Diversification
Diversification refers to a process where a company grows outside its current category. Diversification assumed a significant job in the acquisitions and mergers. That occurred in the third merger wave, also known as the conglomerate era. In the 1960s, huge numbers of firms that developed into conglomerates. Were dismantled through different spin-offs and divestitures in the 70s and 80s. This procedure of de-conglomeration raises genuine questions with regards to the estimation of enhancement dependent on expansion.
Some companies gained significantly, while others didn’t. For instance, General Electric (GE) has not been just an electronics-oriented company despite the name. Through acquisitions and divestitures, the firm has gotten an expanded aggregate. With activities in protection, financial administrations, TV channels, plastics, clinical gear, and many more. Their profit rose significantly during the 80s and 90s when the firm was gaining and stripping multiple organizations. The market reacted well to these diversified acquisitions by following the rising pattern of earnings.
Diversification and the Acquisition of Leading Industry Positions
One of the many reasons why GE has been successful in diversifying is because of the types of companies it has acquired. General Electric looked to get leading positions. In which the different industries in which it claimed businesses. Leading is usually deciphered as the first or second position as indicated by market shares.
GE and other acquiring firms believe that leading positions like number one or two give a more dominant position. Offering more advantages over the smaller competitors. These advantages can show themselves in various manners. Such as a more extensive consumer awareness in the marketplace as leading positions in distribution. Corporations in secondary positions like number four or five, may here and there be at such an impediment. That it is hard for them to produce positive returns. Candidates for divestiture include companies within the overall company framework. That does not hold a leading position and those that don’t have reasonable prospects of cost-effectively acquiring such a position. The discharged resources obtained from such a divestiture would then be able to be reinvested in different companies. That is to exploit the advantages of their prevailing position or used to obtain leading companies in other ventures.
Dynamic Market
Considering that markets are dynamic, a business can be in an attractive industry and be a leader. In which a decade only to see the industry contract in response to changes in the market. Therefore, diversified companies should always examine their constituent units. And know if a business that used to be leading can still generate a return that’s consistent with the parent company’s goals. This evaluation process was experienced by GE in recent years. And shed many units, like consumer finance and media businesses. But in 2015, it acquired the energy business of Alstom SA in a return to the industrial orientation of the GE of the old.
Diversification to Enter More Gainful Industries
Management sometimes chooses to diversify. And expand because of their desire to enter more profitable markets than the acquiring firm’s current industry. The parent company’s industry may have reached maturity or that the competitive pressures within that industry preclude the possibility of raising prices to a level where extranormal profits may be enjoyed.
Profitable industries may not stay in the same profitable state in the future. Competitive pressures serve to achieve a development toward a drawn-out equalization of rates of return over industries. This obviously doesn’t imply that the paces of return in all industries at any second in time are equivalent. The competition that moves industries to have equivalent returns are balanced by restricting powers, for example, industrial development, that causes industries to have to change paces of return. Those with returns that are above average without imposing barriers to entry will have declining returns until they reach the cross-industry average.
In the long run, as implied by economic theory, those industries that are difficult to enter are the only ones that will have above-average returns. This means that diversifying to enter more profitable industries will not be successful after some time. The growing firm will be unable to enter those businesses that show better than expected returns due to obstructions that forestall entry and might have the option to enter just the industries with low barriers. When entering low-barrier industries, the growing company might be required to compete against other entrants who were attracted by the temporarily above-average returns and low barriers. The increased number of competitors will drive down returns and cause the expansion strategy to fail.
Benefits of Conglomerates
Various studies are skeptical of the risk-reduction benefits of conglomerates, although there is evidence that shows the wealth effects of conglomerates positively. For instance, Elger and Clark show that the returns stockholders get in conglomerate purchases are far better compared to those in non-conglomerate acquisitions. They examined 337 mergers from 1957 to 1975 and found that conglomerates offered superior gains compared to non-conglomerates. It also showed gains not just for the buyer, but for the seller firms as well. These significant gains are cataloged by stockholders of the firms who are selling, and the conservative gains are for buying company stockholders.
This was similar to a later study by Wansley, Lane, and Yang, who examined 52 non-conglomerates and 151 conglomerates. This research found that returns to shareholders were bigger in horizontal and vertical acquisitions than in chain acquisitions.
Diversification Discounts
In a study by Henri Servaes in the 1960s, a comparison between Tobin’s qs of diversified and those that were not diversified showed no evidence that diversification may increase corporate values. However, he found that Tobin’s qs for diversified firms were significantly lower than those for multi-segment companies. Other research has discovered that the diversification discount was not confined to the conglomerate era. A study by Berger and Ofek used a huge sample of firms over the 1986–1991 sample period and found that diversification came about in lost firms that averaged between 13% and 15%.35. This investigation assessed the imputed value of a diversified firm’s segments as though they were separate firms. The results show that the loss of firm worth was not influenced by the firm but was less at the point when diversification happened in the related industries.
The loss of firm value was buttressed by the fact that the diversified segments showed lower profitability than single-line businesses. They also showed that the diversified firms invested too much in the diversified segments than single-line businesses, meaning overinvestment may be a reason for the loss of value related to diversification.
Other Sources Influence Diversification
Lang and Stulz tracked value-reducing effects of diversification through a sample of over 1000 companies. They concluded that greater corporate diversification in the 1980s was inversely related to Tobin’s q of these firms. This supports Berger and Ofek’s study, showing that diversification often lowers the value of firms.
