1. Mergers & Acquisitions
1. Values from M&A
2. The practice
1. Takeover effects
2. Anti-takeover devises
3. Other concepts
3. Valuation methods
1 L8: M&A

2. 2 L8: M&A

3. Definitions
 Mergers: the absorption of one firm by another
 Acquisition of stocks -- tender offers
 Bidder offer
 Acquisition of assets – a form mal vote of shareholders of the
selling firm is required. Avoid the hold-out problem
 Proxy contest: designed to gain minority representation on
or control of a board of directors. Typically initiated by a
financial agitator.
 Going-private transactions – LBOs or MBOs
3 L8: M&A

4. Objectives and Considerations
• To achieve cost savings through economies of scale (sharing central services
such as legal, accounting, finance, and executive management) and reduction of
redundant assets (real estate, corporate jets, etc.)
• Before entering into a transaction, companies typically compare the costs, risks
and benefits of an acquisition or merger with their organic opportunity
• This buy versus build analysis is an important departure point for a company as it
begins to think about a transaction. Is it better to build a brand, geographic coverage,
distribution network, installed base of products or services, and relationships, or is it
better to acquire them?
• The inverse decision – whether to sell – is an analysis that asks whether the
benefits of continuing to operate an asset is a better risk-adjusted option than
monetizing the asset (for cash or stock of the acquirer)
4 L8: M&As

5. Synergy from a M&A
Synergy VAB (VA VB )
T
CFt
Synergy t
t 1 (1 r )
CFt Re vt Costt Taxest Capital Re quirementt
• cost synergies
• revenue synergies
• control premium: the percentage difference between the price an acquirer will pay to
purchase control of a target company compared to the price for owning a minority share
(non control) position
• The purchase price premium (to the target’s current share price) in an acquisition is
determined based on consideration of synergies and control premium
5 L8: M&A

6. Sources of Synergy
 Revenue enhance
 Marketing gains
 Strategic benefits
 Market or monopoly power
 Cost reduction
 Economies of scale
 Economies of vertical integration
 Complementary resources
 Elimination of inefficient management
 Tax Gains
 Net operating losses
 Unused debt capacity
 Surplus fund
 The cost of capital
6 L8: M&A

7. Principal Constituents
• Shareholders: concerned about valuation, control, risk and tax issues
• Employees: focus on compensation, termination risk and employee benefits
• Regulators: must be persuaded that anti-trust, tax and securities laws are
adhered to
• Union leaders: worry about job retention and seniority issues
• Credit rating agencies: focus on credit quality issues
• Politicians: they get involved if constituent jobs and tax base are at risk
• Equity research analysts: focus principally on growth, margins, market share
and EPS
• Debt holders: consider whether debt will be increased, retired, or if there is
potential for changing debt values
7 L8: M&A

8. Credit Ratings, Taxes and Acquisition Currency
 Companies must attempt to balance the credit rating, tax and EPS
impact of an M&A transaction
 Paying cash as an acquisition currency often requires borrowing, creating
leverage
 A credit rating downgrade may occur if the transaction creates too much
leverage, resulting in a higher cost of debt capital, but a potential
reduction in weighted average cost of capital
 If the acquisition currency is shares of the acquiring company’s stock,
credit ratings will not likely be downgraded, but the acquirer’s EPS may
drop, often resulting in a share price reduction
 Shares used as consideration may be preferred by target company
shareholders in order to delay capital gains taxes
8 L8: M&A

9. Regulatory Considerations
 There are local, regional, national and international anti-trust and
other regulatory considerations in M&A transactions
 Approvals required from regulators depend on the size of the
transaction, location of the business and the industries of the
participating companies
 In the U.S., most public transactions require a Hart-Scott-Rodino
(HSR) filing with the Federal Trade Commission and the
Department of Justice
 There is a 30-day waiting period after filing
 If there are international operations, filing with the European
Commission (EC) or with antitrust regulators in other countries
may be necessary
9 L8: M&A

10. Strategic Buyers vs Financial Buyers
 Private equity firms (also called LBO firms, buyout firms or
financial sponsors) are considered financial buyers because they
usually do not bring synergies to an acquisition
 Strategic buyers are generally competitors of a target company
and will benefit from synergies when they acquire or merge with
the target
 As a result, in auctions conducted by investment banks for target
companies, strategic buyers are usually able to pay a higher price
than the price offered by financial buyers
10 L8: M&A

