Synergies

Synergies refer to expected cost savings, growth opportunities, and other financial benefits that occur as a result of the combination of two companies. They represent one of the primary value enhancers for M&A transactions, especially when targeting companies in core or related businesses. This notion that “two plus two can equal five” helps support premiums paid and shareholder enthusiasm for a given M&A opportunity. The size and degree of likelihood for realizing potential synergies plays an important role in framing purchase price, often representing the difference between meeting or falling short of internal investment return thresholds and shareholder expectations. Similarly, in a competitive bidding process, those acquirers who expect to realize substantial synergies can typically afford to pay more than those who lack them. As a result, strategic acquirers have traditionally been able to outbid financial sponsors in organized sale processes.

Due to their critical role in valuation and potential to make or break a deal, bankers on buy-side assignments need to understand the nature and magnitude of the expected synergies. Successful acquirers typically have strong internal M&A or business development teams who work with company operators to identify and quantify synergy opportunities, as well as craft a feasible integration plan. The buy-side deal team must ensure that these synergies are accurately reflected in the financial model and M&A analysis, as well as in communication to the public markets.

Upon announcement of a material acquisition, public acquirers typically provide the investor community with guidance on expected synergies. Depending on the situation, investors afford varying degrees of credit for these announced synergies, which can be reflected in the acquirer's post-announcement share price. Post-acquisition, appointed company officers are entrusted with garnering the proper resources internally and overseeing successful integration. The successful and timely delivery of expected synergies is extremely important for the acquirer and, in particular, the executive management team. Failure to achieve them can result in share price decline as well as weakened support for future acquisitions from shareholders, creditors, and rating agencies.

While there has been a mixed degree of success across companies and sectors in terms of the successful realization of synergies, certain patterns have emerged. For example, synergies tend to be greater, and the degree of success higher, when acquirers buy targets in the same or closely-related businesses. In these cases, the likelihood of overlap and redundancy is greater and acquirers can leverage their intimate knowledge of the business and market dynamics to achieve greater success. In addition, cost synergies, which are easily quantifiable (such as headcount reduction and facility consolidation), tend to have a higher likelihood of success than revenue synergies.³ Consequently, cost synergies are typically rewarded by the market via stock price appreciation. Other synergies may include tangible financial benefits such as adopting the target's net operating losses (NOLs) for tax purposes,⁴ or a lower cost of capital due to the increased size, diversification, and market share of the combined entity.

Cost Synergies

On the cost side, traditional synergies include headcount reduction, consolidation of overlapping facilities, and the ability to buy key inputs at lower prices due to increased purchasing power. Following the combination of two companies, there is no need for two CEOs, two CFOs, two accounting departments, two marketing departments, or two information technology platforms. Similarly, acquirers seek opportunities to close redundant corporate, manufacturing, distribution, and sales facilities in order to trim costs without sacrificing the ability to sustain and grow sales.

Increased size enhances a company's ability to leverage its fixed cost base (e.g., administrative overhead, marketing and advertising expenses, manufacturing and sales facilities, and sales force) across existing and new products, as well as to obtain better terms from suppliers due to larger volume orders, also known as “purchasing synergies.” This provides for economies of scale, which refers to the notion that larger companies are able to produce and sell more units at a lower cost per unit than smaller competitors. Increased size also lends towards economies of scope, which allows for the allocation of common resources across multiple products and geographies. Another common cost synergy is the adoption of “best practices” whereby either the acquirer's or target's systems and processes are implemented globally by the combined company.

Revenue Synergies

Revenue synergies refer to the enhanced sales growth opportunities presented by the combination of businesses. A typical revenue synergy is the acquirer's ability to sell the target's products though its own distribution channels without cannibalizing existing acquirer or target sales. For example, an acquirer might seek to leverage its strong retail presence by purchasing a company with an expanded product line but no retail distribution, thereby broadening its product offering through the existing retail channel. Alternatively, a company that sells its core products primarily through large retailers might seek to acquire a target that sells through the professional or contractor channel so as to expand its paths to market. An additional revenue synergy occurs when the acquirer leverages the target's technology, geographic presence, or know-how to enhance or expand its existing product or service offering.

Revenues synergies tend to be more speculative than cost synergies. As a result, valuation and M&A analysis typically incorporate conservative assumptions (if any) regarding revenue synergies. Such synergies, however, represent tangible upside that may be factored into the acquirer's ultimate bid price. Investors and lenders also tend to view revenue synergies more skeptically than cost synergies, affording them less credit in their pro forma earnings projections.

Horizontal Integration

Horizontal integration involves the purchase of a business that expands the acquirer's geographic reach, product lines, services, or distribution channels. In this type of transaction, the acquirer seeks to realize both economies of scale and scope due to the ability to leverage a fixed cost base and know-how for greater production efficiencies as well as product and geographic diversification. InBev's purchase of Anheuser-Busch in 2008 is a high profile example of a deal featuring both economies of scale and scope.

This category of acquisitions often results in significant cost synergies from eliminating redundancies and leveraging the acquirer's existing infrastructure and overhead. In addition, the acquirer's increased size typically affords greater leverage with suppliers and customers, with the former providing greater purchasing power and the latter providing greater pricing power. A horizontal acquisition strategy typically also provides synergy opportunities from leveraging each respective company's distribution network, customer base, and technologies. There are, however, potential risks to a horizontal integration strategy, including anti-trust issues and negative revenue synergies in the event certain existing customers take their business elsewhere post-transaction.

A thoughtful horizontal integration strategy tends to produce higher synergy realization and shareholder returns than acquisitions of relatively unrelated businesses. While the acquirer's internal M&A team or operators take the lead on formulating synergy estimates, bankers are often called upon to provide input. For example, as discussed in Chapter 2, bankers research and calculate synergies for similar deals that have been consummated in a given sector, both in terms of types and size. This serves as a sanity check on the client's estimates, while providing an indication of potential market expectations.