On the other hand, Villalonga believes that the diversification discount is just an artifact of the data used by these researchers. According to him, the data used by these researchers were artificially restricted by the Financial Accounting Standards Board definition of segments, as well as requirements that only segments that makeup 10% or more of a company’s business are required to be reported.
Using a source that is not influenced by the issue, Villalonga finds a diversification premium than a discount. This entangled issue can be complicated. It is also difficult to draw expansive speculations about diversification that apply universally.
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Financial Synergy
The next topic in our Merger Strategy chapter is all about Financial Synergy. The financial synergy is all about the impact of a business merger or acquisition on the costs of capital to the acquiring firm or the combined partners.
The costs of the capital may be decreased significantly depending on the level to which financial synergy exists in a corporate merger. Now, you may ask yourself if the benefits of a specific financial synergy are reasonable. This is a matter of discussion among corporate finance theorists.
The Effect in Terms of Debt Coinsurance
As previously mentioned, the merger of the two firms may reduce risk. But this is only if both firms’ cash flow streams are not perfectly tied in. The suppliers of capital may view or consider the firm less risky if the acquisition or merger lowers the volatility of the cash flows.
Presumably, the risk of a firm getting bankrupt will significantly decrease. This is because of the fact that there will be fewer chances of wild ups and downs on the merged firm’s cash flow. This was explained in detail by Higgins and Schall. They called this effect in terms of debt coinsurance.
For instance, the risk of getting bankrupt that’s associated with the merging of the two firms will be significantly reduced if this result has no general agreement, too. Now, there is a chance that one of the firms could experience certain conditions or circumstances that will force them into bankruptcy. It can be a little bit tricky to know ahead of time which one of the two firms will experience bankruptcy.
That also means that creditors may suffer a loss should one of the firms fail. However, let’s say that both firms were merged ahead of certain financial problems. There is a chance that the excess cash flow of the solvent firm can cushion the decline in the other firm’s cash flow.
Now, in order to prevent the combined or merged firm from falling into bankruptcy. The offsetting earnings of the firm that is in good condition should be sufficient. This will also be helpful when it comes to preventing the creditors to suffer losses.
Debt-Coinsurance Effect
Like with most things in life, there is also a downside to this debt-coinsurance effect. The downside is that the benefits accrue to debtholders at the expense of the equity holders. Remember, these debtholders gain by holding debt in a much less risky firm.
In their observation, Higgins and Schall noted that these gains come at the expense of stockholders. These stockholders are the ones who lose in the acquisition. According to Higgins and Schall, the total returns or the RT that can be provided by the merged firm are constant. Now, if the bondholders (RB) are provided with more of these returns, then the returns must come at the expense of stockholders or (RS). Check the formula below:
RT = RS + RB
Moreover, Higgins and Schall maintain that the debt-coinsurance effect does not make room for any new value. However, it does redistribute the gains amongst the providers of capital to the firm. This result has no generic understanding, too.
For instance, Lewellen has concluded that stockholders gain from these types of mergers or firms’ combinations. However, there is a lot of other research that fails to indicate that the debt-related motives are relevant for the conglomerate acquisitions as opposed to the non-conglomerate acquisitions.
Research Studies
There are also a lot of studies that have proven the existence of a coinsurance effect on bank mergers. In their research, Penas and Unal examined 66 bank mergers. This research looked into the effects of these deals on 282 bonds.
In their research, Penas and Unal found positive bond returns for both targets that are approximately at 4.3%, and for acquiring banks at 1.2%. Some would argue that this is because larger banks may be too big to fail. And that plays a large role in this because regulators would not want to allow a larger bank to fail outright. These regulators would step in to offer their assistance instinctively.
In another research, Billet, King, and Mauer looked into the wealth effects for both the target and acquirer returns. They looked at these wealth effects in the 1980s and 1990s. This particular research concluded that the target company bonds that were below investment grade right before the deal. It received substantially positive returns on the duration of the announcement.
The Debt Equity Ratio
On the other hand, they discovered that the purchase of company bonds received negative returns from the announcement time. More importantly, Billet, King, and Mauer have found that these announcement period returns were far greater in the decade of the 1990s as opposed to the 1980s. These results provide further more proof and support for the coinsurance effect.
Higgins and Schall also showed that the losses of the stockholders may be offset through the means of issuing a new debt after the merger. In return, the stockholders may gain through the tax savings on the payments of debt interest. This result was greatly demonstrated by Galai and Masulis.
The debt-equity ratio of the post-merger firm will also be increased because of the additional firm. It was increased to a level that stockholders must have found good, or at least acceptable, before the merger.
The firm also becomes a higher risk-higher return investment because of the higher debt-equity ratio. As previously mentioned, there will come a point when a company may experience economies of scale through acquisitions.
Production Cost
Usually, these economies are thought to come from production cost decreases. These are attained by operating at a higher capacity level. Similarly, these can also be attained through a reduced sales force or a shared distribution system. These acquisitions may result in the possibility of financial economies scale in the form of lower flotation and transaction costs.
A larger company also has certain advantages that can possibly lessen the firm’s cost of capital in financial markets. This means larger companies enjoy the advantage of better access to financial markets. Another advantage is that they tend to experience lower costs of raising capital. Because it is considered less risky than a smaller firm. This means that the costs of borrowing by issuing bonds are significantly less because a larger firm would be able to issue bonds offering a lower interest rate than a smaller company.