11. Fairness Opinion
• Investment bankers are usually asked to render a fairness opinion to the
respective boards of companies involved in an M&A transaction
• The opinion is made publicly available and it states, among other things,
that the transaction is ―fair from a financial point of view‖
• A fairness opinion is not an evaluation of the business rationale for the
transaction, a legal opinion or a recommendation to the board to
approve the transaction
• The fairness opinion includes a summary of the valuation analysis
conducted by the investment bank to show the basis on which the
opinion is offered
• Companies must decide whether it makes sense for the same investment
bank that provides the fairness opinion to also act as the M&A advisor
(since advisory fees are only paid if the transactions is deemed to be fair)
11 L8: M&A

12. M&A Hostile Defense Strategies
 Shareholder rights plan (poison pill)
 White Knight bidder
 Management Buyout (MBO)
 Stagger board
 Delay annual shareholder’s meeting
 Trigger acceleration of debt repayment
 Litigation
12 L8: M&A

13. Shareholder Rights Plan
 The key feature of a shareholder rights plan involves implementation of a
―poison pill‖, which gives non-hostile shareholders a right to purchase additional
shares in the company at a substantial discount (usually 50%)
 The result of the exercise of this right is that hostile shareholder ownership
percentage declines as ―friendly‖ shareholder ownership increases
 This dilution of hostile ownership economically compels the hostile party to
give up, negotiate a higher price, or launch a proxy contest to gain control of
the target company’s board and then rescind the poison pill
 A shareholder rights plan usually does not require a shareholder vote and often
has a 10-year maturity
13 L8: M&A

14. White Knight Bidder
 The first type, the white knight, refers to the friendly acquirer of a target firm
in a hostile takeover attempt by another firm. The intention of the acquisition is
to circumvent the takeover of the object of interest by a third, unfriendly entity,
which is perceived to be less favorable. The knight might defeat the undesirable
entity by offering a higher and more enticing bid, or strike a favorable deal with
the management of the object of acquisition.
 The second type refers to the acquirer of a struggling firm that may not
necessarily be under threat by a hostile firm. The financial standing of the
struggling firm could prevent any other entity being interested in an
acquisition. The firm may already have huge debts to pay to its creditors, or
worse, may already be bankrupt. In such a case, the knight, under huge risk,
acquires the firm that is in crisis. After acquisition, the knight then rebuilds the
firm, or integrates it into itself.
14 L8: M&A

15. Stagger Board
 Only a fraction (often one third) of the members of the board of directors is elected each
time instead of en masse (where all directors have one-year terms). Each group of
directors falls within a specified "class‖, hence the use of the term "classified" board.
 In publicly held companies, staggered boards have the effect of making hostile takeover
attempts more difficult. When a board is staggered, hostile bidders must win more than
one proxy fight at successive shareholder meetings in order to exercise control of the
target firm. Particularly in combination with a poison pill, a staggered board that cannot
be dismantled or evaded is one of the most potent takeover defenses available to U.S.
companies.
 Institutional shareholders are increasingly calling for an end to staggered boards of
directors—also called "declassifying" the boards. The Wall Street Journal reported in
January 2007 that 2006 marked a key switch in the trend toward declassification or
annual votes on all directors: more than half (55%) of the S&P 500 companies have
declassified boards, compared with 47% in 2005
15 L8: M&A

