ACQUISITION

MEANING

Corporate action in which a company buys most, if not all, of the target company's ownership

stakes in order to assume control of the target firm. Acquisitions are often made as part of a

company's growth strategy whereby it is more beneficial to take over an existing firm's

operations and niche compared to expanding on its own. Acquisitions are often paid in cash,

the acquiring company's stock or a combination of both.

Acquisitions can be either friendly or hostile. Friendly acquisitions occur when the target firm

expresses its agreement to be acquired, whereas hostile acquisitions don't have the same

agreement from the target firm and the acquiring firm needs to actively purchase large stakes

of the target company in order to have a majority stake.

In either case, the acquiring company often offers a premium on the market price of the target

company's shares in order to entice shareholders to sell. For example, News Corp.'s bid to

acquire Dow Jones was equal to a 65% premium over the stock's market price.

TYPES

There are four types of acquisitions:

1. Friendly acquisition

Both the companies approve of the acquisition under friendly terms. There is no forceful

acquisition and the entire process is cordial.

2. Reverse acquisition

A private company takes over a public company.

3. Back flip acquisition

A very rare case of acquisition in which, the purchasing company becomes a subsidiary of the

purchased company.

4. Hostile acquisition

Here, as the name suggests, the entire process is done by force. The smaller company is either

driven to such a condition that it has no option but to say yes to the acquisition to save its skin

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or the bigger company just buys off all its share, their by establishing majority and hence

initiating the acquisition.

THE ACQUISITION PROCESS

Researching Target Companies

The acquisition of companies should be not be a scattershot approach, since the acquiring

entity will end up with a jumble of unrelated businesses. Instead, a serial acquirer typically

builds a database of the companies competing in the market in which it has an interest. This

may be organized as a matrix, with each company categorized by such factors as revenue,

profitability, cash flow, growth rate, number of employees, products, intellectual property,

and so forth. The database will never be complete, since privately-held companies in

particular are not willing to reveal information about themselves.

Nonetheless, there are many sources of information that can be used to continually improve

the database, such as public company filings, personal contacts, third party reports, and patent

analysis. The acquirer should also maintain a listing of the acquisitions that have taken place

in the industry recently, with particular attention to the market niches in which they are most

common. This is useful for discerning the prices at which other sellers might expect to be

sold, since everyone in the industry reads the same press releases, and so is aware of the

acquisitions. A recent upsurge in prices might indicate to an acquirer that the market is

overheated, and so is not worth participating in during the near term.

The Initial Contact

The first step in the acquisition process is the initial contact with a prospective acquiree.

There are a number of methods that an acquirer can use to scout out possible acquisition

candidates. Here are several of the more common methods:

Discrete contact. One of the better ways to buy a business is the discrete inquiry. This

is initiated by a simple phone call to the owner of the target company, requesting a

meeting to discuss mutual opportunities. The wording of the request can vary; use

whatever terms necessary to initiate a one-on-one discussion. The intent is not

necessarily an immediate offer to buy the company; instead, this may simply begin a

series of discussions that may last for months or even years, while the parties become

accustomed to each other.

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Joint venture. One of the better methods for determining the best possible acquisition

candidates is for the acquirer to enter into joint venture agreements with those

companies who might eventually be acquisition candidates. The creation and

management of these joint ventures gives the acquirer an excellent view of how well

the other company operates, thereby giving it more day-to-day operational detail than

it could have obtained through a standard due diligence investigation. The

arrangement may also make the owners of an acquisition candidate more comfortable

with how they would be treated if acquired.

Third party. There may be situations where the acquirer does not want anyone to

know of its interest in making acquisitions within a certain market. If so, it can retain

the services of an investment banker, who calls target companies on behalf of the

acquirer to make general inquiries about the willingness of the owners to sell.

The Non-Disclosure Agreement

If the target company concludes that it may have an interest in selling to the acquirer, the

parties sign a non-disclosure agreement (NDA). This document states that all information

stamped as confidential will be treated as such, that the information will not be issued to

other parties, and that it will be returned upon request. These agreements can be difficult to

enforce, but are nonetheless necessary.

The Letter of Intent

Once the NDA has been signed by both parties, the target company sends its financial

statements and related summary-level documents concerning its historical and forecasted

results to the acquirer. Based on this information, the acquirer may wish to proceed with a

purchase offer, which it documents in a letter of intent (LOI) or term sheet. The acquirer

should request an exclusivity period, during which the target company commits to only deal

with it. In reality, many sellers attempt to shop the offered price around among other possible

buyers, which violates the terms of the exclusivity agreement. When this happens, the

acquirer may elect to walk away from further discussions, since the seller has proven to be

unreliable.

Due Diligence

The acquirer then sends a list of due diligence requests to the target company. This topic is

addressed in the Due Diligence article. It is entirely likely that the target company will not

have the requested information in a format ready for immediate distribution. Instead, it may

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take a considerable amount of time to find some documents. In addition, since the target was

not necessarily preparing itself to be sold, it may not have audited financial statements. If so,

the acquirer may want to wait for these statements to be prepared, which could take about

two months. Audited financial statements give some assurance that the information in them

fairly presents the financial results and condition of the target company.

