Chapter 3

An Overview of the Merger and Acquisition Process

Merging with or acquiring another company is a complicated process. To have a clear understanding of the process, the decision maker must have an overview of different phases of the process. In this chapter, we discuss different phases of an acquisition or merging process.

Although there are many ways to organize an acquisition process, a logical way of doing so is to divide such a process into four categories: strategic planning, screening, acquisition, and integration. We discuss each of these categories next.

Strategic (Long-Term) Planning

Planning implies thinking ahead about how to achieve a goal. Successful enterprises must constantly adjust to changes in technology, changes in production processes, changes in product quality and variety, changes in the organization of industry, and changes in the economic environment in which they operate. Adapting to the changing environment requires planning to compete with the competitors by innovation, which implies lowering the cost of production, offering a better product or service, and providing a superior service to customers. In achieving these goals, the strategic planners must answer the question “how do M&A decisions assist the enterprise to compete successfully?”

Of course in strategic planning for growth of a firm, mergers and acquisitions (M&As) is one of the options available to the enterprise. Table 3.1 shows a framework of five alternative approaches for real growth of the firm. These methods include internal changes, financial restructuring, external opportunities, contracting, and restructuring.

The table lays out the options that are available according to different methods for growth. For example, if a firm wishes to grow using the internal changes, then it has seven available options to choose from: change strategies, change organization structure, expand geographic markets, expand existing products, supply new products, and restructure operations; and management changes. By using the financial restructuring method to create growth opportunities, the firm could adopt dual class stock option, leveraged recapitalization, leveraged buyout, charge-off, or share repurchase policy.

Most of the topics in the table are self-explanatory. However, a few terms require elaboration.

“Dual class stock” refers to issuing of two classes of stocks by a company where the stocks in each class differ in terms of voting right of the stockholders and payment of dividend. The charge-off refers to one-time extraordinary expense of a company or a bad-debt expense, both written on a company’s income statement. Share repurchase is the purchase of a company’s own outstanding stocks from the market. See Chapter 2 for definitions of leveraged recapitalization and leveraged buyouts.

Screening

After developing an acquisition strategy, the acquirer should search and identify a target company. Screening involves application of a set of criteria to the potential target candidates in identifying the most suitable candidate for acquisition. A number of factors should be identified as the primary selection criteria such as industry, and size of the deal, which is determined by the price of the target.

Many acquirers use publicly available databases such as Disclosure, Dun & Bradstreet, Standard & Poor’s Corporate Register, Capital IQ, and EDGAR Online. Moreover, acquiring firms do use investment banks, brokers, and leveraged buyout firms to identify potential candidates for acquisition, by paying a finder fee.

Proper screening targets set the foundation of successful deal execution and subsequent integration of the combined entity.

Acquisition or Execution

This stage of M&A processes involves due diligence, valuation, negotiations, and deal structuring. We will discuss these terms in detail in the following chapters. However, we will give concise definitions for these terms presently.

Due diligence refers to those required activities an investor must undertake to make sure that the target firm will fit the strategy underlying merger or acquisition. Valuation of the target company refers to appraisal of the worth of the target firm. Negotiations refer to all set of activities that result in identifying, acquiring, and successfully completing merger with or acquisition of a company. Deal structuring is an arrangement between the parties in an M&A deal that defines the rights and responsibilities of both parties.

Integration

Integration of two combined business entities is the longest and most challenging stage of M&A. It involves combining strategic, financial, operational, technological, and human capital components of the combined businesses so that the postmerger entity could function smoothly as one unit. Many M&A failures are due to the inability of acquired and acquiring entities to integrate successfully.

Problems Arising During and After Completion of M&As

Studies have shown that most M&As do not fail, if one defines failure as sale and liquidation of the business. However, if failure refers to inability of managers to achieve the goals of merger or acquisition, then the rate of failure is very high. The rate of failure of M&As falls between 70 and 90 percent (Clayton et al. 2011). What are the contributing factors to such a high rate of failure?

Studies have shown that failures can be attributed to problems arising during three phases of M&A: inspection (due diligence), negotiations, and integration (Hopkins 1999). We discuss the potential failures during the three phases next.

Inspection Problems (Due Diligence)

The problem of asymmetric information, referring to the situation in which the managers of the target firm are more knowledgeable about the target in comparison to the management of the acquiring firm, plays an important role in failure of M&As. In most cases, the buyer of a company (or a product) has less information about the target firm (product) than the seller. As a result, the buyer may discover after the completion of the deal, certain information about the target company, which was not apparent before conclusion of the agreement, realizing that the price paid exceeds the true value of the acquired company (product).

