Should debt be completely tapped out or corporates want to stay within their investment grade credit rating (for some names, they may want to stay at a specific credit rating – for example A-), issuing equity or capital with high equity content is an option when a company requires funding for M&A or capital expenditures.
Issuing Common Equity to Consummate a Merger or Acquisition
Common equity is one of the easiest ways to raise capital and can be raised in a variety of ways for M&A. Common equity can be sold on the market as underwritten by investment banks (with funds raised via an equity bridge loan from corporate banks first), raised privately with a strategic investor such as a pension fund, or included in the purchase price of the acquisition.
Although the easiest to raise, strictly positive from a credit rating standpoint and the most accessible even when all other capital markets are not available, raising equity is dilutive to existing shareholders (especially so exactly when other capital markets are not available), creates a larger total dividend obligation if the acquiring company pays a dividend and come with heavier fees for the investment bank than other capital raises.
Vendor Take Back Equity or Cash-Stock Mix
The easiest way is via including shares in the consideration. When purchasing an asset from another company, there will be a component of the deal that is paid via delivering shares to the seller.
So, for instance, if Company A purchases a portfolio of power assets from Company B for $1,000 with $300 in cash and $700 in stock, Company B will receive a number of shares in Company A deemed to be the equivalent of $700.
These Company A shares will be held on the books of Company B as an investment. This equity is sometimes called vendor take-back equity, with the vendor (seller) maintaining an indirect interest in the asset via ownership of the new entity.
When a company is purchasing another company outright in a merger, should a proportion be funded via equity, all of Company B will be dissolved into Company A. As such, the consideration will be to the shareholders of Company B directly.
The merger may offer terms such as “shareholders of Company B will receive $12 and 0.7 shares of Company A for each share of company B for a total consideration of $26, representing a 15% premium to yesterday’s closing price.”
Usually corporates are reluctant to issue shares in any situation due to the dilution to existing shareholders. In most cases, common equity issuance results in a fall in the issuing company’s share price.
However, for the purposes of a merger or acquisition it is not uncommon for the acquiring company’s stock price to go up if the investor universe feels that they are 1) getting a good price for the equity or 2) there are tangible synergies.
A Fairly Priced Merger
A good price would be where the assets of the target company is undervalued while the stock of the acquiring company is trading fairly or better. Getting a good price is difficult as merger approaches are usually conducted at a premium to market prices.
For some corporates, their own shares can be an excellent acquisition currency for larger deals. If shares of a company trade at a premium to their peer group (for instance 20x price-to-earnings versus 15x P/E for comparables), like Starbucks used to do compared to other restaurant stocks, stock for stock deals may more often be accretive on an earnings basis. The premium may be justified due to a history of operating performance and a stable management team, they may buy an asset which would trade at a higher price within the acquiring company as it has been derisked to outside investors.
A good price could also be due to a motivated seller – for instance a company that is looking to divest non-core assets to rationalize their portfolio. For example, if an activist shareholder tells a company to break up its conglomerate structure to streamline operations and unlock value, any dispositions will tend to go at a lower price than an unsolicited approach – which is good for the buyer.
A company which is distressed without an active buyer market would also be attractively priced for opportunistic buyers. For cyclical industries, this can be quite common. During the last oil price crash, several oil and gas producers became far too leveraged and ran into liquidity problems.
Meanwhile, the buyer market dried up as attractive companies that would normally bid in a healthy market needed to shore up their balance sheets. As such, companies that were conservative during the boom were able to snap up assets without competition – a good example is Suncor, who made approaches for Canadian Oil Sands and upped their share of their Fort Hills joint venture while oil prices were depressed.
More often than not, the value lies in the perceived synergies. If Company A has operations close to Company B, there are efficiencies of scale and cost cutting exercises that can be conducted. If Company A and B sell complimentary products, there can be cross-selling initiatives. The possibilities are endless, but investors will generally have their own perceptions about what synergies are real and what management talks about in their analyst calls but never come to fruition.
Preferred Equity for Mergers and Acquisitions
Issuing preferred shares is not common as a source of capital for M&A but will be tapped into by larger corporates with sophisticated treasury teams as they look to avoid issuing as much equity as possible. The reality is that most companies do not have good access to the top preferred share ratings from Moody’s & S&P, and accordingly cannot issue at a low preferred dividend.
In addition, preferred dividends are not tax deductible compared to interest on debt while the capital is only given 50% equity treatment, so the credit rating is not as protected as with an equity issuance.
As such, preferred share dividends are used in conjunction with corporate actions, but less so for M&A. For large capital expenditure or share repurchase programs, preferred shares can be looked at as a funding mechanism in limited quantities if there is investor appetite whereby the weighted-average cost of capital would be lowered.
Potential preferred share issuances in these cases are meticulously planned by treasury and investment bankers and will make sense when they align with attractive pricing – whereas this may often not line up with a pending merger. The preferred market is far smaller than that of equity and debt, and given the transformative nature of mergers whereby large amounts of capital would be needed and the future of the firm uncertain, the attractiveness of preferred shares wanes.