MSIN0224

Corporate
Finance
Practices
Lecture 7 - ASYNC

Mergers, reverse mergers and acquisitions

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 Session 7
Topic: Mergers, reverse mergers and acquisitions
• Definitions: mergers, reverse mergers & acquisitions
• Mergers:
– Types of mergers
– Why do companies merge?
– The acquisition purchase premium (APP)
– Merger waves and (bull) markets
– The seven keys to merger success
• Acquisitions
– Main challenges in an acquisition process
– Valuing synergies

Readings
• Book. The seven keys to merger success. Masterminding the Deal: Breakthroughs in M&A
Strategy & Analysis, London and Philadelphia, Kogan Page, ISBN 978 0 7494 6952 8 / E-ISBN
978 0 7494 6953. Clark, Peter J. & Mills, Roger W. (2013). Please read Chapter 8.
• Slides

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Campillo

2
Acquisitions: main
challenges

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Acquisition challenges - 1
• McKinsey and Co. has examined acquisition
programmes at companies on:
— Did the return on capital invested in
acquisitions exceed the cost of capital?
— Did the acquisitions help the parent
companies outperform the competition?

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 Acquisition challenges - 2
Half of all programs failed one test, and a quarter failed both.
• Synergy is elusive. KPMG in a more recent study of global acquisitions concludes
that most mergers (>80%) fail. Merged companies do worse than their peer group.
• A large number of acquisitions that are reversed within fairly short time periods.
About 20% of the acquisitions made between 1982 and 1986 were divested by
1988.
• In studies that have tracked acquisitions for longer time periods (ten years or more)
the divestiture rate of acquisitions rises to almost 50%.

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 Acquisition challenges - 3

• It seems to be a loser’s game as firms that grow through

acquisitions have generally had far more trouble creating
value than firms that grow through internal investments.
• In general, acquiring firms tend to:
— Pay too much for target firms
— Over estimate the value of “synergy” and “control”
• Have a difficult time delivering the promised benefits
• The same mistakes are made over and over again, often by
the same firms with the same advisors. There is something
structurally wrong with the process for acquisitions which is
feeding into the mistakes.

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 Wrap up on challenges
• Mergers and acquisitions are technically different.
• Deals are paid for using cash, stock, or a combination.
• M&A activity comes in waves.
• M&A waves are divided into four phases.
• Acquiring companies normally pay a premium for the
target.
• Often but not always, shares of the target rise after deal
announcement, while those of acquirer fall.

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Four alternative merger
valuation methods

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Merger valuation methods - 1

Source: Masterminding the deal – chapter 3

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Merger valuation methods - 2

Source: Masterminding the deal – chapter 3

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Sinergy
Assume that you are told that the combined firm
will be less risky than the two individual firms and
that it should have a lower cost of capital (and a
higher value). Is this likely?
• Assume now that you are told that there are
potential growth and cost savings synergies in the
acquisition. Would that increase the value of the
target firm?
• Should you pay this as a premium?

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The Value of Synergy -1

Source: Damodaran

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 The Value of Synergy - 2
1) The firms involved in the merger are valued independently,
by discounting expected cash flows to each firm at the
weighted average cost of capital for that firm.
2) The value of the combined firm, with no synergy, is the sum
of the values obtained for each firm in the first step.
3) The effects of synergy are built into expected growth rates
and cash flows, and the combined firm is re-valued with
synergy.
4) Value of Synergy = Value of the combined firm, with
synergy - Value of the combined firm, without synergy

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 Synergies
• Studies on synergies have concluded that you are far more likely to deliver cost
synergies than growth synergies.
• Synergies that are concrete and planned for are more likely to be delivered than
fuzzy synergies.
• Synergy is much more likely to show up when someone is held responsible for
delivering the synergy.
• You are more likely to get a share of the synergy gains in an acquisition when you
are a single bidder than if you are one of multiple bidders.

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Example 1: P&G –Gillette merger (2005)

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 P&G – Gillette deal

• On 26th January 2005 the share price of Gillette was $45.

• The share price of P&G was $55.04.
• P&G paid $ 53.66 for each share of Gillette, a 18% premium!
• P&G paid $57 billion in 2005 for Gillette.

