MA a practical guide to doing the deal (wiley finance) 2nd edition

M&A History Advanced M&A Industry in the United States M&A in Wealthy Nations Other Than the United States Emerging Market M&A Notes Chapter 3: The Need for Growth Spurs Acquirers to Buy

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M&A

A Practical Guide to Doing the Deal

Second Edition

JEFFREY C HOOKE

4

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Copyright © 2015 by Jeffrey C Hooke All rights reserved.

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Published simultaneously in Canada.

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Hooke, Jeffrey C

M & A : a practical guide to doing the deal / Jeffrey C Hooke — [Second edition]

pages cm — (Wiley finance series)

Preface

Recent Trends

Overview of the Contents

What’s New in the Second Edition

Part One: The Big Picture

Chapter 1: The Global M&A Market: Current Status and Evolution

An Upward Trend, Interrupted by Booms and Busts

M&A Activity by Geography

Deal Categories

Large versus Small Transactions

M&A: No Guarantee of Success

Note

Chapter 2: U.S M&A History, Trends, and Differences from Other Nations

U.S M&A History

Advanced M&A Industry in the United States

M&A in Wealthy Nations Other Than the United States

Emerging Market M&A

Notes

Chapter 3: The Need for Growth Spurs Acquirers to Buy Other Companies

Ten Buyer Motivations

The Most Popular of the 10 Motivations

Tactic #1: Cost Cuts/Revenue Gains

Tactic #3: Financial Arbitrage

Conveying the Three Tactics to Investors

Discounted Cash Flow Analysis Supplements the Tactics

Summary

Notes

Part Two: Finding a Deal

Chapter 5: The Buyer Must Have a Methodical Plan in Order to Find a Quality Transaction

Contacting Possible Sellers

Laying the Groundwork

Four Steps in Beginning a Search

Retaining an Intermediary to Assist in the Search

Summary

Note

Chapter 8: Finding a Deal: Likely Results of a Search

Due Diligence

Structure the Deal

Financing the Deal

Closing and Integration

Publicly Traded Companies

Part Three: Target Financial Analysis

Chapter 10: Sizing Up the M&A Target from a Financial Point of View

Starting the Historical Financial Analysis

Beginning the Historical Analysis

Comparable Company Performance

Review of P.F Chang’s Financial Analysis

Notes

Chapter 11: To Facilitate Financial Projections, the Buyer Needs to Classify the Target as a

Critiquing P.F Chang’s Projection

Preparing Projections

Three Scenarios

Summary

Notes

Part Four: Acquisition Valuation

Chapter 13: The M&A Industry Typically Uses Four Valuation Methodologies

Assessing Each Methodology

Applying Multiple Methodologies

Summary

Chapter 14: The Use of Discounted Cash Flow in M&A Valuation

Discounted Cash Flow versus Comparables

The Discounted Cash Flow Valuation Process

Choosing the Right Discount Rate in Valuing a Standalone Business

Summary

Note

Chapter 15: Valuing M&A Targets Using the Comparable Public Companies ApproachReal Estate Analogy

What’s the Right P/E Ratio?

A Word about Value Multiples

Summary

Chapter 16: Valuing an M&A Target by Considering Comparable Deals and LeveragedBuyouts

Control Premium Is Embedded in Comparable Acquisitions

Understanding Leveraged Buyouts

The Cyclical Company

Speculative High-Tech Companies

Low-Tech, Money-Losing Companies

Turnaround Considerations

High-Leverage Company Considerations

Natural Resources

Emerging Market Acquisitions

Discounted Cash Flow (DCF)

Comparable Public Companies and Comparable Acquisitions in the Emerging MarketsSummary

Notes

Part Five: Combination, the Sale Process, Structures, and Special Situations

Chapter 18: Combining the Buyer’s and Seller’s Financial Results for the M&A AnalysisCombining the Buyer’s and Seller’s Projections

Reality Check

Financing Sources

Summary

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Selling the Business versus an Initial Public Offering