16. Sell Side Transactions and Methods
Alternative Sell-Side Processes
Divestiture Description # of Advantages Disadvantages Circumstances
Strategy Buyers
Preemptive • Screen and identify most 1 • Efforts focused on one • Unlikely to maximize • Have very clear sense of
likely buyer buyer value most logical buyer
• Maximum confidentiality • Tied to result of one • High risk of damage from
• Speed of execution negotiation business disruptions
• Minimum business • Have strong negotiating
disruption position
Targeted • High-level approach to 2 to 5 • Speed of execution • Requires substantial • Have limited group of
Solicitation selected potential buyers • Confidentiality maintained top-level management logical buyers
• Customized executive • Limited business time commitment • Have key objectives of
summary-type presentation disruption • Risks missing confidentiality and
• No pre-established • Sense of competition interested buyers limiting any business
guidelines or formal process enabled • May not maximize disruption
• No public disclosure value
Controlled • Limited range of logical 6 to 20 • Reasonably accurate test • Lack of confidentiality • Seek good balance
Auction potential buyers contacted of market price • May “turn off” logical between confidentiality
• Requires formal guidelines • High degree of control buyers and value
on sale process over process • Potential for disruption
• No public disclosure • Creates strong sense of due to rumors
competition
Public • Public disclosure made N/A • Most likely to obtain • May limit subsequent • Believe business is
Auction • Preliminary materials highest offer options if process fails unlikely to be damaged by
distributed to wide range of • Finds “hidden” buyers • Highest risk of business public process
potential buyers disruption • Have difficulty identifying
potential buyers
16 L8: M&A

17. Break-up Fee
 A break-up fee is paid if a transaction is not completed because a
target company walks away from the transaction after a merger
agreement or stock purchase agreement is signed
 This fee is designed to discourage other companies from making
bids for the target company since they would, in effect, end up
paying the breakup fee if successful in their bid
 A reverse breakup fee is paid if the acquiring company walks away
from a transaction after signing the agreement
 These fees are usually set at 2-4% of the target company’s equity
value, but this is the subject of negotiation
17 L8: M&A

18. Corporate Restructurings
• Carve-out: the sale through an IPO of a portion of the shares
of a subsidiary to new public market shareholders in
exchange for cash
• Spin-off: parent gives up control over a subsidiary by
distributing subsidiary shares to parent company shareholders
on a pro-rata basis
• Split-off: parent company delivers shares of a subsidiary to
only those parent shareholders who are willing to exchange
their parent company shares for the shares of the subsidiary
18 L8: M&A

19. Risk Arbitrage
• In a stock-for-stock acquisition, some traders will buy the target company’s
stock and simultaneously short the acquiring company’s stock, creating a ―risk
arb‖ position
• The purchase is motivated by the fact that after announcement of a pending
acquisition, the target company’s share price typically trades at a lower price in
the market compared to the price reflected by the Exchange Ratio that will
apply at the time of closing
• Traders who expect that the closing will eventually occur can make trading
profits by buying the target company’s stock and then receiving the acquiring
company’s stock at closing, creating value in excess of their purchase cost
• To hedge against a potential drop in value of the acquiring company’s stock, the
trader sells short the same number of shares to be received at closing in the
acquiring company’s stock based on the Exchange Ratio
• Risk arb trading puts downward pressure on the acquiring company’s stock and
upward pressure on the selling company’s stock
19 L8: M&A

20. Risk Arbitrage (cont.)
Median Arbitrage Spread
35
30
Arbitrage Spread (%)
25
20
Failed Deals
15
10
Successful Deals
5
0
125 115 105 95 85 75 65 55 45 35 25 15 5
Number of Trading Days Until Resolution
This chart plots the median arbitrage spread versus time until deal resolution. The arbitrage spread is defined
to be the offer price minus the target price divided by the target price. For failed deals, the deal resolution date
is defined as the date of the merger termination announcement. For successful deals, the resolution date is the
consummation date.
Source: Mitchell, Mark L. and Todd C. Pulvino. “Characteristics of Risk and Return in Risk Arbitrage.” Journal of Finance 56:
2135-2176.
20 L8: M&A

21. Risk Arbitrage (cont.)
Expected Return for Cash Merger
Expected Return = [C*G-L(100%-C)]/Y*P
Where:
• C is the expected chance of success (%)
• G is the expected gain in the event of a success (usually takeover price – current price)
• L is the expected loss in the event of a failure (current price – original price)
• Y is the expected holding time in years (usually the time until the acquisition takes place)
• P is the current price of the security
Example:
Company A makes a tender offer at $25 a share for Company B, currently trading at $15. The deal is expected
to close in 3 months. The stock of Company B immediately increases to $24
• C = 96%
• G = $1.00
• L = $9.00 ($24-$15) Exp. Return = [0.96*$1 - $9*(1 – 0.96)]/(0.25*$24) = 10%
• Y = 25% (3/12 months)
• P = $24
21 L8: M&A

