Mergers & Acquisitions

"Know what you're buying"

• Learn things not fully revealed to public
• Confidential agreement (only in friendly M&A possible)
• Like a call option against unknown discoveries (right to investigate)
• Support valuation process
• Buyer bears risk ("There is no free lunch!")

1. Broad review (look everywhere, time-consuming) → surprises now!
2. Narrow review (brief, focused, mainly legal and accounting) → surprises later!

Risk-return trade-off:

Risk exposure vs. expected benefits from due diligence

1. Previously research

• In publicly available data

2. Lettre of interest

• Deadlines, expenses, break-up fees

3. Period of due diligence

• Legal, accounting, tax, IT, risk & insurance, environmental, slaes, operations, property...

4. Signing of contract

5. Closing

• Tender offer

Topics:

• Valuation models
• Key value drivers
• Implementation of models

Intristic Value_Seller < Price < Intristic Value_Buyer

Different intristic values because of:

• Economies of scale
• Synergies
• Information asymmetries

1. Trading multiples of comparable firms
2. Transaction multiples of comparable transactions
3. Discounted cash flow (DCF)
   • Venture capital approach
4. Option theory
5. Others:
   • Book value
   • Liqudation value
   • Replacement cost
   • Current market value

1. Use comparable companies (size, products, business...)
2. Calculate key ratios
3. Calculate average (median) ratio (!!!Do not include negative values!!!)
4. Apply ratios
5. Calculate average

Enterprise value (EV) multiples:

• EV / Sales
• EV / EBITDA
• EV / EBIT

Price multiples (equity):

• Stock price / Net income or EPS (=P/E ratio)
• Stock price / Book value of equity, equity per share or assets (=P/B ratio)
• Stock price / CF (not CF_op)

Advantages

• Common sense approach
• Use of marketplace transactions
• Widely used / easy-to-use
• Allows valuation of private firms

Disadvantages

• Difficult to find comparable companies
• Ratios may differ widely (outliners)
• Different ratios ⇒ Different results
• Dependence on accounting data

• Same like comparables approach but based on similar merger transactions
• May be difficult to find similar transactions within relevant time period
  • Revenue/CF growth rates, Risk (\(\beta\)), Stage in life cycle...
  • Often wide spread of values
• Possible ratios:
  • Total paid / sales
  • Total paid / book
  • Total paid / Net income
  • Paid premium

1. Formula methodology

2. Spreadsheet approach:

\(EV_0=\sum_{t=1}^{T}{E(FCF_t)\over(1+WACC)^t}+{(1+g)E(FCF_T)\over(WACC-g)(1+WACC)^T}\)

EV₀ - Net dept = Shareholder vale (Value of equity)

Revenues

- Taxes

= NOPAT

+ Depreciation

+/- Change in WC

- Capital expenditures

- Change in other asstes net

= FCF

\(NOPAT = \text {Net Income}+(1-\tau)\times \text {Net interest expense (before taxes)}\)

\(FCF_{Capital}=NOPAT- \Delta [\text {Net WC}+ \text {Net non-current assets (incl. deferred taxes)}]\)

\(FCF_{Equity}=FCF_{Capital}-Net \space interst \space expense \space (after \space taxes)+ \Delta Net \space dept\)

CAPM:

\(k_e=R_f+ \beta [E(R_M)-R_f]\)

\(k_b(1-T)\)

\(DTS_t=s(k_b \times B_{t-1})\)

\(WACC={S \over V}k_e+{B \over V}k_b(1-T)\)

with \(V = B+S\)

Unlevered \(\beta_u\)captures business risk before financing

\(\beta_u={ \beta_e \over {1+(1-T) {B \over S}}}\)or \(\beta_u=\beta_{Dept}{B \over B+S}+\beta_{Equity}{S \over B+S}\)

Levered \(\beta_e\)captures business and financial risk

\(\beta_e= \beta_u[1+(1-T){ B \over S}]\)or \(\beta_e= \beta_u +(\beta_u-\beta_{Dept}){ S \over B}\)

Advantages

• Great flexibility in projections
• Recognizable financial statements
• Growth rate can vary from year to year