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 Maximum price to pay in an M&A
deal

1. Target company market cap and/or DCF valuation if private

2. Value of control = Target company value after improvements
3. The value of control and the value of the synergy are not the same!
1. The value of the synergy belongs to the combined firm (merge).
2. The value of control is based on improvements in the target firm only (A)
4. Consider the time to realise control and synergies

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The seven sins in
acquisitions

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The 7 sins in acquisitions
1. Risk transference: attributing acquiring company risk
characteristics to the target firm.
2. Debt subsidies: subsiding target firm stockholders for the
strengths of the acquiring firm.
3. Auto-pilot control: the “20% control premium” and other
myths.
4. Elusive synergy: misidentifying and mis-valuing synergy.
5. Its all relative: transaction multiples, exit multiples.
6. Verdict first, trial afterwards: price first, valuation to follow
7. Not my fault: no one held responsible for delivering results.

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1. Risk transference
• Your target firm has a cost of equity of 20%. You,
the acquirer are a more stable company with cost
of funding 10%. How should you measure the risk
of this acquisition?
• The cost of equity used for an investment should reflect
the risk of the investment and not the risk
characteristics of the investor who raised the funds.
• Risky businesses cannot become safe just because the
buyer of these businesses is in a safe business.

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2. Debt subsidies
• As an acquiring firm, it is entirely possible that
you can borrow much more than the target
firm can on its own and at a much lower rate.
If you build these characteristics into the
valuation of the target firm, you are
essentially transferring wealth from your
firm’s stockholder to the target firm’s
stockholders.
• When valuing a target firm, use a cost of
capital that reflects the debt capacity and the
cost of debt that would apply to the firm.

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 3. Auto-pilot control
• Assume that you are now told that it is conventional to pay
a 20% premium for control in acquisitions (backed up by
FactSet Mergerstat). How much would you be willing to pay
for the target firm?
• Would your answer change if I told you that you can run the
target firm better and that if you do, you will be able to
generate a 30% pre-tax operating margin (rather than the
20% margin that is currently being earned).
• What if the target firm were perfectly run?

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4. Synergy
• Please go back to slide 61 for details about
synergies.

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5. Don´t be a Lemming - 1
• You are told that an analysis of other acquisitions reveals
that acquirers have been willing to pay 5 times EBIT. Your
target firm has EBIT of $20 million, would you be willing
to pay $100 million for the acquisition?
• What if I estimate the terminal value using an exit
multiple of 5 times EBIT?
• As an additional input, your investment banker tells you
that the acquisition is accretive. (Your PE ratio is 20
whereas the PE ratio of the target is only 10. Therefore,
you will get a jump in earnings per share after the
acquisition).

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5. Don´t be a Lemming - 2
• Basing what you pay on what other
acquirers have paid is a recipe for
disaster. Acquirers typically overpay for
targets. Matching their prices risks
replicating their mistakes.
• You may be basing the prices we pay on
firms that are not truly comparable.
• When using exit multiples, we assume
the market will continue to pay in the
future what it is paying for comparable
companies today.
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5. Don´t be a Lemming - 3
Often, acquisitions are justified by one of two arguments:
— Every one else in your sector is doing acquisitions. You
have to do the same to survive.
— The value of a target firm is based upon what others
have paid on acquisitions, which may be much higher
than what your estimate of value for the firm is.

• With the right set of comparable firms, you can justify

almost any price.
• EPS accretion is a meaningless measure and does not
add value. It occurs when target’s PE is lower than
buyer’s.

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 6. Price first, valuation to follow- 1
• Now assume that you know that the CEO of the
acquiring firm really, really wants to do this
acquisition and that the investment bankers on
both sides have produced fairness opinions that
indicate that the firm is worth $100 million.
• You are told that your competitors are all doing
acquisitions and that if you don’t do them, you
will be at a disadvantage? Would you be willing to
go along?

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6. Price first, valuation to follow- 2
• If you define your objective in a bidding war as
winning the auction at any cost, you will win. But
beware of the winner’s curse.
• The premiums paid on acquisitions often have
nothing to do with synergy, control or strategic
considerations (though they may be provided as
the reasons). They may just reflect the egos of the
CEOs of the acquiring firms. There is evidence that
“over confident” CEOs are more likely to make
acquisitions and that they leave a trail across the
firms that they run.

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 Example: HP & Autonomy

• HP acquired Autonomy, a UK-based business software company, for $11.1 billion in

2011.

