe and/or distribution. For example, a spinning mill may sevens gases Production ‘weaving mill. All these companies are in the same chain of Fusiness ne aCtOrY oF a ginning factory is used by spinning mill to turn it into yarn which is used by meagan, make fabric. Ifa company acquires a supplier, itis referred to as upstrean scquitiote, later tanning factory acquired by shoe manufacturing company) pei a a customer company, itis referred to as downstream aequistion four Seen im acquisition (ea wheat flour mill Horizontal Integration If two or more companies carrying on the same business at the same level decide to combine, such a combination would be called horizontal integration, eg. recently Brooke Bond and Lipton tea companies merged in Pakistan. Another example is acquisition of Pakistan operations of ABN AMRO Bank by Faysal Bank Ltd, Conglomerate Integration If two companies in totally different businesses combine (in whatever form), the integration is said to be of conglomerate nature, eg, a textile mills acquiring an electric goods company. The most common reason for conglomerate integration is to diversify a company’s business interests to protect itself from cyclic changes. REASO NATIONS REASONS FOR BUSINESS COMBINAT ED uions isto allow the company to gow an Sesh The foremost reason for Duin rts can beacheved yay ofthe follow ne mess Elimination or reduction of competition Abuying company may acquire one OF Ore supply or a much larger market share, F ler to either get a monopoly of more ofits competitors in ord « te, when Neste entered into water business in Mayans inthe county. This gave them nit the smaller water comp: ny. Tis eve hem Pakistan, they virtually took ove se yon 7 monopoly in bot ce ao toed the bottled water segment ofthe m Tears moma ke Pepa and coon Cola es raw materia it fresees problems of input Provcing Supplies Sey yay asa of men ses us are company may Be ter Feary, 8 COMPATY Tan acquisition is protective in nature, mend Shoreages in he lent des at a Ma marketshare ore of SUPP a ots (08 CMerOrt SS nner prove he wait of ae Sp their own Fetal Or Tarty distributor. Such ventures Started opening, WF Sing uhroud © MNS aon may not increase the cash ow ot products wimcearanion A Eicisk and improve Ws poten © Fa jwnstrear intel tore ean but ronment 333Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES Fare feruewhen the sie of operation increases through acquisitions, for example yh seater buying power may lead to lower prices through quantity discounts, ‘+ Larger production runs reduce set up costs ‘+ Administrative, accounting and similar activities may be combined to bring down overhey costs, Raising larger loans may bring down borrowing costs. Risk spreading through diversification Merging two businesses with different activities can reduce risk since the ret turns from such different activities are unlikely to be perfectly positively correlated with one another. In othe words, both the businesses are not likely to experience highs and lows at the same time. Thus ifs sroup has interests in steel, sugar and textile sectors, it is unlikely that all these sectors wil gointa recession at the same time. It is theorized that when one sector is experiencing difficulties operations can be sustained by other companies in the group which may be doing better at that time, This concept of diversification may not enhance shareholders’ wealth, but it can certainly protect it from serious erosion, Tax Benefits futte often a company may have huge accumulated losses, This means that the company will ro dee Pay any income tax till it goes into profit again on a cumulative basis, For example, if Niki {ic has accumulated losses of say Rs 234 milion, it will not be required to start paying any income sae entsincome in future years goes beyond Rs 234 million. This may make Nikla Ltd an attractie Candidate for take-over, Law permits that accumulated losses of an acquired company may be of Setagainst future group profits. This may bring down the cost of equity for the group. ‘This benefits sometimes referred to as tax shield on equity. Use of unutilized assets ‘A.company with idle production capacity m ympany that may be facing problems in mectg pacity may be acquired by another company that may "dificult to meet the demand for its produets, it may consider taking over =" shoe manufacturing unit that is runni for its products, it may a u inning below capacity. ye much cheape Removal of ineffective management Quite often companies go into lo an ut © targets and continue to run in loss due to poor management. Sie" install more stent Pee targets for well established companies who can buy these compara lead to replacement qr agement and turn them into profitable units. A merger or acquis ae lead to “nt of Poor managers by more experienced or effective managers from The Chop-shop Approach 10 jometimes due to poor economic condit i ‘a company may un Ht losses'and the market value of ks share none yang i he country, a company its ice meal value ts share may drop even below the book or piece meal P 334rl see Chapter 14 on valuation of financial assets). A company with adequate liquid resources = (iresuch acompany ata relatively low overall price and then sll its assets on a piecemeal trie a net gain. However, such an acquisition cannot be considered a form of business ‘an Companies that carry out such acquisitions are often referred to as corporate raiders eats Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES: eon ister applies to all the benefits that accrue to combining business units due to the factors enmerted above, SONEISSUES RELATED TO ACQUISITIONS ‘Viena company decides to expand its operations through acquisition, it needs to pay attention to tie important areas, namely valuation of the company to be acquired, how to pay for the ‘qustion and finally legal or technical issues related to the process of acquisition. We will briefly discuss these issues below as a detailed study of these matters is outside the scope of this lnroductory text. Yluation issues Avacqusition, merger or amal take place only if both the buyers and sellers of shares , or amalgamation can take pl ‘nthe company being acquired agree on a price. There are a number of ways of calculating the chase price (or sale price) of shares depending on what are the speifis ofa particular take- ver. However, the bottom-line is always: "the figure that is acceptable to 1¢ buyer and the seer, ure. All the normal methods of evaluatin Dying is essentially @ major capital expenditre, cia egemmany