Vertical Integration

Vertical integration seeks to provide a company with cost efficiencies and potential growth opportunities by affording control over key components of the supply chain. When companies move upstream to purchase their suppliers, it is known as backward integration; conversely, when they move downstream to purchase their customers, it is known as forward integration. Exhibit 7.1 displays the “nuts-and-bolts” of a typical supply chain. In addition, Bloomberg provides analysis of a company's supply chain via function: SPLC<GO> (see Appendix 7.1).

An automobile original equipment manufacturer (OEM) moving upstream to acquire an axle manufacturer or steel producer is an example of backward integration. An example of forward integration would involve an OEM moving downstream to acquire a distributor.

Vertical integration is motivated by a multitude of potential advantages, including increased control over key raw materials and other essential inputs, the ability to capture upstream or downstream profit margins, improved supply chain coordination, and moving closer to the end user to “own” the customer relationship. Owning the means of production or distribution potentially enables a company to service its customers faster and more efficiently. It also affords greater control over the finished product and its delivery, which helps ensure high quality standards and customer satisfaction.

At the same time, vertical integration can pose business and financial risks to those moving up or down the value chain. By moving supply in-house, for example, companies risk losing the benefits of choosing from a broad group of suppliers, which may limit product variety, innovation, and the ability to source as competitively as possible on price. A fully integrated structure also presents its own set of management and logistical hurdles, as well as the potential for channel conflict with customers. Furthermore, the financial return and profitability metrics for upstream and downstream businesses tend to differ, which may create pressure to separate them over time. At its core, however, perhaps the greatest challenge for successfully implementing a vertical integration strategy is that the core competencies for upstream and downstream activities tend to be fundamentally different. For example, distribution requires a distinctly different operating model and skill set than manufacturing, and vice versa. As companies broaden their scope, it becomes increasingly difficult to remain a “best-in-class” operator in multiple competencies.

Conglomeration

Conglomeration refers to a strategy that brings together companies that are generally unrelated in terms of products and services provided under one corporate umbrella. Conglomerates tend to be united in their business approach and use of best practices, as well as the ability to leverage a common management team, infrastructure, and balance sheet to benefit a broad range of businesses. A conglomeration strategy also seeks to benefit from portfolio diversification benefits while affording the flexibility to opportunistically invest in higher growth segments.

Two of the largest and most well-known conglomerates are General Electric (“GE”) and Berkshire Hathaway (“Berkshire”). GE operates a variety of businesses in several sectors including aerospace, energy, financial and insurance services, healthcare, and transportation. Like GE, Berkshire is engaged in a number of diverse business activities including insurance, apparel, building products, chemicals, energy, general industrial, retail, and transportation. Investors in GE and Berkshire believe that management competency, business practices, philosophy, and investment strategies at these companies add tangible value. The “GE Way,” for example, was viewed for years as a superior method for operating companies and delivering superior shareholder returns.

Cash on Hand

The use of cash on hand pertains to strategic buyers that employ excess cash on their balance sheet to fund acquisitions. Nominally, it is the cheapest form of acquisition financing as its cost is simply the foregone interest income earned on the cash, which is minimal in a low interest rate environment. In practice, however, companies tend to view use of cash in terms of the opportunity cost of raising external debt as cash can theoretically be used to repay existing debt. As a general rule, companies do not rely upon the maintenance of a substantial cash position (also referred to as a “war chest”) to fund sizeable acquisitions.⁶ Instead, they tend to access the capital markets when attractive acquisition opportunities are identified. Furthermore, a large portion of a company's cash position may be held outside of the U.S. and face substantial tax repatriation expenses, thereby limiting its availability for domestic M&A opportunities. From a credit perspective, raising new debt and using existing cash are equivalent on a net debt basis, although new debt increases total leverage ratios as well as interest expense.

Debt Financing

Debt financing refers to the issuance of new debt or use of revolver availability to partially, or fully, fund an M&A transaction. The primary sources of debt financing include new or existing revolving credit facilities, term loans, bonds, and, for investment grade companies, commercial paper.

• A revolving credit facility is essentially a line of credit extended by a bank or group of banks that permits the borrower to draw varying amounts up to a specified limit for a specified period of time. It may be predicated on the company's cash flows (also known as a cash flow revolver) or asset base (also known as an asset-based lending (ABL) facility).
• A term loan is a loan for a specific period of time that requires principal repayment (“amortization”) according to a defined schedule, typically on a quarterly basis. Revolvers and term loans bear interest on a quarterly basis at a floating rate, based on an underlying benchmark (typically LIBOR), plus an applicable margin.
• A bond or note is a security that obligates the issuer to pay bondholders interest payments at regularly defined intervals (typically cash payments on a semi-annual basis at a fixed rate) and repay the entire principal at a stated maturity date.
• Commercial paper is a short-term (typically less than 270 days), unsecured corporate debt instrument issued by investment-grade companies for near-term use, such as inventory, accounts payable, and other short-term assets or liabilities including acquisitions. It is typically issued as a zero coupon instrument at a discount, like T-bills, meaning that the spread between the purchase price and face value (discount) is the amount of interest received by the investor.

As discussed in Chapter 3, we estimate a company's cost of debt through a variety of methods depending on the company, its capitalization, and credit profile. The all-in cost of debt must be viewed on a tax-effected basis as interest payments are tax deductible. While debt is cheaper than equity in terms of required return by investors, acquirers are constrained with regard to the amount of debt they can incur in terms of covenants, market permissiveness, and credit ratings, as well as balance sheet flexibility considerations.

