Why money men love weddings
Sunday 10 January 1999
Mergers-of-equals and M&A activity in general are driven by the fact that profits of European companies are under pressure. Expansion is one way for firms to alleviate these pressures. By gaining scale and market share, they hope to achieve higher and more sustainable profitability. All firms grow through organic investment but merger and acquisition techniques can enhance this growth.
But there are two main reasons why mergers-of-equals, in particular, have become a popular technique through which to grow.
First, because, unlike traditional acquisitions, they seldom involve the payment of a "control" premium - a premium over the share price of the target firm. Instead, as the shareholders of both original entities hold a roughly even number of shares in the merged company, they share the benefit of any potential synergies.
Second, because mergers-of-equals are financed with shares, they allow the merged firm to avoid borrowing and writing off goodwill.
As a result of the recent boom, shareholders and the press have become sceptical whether the trend is a logical reaction to the pressures facing European companies or whether they simply reflect corporate fashion. JP Morgan has investigated value creation in mergers-of-equals. We believe that shareholders should welcome the trend: we found most mergers-of-equals create value.
The main reason for their success was the determined execution of a clear integration plan that allowed them to realise expected benefits.
However, a minority of mergers-of-equals failed to create value. The reasons for failure are complex but the main one was that they did not achieve cost savings.
So how can shareholders tell whether a merger-of-equals is likely to be successful? Although the key is management's ability to integrate the two companies successfully, there are two primary factors to which shareholders should pay attention.
The first, and more important, is the level of synergies. Cost synergies, that come from cost cuts and economies of scale, are easier and quicker to achieve than revenue synergies, which should he treated as more speculative.
For a deal to be well received by the market, the announced synergies should have a present value of at least 15 to 20 per cent of the sum of the market capitalisation of the companies involved shortly before announcement of the transaction.
To give an example of the calculation involved, in the case of BP/Amoco, short-term synergies were estimated at $2bn a year. To find the value of this number, tax at 30 per cent must be deducted and the resulting figure divided by the business's weighted average cost of capital, say 8 per cent. This gives a value of $17.5bn, a little over 15 per cent of $113bn, which was the combined market capitalisation of the two companies prior to announcement, hence the positive reaction of shareholders to the deal.
The second is the relation between the merger ratio and control of the merged entity. The ratio determines the share each partner's shareholders get in the merged firm. As participants in a merger-of-equals are usually publicly listed firms, the negotiation of a merger ratio often starts with the relative market value of the two partners, sometimes taken as an average over the preceding year in order to eliminate share price volatility. However, the ratio also takes other factors into account, particularly whether the market values of the companies fairly reflect their prospects.
In a true merger-of-equals, where neither party has a dominant influence, the ratio should be decided solely by this method. However, it is common for companies to structure a transaction that appropriately compensates each party for any unevenness in the profile of the merged entity.
Issues commonly considered include the new management structure and the location of the new headquarters. Where the ratio/control balance seems uneven, either because one party appears dominant but the ratio is not skewed in the other's favour, or because one party is paying a premium despite governance being evenly split, shareholders should ask why.
We believe that the boom in the M&A market, and in mergers-of-equals in particular, is set to continue. The pressures on European firms will increase with the advent of the euro and mergers-of-equals are an effective means by which they can counteract these pressures. What is more, shareholders should be happy. But they should also continue to be vigilant; each deal, as ever, should be judged on its merits.
Paul Gibbs analyses mergers and acquisitions for JP Morgan in London.
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