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Operating Synergy
Synergy is often used in the physical sciences. If two substances or influences combine to create a much greater impact together. What we refer to as synergy is the reaction to that merger. The effect of the merger must be greater than the sum of both factors or substances operating independently.
In business, synergy is simply the 1 + 1 = 3 effect. It is where the whole is greater than the sum of its part, so when two or more people or organizations combine their efforts.
As a result, firms are able to incur the expenses of the acquisition process. At the same time, the firms will also be able to provide a premium for the target shareholder’s shares.
Operating Synergy
Now let’s dive deeper into what operating synergy means. Think of it this way, there are two firms that are looking to merge together. If both firms are able to achieve greater value and performance while they merge. They also increase their operating income. This also means higher growth for both firms instead of what they achieve when both firms are apart. That is what operating synergy is. This comes from gains that increase revenues or lower costs, although the former is more challenging to attain. However, as it is with most things in life, gains like these are easier in paper than in real life.
Revenue-Enhancing Operating Synergy
As mentioned, this type of synergy can be a lot more challenging to attain. For instance, in one study, McKinsey revealed that approximately seventy percent of mergers fail to reach or attain their goal or expected revenue synergies.
This can come from sources like pricing power, a combination of strengths, and growth from faster-growth markets. When two companies combine, this may result in greater pricing power. Or purchasing power if both are in the same business. Its possibility of being achieved is dependent on the degree of competition in the industry and relevant geographic markets, as well as the size of the merger partners. This may be attained in terms of pricing power if the combination leads to a more oligopolistic market structure.
Oligopoly
What is an oligopoly? It is a state of limited competition. This means that a market may be big or small, but it is only shared by a limited number of producers, suppliers, and sellers.
The combination of functional strengths is another source of revenue enhancement. This can be possible if, for example, one company has strong production abilities while the other has great marketing and distribution. One merger partner could contribute something that the other lacks.
Another potential source of revenue enhancement is higher-growth new markets. In mature markets, corporate growth slowed in Japan and Europes. Large companies needed to invest greater amounts to increase market share or sometimes to merely maintain what they have. But they can also move into rapidly growing markets as a faster way to realize meaningful growth.
Aside from M&A-related increase in revenue being difficult to achieve, M&A-related losses in revenues may also be difficult to avoid. Larger companies are usually avoided by customers of the target. But when the bidder pays a premium for the target, the profitability of its total revenues was likely used to compute the total price. The deal can be a loser if revenues are lost, that’s why an examination of why simplistic projections of deal gains must be carefully done.
Cost-Reducing Operating Synergy
Cost-reducing synergies, according to merger planners, tend to be the main source of operating synergies as revenue enhancement is more difficult to achieve. Economies of scale, or the decreases in per-unit costs, are the cause of cost reductions. When the operation of a certain company or business increases in either size or scale, the result is what we call economies of scale.
Firms that operate at a high per-unit cost for low levels of output are typically manufacturing firms, especially capital-intensive ones. Their fixed costs of running their manufacturing factories are spread out over lower scales of output.
Take note that spreading overhead is the term for when the per-unit costs decline as their output levels rise. An increase in the specialization of labor and management is also another source of these gains, as well as the more efficient use of capital equipment. However, it may not be probable to use capital equipment at such low output levels. As firms experience higher costs and other issues related to the coordination of a large-scale operation, diseconomies of scale may arise. The extent to which these exist is controversial for economists.
For instance, there are those who argue indications of firms that have displayed continued periods of growth while still paying stockholders sufficient return on equity. On the contrary, some economists believe that these companies would be able to give stockholders a greater rate of return if they were smaller, more competent companies.
Mergers & Acquisitions
There are several examples of mergers and acquisitions motivated by the pursuit of scale economies in the cruise industry. One great example of this would be the 1989 acquisition of Sitmar Cruises by Princess Cruises, and the 1994 merger. It is between Radisson Diamond Cruises and Seven Seas Cruises. This acquisition allowed them to offer a wider range for their product line. It allowed them to produce more ships, beds, itineraries while reducing the costs.
There are many pieces of evidence that show the success of M&As in achieving operating economies. In a study done by Lichtenberg and Siegel, they noted the progress in the capability of plants. That had been through adjustment in ownership.
Additionally, they noted that the plants that had the worst performance were the ones most likely to undergo a change in ownership.
Another study by Shahrur analyzed the returns around 563 announced horizontal mergers and tender offers between 1987-1999. He found that there are conclusive combined bidder/target returns. And interpreted that these findings mean that the market saw these deals as to imply that the market saw the deals as better options. Despite these studies, one should not assume that mergers are always the best way to attain such economies.
Economy Scope
Lastly, the economies of scope are the ability of a certain firm to use a set of inputs to provide ample options when it comes to products and services. This concept is closely related to economies of scale. The baking industry is one great example of scope economies. One factor that affected the consolidation within the industry that occurred on the fifth merger wave is the pursuit of these economies.
A meaningful reduction in costs can also be a result of the combination of two companies that yield enhanced purchasing power. One example can be seen in InBev’s acquisition of Anheuser Busch and Mittal’s consolidation of steel producers.
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Is Growth or Increased Return the More Appropriate Goal?
Without a doubt, the achievement of growth is a company’s management and board’s major goal. However, it must be guaranteed by managers that growth is also what would generate good returns for shareholders. Sometimes, management should keep their company at a stable size while generating good returns, but choose to go with aggressive growth instead. Boards should always determine whether the growth is worth the cost by examining the expected profitability of the revenue derived from growth.
