Lessons 18

LESSONS 18
FIRM GROWTH & VALUE CREATION
Gimede Gigante Università Commerciale Luigi Bocconi

AGENDA
FIRM GROWTH & VALUE CREATION
(a) Why Grow Externally? (b) The Basics of M&A

– Takeover Methods
– What is M&A?
– A Classification Scheme of M&A
– The Goal of a Firm
– Sensible reasons for mergers
– How to Growth
– Dubious reasons for mergers
– Why Growth Externally
– Estimating mergers gains & costs
– Tips for a successful M&A

WHAT IS M&A?
M&A IS A BROAD TERM ENCOMPASSING VARIOUS TYPES OF TRANSACTIONS
M&A can be considered any process where the ultimate beneficial ownership, and
the respective control of a firm, are transferred from a subject (or a group of
subjects) to another
Acquiring Company Acquired Company
Acquires Control Loses Control
Bidder Target Seller(s)

Consideration
Various Dimensions of the M&A Transactions

Objectives Consideration Financing Status of the Target
 Strategic: Bidder is a  Statutory Merger: Target is  Cash: Bidder pays  Debt Financing:  Private: Target is sold
corporate which executes merged into Bidder and Seller(s) in cash Consideration is financed through a private
the M&A transaction to ceases to exists through cash on balance transaction, between
accomplish its own  Equity: Bidder pays sheet or raising debt Bidder and Seller(s)
 Acquisition of Target: Target
corporate objectives Seller(s) with its own
continues to exists as a  Public (Tender Offer):
shares, in exchange of  Equity Financing:
subsidiary of the bidder A public offer to buy
 Financial: Bidder is a the shares of the Consideration is financed
Financial Investor (PEs,  Acquisition of Assets: Target raising equity (e.g. Right shares is made by the
HFs, the management Target’s Assets transferred Issue) Bidder directly to Target’s
etc.) looking for a to the Bidder  Mixed: Bidder pays shareholders
targeted financial return Seller(s) with a mix of
cash and of its own
shares
 An M&A transaction can be shaped in various forms, with different characteristics, depending
on the combination of the above options

THE GOAL OF A FIRM
VALUE CREATION OBJECTIVE
The Goal of a Firm

 Objective of a Firm is to maximize value for stakeholders (including its shareholders)
― Value of shareholders is the NPV of future Cash Flows to the equity
― To create value, Firm should generate higher returns than the market
Value Creation Options

Growth
Increase Size
of the Firm  Potentially limitless subject to
availability of growth options
 Requires expansion of the
Increase Cash Flows to  Organic (Internal) Growth
business
Shareholders  External Growth
Increase Size Margin Improvements Capex

Discipline
of the Firm  Easier / Quicker to implement
Maximize Cash Flows to  Capped
Shareholders given a certain “Size”
of the Firm

HOW TO GROW?
Growth Strategies
Growth
Internal / Organic External
 Increase production capacity  M&A Transactions

 Expand distribution platforms ―Mergers
 Innovation / Product mix ―Acquisitions
 Commercial Strategy / ―JVs
Marketing
 M&A is an alternative form of investment to fuel the growth of a company with respect to
organic / internal development. Selection between the two alternatives should be based on cost
benefit analysis and execution risks assessment (“Make or Buy” decisions). Many of the most
successful growth strategies have showed that the two strategies are more complementary than
antagonists
WHY GROW EXTERNALLY?
Reasons for M&A
Get access to
new market/
geographies/
products
A
Consolidate
market/
competitive
position
B
Rationalise
value chain /
vertical deals
C

TAKEOVER METHODS
I. Merger
II. Consolidation
III. Tender Offer
IV. Acquisition of Assets
V. Leveraged Buy-Out (Management Buy-Out)

TAKEOVER METHODS
Company «A» Company «B»
MERGER
Company «A»

TAKEOVER METHODS

TAKEOVER METHODS
The combination of two or more firms into an entirely

new firm. The old firms cease to exist
 Target is evaluated by the acquirer

 Terms are agreed upon (a sort of romantic
marriage)
 Ratified by the respective boards
 Approved by a majority (usually two-thirds) of
shareholders from both firms