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H.P. CEO
In the face of almost universal feeling that HP had paid too much for
Autonomy, Leo Apotheker, the CEO, addressing a conference at the time
of the deal:

“We have a pretty rigorous process inside H.P. that we follow for all our
acquisitions, which is a D.C.F.-based model,” he said, in a reference to
discounted cash flow, a standard valuation methodology. “And we try to
take a very conservative view.”

“Just to make sure everybody understands, Autonomy will be, on Day 1,

accretive to H.P..... “Just take it from us. We did that analysis at great
length, in great detail, and we feel that we paid a very fair price for
Autonomy. And it will give a great return to our shareholders.

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About a year later..

About a year later, HP announced that it was writing off almost $8.9 billion off its original deal
value and claimed that Autonomy had cooked the books. The CEO was fired with a payment of
around $13 million (severance package + shares) while HP market cap lost more than $30 billion.

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7. Not my fault
• Don’t let size or hubris drive you to “expand” a successful
acquisition strategy you may have.
• Realizable plans for delivering synergy and control have to
be put in place before the merger is completed. The time
frame should reflect the reality that integration takes
time.
• The best thing to do in a bidding war is to drop out.
• Someone (the person pushing hardest for the merger)
should be held to account for delivering the benefits.
• The compensation for investment bankers and others
involved in the deal should be tied to deal success.

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The seven keys to
merger success

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The 7 keys to merger success - 1
1. Following the right merger success criteria
2. Optimal timing within the merger cycle
3. Exploiting superior understanding of merger
segmentation
4. Adhering to absolute and relative limits to APPs
Read them in detail on Chapter 8
@ Materminding the deal
(Moodle)

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The 7 keys to merger success -2
5. Bid pricing integrated with in-depth four synergy
type PMI investigation.
6. Synergy elements: real distinguished from vapor,
offsets included.
7. Avoidance of transactions by “wounded quali”
acquirers, overreaching egos.
Read them in detail on Chapter 8
@ Materminding the deal
(Moodle)

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Merger waves

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Brief History of M&A -1
• Most histories of M&A begin in the late 19th U.S.
However, mergers coincide historically with the
existence of companies.
• In 1708, for example, the East India Company
merged with a former competitor to restore its
monopoly over Indian trade.
• In 1784, the Italian Monte dei Paschi and Monte Pio
banks were united as the Monti Reuniti.
• In 1821, the Hudson's Bay Company (incorporated
in 1670) merged with the rival North West
Company.

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Brief History of M&A -2
• History of merger waves in the US consists of
seven major waves.
• Through each of the waves, the trend of
corporate restructuring varied according to
the prevailing regulatory landscape or the
ongoing stage of technological evolution.

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 Seven waives

Period Name Facet

1897–1904 First Wave Horizontal mergers
1916–1929 Second Wave Vertical mergers
1965–1969 Third Wave Diversified conglomerate mergers

1981–1989 Fourth Wave Congeneric mergers; Hostile takeovers;

Corporate Raiding
1993–2000 Fifth Wave Cross-border mergers
2003–2008 Sixth Wave Shareholder Activism, Private Equity,
LBO
2011-? Seventh Wave Social Media, Internet, Information
Technology, Tax Inversion

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First Wave (1897-1904) -1
• The first wave of M&A came to be known as
the “great merger movement”, particularly
the manufacturing sector. This wave was
characterized by horizontal mergers, where
competitors or rivals combine together,
aiming for more efficient economies of scale.
This was particularly attractive to companies
that wanted to establish monopolies.

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First Wave (1897-1904) -2
• The period between 1893 and 1904, and
immediately before the beginning of World
War I, saw the rise of manufacturing and
transportation giants in the United States,
particularly in the industries of steel, oil,
mining and railroads. The telephone industry
also benefited from horizontal mergers.

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First Wave (1897-1904) -3
• The prime examples of horizontal integration during
the first wave included:
• Standard Oil Company of New Jersey (1899).
• United States Steel Corporation (1901). It was founded in
1901 by merger of Carnegie Steel Company, Federal Steel
Company, National Steel Company and J.P. Morgan. This
made it the largest corporation in the world at the time.
• International Harvester Corporation (1902). IHC is a prime
American manufacturer of machinery and equipment for
agricultural and construction purposes, and commercial and
household products.

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Second Wave (1916-1929) -1
• The second wave saw the rise in vertical mergers
(1916-1929) following the government intervening
and enacting laws that ban or prohibit what they
referred to as “anticompetitive behavior”. Case in
point: the Standard Oil Company was ruled as an
illegal monopoly by the US Supreme Court in 1911.
• It led to the creation of oligopolies in the power, gas
and manufacturing industries.
• The purpose was to combine complementary
resources.