22. Shareholder Activism
Shareholder Activism
• Some corporations are vulnerable to hostile initiatives by activist shareholders
• Hedge funds can be vocal investors who demand change in the corporate governance landscape in a
number of ways:
o Publicly criticizing/challenging Boards and managements
o Nominating Board candidates and pursuing their agenda through proxy contests
o Supporting other activists
• Hedge funds’ activist strategy has been successful by taking advantage of:
o Like-minded hedge funds’ herd mentality
o Ability to overcome reputation for short-term focus
o Ability to skillfully use a deep arsenal of securities and financial instruments
o Familiarity with M&A and legal regulations and rights
o Readiness to go to battle and devote significant resources to full-blown public relations battles
Source: Morgan Stanley
22 L8: M&A

23. Shareholder Activism (cont.)
Comparison of All Hedge Fund Returns vs. Activist Hedge Fund Returns, 2005 – 2008
Annualized total return, %
26.3%
17.8%
9.3%
5.0%
2.7% 4.2%
All hedge funds (HFRX Global Hedge Fund Index)
-23.3%
Activist hedge funds (HFRX Activist Index)
-30.8%
2005 2006 2007 2008
Source: Hedge Fund Research, Inc.
23 L8: M&A

24. Valuation Methods
Summary of Valuation Methods
Publicly Traded
Comparable Comparable Discounted Cash Flow Leveraged Buyout
Companies Analysis Transactions Analysis Analysis Analysis Other
Description
• “Public Market • “Private Market • “Intrinsic” value of • Value to a financial buyer • Sum-of-the-parts analysis
Valuation” Valuation” business • Value based on debt • Liquidation analysis
• Value based on market • Value based on multiples • Present value of repayment and return on • Break-up or net asset
trading multiples of paid for comparable projected free cash flows equity investment value analysis
comparable companies companies in sale • Incorporates both short • Historical trading
• Applied using historical transactions and long-term expected performance
and projected multiples • Includes control premium performance • Discounted future share
• Does not include a • Risk in cash flows and price
control premium capital structure • Dividend discount model
captured in discount rate
Comments
• Similarity of companies • Limited number of truly • The preferred valuation • Usually represents a floor • May be more situational
(size, growth prospects, comparable transactions technique when credible bid because of lack of and not as relevant as a
product mix) • Dated information due to cash flows can be synergies and high cost broad-based valuation
• Placement within peer changes in market projected and confident of capital and high technique
group • Data missing or hard to in WACC determination required return (IRR) • Near-term EPS impact
• Underlying market / find (earnings often • Sensitive to terminal • Requires various may not reflect true
sector trading unavailable on subsidiary value assumptions assumptions on capital value
fluctuations transactions) structure
• Market may view firm’s • May not be a viable
outlook differently option due to size or type
• Valuing synergies, tax of business
benefits problematic
24 L8: M&A

25. Valuation Summary
M&A Valuation Summary (Football Field)
Bid Range
Comparable Companies
Comparable Transactions
DCF
DCF + Synergies
LBO
Break-Up
Current Price
30-Day Moving Avg.
52-Week High/Low
$34 $36 $38 $40 $42 $44 $46 $48 $50 $52
25 L8: M&A

26. Comparable Companies Analysis
 A comparable companies valuation analysis compares similar
publicly trading companies using multiples
 Comparable companies are in the same industry and have
similar growth, profitability, size, capital structure and
margin characteristics
 The key multiples used for comparison are:
 Enterprise multiples: EV/Revenue; EV/EBITDA and EV/EBIT
 Equity multiples: EPS; Market Value/Book Value; PE/Growth
Rate (PEG ratio)
 This analysis values a non-controlling ownership in
comparable companies and does not include any synergy
26
considerations
L8: M&A

