MERGERS & ACQUISITIONS UNIT I

Last decade saw a resounding revival in M& A activity throughout the world and India is no exception to this. Statistics gathered by the Centre for Monitoring Indian Economy (CMIE) reveal that in the 12 months ended October 2003, there were a total of 856 acquisitions or mergers with a total value of Rs. 18,921 crores. Cutthroat competition, proliferation of players and the appetite for growth fuel M & A activity across all the sectors. The shopping spree was hectic and the buzz word was BUY IT OUT The technical difference of Merger /Acquisition/Purchase is only for a corporate accountant, however for a Finance Manager the only concern involved is the RIGHT PRICE There are different views to distinguish Merger and Acquisition and one is, if two companies of approximately equal size were to come together, it is merger and for Acquisition, the larger company taking over another of relatively smaller size is acquisition. However again the finance manager is more concerned with another issue Is the price that he pays for possession an additional source of income or for taking control of certain resources: the right price? It is commonsense that a price that one pays is for the value that one receives. The right price for a buyer therefore should be what he perceives as it value. It is an altogether different story for the seller, because he evaluates the loss of value arising from deprival of the resource he possesses.

Mahindra & Mahindra placed a bid for acquiring Valtra (producer of over 18000 tractors annually and having a foothold in Europe and Brazil, with net sales exceeding Euros 750 million). The bid was for Euro 350 million. As it turned out later, it was not the right price and M & M had lost out to a bid of Euro 600 million made by a US based company called AGCO. The motivating factor behind M & M offer was to make a dent in the European market by their presence.

Is M & A, a simple Investment Decision? The obvious answer is that a decision to take over or merge with another company is not a simple investment decision and the reasons are It is an investment made under conditions of uncertainty and quite often it is difficult, applying the normal principles of valuation, to determine if the investment will generate a positive NPV.

The buyer pays a price, because he perceives that there would be benefits, yet estimating these benefits by using discounted cash flow technique is a difficult process. An M & A invariably involves many legal issues, tax complications and accounting effects on reported financials. When an acquisition or merger is being considered, what is in focus is total value of firm , however once the transaction is completed, may have different degrees of impact on the debt value and the equity value. Not all M & A deals are friendly. Some are less and some others are more unfriendly. One entity seeks another; the entity being sought after can resist and can defend itself successfully. Directors in the board, or the chief executive may not want to conclude an M & A deal as perhaps self interest may dominating over the need to take care of share holders and share holders may in turn want it. It is believed that M & A are strategic decisions leading to the maximization of a company s growth by enhancing its production and marketing operations. Therefore there is consensus on one issue. An M & A deal, whatever structure it may assume, is a form of capital budgeting decision and capital budgeting process involves a cost benefit analysis. Benefits and costs are in turn inter- related, one affecting the other. High costs will erode into future; on the other hand, a perception of substantial benefits can prompt one to pay a high price. Paying a price also implies a need to line up funds, lining up finance for a large capital asset is in fact a capital structure decision and if the capital structure were to be altered it will also have an impact on dividends. The pivotal point, round which all these revolve let us admit, is the right price. Yet it cannot be said with definiteness that there is one single right price for an M & A deal. The right price is dependent on the right reasons.

What Motivates an M & A DEAL? One most important reason is that this coming together will enhance the wealth of share holders. The combined wealth of the new entity should be greater than the wealth of two or more individual entities; else they should have remained independent. In other words, there ought to be some possible benefits and gains to share holder. When coming together of two entities results in a larger net present value to share holders of the combined enterprise, we say there is a net gain. We will refer to these benefits and gains as synergies. For creating such synergies, M & A deals take different forms or structures. Integrate Horizontally when two entities in the same line of business unite it is said to be a horizontal integration (leading to economies of scale) e.g.: Two book publishers or tow luggage manufacturing companies to gain dominant market share. Integrate vertically when a entity brings into its fold another entity, which is operating at a different level in the chain of supply , it is said to be a vertical integrating. Vertical merger may take the form of forward or backward merger, when a company combines with the supplier it is called backward merger

and when it combined with the customer it is called forward merger, integrating with either a supplier, or a customer it is called forward merger. Integrating with either a supplier or a customer leads to cost savings in terms of negotiating of prices, contracting, making payment, or collecting and advertising. E.g.: joining of a TV manufacturing (assembling) company and a TV marketing company or the joining of a spinning company and a weaving company. Two entities carrying on different and unrelated lines of business coming together is said to be a conglomerate. A typical example is merging of different business like manufacturing of cement products, fertilizers products, and electronic products. L & T and Voltas Ltd are examples of conglomerate companies.

In whatever manner an M & A deal may be structured, the root cause (motive) is to achieve strategic benefits and those are:

(i)

Economies of scale

In its simplest form, economies of scale are achieved when we spread out the total fixed costs over a larger quantum of output. This is achieved with least effort when two firms in the same line of business unite, and give rise to a horizontal merger. (Bank of Madura and ICICI bank; Indian equipment leasing and Sundaram Finance Ltd.) Vertical integration also results in economies of scale. Companies may achieve expansion by seeking control over either raw material (backwards) or the process of delivery to the ultimate consumer (forward) there are of course limits to this process of vertical growth. In fact the tide is slowly but surely turning towards outsourcing business activities BPO is the talk of the day Just as Horizontal and vertical integration help avoid duplication of work in many stages, conglomerates also lead to savings, possibly through central facilities such as offices, accounting divisions and centralize information processing set-ups, without the need to have two or more sets of management personnel. (ii) Efficiency Improvement

