Mergers, Acquisitions, and Corporate Restructuring
Research has shown that mergers and acquisitions (M&As) are an effective means of entry into high-growth markets, generating cash in the short run, and gaining advantages over the competitors without expanding production capacity. Furthermore, M&As are efficient methods of acquisition of expertise, new technology, products, brands, and skilled employees. Moreover, M&As reduce risks and assist internal product and process innovation (Brock 2005).
To set the foundation for the subsequent discussions of M&A, in this chapter, we will define terminologies of mergers, acquisitions, and corporate restructuring, discuss motives for M&As, identify risks associated with cross-border M&As, discuss different types of mergers, and differentiate domestic and cross-border M&As.
Types of Mergers and Acquisitions, and Terminologies Used in Business Combinations
We start with a definition of corporate restructuring and examine the various forms in which it appears.
Corporate restructuring activities may be classified into two categories: operational and financial. Operational restructuring involves changes in the firm’s asset structure, which may take place by acquiring another business, by the complete or partial sale of a company, by the spin-off of a subsidiary or product line, or by downsizing unprofitable operations and units. Financial restructuring refers to those activities of the firm, which change its debt and equity structure. These activities include leveraged buyouts, management buyouts, reorganization, liquidation, and stock buyback. We focus on operational restructuring in this book.
Operational restructuring activities assume many forms. They could be workforce reduction or realignment, joint venture, or strategic alliance; divestitures; spin-off; carve-out; and takeover or buyout. The takeover or buyout could be friendly or hostile. The friendly takeover could be merger, consolidation, or acquisition of assets. The hostile tender offer is the method of choice in a hostile takeover. Finally, the merger could be in the statutory form or subsidiary form.
A statutory merger takes place when the acquiring or surviving company automatically becomes the owner of the assets and liabilities of the target firm according to the laws of the land or laws of the state in the United States, where the combined company is incorporated. A subsidiary merger occurs when a subsidiary of the acquiring firm becomes the owner of the assets and liabilities of the target. The acquiring firm is called a parent. The advantage of a subsidiary merger is avoidance of subjecting the acquiring company to the liabilities of the target company.
The Terminologies of Corporate Restructuring
We define terminologies of corporate restructuring and foreign direct investment (FDI) in this section.
1. Merger: Any transaction that forms one business enterprise by two or more formerly independent business entities is called a merger. This implies that one company legally absorbs all the assets and liabilities of another company. Mergers have the following characteristics. First, they are negotiated deals that meet certain technical, legal requirements; second, they are often friendly, but one firm may be stronger and dominate the transaction.1
2. Consolidation: A corporate consolidation is a special form of merger. Corporate consolidation combines two business entities and creates a new enterprise. For example, company A and B consolidate and form a new C Company.
3. Acquisitions: An acquisition refers to the purchase of a controlling interest in a firm, and involves a transfer of ownership.
4. Tender Offers: In a tender offer, one firm or person makes an offer directly to the shareholders of the target to buy their shares at specified prices. A tender offer is hostile when an offer is made to the shareholders without the approval of the board of directors of the target firm.
5. Restructuring: Corporate restructuring refers to changes in organization, operations, policies, and strategies to enable the enterprise to achieve its long-term objectives.
6. Spin-off: In spin-off transactions, some parent company’s shareholders receive shares in a subsidiary in return for relinquishing their parent company shares.
7. Split-up: A split-up is the division of a company into two or more separate companies. It is different from spin-off because it involves the entire company rather than a subsidiary.
8. Equity Carve-out: An equity carve-out is a transaction in which a parent firm offers some of a subsidiary’s common stock to the general public to bring in cash infusion to the parent without the parent’s loss of control.
9. Divestitures: Divestitures involve the sale of a segment of a company (assets, product line, and a subsidiary) to another party for cash and or securities.
10. Industry Roll-ups: In an industry roll-up, the consolidator acquires a large number of small companies with similar operations. The industry consolidator aims to maximize profit or revenue by creating economies of scale through consolidating the purchasing, marketing, information systems, distribution, and senior management of the enterprises.
11. Takeovers or Buyouts: Takeovers or buyouts refer to a change in the controlling ownership of a corporation.
12. Leveraged Buyouts: In a leveraged buyout, a small group of investors purchases a target company by financing the acquisition mainly by borrowed funds.
13. Leveraged Recapitalization: Leveraged recapitalization is a defensive reorganization of the company’s capital structure (the combination of a company’s short-term and long-term debts, as well as common and preferred stocks). In the recapitalization process, the outside shareholders (no management shareholders) receive a large, one-time cash dividend and inside shareholders (shares held by the managers of the firm) receive new shares of stock instead.
