Session 9 CB Acquisitions PDF

**Session 9** **9.1. CB acquisitions** A A cross border acquisition is the purchase of a company or assets located in another country **Increasing trend / factors** 1992 -- creation of a single market in the EU enhanced the free movement of goods, services, capital, and people, making cross-bor...

**Session 9** **9.1. CB acquisitions** A A cross border acquisition is the purchase of a company or assets located in another country **Increasing trend / factors** 1992 -- creation of a single market in the EU enhanced the free movement of goods, services, capital, and people, making cross-border transactions easier and more attractive 1999 -- the introduction of the Euro simplified financial transactions across Eurozone countries, reducing exchange rate risk and facilitating cross-border trade and investments The inclusion of additional countries (particularly from Western Europe such as Poland and Hungary), expanded the market and created new opportunities **Globalisation** surged, converging consumer needs and preferences **Global competition** also heightened, pushing companies to expand operations internationally **Tech advancements** drove massive investments in R&D and enabled firms to operate more efficiently on a global scale. Also facilitated collaboration / communication across borders **Privatisation of state-owned enterprises**, such as power and gas, has opened up new markets for foreign investors More countries adopted a more welcoming stance towards foreign ownership, **reducing barriers** to cross-border investments **The European Directive on cross-border mergers** aims to harmonise rules for cross-border conversions, mergers, and divisions of limited liability companies within the European Economic Area (EEA). 1. The directive reduced legal fragmentation and uncertainty that previously existed 2. It allows companies to move their registered office across borders within the EEA more easily 3. It safeguards creditor and minority shareholder protection, ensuring that their rights are protected during cross-border reorganisations 4. It introduces simplified procedures for less complex mergers, making it easier for companies to undergo cross-border reorganisations **Foreign direct investments** This refers to investments made by a company / individual in one country into business interests located in another country One model to explain FDIs is Dunnings (2000) eclectic model. It consists of three stages / questions 1. Ownership decision: does the firm possess certain competitive advantages that can be exploited to create value through FDIs? - Asset exploiting -- deploy existing competitive advantages, such as tech or reputation, to enter foreign markets. The aim is to transfer the firm's home country competitive advantage to the host country. These firms leverage their competitive business advantages - Asset augmenting -- strengthen their resource and capabilities with those of the host country firms to gain a competitive advantage. These firms seek valuable resource 2. Location decision: is location in foreign country superior to that of home country? - Trade-off: pull (advantages of host country) and push (disadvantages in home country) - Pull factors -- size, demand of product, availability of complementary assets, scale economies - Push factors -- market maturity, intense competition, poor infrastructure, gov regulation, political and economic uncertainty 3. Internalisation decision: should the foreign production be carried out under the ownership and organisational control of the firm or through alternative modes - Make or buy decision: - Make -- produce internally, keeping control over processes and products - Buy -- outsource production / partner with other entities - Trade-offs: - Internalisation -- greater control and protect technology and maintain quality standards - External relationships -- local expertise, reduce costs and share risks **OLI framework (ownership -- location -- internalisation)** **O --** the firms unique assets or capabilities that give it a competitive edge over local firms in the host country **L --** specific attributes of the host country that make it an attractive destination **I --** benefits of maintaining control over foreign operations rather than licensing or outsourcing B **Cross-border M&A** - In 1986 to 2000, CB M&A had a share of 26%. By 2016 this grew to over 50% - R&V (2019) find that while CB M&A can create opportunities by enabling knowledge transfers and exposing the new firm to new practices and techniques, it can also increase social conflicts and induce post-merger coordination difficulties which curb the realisation of synergies - Datta and Puia (1995) find that cultural differences lead to a lack of knowledge about the foreign market and induces the bidder to overpay for the target - Conn et al (2005) finds that while CB deals earn less negative returns than domestic deals in the short run, returns become considerably more negative relative to domestic deals in the long-run stock returns based on BHARs or CTARs. - Long-run stock returns improve when the deal involved high-tech or R&D intensive acquirers, because they can benefit from learning opportunities and knowledge transfers - Additionally, some studies find that CB M&A can create additional synergies with spillovers in governance standards which can benefit both bidder and target shareholders and bondholders, particularly when the bidder's standards are stricter than the target's as this facilitates the bidder to shift the target's focus to shareholder value creation rather than private managerial benefits - From a political perspective, when legal systems are weak and corruption