The Hewlett-Packard Case
For instance, Hewlett-Packard made a questionable $19 billion mega-acquisition of Compaq in 2002. And managed many business segments in which it was a leader in only one. In 2009, the company had revenues over $114 billion. If it had the goal of, say, 10% per year. Then it needs to make about $11 billion in new revenues annually. That said, it still needs to create another large company’s worth of revenues every year to meet the growth goals. Take note that Compaq itself used to acquire Tandem Computers in 1997 and Digital Equipment in 1998. And the case happened post-Fiorina era. Growth can be a huge difficulty when much of its business comes from highly competitive personal computer markets. With its weak margins coupled with steady product price deflation.
After the departure of Fiorina, many failed acquisitions continued to occur in the company, and with Mark Hurd at the helm, HP acquired EDS. The corporation tried hard to catch AT&T for the position of “world leader” in M&A failures. This was followed by an $8 billion write-down, and HP acquired Autonomy in 2011 for $10 billion, with Leo Apotheker as CEO. Later on, an acquisition-related charge was done for $8.8 billion. In 2013, however, HP acquired data storage giant EMC. HP started growing and the market got fed up, deciding it had enough. Later on, it got divided into two, the PC and printer business called HP, Inc., and the services and data unit called HP Enterprise. While the former remained competitive, the latter had been experiencing declines in revenues. Although the enterprise believes it has more potential for growth.
Cross-Border Takeovers
As the word indicates, cross-border activities include interactions between two separate countries, we may, therefore, assume that cross-border mergers and acquisitions. Those transactions in which the target business and the acquirer business originate from different countries of origin. Cross-border acquisitions are a tremendous boost to the regional market for companies with already popular products. They have been a great way to achieve more profits and revenues, even more, convenient than pursuing further growth within their own nation. This is because pursuing growth within the country may potentially diminish their returns. While cross-border acquisitions let them enter a new market. This kind of deal lets acquirers use the country-specific know-how of the target, as the indigenous laborers and distribution network. Many factors encouraging cross-border deals include financial market globalization and market conditions. Also consider the foreign competition, technology shares and the aim of profitably rising.
The main concern here is if the risk-adjusted return from the acquisition is bigger than what can be achieved. With the next best use of the capital that is invested. It’s the same question in every other acquisition.
The European Common Market helped reduce cross-country barriers, giving rise to a spate of cross-border deals in the continent. Asian markets, however, continue to be resistant to foreign acquirers. But it is said that cross-border deals in this region. And it will be less than what it will be in the future if and when the artificial market restrictions be more relaxed. There are actually signs that this is changing.
Challenges with Cross-Border Acquisitions
Despite the potential of cross-border acquisitions, it poses some challenges that domestic deals lack. First, a business model doesn’t always work in two different countries. For example, Target failed to expand in Canada. They thought that Canadian tourists in the US liked to shop at Target and it was a sign to expand into the country. But in 2015, target only closed its 133 Canadian stores two years after the expansion strategy. Another challenge is linguistic barriers. This may pose a challenge not only in the initial negotiations but in the post-deal integration. Physical distance is also an obvious challenge that they may face as this will surely require more managerial demands.
Comparative Study
Just like with any type of acquisition, it is important to consider the reaction of the market to international M&As and compare them to domestic deals. In a study by Doukas and Travlos, they found that unlike many domestic acquisitions. Acquirers enjoyed positive returns when they acquired targets in countries in which they did not previously have operations. Returns are usually negative when the acquirers already had operations in these foreign countries. Investors may be less sanguine about the gains that may be realized through an increased presence in the same region when the company is already in the market.
In another comparative study by Cakiki, Hessel, and Tandon. It is found that non-U.S. acquirers generated statistically significant returns of just under 2% over a 10-day window. Whereas the U.S. acquirers realized the negative returns that we often generally see from acquisitions.
On the other hand, Markides and Oyon used a sample of 236 deals, compared US acquisitions of European ones and US acquisitions of Canadian targets. Results showed found positive announcement effects for acquisitions of continental European targets but not for acquisitions of British or Canadian target firms. The same negative shareholder wealth effects for acquisitions of Candian firms were also discovered in a study by Eckbo and Thorburn. Where they used 390 sample deals that involve Candian companies over the period of 1962-1983.
In these studies, it can be concluded that non-US targets by US companies can be riskier than deals involving all-US targets. This issue is underscored by a large sample study by Moeller and Schlingemann who analyzed 4430 deals from 1985-1992. And, later on, found that US bidders who pursued cross-border deals acquired lower returns than acquisitions where bidders choose US targets.
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Reverse Mergers
When a private company may go public by being one with a public company that is usually a corporate shell or an inactive one, the term for this is a reverse merger. Shell company, on the other hand, is a company that went public in the past but no longer conducts business operations and has few, if any, physical assets and its assets consist mainly of cash and cash equivalents. Although they can be a great opportunity for investors, there are disadvantages in addition to the pros.
The public company, which was once private, has greatly enhanced liquidity for its equity. The process can also be faster and more reasonably priced than a traditional initial public offering. This means it’s not only shorter but it is also simpler in terms of the process than that of a conventional initial public offering where private companies hire an investment bank to underwrite and issue shares of the new soon-to-be public entity. Reverse takeovers and reverse IPOs are also commonly referred to as such. The bank also helps develop value in stock s and advise on suitable initial pricing.