An entity may be operating in a lucrative market. But the efficiency of its management may be so poor as may not facilitate full exploitation of the market. Such a company would be an easy target for the takeover by any other, more capably managed firm. It does not necessarily follow that better management lead to benefits from combining two firms. It may also mean replacement of one team of managers by another team (who can ruthlessly cut costs and increase margins). Efficiency improvements and cost reduction go hand- in- hand

(iii)

Power of market share reduced competition

Price of a product is perhaps the only competitive weapon in a market with limited product differentiation. A company having a large market share may be in a position to drive prices, by keeping the prices low in the initial stages to effectively eliminate competition and increase the prices at a later stage. There are instances where one entity is induced to take over another, with a view to eliminating competition. Also, growth by acquisition to gain a greater share of the market, or to gain entry into new market (including exports) rather than registering a slow but steady organic growth is a factor that motivated M & A deals.

Reliance Industries acquires German company Trevira to become Worlds No.1 polyester maker: 24th June 2004, RIL announces that it has acquired Trevira, a polyester company in Germany for Rs. 440 Cr (Euro 80 million), taking it closer to the position of the worlds largest polyester maker. This is the first time RIL has acquired a company overseas
(iv) Cash Rich firms

Many companies enjoy the luxury of large surplus cash. They are faced with two alternatives. Either to pay out the surplus as dividends to shareholder or buy- back the shares. Entities that are not inclined to dividend distribution often look to acquisition of another company, as an investment opportunity, if it is good and worthwhile. (v) Combining resources that are complimentary

Many firms have products or processes that are unique in them, and yet lack the organizational structure and skills to produce and sell the product. They can invest and develop the required resources over time. A faster and more economical method would be to merge with a larger entity each having what the other needs. Mergers under this category do make sense, and the combined value of the two entities is often greater than the value of independent entities. (vi) Tax considerations

A firm may be entitled to claim relief of tax against various elements of expenses but may be unable to enjoy the full benefit of such tax relief in the absence of adequate profits. Such a company may be a target for acquisition for another entity that generates taxable income. Un-exploited debt raising capacity of one entity quite often gives rise to tax gains to another. (vii) Asset-stripping (Break- up value)

Firms can be valued by book value, economic value or replacement value. Takeover specialists have begun to recognize break-up value as another basis of valuation. Break-up value is the value of the individual parts of the firm if they were sold off separately.

Book value of certain separable assets of a firm may be quite low or even nominal. In most cases particularly, where these are non depreciable assets their true market value would be significantly higher. On acquisition of the firm at or even above current market value, these assets are sold in pieces to reap huge cash gains, even if it were necessary to close down some of its operations. (viii) Effect on cost of capital

In evaluating an M & A proposal, two independent earning streams will require to be evaluated of acquirer and would be acquired. If these two are not perfectly correlated, then the overall risk of the combined cash stream will be lowered. Acquirers do not ignore this concept.

The factors outlined above, if re-grouped can be summarized as under: Market factors Operational factors Acquisition of competing Meeting critical mass needs, to products (ii) reach efficient size (ii) Enter new Market (iii) Economies of scale (i) Management acquisition (ii) Access to innovation (ii) Complementary resources (v) Financial factors Access to liquid funds (iv) Improved asset backing (vii) Asset stripping (vii) Growth in EPS (iii) Tax considerations (vi) Effect on cost of capital (viii)

Two wrong reasons (theoretically only) First one is diversification. A firm should not take over or merge with another with the sole purpose of diversification, on the rationale that diversification reduces risk of the firms involved . Diversification, in any case, does not increase a firm s value. The share holders of the firms can themselves carry out the same diversification, at a much lower cost. They would do this even otherwise if their perception of risk were one that warranted diversification. Second is the shares of the target company are under- valued . If we go by efficient market theory, such a position may not exist at all. However, we do not rule out the possibility of shares of a firm being undervalued. But merger or acquisition does not provide the ideal solution. Here again, the rational share holders can themselves proceed to buy the so called undervalued shares and be the beneficiaries.

The goal: Benefit to Acquirer

Be it a control over management or a complete take over by way of merger, there should be benefits to the acquirer company. This benefit should be clearly identifiable though at times it may not be fully quantifiable. There are however some nuances depending on whether the transaction would lead to a merger or acquisition. Merger Relative values of two companies are considered Degree of control that will emerge is reckoned Acquisition Absolute values of acquired entity is considered Control and Growth are two primary focus areas

In both cases, the value cannot be higher than the capitalized value of income it generates. Studies in UK and US show that the share holders of acquired company stood to benefits in a majority of cases, in terms of at least 15% to 20% capital appreciation.

BPO industry is worth mentioning in the Indian context. BPO sector has witnessed several M & A deals in the 12 months preceding September 2003. ICICI-One Source made its foray into the BPO sector, using acquisition as a method of growth, with a $19 million takeover of Bangalore based customer asset. Late it also took a 51% stake in First Rating. M & A in the BPO sector has been adopted essentially as an entry strategy and to gain specific domain that could add new capabilities that result in higher value addition.

