WSP Red Book: M&A

Can you define M&A and explain the difference between a merger and an acquisition?

M&A relates to two companies combining in an effort for buyers to drive value rather than wait for organize growth, or for sellers to cash out or participate in the risk/reward of the combined entity.

A merger and an acquisition both involve a buyer and a seller, but in a merger the companies are typically closer in size to begin with and some aspect of the deal is in stock so that shareholders from both prior entities remain.

What are some potential reasons that a company might acquire another company?

• Defend market share

• Defend against disruptors

• Realize revenue or cost synergies

• Cross sell to customer base

• Acquire IP

• Talent Acquisition

• Geographic or product expansion

• Tax benefits

• supply chain efficiencies

• Reduced time to market with new product launches

What are the differences among vertical, horizontal, and conglomerate mergers?

• Vertical: company acquires up or down the value chain to own more of the process, getting closer to consumers or raw materials

• Horizontal: acquires a competitor or other businesses at the same stage of the value chain, like two wholesalers combining

• Conglomerate: two companies in completely different industries combining

In terms of vertical integration, what is the difference between forward and backward integration?

A forward integration gets you closer to the end customer, like a manufacturer acquiring a wholesaler.

A backwards integration gets you closer to the raw materials, like a wholesaler acquiring a manufacturer.

Describe a recent M&A deal.

For M&A interviews, come prepared to discuss at least one recent transaction in-detail. To understand the rationale behind an M&A deal and the market’s perception of the proposed (or closed) transaction, review press releases and articles with commentary on the deal from reliable sources. Also, look at the current competitive dynamics within the industries relevant to the deal and the ongoing trends that could further explain why the transaction was completed.

The specific details regarding the deal which should be included in your response include:

• Name of Acquirer and Target Company (along with a business profiles of each)

• Merger or Acquisition Strategic Rationale (can be found in the Form S-4 or publicly announced)

• Approximate Transaction Size, Premium Offered, and Form of Consideration (if publicly disclosed)

• Acquirer and Target's Share Price Movement Post-Announcement

• Personal Perspective on the Transaction – "In your opinion, was this a good deal?"

What are synergies and why are they important in a deal?

Synergies are when 1 + 1 = 3. They’re the expected cost savings or incremental revenues arising from an acquisition. They're important because if an acquirer believes synergies can be realized, a higher premium would be paid.

1. Revenue Synergies: Cross-selling, upselling, product bundling, new distribution channels, geographic expansion, access to new end markets, reduced competition leads to more pricing power

2. Cost Synergies: Eliminate overlapping workforces (reduce headcount), closure or consolidation of redundant facilities, streamlined processes, purchasing power over suppliers, tax savings (NOLs)

Why should companies acquired by strategic acquirers expect to fetch higher premiums than those selling to private equity buyers?

Strategic acquirers look to run the business into perpetuity and add value along the way. So, they will be willing to pay a higher premium if they think they can unlock a lot of value even if the time horizon is a bit longer.

PE buyers target a specific IRR, so they already have a ceiling for what they will pay. Then, they use leverage to drive returns on their investment in a relatively shorter time period of 5-7 years. So, they aren’t as concerned about adding value or long-term prospects. Though, as firms utilize add-on acquisitions more to realize those synergies, they are willing to pay more of a premium.

It’s like a home buyer versus a home flipper.

How do you perform premiums paid analysis in M&A?

Premiums paid analysis is similar to precedent transactions. The average premium paid in comparable transactions serves as a reference point for an active deal. The presumption being the average of the historical premiums paid in those comparables deals should be a proxy (or sanity check) for the premium to be received in the current deal.

Tell me about the two main types of auction structures in M&A.

• Broad Auction: In a broad auction, the sell-side bank will reach out to as many prospective buyers as possible to maximize the number of interested buyers. Since competition directly correlates with the valuation, the goal is to cast a wide net to intensify an auction's competitiveness and increase the likelihood of finding the highest possible offer (i.e., removing the risk of “leaving money on the table”)

• Targeted Auction: In a targeted auction, the sell-side bank (usually under the client's direction) will have a shortlist of buyers contacted. These contacted buyers may already have a strong strategic fit with the client or a pre-existing relationship with the seller.

What is a negotiated sale?