Final Negotiations

The due diligence process can require a number of weeks to complete, with a few stray

documents being located well after the main body of information has been analyzed. Once

the bulk of the information has been reviewed, the due diligence team leader can advise the

senior management of the acquirer regarding issues found and any remaining areas of

uncertainty, which can be used to adjust the initial calculation of the price that the acquirer is

willing to offer. The usual result is a decrease in the price offered.

If the acquirer wants to continue with the acquisition, it presents the seller with the first draft

of a purchase agreement. Since the acquirer is controlling the document, it usually begins

with a draft that contains terms more favorable to it. The attorney working for the seller must

bring any unsatisfactory terms to the attention of the seller, for decisions regarding how they

can be adjusted. If the seller does not retain an attorney who specializes in purchase

agreements, the seller will likely agree to terms that favor the acquirer.

The parties may not agree to a deal. A serial acquirer should have considerable experience

with which types of target companies it can successfully integrate into its operations, as well

as the maximum price beyond which a deal is no longer economically viable. Thus, the

acquirer should compare any proposed deal to its internal list of success criteria, and walk

away if need be. Similarly, since the acquirer likely has a hard cap above which it will not

increase its price, the seller must decide if the proposed price is adequate, and may elect to

terminate the discussion.

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Reasons for acquisitionMergers and acquisitions take place for many strategic business reasons, but the most

common reasons for any business combination are economic at their core. Following are

some of the various economic reasons:

Increasing capabilities: Increased capabilities may come from expanded research and

development opportunities or more robust manufacturing operations (or any range of core

competencies a company wants to increase). Similarly, companies may want to combine to

leverage costly manufacturing operations (as was the hoped for case in the acquisition of

Volvo by Ford).

Capability may not just be a particular department; the capability may come from acquiring a

unique technology platform rather than trying to build it.

Biopharmaceutical companies are a hotbed for M&A activities due to the extreme investment

necessary for successful R&D in the market. In 2011 alone, the four biggest mergers or

acquisitions in the biopharmaceutical industry were valued at over US$75 billion.

Gaining a competitive advantage or larger market share: Companies may decide to

merge into order to gain a better distribution or marketing network. A company may want to

expand into different markets where a similar company is already operating rather than start

from ground zero, and so the company may just merge with the other company.

This distribution or marketing network gives both companies a wider customer base

practically overnight. One such acquisition was Japan-based Takeda Pharmaceutical

Company’s purchase of Nycomed, a Switzerland-based pharmaceutical company, in order to

speed market growth in Europe. (That deal was valued at about US$13.6 billion, if you’re

counting.)

Diversifying products or services: Another reason for merging companies is to complement

a current product or service. Two firms may be able to combine their products or services to

gain a competitive edge over others in the marketplace. For example, in 2008, HP bought

EDS to strengthen the services side of their technology offerings (this deal was valued at

about US$13.9 billion).

Although combining products and services or distribution networks is a great way to

strategically increase revenue, this type of merger or acquisition is highly scrutinized by

federal regulatory agencies such as the Federal Trade Commission to make sure a monopoly

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is not created. A monopoly is when a company controls an overwhelming share of the supply

of a service or product in any one industry.

Replacing leadership: In a private company, the company may need to merge or be acquired

if the current owners can’t identify someone within the company to succeed them. The

owners may also wish to cash out to invest their money in something else, such as retirement!

Cutting costs: When two companies have similar products or services, combining can create

a large opportunity to reduce costs. When companies merge, frequently they have an

opportunity to combine locations or reduce operating costs by integrating and streamlining

support functions.

This economic strategy has to do with economies of scale: When the total cost of production

of services or products is lowered as the volume increases, the company therefore maximizes

total profits.

Surviving: It’s never easy for a company to willingly give up its identity to another

company, but sometimes it is the only option in order for the company to survive. A number

of companies used mergers and acquisitions to grow and survive during the global financial

crisis from 2008 to 2012.

During the financial crisis, many banks merged in order to deleverage failing balance sheets

that otherwise may have put them out of business.

Mergers and acquisitions occur for other reasons, too, but these are some of the most

common. Frequently, companies have multiple reasons for combining.

Even though management and financial stakeholders view mergers and acquisitions as a

primarily financial endeavor, employees may see things a little differently (they’re thinking

WIIFM, or what’s in it for me?).

Combining companies has some potential downsides for employees, who have to deal with

immediate fears about employment or business lines, but more positive sides of merging may

include more opportunities for advancement, or having access to more resources to do one’s

job

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ACQUISITION STRATEGY

A business located in a moribund industry may see an acquisition strategy as its road to glory

– more sales must equate to more shareholder value, right? Instead, when an acquirer

assembles a group of companies in the same industry, all it may achieve is a group of

companies that now operate under a single parent company. These businesses have no better

growth rate than they had when operating alone, their product lines overlap, their salespeople

call on the same customers multiple times a month, and so on – and on top of that, the

acquirer has squandered its resources to complete the acquisitions, and now has a massive

debt burden. So where was the value in the acquisition strategy?

This not-uncommon scenario points out the main problem with acquisitions – growing for the

sake of reporting a larger amount of total revenue does not generate value. Instead, it may

destroy value, since all of the businesses now sheltering under the umbrella of the corporate

parent may no longer have an incentive to compete against each other through innovation or

cost reductions.

