Factors of Takeover Failures - Essay Example

Factors of Takeover Failures Name Course Tutor’s Name Date Introduction A takeover is the acquisition (by purchase) by one company, known as the acquirer, of another company (the target). It can either involve purchase of a private or public company (with shares traded in the stock exchange). Depending on the communication to, willingness and reaction of the stakeholders (shareholders, managers, board, customers and employees) of the target company, a takeover can be friendly, hostile, reverse or backflip. The process of a takeover commences once the directors of the acquirer have substantial reasons and the financial capabilities to acquire a target company. Once the evaluation of the value or expected synergy to be derived from the acquisition, the negotiations are set to begin (Weston & Weaver, 2004). The valuation of the target firm determines whether the takeover will succeed or not. Thus proper valuation should compute the future expected cash flow and assess the synergies expected. The valuation process has to contend with the associated challenges especially when deciding what to pay the shareholders. Lastly, the Post-merger integration ensures that the two companies can work together to benefit from the union. The success of a takeover will depend on the pace of implementation of the last stage (Frankel, 2005). Motivation and evaluation Directors and managers of the acquiring company would wish to take over the target company because of the associated benefits that are expected to accrue as a result of the move. While others acquire in an effort to increase their own prestige and power, most business combinations have provided opportunities of creating new economic value for their shareholders. Some of the major factors include taking advantage of the economies of scale, improving target management, combining complementary resources, capturing tax benefits, providing low-cost financing to a financially constrained target, and increasing product-market rents. As a source of economies of scale, the coming together of the two participating firms succeeds when a function can be performed more effectively as a united force, than when the firms are separated. For instance, being telecommunications equipment makers, Alcatel and Lucent experienced considerable overlap in information technology, management, sales, and R & D activities. The move to merge was anticipated to generate operating synergies by eliminating duplicate functions cutting on excess capacity through minimizing costs in the material, general, research and administrative functions (Copland, Koller & Murrin, 2000). Secondly, an acquisition occurs to improve target management. If a firm has systematically underperformed in its industry, it qualifies as a target, either by bad luck or resulting from poorly made investment and operating decisions by the management. The firm managers could also deliberately pursue goals that increase the personal power despite increasing costs for the shareholders. However, value can be created for the shareholders through combining their complementary resources. If one firm has a strong distribution unit, it is sure to benefit by combining resources with one that has a strong research and development unit. For the Alcatel-Lucent case, Lucent’s global leadership in building IP multimedia subsystems and spread spectrum networks for third generation communication systems, would benefit from Alcatel’s strong market position in IP network transformation and triple play (Frankel, 2005). Mergers and acquisitions grant the merging parties numerous tax benefits, primarily through acquiring operating tax losses. By buying another firm that is earning profits made in the same tax jurisdiction as the losses carry-forwards, works if a firm is not going to earn sufficient profits to maximize operating loss carry-forward benefits. Consequently, the loss carry-forwards and operating losses of the acquiring firm will then be offset against the target firm’s taxable profit. Similarly, mergers benefit from the tax shield resulting from increasing leverage of the target firm. For a financially constrained target, a takeover will provide a low-cost source of financing. Such effects as capital constraints may result due to an imperfect capital market often times due to information asymmetries between management and outside investors. Severe information problems for newly-formed, high-growth firms make it hard for outside investors’ valuation due to the associated short track records and little sight in their growth opportunities via their financial statements. Lastly, mergers may be motivated because of the hope of increasing product-market rents. As a dominant firm in the industry capable of colluding to restrict their output and regulate prices, the two merging firms can thus increase their profits (Weston & Weaver, 2004). What and how to evaluate in a potential merger situation Once the directors of the acquiring firm are satisfied and ready to make the move, valuation of the target firm commences. Due diligence has been identified as the major challenge in the valuation stage of the acquisition process. In order to guide the acquisition process, it is necessary that value is assigned on the target company. The valuation process is conducted as a capital budgeting decision as it employs the Discounted Cash Flow (DCF) model, considering DCF (a) captures all vital valuation elements; (b) is based on the concept that investments add value when returns are greater than capital, and (c) has been proven practical through research and in the marketplace (Copland et al., 2000). The valuation process is a computation by discounting future expected cash flows over a forecasted period; adding a terminal value to cater for the period past the period forecasted; adding the present