VALUATION:
UNIT II
1. Need for valuing shares A doubt that remains in one s mind is when a company is listed, its shares are traded, and the price of its share is also known, what is the need for an independent exercise of valuation? However such an exercise is deemed necessary (i) In the case of listed companies, when there is takeover bid, and the offer is on fair value basis, without reference to market (let us not close our eyes to the possibility that market could be rigged) In the case of unlisted companies, a. An initial price for purpose of listing is essential, if it were to go public b. An equitable price is to be fixed, when it wishes to transfer some share to a third party or where a merger is involved c. A loan against shares may be needed for a director (lender may need a value)

(ii)

2. Methods of Valuation (i) (ii) (iii) (iv) Asset Based Valuation Earnings or Dividend based valuation CAPM based valuation Valuation based on NPV of free cash flows

Asset Based Valuation:

Book value of a firm is based on the balance sheet value of the owner s equity. This method suffers from serious limitation as ti is based on the historical costs of assets of the firm. Historical costs do not bear a relationship either to the value of the firm or to its ability to generate earnings. Nevertheless, it is relevant to the determination of firm s value for several reasons: a. It can be used as a starting point to be compared and complemented by other analysis. b. In the industries where the ability to generate earnings required large investment in fixed assets, the book value could be a critical factor where especially plant and equipment are relatively new c. The study of firm s working capital is particularly appropriate and necessary in mergers involving a business consisting primarily of liquid assets such as financial institutions. In this model, one generally finds a combination of book values, net realizable values and replacement costs and the following additional points to be considered too.

(i)

(ii) (iii)

(iv)

Book value is a function of depreciation policy. Some assets may have been written down faster than others, which may be carried at more than their worth, some assets could be rather old rendering the reliance on their original cost invalid. For asset-values to be useful guide, the target company should have followed a regular depreciation, replacement and revaluation policy. Some business entities may wish to sell not the whole, but only a part of their business. In such cases, there will be a need to compare the NPV of future cash flows of that demerging portion of business with its asset values. In addition the cash flows have also to be evaluated independent of asset values by using an appropriate discount rate Replacement cost method is at best used as a bench mark to estimate the reasonableness of consideration offered.

An asset based valuation is not a simple exercise of adding up the balance sheet figures. Book values require being re-adjusted based on reliability, current market valued and similar factors. This method at (Problem 1) best, gives a minimum value of the entity.

Earnings based Model:

The market value of an equity share is the product of two components. First is Earnings per share and second is Price Earnings Ratio. According to this approach, the value of prospective acquisition is considered to b e a function of the impact of the merger on the EPS. The analysis could focus on whether the acquisition will have a positive impact on the EPS after merger or it will have the effect of dilution it. The future EPS will affect the firms value which is a function of PE ratio and EPS When the share exchange ratio is in proportion to EPS there is no effect on the EPS of the acquiring or surviving firm as well as the acquired firm. When, however, the exchange ratio is different it may result in dilution in the EPS of the acquiring firm and increase in the EPS of the acquired firm. For management of a firm considering acquiring another firm, a merger that results in dilution in EPS should be avoided. However, the facts that the merger immediately dilutes a firm current EPS need not necessarily make the transaction undesirable. Such transaction places undue emphasis upon the EPS. While examining the consequences of merger upon the surviving concerns EPs, the analysis should be extended into future periods and the effect of the expected future growth rate in earning should also be included in the analysis. While assessing the share values using this model, it is useful to bear in mind the following: (i) (ii) (iii) Market price generally reflects the price paid for small lot transactions Such a price is influenced by market risk or non diversifiable risk of the target business. Markets may be at a relatively low level, or may even be at two or three year highs MPS then tends to be either undervalued or perhaps over valued relative to this real worth of target company.

(iv)

If the acquisition is being evaluated, with an ultimate motive of asset stripping at a later date, MPA based on earnings model would require appropriate readjustment. Problem 2

P/E based valuations some aspects In a takeover bid, the target company can be unlisted company, and the deal inevitably involves negotiations. A third party valuer could be involved. PE ratios will also be thought of. The general economic and financial conditions, type of industry and prospects for the target company will needless be kept in view. Some aspects that will influence the valuer s choice of PE ratio include: a. Size of the target company and its status within the industry b. Quoted companies may generally have as much as twice the PE ratio of an unquoted company. In case of unlisted companies, there would be restricted marketability and the PE multiple will tend to be lower than listed companies. c. Diversity of share holdings and the financial status of principal share holders d. Reliability of past profit records, nature of assets, present level of asset backing and liquidity e. Gearing levels f. The extent to which the target company is dependent on one or more independent individual in the area of technical skills, i.e. the greater is such dependence; higher will be the business risk. The main advantage in the case of listed companies is that the price is determined by market forces, and reflects what price people are ready to pay, rather than indicating a maximum price that is worthwhile paying. Relatively speaking, this method is less subjective. Problem 3 Bootstrapping fooling the market One more aspect requires to be highlighted. Assume XYZ is a company with a high PE multiple. A reason for it high PE multiple could be the belief of share holders that the potential for growth of future earnings of XYZ is very good and that such a growth rate will be achieved by more efficient management, exploiting opportunities for investment in high yielding production activities or increased operating efficiency. The intentions of the management my not coincide with those of investors. Some of the enterprises (shares which command a high PE ratio) are also anxious to be register growth as a pace faster than other can. Management of such entities will be unaware of the fact that less can be achieved by capital investment than acquisition. Propelled by a desire to grow quickly, they acquire companies with a lower PE multiple. Problem 4 This technique of inducing a bull effect on share prices is called Bootstrapping . Remember that market cannot be fooled forever. In the long run more so when once the earnings growth flattens or declines market will react seriously and prices will sharply fall. Buying a firm with a lower PE multiple can increase the earnings per share, but this increase should not result in a higher share price.

