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Prof. Eric De KeuleneerProf. Pierre Francotte

Year: 2012-13

FIELD PROJECTS EUROPEAN AND INTERNATIONAL BUSINESS

(GEST S-543) AND

FINANCIAL MARKETS AND SERVICES (ECON S-532)

PART I

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Reading material

• Mc Kinsey (2012), “Taking a longer-term look at M&A value creation”, Quarterly series, January, see McKinsey’s website.

• Mc Kinsey (2011), « Organizing for M&A: McKinsey Global Survey results”, Quarterly series, December; see McKinsey’s website.

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Contents

I. Business frameworkII. Internal process and approvalsIII. Regulatory approvalsAnnex: Checklist

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I. Business framework

A. Strategic contextB. ValuationC. Value generation or destructionD. Financing of transaction

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A. Strategic context

• M&A transactions are means for a company to achieve their business goals, ideally faster and at lower total costs than alternatives.

• They are not a end onto itself, but only a means to achieve goals – distinguish company’s goals, strategy, and tactical

steps– M&A is part of strategy, not goals.

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Alternatives to M&A

• Various alternatives:– Organic growth (competition, internal investments)– Alliances (e.g., reciprocity arrangements, exclusive distribution

contracts)– Joint ventures (set-up of jointly owned company)

• complicated, especially between competitors

• Each has advantages and disadvantages, which make them more or less attractive as a strategy at a given point of time:– no approach is necessarily better for all companies– no approach is necessarily better for given company at all times

of development and in all market conditions.

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Merger vs acquisition

• Legal view: – merger implies disappearance of existing companies and creation of

new legal entity– acquisition implies that one company takes over the other and the

acquired company ceases to exist– but in reality legal arrangements tend to be more flexible, and are

often driven by regulation and tax considerations.

• Business view: – merger is combination of companies of equivalent value– acquisition is take over of one company or line of business by another which

integrates the target company in its own business structure.– smaller company can acquire larger company – many acquisitions presented as « mergers » for “psychological” purposes.

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Nature of transaction

• M&A is a broad concept that includes:– acquisitions of legal entities (and all of its assets

and contracts, including personnel)– acquisitions of lines of business which are not

necessarily legal entities (e.g., branches or representative offices), typically with selected:

• client relationships, • personnel (under various legal arrangements, e.g., TUPE,

voluntary transfers, etc)• relevant assets, such as intellectual property rights,

hardware and software, etc.

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Divestiture• Sale or exit of a line of business/part of company.• Weaning off parts of the existing business must also be part of

strategic planning, e.g.,:– if no longer sufficiently productive (or expected to loose value in

foreseeable future)• for revenue and/or cost reasons

– if not part of core capabilities• insufficient competitiveness

– if company needs cash• to invest (opportunity cost: locks up financial and human resources that could

be better used in other business lines)• to increase core capital (e.g., banks today)• to return capital to shareholders

• Alternatives: outsourcing, JV, etc

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Strategy

• Strategy: set of major intended means to achieve overarching goals of company.

• Covers all aspects of the conduct of business at a high level. Examples:– Pricing– Personnel/technology– Geographical reach– Size and critical mass– Vertical or horizontal expansion, or both– In-house reliance or outsourcing/focus on core – etc

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Strategic review

• Intent:– indispensable to have a clear view of the

strategic intent of the M&A transaction and the likelihood of success for each strategic strand.

• Impact:– should also assess potential unintended strategic

consequences of M&A transaction and how to mitigate or exploit them.

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B. Valuation

• Different methods used to value a business or a company.

• Often one main method used (e.g., Discounted Cash Flow - DCF), but cross-checked and refined with several other methods (e.g., payback, multiples, etc).

• To be discussed with external expert in subsequent lesson.

Evaluation techniquesHow freqently does your firm use the following techniques when deciding which project or acquisition to

pursue?Source: Graham Harvey JFE 2001 n=392

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%

APV

Profitability index

Simulation analysis

Book rate of return

Real options

Discounted payback

P/E multiple

Sensitivity analysis

Payback

Hurdle rate

NPV

IRR

Ev

alu

atio

n t

ech

niq

ue

% always or almost alwaysProf H. Pirotte

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Goodwill

• In a M&A transaction, buyer acquires an « earning machine » and typically pays a price exceeding the value of the current assets: = goodwill

• Is the difference between cost of acquisition and fair value of net assets acquired.

• Intangible fixed asset on balance sheet– originally, goodwill amortised (over 20 years)– now, under IFRS, no amortisation, but company must

review value every year against permanent value reductions.