is essentially a marulstons as wel I adltion, we should keepin mind the meee eeaicure cally apply 2 sy scussed in Chapter 14 Brey, the target companys shares aluing financt ‘may be valued on the basis of: 4 Assets Based Valuation over less the lables being assumed is deemed tobe the tal pce fhe asst TH ment ae, eng th cer te ket value, realizable ValU®, Te over may include an element of goodwil markt valu, rag gens to etaeen oe goodwil 4 Profitabitiy Based Valusti yatue of boty etepenr ephes Shits average profits This involves comPUUME "yen require’ ed ete Paty: For this purpose, the 7 at the rate Of TO ean ofthe profits earned by the company over the recent sage pris are SHEN ened within sty ve ears of acquisition, oo ‘and/or expected Pr ww Based Valuation. « net present value of projected cash flows of involve ghe cost OF —_ 335Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES ‘ d Market Value of Shares : Wie itis noire shareholders ofa target company to sel ff their shares toa bidder at the prevailing market price (atthe stock exchange), market value does provide a good staring point for negotiations. f It may be added here that buying a company is quite different from buying a few shares in g company or an expensive piece of machinery. It involves a much more detailed study ang consideration of several pertinent factors. It frequently happens that an acquisition being made for strategic reasons (e.g securing a source of raw material, or eliminating competition) may not be 2" valued on the basis of financial models alone. Not all the benefits of an acquisition are capable of being quantified in monetary terms. All these things are covered in a due diligence exercise. Again, valuation placed on a target company may not necessarily be acceptable to the sellers. Hence an acquiring company has to prepare its purchase price strategy very carefully. : Settlement of Purchase Price Once agreed, the purchase price of shares in the target company may be settled, subject to agreement between the two parties, in one or combiration of any of the three available modes, ‘namely cash, shares in the acquiring company and debt-instruments of the acquiring company. In. i Pakistan, by far the most common mode of settlement on acquisition of companies is cash. Shares Exchange Settling the share purchase price by issuing shares in the acquiring company to the shareholders of the target company can pose certain problems. This is so because it involves the acceptance ofthe “exchange ratio" by the sellers who must by implication agree to accept not only the valuation ‘being placed on the shares of the target company but also the valuation being placed on the shares of the acquiring company. For example, if the shareholders of Nikki Ltd are offered two shares it ‘Waddi Co, Ltd for every five held in Nikki Ltd, it means that shareholders of Nikki accept their shar® to be worth 40% in value of the share of Waddi Co. Ltd. Thus, settlement of purchase price it shares requires two valuation processes: the shares of both the acquiring company as well 5th target company must be valued. The two shares may be compared in terms of: ‘ © Netassets per share of each company. ; ©. Netearnngs per share ofeach company, & © Dividend pid per share ofeach company. x © Prevaling market valuc of shares oftel company x © Projected earnings, or cash-flows, per share of each company. & ‘Example ‘ Given below is dta rom two companies ak wid ‘Al figures in ions of rupees wagdiued — Misi20 Paid up share capital (all ordinary shares of eat ny i : Accumulated reserves aT Shares oFRS 10 ech) i s ‘Total equity 1400 * Liabilities. bad 336,juedassts, net of depreciation Currentassets, except cash os Cad 710 tae pr share (average over past three years) 40 . famings per share (projected over next five year Bs.3.26 Rs.220 Market value per share eae) Rs. 4.25 Rs. 250 Price Earnings Ratio R940 Re itan 8 * Terket value of shares, with shareholders of Niki Ld being offered a premium Of Rs. 2 per above the market value. Past earnings per share basis, regardless of P/E ratio. | * Projected earnings per share basis, but considering that Wadd Ltd has a P/€ ratio of 9 and Nikki Ltd has a P/E ratio of 8. Cimpute the number of shares of Waddi Ltd to be issued to a shareholder holding 10 shares in Nik Ltd. under each of the above computational basis. ‘Solution: ' Waddi Ltd Nikki Led Replacement cost of fixed ea —2_s Current assets (including ca: Sa #0 tote eee Less total Heelies! eo Net assets at agreed valuat 7 a Number of outstanding share 12825 are 23.21) o ‘Agreed value per rehares of| a Le sgued (162.50/3 Agreed value of 10 Sharer Number of shares of 33715 MERGERS, ACQUISITIONS & DIVESTITURES chapter 1 (with premium) Valuation on basi of market value (with pre Met ay 29.40 value (prevailing) per share i par ea per share to Nik Ltd sharholders 7. ts se price i 2 ‘Agreed purchase pricé : wurchase price of 10 Nikki shares Re ‘rent of shares of Wadd td to be lesued (196.00/29.40) i Valuation of basis of past earnings per share Waddi Ltd Niki tag Average Earnings Per Share 326 220 Total earnings of 10 Nikki Shares ea ‘Number of Waddi shares to be issued (22/3.26) 65 Valuation on basis of projected EPS, considering P/E ratio, Waddi Ltd Niki Ld Projected EPS 425 250 P/Eratio 9 8 Share value on basis of P/E ratio 38.25 2000 Value of 10 Nikki shares 20000 Number of Waddi shares to be issued (200/38.25) $23 25 an be seen, different methods of valuation produce different values for shares. As to whch basis of valuation will be acceptable to both parties, or what price willbe finally agreed upon by the {wo patties is something that is decided by negotiations, often with the help of professional consultants, Settling Share Price by issuing Debt Instrument hile itis quite rare in Pakistan, itis possible that the shareholders ofthe target company ma issued ty ake istument lke a debenture, bond, term finance certificate, or simular othe aE ‘sted by the buying company in part or full settlement of the sale of their shares. I sucht converted na radable. be it is lsted at a stock exchange, it gives the holder an option tf Sihverted into cash at a suitable time, or to continue to hold it for interest income. One matter of mutual agreement as to how many bonds of what face value will be issued by tothe shareholders of the bought company. onds'® trots af two variations to bond issue that are available. The first Is t0 issue converte or the shareholders ofthe target company. These bonds wil pay a fied ate ithe acquiring comps) sreortagretiod