Mergers and Acquisitions: An Overview

Published on 24th October 2006

Mergers

The phrase mergers and acquisitions (or M&A) refers to the aspect of corporate finance strategy and management dealing with the merging and acquiring of different companies and other assets. Usually, mergers occur in a friendly setting where executives from respective companies participate in a due diligence process to ensure a successful combination of all parts. On other occasions, acquisitions can happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market.  

Corporate mergers may be aimed at reducing market competition, cutting costs, reducing taxes, removing management, “empire building,” or other purposes which may not be consistent with public policy or welfare. They can thus be heavily regulated, requiring, for example, approval of the Monopolies Commissioner.  

In business or economics, a merger is a (commonly voluntary) combination of two companies into one larger company. This involves stock swap or cash payment to the target. Stock swap allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and new branding. In some cases, terming the combination a “merger” rather than an acquisition is done purely for political or marketing reasons. Examples include the merger of Universal Bank with Paramount Bank and that of the Heritage Insurance Company with Africa International Insurance Company.  

A Stock Swap is a business taker over in which the acquiring company uses its own stock to pay for the acquired company. Each shareholder of the newly acquired company receives a certain share of the acquiring company’s stock for each share of stock they previously held in the acquired company. Sometimes some shareholders are required to wait for an agreed-upon period before they are allowed to sell their new shares of stock. A good example is the Cross-border share swap between South African Breweries (SABCO) and East African Breweries. Alternatively, it is a method of exercising stock options where shares that the older already owns are used to buy new shares at the exercise price. 

Classifications of Mergers  

Horizontal mergers take place where two merging companies produce a similar product in the same industry. It is a strategy used by a business or corporation that seeks to sell a type of product in numerous markets. To get this market coverage, several small subsidiary companies are created. Each markets the product to a different market segment or geographical area. In Vertical mergers, two firms, each working at different stages in the production of the same good, combine. They are united through a hierarchy and share a common owner. Each member of the hierarchy produces a different product or service, and the products combine to satisfy a common need. Conglomerate mergers take place when two firms operate in different industries.  

The completion of a merger does not necessarily ensure the success of the resulting organization. Indeed, many mergers result in a net loss of value due to monopoly and incompatibility of technology, equipment, or corporate culture hence diverting resources. Incompatibility may be exacerbated by inadequate research or concealment of losses and liabilities by one of the partners. For the merger to be considered successful, it must increase shareholder value faster than if the companies were separate, or prevent the deterioration of shareholder value more than if the companies were separate.  

Acquisitions

An acquisition can involve a cash and debt combination, cash only, a combination of cash and stock of the purchasing entity, or stock only. In addition, the acquisition can take the form of a purchase of the stock or other equity interests of the target entity.

A company may acquire another company by issuing high-yield debt to raise funds (often referred to as a leveraged buyout). The reason the debt carries a high yield is the risk involved. The owner does not want to risk his own money in the deal, but third party companies are willing to finance the deal for a high cost of capital (high interest yield). The combined company will be the borrower of the high-yield debt, and be on its balance sheet. This may result in the combined company having a low shareholders’ equity to loan capital ratio (equity ratio). A good example is the Coca-Cola Sabco Limited on its acquisition of various bottling companies and CFAO S.A. on its acquisition of D.T Dobie (Kenya) Limited.   

Mergers and Acquisitions are intended to add shareholder value through economies of scale. The combined company can often reduce duplicate departments or operations hence lowering the costs of the company relative to theoretically the same revenue stream, thus increasing profit. The Increased revenue/ Market Share motive assumes that the company will be absorbing a major competitor and increasing its power (by capturing increased market share) to set prices. They are also intended to add to shareholder value by Cross selling. For example, a bank buying a stock broker could sell its banking products to the stock broker’s customers, while the broker can sign up the bank’s customers for brokerage accounts. On the other hand, a manufacturer can acquire and sell complementary products.

Mergers and Acquisitions produce synergy, hence better use of complementary resources leading to geographical or other diversification. This smoothens the earning of a company, which over the long term smoothens its stock price, giving conservative investors more confidence in investing in the company.  

Some motives however don’t add shareholder value. While diversification, for example, may hedge a company against a downturn in an individual industry, it fails to deliver values, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger. Overextension tends to make the organization fuzzy and unmanageable. Managers’ overconfidence about expected synergies from M&A (managers’ hubris) may result in over payment for the target company. In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the local profit while decreasing the profit per share hence manager's compensation may be a setback. Another setback is empire building that involves managers having larger companies to manage and hence more power. 

By G. Imende and C. Odhiambo
Mohammed Muigai Advocates


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