Mergers And Acquisitions Explained

The time to buy is when there’s blood in the streets. - Baron Rothschild (1871)

This is the famous proverb coined when everyone was selling after the French defeat in the Franco-Prussian War and the uprising in Paris that followed. Rothschild made a fortune by buying cheap assets and selling them at a huge profit when the markets recovered soon after. While no actual blood has been spilt in this financial crisis, metaphorically speaking, there’s been a bloodbath. As a result, many vulture companies in a strong financial position are snooping around the doors of weakened companies. Mergers and acquisitions (M&A) are likely to be a theme that dominates the rest of this year and into 2010.

In this part, I’ll give an overview of how mergers and acquisitions. Then in Part II, I’ll run through the life cycle of a merger from start to finish and how we can make money from it. Finally in Part III, I’ll look at industries that are prime for M&A activity as well as the companies likely to be involved. Ok, let’s get started.

What The Difference Between Mergers And Acquisitions?

The two terms are always used in the same breath and treated as if they are identical, but there is a distinction. An acquisition is when one company takes over another and clearly established itself as the new owner. The biggest M&A deal ever was the acquisition of Mannesmann by Vodafone for a not-too-shabby sum of $183bn. In contrast a merger is when two firms, often of about the same size, agree to go forward as a single new company. The merger of Exxon and Mobil to Exxon Mobil (XOM) is an example of one that worked, whereas Daimler and Chrysler was one that certainly didn’t. Although both examples were officially mergers, they were really just mergers in name. Real mergers are rare and most could easily be re-classified as acquisitions because there is usually one dominant party in the deal. For example, in essence, Exxon acquired Mobil, and Daimler acquired Chrysler. So in practice, it would be perfectly reasonable to think of “Mergers and Acquisitions” as simply “Acquisitions”.

One more thing before moving on. The company that is being acquired is the target company or the target. The company acquiring the target is the acquiring company or the acquirer. Pretty obvious really.

Types of M&A

1. Horizontal - when the two companies involved are in the same type of business, usually as competitors. This is the most common type of M&A. e.g. Royal Bank of Scotland’s ill-fated acquisition of banking competitor ABN Amro.
2. Vertical - when two companies in the same production chain join together. It’s backward integration when the acquirer purchases a target that is ahead of it in the production chain. For example, let’s be totally unrealistic and say British Airways (BAY) decided to acquire Boeing (BA), well that would be backward integration as British Airways would now be in control of the manufacture of their aircraft. On the other side, it’s forward integration when the acquirer purchases a target that is after it in the production chain. Here an example would be British Airways buying a travel agent that sells the seats on its flights.
3. Conglomerate - when two companies come together and their core competences are completely unrelated. General Electric (GE) is often used as the prime example of a conglomerate as they have purchased companies in a wide range of industries including media, finance, aircraft parts and medical equipment.

Hostile Vs Friendly

Mergers and acquisitions can be friendly when the combination is endorsed by the board of both companies. The deal can often be hammered out pretty quickly in these situations. But it’s not terribly exciting and its more difficult for traders to make money from them. More interesting for us traders are hostile transactions, where the acquirer attempts to takeover the target against the wishes of the target’s board. This can lead to a bloody and bitchy fight (think Ryanair and Aer Lingus) and share price moves that are sharp and volatile.

Motives For Mergers And Acquisitions
Mergers and acquisitions are expensive and a lot of resources go into making them happen. What’s more, only about 35% of them add value to the company, which means about 65% destroy shareholder wealth. But when a merger or acquisition goes well, the benefits are huge. Here’s a list of them:

• Synergy. The combined company is worth more than the sum of its parts. This includes cost reductions by removing duplicate departments. M&A means job losses!
• Economies of scale. Better deals because of increased order size, bulk-buying discounts and other activities.
• Increased revenue and market share. Increased size of the combined company increases market power and ability to set higher prices.
• Cross-selling. This is when the two companies involved in the deal sell each others products and services, increasing sales.
• Diversification. This helps smooth the earnings results of a company, which over the long term, is rewarded by a higher share price.
• Acquiring unique capabilities and resources. Sometimes it’s simply impossible for a company to create the technology, resource etc it needs to sustain its growth. It can be a lot simpler to just buy it.
• International Expansion. Acquiring a local competitor helps to get over culture issues, government policy, regulation and other issues related to international expansion.
• Other advantages include taxation issues, resource transfer and unlocking hidden value.

Simply put, a company can increase its profits and financial performance much more quickly through M&A than simple organic growth. This over-riding motivation will always drive M&A growth.

So that’s a quick overview of Mergers and Acquisitions. In Part II, I’ll look at the process of how a merger or acquisition works and how we can make money from it.

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