ater which they wil be converted into ordinary shares of the 2eQunng the ner. 4 Pre-agreed formula. This arrangement may appeal to certain Peek I Nau the period following acquisition will not be all that profitable but ramehand peta fixed guaran of acquiring company’s shares may go up. Thus they can hold a 338Chapter 15 MERGERS, ACQUISITIONS & pivestitunes, eriod immediately following the acquisii att aig sen the situation has stabilized, (Stabilizing period) and ope 4, ot tion isto issue preference shares, a ste theory works here as well. The sod fora specified period before they are allowed to get eee acquiring company. Here the only respite ta ‘aipat preference dividends are not mandatory; so the Payment of 5s jedby 2 year or to should the situation so demand, onbination of Settlement Modes isposible that the total share price of the stovemodes,Itmay take any of the followi + Partshares, part cash + Partshares, part bonds + Partshares, part bonds and part cash. + Partbonds, part cash, bought shares may be settled through a combination of ing forms: \EGAL AND TECHNICAL ISSUES RELATI epreces of ac the buyers and sellers 0 have to be ley are taking over as the result of the ‘echnical issues relating to acquisition of companies may be: * TEieate of labile being assumed by buying company, various legal cases Outstanding rexyet sen cauired company, detalls of any contractual obligations of tie cone eae ‘otyetreflected in the balance sheet, ete The nature of assets being taken over, their technical state, their title, outstanding a any specific claims igainst any of them, ete. BES of the employees, the nature of thee contrat with the company, labile that ‘may “rseifthey leave or are asked to leave, ete. be Ths re GENCE ; ination of various aspects ofthe target company ‘rest mal exer involving examination of alos “making a decision on its purchase, and on the Pur tea Be "und of due diligence 325 result ofthe United Sates Secures Ax of gen “due diligence” first came into common us the "Due Diligence” defense enact "1933, his act included a defense at Secon 1, referred 0s 339oS chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES broker-dealers when accused of inadeqi uate disclosure to investors of many 0 the purchase of securities. tt could be used by information with respect t ‘exercised “due diligence” in their investigation into the company Md disclosed to the investor what they found, they would 7. that was not discovered in the process ofthat investigate’ As long as broker-dealers yey were selling 2 ‘ear now ascosie information ‘The broker-dealer community quickly institutionalized, as a standard practice, the conducting of due diligence investigations of any stock offerings in which they involved themselves. Original te {erm was limited to public offerings of equity investments, but over time it has come to be ‘associated with investigations of private mergers and acquisitions as well. The term has slowly been adapted for use in other situations. In Pakistan, except for privatization of companies by the government, there are virualy 19 ‘examples of “brokers or middlemen” trying to sell companies with pre-prepared information booklets, Hence, the task of due diligence is mostly performed by the companies that are interested in buying other companies. The task may be assigned to a team comprising of officals ofthe buying ‘company, orto an outside consultant. Forms of Due Diligence Due diligence takes different forms depending on its purpose: ‘The examination of a potential target for merger, acquisition, privatization, or similar corportt finance transaction normally by a buyer. This can include self due diligence or "reverse due diligence’, ic. an assessment of a company, usually by a third party on behalf ofthe compat prior to taking the company to market. b. Areasonable investigation focusing on material future matters. 6 Aninvestgation of current practices, processes and policies ofthe target company. jon aod 4 An examination aiming to make an acquisition decision via the principles of valuation shareholder value analysis, What is involved in Due Diligence? The due diligence process (framework) can be divided into the following ‘simplicity reasons, itis appropriate to treat each area as a sort of an audit: distinct areas FO" Financial audit ae This involves a detalled examination of nancial statements of past few yeats Wi a truly assess the worth ofthe target company. Depending on the nature ofthe 20% puye* . ‘arget company may actually cooperate in this exercise and provide opportunity’ «due diligence team to inspect its books of accounts and supporting records 340Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES atrnjeors audit er of financial projetions of income and cash flows on the basis of information ‘rae the fiancal audt Since an acquisition i aimed at buying the “future” of the son ti ery important that future projections should be carefully prepared and audited fparrveata reliable ‘assessment of purchase price - or ven suitability for purchase. egal Environment audit f the macro environment of the target company. It includes looking at the the state of economy, state of legal regulations, details of any irget company (eg. prudential regulations for banks, environment ‘and Le ‘This is ‘examination of Feamunity in which it operates, omjeuars laws applicable to the tai fesurance Act for insurance companies, etc) al audit val avtvolves examination of all major contracts and legal obligations to which the target Company may be committed, eg. lease agreements, agency agreemen's, agreements with workers, major suppliers, major clients, etc. It will also cover target company's articles and memorandum of association, certificate of incorporation ete. ff the target company. Its product mix, its Marketing audit its distribution net work, its credit This is examination of the mat marketing strategy, its market s policy, ete keting situation of hare, its market potential, i Product ion audit get companys production rocess detalled inspection ofits plant, This involves a review of tar raw materials used, finished products made, et Management audit vs management team at all levels (senior, rgement audi all cover the target cOmPANY Te ean unin) thei eT ee It ay amis ‘and ssscoent of tel ra or onganiainal nears ‘Jepartmentalization, administrative procedures, manageme work procedures, ee Information systems audit agement syste se bythe target company, her «ormation manager , Ti sua covers the 80700 Y formation the vay ofFepors produced, etc. comprehensiveness, .ain