Productivity factor (ROCE) ROCE computed on current cost basis is more meaningful than historical cost basis. A modified method of estimating value of the firm based on earnings is to use the market return on assets as a benchmark. The point of focus is to assess how far the return produced by net assets used in the target business should be as good as that in other businesses in similar risk class. The return on net assets attributable to equity holders is estimated with reference to productivity of the target company. Where past performance shows discernible trends, weight ages are accorded and average level of productivity of (tax adjusted profits on) assets is estimated. Value of the business is then estimated assuming that this productivity represents a normal market return on assets. We should remember that ROCE is meaningful only when expressed in current cost figures. Since financials are generally reported on historical cost basis there can be deviation in value estimations based on ROCE Problem 5

Dividend based valuation Quite often, the amount of dividend paid is taken as the base for deriving the value of a share. The value of a firm is thereafter computed from this base. There can be alternative assumptions as to dividend policy of an entity, namely, (i) (ii) (iii) (iv) No growth in Dividends (problem 6) Constant growth in dividends (problem 6) Abnormal growth for a short period followed by no growth (problem 8) Abnormal growth followed by constant growth (problem 7) (Many other variations in the assumptions are also possible)

CAPM based valuation

Capital Asset Pricing Model can be used to value shares. It is a useful method, when we need to estimate a price, for initial listing of shares in the stock exchange. This method is also used in estimating a market price of an unlisted firm, when acquisition of target company share for control is contemplated. Problem 9

Free Cash flow Model:

M & A deal is more than a mix of capital budgeting and financing decision. But a financing decision can arise only if we can conclude that the capital investment is worth making it. In any routine decision that involves purchase of a single asset, we do look at the cash flows and use a combination of NPV and IRR methods of evaluation. When we move up to the level of purchasing a business itself, cash flows are crucially important. The difference lies not in the fundamental approach of NPV based evaluation but in assessing what constitutes the cash flows (i.e. we have to define and identify relevant cash flows) nothing but Free cash flows. Free cash flow analysis utilizes the financial statement of the target business to determine the distributable cash surpluses and takes into account not merely the additional investments required to maintain growth, but also the tie-up of funds needed to meet incremental working capital requirements. Rather than reckoning dividend payment as the basis for estimating the present values, free cash flow model looks at the cash profits duly adjusted for investment in fixed and current assets (can vary from year to year) and derive the distributable surplus. In both cases, the fundamental principles of estimating the present value of future cash flows remains unaltered. It is also customary to assume that the life of the business is perpetuity and terminal values are derived on the basis that 1. No growth or constant growth after a given period (optimistic and pessimistic) 2. Book value multiplier of equity holder funds Free cash flow model facilitates estimating the maximum worthwhile price that one may pay for a business. To sum up, under free cash model, we estimate the value of a firm by a three step process: 1. Determination of cash flows: Net operating income + Depreciation (-) Incremental investments in capital and/or current asset (working capital) for each year, separately 2. Determination of Terminal cash flows, on the assumption that there would be constant growth, or no growth, or by adopting a book value multiplier approach 3. Present values of these cash flows can then be compared with the price that we would be pay for acquisition

Value should be Fair value

It is well accepted canon that rather than placing reliance on any one single method, it is preferable and safer to derive a benchmark value which in turn is based on the average of results of two or three types of methods. The ultimate aim is to identify, the likely fair value of the equity shares of Target Company. The fair value method has found wide acceptance after the landmark judgment of the Supreme Court in the case of TOMCO (employee union) Vs HLL. Fair value is ascertained as a simple average of net assets value per share and the capitalized value of earnings per share. This particular method of computing average of NAV and EPS capitalization is also known as Berliner Method At the end of the day what really matters is the final price that the buyer and seller agreed upon. Agreement is generally reached after Negotiations. Negotiations, in turn, will revolve round 1. EPS and PE Ratio, where a block of shares or a business as a whole is targeted 2. DCF computations 3. And to some extent NAV per share.

Costs And Gains of Merger Unit III

A finance manager has uppermost in his mind, the need to improve the wealth of the share holders. No decision that he will take, should prejudice their interests. We can be emphatic that this is true in the case of a merger also. He therefore seeks answers to two important questions: 1. If the proposed merger does take place, will it add economic value to the combined entity? 2. Will the existing share holders be better (or worse) off after the merger? A merger is meaningful only if the combined wealth of the new entity should be greater than the wealth of the two or more individual entities. The merger should create some value. This is possible only if there are benefits and gains to the shareholders. It is not always possible to quantify some of these gains. But the finance manager cannot be blind to the fundamental truth that the aim is enhancement in shareholders wealth. Synergies arise from improved management, production and marketing efficiencies, leading to cost savings, operating economies and more attractive growth rates in the long run. There may be hidden values too. Vab = Va + Vb + Synergy It is this additional value (synergy) is the motivating factor. The possibility that the synergy value may turn out to be negative, should also not be ignored. In determining these synergies, tax considerations also do come into play. Nevertheless, gains if any, do not come free and there are costs involved.