14. Greenfield Investment: Greenfield investment project refers to investment in a new project in a host country involving the construction of a new building (or leasing of an existing building); purchasing of new machinery and equipment; and the hiring of managers, administrative staff, and production workers. In short, in a greenfield investment, the investors create a new business entity.
15. Cross-Border M&A: Cross-border M&As are FDIs through which an existing business in part or in its entirety is acquired by a foreign enterprise in a host country.
16. Foreign Direct Investment (FDI): FDI refers to investment in a foreign country and can assume the greenfield or cross-border M&A form.
Reasons for Corporate Restructuring
The fundamental reason for corporate restructuring is achieving the goals of the business entity that initiates the restructuring policy. Most analysts consider profit maximization (using the terminology of financial literature, wealth maximization) as the goal of private enterprises. In achieving the goal, companies adopt different objectives in capturing operating synergy and financial synergy.
The M&As create operating synergies by economies of scale and economies of scope. Economies of scale refer to lowering of the long-run average cost of production as the firm’s output expands. Economies of scope occur where a company produces products that use similar types of inputs. As an example, we may think of a firm using sheets of steel in the production of refrigerators as well as washers and dryers. Both products use the same kind of input, in this example, the steel sheets. A company creates economies of scope if in addition to the production of refrigerators also begins production of washers and dryers.
Financial synergy, on the other hand, occurs when the acquisition of a target firm lowers the cost of capital of the acquiring firm. Financial synergy may be classified into several categories including synergy resulting from diversification, strategic realignment, managerial hubris, purchasing undervalued assets, mismanagement, managerialism, tax considerations, and market power. We discuss each of these categories that create financial synergy next.
Diversification happens when an acquirer buys a target firm outside of its current primary lines of business. Diversification could occur in some ways such as purchasing a target firm, which expands markets for an existing product, or if such an acquisition creates a new product for the current market, or if the acquisition leads to the creation of new products for new markets.
Synergy from strategic realignment takes place when firms use M&As to adjust to the changing economic environments rapidly. Most of the forces that cause such rapid external changes are changing government regulations and technological changes.
Hubris creates synergy, albeit a negative one, for the acquiring entity, because of overoptimistic valuation of the target by the management of the acquiring company. Due to the overestimated value of the target, especially in a competitive bidding environment, and over self-confidence, the winner of the bid ends up in a value-destroying acquisition.
The synergy created by buying undervalued assets is due to the purchase of a target firm when the cost of acquisition of the target is less than the cost of purchasing the assets the acquiring firm intends to replace. This condition occurs when the stock value of an enterprise falls substantially below its assets’ book value (historical cost).
Mismanagement or agency problem refers to a situation where the management of an enterprise takes specific actions that are in their own best interest rather than the interest of the stockholders. The agency problem arises from the separation of management and owners of an enterprise.
It is instructive to discuss the emergence of what Alfred Chandler called managerial capitalism. Chandler (1984) argues that as late as the mid-1800s, managers of major business enterprises were, in fact, the owners of the enterprises they managed. It was only in the 1850s and 1860s that the administrative hierarchies in large corporations grew to co-ordinate the mass production and distribution of goods, which were made possible by the newly constructed railroad and communication (telegram) systems. Managerial capitalism became necessary for management of such large integrated industrial enterprises for the first time in the United States.
Managerialism is a theory, which argues that managers acquire other business entities to increase their prestige, raise their income, to expand their sphere of influence, or for self-preservation.
Tax considerations, as a theory for M&As, indicates that the acquiring firms could use accumulated losses from investment in M&A to reduce the income tax liabilities emanating from the future profits derived from the acquisition.
Market power hypothesis asserts that firms engage in M&A activities to reduce competition and increase their market power so that they could set higher prices by reducing the output.
In addition to these generalized hypotheses concerning motivation for M&As, we will discuss specific motives for cross-border M&A activities of Chinese firms in Chapter 14, Part II of the book in Volume II.
Risks Associated with Cross-Border M&As
Cross-border M&As are international business activities and as such involve some risks that are also associated with FDI. We enumerate and discuss the risks associated with FDI next.
Management Risk
The smooth functioning of a newly acquired firm abroad requires placing a new management team at the helm. Often, the formation of a new management team for an acquired enterprise requires combining some, if not all, of the high-level managers of the acquired firm with existing or newly hired managers of the acquiring firm. Due to cultural differences, both at the firm and national levels, the formation of a new management team involves risk. In fact, as is discussed in Chapter 13, a significant number of M&As fail because the acquiring companies are not able to successfully deal with managing risk.