A negotiated sale involves only a handful of potential buyers and is most appropriate when there's a specific buyer the seller has in mind. A potential reason for this type of sale approach could be the seller intends to stay on and strongly values the partnership and growth opportunities.

Under this approach, the speed of close and confidentiality are two distinct benefits. These deals are negotiated “behind-closed-doors” and generally on friendlier terms based on the best interests of the client.

What are some of the most common reasons that M&A deals fail to create value?

• Synergies don’t materialize or were overestimated

• Poor due diligence, especially prevalent in competitive auctions on short timelines when you only have capacity to look at the good

• Lack of strategic plan, bigger doesn’t always equal better and synergies and growth can be left on the table

• Poor Execution/Integration: poor leadership, culture mismatches, drop in quality. Cultural compatibility can be the trickiest risk to assess.

Studies have repeatedly shown a high percentage of deals destroy shareholder value. If that's the case, why do companies still engage in M&A?

Many deals are done defensively to protect a company’s business model and position in the markets, so a decrease in value may be a lower decrease than an incumbent disrupting them would have been.

What is the purpose of a teaser?

A teaser is a one to two-page marketing document that's usually put together by a sell-side banker on behalf of their client. The teaser is the first marketing document presented to potential buyers and is used to gauge their initial interest in formally taking part in the sale process. The intent is to generate enough interest for a buyer to sign an NDA to receive the confidential information memorandum ("CIM").

The content found in a teaser will be limited, and the name of the company is never revealed in the document (instead “Project [Placeholder Name]”), and the teaser only provides the basic background/financial information of the company to hide the identity of the client and protect confidentiality. The information provided is a brief description of the business operations, investment highlights, and summary financials (e.g., revenue, operating income, EBITDA over the past two or three years) – just enough details for the buyer to understand what the business does, assess recent performance and determine whether to proceed or pass.

What does a confidential information memorandum (CIM) consist of?

A confidential information memorandum ("CIM") provides potential buyers with an in-depth overview of the business being offered for sale. Once a buyer has executed an NDA, the sell-side investment bank will distribute the CIM to the private equity firm or strategic buyer for review.

The format of the CIM can range from being a 20 to 50-page document with the specific contents being a detailed company profile, market overview, industry trends, investment highlights, business segments, product or service offerings, past summary financials, performance projections (called the “Management Case”), management biographies, and the transaction details/timing.

What are the typical components found in a letter of intent (LOI)?

Once a buyer has proceeded with the next steps in making a potential acquisition, the next step is to provide the seller with a formal letter of intent ("LOI"). An LOI is a letter stating the proposed initial terms, including the purchase price, the form of consideration, and planned financing sources. Usually non-binding, an LOI represents what a definitive agreement could look like, but there's still room for negotiation and revisions to be made in submitted LOIs (i.e., this is not a final document).

What are “no-shop” provisions in M&A deals?

In most M&A deal agreements, there'll be a dedicated section called the “no solicitation” provision, or more commonly known as the “no-shop” provision. No-shop provisions protect the buyer and give exclusivity during negotiations. The sell-side representative is prevented from looking for higher bids and leveraging the buyer’s current bid with other buyers. Violating the no-shop would trigger a significant breakup fee by the seller, and an investigation would be made into the sell-side bank to see if they were contacting potential buyers when legally restricted from doing so. On the other side, a seller can protect themselves using reverse termination fees ("RTFs"), which allow the seller to collect a fee if the buyer were to walk away from the deal.

What is a material adverse change (MAC), and could you provide some examples?

In an M&A transaction, a material adverse change ("MAC") is a highly negotiated, legal mechanism intended to reduce the risk of buying and selling parties from the merger agreement date to the deal closure date. MACs are legal clauses included in virtually all merger agreements that list out the conditions that allow the buyer the right to walk away from a deal without facing legal repercussions or significant fines.

Common Examples

• Significant Changes in Economic Conditions, Financial Markets, Credit Markets, or Capital Markets

• Relevant Changes such as New Regulations, GAAP Standards, Transaction Litigation (e.g., Anti-Trust)

• Natural Disasters or Geopolitical Changes (e.g., Outbreak of Hostilities, Risk of War, Acts of Terrorism)

• Failure to Meet an Agreed-Upon Revenue, Earnings, or Other Financial Performance Target

Contrast asset sales vs. 338(h)(10) election vs. stock sales.

