Understanding Mergers and Acquisitions

First things first, what’s the difference between a merger and an acquisition? 

Difference between an acquisition and a merger

An acquisition happens when one firm, usually larger, purchases some or all of another firm’s ownership interest. But when two firms of a similar size combine their shares, the transaction is known as merger. Rather than one company purchasing the shares of the other, each firm purchases a portion of each other’s ownership interest. 

Acquisitions can be carried out in a few different ways. The acquiring firm, known as the bidding firm, can buy all of the shares of the acquired firm –the target firm. But sometimes the bidding firm might buy only some of the target firm’s shares –either a majority share (i.e. over 51%) or a controlling share i.e, a  larger share than any of the target firm’s other shareholders. 

Type of Acquisitions - friendly and unfriendly acquisitions

Friendly acquisitions occur when the target firm’s management wants the firm to be acquired. These often involve direct negotiations between the firm's management. 

Conversely, unfriendly acquisitions, sometimes known as hostile takeovers, are accomplished without the cooperation of the target firm’s management. One way to carry out an unfriendly acquisition is through a tender offer, in which a bidding firm announces publicly that it’s willing to buy the target firm’s shares for more than the current market price. Current shareholders will then sell their shares to the bidding firm, ultimately giving it a controlling or majority share. 

Tender offers can also be used in friendly acquisitions, but in those cases, the offer is carried out with the approval of the target firm’s board of directors. 

Hmmm! Remember Elon Musk’s tweet on his acquisition of Twitter? 

Love Me Tender, 

Mergers can be carried out in the same way as acquisitions; however, they are usually friendly. Moreover, mergers are typically more positively received by employees than acquisitions. Although a merger takes place between two firms of relatively equal size, over time one firm's management may become dominant.

What makes an acquisition or merger valuable in the first place?

As with diversification strategies, these strategic moves create value when the corporate whole is greater than the sum of its parts, or when synergy is generated. According to studies, the more strategically related bidding and target firms are, the more economic value mergers and acquisitions create.

One common system for categorizing the relatedness of firms comes from the Federal Trade Commission (FTC), which monitors consumer protection and anticompetitive business practices.

The FTC categorizes the relatedness of merging firms based on how the merger or acquisition will affect value chain activities or diversification.

The FTC's strategic relatedness categories involves the following: 

• Horizontal merger: competitors in the same industry merge

• Vertical merger: a firm merges with a customer or supplier

• Market-extension merger: firms gain access to new geographic markets

• Product-extension merger: firms gain complementary products

• Conglomerate merger: firms with no business areas in common merge

Despite the ubiquity of mergers and acquisitions, bidding firms—even when they acquire strategically related target firms—often do not earn any economic profits from their acquisitions. In fact, many acquisitions are so costly that generally only the target firm profits economically from the economies of scope generated –when bidding firms offer the target firm a price less than its market value, this may trigger a bidding war. So bids are usually for the market value of the target firm plus the expected value of the merger.

Reasons why bidding firms might engage in mergers and acquisitions, even though they may not be economically profitable

• To reduce production costs through economies of scale: The production capacity of the combined firms is higher than each firm on its own, which makes it easier to achieve economies of scale.

• To overcome barriers to entry in another industry: Merging with or acquiring a firm already established in that industry will definitely help overcome barriers to entry.

• To gain control of specific assets owned by the target firm: This could be anything, including physical assets, intellectual property, or key human resources.

• To gain market power: If two firms in the same industry merge, this increases the market power of the resulting firm. Watch out for monopolies, though!

• To gain a tax advantage: Losses in one firm can be used to offset profits in the other, reducing the firm's overall tax liability.

Although mergers and acquisitions may not confer competitive advantage, they can be used to achieve competitive parity, or the same economic value as a firm's rivals. This is especially true in industries where a firm's competitors have all improved their efficiency through acquisitions. 

Mergers and acquisitions can also be a good use for free cash flow, or cash left over after ongoing business operations have been funded. For companies with limited investment options, although merger and acquisition strategies may not yield significant profits, they can at least be expected to generate competitive parity. Although firms can return this surplus to its shareholders as dividends or stock buybacks, shareholders with high marginal tax rates may prefer the firm to keep and invest its free cash flow.

But beware! Managers may have selfish reasons to support mergers and acquisitions. Managers are often compensated according to firm size, so the larger a firm grows through mergers and acquisitions, the more managers are paid, sometimes regardless of profitability.

Managers may also believe—unrealistically—that they can manage the assets of a target firm better than the current management, a phenomenon known as managerial hubris.