Mergers And Acquisitions Explained - Part 2

In Part I, I went over the basics of mergers and acquisitions (M&A). Now I’m going to look at how the M&A process works and how we can make some money along the way.

The Acquirer Makes The Offer
The M&A process usually starts with the acquiring company discreetly buying up shares in the target company. The reason why the acquirer generally does this is because they can get those shares at the current market price. You see, when they later publicly announce a takeover bid, the offer price usually has significant premium on top of the market price. For example, Ryanair (NASDAQ:RYAAY) built up a sly 29.82% holding in Aer Lingus (AERL.L) before making a proposition.

After this part is done, the acquirer goes public with an offer for the rest of the target’s shares. In the image below, I’ve marked in that Ryanair offered Aer Lingus’ shareholder €1.40 a share, which was 21% over Aer Lingus’ previous price of €1.11. If traders had an inside track on this, they could have gone long on Aer Lingus before the announcement and made a bundle of cash. On average, a study of 2,419 recent European M&A deals found that the positive share price reaction amounts to 21% for the target and 0.9% for the acquirer. So if you manage to predict when an M&A is about to happen, it can be quite lucrative.

The Target’s Response
Once the offer has been made, the target has three choices for it’s response:

1. Accept. Both parties will then go ahead with the deal and try to complete a friendly transaction. They will be minimal further impact to the share price. Not a lot of use for us traders.
2. Negotiate. Here, the target attempts to get better terms from the acquirer, including looking for a higher price. For example, JP Morgan (NYSE:JPM) initially offered to takeover Bear Stearns for $2 a share only to later close the deal at a price of $10. The possibility of a higher price means that the target often trades above the initial offer level. In the image above, traders obviously felt that Ryanair would increase their offer, which resulted in Aer Lingus’ share price trading above the €1.40 purple line.
3. Reject and begin a defence. A target could simply reject the initial offer outright. Often, this is simply to entice another higher bid, and a negotiation, like in number (2), begins. But sometimes, a target simply doesn’t want to be taken over. In these cases, the target can begin a hostile takeover defence.I won’t into detail on the methods, but click the hyperlinks if you want to find out more. Pre-offer defence mechanisms that can be implemented include poison pills, poison puts, incorporation in a place with restrictive takeover laws, staggered board of directors, restricted voting rights, supermajority voting provisions, fair price amendments and golden parachutes. If they aren’t enough, a target can also try post-offer methods including “just say no” defence, litigation, greenmail, share repurchase, leveraged recapitalisation, “crown jewel” defence , “pac-man” defence, white knight and white squire.

Share Price Reaction To Offer
If a target attempts to try response (2) or (3), there’s likely to be some volatile target share price action. It will largely depend on how determined the acquirer is to take the target over.

In the Microsoft (NASDAQ:MSFT) Vs Yahoo! (NASDAQ:YHOO) takeover battle, Microsoft had their initial offer of $31 a share, a 62% premium on Yahoo!’s pre-offer price, rejected, so they offered $33. But Microsoft resolutely refused to go any higher and in the end gave up. Yahoo!’s price fell back down. A similar outcome happened in the Ryanair Vs Aer Lingus battle, as Ryanair CEO Michael O’Leary refused to pay a “stupid” price. So if you think that a takeover won’t succeed, then it could be a good opportunity to short the target.

If the acquirer is unyielding in its pursuit of the target, the target’s share price could continue to rise. For example, Swiss health-care company Roche recently sealed a $47 billion deal to acquire Genentech after raising its $89 a share initial offer to $93 and eventually $95. If you sense that an acquirer won’t give up, you can often make money by going long the target.

How To Pay For The Deal?
Ok, so now all the wheeling and dealing has been done and a price has been agreed upon. But as M&A’s often run to billions, how do companies pay for them? There are three general methods:

1. All Cash. The acquirer offers a fixed cash price for the target. For example, the RBS-led acquisition of ABN Amro was pretty much an all cash deal. How RBS wish they could get that money back now! Cash deals tend to be more popular in recessions, as interest rates are low which makes the financing cheaper.
2. All Stock. Here, the acquirer pays a fixed number of their shares for the target’s shares. Because the acquirer’s share price keeps changing, the total price to be paid changes until the deal is closed. For example, BHP Billiton offered 3.4 of its shares for every one Rio Tinto share in their failed acquisition attempt in 2008. The value of that deal fluctuated as BHP’s share price rose and fell. Also Pfizer got Pharmacia in a 1.4 shares for 1 deal.
3. Cash And Stock Mix. Obviously enough, this is when the acquirer pays a mix of both cash and stock to the targets shareholders. For example, to seal a $78 per share takeover of Rohm and Haas (NYSE:ROH), Dow Chemical (NYSE:DOW) agreed to pay $63 per share in cash and $15 per share in equity to the two largest Rohm and Haas shareholders.

Often the target’s shareholders will accept a price discount for all-cash offers but none of the above methods are inherently better than the other. However, the long term consequences of choosing one over another can be huge. For example, many small entrepreneurs turned down Google’s stock offers in favour of cash offers during Google’s formative years. They are surely kicking themselves now, as Google’s share price has rocketed. On the flip side, RBS paid for the ABN Amro in cash instead of stock. With RBS shares now nearly worthless, ABN Amro’s former shareholders are very happy with the deal they got.

So, that’s a quick overview of the life cycle of merger and acquisition deals from start to finish. In Part III, I’m going to look at what industries are primed for consolidation and what individual companies are looking like potential targets.

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