Introduction
Mergers and acquisitions make possible complete changes in the business. However, this process poses major challenges to the parties involved as it can be quite chaotic if adequate strategies are not instituted (DePamphilis, 2008, pp. 77). Individuals charged with the responsibility of overseeing the mergers and acquisitions must have a clear understanding of what is involved in the process. The current business environment in this globalized world has made mergers and acquisitions part of its undertaking and to be precise, its way of life. For businesses to guarantee themselves a future survival in the increasingly competitive business environment, they have to partake in mergers and acquisitions.
Many people have taken to use the words mergers and acquisitions in tandem without due regard to what exactly these words mean. The term merger means bringing together two existing companies to create a new company whereas acquisition implies both the companies may continue to exist. However, on countless occasions, the two terms are loosely used to refer to a business transaction where one company acquires another company. The company that acquires remains in business while that company that has been acquired or the target company gets integrated into the acquiring company. After the merger, the acquired company ceases to exist.
Reasons behind mergers and acquisitions
There are unique reasons as to why two companies may decide to merge and why they may deem that to be a good business decision. The underlying principle behind mergers is that when two companies are merged, additional value is created. This additional value is often called ‘synergy value’. The synergy value normally takes three forms. The first form is revenues. When two companies are merged, higher revenues are likely to be realized than if the companies operate as different entities. The second form is expenses. When two companies come together, there is a likelihood of lowering their cumulative expenses. The last form of synergy value is the cost of capital. When two companies merge, chances are that a lower overall cost of capital will be realized. The biggest source of synergy value is lower expenses. Many companies merge in a bid to cut costs. In the process of engaging in cost savings, redundant services are normally eliminated. These redundant services may include human resources, accounting, information technology, etc. The best mergers normally have strategic reasons for combining businesses. The strategic reasons may include: positioning, gap filling, organizational competencies, and broader market access. Regarding positioning, the two companies may intend to take advantage of future opportunities that can be optimally exploited when these companies combine. A telecommunications company can only improve its future position if it owns a broadband service company. Companies must take the initiative to position themselves to take advantage of emerging trends within their business environment. Gap filling implies that companies that may have major weaknesses concerning, let’s say, distribution of its manufactured goods or its services and thus undertake to merge with a company that is well endowed in that aspect. When these two companies come together, each of them fills in a strategic gap that is indispensable for long-term survival. Two companies may decide to merge in order to gain organizational competencies. When human resources and intellectual capital are acquired, there are chances that innovative thinking and development within the company will be enhanced. Finally, companies may decide to merge to acquire broader market access. For instance, acquiring a foreign company, gives the acquiring company an edge in terms of access to emerging global markets. Mergers can also be occasioned by basic factors like bargain purchase, diversification, short-term growth, and undervalued targets. Concerning bargain purchase, it may be relatively cheaper to acquire another company than to engage in internal investment. If a company intends to expand its fabrication facilities and another company happens to have such facilities but are not in use. It is prudent for such a company to acquire the company with unused facilities and then initiate the building of new facilities. Pertaining diversification, long-term growth and profitability can only be attained by smoothening out earnings. This resonates well with mature industries that are not anticipating future growth. Traditional financial management does not advocate for the use of mergers and acquisitions as a means of diversification. It holds that it is in the interest of the investors to diversify as opposed to company management. Finally, with regard to undervalued targets, companies may undertake to merge because the company they intend to acquire may be undervalued hence a prospective investment destination. Some mergers are informed by financial factors as opposed to strategic reasons to improve their performance.
