The title of this post is quite literal because I do not have any creative titles off the top of my head right now. M&A brain dump… yes a brain dump. There are a lot of moving parts when talking about mergers and acquisitions, or M&A for short, and these transactions happen all the time between publicly traded (and private) companies. As an investor, whether you are an active investor or a hands-off investor, high level knowledge of what drives individual stock price movement is important in understanding how and why overall markets move over time. Here, we focus on one facet of this driving force, namely M&A.
The long-term goal of any business is to remain operational, profitable, and to grow profitability over time. As a result, businesses are always evolving to meet current customer demands, changes in fiscal and monetary policy, and to compete against new competitors in the industry.
For businesses, what is defined as “success” in accomplishing their long term goals may mean a different narrative for other businesses. Some companies may have exit strategies that involve being acquired by a larger parent company, while others attempt to achieve success through growing and DOING the acquiring of other businesses. There are many ways to go about absorbing another company or business entity, but what if the Target business for acquisition doesn’t want to be acquired? What happens then between a Bidder and a Target company? Let’s examine the fun and exciting world of M&A.
Ultimately there are two ways to grow a company:
· Organic growth: this simply refers to growing the business through increased sales, increased customer lists, reduced overhead expenses, creation of internal efficiencies, and increasing profits year over year, OR
· Through mergers and acquisitions: This involves a company simply buying other companies to help grow their business, and ultimately, profitability.
There are three main different types of M&A:
1) Horizontal: this involves one company merging with an equally sized company with relevant business operations in order to increase market share, create cross departmental efficiencies, to reduce overhead costs, and simply for accretive growth
2) Vertical: this involves a larger company acquiring a smaller relevant company in order to take advantage of production technology, and savings in contracting costs, as well as accretive growth in company value
3) Conglomerate: this is a merger involving two unrelated companies in an attempt to diversify business, take advantage of product extensions, and geographical expansion (open to new markets)
When an M&A deal is being negotiated, there are two main parties here: the Bidder, and the Target. The Bidder is the party making the offer to acquire or merge with another company, i.e. the Target. The Target is therefore the party that receives an offer to be acquired or merged with from the Bidder.
When executing a deal, the Bidder can essentially pay for this M&A deal in two ways:
1) With cash: The use of cash always receives a more positive reaction from the market because it doesn’t dilute current shareholders, and doesn’t involve additional debt, or leverage, being taken on by the Bidder. Using cash in an M&A deal also signals to the market that the Bidder’s stock is currently undervalued
2) With stock: The issuance of new stock dilutes current shareholders (because there are more shares available to own the company, and therefore current shareholders now own a slightly smaller percentage of the company than before), and signals to investors that the Bidder’s stock is currently overpriced because they didn’t use cash for the M&A deal instead.
However, although any company can play the role of a Bidder and put in an offer to acquire or merge with another business, the Target company must ultimately agree to this deal through its board of directors (well technically hostile takeovers bypass the board and the offer goes right to the shareholders, but let’s ignore this case for now). Some businesses may not want to be approached for an M&A deal, or be approached as a potential Target by a Bidder. As a result, companies may implement a number of take over defenses to dissuade any potential Bidders from putting in a tender offer or offer to the Target’s board for an M&A deal.
Take over defenses by a company, or impending Target company, can be executed either before a Bidder approaches them, or after a Bidder has approached them and submitted an offer for an M&A deal. These are referred to as Pre Offer and Post Offer Defenses, respectively. A list of different defense mechanisms are shown below:
· Pre Offer Defenses
o Staggered Boards: this involves staggering the terms of board member expirations to delay the transfer of control to the Bidder
o Poison Pills: this is essentially “screwing over” the Bidder by sacrificing your own shares. This can be done by diluting the interest of the Bidder’s shares through the Target firm repurchasing its own shares at high premiums, or having its current shareholders buying more shares at a discount. This strategy is essentially buying time until the Bidder renegotiates a different set of terms to take over the Target company (and for a higher price)
o Supermajority clauses: this increases the number of board members needed to approve transactions related to control of the company by the Bidder over the Target
o Fair price amendments: this stipulation states that the Bidder must pay the same fair price for all shares of the Target, completely erasing the possibility of a “two tiered” share purchase offer
o Golden Parachutes: this is an incentive or severance package to compensate incumbent managers of the Target firm in an event of a takeover. Shareholders actually like this because this strategy will essentially get rid of the bad managers (bad managers will take the incentive and run for the door!)
o Dual class recaps: this involves splitting the shares of the Target company into different share classes (i.e. Class A, Class B) to give special voting rights to one class of shareholders over the other (this also usually comes with a liquidation priority in the event of bankruptcy: i.e. your shares will be paid out before the next shareholder class)
· Post Offer Defenses
o Pacman defenses: After the Bidder makes a takeover offer of the Target, the Target can turn around and make a counter offer for the Bidder’s shares… surprise!
o Greenmail: This is essentially a bribe or making a side deal and paying off the hostile Bidder from taking over the Target. In other words, this strategy involves the Target company repurchasing a set amount of the Bidder’s stock (do you see the similarity to blackmail?...)
o Asset and Financial Restructuring: A Target company can simply reorganize the capital structure of their business, and move a bunch of things around on their balance sheet to look less attractive to a potential Bidder. Such restructurings by the Target can include:
§ Increasing dividends
§ Drawing down excess cash
§ Accelerating loan payments
§ Acquisitions – Target can start making their own acquisitions of smaller companies
§ Divestitures – Target can “divest” or get rid of certain business units
§ Spinoffs – separate a business unit or subsidiary out of the parent Target company as its own public (or private) entity
§ Equity carve outs – Target can initiate a partial IPO of a subsidiary, while the Target parent company still retains >80% ownership
§ LBO or “Leveraged Buy Out”– this involves borrowing money from private equity firms (taking on a substantial level of debt) and repurchasing all outstanding shares of your own company to take it private (you are buying out your current shareholders with leverage), with the assets of the company acting as collateral to the deal
§ ESOPs or “Employee Stock Option Plans” – this involves purchasing the right to buy stock at a given price at some date in the future (just like publicly traded call options). The exercising of these options creates additional outstanding shares in the company, which dilutes current shareholders. These are often owned and exercised by top management, and huge gains are usually realized from ESOPs since the price stipulated in the contract at which shares must be purchased at was set years ago at a much lower price than where the shares are trading at today (assuming the stock has actually appreciated decently well over time)
§ Other: essentially, any action that involves drawing down cash or increasing leverage is part of an “asset restructuring” takeover defense by the Target. The idea is to make the balance sheet as ugly and unattractive as possible to a potential Bidder
Well there you have it… a huge knowledge dump around M&A and takeover defenses at your fingertips. It’s amazing how much more you will notice M&A deals happening on a weekly basis in the markets with even having a high-level background on how M&A works and how the parties involved interact with each other. There has been ample research into showing stock market reaction of the Target and Bidder firms on the announcement date of M&A deals. Typically, Target firms see a huge increase in their stock price (usually to the price offered by the Bidder), while Bidders tend to see a small decrease in their own stock price when using leverage to finance a deal, or a small increase in stock price when cash is used to finance the deal instead. The market may react differently depending on the transparency of the deal, and whether or not the market believes there to be operational efficiencies, cost reductions, and potential long-term increases in market value created through the M&A deal. It usually isn’t until years later when the market truly can see whether an M&A deal between two companies was really worth it, and whether success was truly achieved by increasing market value, and ultimately shareholder value, over time. After all, as everyday investors, this is what we should be most concerned about.