FREE online courses on Mergers & Acquisitions - Chapter 1 - Reasons for M & A

 

Every merger has its own unique reasons why the combining of two companies is a good business decision. The underlying principle behind mergers and acquisitions (M & A) is simple: 2 + 2 = 5. The value of Company A is $ 2 billion and the value of Company B is $ 2 billion, but when we merge the two companies together, we have a total value of $ 5 billion. The joining or merging of the two companies creates additional value which we call "synergy" value.

 

Synergy value can take three forms:

 

1. Revenues: By combining the two companies, we will realize higher revenues then if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses then if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.

 

For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the need to cut costs. Cost savings often come from the elimination of redundant services, such as Human Resources, Accounting, Information Technology, etc.  However, the best mergers seem to have strategic reasons for the business combination. These strategic reasons include:

 

• Positioning - Taking advantage of future opportunities that can be exploited when the two companies are combined. For example, a telecommunications company might improve its position for the future if it were to own a broad band service company. Companies need to position themselves to take advantage of emerging trends in the marketplace.

 

• Gap Filling - One company may have a major weakness (such as poor distribution) whereas the other company has some significant strength. By combining the two companies, each company fills-in strategic gaps that are essential for long-term survival.

 

• Organizational Competencies - Acquiring human resources and intellectual capital can help improve innovative thinking and development within the company.

 

• Broader Market Access - Acquiring a foreign company can give a company quick access to emerging global markets.

 

Mergers can also be driven by basic business reasons, such as:

 

§         Bargain Purchase - It may be cheaper to acquire another company then to invest internally. For example, suppose a company is considering expansion of fabrication facilities. Another company has very similar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities then to go out and build new facilities on your own.

 

§         Diversification - It may be necessary to smooth-out earnings and achieve more consistent long-term growth and profitability. This is particularly true for companies in very mature industries where future growth is unlikely. It should be noted that traditional financial management does not always support diversification through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the management of companies since managing a steel company is not the same as running a software company.

 

§         Short Term Growth - Management may be under pressure to turnaround sluggish growth and profitability. Consequently, a merger and acquisition is made to boost poor performance.

 

§         Undervalued Target - The Target Company may be undervalued and thus, it represents a good investment. Some mergers are executed for "financial" reasons and not strategic reasons. For example, Kohlberg Kravis & Roberts acquires poor performing companies and replaces the management team in hopes of increasing depressed values.