values of the investment income, other non-operating assets, and excess cash; and deducting the fair market values of debt; hence the equity value. However, the valuation process can either be conducted to assign value to the equity of Target Company, to value the target company on a short or long-term basis; and valuation can cater for company for liquidation or one of a going concern. Because most acquisitions aim at acquiring the equity of the target company, the acquirer will assume the targeted company’s liabilities, which will in turn increase purchase price. The economic value of a publicly traded company can be deduced from the market stock price, given by the value of the debt added to the value of the equity. Because stocks rarely trade in large blocks as compared to acquisition and merger transactions, caution should be taken while depending on market values within the stock market. Similarly, with low trading volumes, the publicly traded target’s value cannot be deduced from the prevailing market prices (Palepu et al., 2007). According to Rezaee (2001), the selection of income streams for discounting is another dilemma during the merger and acquisition process. Some of the commonly used income streams include Earnings Before Interest Taxes Depreciation & Amortization (EBITDA), earnings, Operating Cash Flow, Economic Value Added (EVA), Free Cash Flow, and Earnings Before Interest & Taxes (EBIT). Value in financial management is considered to occur when the difference between cost of capital and return on invested capital is positive. Additionally, Free Cash Flow is another form of reliable cash flows that can be used for valuation, as it accounts for future investments that ought to be made to maintain cash flow. EBITDA in comparison to FCF does not consider any and all future required investments. Furthermore, FCF is relatively reliable than other earnings-based income streams as well as EBITDA. Once the income stream for valuing the target firm has been identified, the discount rate for computing the present values should be determined. Based on the amount of risk expected of the free cash flows, the discount rate should increase as the risk associated with the investment increases (Straub, 2007). Excessive outlays The process of valuing the target company can include valuation of the assets; valuation of historical earnings; valuation of future maintainable earnings; valuation by comparing companies; or valuation of discounted cash flows. The valuation is thus a five-step process that begins with historical analysis, followed by performance analysis, estimate of cost of capital, estimate of terminal value, and ends with test/interpretation of results (Copland et al., 2000). According to Brown (2004), the historical analysis looks into the past performance of the target company by establishing the drivers of performance. This analysis is composed of such financial calculations as return on capital and free, benchmarking, cash flows, and ratio analysis. Secondly, the performance forecast conducted to estimate the target company’s future financial performance, necessitates the understanding of performance drivers and the expected synergies resulting from the merger. Third, the average cost of capital estimate will be used to discount free cash flows. Fourth, the terminal value estimate will be added to the forecasted period meant to cater for the time beyond the forecast period. Lastly, the calculated valuation results should be compared with independent sources, reviewed, and finalized before presenting to the senior management. During the financial analysis, the historical performance must be based on factual information. These evidences should represent the target company’s five to ten years’ financial statements. Such past performance analysis will be ground for a synopsis or forecast of the company’s future expected performance, and an aperture as to how their generated cash flows is invested. By assessing the price earnings per share (P/E ratio), it is possible to determine the effect of the merger on earnings. The higher the P/E ratio of the acquiring firm the greater the increase in EPS for the acquiring firm compared to the target firm (Palepu et al., 2007). Additionally, the exchange ratio is defined as the number of shares offered by the acquiring firm per every share of the target company. Apart from the computation of earnings during the financial analysis, the return on capital as a driver of value ought to be equally attended to. For instance, the EPS and P/E ratios cannot be compared with the combination of free cash flow and economic value considered more crucial drivers of value. Hence, the target company’s source of value creation – from capital structure or equity – should be determined. The three primary drivers of value include free cash flows; return on invested capital; and economic value added. According to Copland et al (2000), value drivers’ examples such as innovative products or great customers refer to the variables that affect the value of the company. With well identified value driver, the company functioning is next on the list, by establishing a fit of the driver between the acquiring and target companies. The value drivers are also categorized into levels in line with the management’s ability to influence. The generic value drivers in level 1 have minimum management influence; followed by business unit driver that have moderate influence; and finally operating value drivers that have high influence from the management. The performance forecast can commence once a strategic view of the target company has been made based on the identified value drivers. According to Palepu et al (2007), the valuation process cannot be considered successful unless certain special problems are taken into consideration. The valuation calculation can be influenced