One of the mergers and acquisitions that have been witnessed in recent times is the announcement on September 8, 2009 by Deutsche Telekom and France Telecom that they intend to merge their British telephone operations. This implied that T-Mobile and Orange would operate as one business entity (The Economist, 2009, pp.1). This was intended to create a new market leader. The two companies have since formed a joint venture where they combine procurement activities of customer equipment, network equipment, service platforms and IT structure on a 50/50 basis. This will ensure that the businesses become so competitive. Suppliers stand to benefit through the harmonization of equipment this will generate synergies and efficiencies. France telecom has 170 000 employees worldwide with sales of 33.8 billion Euros. It is present in 35 countries with a customer base of 221 million customers. By 30th September France Telecom had 162 million mobile customers and 14 million broadband internet customers worldwide. The joint venture between T-Mobile and France Telecom is called Everything Everywhere. The merger is poised to command 37% of market share (Orange, 2011). The merger was initiated when Consumer Focus together with the Communications Consumer Panel sent a joint letter to the competition commissioner requesting for investigation of the merger by United Kingdom authorities. The Office of Fair Trading asked for the EU to be enjoined in the investigation. In March 2011 the EU commission approved the merger with a condition that the two entities agree to sell the 25% spectrum it had in 1800 MHz radio band and amend network sharing agreement with a smaller rival. About price plans, there were revisions to the effect of changing names to small, medium and large, a departure from Dolphin and Racon plans for internet use. Customers now receive 5 pound discount on mobile broadband plans (BBC, 2009). They have since initiated network sharing and cross-platform network life Wi-Fi. One of the synergies the merger has delivered is the cooperative efforts.
Theories and motives for mergers, phenomenon merger waves, its link to share prices and situations prevailing in the stock market
Some of the major theories and motives behind mergers and acquisitions include the value increasing theories, efficacy theory, and the value-destroying theory. The value increasing theory advances that mergers are basically initiated to generate synergy between the acquirer and the target. This synergy increases the value of the firm. The theory of efficacy posits that mergers only occur when there are chances that they can generate enough realizable synergies to benefit the buyer and the seller. Because of expected symmetric gains, the two companies will undertake to merge (Storey, 1994, pp. 12). The theory stipulates that if the value gain is not positive the process of acquisition may not sail through. If the gains are negative to the bidder’s owners, the deal cannot be completed by the bidder. There are different types of synergies like operative synergies that are achieved through economies of scale and scope and allocative synergies (also known as collusive synergies) that arise out of increased market power and enhanced ability to extract consumer surplus. The theory of corporate control justifies why mergers must increase value of a company. It posits that there is always a firm or management team that harbors an interest in acquiring an underperforming company, removing managers who have failed to take advantage of prevailing circumstances to create synergies, and improve on the general performance of the company. According to this theory, managers who have the capability to offer a higher value to the company should take over the management of the company before they are replaced by some other team. This implies that managers that do not maximize profits will not survive in the corporate world. From the bidder’s perspective, the theory of corporate control bears some semblance to efficiency theory with a few notable exceptions. The value-destroying theories are divided into two groups: the first one assumes that the bidder’s management is boundedly rational while the second group assumes that the bidder’s management is rational but self-serving. The theory of managerial hubris (Roll, 1986, pp.200) says that managers always have good intentions including the resolve to increase their firm’s value, however, due to overconfidence, they end up overrating their abilities to create synergies.
Overconfidence contributes to overpayment which condemns the winning bidder to winner’s curse. The theory of managerial discretion absolves overconfidence of blames of unproductive acquisitions. It instead associates unproductive acquisition with presence of excess liquidity and fresh cash flow. The theory of managerial entrenchment associates unsuccessful mergers with managers resolving to make investments that minimize the risk of replacement. Another theory is the theory of empire building.
Benefits and costs of mergers and acquisitions, and the defenses used in actual outcomes
Just as had been enumerated earlier, mergers and acquisitions have several inherent benefits. These benefits include access to a wider pool of capital, lower expenses, increased market share and market access, lower costs of capital, and increase in revenues for the newly merged companies, among other numerous benefits. The company can also gain cost efficiency besides gaining a higher competitiveness.