Instead of simple growth, the acquirer must understand exactly how its acquisition strategy

will generate value. This cannot be a simplistic determination to combine two businesses,

with a generic statement that overlapping costs will be eliminated. The management team

must have a specific value proposition that makes it likely that each acquisition transaction

will generate value for the shareholders. Some of these value propositions (strategies) are as

follows:

Adjacent industry strategy. An acquirer may see an opportunity to use one of its

competitive strengths to buy into an adjacent industry. This approach may work if the

competitive strength gives the company a major advantage in the adjacent industry.

Diversification strategy. A company may elect to diversify away from its core

business in order to offset the risks inherent in its own industry. These risks usually

translate into highly variable cash flows which can make it difficult to remain in

business when a bout of negative cash flows happen to coincide with a period of tight

credit where loans are difficult to obtain. For example, a business environment may

fluctuate strongly with changes in the overall economy, so a company buys into a

business having more stable sales.

Full service strategy. An acquirer may have a relatively limited line of products or

services, and wants to reposition itself to be a full-service provider. This calls for the

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pursuit of other businesses that can fill in the holes in the acquirer’s full-service

strategy.

Geographic growth strategy. A business may have gradually built up an excellent

business within a certain geographic area, and wants to roll out its concept into a new

region. This can be a real problem if the company’s product line requires local

support in the form of regional warehouses, field service operations, and/or local sales

representatives. Such product lines can take a long time to roll out, since the business

must create this infrastructure as it expands. The geographical growth strategy can be

used to accelerate growth by finding another business that has the geographic support

characteristics that the company needs, such as a regional distributor, and rolling out

the product line through the acquired business.

Industry roll-up strategy. Some companies attempt an industry roll-up strategy, where

they buy up a number of smaller businesses with small market share to achieve a

consolidated business with significant market share. While attractive in theory, this is

not that easy a strategy to pursue. In order to create any value, the acquirer needs to

consolidate the administration, product lines, and branding of the various acquirees,

which can be quite a chore.

Low-cost strategy. In many industries, there is one company that has rapidly built

market share through the unwavering pursuit of the low-cost strategy. This approach

involves offering a baseline or mid-range product that sells in large volumes, and for

which the company can use best production practices to drive down the cost of

manufacturing. It then uses its low-cost position to keep prices low, thereby

preventing other competitors from challenging its primary position in the market. This

type of business needs to first attain the appropriate sales volume to achieve the

lowest-cost position, which may call for a number of acquisitions. Under this strategy,

the acquirer is looking for businesses that already have significant market share, and

products that can be easily adapted to its low-cost production strategy.

Market window strategy. A company may see a window of opportunity opening up in

the market for a particular product or service. It may evaluate its own ability to launch

a product within the time during which the window will be open, and conclude that it

is not capable of doing so. If so, its best option is to acquire another company that is

already positioned to take advantage of the window with the correct products,

distribution channels, facilities, and so forth.

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Product supplementation strategy. An acquirer may want to supplement its product

line with the similar products of another company. This is particularly useful when

there is a hole in the acquirer’s product line that it can immediately fill by making an

acquisition.

Sales growth strategy. One of the most likely reasons why a business acquires is to

achieve greater growth than it could manufacture through internal, or organic, growth.

It is very difficult for a business to grow at more than a modest pace through organic

growth, because it must overcome a variety of obstacles, such as bottlenecks, hiring

the right people, entering new markets, opening up new distribution channels, and so

forth. Conversely, it can massively accelerate its rate of growth with an acquisition.

Synergy strategy. One of the more successful acquisition strategies is to examine

other businesses to see if there are costs that can be stripped out or revenue

advantages to be gained by combining the companies. Ideally, the result should be

greater profitability than the two companies would normally have achieved if they had

continued to operate as separate entities. This strategy is usually focused on similar

businesses in the same market, where the acquirer has considerable knowledge of how

businesses are operated.

Vertical integration strategy. A company may want to have complete control over

every aspect of its supply chain, all the way through to sales to the final customer.

This control may involve buying the key suppliers of those components that the

company needs for its products, as well as the distributors of those products and the

retail locations in which they are sold.

Advantage of acquisition are :

Speed: It provide ability to speedily acquire resources and competencies not held in

house. It allows entry into new products and new markets. Risks and costs of new

product development decrease.

Market power: It builds market presence. Market share increases. Competition

decrease. Excessive competition can be avoided by shut down of capacity.

Diversification is aggrieved. Synergistic benefits are gained.

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Overcome entry barrier: It overcomes market entry barrier by acquiring an existing

organization. The risk of competitive reaction decrease.

Financial gain: Organization with low share value or low price earning ratio can be

acquired to take short term gains through assets stripping.

Resources and competencies: Acquisition of resources and competencies not available

in house can be a motive for merger and acquisition.

Stakeholder expectations: Stakeholder may expect growth through acquisition.

PROBLEMS IN ACHIEVING ACQUISITION SUCCESS

Integration Difficulties

Integrating two companies following an acquisition can be quite difficult. Integration

challenges include melding two disparate corporate cultures, linking different financial and

control systems, building effective working relationships (particularly when management

styles differ), and resolving problems regarding the status of the newly acquired firm's

executives. The importance of a successful integration should not be underestimated. Without

it, an acquisition is unlikely to produce positive returns. It is important to maintain the human

capital of the target firm after the acquisition. Much of an organization's knowledge is

contained in its human capital. Turnover of key personnel from the acquired firm can have a

negative effect on the performance of the merged firm. The loss of key personnel, such as

critical managers, weakens the acquired firm's capabilities and reduces its value. When a deal

for an acquisition is being considered, completing due diligence on the human capital to

make sure that key people-who are necessary to help run the company after the integration

process-will not leave is an important consideration? If implemented effectively, the

integration process can have a positive effect on target firm managers and reduce the

probability that they will leave.