IPO versus Sale

Partial Sale/Leveraged Recapitalization

Summary

Notes

Chapter 20: The Sale Process from the Seller’s Vantage Point

Retaining a Financial Adviser

Setting the Stage for the Sale

The Buyer’s List

Approach Tactics

Confidentiality, Operational, and Personnel Issues

Due Diligence Visits

Coming Up with a Bid

Final Due Diligence and Legal Documentation

List of Illustrations

Chapter 1

Figure 1.1 M&A Activity, 1993–2013, by Value in the United States

Figure 1.2 Vertical Industry Diagram: U.S Electric Power

Chapter 3

Figure 3.1 Optimal Track Record for a Business

Figure 3.2 Vertical Chain

Figure 3.3 Oil Exploration Business: Drilling For versus Buying Reserves

Figure 3.4 Capital Structures of Buyouts versus Normal Companies

Chapter 4

Figure 4.1 EPS Accretion/Dilution First Year after a Deal Closing

Figure 4.2 Like-for-Like Deal, Higher Stock Price

Figure 4.3 Discounted Cash Dividend Valuation Approach, Constant Growth ModelChapter 8

Figure 8.1 The Acquisition Search Funnel: 12-Month Process

Chapter 11

Figure 11.1 Cyclical Company Earnings Plotted against GDP

Chapter 14

Figure 14.1 Different Rates of Return: November 2013

Figure 14.2 Sample k Calculation, October 2014, U.S.-Based Company

Figure 17.1 Holding Company Structure with Three Operating Divisions

Figure 17.2 Comparing Problem Companies (In millions)

Figure 17.3 Natural Resources Acquisition—Valuation Methodology

Figure 17.4 Emerging Markets US$ Sovereign Bond Yield/Spreads Against U.S TreasuryBond

Chapter 21

When most people hear the term “mergers and acquisitions,” the impression that comes to mind is amerciless corporate raider, who acquires a weakened corporate behemoth, strips the business of itsassets, and fires thousands of innocent workers in the relentless pursuit of profit This caricature isthe gist for Hollywood films, but it holds true for only a minute fraction of transactions The vastmajority of M&A deals are friendly combinations between companies in the same, or a very similar,business

The arranging, financing, and documenting of these combinations is a large industry in and of itself

—employing a sizeable number of people in many vocations The industry’s attributes—and theprocess through which deals are conceived and closed—thus merit the close attention of a broadcross-section of individuals, such as:

Investment bankers involved with mergers and acquisitions (M&A)

Equity analysts at hedge funds, risk arbitrage, pension funds, commercial banks, endowments,insurance companies, mutual funds, and sovereign wealth funds, who invest in firms engaged inM&A

Private equity professionals at buyout funds, venture capital funds, and hedge funds, whoroutinely buy and sell companies

Corporate financial executives and business development professionals

Institutional loan officers working with M&A and buyout transactions

Business students at colleges and graduate business schools

Investor relations professionals at corporations and public relations firms

Business appraisers, including those at appraisal firms, accounting firms, and consultancies.Lawyers who work with corporate clients on M&A-related legal, financial, and tax matters.Independent public accounting firms that review M&A accounting

Government regulators at the Federal Trade Commission (FTC), Department of Justice, InternalRevenue Service (IRS), Securities and Exchange Commission (SEC), Federal Deposit and

Insurance Corporation (FDIC), Public Accounting Oversight Board (PCAOB), Comptroller of theCurrency, and Federal Reserve (and their international counterparts)

Government elected officials who are interested in privatization or M&A related effects oneconomies

Bank trust and private wealth advisers

Sophisticated individual investors

Consultants that assist acquirers in the M&A due diligence process concerning the informationtechnology, human resources, environmental records and nonfinancial facets of the seller

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Recent Trends

During the 16 years since the first edition was published, M&A activity has skyrocketed—increasing

by a factor of four times—and the M&A community has expanded accordingly Accompanying thisgrowth were important changes to the business, including the following:

Embracing of M&A by smaller firms Previously the province of large companies, M&A is

increasingly a sought-after growth option for mid-market enterprises

Private equity The amount of capital provided to the private equity industry for leveraged

buyouts has increased exponentially Private equity is a more significant player in the M&Abusiness than it was during the first edition’s introduction