levels are high, politically connected bidders outperform unconnected peers by 20%. On the other hand, when corruption levels are low and there is a firm legal structure in place, connected bidders receive 15% lower long-run abnormal returns compared to unconnected bidders **FDI -- OLI Relationship** Foreign Direct Investment (FDI) and Dunning\'s (2000) eclectic model, also known as the Ownership-Location-Internalization (OLI) framework, are closely related as the OLI framework provides a comprehensive explanation for why firms engage in FDI. According to Dunning, firms pursue FDI when they possess Ownership advantages, such as proprietary technology or brand reputation, that give them a competitive edge in foreign markets. These firms are also motivated by Location advantages, such as market size, resource availability, and favourable economic conditions in the host country, which make it attractive for investment. Additionally, Internalisation advantages influence the decision to keep control over their operations abroad, rather than outsourcing or licensing, to ensure quality control, protect intellectual property, and reduce transaction costs. Together, the OLI framework explains the strategic considerations that drive firms to undertake FDI, integrating these three key advantages to optimize their international business operations. Cruz et al (2020) finds that the OLI framework can capture region-specific factors which contribute to the increasing trend in CBAs. The research highlighted the importance of institutional factors, such as local regulations and government quality, in shaping FDI decisions. He finds these factors vary significantly within a country and have a substantial impact on the attractiveness of different regions for foreign investors. C Tiger Brands Ltd / HACO -- a south African food company acquired 51% stake in HACO industries, a Kenyan food processing company. - It allowed Tiger Brands to enter East African market and leverage HACO's local market knowledge and distribution network **9.2. Divestitures** A A divestiture is essentially selling part of a business and is part of the M&A landscape. When a company divests, it is selling off a portion of its operations or assets. Divestitures and M&A are essentially two sides of the same coin in corporate strategy, but serve opposite purposes. If we think about conglomerates, this is acquiring unrelated businesses and studies show this did not prove to be successful. Divesting is basically selling off diverse portfolios of unrelated business (reversing these expansions) and focusing resources on core businesses where the company has expertise and competitive advantages. **Antitrust --** sometimes regulatory bodies require a company to divest part of its operations to prevent anti-competitive market structures. This is to ensure no single company can dominate a market to the detriment of consumers and competition. An example is BT being made to sell Openreach. **Reasons for divesting / their importance** - Underperforming divisions may be divested as it can drain resources and negatively impact overall profitability - Strategic misalignment means that even if the division is performing well, it may not fit the long-term strategic goals of the parent company - Overdiversification is when a company is too diversified and so it is becoming challenging to monitor and manage. By divesting non-core businesses, this can help streamline operations and improve managerial focus - If a company is in financial distress, they may be looking for ways to raise cash quickly and so selling off divisions or assets can provide necessary funds to alleviate financial pressures **Other strategies** **Acquiring and selling parts -** When a company acquires a target firm, it may sell some of its parts or subsidiaries to 1) make it more focused and 2) to raise money to finance the deal **Bust-up Takeover** -- "bust up" the target by selling off parts to strategic buyers, often employed to 'buy low, sell high' and capitalise on the value of individual parts **Buy-Operate-Sell --** acquire a company, operate it to improve performance ir extract value, then sell it (private equity) **Higher value standalone entity** -- the parent company may believe that the divested part will have a higher valuation when it operates independently **Strategic fit** -- the divested part may be a better strategic fit with another company **Defence against hostile takeover --** as a defence mechanism against a hostile takeover, a company might sell its most valuable assets (referred to as 'crown jewels') which can make the company less attractive to the potential acquirer **Types of divesting** **Sell-offs -- less control of divested business** - Company sells off a division, subsidiary or assets to another company or entity - Primary goal is to raise capital, streamline operations, or focus on core business areas - Sell-offs can lead to immediate financial gains, improved operational efficiency, and a more focused business strategy - Could result in job losses and potential disruption to sold-off division **Carve-outs (equity carve-out) -- retains control of divested business** - A parent company sells a minority stake in a subsidiary through an IPO while retaining majority ownership - Parent company aims to unlock value of the subsidiary, raise capital, and provide the subsidiary with more operational independence - Can lead to increased market visibility and access to capital for the subsidiary - May create complexities in governance and potential conflicts of interest between parent and subsidiary **Spin-offs -- less control of divested business** - Distribute shares of a subsidiary to the parent