Inadequate Evaluation of Target

Due diligence is a process through which a potential acquirer evaluates a target firm for

acquisition. In an effective due-diligence process, hundreds of items are examined in areas as

diverse as the financing for the intended transaction, differences in cultures between the

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acquiring and target finn, tax consequences of the transaction, and actions that would be

necessary to successfully meld the two workforces. Due diligence is commonly performed by

investment bankers, accountants, lawyers, and management consultants specializing in that

activity, although firms actively pursuing acquisitions may form their own internal due-

diligence team. The failure to complete an effective due-diligence process may easily result

in the

acquiring firm paying an excessive premium for the target company. Interestingly, research

shows that in times of high or increasing stock prices due diligence is relaxed; firms often

overpay during these periods and long-run performance of the merged firm suffers. Research

also shows that without due diligence, "the purchase price is driven by the pricing of other

'comparable' acquisitions rather than by a rigorous assessment of where, when, and how

management can drive real performance gain the price paid may have little to do with

achievable value.

Many firms use investment banks to perform their due diligence, but in the post-

Enron era the process is increasingly performed in-house. Although investment bankers such

as Credit Suisse First Boston and Citibank still play a large role in due diligence for large

mergers and acquisitions, their role in smaller mergers and acquisitions seems to be

decreasing. However, when it comes to financing the deal, investment banks are critical to

the process, whether the firm remains public or is taken private by a private equity firm.

Large or Extraordinary Debt

To finance a number of acquisitions completed during the 1980s and 1990s, some companies

Significantly increased their levels of debt. A financial innovation called junk bonds helped

make this increase possible. Junk bonds are a financing option through which risky

acquisitions are financed with money (debt) that provides a large potential return to lenders

(bondholders). Because junk bonds are unsecured obligations that are not tied to specific

assets for collateral, interest rates for these high-risk debt instruments sometimes reached

between 18 and 20 percent during the 1980s. Some prominent financial

economists viewed debt as a means to discipline managers, causing them to act in the

shareholders' best interests. Junk bonds are now used less frequently to finance acquisitions,

and the conviction that debt disciplines managers is less strong. Nonetheless, some firms still

take on significant debt to acquire companies. For example, more debt is being used in cross

border acquisitions such as the deal between India's Tata Steel and Corus Group PLC of the

United Kingdom mentioned in the Opening Case. First, the deal went through nine rounds of

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bidding with two main contenders Tata Steel and Brazil's Cia Siderurgica Nacional, or CSN,

which increased the price 34 percent above Tata Steel's initial offer to $11.3 billion.

However, Tata proposed financing the deal using a debt approach, and its shares fell percent

upon this announcement because, as one analyst suggested, 'Tata was paying too much for

Corus and that debt incurred to fund the acquisition could affect the company's earnings for

years to come. High debt can have several negative effects on the firm. For example, because

high debt increases the likelihood of bankruptcy, it can lead to a downgrade in the firm's

credit rating by agencies such as Moody's and Standard & Poor's.8J In fact, in the Tata-Corus

deal just noted, the stock price drop was influenced by a warning from Standard & Poor's that

it might downgrade Tata's debt rating, which would effectively raise its cost of debt.

In addition, high debt may preclude needed investment in activities that contribute to the

firm's long-term success, such as R&D, human resources training, and marketing. Still,

leverage can be a positive force in a firm's development, allowing it to take advantage of

attractive expansion opportunities. However, too much leverage (such as extraordinary

debt) can lead to negative outcomes, including postponing or eliminating investments, such

as R&D expenditures, that are necessary to maintain strategic competitiveness over the long

term.

Inability to Achieve Synergy

Derived from synergos, a Greek word that means "working together:' synergy exists when the

value created by units working together exceeds the value those units could create working

independently. That is, synergy exists when assets are worth

more when used in conjunction with each other than when they are used separately.85

For shareholders, synergy generates gains in their wealth that they could not duplicate or

exceed through their own portfolio diversification decisions.H6 Synergy is created by the

efficiencies derived from economies of scale and economies of scope and by sharing

resources

(e.g., human capital and knowledge) across the businesses in the merged firm.87

A firm develops a competitive advantage through an acquisition strategy only when

a transaction generates private synergy. Private synergy is created when the combination

and integration of the acquiring and acquired firms' assets yield capabilities and core

competencies that could not be developed by combining and integrating either firm's

assets with another company. Private synergy is possible when firms' assets are

complementary in unique ways; that is, the unique type of asset complementarity is not

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possible by combining either company's assets with another firm's assets. Because of its

uniqueness, private synergy is difficult for competitors to understand and imitate. However,

private synergy is difficult to create. A firm's ability to account for costs that are necessary to

create anticipated revenue- and cost-based synergies affects the acquisition's success. Firms

experience several expenses when trying to create private synergy through acquisitions.