Equity Financing

Equity financing refers to a company's use of its stock as acquisition currency. An acquirer can either offer its own stock directly to target shareholders as purchase consideration or offer cash proceeds from an equity offering. Offering equity to the shareholders as consideration eliminates the contingency that could arise as a result of attempting to issue shares in the open market. While equity is more expensive to the issuer than debt financing,⁷ it is a mainstay of M&A financing particularly for large-scale public transactions. For a merger of equals (MOE) M&A transaction, the consideration is typically all-stock and the premium received by the sellers is small relative to a takeover premium.

Equity financing provides issuers with greater flexibility as there are no mandatory cash interest payments (dividends are discretionary),⁸ no principal repayment, and no covenants. In the event that a public company issues 20% or greater of its outstanding shares in a transaction, it will need to obtain shareholder approval as required by stock exchange rules, which adds time and uncertainty to the financing process. This can prove to be an impediment for the acquirer in terms of providing speed and certainty in funding and closing the transaction to the seller.

As would be expected, acquirers are more inclined to use equity when their share price is high, both on an absolute basis and relative to that of the target. From a target company perspective, shareholders may find stock compensation attractive provided that the acquirer's shares are perceived to have upside potential (including synergies from the contemplated deal). Furthermore, tax-sensitive shareholders may prefer equity provided they can defer the capital gain. More commonly, however, target shareholders view equity as a less desirable form of compensation than cash. Acquirer share price volatility during the period from announcement of the deal until consummation adds uncertainty about the exact economics to be received by target shareholders. Similarly, the target's Board of Directors and shareholders must gain comfort with the value embedded in the acquirer's stock and the pro forma entity going forward, which requires due diligence.

Debt vs. Equity Financing Summary—Acquirer Perspective

Exhibit 7.2 provides a high-level summary of the relative benefits to the issuer of using either debt or equity financing.

Stock Sale

A stock sale is the most common form of M&A deal structure, particularly for a C Corporation (also known as a “C Corp”). A C Corp is a corporation that is taxed separately from its shareholders (i.e., at the corporate level only as opposed to the shareholder level). S Corps, LLCs or other partnerships, by contrast, are conduit entities in which corporate earnings are passed on directly to shareholders and therefore not taxed at the corporate level.⁹ C Corps comprise the vast majority of public companies and hence receive most of the focus in this chapter.

A stock sale involves the acquirer purchasing the target's stock from the company's shareholders for some form of consideration. From a tax perspective, in the event that target shareholders receive significant equity consideration in the acquirer, their capital gain is generally deferred. On the other hand, in the event they receive cash, a capital gain is triggered. The extent to which a capital gains tax is triggered is dependent upon whether the shareholder is taxable (e.g., an individual) or non-taxable (e.g., a pension fund).

In a stock sale, the target ceases to remain in existence post-transaction, becoming a wholly-owned subsidiary of the acquirer. This means that the acquirer assumes all of the target's past, present, and future known and unknown liabilities, in addition to the assets. In this sense, a stock sale is the cleanest form of transaction from the seller's perspective, eliminating all tail liabilities.

As part of the deal negotiations, however, the acquirer may receive representations (“reps”) and warranties, indemnifications associated with these reps and warranties, or other concessions to alleviate the risk of certain liabilities. In a public company transaction, the reps and warranties do not survive closing. In a private company transaction with a limited number of shareholders, however, the reps and warranties typically survive closing with former shareholders providing indemnification to the acquirer (see Chapter 6). This affords the acquirer legal recourse against former shareholders in the event the reps and warranties prove untrue.

Goodwill

In modeling a stock sale transaction for financial accounting (GAAP) purposes, in the event the purchase price exceeds the net identifiable assets¹⁰ of the target, the excess is first allocated to the target's tangible and identifiable intangible assets, which are “written-up” to their fair market value. As their respective names connote, tangible assets refer to “hard” assets such as PP&E and inventory, while intangibles refer to items such as customer lists, non-compete contracts, copyrights, and patents.

These tangible and intangible asset write-ups are reflected in the acquirer's pro forma GAAP balance sheet. They are then depreciated and amortized, respectively, over their useful lives, thereby reducing after-tax GAAP earnings. For modeling purposes, simplifying assumptions are typically made regarding the amount of the write-ups to the target's tangible and intangible assets before the receipt of more detailed information.

In a stock sale, the transaction-related depreciation and amortization is not deductible for tax purposes. Neither buyer nor seller pays taxes on the “gain” on the GAAP asset write-up. Therefore, from an IRS tax revenue generation standpoint, the buyer should not be allowed to reap future tax deduction benefits from this accounting convention. From an accounting perspective, this difference between book and tax is resolved through the creation of a deferred tax liability (DTL) on the balance sheet (where it often appears as deferred income taxes). The DTL is calculated as the amount of the write-up multiplied by the company's tax rate (see Exhibit 7.3).

Goodwill is calculated as the purchase price minus the target's net identifiable assets minus allocations to the target's tangible and intangible assets, plus the DTL. Exhibit 7.4 displays a graphical representation of the calculation of goodwill, including the asset write-up and DTL adjustments.

Once calculated, goodwill is added to the assets side of the acquirer's balance sheet and tested annually for impairment, with certain exceptions. While goodwill is no longer amortized in the U.S., impairment could result in a “write-down” to book value, which would result in a one-time charge to the acquirer's earnings.

Asset Sale

An asset sale refers to an M&A transaction whereby an acquirer purchases all or some of the target's assets. Under this structure, the target legally remains in existence post-transaction, which means that the buyer purchases specified assets and assumes certain liabilities. This can help alleviate the buyer's risk, especially when there may be substantial unknown contingent liabilities.¹¹ From the seller's perspective, however, this is often less attractive than a stock sale where liabilities are transferred as part of the deal and the seller is absolved from all liabilities, including potential contingent liabilities. For reasons explained in greater detail below, a complete asset sale for a public company is a rare event.

