Reasons for an acquisition? What are some things an acq considers when looking at a target?
- acq can achieve higher financial performance after the acq: believe what you’re buying is worth more than what you are paying for it
- theoretically:
1) t’s asking price = less than its implied value (PV of its FCFs)
2) acq’s expected IRR from acq exceeds its discount rate - motivations can fall into 2 buckets:
1) Financial: - consolidation/economies of scale
- geographic expansion
- gain market share
- seller is undervalued
- access to new customer base/distribution channels
- product expansion or diversification
- SYNERGIES (cost savings/revenue growth)
2) “Fuzzy”/Other Reasons:
- competition -> defensive acquisition
- hire employees
- office politics/ego
Sell-Side M&A Process
1) plan process & create marketing materials
- (learn about co; set valuation expectations; create CIM)
2) contact initial set of buyers & pitch the co
-> if buyer is interested, negotiate NDA & send CIM
3) schedule meetings b/t management team & interested buyers; deliver “management presentation” on co
4) solicit bids
5) diligence –> negotiate definitive agreement, arrange financing, close the deal
Buy-Side M&A Process
1) research market / pitch ideas for acquisition, including valuation(s) of targets
2) contact potential Sellers -> gauge interest 7 collect info
3) meet w/ management team of sellers
4) submit bid
5) diligence seller –> negotiate definitive agreement, arrange financing, close deal
Ways to fund an acquisition?
1) Cash (cheapest)
2) Debt
3) Equity (most expensive)
Equity Financing - Methods? Cost?
Methods:
1) Buyer issues new shares to OTHER investors -> use cash from those investors to pay for Seller
2) Buyer issue shares directly TO the Seller in exchange for Seller’s shares
Cost: Issuing additional shares dilutes the co’s existing investors -> their stakes decline
Most important criteria for doing a deal?
1) PRICE PAID FOR TARGET: is it reasonable?
2) EPS: will deal be accretive (or neutral) to EPS?
Accretive to EPS = acq will increase buyer’s EPS
Dilutive to EPS = acq may reduce buyer’s EPS
Elements of an M&A Valuation Analysis
1) DCF: analyze intrinsic value of target -> does price paid reflect this?
2) Comparable-Companies analysis: analyze target price -> does it reflect market expectations about its investment and growth opportunities?
3) Comparable-Transactions analysis: is price paid for target consistent w/ similar transactions?
4) Accretion-Dilution analysis: will transaction increase or reduce earnings p/share in future years?
Merger Model
1) Summarizes financial profiles of buyer & seller - includes projections (ex: net income) & each co’s EqV & TEV
2) Lists purchase price & consideration mix (cash/debt/stock)
3) Other key terms of the deal - interest rates on Cash & Debt, estimates for synergies
4) Shows what combined entity will look like & it’s EPS, compared w/ Buyer’s standalone EPS
Why use EPS as key metric in accretion/dilution analysis?
1) SHs care about EPS
2) Only easy-to-measure metric that captures deal’s FULL impact: foregone interest on cash, interest paid on debt, new shares issued to fund the deal
*Contra other metrics:
EBITDA & NOPAT - before interest income & expense; does not reflect share count
FCF p/share & LCFC p/share - not easy to calculate b/c affected by many items other than acq
How to analyze M&A deal and determine whether or not it makes sense?
- can look at both qualitative and quantitative factors - does it meet my strategic goals? and does it make sense financially - will it improve my co’s financial performance?
- qualitative analysis: depends on factors for doing an m&a deal - could deal help co expand geographies, products, customer bases, give more IP, improve its team?
- quantitative analysis: might include valuation of seller to see if it’s undervalued & compare w/ expected IRR to buyer’s discount rate
- EPS accretion/dilution analysis is impt to most deals: buyers prefer to executive accretive deals (increases EPS)
Walk me through a merger model (accretion/dilution analysis)
Merger model: used to analyze financial profiles of 2 co’s, the purchase price & how deal is funded, and determines whether buyer’s EPS increases or decreases afterward.
1) summarize financial profiles or buyer & seller: project out financial statements of buyer & seller. include each co’s EqV & TEV.
2) estimate the PURCHASE PRICE & mix of debt, cash, stock that buyer will use to finance the deal. –> create Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of an acquisition
3) show what the buyer & seller looks like as a combined entity:
- combine BSs: reflect cash/debt/stock used, goodwill created, any write-ups and write-downs
- combine ISs: reflect foregone interest on cash, interest paid on new debt, and synergies
4) calculate accretion/dilution: compare combined EPS vs. buyer’s standalone EPS.
- combined EPS: combined net income / buyer’s existing share count + new shares issued in deal
–> (combined eps / buyer’s stand-alone eps) - 1 = %
Combined Net Income calculation? Combined EPS calculation?
- Combined Net Income = Combined Pre-Tax Income * (1-Buyer’s Tax Rate)
- Combined EPS / (Buyer’s Existing Share Count + New Share Issued in the Deal)
Why might an M&A deal be accretive or dilutive?