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Goodwill reviews

• Companies that have acquired financial assets must review their carrying value at least once a year (IAS 36-39).

• If the value of the asset has dropped, impairment is required:– impact on P/L– asymmetrical (no upward revaluation if value recovers later)

• Applies to full price, including

– any strategic premium– any sharing of synergy value with sellor.

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C. Value generation or destruction

• Generalisations hazardous– difficulty to measure value creation/destruction– significant differences between industries and companies

• But enough major failures to raise questions• Patterns tend to show that:

– Large/public companies rely more on M&A to grow than smaller/private ones

– Companies are more successful with many small deals than a few large ones in growing markets

– Large deals tend to be more successful in mature markets– Companies that have M&A experience are more successful at it.

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Value generation

• M&A can generate shareholder value IF:– undertaken for sound strategic purposes (design)– appropriately valued, and– well executed.

• M&A is typically higher risk/higher rewards than organic growth, – although sometimes failure to act can be

strategically more dangerous.

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Benefits

• M&A can help speed up achievement of goals:– Reach critical mass – Gain market share, clients

• in existing geographic sector• in new geographic areas

– Expand product and service range– Increase profit margins– Reduce unit costs– Acquire tested expertise and intellectual property

• Speed can translate in increased shareholder value:– lower total costs for market penetration– market share protection/gains.

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Cost synergies

• Reduce total cost of doing business compared to previous state of affairs:– Personnel (support groups, and sometimes production teams)– IT, especially in service companies (e.g., financial industry)– Fixed assets, plants, real estate, etc.

• Greatest when companies in a similar line of business, thanks to economies of scale and build-up of critical mass on personnel and production capacity (IT, plants, fixed assets, etc).

• Mostly under control of company• But often more difficult and slower to capture than

anticipated (see below).

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Revenue synergies

• Increase total revenues thanks to transaction• Less control by company

– Expansion of client base (cross-selling)– New services/products– Greater market share/margins - dominant position

• Provided transaction approved by competition authorities

• Subject to ongoing competition law constraints on abuse of dominant positions

• Often prove to be over-estimated.

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Offense and/or defense

• M&A can be for « offensive » or « defensive » reasons,– seek to build larger or more diversified business– seek to remain competitive in terms of costs and/or service

offering vis-a-vis growing competitors.• Can legitimately seek to protect market shares or even build

dominant position, within regulatory constraints:– on build up or abuse of dominant positions– on avoidance of excessive systemic risk.

• Companies rarely take into account externalities if they do not coincide with own shareholders’ value:– need for well calibrated regulation and supervision to set

boundaries (e.g., financial sector, energy sector, etc).

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Value destruction

• Many M&A transactions destroy rather than create value for the stakeholders of the Acquirer and Acquired:– shareholders

• generally of the acquiring party

– clients– employees.

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Why?

• Wrong incentives (cf next lesson)– Financial rather than industrial logic– P/E game– etc.

• Inadequate design, strategic fit.• Poor execution.

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Costs

• M&A implies a cost:– Pay for established value– Opportunity cost (cf next lesson)

• Sharing of synergies estimated value?• Control premium (about 20%) even if for partial stake

• Transaction should generate sufficient return in reasonable time scale over the total cost of the transaction (requires synergies).

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Design risk - examples• Inadequate strategic fit

– Non-exhaustive identification of strategic implications– Incorrect strategic projections– Weakening of strategic fit over time of implementation

• Over-estimation of synergies– Cost synergies– Revenue synergies

• Under-estimation of downsides– loss of clients– cannibalisation of products– stretch of resources (management, IT, investment capabilities)

• Loss of focus on day to day business• Trade-off between integration and service development.

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Execution risk - examples

• Culture clash (especially in case of true or perceived « merger » of equals)– demotivation of staff – productivity losses– loss of good staff, stuck with less good staff– distraction of senior management.

• Slow or biased decision-making, – especially on people and IT issues.

• Loss of focus and follow up– inadequate planning and monitoring– lack of resources

• concern about integration costs at time of cost synergy focus• opportunity cost due to scarcity of financial and human resources.

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D. Financing of transaction

• Two basic financing means:– payment in cash

• with available cash• with debt

– exchange of shares• Share exchange often more palatable, but

– Valuation more complex (need to value both companies)– Overpayment still leads to shareholder value destruction– Shares of acquiring company must be sufficiently liquid

• Difficult for non-quoted companies• Difficult for companies listed on small, illiquid, exchanges.