Legal Risks
Operating in a new country, especially a country with vast legal differences from the home country’s judicial system is risky. Some countries’ legal system might be based on common law, such as the Anglo-American legal tradition. Other countries, such as China, for example, might have a civil law system.2 The variations in the judicial systems could create additional risks in the event of legal disputes. Regardless of the differences among the legal systems of the countries of acquiring and acquired firms, the enforcement of existing laws in the host country might also pose some risk. As an example, despite the existence of intellectual property laws in some emerging economies, issues from a lack of enforcement of the existing laws in many emerging economies do arise.
Taxation Risks
Countries have different tax policies and tax systems. In some emerging economies, tax incentives, tax holidays, and tax rebates vary according to industries and localities. The variance of tax systems could pose some risk.
Distribution Risks
In some emerging economies, the distribution of products could pose major risks. These risks arise from the enforcement of contracts. Manufacturers of products supply goods to the distributor on credit and receive payments only after a certain period. The manufacturer must make sure that the distributor can market the products according to acceptable industry standards and terms of the contract between the manufacturer and the distributor.
Foreign Exchange and Repatriation Risks
Foreign exchange risk arises because of fluctuations in foreign exchange rates. A party to an international business transaction that accepts the terms of the settlement in a foreign currency is exposed to transaction risks. Companies that have accounts receivable are denominated in a foreign currency face risk of the host country’s currency depreciation. Companies that have accounts payable denominated in a foreign currency face high risk if the home currency depreciates.3 Repatriation of the financial assets involves risk of home country’s currency appreciation (host country’s currency depreciation).
Political risks arise when a foreign company suffers losses or does not meet its profit expectations because of adverse political decisions, conditions, or events in the country where the business entity is operating. Notable examples of political risk occurred in Libya. China Railway Construction Corporation had three contracts from the Libyan government for construction of railways for $4.237 billion. All projects were shut down after the war broke out in that country in 2011. Also, China State Construction Engineering Corporation (CSCEC), the largest construction firm in the world, had to terminate its operations in Libya after an investment of RMB17.6 billion (approximately $2.94 billion), after the start of hostilities in Libya. Moreover, the CSCEC had to end the construction of a housing complex with 7,300 apartment units with a contract value of RMB5.54 billion or a little less than $1 billion (Wang 2013).
Types of Mergers
Horizontal Mergers
A horizontal merger takes place between two firms that operate and compete in the same kind of business activities. For example, the merger of two auto firms is a horizontal merger.
Industry roll-ups often involve the horizontal merger of small firms with similar operations.
Vertical Mergers
Vertical mergers take place when firms in different stages of production and distribution operations consolidate. For example, if a company that is involved in exploration, extraction, and transportation of petroleum purchases another company that refines and distributes gasoline, a vertical merger has taken place.
Conglomerate Mergers
Conglomerate mergers occur between firms with unrelated business activities. For example, a merger between an auto company and a department store is called a conglomerate merger.
Buyers of companies fall into one of two categories: the operator buyer and the investor buyer. The operator buyers buy companies to achieve a specific strategic goal and use the target as a complementary unit of existing operations. On the other hand, the investor buyers consider a target enterprise as a profitable investment opportunity and acquire it with the aim of selling the enterprise at a profit later.
Differences between Domestic and Cross-Border M&As
Domestic M&As and cross-border M&As share some attributes. However, they are not identical business activities, and some differences exist between them. Cross-border M&As involve the following risks, which are not present in domestic M&As (Angwin 2001):
1. The acquiring firms may secure funds in one market for investment in another one.
2. The cross-border acquirer faces exchange rate risks.
3. The acquiring company faces uncertainty resulting from changes in the host country’s policies concerning cross-country fund transfers, taxes, and business regulations.
4. The acquiring firm faces political and economic risks in the host country.
5. The acquiring firm faces expropriation risks due to the nationalization of private assets by the government of the host country.
6. The acquiring firm has to contend with the long-distance management of the acquired firm in the host country.
7. The acquiring firm must deal with a different accounting system in the country of the target firm.
8. The acquirer might face restrictions in outflows of capital imposed by the host country.
9. Management of both target and acquiring firms face communication difficulties associated with differences in language and culture.
10. The acquiring firm might face legal obstacles in both home and host countries. The legal risk is particularly formidable in the United States because of the rising number of postmerger, mostly frivolous, class-action lawsuits by shareholders. See Section “Inspection Problems” in Chapter 3 and Chapter 15 of Volume II.
11. The acquiring company might face a certain debt–equity ratio that is imposed by the government of the host country.
Summary
In this chapter, we defined some terminologies used in corporate restructuring, M&As, and FDI. We also discussed the motives for M&As. Moreover, we examined risks associated with cross-border M&As, elaborated on types of mergers, differentiated between two kinds of buyers of businesses, and listed those features of cross-border M&As that are different from domestic M&As.