company's shareholders, creating a separate, independent company - Allows both the parent company and the spun-off entity to focus on their respective core competencies and strategic goals - Leads to enhanced shareholder value, as both entities can pursue their growth strategies independently - It may also result in initial market volatility and the need for new management structures B **Villalonga (2024)** - Finds that divestments have a positive, significant, and substantial effect on raising the profitability of the vendor company - Finds that successful divestitures include three interdependent activities: defining, marketing and disentangling the asset in question - Technological resources drive firms towards alliances to retain **Thompson (2003)** - Divestitures have a positive impact on profitability of the parent company - Limited support for the view that benefits from divestments are greater for larger and/or more diversified firms. This may be because for large firms, divesting parts of the business can be challenging due to interdependencies and complexities involved in disentanglement **Alexandrou and Sudarsanam (2001)** - On average, buyers experience significant buy and hold abnormal returns of 0.48% over three days following the divestiture announcement - Buyers enjoy larger gains when they buy from financially healthy sellers and during recessions **McKinsey (2024)** - Programmatic acquirers, who by far outperform non-programmatic acquirers, are not only acquisitive but they also actively divest nonstrategic assets. They found that programmatic acquirers were more likely than others to say their organisations conducted divestitures in the past five years **Prezas (2012)** - Sell-offs are associated with greater improvements in post-divestiture long-term operating and stock return performance compared to spin-offs **Renneboog and Vansteenkiste (2019)** - Recent empirical evidence supports the value-creating nature of divestitures and on average the market does not react negatively to divestiture announcements - Research also shows that divisions which are retained increase productivity post-divestiture and this leads to an increase in the firm's wealth C Proctor & Gamble sold off Pringles to focus on its core consumer goods business IBM and Lenovo: IBM sold its Personal Computing Division to Lenovo to allow IBM to focus on its core competencies and exit a low-margin, highly competitive market **9.3. Financial advisors** A Large firms who are frequent acquirers may have their internal M&A department which is classed as in-house expertise. However, most bidders require help from outside advisers. This includes investment bankers, lawyers, accountants, tax experts, public relations and actuaries to name a few. **Sell-side (for bidder)** *PK notes:* 1. How we would position / market the company to potential buyers 2. How we will design the sale process to maximise competitive tension, get it done quickly, provide execution certainty etc 3. Who we think the buyers are and our access to them 4. What we think valuation will be, what the key areas of investor push back will be, how we would address those concerns 5. Why we are best placed to sell you vs other banks 6. And then how we will help finance a buyer *Steps involved* - Find potential targets - Evaluate strategic prospect - Suggest financing structure (method of payment, financing resources) - Negotiation tactics - Information about rivals - Profile target firm to 'sell' deal more efficiently - Identify any blockers (antitrust) - Prepare documentation - Deal with takeover regulator **Buy side** *Steps involved* - Monitor target share price and warn for potential bidders - Propose bid resistance strategies - Value the target and negotiate a higher premium - Help target prepare profit forecasts - Getting feedback from financial institutions about the offer an likelihood of acceptance - Negotiate with bidder **FO -- fair value opinion** FO is a detailed valuation of a company used to support M&A decisions. It provides an interdependent assessment of a company's fair value. Its purpose is to: 1. Help bidders and targets justify their M&A decisions to their shareholders 2. Serve as legal protection for management against shareholder lawsuits, ensuring that decisions are based on an independent valuation 3. Used to improve the terms and structure of the transaction, ensuring it is fair and beneficial for all parties involved The role of advisers is to provide FO to companies involved in M&A deals, often investment bankers or financial consulting firms Fos are a legal requirement in some countries like the US to ensure fairness and transparency in M&A. In the UK, Fos are optional and it is left to the discretion of the companies involved **Impartiality concerns -** The fees for advisors usually depend on the completion and success of the deal, which can actually raise questions about the impartiality of the FO. Advisers could be incentivised to complete the deal or a lower one if the target company wants to defeat a hostile bid **Bankers** - Represent companies during financial transactions, such as M&A, acting on their behalf to provide advice and negotiate deals - The market for M&A advisers is dominated by a few large firms. It is possible for the same adviser to represent different companies in various deals over time. - Advisers typically have a fee structure that includes a minimum fee even if the transaction isn't completed - Targets might offer bonuses to advisers to fend off hostile takeover attempts **Impact of financial advisers** - The reputation of advisers helps align their interests with those of corporate clients. A good reputation means they are