questions, First, wil the purchase of this nswers to 02 ‘ i a of the bidding company. And secondl ‘This examination 2 objectives condly, will the ble ter's way of running the business, or will company be compatib’’ wich the Duy ae , oF will it require a tequistion * pa jh ea materi impaton Purchase pice justment great deal of 4 Compatibility audit ag yo find 341> chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES nciliation audit Reconcitir at is commonly refered to as the last stage of due diligence: an overyigy 7 Shean attempt to reconcile them and get an overall picture. Itc 0” all been carried out by different teams; hence there ig fall the different audits carried out. Possbie gt above audits wit 3 need fg, ‘above audits may have reconciling the findings of When is due diligence carried out? Generally a buying company will carry out a good part of the due diligence well beore i n interest in purchasing a target company. Once the target company shows an interes process, they can complete the rest of the due diligence exercise with the cooperation ofthe ty Company. However, in all cases, the due diligence must be completed before negotatinr™” purchase price and mode of setting the purchase price are started. a FINANCIAL STRATEGIES FOR ACQUISITIONS “Acquiring a company is a major decision. It therefore requires a lot of thought and pre-plansing Managers have to evolve financial strategies to deal with the issues that will arise before, dunag and after the acquisition, Some of these issues are enumerated below How to raise funds for an acquisition? ‘A company requires huge amounts of funds to acquire other companies. A part of the finds required may already be with the company in the form of cash at bank, short term deposits orsbot term investments, butt is not normal for any company to carry such large amounts of surplus ih {n anticipation of an acquisition. Again, the funds invested in buying subsidiaries are not reoupe! aver short periods. It may take a while before the new acquisition starts yielding surplus css to pay for its purchase. This simply means that the managers of buyer companies have to draw # sound financial strategies for financing major acquisitions. As stated earlier, the purchase pre shares in a subsidiary company may be paid in cash, in shares or in bonds. Let us assume tis shareholders of the target company are interested only in cash payment. The buying company raise such cash from any of the following sources: 2. Its own liquid sources cash held in bank, short term bank deposits, or short erm invests s liquid . Gleaning cash from its other already existing subsidiaries ifany of them have surplus i issue FO © Selling its own shares atthe market ifthe capital market is conducive t0 St) 2 gs buying company has a good reputation, and the market is aware of its £0 company may be able to get a good premium on its shares issue. ie ital structure 4. Negotiating a loan from a financial institution. Given the history and capital neat buying company, this may be good option in certain situations If the OMPEL . ofexre™ low interest rates and a manageable pattern of loan repayments, this ©" associated with public issue of shares or bonds.chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES: venture, or Term Financing Certificates, etc) at capital market. While isi DON rom general public has its own advantages, it also carries some problems, for eg ac proces, considerable floatation expenses, permissions from a number of i len oc exchange, et Here aga the story and reputation of the company se erotin setingthetsve price ofthe bond nd the rate of return there-on. “a season on raising funds foran aequiston the acquiring company must be guided sisi rang ts own capital structure, [suing too many ‘bonds can land the company into apo rblers during the prio that the new acquston i stl under nursery care att ucng adequate cash lows of its own to assist the acquiring company in repaying the iatre gsing to many equity shares may mean tat in absence for a need to pay interest mle reayments, he acquiring company wil soon have surplus cah fom ergsr ott yr apparent ues dificalto presribe one approach hat wil su all station Bepnpany has to tailor its financial strategy for acquisitions to ‘match its own particular crams. iwtoapproach shareholders of a target company? nies strategy relates to the manner in which the acquiring company conveys its interest huatlders oft target company, Keeping the Pakistani situation in mind, any such approach Matin nde tothe grout of shareholders who are actually running the company. Shares 14 Py tha up are ofl neterred to as management shares. ifthe managing group does not hold & tetaling percentage of total shares of the target company, or if the acquiring comesy itreted norte chars of the target company, an approach may have tobe made 1 ll ‘hrtolders, Generally, te following modes are adopted: 1 Parhase oly controling interest, ue. the management shares, fom the present Holger St mane contol ere mean EE BENE a ee = shares. For example, when Union Bank was sok by the SOP TO t jhange Tare Ie cre ee a hat te Boye Fae glk’ the management shares. Unless such 2 purchase ee maa way frre Starches te mane ften serves asa short cheaper 2 y of acquiring ll management control of a new subsidiary- ers This has the benefit of having to au ars. trl less per share than is paid on management sHTE™Y 2° couired, However, this strategy would much larger number of shares ™may Mey of shares, In Pakistan, almost all ‘ling percentage ‘Succeed onl ne group holds 2 contr ronds or families. Hence, there is virtually tt nly sed. groups of Fene without going through the majority 10 possiblity for a corporate raider © take over ac shareholders’ group. An open cash offer may be made to all their ownership percentage 27 0) attractive hes in the target company ™maY P_., Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES i ld be exch; ‘The question of how many shares of the acquiring companies would be excha many ofthe shares inthe target company is a matter of negotiations 4. Avariation to the above strategy is to make a mixed offer. A slightly lower cas ‘who prefer cash and a slightly higher price to be settled by issue of shares company for those who have an investment interest in acquiring company, company's shareholders get a choice and the chances of the success of acquisit Price for ti in the acquings This way tpt ion bid impor Impact on EPS of the bidder company Earnings per share is an important indicator of a company’s