Asset Sales

• each asset contractually sold, once buyer has all assets they hold everything that made the seller’s equity worth something

• Write-ups are cash-tax deductible, initially creates a DTA that starts unwinding immediately. Seller could face double taxation at corporate and shareholder level

Stock Sales

• seller gives buyer shares, which the buyer owns enough of to control

• Cash taxes don’t step up with write-ups

• Seller is only taxed at shareholder level

333(h)(10) Election

• Buyer and seller must agree on it, seller must be a corporate subsidiary or S-corp, and most often has a high NOL balance.

• Tax treatment of asset sale without hassle of individual assets

• Seller still has double taxation, but buyer gets tax advantage of write-ups and NOLs.

Contrast a friendly acquisition and hostile takeover attempt.

Friendly: Both companies’ management and boards consent and have met. Target’s board notifies shareholders of the bid, and shareholders usually follow the lead and accept

Hostile: Usually after a failed friendly negotiation. Acquirer goes directly to the shareholders to pursue a majority stake

What are the two most common ways that hostile takeovers are pursued?

Tender offer - buyer announces their intention to purchase at a premium, individual shareholders can choose to accept or not. They look to get enough to take a controlling stake.

Proxy fight - Hostile acquirer attempts to get existing shareholders to vote out management by convincing them that they have performed poorly.

How does a tender offer differ from a merger?

A tender offer bypasses management to go directly to shareholders with a premium offer to their shares in hopes of accumulating a majority or all of them. It is characteristic of a hostile takeover.

A merger comes out of a negotiation with the seller’s management and a mutual agreement.

What are some preventive measures used to block a hostile takeover attempt?

• Poison pill defense: Poison pills give existing shareholders the option to purchase additional shares at a discounted price, which dilutes the acquirer's ownership and makes it more difficult for the acquirer to own a majority stake (i.e., more shares necessary).

• Golden parachute defense: compensation packages adjusted for key employees to receive more benefits so that if an acquirer wants to come in and fire them it is much more costly.

• Dead hand defense: like poison pill defense, but instead of making new shares optional, they are automatically issued

• Crown Jewel Defense: Creates an agreement allowing for the sale of a company’s crown jewel assets in the case of a takeover, which makes them less attractive to the hostile bidder

What are some active defense measures to block a hostile takeover attempt?

• White Knight defense: a friendly acquirer steps in to purchase the target, usually happens when they’re already on the verge of being acquired. Even though ownership is lost, it is a favorable alternative

• White squire defense: similar to the white Knight, but the squire only acquires enough of the business to fend off the hostile acquirer and the target retains ownership

• Acquisition strategy defense: target makes an acquisition that involves more cash or less debt on their balance sheet so that it isn’t as attractive to the hostile acquirer

• Pac-Man defense: Target attempts to acquire the hostile acquirer in hopes of dissuading them, not actually having to follow through with the purchase

• Greenmail defense: Acquirer gains a substantial voting stake and threatens takeover unless the target buys back shares at a large premium (helping the hostile cash out big), so the target is forced to buy back. Many anti-greenmail regulations have made this almost impossible today

What is a staggered board and how does it fend off hostile takeover attempts?

When the board of directors of a company is organized as a staggered board, each board member is intentionally classified into distinct classes regarding their term length.

Since the board is staggered, gaining additional board seats becomes a more complicated and lengthy process for hostile acquirers (and deters takeover attempts).

What is a divestiture and why would one be completed?

A divestiture involves selling off a business segment and all its assets and is typically completed if the business determines that the value provided isn’t enough given the associated costs. It allows management to focus on the core business and the divested segment to lean out and hopefully unlock its own value.

A divestiture can also be related to a sale to stay afloat during a restructuring, or to comply with a monopoly ruling.

A divestiture can typically be perceived by investors as a failure because the expected benefits were never attained, they also signal a need for cash to be reinvested for liquidity issues.

Many divestitures are pushed through by activists who use the sale to request a capital distribution or special dividend

How does an equity carve-out differ from a divestiture?