International Like other facets of American business, M&A has gained international

acceptance, particularly in the developed economies of Western Europe In recent years, M&Aactivity in emerging markets, such as China and Brazil, has grown

Natural resources To complement traditional exploration programs, natural resource

companies have ramped up acquisitions as a means to gain additional reserves at a reasonablecost

Expansion of the Internet The expanded use of the Internet has made the M&A process

easier for buyers and sellers, and thus it has facilitated the rise in transactions

Increase in computing power, coupled with a decline in its cost Information related to

prospective deals, their pricing, and their financing structure can be sliced and diced in

numerous ways This allows industry participants to quickly size up likely scenarios

Rise in activist investors After a long hiatus, activist investors are stimulating M&A activity

among publicly traded companies, encouraging those considered “undervalued” to sell

themselves or conduct spin-offs Publicly traded companies represent a small subset of the dealuniverse, but they tend to involve the larger, more publicized transactions

Overview of the Contents

The book starts with a bird’s-eye view We begin with the state of the global M&A markets and themotivations behind most acquisitions I then synthesize the 10 principal motivations into the threefinancial tactics that govern the preponderance of deals These topics represent Chapters 1–4.After this high-level review, the book covers the age-old question: How does a buyer find an

acquisition from the thousands of possible targets? The book outlines the methodical search process

of successful acquirers and ends the discussion with the key attributes of “good” versus “bad” deals.This material is covered in Chapters 5–9

Once the buyer has identified a few acquisition candidates, it assesses their financial histories andfuture prospects (Chapters 10–12) Then, it must consider the appropriate price to offer the owners.Chapters 13–17 provide a brief synopsis of corporate valuation techniques, the subject of many

books including one of my own: Security Analysis and Business Valuation on Wall Street (John

Wiley & Sons, second edition, 2010) The standard techniques for industrial and service firmsrepresent the limit for most valuation books, but here I also cover special challenges, like naturalresource companies, money-losing enterprises, cyclical businesses, and emerging markets firms.The special cases are important; few acquisition targets are U.S.-based, “vanilla” companies with asmooth upward trend of revenue and profit—that is, the kind you see in most textbooks

If the buyer and seller are “close” on the seller’s valuation, the buyer then has to gauge the impact ofthe prospective transaction on its balance sheet, income statement and future equity price Chapter

18 reviews the basics of M&A financial accounting for the combined firms From this initial financialanalysis, the buyer completes a computer model of the transaction As Chapter 18 explains, themodel provides the basis through which other financial actors—lenders, equity investors, and ratingagencies—assess the deal If the seller accepts buyer securities or contingent consideration, it toowill consider modeling the transaction The book discusses debt and equity finance in Chapter 18

Up through Chapter 18, I focus on the buyer’s strategy tactics, valuation, accounting, and financeconcerns, essentially descending from (a) the “big picture” viewpoint to (b) the day-to-day task ofthe buyer’s deal analysis Chapter 19 takes a diversion and it discusses the reasons why sellers selland why a sale is often preferable to an initial public offering (IPO) Chapter 20 then proceeds tocover, in a step-by-step fashion, the process by which a sizeable business is sold

Chapters 21 reviews the key legal documents encompassed in the sale process, as well as the

common legal structures A proper legal structure can save the buyer or seller significant monies,and it can offer either party substantial protection from unforeseen problems

Chapter 22 examines several transaction categories, such as hostile takeovers, demergers, andreverse mergers, which fall into the mainstream from time to time Such transactions gain

popularity only to recede into obscurity, as economic or regulatory conditions change

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What’s New in the Second Edition

The methodical process needed to produce a successful M&A deal has not changed fundamentallyover the past 30 years However, the transaction environment, valuation techniques, financialaccounting, and legal structures have evolved over time This second edition provides the necessaryupdates, additional insights, fresh examples, and current anecdotes I have rewritten the majority ofthe book to provide a more concise treatment of M&A and to reflect my broader internationalexperience This edition takes advantage of the knowledge I have gained from closing more deals,conducting executive education, and lecturing on M&A around the world

To facilitate the reader’s understanding of the subject matter, the book is divided into five parts.Part One: The Big Picture