efficiency and has perhaps the greg influence on its market value ofits shares. As we learned in Chapter 14, share price ofacompan equal to EPS times prevailing P/E ratio. Now, ifthe company finances the acquisition through nex issue of equity shares (either to outsiders, or to the shareholders of target company), any ot following consequences are possible: * Ifthe P/E ratio ofthe acquiring company is greater than the P/E ratio of the target compay, then EPS of the combined operation will go up. * Ifthe P/E ratio of the acquiring company is lower than the P/E ratio ofthe target compa then EPS of the combined operation will go down. * Ifthe P/E ratio of the acquiring company is same as the P/E ratio of the target company, tet EPS ofthe combined operation will be unchanged Letus take the example to understand the above situations. Case1 " Wadai Ltd that has 2,000,000 shares is interested in buying all the shares of Nikki Ltd that aso 1.000,000 shares. Net profit of Waddi Ltd is Rs 12,000,000 while that of Nikki Ltd is Rs 8:00 am ‘The market value of the two shares is assumed to be same (Rs 48) and they therefore agree shareholders of target company will be given one share of Waddi Ltd in exchange of one shat Nikki Ltd Waddi Ltd Nikki td No of outstanding shares 2,000,000 1,000,000 Net Profit, Rs 12,000,000 8,000,000 EPS, Rs 6.00 8.00 Share price, Rs 48 8 Price Earnings Ratio P/E 8 6 After acquisition No of outstanding shares 3,000,000 Total net profit, Rs 20,000,000 EPS, Rs 6.66 vs of Wack You can see that the combined earnings per share at Rs 6.66 are greater than BPS Of MT kt alone at Rs 6.00, IF the company manages to retain its provaling Price Earn 344 BEd for hyv Chapter 15 MERGERS, ACQUISITIONS & oWvesmiTuRes asst acpi rf 2s asbefoe, but now assume that net profits * iad Rs 4,000,000 for Nikki Ltd, Now the situ: wil can rise from Rs 48 to 53.28 (Le. 8x 6.66). Th etalzation ofthe company and wealth of te share is will have tt he impact of cholders, ene of the two companies are Rs 12,000,000 for lation will be as follows: Waddi Ltd Niki Ltd No of outstanding shares 2,000,000 1,000,000 Net Profit, Rs 12,000,000 4,000,000 Earnings per share, Rs 6.00 4.00 Share price, Rs 48 48 Price Eamings Ratio P/E 8.00 12.00 After acquisition No of outstanding shares 3,000,000 Total net profit, Rs 16,000,000 Earnings per share,Rs — « 5.33 ‘will observe that the combined &! PS at Rs 5.33 is lower than EPS of Waddi Ltd. This can have an ‘herseimpact on the market value of Waddi's share after acquisition. Witou going throu Aoquiring comp: combined grou eh the trouble of drawing up another schedule, one can perceive that if both any and target company have the same EPS before the acquisition, the EPS of iP will remain the same. qactaShare Purchase Price to Future Growth (hite often a target company is owned and managed by a few founders - started wich a ove 3d achieved relative sucnoee Wf ee aa a tapes very likely that the main asset ofthe company, ee ieee Fate the company ether mediately or very son fer the akeover. The may lend oa ro in tre ttly and profitability of the acquired company In oder to real such valuable personel Sent terest in the company ave, Ng ste buying price of shares is set ats a ' referred to as Earn-out Method. Under this method, the mediately to the sellers. The rest of the i bigher level but only a part ofthe price is paid immediatly ree ad upon achievement of certain pre-set goals over st-acquisition period. This als over a defined post-acquisition ps tte founder cep work sae hard for the company and help it stabilize nde atthe managers keep working Under th ‘acquisition as set by the buyer, “the new ownership, leading to attainment of objectives of acqu 7 may oa wrocess proceeds amicably. rae * am ene |-naturedly, the pr to get the best den many ort ay Perea reamed seo ath ae tning gn be Se otaons aking ple ines ke aa ag friendly takeover. Most ac in owe estan Ring place In busine nn discussions, Such a 3457 Mort Ay, chapter 15 MERGERS, ACQUISITIONS 8: DIVESTITURES takeover of Union Bank by Standard Chartered, the recent past. 6 tof well negotiated friendly takeover bids, Pal an yaisl Bank have been a result of Bankby Faisal who are running the company) of the target co Oe eau der (yy ‘may act quite indifferently, or defensively. The bog willing to sell the compar te approaching the shareholders direct with ther offer o may try unorthodoy er fots from the open market, in order to force the team incoay at acu shares Sma othe negotiation table. Such a takeover bd i called haste target company © saveva history of many hostile takeover attempts. Perhaps the only on ohich was resented by the managers and majority shareholders and eventually resulted infe DEFENSE STRATEGIES AGAINST TAKEOVER In America and Europe where many companies are managed by people holding only a minoy equity interest, a takeover bid may mean such people losing their jobs. Hence, they often ty's dissuade other shareholders from selling their shares to a bidding company. The situations mua different in Pakistan where most companies, if indeed not all the public limited companies ze ‘managed by people (family or friends groups) who hold a majority of the company’s equity tas Hence, itis virtually impossible for any outsider to take over the company without their corsat ‘Any bidding group has to channel his intentions of taking over through the managers (ie.eteatit directors) of the company. | However, assuming that the board of directors of a Pakistani company does not hold amit share in its company and an outside corporation is keen at taking it over, what defense stat are available to such a board? Essentially, these are as follows: Golden parachute : The directors could award themselves extremely hi 3d men selves igh terminal benefits. This wou any bier that takes their company over and wishes to remove them from te bar »ay them heavily. uch an arrangement is informally referred to as golden parachute Poison Pill T ee ‘may start buying its own shares, thereby causing two ef i, oe Tehciue of the share in the market and secondly improving the £0 yi feof the managers. The target company may resort to heavy Doris et e a te jer thatthe 10% oa Sake ampany shall become immediately repayable if the management jeu company and repensczit becomes very expensive for the bidding company t0 3°41 i. ay its loans almost immediately. This strategy is often called “P™ angel Investor vo susk(Chapter 15 MERGERS, ACQUISITIONS & DivestiTURES omised a higher return on his investment, or offered some i be indirect