in the case of private companies, foreign companies and when a target company wishes to relinquish complete control. Valuation of a private company becomes a difficult process as there exist no marketplace for comparisons. Similarly, the private status means that the historical information will not be publicly available for access. And due to the increased uncertainty and risk, the computed discount rate will commonly be higher. On the other hand, the valuing process of a foreign company will necessitate inclusion of certain pertinent variables such as translation of foreign currencies, political risk, lack of good communication, and differences in regulation and taxes. Other computations such as forecast estimations should take into consideration the inflation rates of the foreign country; while foreign assets should be checked for hidden assets as there exist significant book and market values differences. Lastly, relinquishing of complete and total control by the target company to the acquiring firm will raise the value of the acquired firm. Hence, if no synergies are expected of the merger, the acquiring firm will not be justified in paying above minority value price (Brown, 2004). Poorly planned and executed integration Once the acquisition deal has been made, the process of making the acquisition work occurs as post-merger integration. This stage should be planned as it involves (a) finalizing the common strategy for the newly formed organization, to avoid imposing a strategy that may not fit on the other company, (b) consolidating duplicative services, compensation plans, operating procedures and corporate policies, (c) deciding on the level of integration, and (d) the authority of the new organization overall governor. Failure of the senior management to lead the post-integration process and instead delegating it to the middle level management will result in loss of synergy values (Straub, 2007). According to King et al (2004), a quick decision-making will be required during the post-merger integration (PMI), as the new organization should quickly fall in place for people to resume their responsibilities; against which lower levels of performance results due to delayed PMI. Planning also caters for people issues that impact of productivity and performance upon the acquisition is announced. People will concentrate on their jobs if open and quick communication is used to quell the rumors. Similarly, failed acquisition cases due of unmanaged resistance can benefit through communication, training, involvement and alignment. Furthermore, as a crucial challenge against PMI, the cultural gap resulting from ‘culture shock’ ought to have been identified in the due diligence stage and can be quelled by inventing a third, new corporate culture instead of forcing one culture upon another company. Other gaps that need be bridged include compensation plans and technologies. Once a uniform compensation plan and appropriate technology have been identified, necessary steps should be taken to retain high dependent quality personnel. The customers should also be retained by guaranteeing constant or even better quality on products and services. Finally, the PMI progress should be measured in order to assess the success of the acquisition (Rezaee, 2001). Conclusion The takeover is not complete until the PMI stage proves to be a success. Right from the initial evaluation stage, the focus of the acquiring company is to succeed in acquiring the target company. The decision to acquire depends on such factors as a source of economies of scale; move to improve target management; means of granting tax benefits to the merging parties; and as a source of low-cost source of financing. The evaluation process seeks to value the target firm and determine the amount that the shareholders will be paid. Valuation van be computed using discounted cash flow model, or using the free cash flow model. The valuation is conducted on historical earnings, on future maintainable earnings, by comparing companies, or by valuation of discounted cash flows. While using the exchange ratio model for a publicly traded company targeted for acquisition, the value drivers of the firm should be identified. Nevertheless, valuation should be carefully conducted in case of targeting a foreign company, private companies, or when the target company wishes to relinquish full control to the acquirer. However, the takeover process often results in loss of personnel, which is likely to impact the productivity and performance of the merger. Care should be taken in order to avoid loss of highly performing personnel, and thus prevent loss of customers. Lastly the post-merger integration should be implemented in time for the new company to generate returns for the investment. Reference list Brown, MM 2004, Takeovers: a strategic guide to mergers and acquisitions, Aspen Publishers, New York. Copland, T, Koller, T & Murrin, J 2000, Valuation: Measuring and Managing the Value of Companies, John Wiley & Sons, New York. Frankel, MS 2005, Mergers and acquisitions basics: the key steps of acquisitions, divestitures, and investments, John Wiley and Sons, New York. King, D. R.; Dalton, D. R.; Daily, C. M.; Covin, J. G. (2004). "Meta-analyses of Post-acquisition Performance: Indications of Unidentified Moderators". Strategic Management Journal 25 (2): 187–200. Palepu, KG, Healy, PM, Peek, E, Lewis, VB 2007, Business analysis and valuation: text and cases,Cengage Learning EMEA, London. Rezaee, Z 2001, Financial institutions, valuations, mergers, and acquisitions: the fair value approach, John Wiley and Sons, New York. Straub, T 2007, Reasons for frequent failure in Mergers and Acquisitions: A comprehensive analysis. Wiesbaden, Deutscher Universitätsverlag. Weston, JF & Weaver, SC 2004, Mergers & Acquisitions, McGraw-Hill Professional, 2004, New York. Read More