Mergers and acquisitions

A merger is a friendly reorganisation in which two companies combine into a new one — A and B agree to become C, with both sets of shareholders consenting. It usually happens between companies of similar size, which is what makes agreement possible: neither ends up dominated by the other.

An acquisition, or takeover, is one company buying control of another by acquiring its ordinary shares. The acquirer is normally the larger, the target ceases to exist as an independent company, and the target’s board may or may not have been consulted.

Whichever it is, the combination takes one of three shapes, and the shape determines both the case for it and the regulatory attention it attracts.

Horizontal combinations promise the clearest cost savings and draw the most scrutiny from competition regulators, since removing a competitor is the point. Vertical ones secure a supply chain — worth a great deal in a market where inputs are unreliable. Conglomerate ones are the hardest to justify, because a shareholder who wanted exposure to both industries could simply have bought shares in both.

An acquisition is financially justified only if it increases the wealth of the acquiring company’s shareholders. A merger has to increase the wealth of both sets. Everything else is a reason someone gives, and the reasons sort into three groups.

Economic reasons

• Synergy — the combined output of the two businesses exceeding the sum of what they produced separately. It depends almost entirely on how well the two are integrated afterwards.
• Economies of scale, from operating at a larger size.
• Removing inefficient management, where a falling share price reflects the people running the company rather than the business itself. Buying the company can be easier than voting the board out.
• Entry into new markets — faster and often cheaper than building from nothing, especially across a border.
• Growth when the existing business has matured, and market power once the combination is complete.

Financial reasons

• Financial synergy — the combined company’s cost of capital falling below what either faced alone.
• Buying a target the market has undervalued, which is a claim that the market is wrong about it.
• Tax: a target with losses carried forward brings relief the acquirer can use.
• Raising the acquirer’s earnings per share. Doing this deliberately by buying low-rated earnings with highly rated shares is called boot-strapping.

Managerial reasons

Some acquisitions happen because they suit the managers rather than the shareholders — the agency problem in its most expensive form. A larger company pays its chief executive more, carries more prestige, and is harder for anyone else to take over, which makes the managers’ own jobs safer.

These are worth separating in an answer, because they predict different outcomes. Economic and financial motives can be tested against the numbers. Managerial motives explain a great deal of what actually happens and none of what should.

A share-for-share acquisition changes both halves of the earnings per share fraction: the earnings of the two companies combine, and new shares are issued to pay for it. Which effect is larger decides whether EPS rises or falls, and the answer follows from the two P/E ratios.

Super pays ZMW25 million for Shake — exactly its market value, so no premium — by issuing 10 million of its own ZMW2.50 shares.

Super’s EPS has risen from 10 ngwee to 11.90 ngwee, and nothing whatever has improved. No costs were saved, no revenue was gained, no synergy was assumed. Super simply bought ZMW5 million of earnings for 10 million shares, when its own 200 million shares were only producing ZMW20 million.

That is boot-strapping, and it works because Super’s shares are rated at 25 times earnings while Shake’s are rated at 5. Every share Super issues is expensive currency; every kwacha of Shake’s earnings is cheap. Buy cheap earnings with expensive paper and EPS goes up by arithmetic alone.

Now carry it through to the share price, on the assumption that the market keeps rating Super at 25 times.

The two companies were worth ZMW525 million between them the day before. The no-synergy column says they are worth ZMW625.8 million the day after, which would mean ZMW100 million of value created by a transaction in which nothing happened. That is the assumption failing, not value appearing: an efficient market will not go on applying a growth company’s multiple of 25 to earnings it knows were bought from a business the market rates at 5.

How the bid is paid for is a separate decision from whether to make it, and it changes who carries the risk of the acquisition going wrong.

The choice sends a signal too. A bidder paying in its own shares is asking the target’s shareholders to share the risk of the integration — and may be doing so because it thinks its shares are currently expensive. A cash bid says the bidder wants the whole of the upside for itself.

The strategic process

The whole exercise runs in a fixed order, and the valuation work sits in the middle of it rather than at the start.

• Identify suitable targets.
• Obtain as much information as possible about each one.
• Value each target, and decide the maximum price worth paying for it.
• Choose which target is most appropriate.
• Decide how to finance the bid, taking account of what both sets of shareholders will accept.

The third step is the discipline. Setting a maximum price before negotiations begin is what stops a bidder chasing a target past the point where the acquisition still makes sense — the most reliable way large acquisitions destroy value.

A friendly takeover is negotiated between the two boards. A hostile one is not: the bidder approaches the target’s shareholders directly and the target’s directors resist. Several defences exist, and they work by making the company harder, dearer or slower to buy.

Read them with the agency problem in mind. Directors resisting a bid may genuinely believe the offer undervalues the company — or may be protecting jobs the takeover would remove, at the expense of shareholders who would rather take the premium. A golden parachute makes that tension unusually explicit.

Some defences damage the company whether or not they succeed. Selling the crown jewels destroys the very thing that made the business valuable, and a poison pill leaves a share register nobody intended. They are last resorts, not routine tactics, and the strongest defence remains a share price that already reflects what the company is worth.