benefits to sustain fa rest the company. JRES iE strategic plans for the future, a company may find it necessary to selloff one or more ‘weenfperations oF assets in order to concentrate on more profitable activities. Some of the (8 easors for divestment, or divestiture, areas fllows, o ret concentrate on core activities Purp eampany OF group engaged in diverse activities may find ithelpfl to concertrate fully on its cote business as that may result in better profits, or more rapid increase in shareholdere wealth. Confining your business to your area of special expertise can improve jour competitive edge inthe market, helping you geta larger market share, or better price prensum., Geting rd ofil-conceived acquisitions Corporate history is replete with examples of companies that acquire a number of other companies in their desire to expand - and subsequently discover that the new acquisitions are Pasing more problems than they are solving. Example may be quoted hare of Pepsi cola company that had acquired fast food chains like Pizza Hut, Taco Bell and KFC, soon realized ttt fast food was not really in line with their core business of selling soft drinks. They therefore sold off these fast food companies to Ricon Global Restaurants in order to remain {fesed on their core business. Another example is that of Ford Motor company that acquired {ieetronic Data Systems (EDS), a computer services company, thinking that it wil help them fiuld beter electronics into their cars and thereby improve their core business, Eventually, ‘hey ended up divesting EDS as they failed to get the desired results from this acquisition, Getting rd of problem projects fa project, ora subsidiary company, is experiencing some problems, the holding company may find it more convenient to get rid of such a company then to spend inordinate amount of time ‘nd money on solving the problem. Needto ris cash fr some other project the Tolingconnee come soross a good investment opportanity panes tie doce ‘siness, it may decide to sell off such of its projects or ea a helps the parent coyaPortant from the group's overall strategic hye anctn “ompany to raise cash for financing its other expansion o consl Government or court order ; fits subsidiary companies in sional a company may be order to sl off one or more 0 fs stern ie Wg bfeak the company’s monopoly over a paricuas Wa Mere (on called Wile examples of such incidences are very rare in reand BOD "voluntary divestitures) are not uncommon in Ameri 347ey Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES FORMS OF DIVESTMENT Divestment or divestitures effectively the opposite of merger. These may take ay ft fa ne forms: Straight Divestment Ia holding company selloff the shares of one ofits existing subsidiary books, elu ie management control itis referred to as straight divestment. i Sell offs A sell off involves one established business selling part of its operations (that Is ase fase to another established business, normally for cash. Generally, but not always, only the ane the operation are sold and not the liabilities which remain withthe seller who sees thease of the proceeds of sale of assets, Spin-offs A Spin off, also known as demerger, differs from a sell off in one significant aspect. These. areets to be sold are put together as a unit which is incorporated as a company and then sé offas a company, ie its shares are sold rather than the individual assets This sso dif fon Straight divestment in the sense that spin-off involves setting up a new company to own i Sperate the set of asets being sold whereas under straight divestment, the company being already exists and hi 'as an operational history. Spin-off may be done in one or more stages It certain cases, a group may first get a new company formed and make a nominal public ise Feasenatecrdet to Set its share price. Once the share price of the new company tech! reasonable level, the selling company may offload all or majority of its shares either throu stock exchange or private placement. Such a form Of spin-offs referred to as Equity CarveOit Management Buy Outs as wanagers when Esso sold off its Pakistani operations, Now Es” own to be a huge industrial group in its, : ‘Management Buy Ins ‘were managers in compat oid the project, such a transaction would by the company being sold) join hands together called a Management Buy In or MBI. Leveraged Buy Outs oe pare ern cases of MBO and MBI, managers are notable to raise sufcien cash be Project being sold (or spun off). The selling company may then agree to offer them lon 348, A Chapter 15 MERGERS, ACQUISITIONS & oIvestiTuRES the purchase, or arrange funding for them fro tg so or by offering its guarantee tothe asa with Divestitures js, which the buying team undertakes to pay off from, ed funds, y th orn jeover called Leveraged Buy Out or LB, se 'm a financial ins tution tho lender. Thus the purchase ca Bede purchase i funded by ' earnings of the project ems divest is no less important than a decision to ac ( quire new companies. It needs abou rae degree of preparation and ground work, includ anne ing due diligence, ascertainment of sie ‘sale price of shares, reorganization of staff, etc. as oe io: carried out when a major merger is Some ofthe problems or issues that may be encoun estar tered in the process of divestiture are _ uation problems associated with setting the price ofthe unit being sold off , Nonavalability of willing buyer who are capable of making the requisite investment in the company being sold off. - Possibility oflosing a key asset. Ofte, itis not possible to carry out piece-meal divestment while it is equally difficult to find one buyer to buy all the assets that are deemed surplus by the selling company. t Divestment decision is a strate foow problem, gic decision. It should not be made to solve a temporary cash ‘ Vacompany sell a set of its assets, without selling the attached liabilities, itis possible that the ‘ash received from divestment may be used elsewhere while the company is left with the ‘abies to service in the future. This may place unnecessary strain on future cash flows. ems {introduced in the chay akeovers, acquisitions gers, absorptions ealeamations jeval integration conta integration qelomerate integration nomies of scale Syme ShP approach to acquisition Dre diligence patibility audit Reconciliation Au Management shares Defense strategy against takeover Golden parachute Poison pill Divestiture selloff in off Rlaragenes 5001 ‘Management Buy In Leveraged Buy Out15 MERGERS, ACQUISITIONS & DIVESTITURES, Chapter