Called transaction costs, these expenses are incurred when firms use acquisition strategies to

create synergy. Transaction costs may be direct or indirect. Direct costs include legal fees and

charges from investment bankers who complete due diligence for the acquiring firm. Indirect

costs include managerial time to evaluate target firms and then to complete negotiations,

as well as the loss of key managers and employees following an acquisition. Firms tend

to underestimate the sum of indirect costs when the value of the synergy that may be

created by combining and integrating the acquired firm's assets with the acquiring firm's

assets is calculated.

As the Strategic Focus later in the chapter on the sale of Chrysler by Daimler points

out, synergies are often difficult to achieve. In this regard, Dieter Zetsche, Daimler's

CEO and a former head of Chrysler, pointedly notes: "Obviously we overestimated

the potential for synergies (between Mercedes and Chrysler). Given the very different

nature of the markets we operate in, the gap between luxury and volume was too great."

One analyst noted as well, "What once seemed like a perfect fit now just seems like a

mistaken vision."

Too Much Diversification

diversification strategies can lead to strategic competitiveness and above-average returns. In

general, firms using related diversification strategies outperform those employing unrelated

diversification strategies. However, conglomerates formed by using an unrelated

diversification strategy also can be successful, as demonstrated

by United Technologies Corp. At some point, however, firms can become overdiversified.

The level at which overdiversification occurs varies across companies because each firm has

different capabilities to manage diversification. Recall from Chapter 6 that related

diversification requires more information processing than does unrelated diversification.

Because of this additional information processing, related diversified firms become

overdiversified with a smaller number of business units than do firms using an unrelated

diversification strategy.

Regardless of the type of diversification strategy implemented, however, overdiversification

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leads to a decline in performance, after which business units are often divested.')"

There seems to be a pattern of excessive diversification followed by divestments of

underperforming +business units previously acquired in the automobile industry. We discuss

this issue later in a Strategic Focus on DaimlerChrysler. Not only is Daimler divesting

assets (Chrysler), but Ford and other companies have been unwinding previous acquisitions.

Ford acquired Volvo, beating out Fiat and Volkswagen in a bidding war at a cost

of $6.5 billion. However, Ford is now seeking to sell the Volvo assets and has likewise

considered selling its other luxury brands that it acquired (Jaguar, Aston Martin, and

Land Rover). General Motors has also reversed acquisitions by selling off stakes in foreign

companies such as Fiat and Fuji Heavy Industries.0i These cycles were a]so frequent

among U.S. firms during the 1960s through the 1980s.%

Even when a firm is not overdiversified, a high level of diversification can have a

negative effect on the firm's long-term performance. For example, the scope created by

additional amounts of diversification often causes managers to rely on financial rather

than strategic controls to evaluate business units' performance (financial and strategic

controls are defined and explained in Chapters Il and 12). Top-level executives often

rely on financial controls to assess the performance of business units when they do not

have a rich understanding of business units' objectives and strategies. Use of financial

controls, such as return on investment (ROI), causes individual business-unit managers

to focus on short-term outcomes at the expense of long-term investments. When longterm

investments are reduced to increase short-term profits, a firm's overall strategic

competitiveness may be harmed.

Another problem resulting from too much diversification is the tendency for acquisitions

to become substitutes for innovation. Typically, managers do not intend acquisitions

to be used in that way. However, a reinforcing cycle evolves. Costs associated with

acquisitions may result in fewer allocations to activities, such as R&D, that are linked

to innovation. Without adequate support, a firm's innovation skills begin to atrophy.

Without internal innovation skills, the only option available to a firm to gain access to

innovation is to complete still more acquisitions. Evidence suggests that a firm using

acquisitions as a substitute for internal innovations eventually encounters performance

problems.

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Too large

Most acquisitions create a larger firm, which should help increase its economies of scale.

These economies can then lead to more efficient operations-for example, two sales

organizations can be integrated using fewer sales representative because such sales personnel

can sell the products of both firms (particularly if the products of the acquiring and target

firms are highly related).

Many firms seek increases in size because of the potential economies of scale and

enhanced market power (discussed earlier). At some level, the additional costs required to

manage the larger firm will exceed the benefits of the economies of scale and additional

market power. The complexities generated by the larger size often lead managers to

implement more bureaucratic controls to manage the combined firm's operations.

Bureaucratic controls are formalized supervisory and behavioral rules and policies designed

to ensure consistency of decisions and actions across different units of a firm. However,

through time, formalized controls often lead to relatively rigid and standardized managerial

behavior. Certainly, in the long run, the diminished flexibility that accompanies rigid

and standardized managerial behavior may produce less innovation. Because of innovation's

importance to competitive success, the bureaucratic controls resulting from a large

organization (i.e., built by acquisitions) can have a detrimental effect on performance. As

one analyst noted, "Striving for size per se is not necessarily going to make a company

more successful. In fact, a strategy in which acquisitions are undertaken as a substitute for

organic growth has a bad track record in terms of adding value."

Citigroup is the world's largest financial services company with $270 billion in market

value. However, the company has been pressured to sell some of its assets to reduce

the complexity associated with managing so many different financial service businesses

because its stock price has not appreciated as much as other large but less complex bank

organizations. The cross-selling between insurance and banking services has not created

as much value as expected.