Costs of Merger: Costs of a merger represent the excess price paid over the current market value of target company s shares. Costs here denote the price that A Ltd., would pay to the share holders of B Ltd., in excess of current market value of their own (B s) shares. Cost may vary depending on whether A Ltd., pays in cash, or in the form of shares. An elementary rule to remember is that in either case, the basis for comparison is current market value of the equity of the target company. What they now have Market price of 1 share (X) Market price of 1 share (X) What they will get Cash paid by bidder - (Y) Post merger market value of the equivalent of premerger share (Y)

If cash If shares

Cost of gains is the difference between X and Y Cost of merger under a share offer is estimated on the following lines ---

a) Combined value of merger firm, including present value of synergies is assessed. (A) b) Total number of shares that would emerge after the merger, with reference to share exchange ratio. (B) c) What is the prorated share holding of the target, in the merged entity? This value when related to premerger value of Target Company can throw up an excess. The excess is cost of merger. Gains of Merger: The acquirer will always look at synergies and gains. But will it be possible for him to conclude the deal, without sharing a part of this with the share holders of Target Company? In real world deals, he must share some part of these gains with the target-share holders. He has to identify the most ideal dividing line. Following issues have to be address: 1. If successful, what should an acquirer end up paying to the target? 2. What will be the incremental value for the target shareholders? 3. If each individual stock holder were to act independently, what should one do to maximize his wealth 4. If they can unite, what should they do? 5. If some share holders were to resist the offer, what line should the acquirer tow? (Problem 17) If the stock holders were to act independently it is seen that there are two different price structures, those who can sell their share early enough, can get a higher price. Hence if each SH were to act independently, the psyche will be to be the first in queue for sale. If the stock holders unite if in a group, the bargaining strength of share holders will be greater. They can therefore resist a sale by indicating the price (a better price) at which they can accept the offer for buy . A better price will mean, a larger share of the PV of synergies accruing to the share holders. In simple words, the shareholders can form a cartel and manage to get what they deserve. Tax considerations In an evaluation of M & A deal, tax considerations cannot be ignored. If the acquisition is tax free, the merged entity is taxed as though the two premerger entities were always together, and past losses of one entity is allowed to be set off against the taxable income of profit making entity. This may not always be true. Where the acquisition is found to be taxable, the assets of the selling firm are revalued, which may produce a taxable gain or loss, this in turn will affect future depreciation and related tax shields. In the process of determining the price, the bidder and the biddee will have to invariably assess whether the tax benefits of one group outweigh the tax losses of the other. The right price that gets ultimately settled will emerge to be one which takes care of equitable sharing of net gains between the two.

Market reaction to Merger bids The share prices of the merged entity is not only based on quantitative figures of the companies but markets will react in different manners a) The market will assess the negotiating capabilities of both the buyers and sellers and will draw certain broad conclusions as to what is the likely success rate of the bid. The price can, therefore, show a fluctuating trend rather than registering a one way downward movement. b) The market will also assess the extent of competition from other bidders. The stronger the competition the more likely will be the upward movement in its price. This reaction is based on rationale that the final bidder will pay a premium over his next best competitor. To pay in cash or by share exchange: An issue of concern in any M & A deal is how to pay ? A cash alternative is often more attractive than a share offer. The market price is a result of many interdependent factors. One of these is market psyche as to whether the synergies of merger will or will not be achieved. Although theoretically the present value of future cash (flowing from synergies) is factored in, this PV may turn out to be mirage. The management of combined entity may fail to implement the post merger action plans to reap the benefit of synergies. Because of this uncertainty, the cash alternative is preferred to share offer. Nevertheless the choice will depend on other factors too: a) If the bidder s shares are overvalued, payment by share exchange can be less expensive than cash cost, because what you give has less value than what you take b) Acquisition by cash payment often results in capital gains in the hands of biddee share holders. Companies normally would have reckoned the clientele effect in their dividend policies and if a group of share holders is affected, one may face resistance. At times, one may even have to pay a premium to compensate for the cash out flows towards tax. c) Not all synergies of a merger would be accruing on day 1. There is flow of time between merger date and the synergies materializing. The possibility of biddee shareholders feeling deprived of accretion of such benefits cannot be ruled out. Because, benefits from synergies will accrue to only those who would continue to be members of the merged entity.

DEFENCES IN TAKE OVER Unit IV

A GAME OF DEFENCES
What we have seen so far is only the acquirer s side of the coin. The predator may have many valid reasons to back up his stand. Admittedly, his predominant and strong desire for growth and profits is insatiable! But a coin has two sides! Consider a situation. The affairs of leaders Ltd. are being managed well by a team of managers- perhaps to the envy of at least one competitor. This competitor is keen on taking over leaders. But the management team of leaders does not wish to be taken over by any other group! One straightforward reason is that leaders fear that they will lose their identity in the market. They realize that they need to protect themselves, and defend this move, with whatever weapons they may have in their armory. Lets us see what may happen in such defenses.

A. In the absence of any BID (before the bid)

1. Effective communication with share holders
In any managed well company, a capable and well informed individual preferably specialized in finance liaises with shareholder-community, and constantly communicates with them. The shareholders are kept fully informed about the activities of the entity, prospects and plans for growth. By close interaction with journalists, he also acts as a conduit for adequate and unbiased publicity on all issues that are relevant for the shareholders. Such a liaison ensures transparency, leading to the company being properly and fully valued , irrespective of whether or not there is a takeover bid.

2. Revalue fixed assets

A periodical revaluation of fixed assets is taken up. Asset values are brought to current values. Shareholders are made aware of the net asset book value per share. Take-over bids aimed at asset stripping get dissuaded.

3. MOA/AOA back up
An arrangement by way of merger normally requires approval with 75% majority. It is possible to have appropriate protective clauses incorporated in MOA/AOA such that approval of a larger majority (say95%) is made a pro condition for amalgamation with another company either by take-over or by merger.

