Mergers and acquisitions are the bread and butter of investment banking. Company A buys Company B and the investment bank earns a fee as a % of the total enterprise value of the target. Then, the investment bank will earn fees on the financing – often multiples of the M&A fee itself due to the bridge loan and subsequent debt and equity take out.

M&A is exciting and can transform companies. With large enough industry players, it can transform industries.

There are a variety of reasons why a company may choose to acquire another company. There are also a variety of reasons why a target company would be compelled to sell. We discuss this corporate finance theory here.

Acquirer Company Rationale for M&A

Synergies from Merger

Synergies are when the whole is the greater than the sum of its parts – Company A + B > Company A + Company B.

Synergies can be on the revenue side or on the cost side. Revenue synergies include cross-selling, pricing power, and leveraging a more well-known brand. Cost synergies include supply chain scale advantages, reductions in corporate costs and better operations management.

If an acquirer believes that the synergies from a merger exceed the transaction and restructuring costs, they are more likely to bid.

Buy is Cheaper than Build

From a project evaluation perspective, if a company is considering entering a new market, entering a new product, or expanding an existing line of business it needs to look at the return on capital invested. Sometimes, purchasing a competitor already in that line of business can offer a higher return on capital – and cash flows come a lot faster with much less execution risk.

Attractive Valuation and Opportunistic Acquisition

If a target company is trading well below intrinsic value (as perceived by the acquiring company), it may launch a bid. This is especially apparent for commodity (oil and gas/mining) companies that have good assets but are trading at depressed valuations due to a soft commodity price environment.

If the target company is financially healthy, there will be resistance from the target Board of Directors, who will put out corporate communications expressing that the bid is opportunistic and that shareholders are better off waiting.

If the target company is in distress, there will be less resistance as shareholders will want to take what they can. However, if distress is unique to the target company as opposed to the industry, there should still be a competitive auction process. If distress is widespread (for instance, an oil and gas price crash), an opportunistic acquirer with a strong balance sheet should not see much competition in a bid with a healthy premium.

Inefficient Balance Sheet and Pressure to Acquire

If a company is generating a lot of free cash flow and has a healthy cash balance, it may find itself underlevered without good options beyond raising the dividend. In some cases, the market may expect the company to acquire while in a position of strength.

Target Company Rationale for M&A

Usually, once the price hits a point where the board and management of the target company are satisfied, they will communicate for shareholders that it is a fair price that offers great value for shareholders – and if there is a share component to the purchase, that strategic initiatives will be taken to the next level within a larger platform.

For a seller, the board and management is naturally inclined not to sell without a substantial premium if things are not distressed. Consolidation usually means that their employment is compromised, although deferred and restricted compensation will vest.

However, target boards can be influenced to sell for reasons including:

Poor Share Price Performance/Undervalued Company

If the company feels that the market is not fairly valuing its shares and it trades at a depressed multiple to its peers, the company can hire an investment banker to look into “strategic alternatives”, which means they will start looking for buyers.

Financial Distress

If the company has too much debt on its balance sheet and macroeconomic or firm specific factors have caused it to struggle with paying interest to creditors, a sale to a financially secure company may make sense.

Sometimes, when the due diligence is completed, the buyer may actually pay less than the market assigned equity value of the firm (pay less than the actual share price) as as it knows the extent to which the target is in distress.

An example would be a high yield oil and gas company with low quality assets that would be unable to service its debt in a weaker oil price environment.

Declining Industry and Weakening Position

For industries that have become relatively obsolete, consolidation is necessary to survive. Examples include newspapers.

Shareholder Activism

This has become increasingly common, with activist hedge funds such as Pershing Square and Third Point buying shares and pushing for seats on the board of directors to encourage the company to either sell itself or engage in other corporate finance activity.

Influential Shareholder Wants to Divest

Often tied with the company feeling that it is being undervalued, a full shareholder exit can be achieved through M&A.

Rationale for Selling Assets

Most of the time, an acquirer buys an asset or business line that belongs to the seller instead of an entire corporate. The reasons for divesting specific assets are varied.

Portfolio/Asset Rationalization

The seller company divests non-core assets or assets that are not a good “strategic fit” in the portfolio to focus on its core competency.

For example, if an independent power producer (IPP) is widely responsible and specialises in clean energy (wind, solar, hydro) and has a few stranded natural gas simple-cycle generators, it can sell those to focus resources and expertise on its renewable assets.

Deleveraging/Paying Down Debt via Asset Sales

If a company is at an elevated level of leverage with more debt than in that of an optimal capital structure, it can sell assets instead of issuing equity to pay down debt.

This alleviates the stress from maintenance covenants and interest expense. If shareholders feel that the capital structure is superior after asset sales and deleveraging, the share price can increase post-divestiture announcement.

Raising Funds for Acquisition via Asset Sales

If the company is looking to make a large acquisition, it can only take on so much debt before breaching internal (as disclosed, board of directors approved targets) and external leverage limits (bond and bank loan covenants).

Instead of (or in combination with) issuing equity, the company can sell off more mature assets that are cash flow stable and can command a good multiple.

Some interesting takes on this include asset swaps (sweetened by cash). For instance, if a gas exploration and production company owns a power generation asset attached to their project, they could swap that for a gas field owned by a power generating company.

Taking Advantage of Multiple Arbitrage

If a company operates in a variety of operating segments, it may suffer from a conglomerate discount (investors assign a lower multiple to a company that owns a coffee shop chain and a toy business than the coffee shop chain and toy business would be valued separately).

The best example is a retailer that owns a large amount of real estate. Retail is a business with inherently volatile cash flows but commercial real estate has more stable, contracted cash flows (with the exception of hotels and casinos) and would trade at a much higher multiple outside of the company. However, as the market sees the company as a retailer, the cash flows from the real estate is valued at the same multiple as the broader firm. The real estate can thus be sold according to real estate valuation metrics.

An alternative to this is to put the non-core assets up for an initial public offering (IPO), or a spin-off. An investment bank can run a dual-track process to see what will crystallise more value for the firm – an IPO or a merger/sale.

Frothy Valuation and Fringe Assets

If the broader stock market is trading at historically high multiples or assigning irrational valuation to certain assets, the company can take advantage of a hot market by selling off non-core assets and redeploying the capital.

For commodity companies, an oil field that is only economic at $90 oil may be attractive to sell when oil is $100 – especially if the company has no plans to develop it.

Synergies for Strategic Buyer

With the right strategic buyer where the asset fits well, the seller can realize a higher value than through any other process. For instance, if an oil and gas company owns a number of gas stations, a company that specializes in gas stations and convenience stores could make them more profitable, achieve scale advantages and cut administrative costs. A sale to this acquirer could be more lucrative than a spin-off.

Attractiveness as LBO Target for Financial Sponsor

Provided cash flows are stable, a private equity firm could take on substantial gearing/leverage and receive an adequate return on equity that is not possible given the leverage constraints of the public firm. Additionally, the private equity firm may be able to cut costs and bring in specialized management.