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II. Internal process and approvals

A. Negotiation processB. Shareholders approvalC. Advisory support

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A. Negotiation process

• M&A negotiations must typically be approved by the Board of Directors (BoD)– conducted by Management (sometimes jointly with

Chairman of the Board) within framework approved by the Board

– key roles for the CEO (for significant transactions), CFO and corporate strategy group, with expert support from

• Business line managers• Legal division• Risk division

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Board of Directors approval

• Management needs BoD approval to approach target company and to negotiate key terms of significant M&A transactions.

• BoD recommendation to the shareholders– in acquiring company– in target company

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Hostile or friendly

• Hostile if the acquiring company proceeds with shareholders of target company without positive recommendation of the BoD of target company– either the BoD is completely bypassed (rare)– or the BoD has been approached but is not satisfied with the

proposal, such as the price.• Hostile transactions are often less likely to:

– materialise: shareholders more suspicious, and in some sectors regulators may block deal.

– succeed in generating value: • lack of management support makes integration more complicated • may lead to client defections.

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B. Shareholders approval

• Depends on law and Articles of Association.• Sometimes, under AoA, depends on whether

transaction is for cash or share for share:– may be « de minimis » threshold– sometimes no approval required for share for share

transactions provided issuance of new shares does not exceed pre-approved amount.

• Sometimes qualified majorities required.• All these modalities have a major impact on deals

and their terms and conditions.

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Shareholder structure

• BoD and management must take into account shareholders’ expectations and profiles.

• Many M&A transactions fail because miscalculations about this– special role for shareholders in private or family

controlled companies (e.g., dilution concerns, value expectations, financing, etc)

– « control » depends on company (concentration of shareholding), on possible shareholders’ pacts, on required majority for decision.

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C. Advisory support – investment bank

• Investment bank– advises on options, valuation and price, financing means, etc– participates in negotiations as agent of client firm

• for valuation assumptions, etc• also used to float ideas and unblock impasses while keeping face

– delivers an independent « fairness opinion » to the Board about reasonableness of the price, but subject to assumptions

• meant to be a safeguard to Board and eventually shareholders• may put boundaries on framework of negotiations

– sometimes helps arrange financing of transaction.

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Advisory support- others

• Strategic advisors– Typically advise client over period of time

• intimate knowledge of firm (but sometimes CEO too reliant?)

• has less of a stake than investment bank in whether transaction is completed or not

– typically no « success fee » for deal completion– although business mandates often affected after deals

– Support for post-merger integration• Other advisors

– e.g., external legal counsel

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III. Regulation

A. Sector regulationB. National interest or securityC. Competition law

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A. Sector regulation

• M&A in some industries require prior approval of regulators, e.g., in financial sector:– Banks– Systemically important financial institutions (e.g.,

certain banks, CSDs)»– Others, e.g., stock exchanges, other

infrastructures.

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Acquisition of bank

• EU-wide rules on evaluation criteria for prudential assessment of acquisition and increases in holdings of financial institutions.

• 5 criteria:– reputation of proposed acquirer

• Integrity and professional competence

– Reputation and experience of those who will direct the business• Fit and proper test

– Financial soundness of proposed acquirer• capacity to finance transaction and to maintain viable business

– Compliance with prudential requirements • transaction should not weaken ability off target on compliance

– Suspicion of money laundering or terrorism financing

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Systemically important financial institutions (SIFI)

• Authority of the supervisor to object to M&A transactions by one of its regulated systemic financial institutions:– Power to intervene to detect potential threats to

financial stability.– Obligation of SIFI to report intended strategic

decisions, including, specifically, M&A transactions.– Authority to object to strategic decision if:

• inconsistent with safe and sound management of SIFI, or• apt to affect significantly financial stability.

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B. National interest or security

• Most countries require government or regulatory approval for acquisitions of national companies where security or national interest is deemed to be at stake:– US: Committee on Foreign Investment in the United States

(CFIUS) assessment of security implications of foreign acquisitions of major U.S. infrastructure assets

• E.g., US harbours/Dubai Port (2006)

– France: government approval of 33.3% acquisitions in sectors of « national interest » (Décret « anti-OPA » 2005) in the aftermath of rumoured interest of Pepsi in Danone.

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C. Competition law

• Generally similar rules in US and EU:– Approvals of certain mergers and acquisitions– Prohibition of cartels and abuse of dominant

positions• Although actual rulings may differ based on

technical and political considerations– e.g., NYSE-Euronext/Deutsche Börse in EU vs

CME/CBOT in US.

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Basic EU rules

Two main rules (articles 101-102 of Rome Treaty):– prohibition of agreements or practices that distort

competition, e.g.,:• cartels between competitors • mergers of firms that create new, or strengthen existing,

dominant position

– prohibition of abuses of dominant position• not illegal to have dominant position or even monopoly• but constrains on ability of a dominant firm to leverage

its position to the detriment of consumers.