4. Issue rights carrying special triggers poison pills, poison puts

In certain advanced countries, it is seen that shareholders are issued rights to buy equity or preference shares. Such rights have a prolonged conversion period. One of the conditions of such special rights, would be, in the event of a take-over, these rights can be exercised for buying equity or preference of the acquirer company as well. A predator aiming at control and sharing of profits may not succeed easily if such rights were existing in the target-company. There can be debentures, with a trigger for conversion into equity if there is a change in management, control, composition in the majority of the board, purchase of shares or merger. Existence of such rights can be effective bottleneck areas for the success in a bid.

5. Re-align composition of the board

In order that the interest of the shareholders stand duly protected, a company may also re-align the composition of the board, and induct directors who can effectively represent the shareholders. In addition, in the Indian context, it is also possible for the small-shareholders-subject to fulfillment of certain minimum conditions-to have their nominees in the board under the companies Act 1956. Once in place, such directors can keep a watchful eye on the goings-on and where essential, initiate measures to protect shareholders.

6. Vigil on bid prospects

When any single party makes market purchases of small or big lots of shares, and gradually increases his holding, it would be clear for the management that, prospective bidder in position. Managements therefore, keep a proper vigil on the movements in shareholding pattern, on a weekly basis to identify unusual effectives in the market. Alert managements, begin dialogues with such prospective bidders likely efforts at the bid.

B. When a BID is made (after the bid)

1. Reject the bid
Once a bid springs up, and if it is found to be inconsistent with the management s policies or the interest of shareholders, it is common practice to issue a letter of rejection, briefly explaining the basis and justification for rejection, and why the bid can t be accepted. It is also necessary for the target-company to issue a letter of a communication to all the shareholders, explaining in categorical terms. In most cases, this letter of communication also solicits the support of existing shareholders. Such actions are taken, with the least possible delays at times even within a span of 3days.

2. Issue profit forecast statements

This step is to educate the shareholders, and is necessary particularly when poor performance in the past year or two, is truly likely to be compensated by better results in the short term future. The board of bide-company acts with abundant caution in publicizing this forecast, lest they should lose their credibility.

3. Use offence as a defence

At times, a bidder s management style, accounting policies, and methods adopted to increase earnings per share could be so dubious that they are worth getting exposed. If the prospective bidder falls, under this category, the target-company can effectively take an offensive posture and may attack the bidder.

4. White knight
This strategy allows a friendly company to step in. More popularly this is known as white knight .Rather than succumbing to the pressure of a hostile bidder, another friendly company is allowed to present itself as a bidder and acquires shareholding and also apposition in the board. This facilitates active support to the existing board to thwart the attempts of hostile bidder. Often, this friend will be one among the group companies. Though it may not strictly fall within the white knight strategy, an interesting example is the case of struggle for control of Herbertsons. At a time when the control issue was legally challenged at SC level, UB group came up with a competitive bid 200/_ per share and supported it by a public announcement that the counter offer of the acquirer is a competitive bid and has been made with intention of consolidating the holding of the UB group, Promoters of the target company .

5. Enter into a standstill agreement

It is not uncommon for target companies to enter into voluntary agreements with the bidders. One important provision in such agreements is that the bidder shall not, for an agreed period (say2 or 5y.) increases his shareholding beyond the predetermined level. The provision is backed up by conditions prohibiting the bidder in participating on any contest for control of the board.

6. Proceed with a reserve bid

In this process, the bidder becomes the target-company and the original target company becomes the bidder. Before the attackers enter, you take him over! Quite often, managements can and do bid for the shares of the acquirer. There is no empirical evidence to draw any definite conclusion that the reverse bids succeed, or fail. But this strategy does work as a deterrent and, can either delay or complicate the process of acquisition.

Other defensive strategies available to a target - company includes:

1. Declaration of special one-time cash dividends. This move is aimed at draining away all the liquid funds presently available, and hence the cash surplus target would not be any more a source of attraction. 2. Buy back of shares: This is double - edged sword. This step can t only drain off surplus cash, but also helps reduces 3. Stock splits: this move helps the target to increase the number of shares in the hope of gaining the support of existing stock holders 4. Divest some of its shares, or spin off one or more divisions into a separate subsidiary. This tactic is known as Crown Jewels Defence 5. Refuse to transfer the shares and seek legal recourse instances in the past have been many when recourse to legal action, had paved the way for thwarting the actions of bidder 6. Taking the help and advice of large institutional investors. In the Indian context, LIC and UTI such public financial institutions have share holding interest in listed companies. It is customary to seek their support to defend takeover. 7. Buy back the share lot held by attacker. When a battle for take over and reverse bids gets fierce over time (increased bid price by acquirer and counter bids by target company become a vicious circle), a stage comes when either the attacker or the target company is required to call a halt. However, during this period, the cross holding level would have reached a meaningful size. As a solution, the more profitable of the two, buys back the share of the other at a premium. This is also called green mail payment.

C. The right Approach

Taking all the right actions at the right time is only a part of the story. A well-managed company may still conclude that (a) the price is right and therefore, (b) "giving in" could be in the best interests of shareholders. This approach demands: i. ii. iii. iv. Ability to correctly evaluate the strengths and weaknesses of prospective bidder Capacity to determine the right price (a price higher than even the highest bid and yet provides a value addition to the bidder) Competence in concluding the negotiations successfully, including terms of merger. and structuring the mode and timing of payments Deep understanding of the aspirations of the biddee and a navigational skill that permits managing the changes in leadership styles and beliefs and yet riding along.