TAKEOVER METHODS
Company «A» Company «B»
CONSOLIDATION
New Company «C»

TAKEOVER METHODS
+ =

TAKEOVER METHODS
An offer to buy current shareholders’ stock at

a specified price, often with the objective of
gaining control of the company. The offer is
often made by another company and usually
for more than the present market price.
 Allows the acquiring company to bypass

the management of the company it
wishes to acquire.
TAKEOVER METHODS
 It is not possible to surprise another company

with its acquisition because the watchdog
authority (SEC/CONSOB) requires extensive
disclosure
 The tender offer is usually communicated
through financial newspapers and direct
mailings if shareholder lists can be obtained in
a timely manner.
 A two-tier offer may be made with the first tier
receiving more favorable terms.

TAKEOVER METHODS
Two-tier Tender Offer – Occurs when the

bidder offers a superior first-tier price (e.g.,
higher amount or all cash) for a specified
maximum number (or percent) of shares and
simultaneously offers to acquire the
remaining shares at a second-tier price
 Increases the likelihood of

success in gaining control of the
target firm.
TAKEOVER METHODS
One firm can acquire another by buying all of

its assets
 A formal vote of the shareholders of the selling firm is

required
 Advantage of this approach: it avoids the potential
problem of having minority shareholders that may
occur in an acquisition of stock
 Disadvantage of this approach: it involves a costly
legal process of transferring title
TAKEOVER METHODS
A primarily debt financed purchase of all the

stock or assets of a company, subsidiary, or
division by an investor group
 The debt is secured by the assets of the enterprise

involved. Thus, this method is generally used with
capital-intensive businesses.
 A management buyout is an LBO in which the pre-
buyout management ends up with a substantial
equity position.
TAKEOVER METHODS
The Process of an Acquisition
Friendly Acquisition -- The managers of the target

firm welcome the acquisition and, in some cases,
seek it out
Hostile Acquisition -- The target firm’s management

does not want to be acquired. The acquiring firm
offers a price higher than the target firm’s market
price prior to the acquisition and invites
stockholders in the target firm to tender their
shares for the price
TAKEOVER METHODS
The Process of an Acquisition (Method of Payment)
Acquisition Premium -- The difference between the acquisition

price and the market price (prior to the acquisition)
Acquisition Price (mergers and consolidations) -- The price

that will be paid by the acquiring firm for each of the target
firm’s shares.
Acquisition Price (tender offer) -- The price at which the acquiring

firm receives enough shares to gain control of the target firm.
This price may be higher than the initial price offered by the
acquirer, if there are other firms bidding for the same target firm
or if an insufficient number of stockholders tender at that initial
price.

TAKEOVER METHODS
 The Process of an Acquisition

TAKEOVER METHODS
Cash offering -- It may be cash from existing

acquirer balances or from a debt issue.
.
Securities offering -- Target shareholders receive
shares of common stock, preferred stock, or debt
of the acquirer. The exchange ratio determines the
number of securities received in exchange for a
share of target stock.

TAKEOVER METHODS
Cash offering
vs
Securities offering
Factors influencing method of payment:
 Sharing of risk among the acquirer and target
shareholders
 Signaling by the acquiring firm
 Governance

TAKEOVER METHODS
Merger Transactions
Cash only
Stock only
Cash and securities
Other securities
Copyright CFA Institute

TAKEOVER METHODS
The Process of an Acquisition (Tax Considerations)
At the time of acquisition, for the selling firm or its

shareholders, the transaction is:
 Taxable -- if payment is made by cash or with a
debt instrument.
 Tax-Free -- if payment made with voting preferred
or common stock and the transaction has a
“business purpose.” (Note: to be a tax-free
transaction a few more technical requirements
must be met that depend on whether the purchase
is for assets or the common stock of the acquired
firm.)
A CLASSIFICATION SCHEME FOR M&A DEALS
 Horizontal Merger:
– combinations of two (2) firms in the same line of business:
» ex. Bank of America’s acquisition of Merrill Lynch;
» Adidas and Reebok
 Vertical Merger:
– between companies operating in different stages of production:
» ex. Tele Atlas bought by Tom Tom;
» BskyB and Amstard
 Conglomerate Merger:
– between companies operating in unrelated businesses;
» ex. AOL’s – Time Warner;
– much less popular now

