Do Mergers and Acquisitions Help Or Harm Your Portfolio?

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Do Mergers and Acquisitions Help Or Harm Your Portfolio?

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The Basics Of Takeovers

Finance nerds love mergers and acquisitions between companies (sometimes abbreviated to M&A). Billion-dollar deals shake up the market like nothing else, with traders glued to their screens tracking every movement. And that has knock-on effects for all investors and customers – including you. But how exactly does one company gobble up another? The process is complex – competing motives, regulators and negotiations create a minefield. We’re here to guide you.

What is M&A? Mergers and acquisitions are when two companies combine with the aim of creating a greater whole – like in those Captain Planet cartoons from the ‘90s.

In an acquisition, one company buys out another and the target is often absorbed into the larger company. A merger is traditionally understood as a combination of two equals (where both will cease to exist and a new combined company is created). In reality, the words are used fairly interchangeably: because two companies are rarely entirely equal, most deals are more accurately described as acquisitions, but “merger” puts a polite spin on it.

Why do companies do this? Once companies reach a certain size it can be hard to keep growing – but an acquisition can leapfrog you to the top. Shareholders of the acquired company can get a nice payday, either in cold hard cash or shares of the new, super-sized business. Joining forces might give two companies the oomph they need to dominate a market, rather than each struggling along solo.

Why do I need to know this? If you’re invested in the stock market, you’ll probably be affected by a merger or acquisition at some point. If you own shares in the target company, they’re likely to rocket in value once the news becomes public. But if you own shares in the acquirer, you’ll often see their price fall – though the bolted-on company might benefit performance in the long-run.

Understanding the mechanics of M&A, how to evaluate a deal and how prices might move during the process can help you make better decisions – and make you a pretty penny. Next up: different types of deals, and the means, motives, and opportunities you’ll see.

Types Of M&A

Different M&A varieties depend on the motivation for the merger. We’ll look at the main ones here.

Horizontal Merger: Where two companies that directly compete join up. Disney and Fox fused to spawn one monster film studio. The benefit is reduced competition and increased negotiating heft in the marketplace.

Vertical Merger: Where companies along a supply chain join up. For example, when cable TV company Time Warner merged with AT&T, a provider of the wires that pipe Time Warner’s content to viewers. Were McDonald’s to buy a farming company, that would also be a vertical merger, aiming to create efficiencies and hurt competitors.

Concentric Merger: Or “congeneric merger” – where companies selling to the same audience of customers join up. Like when dieting service Weight Watchers gobbled up Hot5, a maker of fitness apps.

Conglomerate Merger: Some entities are “holding companies”, which don’t have a core business outside of owning other firms. Warren Buffett’s Berkshire Hathaway has bought a stable of businesses like Dairy Queen and Duracell as investments. He keeps them all relatively independent from each other.

An acquisition can also help expansion into another country (as with Amazon buying Arab retail site Souq.com), or to snap up talented employees in an “acquihire” (like Google or Facebook hoovering up tech startups).

So companies merge to reap rewards? That’s the aim. Strengthened market position and economies of scale come easy when two companies swell into one bigger entity. The combined firm might be able to squeeze a better deal from suppliers. Then there’s the potential to cut costs by eliminating functions replicated across the two business. Disney laid off thousands of Fox employees doing similar jobs to folks already at the House of Mouse, hoping to run Fox’s operations more cheaply. These benefits – often referred to as synergies – can also be more obscure: like Disney dragging Fox’s X-Men characters into The Avengers films to assemble bumper audiences.

More cynically, buying a foreign company to shift your headquarters there can lower your tax bill, something called “inversion”. Burger King flipped itself to Canada when it gobbled up smaller chain Tim Horton’s in a whopper case of (legal) tax avoidance.

However, it’s very possible that these benefits will never materialize. Accountancy firm KPMG says 83% of mergers fail to deliver shareholder returns. Too often, the price for the target is too high; integrating two companies is rarely easy; and the fabled synergies turn out to be another CEO fantasy.

Despite that, M&A is a fever and the only prescription is more deals. A colossal deal can define a CEO, and that ego trip will drive the world until nothing beside remains. So how exactly does a monarch expand his or her fief?

How M&A Happens

M&A normally begins with whispers. Managers of each company meet and sound each other out. If things go well, the acquiring company will start a period of early due diligence, where they appoint bankers and lawyers to start nosing into the target’s finances and mull what they’re getting into.

How do they keep all this secret? They often can’t, and information leaks to the financial press – accidentally or on purpose. If journalists get hold of it, their reports can trigger big movements in stock prices.

Eventually (sometimes behind closed doors and sometimes in the glare of the media) the acquirer will decide whether or not to make a formal takeover offer. This will state the price the acquirer is willing to pay and outline the rationale for the merger. An acquisition can be an all-cash deal, an all-stock deal, or a combination of the two (more on that in the next session).

What happens then? The target firm’s management will decide to accept or reject the offer – sometimes in consultation with major shareholders. They might negotiate on price, or ask other companies to acquire them. That can trigger a bidding war, where multiple acquirers duke it out to buy the company (Disney had to outbid Comcast to nab Fox).