To make the merger a success, it is incumbent on the new group to gain the correct understanding off all the stakeholders (be it creditors, employees, or others) and an appreciation of the products or services. This post-merger action is a wide-ranging one and is in the natured of "position-audit". In many cases, "integration task forces" are set up with representation from both sides and the process of post-acquisition change over is so made as could be seen by third party observers as transparent and fair. This process will take time. Once properly handled, this ensures as smooth a transition as possible and reduces the time involved in "getting to know you". Despite the best efforts of both the bidder and the biddee, many mergers turn out to be unsuccessful. We shall now consider a few.

D. Bids succeed but mergers fail

An M&A deal may be driven by proper motives. The bid price may be accepted. The deal may also get consummated. All this does not necessarily lead to the ultimate success of a merger action. There are many reasons why merger-actions may fail. 1. Not the right price (paying too much) The predator makes his first move by acquiring from the market only a small percentage of shares. Over time, he increases his holdings gradually. When he decides and makes a bid, in his perception the offer is the "right price". But M&A deal are not easy to come by. The target-company adopts defensive strategies and competing bids do emerge. An otherwise normal predator gets propelled by a desire to be the successful bidder and turns out to be aggressive. He also ends up paying a high premium. Failure will result when the price paid is, subsequently seen to be beyond that which the acquirer originally deemed to be acceptable to increase satisfactorily the long-term wealth of the shareholders. 2. Cheap Purchases An acquisition may be concluded at a budget price there will emerge turn-around costs. What initially seems to be a bargain may later turn out to be a high multiple of that price. The additional resources to be deployed - - in terms of cash and management time - - could well damage the bidder's core business. In preparing a bid, a would be acquirer should always take into account the likely total cost of an acquisition, including the input of its resources, before deciding on making an offer or setting an offer price. Lack of diligent planning the post-merger costs, can lead to failures. 3. Goal congruence This may apply not only to the biddee, but, more dangerously, to the acquirer. There can be disputes over the treatment of the management staff of biddee. This could take away the benefits of an otherwise excellent acquisition. 4. The fit or lack of fit syndrome

For a merger to be successful, two aspects need to be aligned properly, i.e., (a) products or services and (b) management styles and corporate structures. Once the merger deal is signed up, a new environment emerges. Products or services are seen to be a "good fit". But, a serious lack of fit may arise in terms of management styles or corporate structures. The biddee may also turn out, not to have the product range or industrial position that the acquirer anticipated, Usually, where a customer-entity or a supplier-entity is acquired, the acquirer already is well aware of biddee. Even so, there may be aspects of the biddee's operations which may cause unexpected problems for the acquirer, such that, a prospective acquisition should be planned with due diligence and not be based solely on experience gained from a direct relationship with the biddee.

5.

Failure to integrate effectively

Prior to concluding a deal, it is expected of the predator, to have a practicable and transparent plan of the extent to which the biddee is to be integrated and the amount of autonomy to be granted. In some cases, it may be required to have this plan negotiated with the biddee's management and staff. Nevertheless, its essential requirements should be fairly but firmly carried out. The plan must address such problems such as differences in management styles, incompatibilities in data information systems and continued opposition to the acquisition by some of the biddee's staff. Failure to plan and take appropriate action in this area can - and often does - lead to failure of an acquisition. This situation also leads to drift and de-motivation not only within the biddee's organization but also within the acquirer itself. 6. Inability to manage change

The points brought above, revolves round one single aspect. There is a need for the acquirer to plan effectively before and after an acquisition if failure is to be avoided. Planning is for managing the change. Therefore, there is an implied requirement that there should also be an ability to accept the change - perhaps even radical changes - from established routines and practices. Indeed, many acquisitions fail mainly because the acquirer is unable or unwilling - reasonably to adjust its own activities to help ensure a smooth take over.

LEVERAGED (AND MANAGEMENT) BUY-OUTS UNIT V

Meaning Significant amount of debt and very little equity capital of his own, for payment of consideration for the acquisition. It has often been described as buying a business with other people's money. With the popularity of LBOs, Management Buyouts (MBO) also became popular. MBO is the purchase of a business by its Management, who when threatened with the sale of its business to third parties or frustrated by the slow growth of the Company, steps in and acquire the business from the owners, and run the business for themselves. The financing of an MBO adhered closely to the LBO model where very substantial external funds were utilized to purchase the business rather than that of the future shareholder(s). We will have a peep into the factors that prompt a buy out. Internal It is not unusual for a listed Company to have the share prices below its net asset values. The Company would usually have a steady income, but is unlikely to increase its annual profits in multiples. Additionally, the steady profit growth is not sufficiently, reflected in its share price also. In such cases, new investors are attracted, and make a bid for acquisition, for either of two reasons: y
y

They recognize that the real value of Company's assets when sold, is a significant multiple of its book value, or They are confident of growing the Company at a much faster rate.

(a) Real value of asset base The Company either becomes a target for "asset strippers" or for those who see an opportunity to obtain extraordinary returns by realizing the companies' full potential within a short period of time, either by sale of its assets, or by expanding its business. There is also an overwhelming possibility of operating management of such companies who are frustrated by the under valuation of the companies' shares making an offer to all shareholders and take the company private. A Company with steady growth prospects and valuable assets, but which does not find favor in the share market is usually a target for a takeover, preferably through an LBO route, because of its strong cash flows and its reliable profit record. Companies that have an asset base particularly in the manufacturing sector are popular with investors involved in LBOs. Because, investors do understand the manufacturing business better than say the hitech businesses, which require substantial amounts of R&D expenditure. Additionally, the assets of a manufacturing company together with future earnings can be used as security for the borrowings.

