Mergers and acquisitions - Essay Example

? Table of Contents Introduction 2 HCL acquisition of Axon Plc. 3 Timelines of the acquisition 3 Deal Structure Analysis 3 Deal Valuation 4 Motives behind mergers and acquisitions 7 Synergy 8 Motives behind deal between HCL and Axon: 9 Merger waves 11 Reasons for merger waves 11 Types of bids in a merger 12 Hostile takeover bids 12 Factors in International mergers and acquisitions 14 Conclusion 15 Reference 16 Introduction The recent global economy has thrown up significant new developments in the last decade. New countries have taken dominance in the economic equation of the world. Companies have a large cash reserves. At the same time, it has now become to raise cash. All of this has led to increase in the number of mergers and acquisitions across the world. A specific development in this area is the increase of cross-border and international acquisitions. This has now become as the preferred mode of foreign direct investment (FDI). The objective of this paper is to analyze the concept of mergers and acquisitions through a case study. We will be analyzing the common factors and motives of going for an acquisition. We will also analyze the concept of merger waves and the result of the same on stock market. We will study the benefits and costs for the acquired as well as the predator company. Lastly, we will also analyze the defense mechanism taken in hostile bids. We will be analyzing the case study of acquisition of Axon Plc. by the Indian firm HCL Technologies. HCL acquisition of Axon Plc. HCL technologies, the fifth largest IT software and services provider completed its acquisition of Axon Group Plc., a UK based SAP consulting company on 15th December 2008. The acquisition was done for ?440 million (around Rs 3,100 crore – 647.75 pence per share) cash offer. Timelines of the acquisition The following sequence shows the important events that took place during the acquisition process: On 25 August 2008, it was announced that the boards of Infosys Technologies Limited ("Infosys") and Axon had reached agreement on the terms of a recommended acquisition by Infosys of the entire issued and to be issued share capital of Axon at a price of 600 pence in cash per Axon On 26 September 2008, HCL announced the terms of a cash offer to be made by HCL EAS Limited ("HCL EAS"), an indirect wholly owned subsidiary of HCL, for the entire issued and to be issued share capital of Axon at a price of 650 pence in cash per Axon Share (including the Interim Dividend of 2.25 pence announced on 26 August 2008) On 2 October 2008, the Axon Board announced that it had withdrawn its recommendation for the Infosys Acquisition and intended to recommend unanimously the HCL Offer On November 25, Axon approved the scheme of arrangement to implement its acquisition by HCL EAS. HCL got 99.9 per cent votes in its favor and the company acquired 34.7 million shares of the British firm On 15 December, 2008 HCL Technologies completed its ?441 million (around Rs 3,100 crore) cash offer Axon Group Plc. Deal Structure Analysis HCL EAS, an indirect wholly owned subsidiary of HCL Technologies which had been formed specifically for the purposes of making the offer, announced a cash offer to acquire the entire issued and to be issued share capital of Axon for ?441.1 mn. HCL EAS is a private limited company incorporated in England and Wales and an indirect wholly owned subsidiary of HCL Technologies. Axon shareholders received for each Axon Share 647.75 pence in cash. Shareholders who were on the register of members of Axon on 24 October 2008 will also be entitled to receive an additional 2.25 pence for each Axon Share held by way of the Interim Dividend. Such Shareholders therefore received an aggregate of 650 pence per Axon Share. Financing arrangements: The cash consideration payable by HCL EAS under the terms of the HCL Acquisition was funded using a combination of the HCL Group’s existing resources and committed loan facility arranged by Standard Chartered for the purposes of the HCL Acquisition. New debt was given to HCL EAS pursuant to a ?400,000,000 senior facility agreement between Standard Chartered as original lender and in various other capacities, HCL EAS as original borrower, HCL Technologies as original guarantor and HCL Bermuda Limited as parent. Deal Valuation For the purpose of valuation we have chosen the Discounted Cash Flow model. Since the firm is almost a debt free company so it does not make a difference whether we take Free Cash Flow to the Firm or Free Cash Flow to Equity. Although for the purpose of calculation we have taken free cash flow to the equity. The model calculates the value of the firm based on cash flow available to firm, the risk involved in that cash flow, and the growth rate of that cash flow. Free Cash Flow to Equity: The free cash flow to equity is defined as: FCFE = Net Profit – Capital Expenditure + Depreciation – Net Change in Working Capital + New Debt Issued – Debt Repayment All the factors that affect the cash flow to the firm have been associated with the revenues of the firm and then future prediction about those factors has been done. Risk: Risk is taken into consideration through cost of equity, which incorporates risk through beta coefficient between Axon’s returns and market returns. The cost of equity is calculated by Capital Asset Pricing Model as follows: Cost of Equity = Risk Free Rate + Beta Coefficient * (Risk Premium) Risk Free Rate 6.30% Beta Coefficient 0.567 Risk Premium 6% Cost of Equity 9.70% Risk Free Rate is calculated by taking the weightage average of the risk free rates of the regions where the Axon is having business. Majorly the firm has business in Europe, USA and Pacific Asia. The Risk Free Rate for the Europe is estimated through Euro Libor (7%), for the USA it is estimated through US Treasury bill rate (5%) and for the Asia pacific the risk free rate has been taken as 9% as being the region with highest risk among all. The revenues that come from each firm have been taken weights of these risk free rate; 70%, 19% & 5% for Europe, USA and Pacific Asia respectively. Beta coefficient has been calculated with respect to the return of FTSE 100 returns. Growth Rate: Growth rate for the year 2008 and 2009 has been taken only 5% because of the global economic slowdown, which had severely affected the IT industry. From 2010 onwards the growth rate has been predicted to be 10% till 2012 and then from there onwards the 3% of perpetual growth rate has been taken. Using all the three mentioned inputs we have calculated the present value of future free cash flows to the equity (?524.31 million) which shows the value of the firm currently. The per share value of the firm is calculated by dividing this figure by the number of outstanding shares of Axon and that came ?7.73, which is higher than (650 pence) what HCL had paid to Axon. Motives behind mergers and acquisitions There are many theories and motives that have given us useful reasons why mergers and acquisitions that take place. Williamson (1991) proposed the concept of transaction cost economics (TCE) through which an organization can find out ways of optimizing its activities so that the production and transaction costs are minimized. He proposed that it is generally cheaper to buy a generic product from an outsider which is having its core competency in the same area. However, firms might be interested in internalizing the above exchange. Therefore, firms might want to acquire other organizations. Another parallel theory that is often cited is the theory of resource dependence (Scott, 1987). It is proposed that organization exchange resources within their environment which include suppliers or competitors. Theorists claim that organizations go for acquisitions to take control over critical resources in order to decrease its dependence on outside. Mergers and acquisitions lead to organizations having access to critical resources thereby increasing their market power. Another motive in organizations going for mergers and acquisitions is the drive for organizations to acquire knowledge. Firms acquire or merge with other companies in order to take advantage of opportunities in organizational learning (Hamel, 1991; Kogut, 1988; Mowery, Oxley, & Silverman, 1996). This theory is based on the increasing importance of knowledge in achieving competitive advantage. Mergers are a preferred more of acquiring specific technical skills and capabilities that are difficult to buy (Mowery et al., 1996). Firms acquire organizations outside their own country in order to get knowledge about the market structure, the competitive intelligence and customer insights of the target country. Mergers are often the preferred mean of entry into foreign markets (Shan & Hamilton, 1991). Some other reasons, organizations go for acquisitions include ability to improve its competitiveness, market position and time to market. Mergers increase the ability of firms to provide value based products or services. Organizations also merge with others in order to reduce costs and share risks. Researchers (Oliver, 1990; Scott & Meyer, 1983; Zucker, 1977, DiMaggio & Powell, 1983) suggest that institutional environments play a very key role in organizations going for mergers and acquisitions. Institutional environments impose pressures on organizations to acquire other firms so that they are in agreement with the prevailing business environment and social norms. To summarize, the key factors and motives behind mergers and acquisitions include: 1. Increase in market power through erection of entry barriers 2. Increase in political power by ability to influence governing bodies 3. Increase in the key niche knowledge 4. Increase in the