In our previous article, we introduced LBOs. This time, we will have a closer look at Mergers and Acquisitions.
Mergers are often categorized as horizontal, vertical or conglomerate. A horizontal merger is a merger that takes place between two firms in the same line of business. A vertical merger involves companies at different stages of the production chain. A conglomerate merger is one that involves companies in unrelated lines of businesses.
The ultimate aim of all mergers and acquisition is to maximise shareholders’ wealth. A merger only adds value when two companies are worth more together than apart. Simply said, one plus one should equal more than two. This is however not always the case.
Many mergers that seem to make economic sense fail. This was the case for AOL which spent record-breaking $156 billion to acquire Time Warner. Later, the merger turned out to be a massive failure. Many mergers fail because managers are unable to handle the complex task of integrating two firms with different production processes, accounting methods and corporate cultures.
Let’s look at some possible synergies stemming from a merger.
The most commonly mentioned synergy is economies of scale. Achieving economies of scale is a natural goal of horizontal mergers. The larger the company, the greater its negotiating power and the greater the possible reduction in costs.
Economies of vertical integration is another type of synergy which is sought when a vertical merger takes place. Vertical mergers seek to gain control over the production process by expanding back toward the output of the raw material or forward to the ultimate consumer.
Complementary resources can be provided by large firms that acquire smaller firms to supply small firms with the missing ingredients for the small firms’ success. A small firm can for example lack engineering and sales organization required to produce and market a product it produces on a large scale.
A firm in a mature industry might be generating a substantial amount of cash and struggle to deploy it profitably. Rather than purchasing its own shares, a company can decide to purchase shares of another company. This company can finance merger by cash and thus find new profitable opportunities.
There are some further arguments for mergers, which are supposed to create synergies, but they are often considered dubious. These include diversification, increasing earnings per share or lower financing costs. Now let’s have a look at some formulas.
Gain from a merger can be estimated by the following equation.
The present value of the combined entity (PVab) minus the present value of A and B should be greater than 0 if there is an economic gain to be obtained from the merger.
The cost for a cash merger would be the cash paid minus the present value of the target company. The net present value to the buyer would be the Gain minus the Cost.
We have seen a rapid increase in M&A activity over the past 20 years compared to the history. Many of these mergers, however, ended up as complete disasters. Motives for a merger should, therefore, be always closely examined.