An asset sale may provide certain tax benefits for the buyer in the event it can “step up” the tax basis of the target's acquired assets to fair market value, as reflected in the purchase price. The stepped-up portion is depreciable and/or amortizable on a tax deductible basis over the assets' useful life for both GAAP book and tax purposes. This results in real cash benefits for the buyer during the stepped-up depreciable period.

In Exhibit 7.5, we assume a target is acquired for $2 billion and its assets are written up by $1,500 million ($2,000 million purchase price – $500 million asset basis) and, for illustrative purposes, depreciated over 15 years (the actual depreciation of the step-up is determined by the tax code depending on the asset type). This results in annual depreciation expense of $100 million, which we multiply by the acquirer's marginal tax rate of 38% to calculate an annual tax shield of $38 million. Using a 10% discount rate, we calculate a present value of $289 million for these future cash flows.

The seller's decision regarding an asset sale versus a stock sale typically depends on a variety of factors that frequently result in a preference for a stock deal, especially for C Corps. The most notable issue for the seller and its shareholders is the risk of double taxation in the event the target is liquidated in order to distribute the sale proceeds to its shareholders (as is often the case).

The first level of taxation occurs at the corporate level, where taxes on the gain upon sale of the assets are paid at the corporate income rate. The second level of taxation takes place upon distribution of proceeds to shareholders in the form of a capital gains tax on the gain in the appreciation of their stock.

The upfront double taxation to the seller in an asset sale tends to outweigh the tax shield benefits to the buyer, which are realized over an extended period of time. Hence, as discussed above, stock deals are the most common structure for C Corps. This phenomenon is demonstrated in Exhibit 7.6, where the seller's net proceeds are $1,775 million in a stock sale vs. $1,290.5 million in an asset sale, a difference of $484.5 million. This $484.5 million additional upfront tax burden greatly outweighs the $289 million tax benefits for the buyer in an asset sale.

In deciding upon an asset sale or stock sale from a pure after-tax proceeds perspective, the seller also considers the tax basis of its assets (also known as “inside basis”) and stock (also known as “outside basis”). In the event the company has a lower inside basis than outside basis, which is commonplace, the result is a larger gain upon sale. This would further encourage the seller to eschew an asset sale in favor of a stock sale due to the larger tax burden. As a result, asset sales are most attractive for subsidiary sales when the parent company seller has significant losses or other tax attributes to shield the corporate-level tax. This eliminates double taxation for the seller while affording the buyer the tax benefits of the step-up.

An asset sale often presents problematic practical considerations in terms of the time, cost, and feasibility involved in transferring title in the individual assets. This is particularly true for companies with a diverse group of assets, including various licenses and contracts, in multiple geographies. In a stock sale, by contrast, title to all the target's assets is transferred indirectly through the transfer of stock to the new owners.

338(h)(10) Election

A more common derivation of the 338 election is the joint 338(h)(10) election, so named because it must be explicitly consented to by both the buyer and seller. As with an asset sale, this structure is commonly used when the target is a subsidiary of a parent corporation. In a subsidiary sale, the parent typically pays taxes on the gain on sale at the corporate tax rate regardless of whether it is a stock sale, asset sale, or 338(h)(10) election.

The 338(h)(10) election provides all the buyer tax benefits of an asset sale but without the practical issues around the transfer of individual asset titles previously discussed. Therefore, properly structured, the 338(h)(10) election creates an optimal outcome for both buyer and seller. In this scenario, the buyer is willing to pay the seller a higher price in return for acquiescing to a 338(h)(10) election, which affords tax benefits to the buyer from the asset step-up that results in the creation of tax-deductible depreciation and amortization. This results in a lower after-tax cost for the acquirer and greater after-tax proceeds for the seller. The Internal Revenue Code requires that the 338(h)(10) be a joint election by both the buyer and seller, and therefore forces both parties to work together to maximize the value.

The ability to utilize a 338(h)(10) election often stems from the fact that a subsidiary's outside basis is generally greater than its inside basis. This occurs because a subsidiary's assets are depreciated over time, which is not the case with its stock basis. In the event that the subsidiary or business has been purchased recently, the stock basis may be particularly high relative to its inside basis. Therefore, the taxable capital gain amount is often lower for a stock sale than an asset sale.

In a subsidiary sale through a 338(h)(10) election, the corporate seller is not subject to double taxation as long as it does not distribute the proceeds from the sale to shareholders. Instead, the seller is taxed only once at the corporate level on the gain on sale. As shown in Exhibit 7.7, Seller Net Proceeds are $1,430 million in both the subsidiary stock sale and 338(h)(10) election scenarios. In the 338(h)(10) election scenario, however, the buyer's Net Purchase Price of $1,711 million is significantly lower due to the $289 million tax benefit.

In this scenario, the buyer has a meaningful incentive to increase its bid in order to convince the seller to agree to a 338(h)(10) election. As shown in the Buyer Breakeven column in Exhibit 7.7, the buyer is willing to pay up to $2,358 million before the tax benefits of the deal are outweighed by the additional purchase price. At the same time, the seller gains $0.62 (1 – 38% marginal tax rate) on each additional dollar the buyer is willing to pay. This provides strong incentive to consent to the 338(h)(10) election as purchase price is increased. At the breakeven purchase price of $2,358 million, the seller receives Net Proceeds of $1,652 million.

In the Split Difference column, we show a scenario in which the buyer and seller share the tax benefit, which is a more typical 338(h)(10) election outcome. Here, we assume the buyer pays a purchase price of $2,179 million, which is the midpoint between a purchase price of $2,000 million and the buyer breakeven bid of $2,358 million. At the Split Difference purchase price, both buyer and seller are better off than in a stock deal at $2,000 million. The seller receives net proceeds of $1,541 million and the buyer's net purchase price is $1,855.5 million.