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Takeover

In business, a takeover is the purchase of one company (the target) by another (the acquirer,

or bidder). In the UK, the term refers to the acquisition of a public company whose shares are

listed on a stock exchange, in contrast to the acquisition of a private company

Types of takeover

Friendly takeovers

Hostile takeovers

Reverse takeovers

Blackflip takeovers

Friendly takeovers

A "friendly takeover" is an acquisition which is approved by the management. Before a

bidder makes an offer for another company, it usually first informs the company's board of

directors. In an ideal world, if the board feels that accepting the offer serves the shareholders

better than rejecting it, it recommends the offer be accepted by the shareholders.

In a private company, because the shareholders and the board are usually the same people or

closely connected with one another, private acquisitions are usually friendly. If the

shareholders agree to sell the company, then the board is usually of the same mind or

sufficiently under the orders of the equity shareholders to cooperate with the bidder. This

point is not relevant to the UK concept of takeovers, which always involve the acquisition of

a public company

Hostile takeovers

A "hostile takeover" allows a suitor to take over a target company whose management is

unwilling to agree to a merger or takeover. A takeover is considered "hostile" if the target

company's board rejects the offer, but the bidder continues to pursue it, or the bidder makes

the offer directly after having announced its firm intention to make an offer. Development of

the hostile tender is attributed to Louis Wolfson.

A hostile takeover can be conducted in several ways. A tender offer can be made where the

acquiring company makes a public offer at a fixed price above the current market price.

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Tender offers in the United States are regulated by the Williams Act. An acquiring company

can also engage in a proxy fight, whereby it tries to persuade enough shareholders, usually a

simple majority, to replace the management with a new one which will approve the takeover.

Another method involves quietly purchasing enough stock on the open market, known as a

"creeping tender offer", to effect a change in management. In all of these ways, management

resists the acquisition, but it is carried out anyway.

The main consequence of a bid being considered hostile is practical rather than legal. If the

board of the target cooperates, the bidder can conduct extensive due diligence into the affairs

of the target company, providing the bidder with a comprehensive analysis of the target

company's finances. In contrast, a hostile bidder will only have more limited, publicly-

available information about the target company available, rendering the bidder vulnerable to

hidden risks regarding the target company's finances. An additional problem is that takeovers

often require loans provided by banks in order to service the offer, but banks are often less

willing to back a hostile bidder because of the relative lack of target information which is

available to them.

Reverse takeovers

A "reverse takeover" is a type of takeover where a private company acquires a public

company. This is usually done at the instigation of the larger, private company, the purpose

being for the private company to effectively float itself while avoiding some of the expense

and time involved in a conventional IPO. However, in the UK under AIM rules, a reverse

take-over is an acquisition or acquisitions in a twelve month period which for an AIM

company would:

exceed 100% in any of the class tests; or result in a fundamental change in its business, board

or voting control; or in the case of an investing company, depart substantially from the

investing strategy stated in its admission document or, where no admission document was

produced on admission, depart substantially from the investing strategy stated in its pre-

admission announcement or, depart substantially from the investing strategy.

An individual or organization, sometimes known as corporate raider, can purchase a large

fraction of the company's stock and, in doing so, get enough votes to replace the board of

directors and the CEO. With a new agreeable management team, the stock is a much more

attractive investment, which would likely result in a price rise and a profit for the corporate

raider and the other shareholders.

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Backflip takeovers

A "backflip takeover" is any sort of takeover in which the acquiring company turns itself into

a subsidiary of the purchased company. This type of takeover rarely occurs

Financing a takeover

Funding

Often a company acquiring another pays a specified amount for it. This money can be raised

in a number of ways. Although the company may have sufficient funds available in its

account, remitting payment entirely from the acquiring company's cash on hand is unusual.

More often, it will be borrowed from a bank, or raised by an issue of bonds. Acquisitions

financed through debt are known as leveraged buyouts, and the debt will often be moved

down onto the balance sheet of the acquired company. The acquired company then has to pay

back the debt. This is a technique often used by private equity companies. The debt ratio of

financing can go as high as 80% in some cases. In such a case, the acquiring company would

only need to raise 20% of the purchase price.

Loan note alternatives

Cash offers for public companies often include a "loan note alternative" that allows

shareholders to take a part or all of their consideration in loan notes rather than cash. This is

done primarily to make the offer more attractive in terms of taxation. A conversion of shares

into cash is counted as a disposal that triggers a payment of capital gains tax, whereas if the

shares are converted into other securities, such as loan notes, the tax is rolled over.

All share deals

A takeover, particularly a reverse takeover, may be financed by an all share deal. The bidder

does not pay money, but instead issues new shares in itself to the shareholders of the

company being acquired. In a reverse takeover the shareholders of the company being

acquired end up with a majority of the shares in, and so control of, the company making the

bid. The company has managerial rights.

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EXAMPLES OF TAKEOVERS

One good example of a business takeover is that of Cadbury by Kraft foods in 2010. There

was uproar by the British public when it was announced and rumours of staff reductions and

operations closures spread and produced a negative effect for Kraft. Kraft had to borrow over

$7billion to fund the takeover and this increased its already unstable debt problems. A major

reason for the takeover was for Kraft to increase its brand range and acquire the Cadbury

chocolate brand. 

Another example is that of AOL the Internet service provider acquiring Time Warner. This

was the highest valued takeover in the world during the 21st Century and is also a textbook

case as to how not to do a takeover. Cultural problems as well as management and

organizational clashes made it difficult for AOL to achieve the benefits it was hoping for

from the takeover and made it one of the most costly mistakes AOL had made

Pros and cons of takeover

While pros and cons of a takeover differ from case to case, there are a few reoccurring ones

worth mentioning.