Disadvantages

• Projected numbers \(\neq\)"actual" numbers
• Possible disconnect between business logic and projections
• Complexity of spreadsheets

Compact expression of spreadsheet approach

Advantages

• Focus on key drivers
• Sensitivity analysis can easily be executed
• Compact mathematical summary of DCF

Disadvantages

• Less flexible than spreadsheet approach
• Link between parameters and financial data less clear
• Possibility of calculation errors

1. No growth

\(V_0={R_0[m(1-T)] \over k}\)for k>0

with R₀=Sales, m=EBIT/Sales

2. Constant growth

\(V_0={R_0(1+g)[m(1-T)-I] \over k-g}\)for k>0

\(I={\Delta \text {Total capital} \over Sales}\)with Total capital=WC+Fixed assets

Value of combined company A+B

- Paid price for B

- Premerger value A

= Gain from merger

A

e.g. 70% of gain from merger

B

e.g. 30% of gain from merger

+ Paid premium

Total gain from merger for B

Not only forecast and TV (formula approach). Add additional stages e.g.:

1^st stage: Competitive advantage

2^nd stage: Growth like economy as a whole

Advantages

• Easy concept: FCF are objective and not affected by accounting
• Familiarity: Application of familiar NPV techniques

Disadvantages

• Does not measure value added
• Investments are treated as loss of value
• Partly a liquidation concept: Investments(+) → FCF(-) and Investments(-) → FCF(+)

Topics:

Valuation of synergies

NPV does not recognize flexibility of postponement, abandoning, extending...

NPV may over- or underestimate value

Mangerial flexibility to (dis-)invest, enter/exit a business, delay/accelerate harvesting

• Long Call: Right to invest
• Long Put: Right to sell

Commitment (give) to (dis-)invest, delay/accelerate harvesting upon the action of another party

• Short Call: Promise to sell
• Short Put: Promise to buy

• Option that is not obvious
• E.g. Ongoing R&D program at target firm
  • Firm gets a new product if R&D is successful (→ Call option)
  • Firm gets flexibility in its product offerings (→ Long call)

\(NPV=\text {PV of CF}-\text{PV of Investment}\)

Black-Scholes-Formula:

\(C=S \space N(d_1)-Xe^{-r_fT} \space N(d_2)\)

with \(d_1={ln({S \over X})+(r_F+{\sigma^2 \over 2})T \over \sigma \sqrt{T} }\)and \(d_2=d_1- \sigma \sqrt{T}\)

• Spread [Difference between underlying (S) and strike (X)] (+call, -put)
  • In the money, out of the money, at the money
• T = Time to expiration (+)
• \(\sigma\)= Risk / volatility of underlying (+)
• Dividends paid on underlying (-call, +put)
• r_F = Interest rate (+call, -put)

= The whole is greater than its parts

1) Value creation as fundamental aim in M&A

2) Assessing synergies:

• Buyer's share price will:
  • Rise if price < V_Target + V_Synergies
  • Not change if price = V_Target + V_Synergies
  • Fall if price > V_Target + V_Synergies

3) Disclosing synergies to investore

4) Post-merger integration strategy

1) Synergies in place

2) Real option synergies

\(V_{\text{Synergies in place}}=\sum_{{\color{red}t}=0}^{n}{{\color{red}FCF_t}\over (1+{\color{red}WACC})^{\color{red}t}}\)

Improvements in compontents t, FCF or WACC:

1) Revenue enhancement

• Cross-selling/-branding through buyer's or target's distribution channel

2) Cost reduction

• Economies of scale due to higher capacity utilization, greater purchasing power, elimination of intermediaries, improvements in logistics, reduce overhead costs

3) Asset reduction

• Selling non-core assets (as "one-shot")

4) Tax reductions

• Step-up in basis/depreciation tax shield: assets(+), depreciation(+), taxes(-), FCF(+)
• Tax-loss carry-forwards (Transfer of tax losses from target to buyer)

5) Financial synergies

• Use of dept tax shields: dept(+), taxes(-)
• Co-insurance effects and WACC shifting: PF diversification if correlation<1 (see exhibit)