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M&A

• EU Competition authorities will reject M&A transactions with a Community dimension that significantly impede competition within EU, – in particular if they create a new, or strengthen an existing,

dominant position – if they assess that consumers will be worse off after the

transaction.• More demanding criterion for M&A than for stand alone

companies:– M&A: no creation or strengthening of dominant position.– Stand alone: dominant position accepted, only abuse is

prohibited.

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Complex set of rules

• EU competition law rules are highly complex and technical.

• Substantial guidance provided by the Commission, e.g., – Council Regulation (139/2004) on the Control of Concentration

of Undertakings.– Commission Guidelines on assessment of non-horizontal

mergers (2008/C-265/07). – Commission Notice on Remedies Acceptable (2008/C-267/01)

• Yet, requiring competition approval is often a long and uncertain path, which can have significant impact on business in the meantime.

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Definition of dominant position

• Dominant position assessed by competition authority in circumstances of each case.

• Firm may be dominant in some services or some geographical markets and not others.

• Dominant generally determined by reference to market share and/or Herfindahl-Hirschman index– as a general rule: >50% market share means

dominant position and < 25% non-dominance,– market share determined by reference to « market ».

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Definition of « market »

• Two relevant markets:– geographical market:

• national, regional (e.g., Europe) or global?• depends on whether firm involved in supply and demand of the relevant

products in areas that are sufficiently homogeneous (and can be distinguished from neighbouring geographic areas because, in particular, conditions of competition are appreciably different in those areas).

• takes into account existence of barriers to entry, consumer preferences, markets shares, substantial price differences, etc

– product market:• products are part of the same « product market » if they are

interchangeable/substitutable for the consumer,• takes into account characteristics of product, prices, and intended use

by consumers.

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Beneficial impact of M&A

• Commission may allow a M&A transaction if efficiencies generated by the concentration counteract the negative effect on competition for consumers.

• For instance:– cost synergies will be passed on to consumers in the form of

tariff reductions– governance arrangements will contribute to protect consumers

against abuses of dominant position• But efficiencies must be both « likely » and

« substantiated ».– demanding standard– cf NYSE-Euronext/Deutsche Börse merger attempt.

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Remedies

• In order to secure approval, companies may propose « commitments » which eliminate the competition restriction concerns.

• Two main categories:– Structural: e.g., divestitures– Behavioural: e.g., promise not to increase fees

• Commission reticent about behavioural remedies• If accepted, remedies must be implemented before

M&A or within a relatively short period of time after M&A.

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Divestitures

• Preferred remedy of the Commission.• Yet, demanding conditions.• Divested business must be viable and competitive

– transfer of all relevant assets and staff– including those that are shared with retained businesses, but

are necessary for viability or competitiveness of divested unit • Preferably a stand-alone unit

– carve-outs only allowed if future viability ensured• There must be a known or potential suitable buyer, so

as to ensure continuing competition.

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Other remedies

• Commission will only accept non-divestiture remedies if their effects are at least equivalent as a divestiture.– Effect must be to allow the entry of sufficient new

competition in the market fast enough.• Examples: access rights to infrastructures and networks

on a transparent and non-discriminatory basis.• Often not sufficient on their own and are combined with

some divestitures.• General behavioural commitments (e.g., promises not to

bundle services, not to raise prices, etc) typically not accepted as being too vague and uncertain.

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Annex: Checklist for deal

• Strategy• Price• Regulatory approvals

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Checklist - Strategy

• Does the M&A transaction have a clear and compelling strategic value?– Realistic upside compared to alternatives, including

organic growth?– What is the current strategy of each company and which

changes should be made to extract benefits of M&A and how (sequence, timing, management of trade offs, etc)

– What are the benefits expected to be generated, what is their size (with stress tests), over what period of time?

– Idem about potential risks/downsides.

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Checklist- Price

• Is the price right?– Are projections of business growth not over-optimistic?– Have synergies been properly estimated?– Has due diligence been properly performed and have

appropriate reps and warranties been incorporated (price trade-off)?

– Have synergies not been over-estimated and « negative synergies » overlooked?

• e.g., cost of downsizing, prospects of IT integration (legacy costs), sale value of assets to be divested

– Have integration costs been properly included in estimates and has disruption on organic business growth been taken into account?

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Checklist – Approvals

• Have regulatory approvals and constraints been identified and assessed properly?– approval requirements– constraints over time on combined going concern.

• Can shareholders be reasonably expected to accept the transaction– shareholders of target company– shareholders of acquiring company (if necessary).