Part Two: Finding a Deal

Part Three: Target Financial Analysis

Part Four: Acquisition Valuation

Part Five: Combination, the Sale Process, Tax and Legal Structures, and Special Situations

Instructors may visit the Wiley Higher Education website for M&A, Second Edition for Q&A,

PowerPoint Slides, Sample Exams, Cases and Exercises, and other classroom tools

For convenience, the pronoun he has been used throughout this book to refer nonspecifically to

capital markets participants The material herein will be equally useful to both men and women whoevaluate M&A transactions

This book will help you consider corporate strategies, make optimal M&A transactions, close betterprivate equity deals, obtain superior arbitrage investments, and assess relevant regulatory matters

M&A: A Practical Guide to Doing the Deal provides a practical, well-rounded view of the M&A

business and enables you to make sound judgments and to confront M&A’s many challenges

JEFFREY C HOOKE

Chevy Chase, Maryland

August 2014

Part One

The Big Picture

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CHAPTER 1

The Global M&A Market: Current Status and Evolution

This chapter reviews the global merger and acquisition (M&A) market and traces its expansion.Transactions are segmented into several categories, with most deals being medium-sized, privatetransactions There is no guarantee of success in acquisitions

An Upward Trend, Interrupted by Booms and Busts

M&A activity over the past 20 years has shown a marked growth trend, interrupted by peaks andvalleys related to financial booms and busts Volume spiked during the Internet bubble (1998–1999)and the private equity boom (2006–2007), only to drop significantly and then recover Announceddeals in the United States in 2013 totaled $1.1 trillion in volume, encompassing over 15,000

transactions Figure 1.1 shows the trend line

Figure 1.1 M&A Activity, 1993–2013, by Value in the United States

Data Source: Bloomberg and Reuters

As the figure shows, the M&A market is a cyclical business Activity is tied to several variables:Stock market valuations

Availability of debt financing

Optimistic views on the economy

When equity values rise in the stock market, an acquirer can offer his inflated stock to a seller ascurrency for the transaction Using high-priced stock in a deal makes the transaction’s mathematicsmore attractive for the buyer Alternatively, if the seller doesn’t want the buyer’s stock, the buyer cancomplete an equity raise in the public (or private) markets, and provide the seller with the necessarycash The end result is thus identical

For buyers to complete deals that make sense for their shareholders, borrowed money usually is part

of the financing package M&A activity is thus dependent on lenders—such as banks, finance

companies, and bond funds—being open for business and willing to sign-off on the aggressiveassumptions that often drive transactions

High-priced stock investors, liberal lenders, and motivated buyers are all reflective of positive views

on the strength of the economy, and this optimism promotes deals Once a recession hits and thepsychology goes negative, transaction volume dries up

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M&A Activity by Geography

The United States and Canada represent a large share of M&A activity, and this continued to be thecase in 2013 Typically, transactions are aggregated by four geographies See Table 1.1

Table 1.1 M&A Volume by Value, Year Ended December 31, 2013

Data Source: Bloomberg.

of global GDP, yet their percentage of deals is much lower We discuss these disparities in the nextchapter

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A horizontal deal is when a company acquires (a) a competitor, (b) a firm doing the same business

in a different geography, or (c) an enterprise engaged in a product line that is similar to that of thebuyer Recent horizontal mergers include: (a) El Paso/Kinder Morgan, two U.S pipeline companies,

$36 billion value; (b) Amgen (U.S.)/Onyx (U.S.), two drug firms, $10 billion; and (c) Valeant

Pharmaceuticals (Canada)/Bausch & Lomb (U.S.), two health-care product firms, $9 billion

Horizontal is the most popular deal category because it presents the buyer with the fewest operatingrisks The buyer knows the target’s product line, suppliers, and customers, and it can institute costsaving measures with little disruption to the seller’s operations Furthermore, in the case where theseller is a direct competitor, the acquirer has the added benefit of potentially raising prices withminimal customer resistance Perhaps three quarters of all M&A deals fit the horizontal category

