I am trying to get 'clued-up' on investment banking. I am particularly interested in M&A (Editor: mergers and acquisitions) because this area of banking seems to suit my personality and skills. My question is, what is the point of M&A?
*London School of Economics *
Do you intend to get married one day, Martin, or would you rather stay single? In other words, is there more value to you in combining aspects of your life with others, or operating alone?
Fear not, this is not a roundabout way of asking for your hand in marriage. The point is, in the business world this, in simple terms, is the conundrum facing companies and private equity houses when considering a merger or acquisition.
The single most glamorous event in the commercial world is what the media often refer to as a 'corporate takeover'. Technically, this is just a merger or acquisition, i.e. an M&A deal. A big wedding, if you will. The analogy should not be stretched too far as not all takeovers are friendly. Under the circumstances of a 'hostile' takeover, while some interested parties (e.g. a company's shareholders) are happy with the final arrangement, others (e.g. a company's management board) are not.
The biggest headlines in the business sections of the daily newspapers are reserved for M&As. CEOs only feel validated in the eyes of the City when they have a completed a takeover. Investment banks make their biggest fees by brokering M&A deals.
What motivates corporate predators to launch a takeover? And are they always good news for the shareholders who own the companies involved?
There are, in fact, only two 'good' reasons for mergers. The first is the creation of synergies. The second is the opportunity to buy something at an 'undervalue' (a value lower than the true value). There are 'bad' reasons too, and unfortunately mergers do not always come about for the right reasons.
Let's explore the good reasons first.
Synergies can be created when two companies are worth more together than apart and they can arise on the demand side or the supply side of a business.
On the demand side, there might be the opportunity for two companies to cross-sell products to each others' customers. Or the chance to use their expanded market power to control the way their products are retailed to customers.
On the supply-side, they might be able to eliminate duplicated costs, as, for example, the newly-combined company may not need two accounting or IT departments.
Buying a company at an undervalue is a matter of perception and opinion. If a potential buyer thinks the true value of its takeover target is higher than its current market value, and the chance to profit from the difference warrants the costs and effort involved, it will make a bid.
Everyone has a different perception of what constitutes 'true value' including the current owners - and the prospective sellers - of the shares who will vote for or against accepting a takeover bid.
Investment bankers help their clients form an opinion of the value of synergies and / or the true value of a company. If a bid is made, the bankers will also help manage the process and administer the small forest of paperwork involved.
The recent mergers between retail banks (eg RBS buying Natwest and, more recently, ABN Amro) have been principally cost-led, with massive savings available in the consolidation of their back-office functions.
In the technology sector, the buy-out of YouTube by Google was demand led.
Both of these mergers were between companies in the same industry as each other, at the same stage of production - ie they were horizontal mergers.
One way to unlock extra value in a company is by financing it in a different way. The primary trick of private equity houses is to buy-out a publicly listed company ('public' in that its shares - its equity - are able to be bought and sold on a public stock exchange) replacing its expensive equity using cheap debt.
In this vein, KKR's leveraged buy-out of Alliance Boots was a financial takeover. There were no synergies available to KKR, it not being a chemist.
So what are the bad reasons for takeovers? The worst reason of all is vanity: CEOs wanting to prove their mastery of the universe by playing the great M&A game. CEOs also get bored or frustrated trying to grow the profits of their companies by the old-fashioned route of selling more stuff to customers. They also come under enormous pressure from investment bankers hassling them to do deals (so the bankers can earn their huge fees).
Another bad reason is 'boot-strapping' where a company with weak earnings takes over a company with strong earnings, but without any extra earnings being created from synergies. Marrying a partner solely for their money and not for the joint benefits can end in tears.
The period from 2004 - 2007 saw unprecedented levels of takeover activity although the biggest takeover in history is Vodafone's $183 billion takeover of German wireless communications company Mannesmann in 1999.
The second biggest takeover of all time is arguably the most disastrous: the film company Time Warner's $165 billion merger in 2000 with internet service provider AOL. This deal is hard to beat for its destruction of the shareholder value of the company that gave the world 'Casablanca' - which is, by the way, Alice's favourite film. At the end of last year, Time Warner's CEO, Jeffrey Bewkes, hinted that a 'divorce' could be on the cards. Don't play that one again (Uncle) Sam.