Legal and regulatory frameworks governing takeovers
Negotiations normally take center stage after a company has shown interest in acquiring another company. The acquiring company has to come up with a well-developed negotiating strategy. After the target company is convinced that a merger is in the offing, the two companies enter into a ‘letter of intent’. This letter outlines terms of future negotiations. The target company is committed to giving serious considerations to the merger. The letter of intent gives the acquiring company the green light to move to Phase II Due Diligence (Scharfstein, 1998, pp.186). The letter of intent answers questions related to the determination of acquisition price, what exactly is being acquired, the design of merger transaction, forms of payments, how the purchase price will be deposited, the estimated time frame of the merger, the scope of due diligence, the time that will be allowed by target company for negotiations, the compensation that the acquiring company will be entitled to in the event that the target is acquired by another company, operating restrictions imposed on the two parties during the process of negotiations, the state or country that will govern the merger transaction, and possibility of adjusting final purchase price occasioned by losses or events before closing of the merger. As negotiations progress, the parties will engage in extensive Phase II Due Diligence with the sole aim of identifying issues that have to be amicably solved for the merger to be successful. If significant issues are promptly resolved and parties are convinced that the merger will be beneficial to them, a formal merger and acquisition agreement gets formulated. Phase II Due Diligence is intended to resolve issues that were not adequately handled in the letter of intent. The integration process has to be agreed on by the two companies. This is catered for by putting in place Transition Service Agreement to cover services like payroll where Target Company continues to handle payroll up to when the integration process is complete. After this the acquiring company takes over the payroll responsibilities. The Transition Service Agreement covers aspects of types of services, timeframes, and fees associated with integration process. About representation, a warranty must be provided by the two companies that what has been conveyed is complete and accurate (Schwert, 1996, pp.155). The acquiring firm expects that complete disclosure is critical for it to develop a deeper understanding of the firm it is acquiring. If the firm being acquired misrepresents certain information from the buyer, the buyer’s interest in acquisition can possibly wane. Sellers normally prefer to limit the number of representations within the M & A agreement. For a balance to be stricken, materiality limits on certain representations have to be established. In order to alleviate misrepresentations, it is imperative that language like ‘to the best of sellers knowledge be used’. An integral component of M&A agreement is indemnification. This agreement specifies the nature and extent to which each company can recover damages if a breach of contract occurs. There will always be a provision that damages are due until the indemnification amount reaches specific threshold. When the basket amount is exceeded, the indemnification amount becomes payable. The target company normally lays claim having a ceiling for basket amount in the M&A agreement. Because chances are remote that both sides can agree on indemnification, it is imperative that a provision on how emerging disputes will be solved be included in the agreement. The indemnification also covers the right to sell off for the buyer because he has already deposited the part of purchase price to escrow account. This right allows the buyer to offset indemnification claims against amounts deferred within the purchase price of the merger. Legal action is the only route to go when the purchase price has been paid to resolve the indemnification issue. Both parties must practice utmost confidentiality (Singh, 1986, pp.580) before merger is announced because the target company stands to lose a lot of value if its customers, suppliers, owners, and other parties get to know of impending merger before it is actualized. The key personnel may resign, prompting a decline in productivity. Customers may also switch to other companies while suppliers may refuse to renew their contracts with the company. To avert this crisis, the two parties have to enter into confidentiality agreement. When all thorny issues have been resolved by the two companies, the M&A agreement is then signed. The legal teams for the two parties then exchange documents that also include the closing date for the merger and acquisition. The transaction takes place through exchange of stock, cash, and or notes. A formal announcement is then made. Payments are normally deferred until legal opinions are issued and financial statements audited.
Regulations that impact mergers and acquisitions in the U.S. are divided into state laws, federal anti-trust laws, and federal security laws. One of the most important antitrust laws is Section Seven of Clayton Act which underscores that mergers and acquisitions cannot substantially lessen competition or result in a monopoly. The United States Justice Department and Federal Trade Commission’s involvement with mergers and acquisitions are envisaged in the signing of 16-page form. The form calls for complete disclosure and description of the two companies. The companies must be registered with the Securities and Exchange Commission.