In those cases where the target's inside basis is significantly lower than its outside basis, the seller needs to be compensated for the higher tax burden in the form of a higher purchase price or else it will not agree to the 338(h)(10) election. At the same time, as demonstrated above, the acquirer has a ceiling purchase price above which it is economically irrational to increase its purchase price, represented by the incremental value of the tax benefits. Therefore, depending on the target's inside stock basis and the incremental value of the tax benefit, the buyer and seller may not be able to reach an agreement.

A comparison of selected key attributes for the various deal structures is shown in Exhibit 7.8.

Football Field

As previously discussed, a “football field,” so named for its resemblance to a U.S. football playing field, is a commonly used visual aid for displaying the valuation ranges derived from the various methodologies. For public companies, the football field also typically includes the target's 52-week trading range, along with a premiums paid range in line with precedent transactions in the given sector (e.g., 25%–40%). The football field may also reference the valuation implied by a range of target prices from equity research reports.

Once completed, the football field is used to help fine-tune the final valuation range, typically by analyzing the overlap of the multiple valuation methodologies, as represented by the bars in the graphic below. As would be expected, certain methodologies receive greater emphasis depending on the situation. This valuation range is then tested and analyzed within the context of merger consequences analysis in order to determine the ultimate bid price. Exhibit 7.9 displays an illustrative enterprise value football field for ValueCo.

As discussed in Chapter 3, the DCF typically provides the highest valuation, primarily due to the fact that it is based on management projections, which tend to be optimistic, especially in M&A sell-side situations. We have also layered in the present value of $100 million potential synergies (see dotted line bar above), assuming the acquirer is a strategic buyer. This additional value is calculated by discounting the projected after-tax synergies to the present using the target's WACC (see Exhibit 7.10).

Precedent transactions, which typically include a control premium and/or synergies, tend to follow the DCF in the valuation hierarchy, followed by comparable companies. This hierarchy, however, is subject to market conditions and therefore not universally true. Traditionally, LBO analysis, which serves as a proxy for what a financial sponsor might be willing to pay for the target, has been used to establish a minimum price that a strategic buyer must bid to be competitive. As discussed in Chapter 4, however, while the valuation implied by LBO analysis is constrained by achievable leverage levels and target returns, strong debt markets and other factors may drive a superior LBO analysis valuation.

Based on the football field in Exhibit 7.9, we extrapolate a valuation range for ValueCo of $5,250 million to $6,000 million, which implies an EV/LTM EBITDA multiple range of approximately 7.5x to 8.5x LTM EBITDA of $700 million. This range can be tightened and/or stressed upwards or downwards depending on which valuation methodology (or methodologies) the banker deems most indicative.

Exhibit 7.11 displays an illustrative share price football field for ValueCo. Here we layer in the target's 52-week trading range, a 35% premium to the target's 3-month trading range, and a range of target prices from equity research reports. This analysis yields an implied share price range of $52.50 to $60.00 for ValueCo.

Analysis at Various Prices

Buy-side M&A valuation analysis typically employs analysis at various prices (AVP) to help analyze and frame valuation. Also known as a valuation matrix, AVP displays the implied multiples paid at a range of offer prices (for public targets) and transaction values at set intervals. The multiple ranges derived from Comparable Companies and Precedent Transactions are referenced to provide perspective on whether the contemplated purchase price is in line with the market and precedents. Exhibit 7.12 shows an example of a valuation matrix for ValueCo assuming a current share price of $43.50 and premiums from 25% to 45%.

For a public company, the valuation matrix starts with a “premiums paid” header, which serves as the basis for calculating implied offer value. The premiums to the current stock price are typically shown for a range consistent with historical premiums paid (e.g., 25% to 45%) in increments of 5% or 10%, although this range can be shortened or extended depending on the situation.

The offer price at given increments is multiplied by the implied number of fully diluted shares outstanding at that price in order to calculate implied offer value. As the incremental offer price increases, so too may the amount of fully diluted shares outstanding in accordance with the treasury stock method (see Chapter 1, Exhibit 1.7). Furthermore, as discussed in Chapter 2, in an M&A scenario, the target's fully diluted shares outstanding typically reflect all outstanding in-the-money stock options as opposed to only exercisable options. This is due to the fact that most stock options contain a provision whereby they become exercisable upon a change-of-control if they are in-the-money.

Once the implied offer values are calculated, net debt is then added in order to obtain the implied transaction values. For example, at a 35% premium to the assumed current share price of $43.50 per share, the offer value for ValueCo's equity is $4,700 million. After adding net debt of $1,250 million, this equates to an enterprise value of $5,950 million. The enterprise value/EBITDA multiples at a 35% premium are 8.5x and 8.2x on an LTM and 2012E basis, respectively. At the same 35% premium, the respective LTM and 2012E offer price/EPS multiples are 18.2x and 17.5x, respectively.

Contribution Analysis

Contribution analysis depicts the financial “contributions” that each party makes to the pro forma entity in terms of sales, EBITDA, EBIT, net income, and equity value, typically expressed as a percentage. This analysis is most commonly used in stock-for-stock transactions. In Exhibit 7.13, we show the relative contributions for BuyerCo and ValueCo for a variety of key metrics.

The calculation of each company's contributed financial metrics is relatively straightforward as no transaction-related adjustments are made to the numbers. For public companies, equity value is also a simple calculation, including the premium paid by the acquirer. For private company targets, equity value needs to be calculated based on an assumed purchase price and net debt. While technically not a “valuation technique,” this analysis allows the banker to assess the relative valuation of each party. In theory, if both companies' financial metrics are valued the same, the pro forma ownership would be equivalent to the contribution analysis.