An equity carve has many similarities to a divestiture and is often referred to as a “partial IPO.” The mechanism of an equity carve-out is that the parent company will sell a portion of their equity interest in a subsidiary to public investors. In nearly all cases, the parent company will still retain a substantial equity stake in the new entity (usually > 50%).

Upon completing the equity carve-out, the subsidiary will be established as a new legal entity with its separate management team and board of directors. The cash proceeds of the sale to 3rd investors are then distributed to the parent, the subsidiary, or a combination.

What is a spin-off and why are they completed?

In a spin-off, a parent company will separate a particular division to create an independent entity with new shares (ownership claims). The existing shareholders will receive those shares in proportion to their original proportion of ownership in the company (i.e., pro-rata). The decision is up to the shareholders whether to hold on to those shares or sell them in the open market. The rationale for spin-offs is usually in response to shareholders' pressure to divest a subsidiary that would be better off as a standalone company.

What is the difference between a subsidiary and an affiliate company?

Subsidiary: A subsidiary is when the parent company remains the majority shareholder (50%+).

Affiliate Company: An affiliate company is when the parent company has only taken a minority stake.

What is a reverse merger and what benefits does it provide?

A reverse merger is when a privately held company undergoes a merger with another company that's already publicly traded in the markets. The public company can either be an operating company or be an empty corporate shell. The benefit of reverse mergers is that the public entity can now issue shares without incurring the costs associated with IPOs.

What is an S-4 filing and when does it have to be filed?

An S-4 is a required form that must be filed with the SEC prior to a merger and acquisition activity taking place. Contained in the S-4 will be material information related to the transaction, such as the deal rationale, negotiated terms, risk factors, pro forma financials, and other related material.

What is the difference between the Schedule 13-D and 13-G filing?

The Schedule 13-D and 13-G are forms intended to disclose publicly when an investor has taken a significant stake in a company in terms of ownership and voting power. These filings notify other investors of the influential investor’s stake (i.e., “beneficial owners”).

Schedule 13-D: A Schedule 13-D must be filed when an investor acquires a minimum of 5% of a public company's total common equity, and over 2% was acquired in the last twelve months. Within ten days of the triggering acquisition, the Schedule 13-D must be filed. There must be a direct statement in the filing, answering whether they intend to acquire more of the company’s shares to gain further influence.

Schedule 13-G: A Schedule 13-G can be filed in lieu of the 13-D as long as the investor doesn't intend to take control of the company. This alternative, short-form version is filed when an investor acquires 5%+ of the total equity but less than 2% in the last twelve months. Since there appears to be no intent to further increase their stake on the filing date, the reporting requirements are shorter, less detailed, and depend on the investor's classification (e.g., institutional investor, passive investor). If the investor's intent is amended, the 13-D must be filed within ten days of the change.

Can you explain what the “winner’s curse” is in M&A?

The so-called winner’s curse in M&A is the tendency for the winning bidder to have paid far beyond the target's fair value. While a certain premium is expected during competitive processes, this can often be elevated to irrational levels. The buyer may later feel buyer’s remorse and receive scrutiny for overpaying, especially if the acquisition doesn't pan out as expected, which can lead to write-downs of the acquired assets. Financial buyers also experience greater difficulty meeting their fund's required returns threshold if a higher multiple was paid.

What is a holdback in M&A?

To help mitigate transaction risks, a holdback mechanism can require a portion of the purchase price of an acquisition to be placed in escrow to protect the interests of the buyer post-closing until the terms of the agreement have been satisfied. This provision can be used to ensure the seller follows through on all agreed upon conditions outlined in the deal agreement and minimize the risk of monetary loss for the buyer. These funds would be held in escrow and can be released to the buyer if the seller violates the terms.

What type of material is found in an M&A pitchbook?

A pitchbook is a marketing document used by investment banks to pitch potential clients to hire them for a particular transaction. The pitchbook will differ by each investment bank, but the general M&A transaction pitchbook will include:

1. Introduction of the Investment Bank and Dedicated Team Members

2. Situational Overview of the Deal and Client Company

3. Prevailing Market and Industry Trends

4. Implied Valuation Range and Combined M&A Model

5. Proposed Deal Strategy Outline and Key Considerations

6. Credentials and Tombstones of Relevant Industry Experience

7. Appendix (DCF Model, Trading Comps, Transaction Comps)