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2022 Curriculum CFA Program Level II Corporate Finance

Mergers and Acquisitions

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Introduction

Companies enter into corporate restructuring activities such as mergers and acquisitions for a variety of reasons. Many companies use mergers as a means to achieve growth or gain operational efficiencies. Others seek to acquire unique capabilities or resources, increase market power, or diversify their businesses. In all cases, it is important for both equity and fixed income analysts to understand the motives for mergers and their financial and operational consequences.

Merger and acquisition (M&A) activities involve a variety of complexities and risks. Analysts should assess these factors, including the expected value arising from a proposed business combination relative to deal price, in addition to the likelihood that the combination will take place and the intended results will be achieved. They should also consider actions taken by other shareholders, regulators, market participants, and competitors, in addition to transaction specifics, given the potential impact of all these factors on deal completion and valuation.

Analysts should be able to answer questions such as: Does the proposed transaction make economic sense and align with management’s stated business strategy? How is the transaction being financed, and how will this financing approach affect company financials? How likely is the deal to take place, and what are associated risks? In the case of a hostile bid, does the target company have options to successfully fend off the unwanted bid? What is the anticipated impact for shareholders? Bondholders?

Example 1

Takeda–Shire Acquisition

On 5 December 2018, shareholders of Takeda Pharmaceutical, a 237-year-old company and Japan’s largest pharmaceutical firm, approved the acquisition of Shire, a UK-listed, Irish-headquartered drug maker of similar size with an operational base in the United States. Announced in May 2018, the US$62 billion deal was aimed at transforming Takeda into a top 10 global pharmaceutical company with a sizable US footprint. It was the largest deal announced worldwide for 2018.

The deal was also the largest international acquisition ever attempted by a Japanese company. Takeda’s offer consisted of shares and cash. It also involved a US$30 billion increase in balance sheet debt. Takeda’s CEO undertook a nine-month-long campaign to secure the deal. The deal was confirmed in December 2018 with 88% Takeda shareholder approval, despite significant resistance from some Takeda shareholders, including the original Takeda family, who were concerned about the additional risk created by the acquisition.

 

Takeda–Shire Deal Timeline
Strategy
September 2016 Takeda’s “Vision 2025” business plan envisions sustaining growth year over year.
Rumor
28 March 2018 Takeda says “considering making an approach to Shire.”
6 April Takeda, Pfizer, and Amgen viewed as likely bidders for Shire.
Courtship
29 March 2018 Takeda initial offer: £44/share, with £16 in cash.
11 April Takeda second offer: £45.5/share, £16.75 cash.
13 April Takeda third offer: £46.5/share, £17.75 cash.
14 April Shire’s board announces it unanimously rejects third offer.
20 April Takeda fourth offer: £47/share, £21 cash.
24 April Takeda fifth offer: £49/share, £21.75 cash.
Acquisition
8 May 2018 Shire accepts fifth offer of £49/share, £21.75 cash, valuing deal at US$62 billion.
14 May Takeda announces asset disposals to help fund the acquisition.
10 July US Federal Trade Commission grants regulatory approval for Shire deal.
14 September Chinese regulator approves Shire deal.
18 October Japanese regulator approves Shire deal.
20 November EU regulator approves Shire deal.
20 November Proxy advisors Glass, Lewis & Co. and Institutional Shareholder Services recommend deal.
May–November 2018 Takeda minority shareholders (including Takeda family) lobby against proposed deal, citing increased risk and loss of Japanese “roots.”
Integration
5 December 2018 Takeda shareholders vote to approve deal.
7 January 2019 Takeda CEO announces integration “well underway.”
8 January 2019 Deal closes.
Value creation
14 May 2019 CEO announces 43% increase in original cost synergies anticipated from acquisition.
December 2019 Takeda’s core earnings margin expected to reach 25%, with long-term earnings margin forecast for 35%, up from an earnings margin of 22% in 2018.
March 2020 Takeda sales expected to rise 57% year over year.
Projection for 2023 Divestments of US$10 billion expected to stabilize balance sheet, with the expansion of five key businesses including in neuroscience and in treatments for cancer and rare diseases.

Takeda’s motivations for the deal included the potential for sustainable earnings growth believed to be available through Shire’s products and markets. Takeda was at that time projecting declining profitability from existing products and limited growth in the Japanese market. Additionally, synergies through new product development, earnings diversification, and cost savings were anticipated from the deal. Despite positive expectations, in the nine months between Takeda’s announcement in March 2018 and the time the deal closed, Takeda’s share price dropped 26% while Shire’s rose 33%.

Following increasing offers in value by Takeda, a series of regulatory approvals post–Shire acceptance, and announcements of a divestments program to help fund the acquisition, the deal finally closed in January 2019. By May 2019, Takeda’s management was reporting significant cost savings and projecting major improvements to core earnings margins in the years ahead.

