A Lesson in Mergers & Acquisitions Theory

Step back for a second and forget all of the accretion/dilution, tax implications and purchase price allocation jargon that goes into mergers and acquisitions and read this to understand the basics of mergers and acquisitions.

A firm buys another firm. There are no synergies and no premium paid.

Value (combined) = Value (firm A) + Value (firm B)

This seems like a simple enough concept. However, in reality shareholders of firm B – which for all intents and purposes we will call TargetCo, will require a premium versus its current share price to entice them to sell. Otherwise why not hold the stock, especially if they like the management and strategy?

So assuming that the market is fair and TargetCo is fairly valued, in order for AcquirerCo to justify paying a premium for TargetCo, the synergies from the acquisition have to be greater than the premium paid.

Value (A + B) = Value (Acquirer) + Value (Target) – Premium + Synergies

There are a lot of permutations for this because the target is not necessarily fairly valued. So for instance, if AcquireCo prescribes a $50 billion intrinsic value to TargetCo and TargetCo’s market enterprise value is $40 billion, the premium that AcquireCo can afford to pay in theory could be higher. Likewise, if AcquireCo feels that their stock is overvalued (which they would never say publicly – in fact, we should call it richly valued instead of overvalued), their stock can be effective currency for an acquisition.

This dynamic of what is worth what causes differing opinions and a negotiating zone for price. When the synergies are only made possible by the AcquireCo firm, they should not pay TargetCo shareholders for this by way of premium.

Mergers and Acquisitions in Reality

Now in reality, this value metric is more difficult to identify because TargetCo may not be fairly valued – and the market may not react in the same way that the AcquireCo’s management had theorized.

As Warren Buffett loves to say, “the market can remain irrational longer than you can remain solvent.”

As an acquirer generally pays a premium to acquire the target, when a merger is announced TargetCo will see its share price pop. However, there can be various outcomes for AcquireCo stock – generally it goes down, but when the market believes the synergies, AcquireCo can see its share price jump as well.

Prescribing value is hard. What investment bankers can do is model out accretion and dilution in terms of earnings per share and cash flow per share.

Sources and Uses for Mergers and Acquisitions

To do this, they must map out a sources and uses table.

Although we always say it in that order, the investment banking analyst should figure out the uses first.

The uses is the TargetCo equity (including the premium), the TargetCo debt and the TargetCo preferred shares (and anything else in the TargetCo capital structure) plus any associated transaction fees (M&A bankers, financing fees, lawyers, accountants, trustees). Any stock based compensation will also have to be paid (DSU, RSU, PSU).

The TargetCo equity is calculated by the unaffected share price plus the premium multiplied by the fully diluted shares outstanding.

Then the analyst looks at the sources of cash to fund the transaction.

Any spare cash on the balance sheet can be used, debt from the TargetCo can be assumed (this generally only works if the AcquireCo is more creditworthy than the TargetCo – otherwise it will need to be refinanced and increase the amount of debt needed), preferred shares (which are good for preserving credit ratings as a funding source), new debt and new equity.

Obviously, sources must equal uses.

Merger Math Basics

Now if the combination is funded entirely with debt, the share count remains the same. This will usually be accretive.

Net Income (MergeCo) = Net Income (TargetCo) + NI (AcquireCo) + Synergies (1 – Tax) – incremental Interest Expense (1 – Tax)

So the new net income over an unchanged shares outstanding for AcquireCo is the new EPS.

The new debt has associated interest. So it is very rare that an all debt transaction is dilutive, and if it is, shareholders will be rightfully asking why the AcquireCo is paying so much.

If it is funded entirely with cash, it is even more simple. Just tack on the earnings and synergies from TargetCo and earnings will rise. EPS will accordingly rise as the share count is unchanged.

This is why companies with huge cash balances are obvious acquirers. Cash burning a hole in their pocket is very real in corporate finance – having a ton of spare cash on the balance sheet is not efficient. It needs to be deployed.

Merger Math with New Share Count from Equity Consideration

When shares are issued, this is when merger math becomes a little more complicated (but not that complicated, investment banking is a remarkably easy business).

The equity amount under uses is divided by the current AcquireCo share price to solve for the additional shares outstanding. If the AcquireCo convinces the TargetCo shareholders to accept stock, this is an easy calculation and has no additional friction costs.

If the offer is for cash, AcquireCo must issue stock on the open market, which will come with associated equity underwriting fees paid to the investment banks. Additionally, the stock will likely have to be issued at a discount to the unaffected share price, causing more dilution than a transaction where the TargetCo shareholders take shares.

So now, the formula is still:

NI (MergeCo) = NI (AcquireCo) + NI (TargetCo) + Synergies

However, the denominator (shares outstanding) has increased, so the banker has to run the math to see whether it is accretive or dilutive.

With all mergers, it can be funded with debt or stock or any combination in between.

Strategic Alternatives in Practice in an M&A Context

When looking at strategic alternatives, investment bankers will look at the offer from AcquirerCo and evaluate whether they should stay the course or ask for more money – as well as where the breakeven point is.

So assuming that AcquirerCo offers $35 a share to TargetCo that was trading at $25 a share, the investment bank will look at management projections for TargetCo and look at where their hypothetical share price would be given the appropriate EV/EBITDA or EV/Sales or Price/Earnings ratio in 5 years after the successful execution of their current corporate plan and discount that back by an appropriate discount rate.

If there is no situation where TargetCo can achieve the PV equivalent to the $35 offer or the path forward is not obvious and management just wants to exit, it makes sense to accept the offer – but it never hurts to ask for more money.

Investment bankers can also look for a competing bidder or white knight that hopefully causes a bidding war, rewarding TargetCo shareholders and the investment bank where the fee is based off of the transaction value (always enterprise value, never market capitalization).

A compromise is to accept more equity consideration instead of cash consideration so that if there is a good thesis for TargetCo, selling shareholders can continue to ride the upside via rising MergeCo (new AcquireCo) stock. Of course, this means that AcquireCo itself needs to be a respectable company with a believable strategy so that there is less shareholder churn (TargetCo shareholders that receive MergeCo shares immediately dump it).