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(a) Surplus managerial talent
Companies with highly skilled managers can make use of this resource only if they have problems to solve. The acquisition of inefficient companies is sometimes the only way of fully utilizing skilled managers.
(b) Surplus cash
Companies with large amounts of surplus cash may see the acquisition of other companies as the only possible application for these funds. Of course, increased dividends could cure the problem of surplus cash, but this may be rejected for reasons of tax or dividend stability.
(c) Market power
Horizontal mergers may enable the firm to obtain a degree of monopoly power which could increase its profitability.
(d) Speed
Acquisition may be far faster than organic growth in obtaining a presence in a new and growing market.
Many acquisitions are by mutual agreement, so small companies being acquired may welcome such a move. There are a number of possible reasons:
‘ (a) Personal – e.g., to retire, for security, because of the problem of inheritance tax.
(b) Business – an expanding small company may find that it reaches a size where it is impossible to restrain growth, but funds or management expertise are lacking.
(c) Technical – increasing sophistication presents a problem for the small company, e.g.:
(i) cost of research and development may be prohibitive;
(ii) inability to employ specialized expertise;
(iii) inability to offer a complete range of services or products to customers.
Such factors can apply to companies that are quite large by most standards, eg, Rolls-Royce Ltd was too small to absorb the losses on one new engine.
Acquisition is a popular route to growth and we have noted several arguments to justify expansion based on acquisition. We have also seen that many of these arguments are suspect.
Research in this area has two major conclusions:
(a) Value or synergistic gains are in practice quite small.
(b) Bidding companies usually pay a substantial premium over the market value of the victim company prior to the bid.
The implications of these findings are quite significant and may be demonstrated by returning to Application #3 of our two companies, A and B, both having a market value of £2m each in isolation.
Let us assume that when these are combined a small amount of synergy is obtained and their combined value rises to £4.5m.
Let us further assume that to acquire B’s shares A has had to pay a premium of £1m, i.e., total cost of B is £3.m
The benefit/(cost) of the takeover to A’s shareholders is as follows:
£ Market value of AB 4.5m Original value of A 2.0m Price paid for B 3.0m Loss (0.5m)
This loss will be to the cost of the acquiring company shareholders but to the benefit of the victim company shareholders (as they received the £1 m premium).
This in fact reflects the overall conclusion of research in this area: the consistent winners In mergers and takeovers are victim company shareholders; the consistent losers are acquiring company shareholders.
Reasons advanced for the high failure rate of takeovers are:
(a) Over-optimistic assessment of economies of scale. Such economies can be achieved at relatively small size; expansion beyond the optimum results in disproportionate cost disadvantages.
(b) Inadequate preliminary investigation combined with an inability to implement th amalgamation efficiently.
(c) Insufficient appreciation of the personnel problems which will arise.
(d) Dominance of subjective factors such as the status of the respective boards of directors.
Perhaps the fact that acquisition is often favored as an alternative to expansion by other means implies a tendency towards laziness in management. It is probably considered easier to acquire an existing business rather than to subject oneself to the discipline of seeking and justifying more difficult investment projects. Furthermore, the high level of redundancies evidenced in larger groups indicates that mergers and acquisitions create a situation where rationalization (which would otherwise be shirked) may be carried out more acceptably.
(a) Not all mergers are failures; some in fact are very successful. On average, however, research shows that expansion based on merger and takeover seems to bring few value gains to acquiring company shareholders.
(b) Mergers, however, are often in the interests of managers. They view success in a different light from shareholders and are often more concerned with the job security and career prospects brought by sheer size.
(c) There are alternatives to growth by acquisition. It is sometimes argued that as markets become more global mergers are required to allow companies to be large enough to compete. For example, telecommunications companies need to be very large to support the required research and development overhead. Other industries have, however, found ways round this problem. Joint ventures in the car industry between Honda/BL and Ford/Mazda are examples of alternatives to merger.
Merger and acquisition activity is much more common in the UK and USA than in Germany or Japan. This is principally because banks dominate the financial systems of Germany and Japan, and develop long-term relationships with the companies they serve, taking significant equity stakes and perhaps having board representation. These banks would not sell their stakes to a predator, whatever price is offered.
In the UK and USA most shares are held by institutional investors (pension funds, unit trusts, insurance companies, etc,). Their traditional tendency has been to sell their shares if they are dissatisfied with the company’s performance or if offered a significant premium to market price.
Some commentators have also argued that lax accounting standards in the UK have encouraged takeover activity in the past. Mergers were generously defined in SSAP 23 so that many acquisitions could be structured to fall within the SSAP 23 definition of a merger and so be accounted for using merger accounting. Additionally SSAP 22 allows purchased goodwill to be eliminated directly against reserves on acquisition, which is more generous than the international standard requiring capitalization and amortization. The ASB are grappling with these problems as part of their current work programmed and hope that FRS 6 will prove more acceptable than SSAP
The implications of high takeover activity in the UK and USA are not clear cut. One view is that this contributes to the efficiency of the market, with resources being directed towards good managements. The opposing view is that most anticipated synergy gains are not realized in practice and that high takeover activity simply leads to short-term investment horizons by managers. This is an interesting area of the current debate on corporate governance in the UK.