This reading will discuss many of the issues involved in M&A deals, such as form of payment in a merger, legal and contractual issues, and the necessity for regulatory approval. Most importantly, this reading aims to equip you with basic tools and a framework for analyzing such deals. In subsequent sections, we will discuss basic types of M&A, underlying motives, transaction characteristics, governing regulations, and how to evaluate a target company and a proposed merger.

Learning Outcomes

The member should be able to:

  1. classify merger and acquisition (M&A) activities based on forms of integration and relatedness of business activities;

  2. explain common motivations behind M&A activity;

  3. explain bootstrapping of EPS and calculate a company’s post-merger EPS;

  4. explain, based on industry life cycles, the relation between merger motivations and types of mergers;

  5. contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management;

  6. distinguish among pre-offer and post-offer takeover defense mechanisms;

  7. compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each;

  8. evaluate a takeover bid and its effects on the target shareholders versus the acquirer shareholders;

  9. explain how price and payment method affect the distribution of risks and benefits in M&A transactions;

  10. describe characteristics of M&A transactions that create value;

  11. distinguish among equity carve-outs, spin-offs, split-offs, and liquidation;

  12. explain common reasons for restructuring.

Summary

Mergers and acquisitions are complex transactions. The process often involves not only the acquiring and target companies but also a variety of other stakeholders, including competition law regulatory agencies. To fully evaluate a merger, analysts must ask two fundamental questions: First, will the transaction create value; and second, does the acquisition price outweigh the potential benefit? This reading has made the following important points.

  • An acquisition is the purchase of some portion of one company by another. A merger represents the absorption of one company by another such that only one entity survives following the transaction.

  • Mergers can be categorized by the form of integration. In a statutory merger, one company is merged into another; in a subsidiary merger, the target becomes a subsidiary of the acquirer; and in a consolidation, both the acquirer and target become part of a newly formed company.

  • Horizontal mergers occur among peer companies engaged in the same kind of business. Vertical mergers occur among companies along a given value chain. Conglomerates are formed by companies in unrelated businesses.

  • Merger activity tends to be concentrated in industries undergoing changes, such as deregulation or technological advancement.

  • The motives for M&A activity include synergy, growth, market power, the acquisition of unique capabilities and resources, diversification, increased earnings, management’s personal incentives, tax considerations, and the possibilities of uncovering hidden value. Cross-border motivations may involve technology transfer, product differentiation, government policy, and the opportunities to serve existing clients abroad.

  • A merger transaction may take the form of a stock purchase (when the acquirer gives the target company’s shareholders some combination of cash or securities in exchange for shares of the target company’s stock) or an asset purchase (when the acquirer purchases the target company’s assets and payment is made directly to the target company). The decision of which approach to take will affect other aspects of the transaction, such as how approval is obtained, which laws apply, how the liabilities are treated, and how the shareholders and the company are taxed.

  • The method of payment for a merger can be cash, securities, or a mixed offering with some of both. The exchange ratio in a stock or mixed offering determines the number of shares that stockholders in the target company will receive in exchange for each of their shares in the target company.

  • Hostile transactions are those opposed by target managers, whereas friendly transactions are endorsed by the target company’s managers. There are a variety of both pre- and post-offer defenses a target can use to ward off an unwanted takeover bid.

  • Examples of pre-offer defense mechanisms include poison pills and puts, incorporation in a jurisdiction with restrictive takeover laws, staggered boards of directors, restricted voting rights, supermajority voting provisions, fair price amendments, and golden parachutes.

  • Examples of post-offer defenses include the “just say no” defense, litigation, greenmail, share repurchases, leveraged recapitalization, “crown jewel” defense, Pac-Man® defense, or finding a white knight or a white squire.

  • Competition law prohibits mergers and acquisitions that impede competition.

  • Three major tools for valuing a target company are discounted cash flow analysis (which involves discounting free cash flows estimated with pro forma financial statements), comparable company analysis (which estimates a company’s intrinsic value based on relative valuation metrics for similar companies), and comparable transaction analysis (which derives valuation from details of recent takeover transactions for comparable companies).

  • In a merger bid, the gain to target shareholders is measured as the control premium, which equals the price paid for the target company in excess of its value. The acquirer gains equal the value of any synergies created by the merger minus the premium paid to target shareholders. Together, the bid and the method of payment determine the distribution of risks and returns among acquirer and target shareholders with regard to realization of synergies as well as correct estimation of the target company’s value.

  • The empirical evidence suggests that merger transactions create value for target company shareholders. Acquirers, in contrast, tend to accrue value in the years following a merger. This finding suggests that synergies are often overestimated or difficult to achieve.

  • When a company decides to sell, liquidate, or spin off a division or a subsidiary, it is referred to as a divestiture. Companies may divest assets for a variety of reasons, including a change in strategic focus, poor fit of the asset within the corporation, reverse synergy, or cash flow needs.

  • The three basic ways that a company divests assets are a sale to another company, a spin-off to shareholders, and liquidation.