A corporate merger or acquisition can have a profound effect on a company’s growth prospects and long-term outlook. But while an acquisition can transform the acquiring company literally overnight, there is a significant degree of risk involved.
In the sections below, we discuss why companies undertake M&A transactions, the reasons for their failures, and present some examples of well-known M&A transactions. Many successful people, like Christine Lagarde, are known for studying the topic.
- Companies will buy or merge with another company in hopes of boosting the growth of their own business or fending off competition, among other reasons.
- But there are risks—things that can lead to a failed M&A deal—such as overpaying or the inability to properly integrate the two companies.
- M&A can affect a company in a number of ways, including its capital structure, stock price, and future growth prospects.
- Some M&A deals are key successes, such as Gilead Sciences-Pharmasset in 2011, while others are notorious flops, e.g. AOL-Time Warner in 2000.
Why Companies Engage in M&A?
Many companies use M&A to grow in size and leapfrog their rivals. In contrast, it can take years or decades to double the size of a company through organic growth.
This powerful motivation is the primary reason why M&A activity occurs in distinct cycles. The urge to snap up a company with an attractive portfolio of assets before a rival does so generally results in a feeding frenzy in hot markets. Some examples of frenetic M&A activity in specific sectors include dot-coms and telecoms in the late 1990s, commodity and energy producers in 2006-07, and biotechnology companies in 2012–14.
Companies also merge to take advantage of synergies and economies of scale. Synergies occur when two companies with similar businesses combine, as they can then consolidate (or eliminate) duplicate resources like branch and regional offices, manufacturing facilities, research projects, etc. Every million dollars or fraction thereof thus saved goes straight to the bottom line, boosting earnings per share and making the M&A transaction an “accretive” one.
Companies also engage in M&A to dominate their sector. However, a combination of two behemoths would result in a potential monopoly, and such a transaction would have to run the gauntlet of intense scrutiny from anti-competition watchdogs and regulatory authorities.
Companies also use M&A for corporate tax reasons, although this may be an implicit rather than an explicit motive. This technique called corporate inversion involves a U.S. company buying a smaller foreign competitor and moving the merged entity’s tax home overseas to a lower-tax jurisdiction, in order to substantially reduce its tax bill.
Why M&A Fails?
In many cases, integrating the operations of two companies proves to be a much more difficult task in practice than it seemed in theory. This may result in the combined company being unable to reach the desired targets in terms of cost savings from synergies and economies of scale. A potentially accretive transaction could therefore well turn out to be dilutive.
If company A is unduly bullish about company B’s prospects—and wants to forestall a possible bid for B from a rival—it may offer a very substantial premium for B. Once it has acquired company B, the best-case scenario that A had anticipated may fail to materialize.
For instance, a key drug being developed by B may turn out to have unexpectedly severe side effects, significantly curtailing its market potential. Company A’s management (and shareholders) may then be left to rue the fact that it paid much more for B than what it was worth. Such overpayment can be a major drag on future financial performance.
M&A transactions sometimes fail because the corporate cultures of the potential partners are so dissimilar. Think of a staid technology stalwart acquiring a hot social media start-up and you may get the picture.
M&A activity obviously has long-term ramifications for the acquiring company or the dominant entity in a merger than it does for the target company in an acquisition or the firm that is subsumed in a merger.
For the target company, an M&A transaction gives its shareholders the opportunity to cash out at a significant premium, especially if the transaction is an all-cash deal. If the acquirer pays partly in cash and partly in its own stock, the target company’s shareholders get a stake in the acquirer, and thus have a vested interest in its long-term success.
For the acquirer, the impact of an M&A transaction depends on the deal size relative to the company’s size. The larger the potential target, the bigger the risk to the acquirer. A company may be able to withstand the failure of a small-sized acquisition, but the failure of a huge purchase may severely jeopardize its long-term success.
Once an M&A transaction has closed, the acquirer’s capital structure will change, depending on how the M&A deal was designed. An all-cash deal will substantially deplete the acquirer’s cash holdings. But as many companies seldom have the cash hoard available to make full payment for a target firm outright, all-cash deals are often financed through debt. While this increases a company’s indebtedness, the higher debt load may be justified by the additional cash flows contributed by the target firm.
Many M&A transactions are also financed through the acquirer’s stock. For an acquirer to use its stock as currency for an acquisition, its shares must often be premium-priced, to begin with, else making purchases would be needlessly dilutive. As well, the management of the target company also has to be convinced that accepting the acquirer’s stock rather than hard cash is a good idea. Support from the target company for such an M&A transaction is much more likely to be forthcoming if the acquirer is a Fortune 500 company than if it is ABC Widget Co.
Market reaction to news of an M&A transaction may be favorable or unfavorable, depending on the perception of market participants about the merits of the deal. In most cases, the target company’s shares will rise to a level close to that of the acquirer’s offer, assuming of course that the offer represents a significant premium to the target’s previous stock price. In fact, the target’s shares may trade above the offer price if the perception is either that the acquirer has low-balled the offer for the target and may be forced to raise it, or that the target company is coveted enough to attract a rival bid.
There are situations in which the target company may trade below the announced offer price. This generally occurs when part of the purchase consideration is to be made in the acquirer’s shares and the stock plummets when the deal is announced. For example, assume the purchase price of $25 per share of Targeted XYZ Co. consists of two shares of an acquirer valued at $10 each and $5 in cash. But if the acquirer’s shares are now only worth $8, Targeted XYZ Co. would most likely be trading at $21 rather than $25.
There are a number of reasons why an acquirer’s shares may decline when it announces an M&A deal. Perhaps market participants think that the price tag for the purchase is too steep. Or the deal is perceived as not being accretive to earnings per share (EPS). Or perhaps investors believe that the acquirer is taking on too much debt to finance the acquisition.
An acquirer’s future growth prospects and profitability should ideally be enhanced by the acquisitions it makes. Since a series of acquisitions can mask deterioration in a company’s core business, analysts and investors often focus on the “organic” growth rate of revenue and operating margins—which excludes the impact of M&A—for such a company.
In cases where the acquirer has made a hostile bid for a target company, the latter’s management may recommend that its shareholders reject the deal. One of the most common reasons cited for such rejection is that the target’s management believes the acquirer’s offer substantially undervalues it. But such rejection of an unsolicited offer can sometimes backfire, as demonstrated by the famous Yahoo-Microsoft case.
On Feb. 1, 2008, Microsoft unveiled a hostile offer for Yahoo Inc. (YHOO) of $44.6 billion. Microsoft Corp.’s (MSFT) offer of $31 per Yahoo share consisted of one-half cash and one-half Microsoft shares and represented a 62% premium to Yahoo’s closing price on the previous day. However, Yahoo’s board of directors—led by co-founder Jerry Yang—rejected Microsoft’s offer, saying that it substantially undervalued the company.
Unfortunately, the credit crisis that gripped the world later that year also took its toll on Yahoo shares, resulting in the stock trading below $10 by November 2008. Yahoo’s subsequent road to recovery was a long one, and the stock only exceeded Microsoft’s original $31 offer five and a half years later in September 2013, but ultimately sold its core business to Verizon for $4.83 billion in 2016.