- accretive: yield from seller at purchase price (additional net income contributed) exceeds buyer’s cost of acq (in form of foregone int on cash, int paid on new debt, new shares issued) -> buyer’s EPS increases
- dilutive: yield from seller at purchase price (additional net income contributed by seller) is not enough to offset buyer’s weighted cost of acquisition (foregone interest on cash, additional int paid on debt, effects of issuing additional shares) -> buyer’s EPS decreases
How to tell - accretive vs. dilutive deal?
compared yield from seller (at purchase price) vs. buyer’s weighted cost of acq
- if weighted cost < seller’s yield –> accretive
- if weighted cost > seller’s yield –> dilutive
yield from seller (at PP) = net income / purchase EqV
vs.
buyer’s weighted cost of acq = cost of cash * % of cash + cost of debt * % of debt + cost of stock * % of stock
- cost of cash = foregone interest rate on cash * (1-buyer’s tax rate)
- cost of debt = interest rate on new debt * (1-buyer’s tax rate)
- cost of stock = (*buyer’s after-tax yield) = buyer’s earnings p/share / buyer’s price p/share (aka net income / eqV)
M&A deal - how to determine Purchase Price?
- PUBLIC COS - purchase price paid in an acq (p/share) = seller’s current share price w/ an acq premium
- premium = based on avg premiums for similar deals in the market (usually bt 10-30%). can use standard valuation methodologies to cross check this #
–> do potential synergies justify this deal? - PRIVATE COS - purchase price - based standard valuation methodologies & link to EBIT, EBITDA, or Revenue multiplies (since private co does not have easy to determine share price)
–> can then back into a purchase equity price
Why would a buyer be willing to pay a higher premium for the seller?
=> If Buyer expects to realize significant synergies, often willing to pay a higher premium for Seller b/c PV of the synergies might exceed this premium to the seller’s current market value.
Advantages/disadvantages to using each purchase method: Cash? Debt? Stock?
Cash: (CHEAPEST)
(+): cheapest (int paid on cash is v low) in a low interest rate environment (foregone int in cash); easiest & fastest to close
(-): taxed immediately; seller can’t take adv of potential upside in buyer’s stock price; less flexible - if buyer needs funds for something else soon
Debt:
(+): cheaper than stock
(-): more expensive than cash (debt interest payments & principal repayment); increases debt profile for combined co -> increased risk; taxed immediately; seller can’t take adv of potential upside in buyer’s stock price; less flexible - makes FUTURE debt issuances more difficult/expensive
Stock: (MOST EXPENSIVE)
(+): prevents buyer from paying an additional cash expense for the deal; seller’s SHs are not taxed immediately;
greatest flexibility: no mandatory cash interest payments (dividends are discretionary), no principal repayment.
acqs more inclined to use when share price is higher. target SHs may find stock compensation attractive if acq’s shares are perceived to have potential upside (including synergies from the deal).
(-): most expensive option; dilutes buyer’s existing investor. more time-intensive/uncertain: public co’s need SH approval is issuing 20%+ stock.
riskier option: acq share price volatility from deal announcement till close –> adds uncrtainty.
How to decide on consideration mix?
- most acq’s use all the cash they can before moving to other funding sources (b/c cash is the cheapest). so, might assume use up as much cash as possible to maintain minimum cash balance. (might also include target’s cash balance if it is significant)
- then, acq might raise DEBT up to a reasonable amount: level where debt/ebitda and ebitda/interest ratios are similar to comparable companies
- lastly, if needed, issue equity as last option (b/c most expensive). but, usually up to amount that doesn’t give up majority ownership of combined company, and up to level where the deal remains accretive.
Purchase method preferred by Sellers?
- sellers balance diff factors: taxes, certainty of payment, and potential future upside
–> depends on seller’s confidence in the buyer.
to a seller
- cash/debt = similar b/c
(+) immediate payment; no risk if buyer’s share price decreases
(-) but also, immediate taxes for seller’s SHs & no potential upside if the buyer’s share price increases from deal
–> better if there is higher uncertainty
- stock = a gamble - if buyer’s share price increases, could end up w/ a higher price, but could also get a lower price if share price drops. sellers also avoid immediate taxes (taxed only when they sell their shares.
–> better w/ large, stable buyers
Impact of each purchase method in an M&A deal? How to estimate cost of each method?
Cash:
- cost of cash = foregone interest on cash: buyer loses out on future projected interest income on cash by using it up to fund the deal.
= interest rate * (1-tax rate)
Debt:
- cost of debt = interest expense on new debt
= interest rate * (1-tax rate)
Stock:
- cost of stock = additional shares created in a deal & how those shares reduce the combined co’s EPS
= reciprocal of acq’s P/E multiple (buyer net income / buyer eqV)
Foregone Interest of Cash - why is it included?
- NOT just an “opportunity cost”: acq’s PROJECTED Pre-tax income already includes interest income that the co expects to earn on its cash balance
–> if it uses cash to fund deal: buyer’s projected pre-tax income & net income will fall
Cost of Stock - M&A deal
- cost of stock = reciprocal of buyer’s P/E multiple
–> earnings p/share / price p/share = net income / equity value
==> diff way of measuring cost of equity!
*measures coe in terms of EPS impact, rather than basing in on stock’s expected annualized returns (capm)
Why might an Acq use Debt or Stock to fund a deal, even if it could pay for the target w cash?
- preserving cash (ex- future expansion plan or debt maturity)
- cash is restricted (ex - much of cash is overseas)
- might be cheaper to use stock (ex - if acq is trading at high multiples)
EPS accretion/dilution - when is it not impt? Alternative ways to evaluate M&A deal?
- EPS accretion/dilution not impt: 1) private co buyer, 2) buyer w/ negative eps, 3) buyer far bigger than the seller
alternative methods:
- value creation analysis (how buyer’s share price will changer after deal closes)
- irr vs. discount rate analysis
- M&A valuation (value seller + synergies vs. eq purchase price)
- relative contribution analysis (compare contribution %s to ownership %s)
- qualitative & “strategic” analysis