Processing Reverse Mergers
As said earlier, a reverse merger is quick to process also tackled in another article (Tender Offers vs. Long-Form Merger). It may take between two and three months to complete, whereas an IPO is more is a more involved process that takes more months. Reverse mergers, unlike IPOs, also do not require dilution which may involve investment bankers requiring the company to issue more shares than what it would prefer. This saves a lot of time and money for the company, making sure the business is running efficiently enough.
Furthermore, reverse mergers are less dependent on the state of the IPO market. When the market is weak, reverse mergers are unaffected as they can still be viable. Because of this, there is usually a steady flow of reverse mergers, which explains why it is common to see in the financial media corporate “shells” advertised for sale to private companies seeking this avenue to go public.
Because reverse fusions only serve as a tool for conversation market conditions have little effect on the bid. Instead the process is followed to try to realize the benefits of being a public entity.
Unlike the traditional IPO, a reverse merger is also not a capital raising event. Here, the shares are exchanged but commonly not cash. However, with reverse mergers, the shares are usually very thinly traded after the deal. Because of this, insiders usually cannot use a reverse merger to cash out their ownership in the firm, whereas in an IPO this may be possible.
They are indeed an attractive strategy for corporate managers and investors alike. For example, a majority of the shares of the public shell company are acquired by private company investors, which are then combined with the buyer. Investment banks and financial institutions typically use shell companies as vehicles and tools to complete these deals
Another benefit of doing a reverse merger is that it allows the company to have more liquid shares to use in order to purchase other target companies. This may be appealing to corporate managers or investors whose goal is to finance stock-for-stock acquisitions.
The reverse merger has often been associated with stock scams since market manipulators have often merged private companies with little business activity into public shells and tried to “hype” up the stock to make short-term fraudulent gains, but the conventional IPO process does not guarantee that the company will ultimately go public. Managers may prepare for a typical IPO for hundreds of hours. But if stock market conditions are detrimental to the planned bid, the contract can be canceled, and all these hours will be a waste of effort. This risk is reduced by seeking a reverse merger. Hence, it defeats the goal of converting the private company into a public entity. Private firms, typically those with $100 million to several million in revenue, often use this technique. Having settled on this, the company’s shares are listed on an exchange and enjoy higher liquidity. The original investors gain the ability to liquidate their investments, offering a convenient alternative to buying back their shares from the firm. The business has more access to capital markets, as management now has the ability to issue additional stocks via secondary offers.
Reverse mergers increased from 2003 to 2010 but declined from 2011 to 2016. For many companies, going public through a reverse merger may seem attractive and interesting, but it actually lacks some of the important benefits of a traditional IPO. These benefits of the IPO actually make the financial and time costs of an IPO worthwhile.
One drawback is that due diligence is required. Managers need to thoroughly examine the public shell company’s shareholders. They must know the motivations for the merger and if they have done their homework to make sure the shell is not tainted. Pending liabilities, like those from litigation and other “deal warts” that hound the, shall also be considered. Public shell shareholders should also carry out due diligence on the private company.
It should be important to know if the shareholders really get enough liquidity after the private company completes the reverse merger. Smaller companies might not be prepared to be a public company since there may be a lack of operational and financial scale. On the contrary, the traditional IPO allows the company going public to raise capital and usually provides an opportunity for the owners of the closely held company to liquidate their previously illiquid privately held shares.
Last but not least, mergers are typically inexperienced in the regulatory and enforcement aspects of being a public traded company when a private company goes public. These time-and-money related constraints and costs can be severe, and the initial effort to comply with additional regulations may results in a slow and underperforming company when managers devote much more time to administrative issues than business management.
Freezouts and the Treatment of Minority Shareholders
Have you ever wondered what happens to minority shareholders in the event of a freezeout or a merger? Well, if this has already happened to you several times before, or if you have a lot of experience when it comes to handling share, you probably already know.
However, if you are still finding your footing in the corporate and stockholders world, you are in the right place. Today, we will discuss a lot about freezeouts and the treatment of minority shareholders.
Freezeouts and the Treatment of Minority Shareholders
Usually, the approval of a majority of the shareholders is needed before a merger can be completed. The most common majority threshold is a 51% margin. Now, when the majority shareholders approve the deal, what happens to the minorities?
The minority shareholders are now required to tender their shares to the controlling shareholder. This remains true even though they may not have voted in favor of the deal, unfortunately. Most of the time, minority shareholders are said to be frozen out of their positions. It is just how mergers and acquisitions work.
Voting Approval
In a previous article, we have discussed voting approval and the process in which shareholders go through voting to close out or approve a deal. The approval of the shareholders is needed in able to close the deal.
Why does this happen and what is the reason behind this? Well, the majority approval is required so holdout problems can be avoided in the future. Usually, holdout problems can occur when a minority attempts to hold up the completion of any transaction unless they receive some type of compensation over and above the acquisition stock price. This happens in a lot of merger deals, so the majority approval was designed to help put a stop to this problem.
However, the majority approval doesn’t mean that the dissenting shareholders don’t have any rights to the deal. Those shareholders who highly believe that their shares are worth a lot more than what the terms of the merger are offering do have the option to go to court.
In court, dissenting shareholders can pursue their shareholder appraisal rights. One must remember that the dissenting shareholders must follow the proper procedures in able to successfully pursue these rights.