A vertical transaction occurs when a company buys a supplier, distributor, or customer A

coal-burning electric utility that acquires a coal miner is one illustration Most industries have driftedaway from vertical integration, with exceptions being the big oil companies, like Exxon and

Chevron So, vertical deals tend to be quite rare See Figure 1.2

field that is unrelated to the seller Sometimes, the buyer believes it has a set of strengths that canpropel the seller’s business (or vice versa), and the transaction is thus part of a grand strategy toboost the buyer’s future At other times, the buyer seeks to redeploy capital from its core businessinto another primary line, rather than disposing of the cash by paying higher dividends or

repurchasing stock Berkshire Hathaway, the insurance conglomerate, completed one of its manydiversification deals when it purchased railroad Burlington Northern for $34 billion in 2010

Strategic, diversification, and conglomerate deals represent about 10 percent of M&A activity

Private equity participates in M&A principally through the leveraged buyout (LBO) An LBO is a

transaction whereby a private equity fund (or a similar investor group) acquires a company and usesborrowed money to meet most of the cost of the deal The private equity fund does not guarantee theloans, so the lenders look solely to the acquired company for repayment Because an LBO is not acombination of similar businesses, the opportunities for an LBO to cut duplicate costs are minimal,and the investors rely on new management, new operating tactics, or a rising stock market to boostvalues

Through the LBO, private equity funds control many large U.S corporations, such as Hertz Car, Hilton Hotels, and Caesar’s Entertainment, and the funds have made substantial inroads intoWestern Europe At the LBO peak in 2006, such debt-funded deals represented 30 percent of M&Aactivity, a figure that has since dropped to about 10 percent according to data generated by CapitalIQ

Rent-A-26

Large versus Small Transactions

Large transactions involving publicly traded companies garner most of the media attention, andthey account for 60 percent of dollar volume, out of 30,000 to 40,000 global deals per year, based

on my estimations and data services Three quarters of transactions involve privately owned firms(or divisions of publicly traded companies) with annual revenue under US$100 million equivalent,and 97 percent of purchase prices are under US$100 million.1 One big $10 billion deal, therefore,equals the value of two hundred $50 million deals

M&A: No Guarantee of Success

Despite all the hullaballoo surrounding M&A, numerous studies over the years have proven thatover half of acquisitions do not increase the buyer’s per share equity value However, most buyerexecutives, investment bankers and other practitioners fail to take such studies seriously, and theythink that their deal will beat the odds Such action is a calculated risk, and it reflects the corporateview that M&A is often the fastest means of growth Why spend years developing new products andcultivating new customers, when you can acquire both in a few months with an M&A transaction?For many corporate managers, this logic is compelling and the opportunity for a big score outweighsthe risk

M&A’s acceptance by United States’ operating companies and financial markets is facilitated by thegovernment’s light regulatory hand Most deals involve competitors or similar businesses, yet U.S.authorities rarely challenge transactions on antitrust grounds Compared to other jurisdictions, legalprotections for those U.S workers displaced by M&A cost-cutting are minimal; and, thus, acquirerscan realize cost synergies with little government interference For large public deals, federal andstate regulations allow the buyer’s stockholders a minor role Management dominates the processeven if the acquisition price appears overly generous and thus injurious to the buyer’s stockholders.Finally, the U.S government welcomes foreign corporations to buy into the United States

The U.S regulatory attributes are lacking, to one degree or another, in foreign markets, whichexplains their relative lack of activity We cover the differences in the next chapter

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1 Bloomberg, “Global Financial Advisory—Mergers and Acquisition Rankings 2013.”

CHAPTER 2

U.S M&A History, Trends, and Differences from Other Nations

The U.S M&A market is more advanced than those of other countries, and, as a result, the UnitedStates has a disproportionate share of transactions The reasons behind the disparity are covered inthis chapter

In my travels, I have given M&A seminars on several continents Inevitably, the attendees want toknow how their local market stacks up against the United States, where the M&A business is highlyadvanced

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U.S M&A History

To give the response some context, a review of the U.S market’s 120-year evolution is helpful.Historians and M&A experts identify six merger waves