If the target’s management agrees to the takeover, a special meeting will be called for shareholders (the ultimate owners of the company) to accept or reject the offer. They generally say yes.

But even that doesn’t mean it’s a done deal. Regulatory authorities can block a takeover if they think it might create a monopoly that would hurt consumer choice or lead to the loss of a key national industry. These antitrust regulators can take their sweet time, and if a merger crosses national borders there can be regulators from several different countries involved.

Finally, usually many months later, the deal can close. At the appointed time, shareholders in the target company receive either cash or a bunch of new shares, and the deal is done. Phew!

(The details of all the above will vary from country to country, but you get the gist!)

When do acquisitions get hostile? Hostile takeovers are a controversial part of M&A where an acquirer buys up enough stock to gain ownership control of the target company, against its management’s wishes. The bad blood this stirs up can make it even harder to integrate the two firms.

Price is the key to any acquisition, hostile or not. Next, we’ll weigh what to pay for a firm.

How Deals Are Valued

Deciding on a “fair” price for a takeover is hard – but ultimately a company is worth what its investors will accept. Shareholders will generally expect a hefty premium over and above the pre-bid stock price to compensate them for the hassle and loss of potential future growth. An acquirer will generally offer a 20%-plus premium over the recent share price to tempt shareholders to agree to a deal.

How does an acquirer decide on a premium? It’s not easy. A target firm’s earnings, assets, and prospects for future cash flow give you an idea of what it might be worth. And when buying a target to expand into a new business, the acquirer can figure out how much it would cost to build that business from scratch – and refuse to pay much more than that upper limit. Brand reputation plus relationships with customers and suppliers also add value.

But the thing that really drives the premium (and indeed the attractiveness of the merger in the first place) is the potential for those lovely synergies. Target shareholders need to agree they will make more by selling than from just holding onto their stock. So the acquisition needs to create additional value from the companies. But again, synergies often fail to materialize – so shareholders have to be cautious if they’re accepting stock rather than cash. Don’t get caught holding shares in an acquirer that promptly suffers, having overpaid for its target.

Who actually decides? Buyers and sellers need to agree what the target firm is worth or there’s no deal. And because that can be hard, the M&A process is riddled with advisory firms. Consultants, accountants, auditors, and bankers swoop in, offering financial analysis, due diligence, and tax advice to both buyers and sellers so that (in theory), the price is right. The only guarantee in M&A is advisors’ titanic fees, which often run to the tens of millions.

And how is the price actually paid? If the acquirer has cash reserves to dip into then it can just use these. A hard-up or miserly acquirer can turn to debt instead, taking out a big bank loan to fund the deal. But when a transaction outstrips even what the acquirer can borrow, it can pay with its own stock – though as this is usually less attractive to investors in the target company, they may well have to up the purchase price.

An acquirer can issue new shares to give to the target’s shareholders: if the acquirer’s shares are worth $100 and the target’s $50, it might offer to exchange two shares in the target for one share in the acquirer, for example. Existing shareholders in the acquirer have their stockholding diluted, now owning a smaller proportion of a much bigger pie. And this forces the target’s shareholders to take on some of the risk of the merger, with a stake in the new venture’s success.

So share prices fly around like nobody’s business during M&A, but there are common trends. Next, we'll look at those – and maybe you can avoid losing out.

How To Trade M&A

How do stock prices move during an acquisition? Price fluctuations begin as soon as a deal is whispered: normally the target company’s share price immediately rises, and upon a formal offer the share price should instantly jump near the price offered – but remember it’s not a done deal yet.

However, the acquirer’s share price will normally fall because it’s using up resources, taking on debt, or diluting its existing shareholders – along with taking on risk. That risk, and the amount shares might fall, can vary: should shareholders believe the company is overpaying or won’t be able to successfully integrate the target company, they may abandon ship before the deal sails through.

Big acquisitions can face uncertain regulatory approval. Investors have to judge whether a deal will be approved: betting the target’s shares will fall if the deal’s dead on arrival at the regulator’s office.

Can I make money trading on this? Maybe! But you’re up against some of the fiercest traders in the world: M&A arbitrageurs. They track every word both said and unsaid, have a scarily detailed feel for regulators’ whims, and can build algorithmic trading programs to react instantly to developments.

You can try playing with these guys, but good luck. You could bet on information the professionals are ignoring, if you have a particularly strong hunch – but that’s very risky and you might prefer the lottery. Loads of M&A “news” prematurely erupts in some of the lower-quality corners of the financial press. Journalists want their name on scoops and not every publication has the same rigorous standards of verification – which means that you might be trading on a deal that’s already dead.

The fun of M&A is to sit back and watch the events unfold: big deals can fundamentally reshape society. What would Facebook be had it not bought Instagram and WhatsApp? Knowing how these deals work and how it can help or hurt the companies involved lends you insight. You’ll notice acquisitions all around you – and you’re perfectly primed to judge what matters.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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