27. Using Multiples in Valuation
 Multiples based analysis incorporates key accounting concepts and financial
information in the process of valuing of companies
 Comparable Companies analysis and Comparable Transactions analysis are the
two principal multiples based valuation methodologies
 Enterprise Value (EV) = a company’s total economic value, which is shared by
holders of equity, debt, preferred stock and minority interest
 To determine EV, calculate market value of equity, debt, preferred stock and
minority interest and then deduct cash and cash equivalents
 Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is
important to determine since it and EBIT are often used in multiples
calculations: EV/EBITDA and EV/EBIT
 Earnings Per Share (EPS) and Price Earnings (PE) are also important multiples
used in valuing companies
27 L8: M&A

28. Comparable Transactions Analysis
 A comparable transaction analysis compares historical M&A transaction
values for companies in the same industry that have similar growth,
profitability, size, capital structure and margin characteristics
 This valuation assumes that the acquirer obtains control (usually 51%-
100% ownership of the target), so a control premium and synergies are
included in the purchase price
 The principal multiples used in this analysis are similar to the multiples
used in a comparable companies analysis
 To determine value/share for enterprise multiples based valuation
methodologies, use the following formula:
 Value/share=[EV-debt-preferred stock-minority interest+cash]
divided by total (fully diluted) shares outstanding
28 L8: M&A

29. Discounted Cash Flow (DCF) Analysis
 This analysis determines the intrinsic value of a company. DCF analysis
determines EV for a company by calculating the present value of a) projected
unlevered (not including financing costs) future cash flows and b) projected
terminal value
 Present value is typically calculated by using a discount rate equal to the
weighted average cost of capital (WACC)
 levered beta
 The quality of this analysis depends on the accuracy of cash flow projections and
the assumptions used in determining WACC and terminal value
29 L8: M&A

30. Levered beta and WACC
If debt beta is 0, then
This is WACC. rs is determined by equity beta.
30 L8: M&A

31. Example (1)
 Consider a firm whose debt has a market value of $40
million and whose stock has a market value of $60 million.
The firm pays a 15-percent rate of interest on its new debt
and has an asset beta of 1.41. The corporate tax rate is 34%.
Assume that the SML holds, that the risk premium on the
market is 9.5 percent, and that the current Treasury bill rate
is 11 percent. Answer the following questions:
 What is debt beta?
 What is equity beta?
 What is WACC?
31 L8: M&A

32. Example (2)
 Assume a company has been growing at a rate of 10% for
5 years and then drops to 3% per year and remains
constant indefinitely. Its total cash flow in the past year
was $5 million and required rate of return is the WACC
we got from Example (1). What is the total value of the
stock?
32 L8: M&A

33. Leveraged Buyout (LBO) Analysis
 This valuation analysis is used only if the company being valued has
characteristics that make it an interesting target for a Buyout fund
 These characteristics include: strong and predictable cash flow, clean balance
sheet with room for leverage, limited need for future capital expenditures,
quality assets that can be used as collateral for loans, cost cutting opportunities
and a viable exit strategy in 3-7 years
 Buyout funds target an IRR (compound annual return) of more than 20% and
determine the highest price they can pay such that this return is achieved as of
the assumed exit date
 Buyout funds will not be competitive bidders if the maximum price they can
bid that achieves their minimum IRR return target is substantially less than the
price that strategic buyers will bid
33 L8: M&A

34. Comparing LBO and DCF Analysis
LBO Analysis and DCF Analysis
DCF Analysis LBO Analysis
• Projected Cash Flow • Projected Cash Flow
Inputs • Terminal Value • Terminal Value (Sale Price)
• Discount Rate • Present Value (Purchase Price)
Creates
Creates
Enterprise Value IRR
Outputs (Present Value) (Discount Rate)
Source: Castillo, Jerilyn and Peter McAniff. The Practitioner’s Guide to Investment Banking, Mergers & Acquisitions,
Corporate Finance. Circinus Business Press, 2007.
34 L8: M&A

35. Other Potential Valuation Analysis
 Sum of the parts analysis (break-up analysis) is a useful additional
valuation tool when a company has many different businesses that,
when analyzed separately and then added together, are worth
more than the value of the company as a whole
 In this analysis, EV for each separate business is calculated based
on comparable transaction multiples (multiplying EBITDA for
each business by the relevant comparable company multiple) to
determine the total EV for the target company when the EVs for
each business are added together
 Other valuation methodologies may be appropriate for certain
industries, including an analysis of acquisition premiums in
comparable transactions
35 L8: M&A