First Wave: 1895–1907

The first wave saw a horizontal M&A boom, as larger enterprises gobbled up their smaller

competitors Monopolistic firms, such as U.S Steel and Standard Oil, became dominant, with anumber later broken up by newly empowered antitrust authorities The wave ceased with thefinancial panic of 1907

Second Wave: 1920–1929

Vertical mergers gained popularity, as firms integrated backward by buying supply sources or

forward by acquiring distributors Holding companies assembled many individual electric utilities

into vast corporations A decade of economic prosperity saw new technologies, such as commercialradio broadcasting, and higher stock prices propelling M&A volume The wave ended with the 1929stock market crash

Fifth Wave: 1992–2000

From 1992 to 2000, the stock market and the economy experienced an expansionary period,

precipitated in part by the Internet boom Lofty high-tech stock prices spurred many stock-for-stockmergers, as dot-com buyers took advantage of high equity valuations The frenzy declined with thebear market’s start in late 2000, and the S&P 500 index lost 50 percent of its value by October

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Advanced M&A Industry in the United States

During these M&A waves, a large group of U.S practitioners representing a variety of disciplines(including valuation, lending, investment banking, legal, accounting, exit planning, regulatory, andtax) have established an M&A Industry, employing tens of thousands of people, whose principalfunction is to provide advice and other services related to the successful completion of M&A deals byoperating businesses, private equity firms, and other entities (i.e., “buyers” and “sellers”) Theindustry has a body of knowledge, customs, and procedures that tend to dominate the manner inwhich businesses prepare for, and carry out, M&A transactions Due to the influence, expertise, anddominance of the industry in these transactions, corporate executives and corporate directors—particularly in larger companies—find it necessary to familiarize themselves with the relevantknowledge, because M&A, at times, is a contributor to corporate growth and shareholder value.Practitioners convey this knowledge formally, to corporate executives and others, in books, articles,presentations, and seminars Universities, executive education institutes, family business

organizations, and other groups provide information on M&A as well Formal presentations areoften portrayed from the point of view of the principal actors—that is, the buyer or the seller—although a lengthy book, like this one, for example, incorporates multiple viewpoints Many articlesand short presentations address special topics—leveraged buyouts and leveraged recapitalizations,high-tech or natural resource industries, tax and legal matters, and postmerger integration

Furthermore, in the United States, a publicly traded company CEO is approached by investmentbankers (or business brokers) offering to sell him smaller companies operating in his industry on aregular basis Privately owned enterprises also receive frequent contacts from investment bankers,business brokers, and private equity firms, with the subject of the inquiry being whether the

enterprise desires to be acquired or needs capital

M&A in Wealthy Nations Other Than the United States

Highly industrialized countries include most Western European nations, Japan, and Australia.Relative to the United States, they have a smaller proportion of M&A to national income Primecontributors to the differential are:

Fewer publicly traded companies

Stronger layoff protections

Heavier regulation

Publicly traded companies help to drive M&A activity because they are under more pressure—compared with family-owned or private firms—to generate revenue and earnings growth They tend

to be more acquisitive Publicly traded companies are less of a presence in other developed

countries, promoting the disparity Relative to the United States, other wealthy nations havestronger layoff protections for employees These protections make a combination of like companiesless efficient, from a financial point of view, in countries like France and Spain when compared tothe United States Other developed nations also tend to have more interventionist regulation in theM&A arena, retarding deal volume versus the United States

In Japan, the world’s third largest economy, the business establishment has never accepted thenotion of American-style M&A Japan is still the home of sizeable conglomerate groups (both

vertical and horizontal conglomerates, called keiretsu) that have resisted successfully the

restructuring and core competency focus that has driven M&A growth in other nations Inside the

keiretsu, layoffs are frowned upon, although smaller Japanese companies use such actions to cut

costs

34

Emerging Market M&A

Emerging markets are poor countries with per capita income of less than $9,000 In contrast, theUnited States has a per capita income of $50,000 These markets are extremely diverse in language,politics, and culture, yet patterns of business circumstances are recognizable The economic

influence of emerging markets is often overstated With 85 percent of the world’s population, theyrepresent just 35 percent of global GDP The top three emerging markets—China, Brazil, and Russia