Pros:

1 Increase in sales/revenues (e.g. Procter & Gamble takeover of Gillette)

2 Venture into new businesses and markets

3 Profitability of target company

4 Increase market share

5 Decreased competition (from the perspective of the acquiring company)

6 Reduction of overcapacity in the industry

7 Enlarge brand portfolio (e.g. L'Oréal's takeover of Body Shop)

8 Increase in economies of scale

9 Increased efficiency as a result of corporate synergies/redundancies (jobs with overlapping

responsibilities can be eliminated, decreasing operating costs)

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Cons:

1 Goodwill, often paid in excess for the acquisition

2 Culture clashes within the two companies causes employees to be less-efficient or

despondent

3 Reduced competition and choice for consumers in oligopoly markets. (Bad for consumers,

although this is good for the companies involved in the takeover)

4 Likelihood of job cuts

5 Cultural integration/conflict with new management

6 Hidden liabilities of target entity

7 The monetary cost to the company

8 Lack of motivation for employees in the company being bought.

Takeovers also tend to substitute debt for equity. In a sense, any government tax policy of

allowing for deduction of interest expenses but not of dividends, has essentially provided a

substantial subsidy to takeovers. It can punish more-conservative or prudent management that

do not allow their companies to leverage themselves into a high-risk position. High leverage

will lead to high profits if circumstances go well, but can lead to catastrophic failure if

circumstances do not go favorably. This can create substantial negative externalities for

governments, employees, suppliers and other stakeholders.

TAKEOVERS AND THE ROLE OF EQUITY MARKETS

Efficient equity markets are fundamental to the operation and indeed existence of large

companies in modern economies. The capacity for individual shareholders readily to buy and

sell shares in the equity of a company increases the attractiveness of shares as financial

assets, facilitates the diversification of equity portfolios and the spreading of risk and so

provides the basis for companies to raise the large volumes of equity capital required for

major business activities. This capacity to raise equity capital also underlies companies

ability to borrow loan funds; it thus underpins the capital base for virtually the whole of the

corporate sector.

The existence of efficiently functioning equity markets inherently provides opportunities for

takeovers. Takeovers are just one form of market activity and action to regulate takeovers

which constrains the ability of buyers and sellers to trade on terms that they regard as

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mutually beneficial must affect the overall attractiveness of shares as assets and thus

ultimately the ability of companies to raise equity capital.

Of course, some forms of regulation can improve the efficiency of share markets and this is

the basic rationale for rules such as those contained in the Takeover Code administered by the

National Companies and Securities Commission (NCSC). The Code includes rules to ensure

the fuller provision of information to market participants and to require offers by buyers (in

specified circumstances) to be open equally to all existing shareholders. Such rules are

designed to encourage 'fair play' between market participants and, in particular, to protect the

interests of minority shareholders. They are not designed to assess the merits of individual

takeovers, and operate irrespective of those merits. However, by providing fuller information

and reducing the possibility of coercion in takeover situations, they may help market

participants to make better decisions in relation to particular proposals. Such rules should be

assessed in terms of their effects on the efficiency with which share markets operate rather

than as a means of generally encouraging or discouraging takeover activity. Takeovers

provide a means by which entrepreneurs who believe that they can use the assets of a

company more efficiently than its existing management can bid for the company and put their

beliefs to the test. The expectation that they can generate higher returns will mean that the

assets will be worth more to them and they will be prepared to offer a higher price. Takeovers

can thus contribute to promoting the most efficient use of existing corporate assets.

Apart from that potential of increasing the efficiency of assets in existing uses, takeovers can

also assist allocative efficiency by facilitating the reallocation of capital between industries.

Many firms are often reluctant to invest outside their own or closely-related industries, even

though returns may be substantially higher elsewhere, as their managers' skills and

experience are often highly industry-specific. Takeover specialists often have less attachment

to a particular industry and are more willing to invest in alternative, potentially higher-

yielding activities. In this context, firms with large cash flows operating in industries with

poor to average prospects are particularly likely to be takeover targets.

The efficiency gains from takeovers do not necessarily depend on takeovers actually

occurring. The mere threat of a takeover may galvanise the existing management of a

company into improving its performance and raising the returns obtained on assets. It is, for

example, widely believed that over the last few years the threat of takeover of certain very

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large companies has provided a strong spur to their managements which was not present

when the companies regarded themselves as secure from takeover because of their size.

The existing managements of companies may at times devote considerable effort to resisting

takeover attempts, including organising 'white knights' to purchase strategic shareholdings

and arranging defensive share swaps with friendly companies. In some cases, these activities

may serve no economic purpose but merely entrench existing management. If management

becomes preoccupied with such defensive activities, other managerial tasks may be neglected

with consequent adverse effects on the efficiency of the firm. On the other hand, the best

form of defence is a high share price and much defensive activity may take forms, such as

revaluing assets and rationalising and diversifying activities, which act to raise returns and

increase efficiency.

The effects of takeovers on the efficiency of the corporate sector are thus considerably more

pervasive than may appear from the consideration of individual instances. In that respect,

they may be compared to the effects on efficiency of competition in product markets. In

either case, measures taken to restrict the free operation of markets may reduce the incentives

and pressures on managements to perform. Any assessment of the overall costs and benefits

of takeovers needs to take this as a starting point.