Direction Explanation
Forward + vertical Acquiring a business further up in the supply chain –
e.g. manufacturer buys a distributor.
Backward + vertical Acquiring a business operating earlier in the supply
chain – e.g. a retailer buys a wholesaler
Horizontal Acquiring a business at the same stage of the supply
chain – e.g. a manufacturer buys a
competitor
Conglomerate Where the acquisition has no clear
connection to the business buying it

A CLASSIFICATION SCHEME OF M&A DEALS

= CONGLOMERATE ACQUISITION

SENSIBLE REASONS FOR MERGERS (1/4)
 Economies of scale
» Just as most of us believe that we would be happier if only we were a little richer, so
managers always seem to believe their firm would be more competitive if only it
were just a little bigger
 Economies of vertical integration

» Large companies commonly like to gain as much control and coordination as possible
over the production process by expanding back toward the output of the raw material
and forward to the ultimate consumer. One way to achieve this is to merge with a
supplier or a customer. Vertical integration has fallen out of fashion recently. Many
companies are finding it more efficient to outsource many of their activities
 Complementary resources
» The small firm may have a unique product but lack the engineering and sales
organization necessary to produce and market it on a large scale. The firm could
develop engineering and sales talent from scratch, but it may be quicker and cheaper
to merge with a firm that already has ample talent. The two firms
have complementary resources

SENSIBLE REASONS FOR MERGERS
 Economies of scale:
– a larger firm may be able to reduce its per-unit cost by using excess capacity or
spreading fixed costs across more units;
– natural goal of horizontal mergers;
 Economies of vertical integration:
– occurs with a merger between a firm and one of its suppliers/customers;
– control over suppliers «may» reduce costs and increase efficiency;
– eases the firm’s coordination and administration;
– over-integration can cause the opposite effect;
 Complementary resources:
– merging may results in each firm filling in the «missing pieces» of their firm with
pieces from the other firm
– each firm has what the other one needs;

SENSIBLE REASONS FOR MERGERS (3/4)
 Surplus funds
» Suppose that your firm is in a mature industry. It is generating a substantial amount of
cash, but it has few profitable investment opportunities. Ideally such a firm should
distribute the surplus cash to shareholders by increasing its dividend payment or by
repurchasing its shares. Unfortunately, energetic managers are often reluctant to
shrink their firm in this way
 Eliminating inefficiencies
» Cash is not the only asset that can be wasted by poor management. There are
always firms with unexploited opportunities to cut costs and increase sales and
earnings. Such firms are natural candidates for acquisition by other firms with better
management
 Industry consolidation
» The biggest opportunities to improve efficiency seem to come in industries with too
many firms and too much capacity. These conditions force companies to cut capacity
and employment and release capital for reinvestment elsewhere in the economy. For
example, when U.S. defense budgets fell after the end of the Cold War, a round of
consolidating takeovers followed in the defense industry

SENSIBLE REASONS FOR MERGERS
 Surplus funds:
– if the firm is in a mature industry with few, if any, positive NPV projects available,
acquisition may be the best use of funds;
– firm with a cash surplus and a shortage of profitable investment opportunities often
turn to cash-financed mergers as a way of redeploying their capital;
 Eliminating inefficiencies:
– cost cuts generate increases in sales and earnings;
– firms with unexploited opportunities to cut costs/increase sales and earnings are
natural candidates for acquisitions by other firms with better management;
 Industry consolidation:
– industries with too many firms and too much capacity usually trigger waves of M&A;

DUBIOUS REASONS FOR MERGERS (1/6)
 Diversification
» We have suggested that the managers of a cash-rich company may prefer to see that
cash used for acquisitions. That is why we often see cash-rich firms in stagnant
industries merging their way into fresh woods and pastures new. But what about
diversification as an end in itself? It is obvious that diversification reduces risk. Isn’t
that a gain from merging?
 The «Bootstrap Game»
» Suppose that you manage a company enjoying a high price-earnings ratio. The
reason it is high is that investors anticipate rapid growth in future earnings. You
achieve this growth not by capital investment, product improvement, or increased
operating efficiency but by purchasing slow-growing firms with low price-earnings
ratios. The long-run result will be slower growth and a depressed price-earnings ratio,
but in the short run earnings per share can increase dramatically. If this fools
investors, you may be able to achieve the higher earnings per share without suffering
a decline in your price-earnings ratio. But in order to keep fooling investors, you must
continue to expand by merger at the same compound rate. Obviously you cannot do
this forever; one day expansion must slow down or stop. Then earnings growth will
cease, and your house of cards will fall.