QUESTIONS 10, rrr 2 13, 4 15, 16. in business? Why is growth necessary even to stay saplain the diference between internal and external growth, Giveexampls fg, plain , How does a takeover differ from a merger? How does a merger differ from an amalgamation? Discuss the relative advantages of acquisition, merger and amalgamation, yyy situations would each mode be of greater relevance? How does vertical integration differ from horizontal integration? Give examples. What are the principle reasons for conglomerate integration? Discuss the reasons for business combinations. Discuss the issues and problems related to acquisi 1s. How may an acquiring company pay the shareholders of the target company? How may raise finances to pay them? Brel discuss the various modes of share-exchange in the event of settlement Purchase price through issue of buyer's shares, ‘What is meant by divestment or divestiture? plain the difference between sell ff and spin oft How does an MBO differ from an MBI? ‘Oran LBO? Why may a divesting company encourage MBO and offer assistance in arranging hats meantby ue diligence? Who does it? When? Why? 350- cose Sad sind 2 AeLABORAT Chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES inate Limited Company ‘ORIES LIMITED ypeeigten years old Rafagat Ahmedeen Yazdanlanded in England to pursue a fist degree in ene gwpevienced considerable problems in making friends at his university. He soon meets that the mal impediment to friendship was his name. His colleagues from England, Sec mapean countries and even from Far East found it difficult to pronounce his name, which (Gthem to shy away from his company. So Rafagat Ahmedeen Yazdani became R.A. Yandank lethot much later that the penny dropped, and he adopted RAY, or Ray, as his name. His Fenuships soon flourished, This ls one marketing lesson that he never forgot. When he returned to Pakistan after six or so years, with a degree in pharmacy and another in management, he was simply Ray. His original name was confined only to his formal documents. Every one called him Ray. Even his family in Pakistan started calling him Ray. Acareer in civil service Against his personal preference, Ray was forced by his rather dominating father to sit for and pass with distinction the CSP examination. He joined the civil service and while he did well, rising to the rank of deputy secretary in the Ministry of Health within fourteen years, his heart never belonged there. He considered himself a scientist at heart whose personality was being suffocated by the stifing atmosphere of civil service. So when his father died in 1996, he promptly resigned from the ‘Sovernmentto venture on his own, fclentist joins the Business World Weld his share of ancestral land, took a loan from a bank headed by a friend, and bought a Pharmaceutical company that was running in a loss at the time. He was able to get itat a fairly low Brice but had to spend considerable funds on balancing and modernizing its plant. Ile renamed the SiPany, Ray Laboratories Private Ltd. (RLL). The first three years were pure hell, but through eater hard work, some smart decisions and efficient management, Ray was able to rebuild his "many and to take it to near the top of the local pharmaceutical companies pyramid. Despite his connections in the civil service, and his excellent inter-personal skills, Ray had to work to make his company a success story in the face of stif competition in a market by foreign ci "s. He never compromised on quality, kept his margins within centage of his total operational income on research and development, which started paying off Nao" enough. His company developed a number of new medical formulations. He gave very simple Mes to his products — to ensure their instant recognition and remembrance, This helped his oo ""pany win alot of loyalty among user. dominated Seb fPes public ars after a orator cor equiring Ray Labora ™Pany. A year later he got it listed at converted into public limited jes Private Ltd. he Got Mange and made a massive public ‘the Karachi Stock Exchant 7 @chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES later, ie. at the end of 2013, the Expansion throu; ification products seems to offer litle scope for expansion, so the best way forward for his diversification. One line that his advisory team feels would be an excellent field to expand int manufacturing of disposable medical supplies like infasfons, drips, solutions, disposable syringes etc. It was recommended that instead of setting up a new plant for this purpose, he should buy existing company that specializes in this line of products. Identification ofa target company One such company, Himaliya Pharma Private Ltd, has been identified. It is based in Kahuta Industrial Area, near Islamabad. Ray formed a team of three persons, one each from finance Production and marketing departments to develop a proposal. The team, headed by Qasim Mali, (the finance director of Ray Laboratories) visited the plant and felt that with good management and 8 dose of capital for upgrading certain machines, it can be turned into a fine outfit. They also went ‘through the financial reports forthe past few years which showed that the company had incurred net loss in each of the last three years. Given the relatively stable market situation in the Pharmaceutical industry and general positivity about the economy of the country, Qasim Malik was 204 able to fathom the true reasons for company’s dismal performance over the recent past. The fiblanations offered by the sellers like lack of additional capital appeared less than satisfactory clusion that with astute financial management, the r. establishment of a emall internal ait section tit fe the reliability and accuracy of financial and co Disillusioned work force While they did not hire a lawyer or a HR co company, the sam tore ht te oi a he pny a rte a Nm welcome a changy beared unmotivated, were worried abert thee Job cecorty and tel welcome a change in ownership of the company, However, no grounds existed to assure the longevity of the honeymoon. There were five legal cases filed by present and past employ" ~ three in labor court and the others in Islamabad La sons had let the company during the past three => 352yo however workers appeared quite united, mainly due to factory During his second visit to the factory, Qasim Malik was appr ndany claimed to be qe bresenting the majority of, if not all the ir their desire to work even harder in the face fable again. But they wanted some categorical assure gabe 2 Service will not