Strategies and tactics of both hostile and agreed bids
Strategies have to be devised so that a lot of information is gathered on Target Company. Desperate measures have to be used to get this information. The services of undercover agents may be needed. This is very important when very important information like corporate records, financial records, tax records, regulatory records, debt records, employment records, property records, and miscellaneous agreement records do not give as much information that is needed (Williamson, 1964, pp. 62). Corporate records should give information related to articles of incorporation, bylaws, minutes of various meetings that were initiated by the target company, and the shareholder list. Financial records must show the company’s financial statements for the last five years, the legal council letters, budgets, and assets schedules. Tax records should reflect federal, state, and local tax returns for the past five years, the company’s working papers, its schedules, and correspondences made. Regulatory records normally show the filings with SEC, reports compiled by different government agencies, licenses, permits and decrees. Debt records of the target company should show the loan agreements it signed, the mortgages, and the lease contracts. Employment records should reflect labor contracts, employee listing with salaries, employee pension records, bonus plans, and their personal policies. Finally, property records are supposed to show title insurance policies, legal descriptions, site evaluations, appraisals, and trademarks. The miscellaneous agreements that the company had engaged in like the joint venture, marketing contracts, and purchase contracts, agreements with directors and consultants, and contract forms should be willingly given to the buyer. If this is not easy then due diligence dictates that some other means be used to obtain this information.
Financial objectives/strategies of the firm, and selection of investment projects
Due diligence is supposed to alleviate fears related to the financial statements of the target company. The acquiring company is entitled to ascertaining the realistic value of the target company. The buyer has to critically look at the target company’s balance sheet. This is important in helping it to know whether liabilities like pensions, allowances for bad debts have been understated. The buyer also gets to know the relative market value of the target company’s assets and whether they have been overvalued. The balance sheet should also be strategically used by the buyer to get to know some hidden liabilities like contingencies for lawsuits that are not recognized (Fleuriet, 2008, pp. 87). The buyer, through the balance sheet, will also get to know some overstated receivables and overstated inventories. Rise in the level of inventory over time will imply obsolescence and lack of marketability. The presence of LIFO reserve should denote distortion of inventories (Sapienza, 2002, pp.300). The buyer has to use the balance sheet if he or she wants to perform valuation of short-term marketable securities of the target company. If by chance the target company holds marketable securities, have these securities been properly valued? If the target company has investments that are not marketable, are there chances that they have been overstated? Finally, balance sheet helps the buyer to know if intangibles like brand names have been undervalued (Wald, 1940, pp.290). The buyer has to be in a position to differentiate between book values and market values. The substantial difference between the two implies that due diligence has to be taken to do away with the possibility of manipulation of values. Income statement is supposed to reflect quality earnings.
Reference List
BBC. (2009). T-Mobile and Orange in UK merger. Web.
DePamphilis, D. (2008). Mergers, Acquisitions, and Other Restructuring Activities. New York: Elsevier Academic Press.
Fleuriet, M. (2008). Investment Banking explained: An insider’s guide to the industry. New York, NY: McGraw Hill.
Orange. (2011). Deutsche Telekom and France Telecom-Orange to form procurement joint venture. Web.
Roll, R. (1986). The Hubris hypothesis of company takeovers. Journal of Business, 59(31), 197-216.
Sapienza, P. (2002). The effects of banking mergers on loan contracts. The Journal of finance, 57(22), 329-367.
Scharfstein, D. (1998). The disciplinary role of takeovers. Review of economic studies, 55(2), pp.185-199.
Schwert, G. (1996). Mark up pricing in mergers and acquisitions. Journal of financial economics, 41(18), 153-192.
Storey, D. (1994). Understanding the small firm sector. London: Rutledge.
Singh, J.V. (1986). Performance, slack, and risk taking in organizational decision making. Academy of management journal, 29(43), 562-585.
The Economist. (2009). Mergers and acquisitions make a comeback: The return of the deal. The Economist, 10 Sep. p.1.
Wald, A. (1940). The fitting of straight lines if both variables are subject to error. Annals of mathematical statistics, 11(3), pp. 284-300.
Williamson, O.E. (1964). The economics of discretionary behavior, New Jersey: Prentice Hall.