Mergers and acquisitions (M&As) occur when companies combine forces or acquire one another. M&A transactions enable companies to achieve economic efficiencies and diversify risk, playing an important role in the efficient functioning of the economy.
This article looks at what mergers and acquisitions involve, how they work, and why companies choose to merge or make acquisitions.
An introduction to M&As
Mergers and acquisitions happen when two or more companies consolidate, or one company acquires another. Combining the operations of previously separate companies can achieve significant operational advantages. For example, they can realise economies of scale and scope, improve access to resources, and diversify risks.
This can result in cost savings, competitive advantages, and the opportunity to generate additional value. Over the long term, this can improve shareholder value, which is the goal of most M&A transactions.
Takeovers are similar to mergers and acquisitions in that they involve the combination of two previously separate companies. We characterise takeovers, however, by the acquisition of a smaller company by a larger one.
Like acquisitions, takeovers can be friendly or hostile – the difference depends on how the deal is communicated to stakeholders such as the target company's investors, employees, and board.
Corporations law regulates takeovers on the Australian Securities Exchange (ASX). This ensures takeovers occur in an efficient, informed, and competitive market and that investors in the target company are treated equally and have a reasonable time to consider takeover proposals.
What are the different types of M&A deals?
Merger: This occurs when two companies join forces to become a single entity. A merger will happen when both companies agree it is in their best interests to combine their operations.
Acquisition: An acquisition occurs when one company buys another company outright, with the first company becoming the new owner of the second. The process can be friendly or hostile. A friendly acquisition takes place when the target company agrees it is in its best interests to be acquired. A hostile acquisition occurs when the target company does not want to be purchased by the acquirer.
Tender offer: A tender offer refers to a public offer made by one company, known as the acquiring company or the tender offeror, to purchase the shares of another company, known as the target company or the offeree, directly from its investors. The offer is usually made at a specific price and for a limited time.
Consolidation: This refers to the process of combining two or more companies into a single entity or integrating their operations, assets, and resources. It involves bringing together the companies' businesses to create a more streamlined and efficient organisation.
Divestment: A divestment refers to the strategic decision of a company to sell, spin off, or otherwise dispose of a subsidiary, business unit, or non-core asset. It involves the act of intentionally reducing or eliminating a part of the company's operations or portfolio. Divestitures enable companies to shed non-core assets or businesses to focus on their core strengths and generate capital for reinvestment.
What are the three main types of M&A transactions?
A horizontal merger is a type of merger between two companies that operate in the same industry and are direct competitors. In this type of merger, companies that offer similar products or services combine their operations to form a single entity.
The goal of a horizontal merger is often to gain market share, increase competitiveness, and achieve economies of scale.
A vertical merger is a type of merger that occurs between two companies operating at different stages of the same supply chain or production process. In a vertical merger, a company acquires or merges with a supplier or customer, thereby integrating operations along the supply chain.
The goal of a vertical merger can be to enhance efficiency, control costs, improve coordination, and gain a competitive advantage.
In a conglomerate merger or acquisition, two companies from different industries or with unrelated lines of business combine their operations, or one company acquires another. The lack of a direct competitive relationship or synergy between the businesses involved characterises this type of merger/acquisition.
The purpose of a conglomerate merger/acquisition is typically to diversify a company's operations or expand into new markets beyond its existing industry. It allows companies to spread risks across different sectors, access new customer bases, and leverage their management expertise or financial resources in new areas.
How do mergers and acquisitions work?
Implementing an M&A deal involves several steps, which can take months to years to complete. They usually start with discussions between the companies involved. If these go well, the buyer (and its advisers) will evaluate the target's financials and business operations.
This information allows the acquirer to formulate a valuation of the target. The buyer will make an offer, which the parties will then negotiate in further detail. The buyer will conduct due diligence on the target, which involves a detailed analysis of the target's financials, assets and liabilities, contracts, customers, and human resources.
The due diligence process is a comprehensive analysis that potential acquirers undertake to assess the legal, financial, operational, and commercial aspects of a company they are considering acquiring or investing in. Due diligence is a critical step in the M&A process and aims to uncover information, identify risks, and validate the assumptions and representations made by the target company.
The information uncovered in due diligence allows the acquirer to formulate a target valuation. The buyer will make an offer, which the parties will then negotiate in further detail.
The buyer and target will negotiate a sale contract assuming no significant issues arise during due diligence. The sale contract can take several forms – the acquirer could purchase the target company's shares or its assets.
The buyer will need to finalise financing for the transaction once the sale agreement is signed. Completion occurs once any conditions of sale have been met, after which the management of the buyer and target work together to merge the company operations.
The M&A market
Companies usually undertake mergers and acquisitions to increase overall investor value. Most large and successful companies have completed at least a few mergers and acquisitions, and many employ teams of professionals to identify attractive potential acquisitions.
The M&A market is a dynamic landscape that takes place against movements in capital markets. Companies across industries and private equity players engage in M&A activity to strategically create value and optimise their portfolios.
Capital markets play a vital role in financing M&A activity, providing access to funding through equity, debt, or hybrid instruments.
Pros and cons
The benefits of mergers and acquisitions include:
- Economies of scale: Increased production levels can save proportionate costs.
- Economies of scope: These savings occur when the cost of producing two or more distinct goods is less than that of producing each separately.
- Increased market share: Upping the proportion of total sales in an industry generated by a particular company.
- Synergies: When the combination of two or more companies produces a combined effect greater than their separate effects.
- Diversification: The expansion of product or service offerings or branching out into new markets.
Despite the potential benefits of mergers and acquisitions, they have some disadvantages and risks. These include:
- Expenses: Acquiring a company can be expensive, involving legal and financial professionals and their associated fees.
- Debt: The acquiring business has to pay for the shares or assets of the company being acquired, and these funds have to come from somewhere. Often this means taking on increased debt.
- Lost opportunities: Mergers and acquisitions take time and resources, which may mean businesses miss out on other options.
- Duplication: When two companies become one, there can be duplication in capacities, resulting in wasted resources and job losses.
- Integration failures: Integrating two companies post-acquisition is a complex process involving many issues that can ultimately result in a loss of value.
What happens to your shares when a company merges or is acquired?
This depends on the structure of the deal. In some cases, shareholders will be paid cash for their shares. In others, shareholders may receive shares in the acquiring company or the new, merged company.
The target company's share price often rises when a merger or acquisition is announced. This is because the acquiring company usually has to pay a premium as an incentive to target shareholders. Target company shareholders have no motivation to agree to an acquisition at a lower price per share than the current share price.
The opposite often occurs to the share price of the acquiring company. This is because they must pay a premium to make the acquisition, which can exhaust their cash reserves and involve additional debt.
There are other reasons the acquiring company's share price could fall. These include unforeseen expenses associated with the acquisition, regulatory complications, and investors believing the premium paid to acquire the target is too high.
Over the long term, however, the acquiring company's share price should increase, provided its management properly values the target and the two companies are integrated efficiently.
Ultimately, the outcome for shareholders will depend on the success of the merger or acquisition. Intangible factors such as differences in company cultures, management power struggles, and integration problems can impact this success.
The combined entity becomes a more valuable business when mergers and acquisitions work well. This is the ultimate aim. But success is not guaranteed — careful planning and consideration are required to ensure a prosperous outcome.