be negatively altered, They im that cea sea otfand oe wed were no longer in the company, had been invol Chapter 15 MERGERS, ACQUISITIONS & oIVesTTTURES the common fear of «! roached by a group of " tal problems lnaldtion, there was a legal wrangle about the rightful title to aetna tees uets insisted that the case against the company is ure fabrication with no tithood of success, they were not prepared to give any written ‘warranty in this regard, The team vant through the case file and also discussed it with the law firm aye was representing the sagan atthe court. They appeared satisfied with the views put forward by the sellers and did not ‘SSonlncluding any particular clause in the share purchase agreement arog this land dispute, Helpful Bank fyand Qasim Malik met the branch manager and regional chief of Pak Industrial Bank, the vider of the long term I Noa oan to the company. They had a fruitful meeting. While the bank did see orate off any loan or outstanding interest they did eflerta reschedule the loan, so that next eeaygt Wil not be due for another two years, The long tore lose carries a fixed rate of interest ferest rate for similar debts isin the region of 14.259. The interest {iim Malik did not discuss th 2 bed acquired the compa ie interest rates at this stage. He felt he will broach the subject after. "eduction of. ny and showed some good financial performance. He expected a ‘least 2% in interest rates applicable to both the long term loan and overdra cluded in the er materials for were goi i actually represents import value of editors is an amount of Rs 4.53 million which actually $52200. The curren exchange ate was inthe region of 102 perdalan tase ing to be a regular feature of their business. h "paring an offer e current owners of Himaliya 2 as asked his team to prepare a reasonable offer to be putt the current umes of Himaly nape Private Ltd, He plans to buy all the shares and retin the company as 2 wholly owned deta Of Ray Laboratories Led atleast for the nest ive Ye The eer ofthe company have Lint their wilingness to accept 50% of the total purchase pric nthe form of "Fatories, and the rest in cash. However, the basis of valuat vsexqlon J various aspects ofthe acquisition etm ha been meeting fo the las to weeks examining the various arco vg that in addition to the purchase price, hey wi A ae sodas were “Sth unt viable Some of i commendations BCs 353os chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES smpany, increasing its pald u .r Rs 20 million into the company, increasi P capital ty milion, The adtions cachines to enable the firm print its own packaging material ee? complete et of Prt il signicandly improve the marketability of ther produc, te them aunch some new lines of products. ‘They wi rename the company as Ray Medical Support Products Private Ltd but let i opr asa private limited company. ‘The team members are very optimistic that their combined technical experience and hard wo vwll soon bear fruits. They have addressed the employees of the company and assured them oft only continued service, but also improvement in terms of employment in very near future. The team’s optimism is somewhat clouded by Ray's concern at the risks that are being assumed and tie ‘magnitude of problems that lie ahead, The financial statements of Ray Laboratories and Himaliya Pharma are given as exhibits, Exhibit A: Income Statements of Ray Laboratories Ltd [or the year 2010 2011 2012 Rs'000 Rs'000_ Rs'000. Sales. 2,062,588 2,190,629 2,655,333 Cost of Goods Sold 1,526,315 1,621,065 1,964,947 Gross Profit $36,273 369,563 90387 Other Income 91304 93394 10516 Gross Operating Profit (THe s7a9s7 10088) Administration Overheads 16653 Marketing Overhede isizio tose 58 Research and Development 45,210 35,650 mat Financial Overheads 12:50 10,800 sas Total Overheads 370347 39727 (8188 let ot Retro (aso eS eh-warhingl 56,540 59,900 300 Profit after Tax ¢ 31.780 se Poul eee ae Retained Earnings forthe year 2378 41,780 08 Retained Earnings b/f 3 aiz420__ 35500) Retained Earnings ¢/f 283.640 : 2 i 312,420 354,200 384vy Chapter 15 MERGERS, ACQUISITIONS & DIVEST Times, Exhibit B Balance Sheet of Ray Laboratories fat the end of 72010 2011 2012 = Rs'000 ‘000 Rs'000_ “land Bldgs 54.240 51,540 49.478 fan Machinery 684,520 698,200 677,254 er Fined Assets 21,450 23,600 25,488 ‘Teal Fed Assets 760,210 773,340 752,220 sees in Trade 212,400 233,640 252,331 Trade Receivables 145,300 162,736 180,637 Shut Term investments 85,400 85,400 95,600 Ghat Bank & in hand 11,450 8,884 11611 Teal Current Assets 454,550 490,660 540,179 Toalassets Stare Capital 450,000 450,000 450,000 Reserves 312,420 354,200 428,500 Total Equity 762,420 804.200 878,500 long Term Debts 100,000 70,000 40,000 Trade Payables 204,640 311,450 322,500 ther payables 67,700 78,350 51,400 Total Current Liabilities 352,340 389,800, 373,900 Total Equity & Liabilities (aia 760 264000 —a350 00chapter 15 MERGERS, ACQUISITIONS & DIVESTITURES Exhibit C: salance Sheet of Himaliya Pharma on the date of ac uisition Land (leasehold, 124 years remaining) . Buildings, a cost, no depreciation provided = Plant and Machinery, net of depreciation imo Vehicles, furniture & fittings, etc, net of depreciation aay Total fixed assets 270, Stocks 44,000 Trade Receivables 2,600 Prepayments and deposits 24,300 Cash at Bank and in hand 2,300 Total assets 800 7000 Paid up share capital, ordinary shares of Rs Rs'000 Retained earnings id cteekea 32,400 Equity 1.200 Long Term Loan, inclusive of unpaid 31,200 ‘Trade payables and accruals paid accrued interest 25,400 Bank overdraft 11,100 Total Liabilities 16300 74000 QUESTIONS FOR DISCUSSION 1. Based purel ly on the available inf financial perform: inform, how would you explain the less than sati sfactory performance ofthe target company over its recent past? os 2. What points should thea Paints should be specifically covered in the Due Diligence exercise to be carried out by 3. What risks are at sk ar being assumed by Ray Laboratories? Which of these risks are inevitable and ey cover, eliminate or minimize the impact of those risks? 4. Which: of the risks faced by Himaliya Pharma Ltd are avoidable? What would be your advice °° ‘such risks? How should Ray Laboratories handle these risks? 5. What wo os ~ bd be a fair acquisition price for Ray Laboratories Ltd to pay for Himaliya Pharma? Assuming that Ray Laboratories agree to stile S0% ofthe purchase price through ss ofits ares, how would you value RLL shares for this purpose? 6 How may Ray Laboratories raise funds to finance this acquisition? 356