The dissenting shareholders are also required to object to the deal within the designated period of time – this is a big deal to these procedures and must be followed. The minority shareholders who pursue their shareholder appraisal rights will then demand a cash settlement for the difference between the fair value of their shares and the compensation they actually received should they choose to do so.
When the dissenting shareholders want to ask a court to judicially determine the value of their shares, they are given 120 days to file suit. In essence, the potential appraisal payments are a post-closing obligation of the buyer. And there are certain hedge funds who have pursued this appraisal process as an investment strategy which is more commonly known as appraisal arbitrage. We will discuss appraisal arbitrage in another article for another time.
As expected, most corporations resist these maneuvers because the payment of cash for the value of shares will raise some problems. Most of the time, the problems are related to the positions of other stockholders. At the end of the day, suits like these are difficult for dissenting shareholders to win.
Dissenting shareholders may also choose to file a suit only if the corporation does not file suit to have a fair value of the shares determined. This is after having been notified of the dissenting shareholders’ objections. In the event that there is a suit, the court may then choose to appoint an appraiser to assist in the determination of the fair value.
Additionally, freezeouts can also occur after tender offers as well as controlling the shareholder closeouts in going-private transactions. Let’s take the 2001 Siliconix decisions for instance. Prior to this decision, all freezeout bids in Delaware were then subject to the demanding “entire fairness” standard governing such transactions.
For those who are confused, allow us to explain further. The Delaware Chancery Court decided that freezeouts in tender offers would not be subject to this standard in Siliconix. Subramanian then analyzed a database of freezeouts in the years immediately following this monumental Siliconix decision. In their analysis, it was revealed that controlling shareholders paid less to minority shareholders in tender offers than they did in mergers. This was discussed in “Post-Siliconix Freeze-outs: Theory, Evidence, and Policy,” Journal of Legal Studies 36, no. 1 (2007): 1–26. By Guhan Subramanian.
Now, following a Merger and Acquisition, it is not uncommon or unusual that there are still shareholders who still have not exchanged their frozen-out shares for compensation months after the deal. This is most common to as much as 10% to 20% of shareholders in a company.
Companies then offer services paid by the shareholders where they locate the shareholders and seek to have them exchange their shares. This is usually done for a fee which is negotiated between shareholders and companies themselves.
Revenue-Enhancing Operating Synergy
When people think or say the term ”synergy”, it is often associated with the physical sciences. Not a lot of people would think about what the term synergy means in the world of economics and finance.
The term itself plays a huge role in the financing and economics world. It means that the profitability of a corporate combination as opposed to the individual parts of the firms that were combined.
Think of it this way, if there is a synergy in both corporations, the anticipated existence of the synergistic benefits will allow both firms to incur the expenses of the acquisition process. In addition to that, both will still be able to afford to give their target shareholders a premium for their shares.
Synergy
Here’s an equation for you: Synergy may allow the combined firm to appear to have a
positive net acquisition value (NAV).
NAV = VAB − [VA + VB] − P − E
where:
VAB = the combined value of the two firms,
VA = the value of A,
VB = the value of B,
P = the premium paid for B, and
E = the expenses of the acquisition process.
If we reorganize the equation above, we get:
NAV = [VAB − (VA + VB)] − (P + E)
Looking closely at the equation above, you will notice that the term in the brackets is the synergistic effect. The effect must always be greater than the sum of the P+E in able to justify going forward with the merger.
However, in any case, that the bracketed term is not greater than the sum of the P + E, the bidding firm will have overpaid for the target. So, what does it really take to be considered synergistic effects?
Well, there are some researchers who view synergy broadly. These researchers include the elimination of inefficient management by installing the more capable management of the acquiring firm.
The Revenue-Enhancing Operating Synergy
Now that we have established what the term synergy means in the financing and economics world, we will discuss the first main type of synergy: the revenue-enhancing operating synergy.
Before we dive in deeper, it is important to know that there are two main types of synergy that are both operating synergy forms. There are revenue enhancements and cost reductions synergy. As stated above, today’s discussion is all about the former. What is revenue enhancing operating synergy?
Revenue enhancements and efficiency gains or operating economies may be derived in horizontal or vertical mergers. These revenue-enhancing operating synergies are not too easy to achieve.
In fact, there was a survey once by McKinsey in which they concluded that 70% of mergers have failed to achieve their expected revenue synergies. So, how do corporations go about this? Well, first, let us establish that these revenue-enhancing synergies can come from different sources which are listed below:
- The pricing power or purchasing power.
- The combination of functional strengths
- The growth from faster-growth markets or new markets
Now, how will two companies merge create synergy? The combination of two companies may lead to greater pricing power or purchasing power. Greater pricing or purchasing power can be achieved only if the two companies are in the same business.
However, it’s success ability will also depend on the degree of competition in the industry both companies are in. It will also depend on the relevant geographic markets as well as the size of the merger partners. With respect to the pricing power, if the combination leads to a more oligopolistic market structure, this can be highly possible.
Increased Concentration
On the other hand, if there are large pricing gains to be achieved through the increased concentration, then the deal may not get regulatory approval. There is research on the source of gains from horizontal mergers that concluded that the gains associated with such deals can be attributed to efficiency improvements and not attributed to the increased market power.
The studies mentioned above have examined the stock market response reactions – or sometimes the lack of a response by every competitor, customer, and suppliers. Additionally, there is another potential source of merger revenue enhancement. This can be the combination of functional strengths.