ability to provide differentiated products and services 5. Ability to enter new markets 6. Ability to reduce its resource dependence 7. Institutional pressures Synergy Synergy is the revenue enhancement or cost savings that arise as a result of the merger or acquisition. The two companies merging expect to get advantages from: Reduction in employee count – The merged entity can save money from reduction in jobs of employees in support functions such as accounting, marketing, HR and other departments Economies of scale – The large size of the merged entity leads to increased savings in procurement Acquisition of new technology – Companies learn new technologies skills which enable it to achieve competitive advantage Reach to new markets – Organizations are able to enter new markets through mergers and improve their visibility Motives behind deal between HCL and Axon: As a part of strategy, HCL has identified 8 focus areas to grow which include enterprise application services. For such opportunities, HCL followed a diligent selection process of proactively identifying target acquisition opportunities and evaluating them against the long term strategic growth objectives. The acquisition of Axon by HCL was at a time when UK based clients were asking for value-added services. At the same time, the competition in the IT services space was getting tougher with IBM, Accenture and HP getting huge advantages because of their large size and number of offerings. The acquisition was made at the time when the world economic cycle was witnessing a downturn. As a result, many organizations reduced their IT spend. Most of the largest clients of Axon were in relatively defensive sectors. Therefore, Axon was able to perform well in-spite of competitive pricing and uncertain macroeconomic environment. Axon is known for significant degree of success in creating a leading SAP implementation services in United Kingdom which gave HCL an attractive reason to buy. The acquisition would have enabled HCL Technologies to increase its expansion of product and services capabilities in SAP implementation services. The combined group of HCL and Axon called the Enlarged Group will provide ability to meet increasing client requirements. The merger provided a perfect fit because of Axon’s SAP implementation experience along with HCL’s scale and global reach. In addition, the US economy was suffering from economic downturn during 2008-2009. This had a negative impact on the revenues and profits of major IT companies. As a result, Indian IT service providers started focusing on Europe for business. Axon with its extensive reach, expertise and experience in the European market provided a suitable opportunity to HCL to increase focus on Europe. The combined strengths of HCL and Axon provide a number of potential benefits and opportunities: Axon had a high performance and employee-centric culture that fits in well with HCL’s “Employee First” philosophy Axon’s process consulting and implementation capabilities complemented HCL’s application and infrastructure management capabilities HCL’s services / industry offering will create value for Axon’s diversified blue-chip customer base with a strong position across the United Kingdom, North America, and Asia that is complementary to HCL’s own customer base HCL’s strong SAP presence in the US and Asia complemented Axon’s excellent position in the UK HCL’s position as a ‘Global Services Partner ‘of SAP would have strengthened Axon’s ability to win more transformational customers Merger waves It has often been found that mergers and acquisitions often take place in bundles with certain factors that operate at the level of industry. Brealy and Myers (2003) confirm evidence of occurrence of merger waves on an industry level. Mitchell and Mulherin (1996) propose that the merger activities are often clustered as per industry and are correlated to economic, regulatory and technology shocks in the industry. Other researchers (Mulherin and Boone, 2000; Andrade et al., 2001) also confirm existence of such merger waves. Economists have identified six major merger waves in United States, the first one starting in the 1890s. Reasons for merger waves Researchers have taken keen interest in analyzing reasons of such merger waves. The reasons for the same have been classified as neoclassical and behavioral (Harford, 2005). Jovanovic and Rousseau (2002) under the purview of the neoclassical model argued that technological changes in an industry lead to scattering of Tobin’s q. This results in firms with high q taking over the firms with lower q within the industry. Harford (1999) proposed that higher cash resources are associated with higher takeover activities. Rhodes-Kropf et al (2004) indicated that merger waves occur when the aggregate industry market valuation is higher as compared to the estimations of true