EFFECTS ON COMPETITION

In some cases, takeovers may result in reductions in competition, thereby allowing prices to

be raised at the expense of the consumer. In these cases, the resulting private gains to the

companies would not represent genuine improvements in efficiency for the economy as a

whole.

The Trade Practices Act already provides for the scrutiny of mergers and takeovers where

they may result in a reduction in competition. It also includes provisions to limit abuses of

market power. The Trade Practices Commission (TPC) has scrutinised a number of recent

takeover bids involving firms in similar fields. In some cases, it has sought and obtained

undertakings from bidders as to future conduct should their bids succeed (eg

Bond/Castlemaine Tooheys and Amatil/Fielder Gillespie). In other cases, the TPC has

expressed concern at the possible anti-competitive effects of the proposed merger and

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indicated that it will monitor post-merger developments closely (eg Coles/Myer merger).

According to a recent press statement by the TPC Chairman, the TPC only institutes court

proceedings if there is no feasible alternative available (eg Fielder Gillespie Davis takeover

proposals for Allied Mills and Goodman Group of New Zealand). Such cases can be

protracted and the outcome uncertain because of the fine judgments required (and the TPC

carries the onus of proof).

Whether the TPC's powers to intervene in relation to takeovers which it regards as anti-

competitive are too limited is a matter which requires careful judgment. The cases mentioned

above certainly have elements which justify concern, but it is not clear that the approach

adopted by the TPC, of monitoring developments, will prove inadequate. Assessments of

anti-competitive actions are complicated because, while a takeover may result in reduced

competition within an industry, there may be offsetting benefits in the form of scale

economies and avoidance of fragmentation. Also, so long as there are no artificial barriers to

entry to the industry, market dominant firms should be constrained from excessively anti-

competitive practices. Increased regulatory action, particularly where this is pursued through

extended legal processes of litigation, may be more disruptive than the problems it is

intended to remedy. In any case, to the extent that further action is warranted, the appropriate

course would be to strengthen the relevant specific provisions of the Trade Practices Act

rather than to take action to limit takeovers generally.

Although there has been a long history of takeover activity in major countries over the last

century or so, there seems to be little indication that this has led to overall decreases in the

intensity of competition over the long term. In part this may reflect the effects of anti-trust or

trade practices legislation. In many areas it reflects increased international competition where

barriers to trade have declined. But it probably also reflects some underlying limitations on

corporate growth: large organisations tend to develop their own internal problems of

maintaining managerial control and efficiency. The entry of new firms may then bring new

competition, and technical innovations can also help to break down existing concentrations of

market power.

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THE COST TO REVENUE OF TAKEOVER ACTIVITY

Takeover involves a change of ownership of shares. The means of acquiring the target shares

might be provided by:

1 borrowing, whether from home or abroad;

2 activation of idle cash balances;

3 liquidation of physical assets which may be 'income-producing'; or a share-swap or new

share issue, whether directly or indirectly, possibly involving one or more third parties

TAXATION ASPECTS

Concern has been expressed in some quarters regarding the possible cost to revenue of

takeover activity - that cost deriving from tax deductions allowed to the predator company.

For the most part, that concern has related to takeovers where the predator uses a high level

of borrowings. Some however, have also expressed concern with the opposite situation; ie

predator companies which resort to equity - through the issue of redeemable preference

shares - rather than debt to gain tax advantage.

This dual concern with the loss of tax revenue from two opposing situations - 'excessive'

resort to either debt or equity - indicates a need to look to the principles involved and

cautions against hasty adoption of 'solutions'.

Similar caution is required in responding to the claim that takeover activities involve the

exploitation of tax loopholes which must be closed. Where loopholes exist they should, of

course, be closed - but it is always essential to ensure that a loophole does, in fact, exist.

There will be occasions, for example, where the tax advantage derives from a justifiable

reaction to unintended or undesirable features of the tax law or its interpretation. In other

cases, competing principles may be involved or the tax system may be being expected to

serve competing objectives. In some cases, 'solutions' which yield the highest revenue may be

quite contrary to basic economic or social objectives.

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CONCLUSION

Not all takeovers necessarily increase economic efficiency. Some may be misjudged; all can

consume substantial amounts of managerial time and resources. But government 'vetting'

mechanisms are unlikely to be able to distinguish between takeovers that will effectively

improve returns from existing assets and those that will not. That particular function is best

left to the market itself.

These considerations suggest that policy should neither actively encourage nor discourage

takeover activity, ie it should be neutral in its impact. Policy should be directed towards

fostering efficient and informed share markets that facilitate the monitoring of company

performance but not provide either undue encouragement or discouragement for takeovers.

There may be scope for regulatory changes in pursuit of that objective. Where there are

particular reasons for concerns about the effects of takeovers - for example in restricting

competition, in giving rise to costs to tax revenue, or in relation to foreign ownership and

control - the appropriate course is to make adjustments to the policies applying to those

particular areas, rather than action directed to restrict takeovers as such. In the case of

taxation concerns, the introduction of the imputation system for company taxation in July

1987 and the comprehensive capital gains tax now in place should largely remove any present

bias towards debt over equity financing which may have been relevant to some takeovers.

Taxation measures designed to restrict takeover activity would have no sound basis in

economic principle, would be readily circumvented and could do serious damage to the

operation of equity markets in the short period prior to the commencement of the imputation

system

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