—account for 19 percent of global GDP Domestic economies are small—India, with 1.2 billionpeople, has a GDP equivalent to the state of California—thus restricting the number of targets formultinationals that seek domestic entry points, production platforms, and natural resources Privateequity funds and local players face a similar dearth of acquisition targets

Publicly traded companies are underrepresented relative to wealthier nations, and most emergingmarkets have a handful (perhaps 30–50) of large capitalization firms A number of such firms haveoutgrown the home markets and now look abroad for expansion opportunities Notable emergingmarket acquirers of international businesses include China National Oil (China, oil), Mittal (India,steel), and 3G Capital (Brazil, consumer)

With the exception of China and Russia, emerging markets are dominated by companies that cling

to the family business model, a factor that limits buying for the following reasons:

Less growth pressure: Family-controlled companies, even when publicly traded, have less

pressure (than an investor-owned business) to push acquisition-style growth, since the company

is immune to a hostile takeover or proxy fight prompted by a low stock price

Less management incentive: Nonfamily managers generally have no stock options in the

business, and thus little incentive to achieve growth through acquisition

Aversion to ownership dilution: As I discuss later in the book, buyers sometimes need to

sell equity in the business to finance a takeover Many families are reluctant to take this actionfor fear of diluting their ownership

Anxiety regarding leverage: Similarly, deals sometimes require the acquirer to take on a

higher-than-normal debt load High leverage is frowned upon by emerging market families, whoprefer a conservative stance to weather the volatile cycles in their home economies

Seller attitudes play a role in restricting M&A activity as well:

Secrecy concerns: Emerging market family businesses are more paranoid about divulging

routine business information (to possible acquirers) than their developed country counterparts.Among other reasons, “confidentiality agreements are difficult to enforce in emerging markets”says Laura Aleran, a lawyer at Peruvian law firm, Payes, Rey, and Canvi.1 And furthermore, thefamily business may keep two sets of books—one for the tax authorities and one for the family—and information provided to competitors could find its way to local government officials

Unrealistic views on valuation: With few local deals to provide benchmarks, the emerging

market business owner approached by a buyer tends to suggest a lofty valuation, making thetransaction untenable The wide bid and ask gap reduces deal flow

China and Russia

M&A debt financing in the United States and Western Europe relies on the cash flow loan Thebuyer typically acquires the seller at two times (or more) its historical accounting value, so theborrower sometimes lacks sufficient hard collateral to cover the debt obligation Hard collateralmight be inventory, plant, or equipment As a result, the lenders look to the future earnings power ofthe combined businesses for repayment In contrast, emerging market banks are uncomfortablewith cash flow loans They want 150 percent collateral coverage as a requirement, which oftenupends a transaction’s mathematics, according to Luo Yang of China Bond Research.2 Corporatebond markets (including junk bonds) are undeveloped, and they can’t fill the void left by the skittishcommercial banks.

On the equity finance side, local investors in the emerging markets are unfamiliar with the buyerbenefits of an M&A deal The analysts at brokerage firms and financial institutions are unfamiliarwith M&A accounting and they lack experience in sizing up transactions The bias tends towardorganic growth, similar to the U.S thought pattern in the 1950s and 1960s

Emerging Market Structural Issues

Like Western European nations, emerging markets make M&A-related layoffs difficult (or

expensive) for the acquirer, thus undercutting cost initiatives from an M&A combination

Governments discourage foreigners from controlling leading economic sectors or prominent brands,and local monopolies seek protection from outsiders entering the country and creating new

competitors Mexico, by way of example, has just two soft drink companies, two phone serviceproviders, two TV networks, two beer brewers, two cement companies, and so on Meanwhile, theworld’s largest M&A market, the United States, is right next door

36

1 Interview with Laura Aleran, November 20, 2013

2 Interview with Luo Yang, China Bond Research, October 16, 2012

CHAPTER 3

The Need for Growth Spurs Acquirers to Buy Other Companies

The need for growth sparks companies’ desire to acquire other businesses Growth tends to promote

a higher stock price, which helps a firm to retain good employees and to sustain operations In thischapter, we look at the 10 principal motivations