(b) Earnings and steady cash Earnings are an important ingredient in considering a buyout, whether it is by third parties or by the management itself. The target-company should have a steady earnings and profit record of at ledst five years and be suitable for continuous growth. On account of the fact that the acquisition in an LBO is financed through high level of borrowings, an assessment of whether the earnings are adequate to service the debt and make principal repayments becomes very important. Investors will, therefore, endeavor to see whether even in a `bad' year there will be enough cash flows to enable the repayment of debt. A cash cow is the ultimate dream of a person using the LBO route for a purchase, where the return on assets exceeds the average growth rate of other companies in a similar business. By the same token, companies that require additional investment for research and development, or companies that require additional equipment or assets either to sustain existing profitability or for growth will not be considered suitable for acquisition through an LBO route. The rationale lies in the fact that a high gearing will not permit borrowing of additional funds and the limited funds available with owners will have to be used to repay debts, rather than expand the .business. It is safe to conclude that, in an LBO balance Sheet of the target Company a. Must be strong, b. with tangible, preferably unencumbered assets available for security c. supported by sizeable liquid assets that can be accessed for meeting future working capital, the component of trade debts should be good and relatively new with negligible element of long outstanding or doubtful debts (C) Size Size is not an important criterion in an LBO. Many LBO deals have been concluded with borrowings exceeding a $ billion-mark. Equally there have been large number of deals in the range of only $ 1 million. Rather than the sheer size of acquisition, the other criteria namely, real value of assets, earnings record and cash flows are more important. External Factors Historically, it is seen that there is a close link between interest-rates and acquisition activity. When interest rates are high, acquisition activity slows down. When interest rates begin moving southwards, lending activity picks up and new investors evince stronger enthusiasm in acquisitions. When the money market is tight, share prices are depressed, and more companies become available for acquisition, but it becomes more difficult to raise money to buy them. When the money market is easy, prices go up and competition in the corporate sector also increases. Inflation plays a major role in LBO activity. Money borrowed during a period of inflation, can be used to acquire assets that may appreciate in value at a much higher rate than the interest rates and eventually

the pay back of the principal is cheaper especially if it is in inflated Rupees. A debt already due will invariably be more burdensome than a debt due 3 years from now. A 1990 rupee may be worth only 40 paise in 2003 and is therefore relatively less expensive to pay back. In inflationary times, the winners are those who borrow heavily. The players: Role and perspective In an LBO, purchase of a business is financed with funds provided by parties, usually by banks or by outside investors. The new owners would secure the loans raised by assets and future cash flows of the target company. The borrowings would usually be a mix of two varieties 1. it would be a straight forward secured loan from a financial institution 2. There would be a redeemable bond issue (usually unsecured) with a high coupon rate. The high coupon rate is the benefit for the new investor-lender for the additional risk taken. (a) Lenders A number of financial institutions participate in LBOs. There is the conventional commercial bank, investment bankers, venture capitalists, and pension funds or insurance companies. The LBO is only an alternative vehicle available to investors seeking return for their Investment. Therefore each investor and participant will have their own evaluation criteria in deciding whether or not to participate in the "lending" process which enables the acquisition to materialize. (b) Merchant Bankers Merchant banks do have a major role in identifying potential candidates of LBO/MBO. They also act as go-between (negotiators) the buyers and sellers. They have expertise in valuation of a company and also in identifying potential investors. They also take up post acquisition monitoring of the value investment. (c) Acquirer Himself Every prospective acquirer is basically an investor. As an investor, LBO/MBO is no more than another investment vehicle to deploy his funds for a valuable return. Yet and investor opting for an LBO route, ought to be clear that he will be seeking a very substantial amount of external funds for the successful conclusion of the purchase, which in turn will enable him to make his share of investment in the acquisition. On the other hand the lenders in an LBO are also investors. The evaluation criteria of each of these parties differ.

The flip side: It is generally accepted that LBOs tend to increase the shareholder value by reflecting the full value of hidden assets or helping to assist in bringing out the full potential of an other wise less than active company. However, in the case of MBOs, potential conflicts cannot be ruled out, in as much as the management and the owners are the same, and are not separate from each other. Prior to MBO, with management and owners being different there was some separation of responsibilities. However after the MBO they not being different from management are responsible for strategic planning, as also for implementation, in its role as management, despite also being owners. In a management buyout, separation of management from its owners is nonexistent. Another area of potential conflict is between existing lenders and new lenders. With future cash flows being first made available-to new lenders, the existing lenders could be in a worse off position, and if it is a traded debenture, its market value could fall, to the detriment of the existing debenture holders.

Summing up LBOs The financial structure of LBOs and MBOs are relatively quite straightforward. There is financial participation by the acquirer, with significant additional loan contributions by banks, by venture capitalists or by merchant bank that do not mind high risk but look for high returns. The new owners run a tight ship, work within available working capital, cannot look forward to outside borrowings to-grow the business, and face the necessity of funding possible expansions from internally generated funds. The acquired business of Target Company ought to have a good business record, preferably have fixed assets available for collateral and generate steady cash flows to make repayment of interest and principal.