A great example of this would be if one company has a strong R&D or production abilities while the other company is great at doing marketing and distribution. In every deal, there is a high possibility that each merger partner could be bringing important capabilities that the other company lacks on the table.
There are plenty of great examples of this that have happened in the pharmaceutical industry through the mergers between drug companies with good R&D and large pharmaceutical companies with great manufacturing capacity and quality control as well as global marketing and distribution capabilities.
The pharmaceutical industry has been struggling to improve in R&D areas and quality control. A merger between two companies who have at least one of these capabilities is a surefire revenue-enhancing operating synergy.
Slow Growth
In mature markets like Japan and Europe, corporate growth has slowed for a significant number of years. The slowed growth in these markets has made it harder and harder for different companies (small and large) to achieve meaningful growth.
In cases like this, it sometimes means that large companies have to invest greater amounts to increase market share. There are also cases when large companies invest greater amounts only to maintain what they already have.
However, companies like these may be able to achieve a significant increase in growth by moving into a more rapidly growing market such as those in the emerging world. But what do companies do when they struggle to expand their mature markets?
There are plenty of companies who are struggling to expand and reach their rapidly diminishing returns who enter a higher-growth new market. This is one of the fastest ways to realize meaningful growth for a large company.
There you have it for the discussion of revenue-enhancing operating synergy. We hope this article has helped you gain new information on how to improve your company’s growth and do better in your market or industry. Read also: Acquisition: Achieving Growth in a Slow-Growth Industry
Acquisition: Achieving Growth in a Slow-Growth Industry
Business owners are always in constant search of how they can keep achieving growth despite the slow growth of the economy through acquisition. They always aim to make more profit and cater to a larger customer base. However, the problem is which method they shall use best in growing their business in the slow-growth industry at a rapid pace.
One way to keep achieving growth is through mergers and acquisitions (M&A). Many companies utilize this as they seek to expand their products and services (diversification) or their geographic boundaries. For instance, they could expand from one region to another, or even a country to another.
As for the goal of expanding to a geographic region, more factors will have to be considered, such as language, customs barriers, recruiting of personnel, and many more.
Whatever the goal is, these companies are often faced with a choice between internal growth or acquisition. Growth through M&A is surely faster, but other outcomes are unpredictable. For example, Companies may grow within their own industry or they may expand outside their business category.
Advantages and Disadvantages of Acquisition
It is never easy to attain consistent growth in a very small industry. Corporate managers are always pressured on employing strategies for more returns. In fact, there is only one-tenth of 1 percent of the corporations and businesses will reach an annual revenue peak of $ 250 million. There is plenty of research that supports this. It’s even more difficult when the company has been expanding in the past and the products and services soon slow down.
When this occurs, companies often opt for strategies that result in revenue growth and profitability through synergistic gains such as M&A.
Acquisition by a Small Business
Acquisition is usually just a big-business strategy especially when achieving growth because it is only them who can acquire such companies. Small businesses usually can’t afford the large amount to cover the purchase price. And even if they can, the risk that it is a bad purchase is just too big to deal with.
Market Shares
This strategy secures larger market shares and more revenue. With it, you diversify products and services, as well as long-term opportunities for your business. Your business can expand its reach and increase market share with increased economic activity,
When it increases, it becomes harder for your competition to compete. In these cases, there are three options: cease operations, be content with a small market share, or be another acquisition of your company.
The downside to this is that it is much easier to generate sales growth by simply adding the revenues of acquisition targets than it is to improve the profitability of the overall enterprise.
The Global Market
The acquisition enables small industries to achieve growth to establish powerful positions in the market and even encourage them to break geographical boundaries. You can use the distribution channels and/or systems from the business that is being acquired for the existing customer base. This makes it possible to penetrate the existing market while also marketing the existing products and services to the new market.
Efficiency
Acquiring another business is a great way to grow without the necessity to wait for years on marketing and sales strategy to pay off. However, it could also be very demanding to the management despite the immediate growth. Combining both businesses can result in a lot of new issues that were not there before.
There are a lot of requirements such as a bigger customer base, a variety of markets, portfolios that are more complex, and higher people in management and complex operations. This is why a third, or at least 75% of all acquisitions fail to deliver on the predicted value or efficiencies.
Ways of Acquiring
One key factor that could determine the success of your acquisition or integrative growth strategy is the way by which you acquired a company. Here are three ways:
In Horizontal
This involves buying a competing business or businesses. If you want to add to the growth of your company and eliminate another barrier that stands between you and future growth.
In Backward
This involves buying one of your suppliers as a way of controlling your supply chain better.
In Vertical
Part companies that are part of your chain of distribution. For example, you could promote your goods at the cost of your other rivals to start buying retail stores.
Read also: Do Diversified or Focused Firms Do Better Acquisitions?
Making the Decision
There are plenty of decisions that will affect your business’s success and deciding to make any sort of deal is just the first. With this in mind, you start to wonder if a merger and acquisition is the most logical step for your business. Because of this, you want to study and understand every aspect including your odds at success and whether or not the challenges are worth the try.
If you have finally analyzed the situation and you’re confident in buying one or more companies, the next step will be easier. You just have to bring a team of experienced advisors. A lawyer, an accountant, a business broker, and a commercial real estate agent, to help you begin searching out the right business to buy, negotiating, and managing the transition.
Take as much time as you need, do your due diligence, and make sure that you are not in a hurry when it comes to decision-making. Even if your company is qualified for growth through acquisition, acquiring one that doesn’t fit well or doesn’t offer enough positive return on investment can shatter your goals.