To overcome asymmetric information, in-depth due diligence is absolutely necessary. However, in-depth due diligence is very costly and, in many cases, may be infeasible owing to reluctance of the target company to provide requested information.

One of the major after-the-fact unpleasant discoveries is that the target firm may have substantial off-balance sheet liabilities.1 Often, the intent of off-balance sheet transactions is to show a low debt-to-equity ratio. As examples, we cite, by now famous, cases of large corporate failures of Enron Corporation, an American giant energy trading company, the world’s largest, in December 2001; and the Parmalat group of Italy, a world leader in dairy food business in December 2003. Both of these firms through fraudulent accounting practices and off-balance sheet activities, which camouflaged the fundamental weakness of these enterprises, failed after the unlawful practices of the top corporate managers became publicly known. For details of the illegal accounting practices of these firms, which were unlawfully certified by the auditing firms, refer to Chapters 11 (Enron) and 13 (Parmalat) by O’Brien (2005).

The point of the using the aforementioned listed companies as examples is that even in cases where ostensibly all is fine with a target firm, there might be some dreadful, unknown underlying reasons that would make the target not suitable for merger or acquisition. Moreover, an increasing number of postmerger lawsuits by stockholders challenging transactions on grounds of misleading information given by targets have been filed in the courts of the United States in recent years. A study by Cornerstone Research Consulting firm reports that the researchers “…reviewed reports of M&A shareholder litigation in Securities and Exchange Commission (SEC) filings related to acquisitions of U.S. public companies valued over $100 million and announced in 2010 or 2011. We found that almost every acquisition of that size elicited multiple lawsuits, which were filed shortly after the deal’s announcement and often settled before the deal’s closing. Only a small fraction of these lawsuits resulted in payments to shareholders; the majority settled for additional disclosures or, less frequently, changes in merger terms, such as deal protection provisions” (Daines and Koumrian 2012, 1). 2 These lawsuits make careful inspection of the target companies compelling.

One approach that many entities use to acquire in-depth knowledge of the target company is an initial purchase of a large percentage; say 30 percent of the target firm simply to test the waters. As an example of such a defensive measure, we cite the merger of Renault and Nissan, when initially Renault, a French state owned enterprise, purchased 35 percent interest in Nissan before acquiring the entire company.

Negotiation Problems

Negotiations, in general, and cross-border negotiations, in particular, are very complex processes. The high complexity of cross-border negotiations that often leads to emergence of problems during its progress arises from differences in accounting, regulatory, taxation, and corporate governance systems of countries of acquiring and target companies. We use the differences between Anglo-American corporate governance laws and Germany’s corporate governance to illustrate how the differences in the laws could pose problems in M&A transactions.

Corporate governance laws in Germany require that each publicly traded company with 2,000 or more employees have a supervisory board with 50 percent of its members elected by stockholders and the other 50 percent by the workers (McCann 2005). Usually, this arrangement means that any mergers, acquisitions, or restructurings that would result in worker layoffs would be blocked by the supervisory board. Furthermore, as an antitakeover defensive measure, German corporate laws allow firms to add to their constitution, limits to the voting power of any shareholder to a maximum of 5 percent of the total outstanding shares, regardless of the percentage of share held by any one shareholder. In these situations, the negotiating team must overcome these problems.

Articulating the implication of corporate governance laws in Germany for decision makers in the acquisition of targets in that country is straightforward. Acquiring a company in Germany to capture synergies by layoff of excess workers would pose major postmerger integration and legal difficulties.

Integration Problem

Finally, problems at the integration phase of a merger or acquisition are considered to be the major factors for the failure of M&As. We will discuss the issues related to postmerger integration in depth in Chapter 13; however, here it suffices to say that poor planning; poor execution; or the pace of integration, whether it is taking place too fast or too slow, are the major causes of failures.

Summary

This chapter gave an overview of M&A processes by discussing four stages of the M&A process, that is, strategic planning; screening; negotiation, acquisition, execution; and integration. The chapter also enumerated the alternative methods that are usually available for the growth of enterprises. Furthermore, the main problems that often arise during negotiations and after completion of M&A transactions, which usually lead to a high rate of failure of M&A deals, were briefly reviewed.