valuations. The authors argued that the difference in valuations can be due to misplacement as well as presence of actual growth opportunities. Schleifer and Vishny (2003) argued that merger waves arise out of managerial timing of firm overvaluations. For merger waves to happen, it is necessary that there are significant economic motivating factors for mergers as well as low transaction costs so as to achieve large number of merger transactions. As a result, merger waves do occur without any industry shocks if there is enough liquidity at the macro-economic level. Types of bids in a merger Following are the types of bid that usually take place during the merger process: Friendly bids – Target’s Board of Directors is told of the bidder’s interest in the merger Hostile bid – Used when the target’s Board of Directors or management is unwilling to a merger or takeover Reverse takeover – Acquisition of a public company by a private company Backflip takeover – Acquiring company takes form of the subsidiary of the purchased organization Hostile takeover bids Hostile takeover bids occur when the target’s Board of Directors or management refuse to get acquired by the acquiring company. The bidder in this case continues to pursue in-spite of the opposition. Companies engaging in hostile takeover can use either of the following techniques: Tender Offer – The bidder makes a public offer to the target company sharehodlers. This offer is made at a fixed price which is above the current market price Proxy fight – The bidder makes attempts to persuade shareholders to get simple majority to replace the current management. The new management proposed will approve the takeover Creeping tender offer – Purchasing the target stock from the open market quietly For a hostile bid, the target company directors attempt to block takeover by various techniques: Advising shareholders against the merger Poison pill – Discouraging an acquisition by reducing the value of the target business or increasing the cost of acquisition. Some techniques include: Convertibles issue below market exercise prices Options to employees or directors which are exercised on event of takeover Compensation to customers in cases of acquisitions White knight – Identifying a bidder that the management and board is comfortable with and who can make an agreed takeover bid Increasing the market capitalization of the target company my acquiring or issuing new shares Factors in International mergers and acquisitions The internationalization of the merger and acquisition in the recent past is one significant trend. However, many of the mergers fail. This is because the decision to merge is primarily driven by business or financial viability rather than psychological or cultural issues (Bijlsma – Frankema, 2001). It is important to analyze the cultural factors in international mergers and acquisitions (Rondinelli & Black, 2000). Cultural factors in international mergers and acquisitions are studied at two levels – organizational as well as cultural factors. These factors have been keenly studied by different researchers. Larsson and Lubatkin (2001) assessed that clash in cultures during the merger leads to decline of the shareholder value at the acquiring organization. Marks and Mirvis (2001) argue that harmonious integration of the beliefs and values of the merging firms and the ability to integrate organizational culture is more important to merger success than financial or strategic factors. Besides these factors, the leadership of two firms also play a key role in the mergers (Malekzadeh and Nahavandi, 1998). Conclusion We have studied the primary reasons and motives of an organization going for merger. While some organizations decide to merge in order to enter new markets, other organizations acquire other firms having complementary skills. The firms that are merging aim to achieve synergies with the merger and increase revenues or cut costs. We also studied the various types of bid methodologies used by companies and the tactics for each. We studied the concept of merger waves and analyzed the reasons behind the same as either of technological shocks or availability of sufficient liquidity in the market to facilitate continual mergers. We studied the acquisition of Axon Plc. by HCL Technologies from India. Finally, we studied the cultural factors that take important role in the success or factor of the merger. Reference Andrade, G., Mitchell, M., Stafford, E., 2001. “New evidence and perspectives on mergers” Journal of Economic Perspectives” Vol.15, pp103–120. Bijlsma-Frankema, K. (2001). On managing cultural integration and cultural change processes in mergers and acquisitions. Journal of European Industrial Training, 25(2–4), 192–207. Brealey, R. and Myers, S., 2003. Principles of Corporate Finance, 5th edition. 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