How to Grow Through Acquisition
They say that the key to achieving growth by acquisition is acquiring a business that has synergy with your existing business. Try and go outside the box, there is no limit and you have more options other than buying out direct competitors.
As you go through this, you will find that it is not uncommon for any company to take advantage of each other’s distribution channels by buying another company. This is done in able to expand to other markets.
There is also the option of buying or purchasing another company that is in the same industry as long as it is indifferent geography. With this, a business can now compete better regionally or even national.
If you think that acquisition is not suitable for your small company, you can employ other growth strategies like intensive growth. This involves market penetration development, product development, new products, and many more. You can also seek to diversify how you expand your company by completely unrelated products or services.
As with everything in life, there is no instant gratification to growth strategies. You have to be willing to change the course depending on the feedback you will get from your market. This is extremely important.
Conclusion
Most times, it takes at least a year for companies to develop a strategy and by the time they try to implement said strategies, they find out that the market has changed.
And besides, growth should always ensure that it will generate good returns for shareholders. Most of the time, it is possible for managers to continue to generate acceptable returns by keeping a company at a given size, but instead, choose to pursue aggressive and unmanageable growth. Don’t let this happen to your company.
Do Diversified or Focused Firms Do Better Acquisitions?
Planning to change or renew your business structure, there are a lot of factors to consider: Do Diversified or Focused Firms Do Better Acquisitions? Additionally, there are also plenty of questions to ask so you can lead your business on the right path to success.
One of those questions is whether or not diversified firms do better acquisitions than focused firms? If this is one of the questions you had in your mind, then you are in the right direction. To better answer this question, let us first discuss the difference between diversified and focused firms.
Diversified firms
A diversified firm or company runs multiple unrelated businesses and/or products. This means that while you’re running your company, you are also running multiple other businesses or selling other products.
Usually, these unrelated businesses require unique expertise in management. These also have different end customers than your primary business’ customers. An unrelated business under a diversified firm can also produce different products or provide different services.
To make it short, a diversified business is not focused and needs a lot of management. Because you have different products and services, you also have different consumer markets.
The idea is to spread or smooth financial operations or geographic risk concentrations. It is time-consuming and requires a lot of effort. But at the end of the day, what type of business doesn’t, right?
There are good sides and silver linings to running a diversified business, too. One of the main advantages of operating a diversified business is that it helps protect a company from drastic volatility in any market. This means that one business under a diversified firm can do bad at the stock market without affecting the others, or vice versa.
Another silver lining is that you can run multiple businesses, therefore, multiple sources of income without affecting the others. With multiple businesses, you also have the ability to create more jobs for people and help improve your local economy.
A company may diversify by entering into a new type of unrelated business on its own, combining with another company, or buying another company operating in a very different field or service sector.
There are plenty of diversified firms that are very successful at what they do. Some great examples of these types of diversified companies are General Electric, Motorola, 3M, Toshiba, Hitachi, and Siemens and Bayer. But do they have better acquisitions than focused firms?
Focused Firms
On the other hand, you have a focused firm that focuses on one specific brand or type of business. These focused firms immediately eliminate the complexity of running a diversified business.
It creates opportunities for simplification. Virtually every area of the business is simple enough. You no longer have the need for several management teams, and you don’t have to diverse your focus on other businesses.
You have your clear objectives, and you have a precise understanding of who your customer base is. This comes in handy especially when you are trying to focus on giving your customers the best products or services you can possibly provide.
This allows a businessman to focus more on other areas of the business such as determining which products or services will most appeal to the customers. It also helps you understand what your customers like or don’t like.
A focused firm helps you create a focused strategy. It helps with effective decision making and execution because you have the time and energy to focus on one specific niche. Therefore, it is easier to achieve your business’ objectives.
Throughout the companies’ lifespan, a focused firm is not interested in expanding, merging or entering into a new type of business. It focuses on one specific business model. But is it a better business model than a diversified firm?
Which One Did It Better?
An examination of the benefits and costs between a diversified and a more focused business structure has revealed a lot of information on which structure does better. Another separate question is which of the two business models are better at merger and acquisition.
For a period of two decades from 1981 to 2010, Cihan and Tice analyzed and studied a large sample of 1,810 deals. They found in the study that diversified firms had announcement returns that were 1.5 percent higher than single-segment bidders.
But that is not all that they found out. Cihan and Tice also went on to try to find the source of the higher value for diversified acquirers. They have conducted a regression analysis in which post-merger performance measures reflecting the profitability and costs were regressed against bidders’ diversification status and premerger performance.
What they found was that for firms with diversified acquirers, the Selling, General and Administrative is 1.8% to 2.6% lower than those firms with focused acquirers. Furthermore, the study that was conducted concluded that the combined companies where the bidder was diversified had higher profit margins and lower costs.
In the end, the results implied that the diversified acquirers are at a better position to implement post-deal efficiency improvements as opposed to those who are more focused bidders.
The results of this study play a major learning lesson for those who are running a business today. It has been a general guide for businessmen who are trying to do better at running and expanding their businesses.
We hope that this blog post has helped you understand the difference between a diversified business and a focused firm better. The data in this post aims to help you decide on which route to take to create a better business model.
Now that you have the data in mind, you can think about what type of business model you want to do, and whether or not you should enter a diversified business or stick to a focused business. At the end of the day, it all boils down to what risks you are willing to take, and how hard you are willing to work to help lead your company to a better path.