DUBIOUS REASONS FOR MERGERS
 Diversification:
– easier/cheaper for stockholders than for the firm itself;
– investors should not pay a premium for diversification since they can do it
themselves;
– value additivity principle;
 The «Bootstrap Game»:

– acquiring firm has high P/E ratio;
– selling firm has low P/E ratio (due to low number of shares);
– after merger, acquiring firm has short-term EPS rise;
– long-term acquirer will have slower than normal EPS growth due to share dilution.

TIPS FOR A SUCCESSFUL M&A
INCREMENTAL
VALUE
MARGIN LISTEN YOUR

FOREVER ADVISORS
SELECTIVELY
TYPES
INTEGREGRATION OF
PLAN SYNERGIES

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LESSONS 18

FIRM GROWTH & VALUE CREATION

Gimede Gigante Università Commerciale Luigi Bocconi

(a) Why Grow Externally? (b) The Basics of M&A

– Tips for a successful M&A

Gimede Gigante Università Commerciale Luigi Bocconi

Acquires Control Loses Control

Bidder Target Seller(s)

Various Dimensions of the M&A Transactions

Gimede Gigante Università Commerciale Luigi Bocconi

The Goal of a Firm

Value Creation Options

Increase Size Margin Improvements Capex

Gimede Gigante Università Commerciale Luigi Bocconi

Internal / Organic External

 Increase production capacity  M&A Transactions

Reasons for M&A

Gimede Gigante Università Commerciale Luigi Bocconi

III. Tender Offer

IV. Acquisition of Assets

V. Leveraged Buy-Out (Management Buy-Out)

Gimede Gigante Università Commerciale Luigi Bocconi

Company «A» Company «B»

Gimede Gigante Università Commerciale Luigi Bocconi

Gimede Gigante Università Commerciale Luigi Bocconi

The combination of two or more firms into an entirely

 Target is evaluated by the acquirer

Gimede Gigante Università Commerciale Luigi Bocconi

Company «A» Company «B»

New Company «C»

Gimede Gigante Università Commerciale Luigi Bocconi

Gimede Gigante Università Commerciale Luigi Bocconi

An offer to buy current shareholders’ stock at

 Allows the acquiring company to bypass

 It is not possible to surprise another company

Gimede Gigante Università Commerciale Luigi Bocconi

Two-tier Tender Offer – Occurs when the

 Increases the likelihood of

One firm can acquire another by buying all of

 A formal vote of the shareholders of the selling firm is

A primarily debt financed purchase of all the

 The debt is secured by the assets of the enterprise

The Process of an Acquisition

Friendly Acquisition -- The managers of the target

Hostile Acquisition -- The target firm’s management

The Process of an Acquisition (Method of Payment)

Acquisition Premium -- The difference between the acquisition

Acquisition Price (mergers and consolidations) -- The price

Acquisition Price (tender offer) -- The price at which the acquiring

Gimede Gigante Università Commerciale Luigi Bocconi

 The Process of an Acquisition

Gimede Gigante Università Commerciale Luigi Bocconi

The Process of an Acquisition (Method of Payment)

Cash offering -- It may be cash from existing

Gimede Gigante Università Commerciale Luigi Bocconi

The Process of an Acquisition (Method of Payment)

Gimede Gigante Università Commerciale Luigi Bocconi

Cash and securities

Copyright CFA Institute

Gimede Gigante Università Commerciale Luigi Bocconi

The Process of an Acquisition (Tax Considerations)

At the time of acquisition, for the selling firm or its

– combinations of two (2) firms in the same line of business:

» ex. Bank of America’s acquisition of Merrill Lynch;