Purchase Price Assumptions

Based on the valuation analysis performed in Exhibits 7.9 through 7.12, as well as the outputs from Chapters 1–3 and 5, we assume BuyerCo is offering $58.73 for each share of ValueCo common stock. This represents a 35% premium to the company's current share price of $43.50. At a $58.73 offer price, we calculate fully diluted shares outstanding of approximately 80 million for ValueCo, which implies an equity purchase price of $4,700 million. Adding net debt of $1,250 million, we calculate an enterprise value of $5,950 million, or 8.5x LTM EBITDA of $700 million (see Exhibit 7.14).

The 8.5x LTM EBITDA purchase price multiple is 0.5x higher than the 8.0x LTM EBITDA multiple under the LBO scenario shown in Chapter 5. BuyerCo is able to pay a higher price in part due to its ability to extract $100 million in annual run-rate synergies from the combination. In fact, on a synergy-adjusted basis, BuyerCo is only paying 7.4x LTM EBITDA for ValueCo.

Sources of Funds

Assuming a 50% stock / 50% cash consideration offered to ValueCo shareholders, the sources of funds include:

• $2,350 million of stock (50% of $4,700 million equity purchase price for ValueCo), or 33.6 million shares ($2,350 million / BuyerCo share price of $70.00)
• $2,200 million of term loan B
• $1,500 million of senior notes
• $300 million of cash on hand (including $50 million of existing BuyerCo cash)

Uses of Funds

The uses of funds include:

• the purchase of ValueCo's equity for $4,700 million
• the repayment of ValueCo's existing $1,000 million term loan and $500 million senior notes
• the payment of total fees and expenses of $150 million, consisting of: i) M&A advisory and other transaction fees of $40 million, ii) debt financing fees of $90 million, and iii) tender/call premiums of $20 million¹²

The sources and uses of funds table is summarized in Exhibit 7.16 (excerpt from the transaction summary page) together with implied multiples of the pro forma combined entity through the capital structure and key debt terms.

Goodwill Created

Once the sources and uses of funds are inputted into the model, goodwill is calculated (see Exhibit 7.17). For the purchase of ValueCo by BuyerCo, we introduce additional complexities in calculating goodwill versus LBO Analysis in Chapter 5. Here, we assume a write-up of the target's tangible and intangible assets, as well as a deferred tax liability (DTL).

Goodwill is calculated by first subtracting ValueCo's net identifiable assets of $2,500 million ($3,500 million shareholders' equity – $1,000 million existing goodwill) from the equity purchase price of $4,700 million, which results in an allocable purchase price premium of $2,200 million. Next, we subtract the combined write-ups of ValueCo's tangible and intangible assets of $550 million from the allocable purchase price premium (based on a 15% write-up for the tangible assets and a 10% write-up for the intangible assets). Given this is a stock deal, we then add the deferred tax liability of $209 million, which is calculated as the sum of the asset write-ups multiplied by BuyerCo's marginal tax rate of 38%. The net value of these adjustments of $1,859 million is added to BuyerCo's existing goodwill.

Annual Depreciation & Amortization from Write-Ups

The assumed write-ups of ValueCo's tangible and intangible assets are linked to the adjustments columns in the balance sheet and increase the value of PP&E and intangible assets, respectively. As shown in Exhibit 7.18, these additions to the balance sheet are amortized over a defined period—in this case, we assume 15 years for both the tangible and intangible write-ups. This creates additional annual PP&E depreciation and intangible amortization of $22 million and $14.7 million, respectively.

Deferred Tax Liability

In Exhibit 7.19, we demonstrate how the DTL is created on the balance sheet in the Deferred Income Taxes line item and amortized over the course of its life. Recall that in Exhibit 7.17, we calculated a DTL of $209 million by multiplying the sum of ValueCo's tangible and intangible asset write-ups by BuyerCo's marginal tax rate of 38%. We then determined annual depreciation and amortization of $22 million and $14.7 million, respectively, in Exhibit 7.18. This incremental D&A is not tax deductible, thereby creating a difference between cash taxes and book taxes of $13.9 million (($22 million + $14.7 million) × 38%). Therefore, DTL is reduced annually by $13.9 million over 15 years, resulting in remaining DTL of $539.3 million on the balance sheet by 2017E.

Balance Sheet Effects

Balance sheet considerations play an important role in merger consequences analysis, factoring into both purchase price and financing structure considerations. They must be carefully analyzed in conjunction with EPS accretion/(dilution). The most accretive financing structure (typically all debt) may not be the most attractive or viable from a balance sheet or credit perspective. As such, the optimal financing structure must strike the proper balance between cost of capital (and corresponding earnings impact) and pro forma credit profile.

As in the LBO model, once the sources and uses of funds are finalized and goodwill created is calculated, each amount is linked to the appropriate cell in the adjustments columns adjacent to the opening balance sheet (see Exhibit 7.20). These adjustments, combined with the sum of the acquirer and target balance sheet items, serve to bridge the opening balance sheet to the pro forma closing balance sheet. After these balance sheet transaction adjustments are made, we calculate the pro forma credit statistics and compare them to the pre-transaction standalone metrics.

Balance Sheet Adjustments

Exhibit 7.21 provides a summary of the transaction adjustments to the opening balance sheet.

Strategic acquirers tend to prioritize the maintenance of target credit ratings, which directly affect their cost of capital as well as general investor perception of the company. Some companies may also require a minimum credit rating for operating purposes or covenant compliance. Consequently, companies often pre-screen potential acquisitions and proposed financing structures with the rating agencies to gain comfort that a given credit rating will be received or maintained. The ultimate financing structure often reflects this rating agency feedback, which may result in the company increasing the equity portion of the financing despite an adverse effect on pro forma earnings.

The balance sheet effects analysis centers on analyzing the acquirer's capital structure and credit statistics pro forma for the transaction. It is driven primarily by purchase price and the sources of financing.

