Mergers and acquisitions (‘M&A’) is a term used to describe the purchase or consolidation of companies or trade and assets.
Types of acquisitions
Acquisitions either involves the purchase of shares or trade and assets. In a share purchase acquisition, the target entity retains its preexisting assets and liabilities. A trade and assets purchase differs in that the vendor remains the legal owner of the entity, whilst the acquirer takes ownership of some or all of its assets.
Depending on the acquisition structure, either a share purchase agreement (‘SPA’) or an asset purchase agreement (‘APA’) is drawn up to facilitate the acquisition. An SPA is signed by both the owner of the target business and the acquirer, whilst an APA is signed by both the legal entity selling its assets and the acquirer.
The key distinguishing factor between the two types of acquisition is that in a share sale the acquirer takes responsibility for all of the target business’ existing liabilities and any historical issues it may have. Meanwhile, structuring an acquisition as a trade and asset purchase can potentially be more buyer-friendly as it is possible to specify which assets you want as well as which liabilities you do not want.
Acquisition of shares typically take place assuming that the business is cash-free and debt-free and will transfer with a normal level of working capital. For further information about this, read our article on the enterprise value to equity value bridge.
With trade and asset deals, the logic of equity value adjustments remains applicable, but the application of these adjustments will depend upon which assets and liabilities are agreed to transfer. Despite the labelling which suggests that only assets will transfer to the acquirer, a trade and asset deal often involves the transfer of net working capital which itself includes liabilities such as trade creditors. Of course, the deal can be structured in any way provided that it is agreeable to both buyer and seller.
Types of mergers
A merger is a business combination involving two or more entities joining together to become one new legal entity.
There are five main types of merger:
- Horizontal merger – companies in direct competition with one another both in terms of product and market (e.g. two UK supermarket chains merging).
- Vertical merger – companies who are part of the same supply chain (e.g. an electronics company acquiring its chip manufacturer).
- Conglomerate merger – companies operating in totally unrelated segments (e.g. a vetinary care business acquiring a clothes retail store)
- Product-extension (or congeneric) merger – companies operating within the same market segment but selling different products (e.g. a shoe manufacturer and a manufacturer of insoles)
- Market-extension merger – companies in different markets but selling similar products (e.g. a UK bank merging with a Spanish bank).
Benefits of pursuing an M&A strategy
Potential for synergies
A synergy is where the value of bringing two companies together is expected to be greater than the individual values of those two companies combined. For example, an acquirer may be able to go through a cost saving process to make certain staff redundant. Another example would be that in a vertical merger, cost savings could be made because Company A would no longer be charged a markup by its supplier Company B.
Faster growth
A business may be growing fast organically, but by pursuing an M&A strategy, it is possible to increase that speed of growth significantly. Increased market share can also open doors to new business opportunities as customers who perhaps would not have dealt with a smaller business now view the enlarged entity as more credible.
Increased business value
A common strategy pursued by private equity buyers is to purchase a new portfolio company and then make numerous bolt-on acquisitions to grow EBITDA.
For example, imagine a software business is acquired for 25x EBITDA (£1m x 25 = £25m). One year later, a smaller competitor is acquired for 15x EBITDA (£0.5m x 15 = £7.5m). The combined purchase price is £32.5m and the combined EBITDA ignoring any organic growth achieved will be £1.5m. When, in four years time, the private equity firm places the business for sale, it will seek a multiple greater than the 25x it paid for the business originally. However, even if it achieves a 25x multiple, the target selling price would now be £37.5m (£1.5m x 25) purely due to the fact a bolt-on acquisition was made.
At the same time, the PE house will seek to improve the target company’s performance. For instance, through seeking revenue growth, margin improvement and/or cost savings.
Acquisition of expertise and/or technology
For example, a large technology business may acquire a smaller competitor in order to absorb its employee base and/or technological capability. This is often done where hiring or developing that capability in house would take longer, or where the business wants avoid royalty payments for using the technology or wants to prevent competitors from acquiring it.
Reduced entry barriers / increased market access
For example, if an acquiring company purchases a company with operations in China, it will decrease its own barriers to selling its products in that country. Another example would be where a smaller company lacks the scale to sell its product across multiple markets. An acquirer with a preexisting sales force across multiple markets could immediately begin selling the targets product to a much wider audience.
Improved access to capital
Larger companies often find it easier to gain access to cheaper borrowing.
Remove excess capacity in the industry
In mature industries, supply can often outweigh demand where there is excess capacity. It often does not make sense for individual companies to reduce their own output. However, there can be potential opportunities to reduce capacity where an acquisition or merger is taking place. By reducing capacity, this can rebalance supply and demand dynamics, reducing downwards pressure on pricing.
Risks of pursuing an M&A strategy
Whilst there are numerous potential financial benefits of pursuing an M&A strategy, there are also a number of risks to be aware of.
Culture clash
The two organisations may have featured very different corporate cultures. Joining together two companies can result in an ‘us vs them’ feeling which can reduce employee efficiency and increase employee churn.
Potential synergies may not be as high as expected
It is not uncommon for Management teams to overestimate potential synergies. By setting ambitious synergy estimations when calculating what you are willing to pay for a business, it increases the likelihood of overpaying.
Overpaying
There is a risk of overpaying for the target business which ultimately has the effect of reducing shareholder value.
Neglecting acquired brand
Where a business is acquired and then neglected, this can destroy shareholder value. This can be an even greater risk where a post acquisition cost cutting exercise is carried out, leaving staff of the acquired business feeling unmotivated.
Poor due diligence
For example, missing a risk which could have been identified had a more rigorous process been followed.
Poor integration / internal communication
If the rationale behind a deal is not well communicated across the business, teams may work in silos and neglect the potential benefits gained through the new acquisition (e.g. not attempting to cross-sell the products sold by the acquired company).
Taking on too much debt to acquire a business
If the acquisition is not as successful as expected, this could present a significant risk where a company has increased its debt and associated interest payments significantly in order to acquire it.