Most businesses strive for consistent increases in sales and earnings, as depicted in Figure 3.1.Upward-trending track records bring publicly traded firms higher-than-average price earning (P/E)ratios, premium stock prices, attractive financing offers, new business proposals, and many

acquisition opportunities Much of the same holds true for similarly situated private enterprises.Success breeds success

Figure 3.1 Optimal Track Record for a Business

Companies make acquisitions in order to grow Growth is critical to a profit-seeking enterprise forseveral reasons:

Retain talent: A business needs growth in order to retain good employees Growth provides

additional promotions and rewarding compensation schemes—such as stock options—for thoseemployees who otherwise might depart to greener pastures

Capital: A growth record facilitates the raising of debt and equity capital needed to sustain

operations

Constituent confidence: A growing business imparts confidence to customers and suppliers

that are vital for survival

Fundamentally, a business has three strategies to promote this growth:

Customers: Gain more revenue from existing customers, or find new customers for existing

products

Products: Develop new products.

Acquisitions: Obtain more products and/or customers through acquisitions (sometimes called

“buy” versus “build”)

The growth plans of large companies include elements of each strategy

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Ten Buyer Motivations

Ten M&A motivations for a buyer are:

1 Economies of scale

2 Achieve oligopoly power

3 Speed growth through diversification

4 Vertical integration

5 Buying technical expertise

6 Avoid new product risk

7 Capture natural resources

8 Cut target’s costs

9 Enter new country

10 Private equity

Acquisitions are built upon these 10 buyer motivations

1 Synergies/Economies of scale When buying similar businesses, a company achieves

economies of scale, as fixed costs are spread over a wider production (or service) base Theseeconomies sometimes spill over into the revenue side, as the buyer may have superior marketing

or distribution systems that can help the seller’s operation Acquisition-related cost reductions

and revenue enhancements are termed synergies

Cost reductions fall heavily on the target as the buyer eliminates parts of the target’s business

that are readily duplicated by the buyer For example, the buyer will have its own chief executiveofficer, chief financial officer, general counsel, human relations (HR) department, and legaldepartment; and, therefore, such functions at the target are no longer needed A working numberfor cost synergies in a like-for-like deal is 2 percent of the target’s revenue, although this rule ofthumb varies by industry In 2013, for example, Tenet Healthcare projected cost savings

amounting to 2 percent of the annual revenues of acquisition Vanguard Health Systems, a fellowhospital operator.1

In many instances, the buyer’s marketing, sales, and distribution power are applied to the seller’s

business, and the result is a revenue gain for the seller Such revenue synergies are harder to

predict than cost cuts, but buyers include revenue enhancements into many like-for-like deals,despite the uncertainty The combination of cost cuts and revenue increases often boosts aseller’s earnings—postacquisition—by 20 percent or more Economies sometimes increase abuyer’s profit margins as well, as efficiencies are spread throughout both operations (this

incurred in one of my deals in which two distributors combined overlapping service areas.) Asthe like-for-like deals multiply, the acquirer evolves into a member of an oligopoly, and it thenseeks motivation #2 below

2 Achieve oligopoly power In the long run, a profit-seeking business seeks oligopoly

positioning, where it has little competition, strong pricing power, and an enhanced ability topressure suppliers for lower costs Acquisitions of competitors represent a prime vehicle toaccomplish this objective

The United States, for example, is home to many oligopolies constructed through takeovers, such

as the cell phone, cable TV, airline, and commercial banking industries, to name a few One job

of government is to prevent oligopolies, although regulatory success is spotty in the UnitedStates and elsewhere One example is the increase in airfares between Chicago and Houston, thehome bases of United and Continental After their merger, average airfares rose 57 percent,versus 16 percent elsewhere.2

3 Growth through diversification Sometimes, a business decides to expand beyond its

existing industry niche It may have reached its maximum market share, or management maybelieve alternative industries represent better investment opportunities The stage is then set for

a diversification acquisition, whereby the company buys into an unrelated industry “It’s the

fastest means to diversity,” indicates Paul Murray, chief financial officer of Digital Management.3Although such “buy-ins” seem illogical to many stockholders, these transactions are justified as

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