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Summary of the slides of the M&A elective of Finance & Investments.
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LECTURE 1Mergers vs. Acquisitions vs. Buy-outs
A firm can be acquired by:
- Another firm
o Merger – target firm becomes part of acquiring firm; stockholder approval needed
from both firms
o Consolidation – target and acquirer become new firm; stockholder approval needed
from both firms
o Tender offer – target firm continues to exist, as long as there are dissident
stockholders holding out. Successful tender offers ultimately become mergers. No
shareholder approval is needed
o Acquisition of assets – target firm remains as a shell company, but its assets are
transferred to the acquiring firm. Ultimately, the target firm is liquidated.
- Its own managers and outside investors
o Buy-out – target firm continues to exist, but as a private business. Buy-outs are
usually accomplished through a tender offer.
Mergers
In a merger, the target company ceases to exist as a separate entity. All its assets and liabilities are
assumed by the surviving entity.
- Requires the approval of at least 50% of the shareholders of each company.
- Generally, takes place between companies of more or less the same size.
In a consolidation, stocks of both companies are surrendered and new stocks in the name of the new
company are issued to the acquiring- and target firm shareholders.
A merger can be a:
- Horizontal merger – firms operating in similar lines of business (i.e. HP & Compaq)
- Vertical merger – firms related via the supply chain (AOL & Time Warner)
- Conglomerate merger – firms in unrelated business activity (Berkshire Hathaway)
Acquisitions
In an acquisition, the buyer purchases some or all of the assets or the stock of the selling firm. Tax
considerations, legal requirements and the ability to attain shareholder approval determine the type of
acquisition. An acquisition can be financed with cash or stock, and can be structured as:
- Purchase of stock
- Purchase of assets – unincorporated proprietorships can only be acquired via a purchase of
assets.
The acquisition strategy (i.e. purchase of stock or assets) has significant tax implications for both the
buying- and selling firm.
Purchase of Purchase of
Stock Assets
Taxable to seller at corporate level? No Yes
Taxable to seller shareholders? Yes Yes
Buyer can use target non-operating losses to reduce tax liability? Yes No
Buyer can step-up the tax basis of target’s assets for tax No Yes
purposes?
Buyer shielded from potential undisclosed liabilities? No Yes
Reassignment of contracts necessary? No Yes
Additional tax implications arise based on the method of payment. If paid in cash, it imposes
immediate tax liability for the seller shareholders. If paid with stock, seller shareholders may defer tax
liability until the point when they sell the stock. Depending on how the buyer wants to pay (cash or
,stock), sometimes there might only be one feasible arrangement (i.e. either purchase of stock or
purchase of assets).
Proceeds under Stock vs. Purchase-of-Assets
Proceeds under Stock=Purchase price−PersonalTaxRate∗¿
( Purchase Price−TargetShareholdersTaxBasisStock )
Proceeds under Assets=Purchase Price−CapitalGainsTaxAssets ( Corporate )
−CapitalGainsTaxes( Shareholder Level)
CapitalGainsTaxAssets=T c∗(Purchase Price−TargetTaxBaseAssets)
CapitalGainsTaxShareholders=PersonalTaxRate∗¿
( PurchasePrice−CapitalGainsTaxAssets−TargetShareHoldersTaxBasisStock )
Stepping-up tax basis
Basically, implies the tax savings as a result of amortization of goodwill. Goodwill is defined as:
Goodwill=Purchase Price−TargetTaxBaseAssets
Generally, goodwill is amortizable over 15(t) years, hence the per year tax savings (or the annual
value that can be stepped-up) can be calculated by:
Goodwill∗T c
AnnualStepUp=
t
The result is the PMT of an annuity, to calculate the present value of the step-up:
AnnualStepUp∗1−( 1+r )−t
PV of StepUp=
r
Leveraged Buy-Outs
A Leveraged Buy-out (LBO) is the acquisition and delisting of an entire company or division,
financed primarily with debt. The buyer is typically a private equity fund managed by a LBO sponsor.
The sponsor raises debt to finance the majority of the purchase price and contributes an equity
investment to the fund. The objective is to improve efficiency and grow revenue for a 3-5-year period
before divesting the firm.
Debt is paid down over time and excess returns accrue to the equity holders
The exit may be in the form of an IPO, a sale to strategic buyer, or a sale to another LBO
fund.
Characteristics of LBOs
- LBOs are cash, rather than stock purchases
- The cash is borrowed using the target’s assets and expected cash flows as collateral (asset
backed financing).
- Large increases in leverage (average debt to capital ratio increases from 20% to 70%).
- The end result of an LBO is that the target becomes a private company
- Most LBOs involve a purchase of a division of a firm or sub-unit rather than the entire firm.
LBO Financing
Financial sponsors in the form of limited partners contribute money to the private equity fund. The PE
fund uses this money to buy some fraction of the target company. It funds the remaining part of the
, deal with bank debt (also senior credit facility) and high-yield debt (mezzanine debt). The target uses
the proceeds from the buy-out to pay-off existing lenders and bondholders and its shareholders.
Most LBO sponsors are paid a management fee of 2% on the fund’s capital and receive a carried
interest of 20% on the profits realized by the fund. Private equity is the most junior in the capital
structure, it typically has voting rights, but does not receive any dividends.
Financing Buy-out Premium
1. Get as much as possible from senior lenders (bank debt)
2. Get as little as possible from the equity investors
3. Tailor the terms of the mezzanine to be serviced from the expected cash flows
Debt Multiple = Ratio of Total Debt adjusted to EBITDA.
Characteristics of LBO targets
- Profitable firms with predictable cash flows
- Little danger of technological change
- Low current debt
- Strong asset base with readily separable assets or businesses
- Leading and defensible market position
- Proven management team – risk tolerant
- Relatively low market valuation or firms with scope efficiency enhancement opportunities
Goal is to take on a firm with low risk business and generate returns by taking on risky
financing.
Drivers of LBOs
- Most LBOs in the late 80s and 90s were acquisitions of private firms or divisions of firms
fueled by the junk bond boom.
- LBO volume in the 90s and early 200s was related to corporate governance failures
- The public-to-private LBO boom in the mid-2000s was fueled by easy availability of debt
financing.
Drivers of M&A
Why managers pursue mergers & acquisitions, according to managers (from most to least relevant):
1. Expand customer base
2. Enter into new lines of business
3. Expand geographic reach
4. Enhance intellectual property or acquire new technologies
5. Opportunistic – i.e. target becomes available
6. Financial buyer looking for profitable operation and/or gain on exit
7. Invest in another function of the supply chain
8. Respond to activist investor
Factors that managers argue to drive deal activity:
1. Large cash reserves and commitments (make money work, especially in current low interest
environment, i.e. almost no interest income from reserves).
2. Availability of credit on favorable terms
3. Improved customer confidence
4. Opportunities in emerging markets
5. Improving equity markets
Academics argue managers pursue M&As for:
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