Investment Banking: Understanding the M&A (Merger and Acquisition) Process

What is M&A and its types?

Mergers and Acquisitions is often commonly used as a single term but the two terms have entirely different meanings in the finance domain.

Merger is a process wherein two different companies unite to form a single entity while an Acquisition refers to the purchase of ownership of a company by another. In the M&A process generally, the buying company is called bidder/acquirer and the selling company is known as target.

There are broadly 5 categories of M&A-

1. Horizontal: both the companies are in the same industry and in the same sector
2. Vertical: both the companies are in the same industry but of different product verticals
3. Conglomerate: both the companies are from completely different industries.
4. Friendly takeover: target company’s management and Board of Directors agree to the M&A
5. Hostile takeover: bidder firm tries to take over target firm without the consent of latter by purchasing majority of its shares
6. Reverse takeover: a private company acquires a public company, therefore, avoiding the IPO process

Why M&A?

The rationale behind this corporate strategy is to improve the financial performance and to reduce company’s risks. Some of the ways in which this can be achieved are-

1. Synergy: this refers to the overall increase in the combined firm’s value as compared to the sum of the individual parts. This increase in value occurs because of cross-selling and economies of scale
2. Accretion: a deal is said to be accretive if the Earnings per Share (EPS) of the combined firm is greater than that of buyer’s firm
3. Market power: companies undergo M&A to eliminate the competition and establish market dominance

Due diligence

Before conducting company’s valuations, the acquirer does a thorough analysis of the target firm. This is done by performing multiple rounds of due diligence to look at all the critical aspects of the target company. Some of them are as follows-

1. Commercial: includes company market position, past performance and market trends
   • Competitive landscape and market position
   • Industry growth
   • Customer segment
   • Capital requirements
2. Financial: includes all the financial information to understand company’s dynamics
   • Balance Sheet & Income Statement analysis
   • Cash flows
   • Quality of earnings
   • Human Resources

1. Legal: confirming the regulatory issues and provisions
   • Corporate filings
   • Lawsuits/Litigations

Company valuations:

In an M&A process, it is of paramount importance to accurately determine the target firm’s value. There are many legitimate ways to conduct company valuations but here are the some of the most commonly used models-

1. Comparable company: it’s a market-based valuation analysis where the target firm is evaluated using business metrics of other companies of similar sizes operating in the same industry vertical and experiencing similar growth levels. This method is best suited when a minority stake in the company is being acquired The most preferred valuation metrics are-

• Enterprise value to EBITDA (Earnings before Income, Taxation, Depreciation and Amortization)
• Price to Earnings ratio (P/E): Price per share/ Earnings per Share

1. Discounted Cash Flow (DCF) analysis: it’s a method where a company’s future cash flows are discounted to the present year using a suitable discount rate (Weighted Average Cost of Capital). It uses the concept of time value of money (TMV) to determine the net present value of the target firm using its projected future cash flows and terminal value.

1. Precedent transaction: this process estimate purchase price by considering the relative price paid in the past M&A transactions of the same business line. It is generally incorporated when a buyer assumes majority control of the acquired equity.  There is a control price premium paid by the buyer which is the difference between the actual price paid and the market value of the target firm. Some of the commonly used multiples are-

• Enterprise value to EBITDA(Earnings before Income, Taxation, Depreciation and Amortization)
• Price to Earnings ratio (P/E): price per share/ Earnings per Share
• Control price premium: determines how much (%) the actual cost of acquisition is higher than target’s market price

Pricing structure:

Once the target firm has been evaluated and cost of acquisition is determined, the acquirer can choose either of the following ways to finance it-

1. Cash: buyer uses its cash and liquid assets to pay the acquisition price
2. Stock: target firm receives shares of the combined firm
3. Both: buyer pays a fraction of the purchase price via cash and rest via stocks

Company proposal

This process includes preparing the Investment Memorandums, conducting management presentations and meetings and reporting the detailed information of both the companies and sending proposals for a merger/acquisition with complete details including the strategies, amounts and the commitments

Integration process

This process involves both the companies coming together with their own parameters and majorly includes the processes of –

1. preparing documents and signing agreements
2. negotiating the deal
3. preparing financial statements (pre-forma statements) of the combined entity
4. merging their operations

Exit opportunities:

Following are most common exit strategies opted by companies in M&A-

1. Divestiture: refers to a complete sell-out of a business/operational unit because of its non-profitability or simply to meet its own financial obligations
2. Spin-off: a case where the buyer forms a separate business unit from the merger via distribution of new shares of the parent company
3. Equity carve-out: a corporate restructuring where a company dilutes its ownership in the acquired firm by selling its minority shares to outside investors
4. Leveraged Buyout (LBO): an acquisition of a company with significant amounts of debts on the buyer. During the ownership, target firm’s cash flow is used to service and pay down the outstanding debt and then it is sold after 5-6 years

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