Mergers are an important part of the corporate finance world. Companies pursue mergers for a variety of strategic reasons, and understanding mergers is key to interpreting events in the business world. This article will explain what mergers are, why they happen, the different types of mergers, the merger process, and the potential advantages and disadvantages. We’ll also discuss how to analyse mergers from a corporate finance perspective, including building merger models to evaluate potential deals.

Article Contents

• What is a merger?
• Why do mergers happen?
• Types of Mergers
• Merger Process
• Advantages and Disadvantages of Mergers
• Interpreting Mergers in Corporate Finance
• Merger Modelling

What is a merger?

A merger occurs when two formerly separate companies combine to form a new single company. The term “merger” has fallen out of fashion:  Until 2001, there were two alternative methods for accounting for a “business combination”. In one case “merger accounting” the balance sheets were effectively added together.  This is no longer allowed, so now all “mergers” are accounted for as the “acquisition” of one company by another. Some key examples of high-profile mergers/acquisitions include Exxon and Mobil merging to form ExxonMobil and Chase Manhattan Bank merging with J.P. Morgan to form JPMorgan Chase.

The concept of an acquisition also hides another level of detail in that when a transaction is consummated, it can be done as a purchase of shares- so one company becomes the subsidiary of the other, or the assets of the target can be purchased.  In this case, the Target company is left as a “shell” – a company with no operations but instead the proceeds of the sale.  The selling shareholders would then liquidate the company and return its assets (i.e. the cash sales proceeds) to the shareholders.

Why do mergers happen?

There are several strategic rationales for why companies pursue mergers:

• Gain scale and cut costs – By combining, companies can consolidate operations and eliminate overlaps, improve capacity utilisation, decrease overheads to improve profitability, improve purchasing power and selling power.
• Expand into new markets – Mergers provide a faster way to enter new business lines and geographic markets rather than building organically.
• Acquire talent and technology – Companies can gain talent, Intellectual Property, and technology more quickly through M&A rather than internal development.
• Diversify business mix – Combining companies can create a more diversified portfolio and smooth out volatile earnings.

Types of Mergers

There are several different types of mergers based on the relationship between the merging companies, including:

• Horizontal merger – Two direct competitors in the same industry and market combine. For example, Exxon and Mobil (oil companies).
• Vertical merger – A company merges with a supplier, customer, or other company in its value chain. For example, a car manufacturer merging with an auto parts supplier.
• Conglomerate – No direct relationship between the merging companies, simply expanding into new markets. For example, a consumer goods company acquiring a technology company.
• Concentric – Related and complementary businesses.
• Reverse – A smaller company acquires a larger company. In this case, this is done through exchanging shares.

In the case of reverse mergers, a takeover has just been proposed of a biotechnology fund called Arix Bioscience by another Fund called RTW Bio at the time of writing.  Each Arix shareholder will receive approximately 1.4 RTW shares in exchange for each Arix share owned.  The owners of Arix will own roughly 30% of the enlarged group.  In a reverse takeover, the shareholders of the “seller” will end up owning the majority of the Bidder.  This kind of deal can be a way of listing a company on a stock exchange without the scrutiny of a regulator: a “cash-shell”, i.e. a small, listed company that has sold its operations will exchange new shares representing a majority stake in the merged group for all the shares of the target.

Merger Process

The typical steps in the merger process include:

1. Identifying potential targets and assessing strategic rationale
2. Valuing the target company
3. Securing financing and advice from investment banks
4. Performing due diligence
5. Negotiating terms and announcing the deal
6. Seeking shareholder and regulatory approval
7. Integrating the merged companies after close

Advantages and Disadvantages of Mergers

Potential advantages of mergers include:

• Improved market power and efficiencies
• Access to new markets and distribution
• Cost savings through consolidation
• Diversification benefits
• Acquiring talent and technology

Potential disadvantages include:

• Clash of corporate cultures
• Integration challenges
• Loss of productivity during transition
• Overpayment for the target company
• Increased debt load and interest expenses

Unfortunately, the academic structures of the success of mergers and acquisitions tend to show that companies overestimate the potential synergies in deals and overpay in order to get control.  The benefits of mergers go to the vendors rather than the acquirors.

Interpreting Mergers in Corporate Finance

From a corporate finance perspective, analysts evaluate mergers by building merger models to determine whether the deal is accretive or dilutive to earnings per share (EPS). Other key questions include:

• Is there sound strategic rationale?
• Does the combined business have potential synergies?
• Is the target valuation appropriate?
• Can the deal structure and financing terms work?
• What are the risks and challenges to integration?

By analysing these aspects, corporate financiers help determine if a merger makes financial and strategic sense.

Merger Modelling

Merger models are constructed in Excel to analyse the proforma financial profiles of the merged companies. Key outputs include the projected EPS accretion or dilution, balance sheet effects, and cash flow projections.

A merger model is not strictly speaking a valuation model, rather you should think of it as an affordability model.   When an adviser values a business in the context of a proposed merger, they will establish a “trading valuation”, i.e. based on the earnings or EBITDA multiples on which peer companies trade, what is a fair value?  Separately, they will then consider previous deals and assess what typical premia have been offered in previous transactions in the sector.

The merger model, rather than telling us what a fair price is, tells us what the impact on our profitability and shareholder value will be if we pay a premium to buy a company but benefit from potential synergies.  The model will also help us assess the impact of how we finance the deal on shareholder returns.  Specifically, what will be the impact of financing with equity (i.e. issuing new shares) rather than borrowing?  Building merger models is an important finance skill for analysing M&A deals. Here’s a simplistic guide:

1. Sourcing Data: Gather financial statements and projections of both companies.
2. Build a sources and uses of funds: what money will have to be raised from our own cash, new debt and or equity and what will we need to spend it on, i.e. buying shares, refinancing debt, paying fees.
3. Consolidation: Combine the income statements of both companies.
4. Adjustments: Factor in merger-specific adjustments like financing costs, synergies, and integration costs.
5. Balance Sheet Analysis: Examine the impact on the combined company’s balance sheet, the pro forma debt and number of shares of the acquiror.
6. EPS Calculation: Determine if the merger would be accretive or dilutive by comparing pre-merger and post-merger EPS.
7. Cash Flow Projections: Project future cash flows and assess any changes post-merger.

In summary, mergers represent a major strategic tool for companies looking to grow and combine forces with other players in their industries. By understanding the mechanics, motivations, and analysis behind mergers, finance professionals can better interpret these transformative events.