M&A basics

Mergers and acquisitions are the work most people picture when they think of investment banking. Spring week interviewers will not expect you to structure a deal, but they may ask why a recent deal happened, whether it was a good idea, or how a bank helps. This lesson gives you the vocabulary and the logic to answer well.

Why companies buy other companies

• Growth: buying revenue, customers or new markets faster than building them
• Cost synergies: combining head offices, systems, sites or purchasing to cut costs
• Revenue synergies: selling each company's products to the other's customers
• Capabilities: acquiring technology, talent, brands or licences
• Consolidation: gaining scale and pricing power in a fragmented industry

Buyers are usually split into strategic buyers, companies in the same or a related industry, and financial buyers, such as private equity funds, which aim to improve a business and sell it on within a few years. Strategic buyers can often pay more, because they can count on synergies that a financial buyer cannot.

How a sale process works

When a private company or a division is sold, the seller's bank usually runs an auction to create competition. A typical process runs like this.

• Preparation: the bank and the company prepare materials and a list of likely buyers
• Teaser and NDA: interested parties see an anonymous summary, then sign a non-disclosure agreement
• Information memorandum and first-round bids: buyers receive detailed information and submit indicative offers
• Due diligence: a shortlist gets access to a data room and management, and advisers check the numbers, contracts and risks
• Final bids and negotiation: buyers submit binding offers and a marked-up sale and purchase agreement (SPA)
• Signing and completion: the SPA is signed, approvals such as competition clearance are obtained, and the deal completes

On the sell side, the bank aims to get the best price and terms. On the buy side, it helps a client value the target, decide how much to pay, and structure and finance the offer.

Premiums

To buy a listed company, a bidder normally pays a premium over the share price, because it is buying control and shareholders need a reason to sell. The premium is measured against the undisturbed share price, before any rumours of the bid moved it.

Cash or shares

A bidder can pay in cash, in its own shares, or a mix. Cash gives the target's shareholders certainty and means the buyer keeps all the upside, but it may need new debt. Shares let the target's shareholders share in future gains and synergies, and avoid borrowing, but they dilute the buyer's existing shareholders and tie the deal's value to the buyer's share price. Which a buyer chooses often signals whether it thinks its own shares are cheap or expensive.

Synergies

Synergies are the extra value created by combining two businesses. Cost synergies are more believable, because management controls them. Revenue synergies depend on customers, so markets treat them with more caution. A quick way to value synergies is to take the annual after-tax amount and multiply it by a sensible multiple, then subtract the one-off cost of achieving them.

If the premium paid is larger than the value of synergies, the buyer's shareholders are effectively handing value to the seller's. That is a sharp way to judge whether a deal made sense.

Accounting for the deal

Under IFRS 3, the buyer records the target's identifiable assets and liabilities at fair value, including intangible assets such as brands and customer relationships. Any excess of the price paid over those net assets is goodwill. Under IFRS, goodwill is not amortised. Instead it is tested for impairment at least once a year, and written down if the business is worth less than expected.

UK public takeovers

Bids for UK listed companies follow the Takeover Code, run by the Takeover Panel. A few rules come up often.

• Once a possible offer is announced, the bidder generally has 28 days to announce a firm offer or walk away, known as put up or shut up
• Anyone whose holding, with parties acting in concert, reaches 30% or more of the voting rights generally has to make a mandatory offer for the rest
• A contractual takeover offer lets the bidder buy out the remaining shareholders once it has acquired 90% of the shares the offer relates to
• Many deals use a scheme of arrangement instead, which needs approval from a majority in number of shareholders voting, holding at least 75% by value of the shares voted, plus court sanction

You do not need the rule numbers. Knowing that UK bids follow a strict timetable, and that 30%, 75% and 90% are the thresholds that matter, is more than most spring week candidates can say.