likely to act in the best interest of the companies they advise B Kisgen, Qian, and Song (2009) explore two hypotheses related to FO: 1. Legal protection hypothesis is when the FO acts as legal protection for management against shareholder litigation 2. Transaction improvement hypothesis is when the FO is used to enhance the terms and fairness of the transaction Bowers and Miller (1990) find there is no significant difference in abnormal returns generated by top-tier vs non-top-tier advisers Travlos (2010) found that top-tier advisers deliver higher abnormal returns compared to non-top-tier advisers, suggesting the quality of the adviser can impact the outcome of the deal **Kevin Kaiser, Professor at Wharton Business School, podcast discussion:** Advisers, bankers, lawyers etc all have their own incentives and those incentives also play a role in how the M&A industry operates. He argues that the ones most commonly targeted for success and failure, rightly or wrongly, are the investment bankers who are highly skilled and very good at their jobs. They are incentivised to get the deal done and he argues that this is perfectly legitimate. He argues that the role of investment bankers are one of the most important professions on the planet because what they do, in essence, is make markets. They find a price that clears supply and demand: 1. in selling shares to an IPO market 2. in selling debt to a debt market 3. in doing M&A or divestitures between buyers and sellers He explains that finding the price that clears supply and demand is an extremely important role to be played and enables any market to function He offers another perspective that investment bankers and other advisers are agnostic on value because it doesn't matter to them if the buyer is paying a price above or below the value, their job is to find that price that clears supply and demand He argues that it is ultimately up to the buyer or the seller to determine whether the price is right or wrong and in his view it is not the job of the investment banker to point out whether ut is right or wrong. If this was their responsibility, bankers would not be fulfilling their primary role which is making markets He says many clients make the mistake of asking investment banks to give them an opinion on the value and he considers this to be an unfair thing to do to an investment banker. By asking a banker to both find a price that clears supply and demand, but also find a price that doesn't destroy value, these are inconsistent task and bankers will feel this conflict. The result is, the banker is going to make sure the transaction happens because that is the basis on which they are paid. **5.4. Method of payment (why is this so important for the success of a deal?)** **5.4.1. The role of taxation ad bank financing on the selection of payment method** A Method of payment can be distinguished between: - Cash - Share exchange - a number of bidder's shares for each target shares - Cash under-written share offer -- target receives bidder's shares, then sells its shares to underwriter (investment bank) for cash - Loan stock -- target receives a loan stock in exchange of cash - For the bidder, the interest on loan stock is tax-deductible, reducing their overall tax liability. The target company is subject to income tax on the interest received from loan stock - Convertible loan or preferred shares -- convertible into ordinary shares at a predetermines conversion rate over a specified period - Deferred payment -- part of consideration after a specific period, subject to performance criteria **Cash vs stock** **Tax consideration --** cash offers can lead to immediate tax liabilities for tehe target company's shareholders, while stock may allow deferral **Liquidity --** cash offers provide immediate liquidity to the targets shareholders **Gearing --** refers to the ratio of a company's debt to equity. A company may prefer cash or stock offers based on how it impacts their gearing ratio. Using cash can increase debt levels while stock offers can dilute existing shareholders **Cash --** may offer immediate liquidity but can result in tax liabilities and increase bidders debt **Stock --** potential tax deferral and continued investment in the combined entity, but comes with the risk of stock price volatility The method of payment can affect who controls the merged entity - Stock offers give the target company's shareholders a stake in the new entity, potentially influencing control and governance In the UK, it is a legal requirement to make a cash offer or attach a cash alternative to ensure fairness and provide a choice to the target's shareholders **History** **1994-1999 --** stock dominated (an overvalued market) **2003 -- 2007 --** cash dominated due to greater liquidity in markets and a powerful role of PE acquirers. **2023 to present** -- at the end of 2023, there was a significant amount of unused cash in the market due to a combination of high interest rates and economic uncertainty. As a result, private equity players saw this as an opportunity to deploy their capital and sought to take advantage of the available cash to invest in undervalued assets. Theory suggests equity-financed deals should earn significantly lower returns relative to cash-financed deals because if the management opts for equity this infers to the market that the firm's stock is overvalued. Firms with higher asset growth rates and poor monitoring tend to use stock financing and perform poorly in the long run **Explanations for poor performance in stock-deals** - Bidders are more likely to use stock when overvalued - Information asymmetry between managers and investors - Stock deals signal overvaluation / bad