Both organic growth and external growth as possible long-term growth strategies. No external growth should be considered unless the organic alternative has been dismissed as inferior. Assuming then that external growth has been decided upon, the remainder of this chapter considers the steps to be taken. A possible sequence of steps is as follows.
Step 1 -Appraise possible acquisitions
Step 2 - Select the best acquisition target
Step 3 Decide on the financial strategy ie, the amount and the structure of the consideration
Step 1 - Launch a dawn raid subject to the City Code
Step 2 -Make a public offer for the shares not held
Step 3 - Success will be achieved if more than 50% of the target company’s shares are acquired
Once a company has decided to expand by acquisition, it must seek out prospective targets in the business sectors it is interested in.
For each company examined, clearly the first objective is to examine the prospect closely from both a commercial and financial viewpoint. In general businesses are acquired as going concerns rather than the purchase of specific assets, and thus this section summarizes the variety of areas which require special examination:
(a) Organization
Special requirements:
(i) Organization chart.
(ii) Key management and quality.
(iii) Employee analysis.
(iv) Terms and conditions.
(v) Unionization and industrial relations.
(vi) Pension arrangements.
Clearly, businesses are about people, and their quality and organization requires examination. Further, comparison needs to be made with existing group remuneration levels and pensions, to determine the financial impact of their adoption, where appropriate, on the acquisition.
(b) Sales and marketing
Special requirements:
(i) Historic and future sales volumes by:
(1) Major product group.
(2) Geographical location.
(3) Major channels of distribution.
(ii) Market position, including customers and competition for major product groups.
(iii) Sales organization.
(iv) Normal trading terms.
(v) Historic sales and promotions expenditure by product group.
(vi) Trade marks and patents byproduct group.
This additional information should provide a detailed assessment of the market and customer base to be acquired.
(c) Production, supply and distribution
Special requirements:
(i) Total capacity and current usage levels.
(ii) Need for future capital investment to replace existing assets, or meet expanded volume requirements.
This would provide an assessment of the overhead burden due to undercapacity production and of the potential future capital requirements to maintain the required productive capacity of the business.
(d) Technology
Special requirements:
(I) Details of particular technical skills inherent in the acquisition.
(ii) Research and development organization and historic expenditure.
Thus, an analysis would be made of the technical assets acquired, and their past and potential future maintenance costs.
(e) Accounting information
Special requirements:
(i) All companies in business acquired, and legal structure.
(ii) Company searches for all companies.
(iii) Historic consolidated and individual company accounts.
(iv) Detailed explanation of accounting policies.
(v) Explanation for any extraordinaries, exceptional or other non-recurring income or expenditure.
(vi) Explanation of major fluctuations in sales, gross margins, overheads and capital employed.
These provide the background for basic financial analysis.
(f) Treasury information
Special requirements:
(i) Amounts and terms of bank facilities and all other external loans and leasing facilities (including capitalised value, if not capitalised).
(ii) Details of security for such facilities.
(iii) Details of restrictive covenants and trust deeds for such facilities.
(iv) Details of guarantees and indemnities given for financial bonds, letters of credit, etc.
(v) Details of forward foreign exchange contracts, and exchange management policies.
All this information will be useful in planning the financial absorption of the business into the acquiring group, and will in particular reveal any ‘hidden assets’ (eg, low coupon loans) and ‘hidden liabilities’ (guarantees liable to be called, or hedged foreign exchange positions).
(g) Tax information
Special requirements:
(i) Historic tax computations, agreed, submitted and unsubmitted by company.
(ii) Significant disputes with Revenue.
(iii) Trading losses brought forward.
(iv) Potential deferred tax not recorded as a liability in the accounts.
(v) Other potential tax liabilities, including VAT and PAYE.
(vi) Understanding of tax position of vendors, especially with respect to capital gains tax liability as a result of sale.
This can identify any potential tax assets (eg, utilisable losses) and liabilities (eg, likely payments of tax not provided), and assist in pricing and structuring the transaction having regard to the vendor’s tax position.
(h) Other commercial/financial information
Special requirements:
(i) Details of ordinary and preference shareholders, with amounts held by each class, and voting restrictions if appropriate, together with share options held and partly paid shares.
(ii) Details of trading with related parties; management charges and prices.
(iii) Contingent liabilities, including litigation, forward purchase or sales contracts, including capital commitments and loss-making contracts not otherwise provided for.
(iv) Actuarial assessment of current pension funding, with assumptions.
(v) Details of important trading agreements.
This relates primarily to a better understanding of the capital structure and shareholdings to be acquired, and any potential financial liabilities overhanging the acquired company, of which the most significant may well be underfunded pension schemes.
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