Credit Statistics

As discussed in Chapters 1 and 4, the most widely used credit statistics are grouped into leverage ratios (e.g., debt-to-EBITDA and debt-to-total-capitalization) and coverage ratios (e.g., EBITDA-to-interest expense). The rating agencies tend to establish target ratio thresholds for companies that correspond to given ratings categories. These ratings methodologies and requirements are made available to issuers who are expected to manage their balance sheets accordingly. Therefore, acquirers are often guided by the desire to maintain key target ratios in crafting their M&A financing structure.

As shown in Exhibit 7.22, assuming a 50% stock/50% cash consideration offered to ValueCo shareholders, BuyerCo's credit statistics weaken slightly given the incremental debt raise. Pro forma for the deal, BuyerCo's debt-to-EBITDA increases from 1.5x to 2.6x while debt-to-total capitalization of 47% increases to 55.3%. By the end of 2013E, however, the pro forma entity deleverages to below 2.0x and further decreases to 1.4x by the end of 2014E (in line with BuyerCo's pre-transaction leverage). Similarly, by the end of 2013E, debt-to-total capitalization reaches 45.2%, which is slightly lower than the pre-transaction level.

At the same time, EBITDA-to-interest expense decreases from 10.3x pre-deal to 7.1x by the end of 2013E while capex-adjusted coverage decreases from 8.9x to 6.0x. These coverage ratios return to roughly pre-transaction levels by 2015E-2016E.Therefore, the pro forma combined entity has a moderately weaker credit profile than that of standalone BuyerCo. Within a relatively short time period, however, BuyerCo's credit profile returns to target levels. BuyerCo's use of significant equity as a funding source, combined with the synergies from the combination with ValueCo, helps to maintain credit ratios within an acceptable range.

Given the borderline nature of these pro forma credit statistics, BuyerCo may consider the use of more equity to ensure there is no ratings downgrade. As previously discussed, however, this typically has a negative impact on income statement effects, such as EPS accretion/(dilution). In order to assess these situations, it is common to sensitize the acquirer's pro forma credit statistics for key inputs such as purchase price and financing mix. In Exhibit 7.22, we sensitize key credit statistics (i.e., debt-to-EBITDA and EBITDA-to-interest expense) for purchase price and finance mix.

Accretion/(Dilution) Analysis

Accretion/(dilution) analysis measures the effects of a transaction on a potential acquirer's earnings, assuming a given financing structure. It centers on comparing the acquirer's earnings per share (EPS) pro forma for the transaction versus on a standalone basis. If the pro forma combined EPS is lower than the acquirer's standalone EPS, the transaction is said to be dilutive; conversely, if the pro forma EPS is higher, the transaction is said to be accretive.

A rule of thumb for 100% stock transactions is that when an acquirer purchases a target with a lower P/E, the acquisition is accretive. This concept is intuitive—when a company pays a lower multiple for the target's earnings than the multiple at which its own earnings trade, the transaction is de facto accretive. Conversely, transactions where an acquirer purchases a higher P/E target are de facto dilutive. Sizable synergies, however, may serve to offset this financial convention and result in such acquisitions being accretive. Transaction-related expenses such as depreciation and amortization, on the other hand, have the opposite effect.

Acquirers target accretive transactions as they create value for their shareholders due to the fact that the market usually responds favorably. Ideally, acquirers seek immediate earnings accretion although certain transactions may not be accretive on “day one.” Rather, they are longer-term strategic moves focused on creating value for shareholders over time. For this reason, as well as the fact that equity markets in general are forward-looking, accretion/(dilution) analysis focuses on EPS effects for future years. Therefore, accretion/(dilution) analysis captures the target's future expected performance, including growth prospects, synergies, and other combination effects with the acquirer.

Accretion/(dilution) analysis is usually a key screening mechanism for potential acquirers. As a general rule, acquirers do not pursue transactions that are dilutive over the foreseeable earnings projection period due to the potential destructive effects on shareholder value. There may be exceptions in certain situations, however. For example, a rapidly growing business with an accelerated earnings ramp-up in the relatively distant future years may eventually yield accretive results that do not show up in a typical two-year earnings projection time horizon.

The key drivers for accretion/(dilution) are purchase price, acquirer and target projected earnings, synergies, and form of financing, most notably the debt/equity mix and cost of debt. The calculations must also reflect transaction-related effects pertaining to deal structure, such as the write-up of tangible and intangible assets. As would be expected, maximum accretive effects are served by negotiating as low a purchase price as possible, sourcing the cheapest form of financing, choosing the optimal deal structure, and identifying significant achievable synergies.

Exhibit 7.23 is a graphical depiction of the accretion/(dilution) calculation, which in this case begins by summing the EBIT of the acquirer and target, including synergies. An alternative approach would begin by combining the acquirer's and target's EPS and then making the corresponding tax-effected adjustments.

Transaction expenses related to M&A advisory and financing fees may also be factored into accretion/(dilution) analysis. As discussed in Chapter 4, M&A advisory fees are typically expensed upfront while debt financing fees are amortized over the life of the security. In many cases, however, transaction fees are treated as non-recurring items and excluded from accretion/(dilution) analysis, which is the approach we adopt in our analysis.