news - Stock price declines Gains for stock acquisitions are better when private target firms are acquired. This is because: 1. Small private firms usually have a concentrated ownership, resulting in better monitoring which reduces agency costs 2. Small concentrated ownership of private firms have more incentives to examine bidders' stock and is unlikely to accept overvalued stock (conveying a positive news story) **Taxation** - Both parties aim to maximise tax relief and tax systems vary from country to country. - Effective tax strategies offer flexibility and understanding / leveraging the tax aspects of the deal can offer a competitive advantage during negotiations - Method of payment is closely linked with tax implications - Capital gains tax can influence the choice between cash and stock payments. For example, in some jurisdictions, capital gains taxes are deferred when stock is used as payment, whereas they are immediate when cash is used - For the bidder, the interest on loan **Bank financing** - Banks providing finance is often in the case of LBOs, where the acquisition is financed with a significant amount of debt - The cost of debt in financing can influence the decision to use cash or stock. If debt is cheap and readily available, companies might prefer cash payments to avoid over-leveraging **Earnings dilution** - Acquirer's post-acquisition EPS is lower than its pre-acquisition value - The opposite of this is called accretion when post-acquisition EPS is higher than its pre-acquisition value **Bidder / target preferences** **Bidders** prefer stock offers to share risks and cash offers to keep all benefits **Targets** prefer cash to avoid downside risks but lose potential upsides with stock offers **Both** must balance these considerations to decide on the best payment for the deal **Adverse selection** occurs when bidders fear buying overvalued targets. Stock offers help share this risk. Targets might accept overvalued equity due to information asymmetries. To mitigate this risk, bidders offer cash or a higher Exchange Ratio. The ER can increase if the bidder's stock price drops below a certain threshold **Cash offers** - Provides certainty because not dependent on post-acquisition performance - Simpler to evaluate as don't involve derivative contracts - No lemon problem referring to the risk of accepting overvalued - Cash signals the bidder's confidence in ability to manage target company effectively and increase its value **Factors which determine financing method choice** **Bidder liquidity --** companies with higher cash reserves are more likely to use cash financing **Recent stock price performance --** a strong stock performance can make equity financing more attractive **Nature of business acquired --** volatile or tech-heavy businesses might influence the choice of financing methos due to unique risks **Information asymmetry --** less information about target company may lead to a 0reference of stock offers to share the risk **Management ownership --** when managers own significant shares, they may prefer cash payments to avoid diluting their control B For a study using a sample of European deals, it was found that long-term operating performance increases by 1% for cash offers and decreases by 1.2% and 19% for all-equity and mixed offers respectively. Another study finds that companies that are overvalued tend to use stock to buy companies. These overvalued companies often end up paying too much for the companies they acquire and these deals usually don't create value for the shareholders of the acquiring firm. The stock prices of these acquiring companies tend to drop, and they perform worse in the long run compared to companies that use cash for the acquisitions or don't require other companies at all. An alternative perspective on stock financing is that firms are more likely to choose stock financing in financial constraints increase. Large controlling shareholders discourage stock financing because it may lead to a dilution of control. Savor and Lu (2009) show that stock-financed deals are not all bad for shareholders, as bidders' long-term shareholders are still better off in a stock deal than they would have been if the firm had not pursued the deal at all. In accordance with liquidity hypothesis, Yang et al (2019) suggest that cash-financed deals can underperform in both the short and long run in Chinese deals because cash-rich firms with lower costs for holding cash are less selective and more likely to engage in value-destroying deals. As an alternative to cash and equity, conditional value rights (CVRs) -- a promise of extra payments if the company hits specific post-merger targets (Royal, J., 2018) - has been shown to enhance performance. They provide a guarantee of additional cash or stock if the share price falls below a certain level, thereby reducing associated risk with stock payments. One study observes a preference for cash financing across domestic and cross-border transactions and find payment methods are influenced by strategic goals and regulatory landscapes. **Summary** - Asymmetric information between acquirers and targets significantly influence choice of payment methods - Overvalued acquirers are more likely to use stock financing - The method of payment (cash, stock, etc.) is important, but the source of financing (e.g., bank loans, issuing new equity, etc.) also significantly affects market perceptions and the overall valuation of the merger **Bank financing** One study finds that using cash from bank financing tends to result in a favourable market reaction. This is because banks actively monitor acquisitions that they finance, which is perceived positively by the market.