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 Second Wave (1916-1929) -2
• One effect of this M&A wave was oligopolies taking the
place of monopolies.
• This wave ended during the Great Depression and the
crash in 1929.
• The major players were automobile manufacturers, with
Ford and FIAT leading the pack.
• The oil and gas industry also adapted during the second
wave, as evidenced by the Standard Oil Company moving
from horizontal to vertical integration, expanding its
operations to oil refining, retailing and marketing.

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Third Wave (1965-1969) -1

• Expansion and diversification became the

main drivers of the decisions made by
companies, so they turned their attention to
conglomerate mergers and acquisitions.
• Conglomerate mergers and acquisitions
involve companies or corporations that
belong to various fields of business, often
unrelated to each other.

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 Third Wave (1965-1969) -2
• This Wave was spurred by the desire of US corporations to
enter new markets and diversify their revenue streams.
• Therefore, holding companies and conglomerates cropped
up left and right.
• It did not last long, however. The crash in share prices,
amplified by the oil crisis in the first part of the 1970s,
resulted in the end of the Third Wave.
• One of the major names that resulted during the Third
Wave was the General Electric Company.

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 Fourth Wave (1981-1989) -1
• The Fourth Wave (1981-1989) saw the arrival of
corporate raiders and hostile takeovers on the scene.
• “Corporate raider” refers to an investor or financier
who seeks to take control of a business by acquiring a
controlling interest, often in a less than congenial
manner.
• The term “hostile takeover”, which is a type of
acquisition or merger made without the wishes or
even the consent of the owners, shareholders, or
management of the company being acquired.

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 Fourth Wave (1981-1989) -2
• Underperforming companies faced hostile takeover bids, with
many as Leveraged Buyouts (LBOs).
• The end of the fourth wave came in 1989, when the banks
ended up lending too much, too often, and at high rates that
they were unable to sustain their capital structures.
• This was aggravated even more by the crash of the stock
market in 1987.
• This wave ended with indictments (Milken, Boesky),
bankruptcies (Drexel, Burnham, Lambert), and the Gulf War.

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Fifth Wave (1993-2000) -1
• The fifth wave (1992-2000) was inspired by technological changes,
globalization, stock market boom and deregulation.
• The ‘90s welcomed the entry of the “mega deals”, leading to the
creation of multinational companies and conglomerates.
• As such, foreign investors began entering the US market (and vice
versa) leading to “cross-border mergers”.
• This wave took place largely in the banking and
telecommunications industries.

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Fifth Wave (1993-2000) -2
• Notable Fifth Wave mergers include Vodafone AirTouch
purchase of Mannesman in 1999, the merger of Exxon and
Mobil, the merger of Glaxo Wellcome and SmithKline
Beecham, the historic merger of Daimler and Chrysler, and
Ford’s acquisition of Volvo.
• The deals were mostly equity rather than debt financed.
• The mergers were driven by long term profit motives.
• This wave ended with the bubble in the stock market
bursting.

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 Sixth Wave (2003-2008) -1
• The sixth wave (2003-2008) was marked by the
proliferation of M&A activities and the creation of
large corporations equipped to take on global
competition.
• Leveraged Buyouts (LBOs) also became prevalent.
These are mergers or acquisitions where the
acquiring company borrows money in order to meet
the cost of acquiring its target company, allowing
them to make acquisitions or mergers without the
need to commit a large amount of capital.

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 Sixth Wave (2003-2008) -2
• Shareholders became more involved, leading to
shareholder activism, where they displayed more influence
and power over the actions and behavior of a corporation.
• Globalization became a key point in acquisitions and
mergers, and more and more companies – even the larger
and already established corporations – are more intent on
expanding their reach to multinational and global markets.
• The sixth wave came to a screeching halt in the wake of the
global financial crisis in 2008.

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 Seventh Wave (2011-2020) -1
• Driven mostly by zero interest rates and quantitative easing.
• Combinations including Dow Chemical and DuPont, and
Kraft and Heinz.
• The health-care industry became addicted to “tax
inversions”, with American firms taking over European ones
to shift their legal domicile and cut their tax bill.
• The $120bn purchase by Anheuser-Busch InBev of SABMiller
will create a beer monster that sells almost one in three
bottles emptied around the world.

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The Last Four Waves

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Thank you

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