The EPS accretion/(dilution) analysis calculation in Exhibit 7.23 consists of the following ten steps:

1. I. Enter the acquirer's standalone projected operating income (EBIT)
2. II. Add the target's standalone projected operating income (EBIT)
3. III. Add expected synergies from the transaction for the projection period
4. IV. Subtract transaction-related depreciation and amortization expenses (typically associated with writing up the target's tangible and intangible assets)
5. V. Subtract the acquirer's existing interest expense
6. VI. Subtract the incremental interest expense associated with the new transaction debt to calculate pro forma earnings before taxes¹³
7. VII. Subtract the tax expense at the acquirer's tax rate to arrive at pro forma combined net income
8. VIII. In the event stock is used as a portion, or all, of the purchase price, add the new shares issued as part of the transaction to the acquirer's existing fully diluted shares outstanding
9. IX. Divide pro forma net income by the pro forma fully diluted shares outstanding to arrive at pro forma combined EPS¹⁴
10. X. Compare pro forma EPS with the acquirer's standalone EPS to determine whether the transaction is accretive or dilutive

In Exhibits 7.24 through 7.26, we conduct accretion/(dilution) analysis for BuyerCo's illustrative acquisition of ValueCo for three scenarios: I) 50% stock/50% cash, II) 100% cash, and III) 100% stock. In each of these scenarios, we utilize the purchase price assumptions in Exhibit 7.15, namely an offer price per share of $58.73, representing an equity purchase price of $4,700 million and enterprise value of $5,950 million. We also assume the deal is structured as a stock sale.

Acquisition Scenarios—I) 50% Stock / 50% Cash; II) 100% Cash; and III) 100% Stock

Scenario I: 50% Stock / 50% Cash

In scenario I, a 50% stock/50% cash consideration mix is offered by BuyerCo to ValueCo shareholders. This serves as our base case scenario as shown on the transaction summary page in Exhibit 7.15. Public companies making sizeable acquisitions often use a combination of debt and equity financing to fund a given acquisition.

In Exhibit 7.24, 2013E pro forma EBIT of $2,066.4 million is calculated by combining BuyerCo's and ValueCo's EBIT plus expected synergies of $100 million. Transaction-related depreciation and amortization expenses of $36.7 million from the write-up of ValueCo's tangible and intangible assets ($22 million + $14.7 million) are then deducted. BuyerCo's existing interest expense of $140.6 million and the incremental interest expense of $206.4 million from the acquisition debt (including refinancing ValueCo's debt) are also subtracted. The resulting earnings before taxes of $1,682.7 million is then tax-effected at BuyerCo's marginal tax rate of 38% to calculate pro forma combined net income of $1,043.3 million.

In calculating pro forma EPS, BuyerCo's 140 million shares outstanding are increased by the additional 33.6 million shares issued in connection with the acquisition. Pro forma EPS of $6.01 is determined by dividing net income of $1,043.3 million by 173.6 million total shares outstanding. Hence, the transaction is accretive by 7% on the basis of 2013E EPS. Excluding synergies, however, the transaction is only accretive by 0.5% (see Exhibit 7.27). In Exhibit 7.24, the bottom section shows the pre-tax synergies necessary to make the transaction breakeven (i.e., neither accretive nor dilutive). In the event the transaction is dilutive in a given year, this analysis determines the amount of pre-tax synergies necessary to make pro forma EPS neutral to standalone EPS. Similarly, in the event the transaction is accretive, the analysis determines the synergy cushion before the transaction becomes dilutive.

Scenario II: 100% Cash

Scenario II demonstrates an illustrative accretion/(dilution) analysis assuming ValueCo shareholders receive 100% cash consideration. As shown in Exhibit 7.25, 2013E pro forma EBIT of $2,029.8 million after transaction-related adjustments is calculated in the same manner as Scenario I. However, interest expense is $120 million higher given the financing structure includes $2,350 million of additional debt to fund the $4,700 million equity purchase price for ValueCo. As a result, pro forma 2013E net income is $968.9 million vs. $1,043.3 million in Scenario I.

Pro forma 2013E EPS of $6.92 (vs. $6.01 in Scenario I) is calculated by dividing pro forma net income of $968.9 million by BuyerCo's fully diluted shares outstanding of 140 million. As the consideration received by ValueCo shareholders is 100% cash, no new shares are issued in connection with the transaction. Hence, as shown in Exhibit 7.25, the transaction is accretive by 23.2% on the basis of 2013E EPS, versus 7% in the 50% stock/50% cash scenario. From a balance sheet effects perspective, however, this financing mix is less attractive. Pro forma leverage in the all cash scenario is 3.6x vs. 2.6x in Scenario I (see Exhibit 7.22), which significantly weakens BuyerCo's credit profile and likely results in a credit ratings downgrade.

Scenario III: 100% Stock

Scenario III demonstrates an illustrative accretion/(dilution) analysis assuming ValueCo shareholders receive 100% stock consideration. As shown in Exhibit 7.26, total interest expense of $180.8 million in 2013E is the lowest of the three scenarios given no incremental debt issuance (beyond the refinancing of ValueCo's existing net debt). As a result, pro forma net income of $1,146.4 million is the highest. However, given the need to issue 67.1 million shares (twice the amount in Scenario I), pro forma 2013E EPS is $5.53 vs. $5.62 on a standalone basis. Hence, the transaction is dilutive by 1.5%, versus 7% accretive and 23.2% accretive in Scenarios I and II, respectively.

Sensitivity Analysis

Given the prominence of accretion/(dilution) analysis in the ultimate M&A decision, it is critical to perform sensitivity analysis. The most commonly used inputs for this exercise are purchase price, financing consideration (% stock and % cash), and amount of synergies. The data tables in Exhibit 7.27 show three different EPS accretion/(dilution) sensitivity analysis output tables:

1. I. Projection year and premium paid from 25% to 45%, assuming fixed 50% stock/50% cash mix and annual synergies of $100 million. Accretion decreases as purchase price is increased.
2. II. Consideration mix from 0% to 100% stock and premium paid from 25% to 45%, assuming annual synergies of $100 million. Accretion increases in accordance with a higher proportion of debt financing and a lower offer price.
3. III. Pre-tax synergies from $0 million to $200 million and premium paid from 25% to 45%, assuming fixed 50% stock / 50% cash mix. Maximum accretive results are achieved by increasing synergies and decreasing offer price.