Implications of Acquisitions, Mergers and Divestments

CIMA-F3 · Chapter 11

Implications of Acquisitions, Mergers and Divestments

1 Introduction

Companies grow in two ways. They grow organically, by selling more of what they already make, and they grow by acquisition, by buying a business that somebody else has already built. This chapter is about the second route: why one company buys another, how the two boards see the same transaction from opposite sides, how the transaction is regulated, what it does to the tax position of everyone involved, and why the lenders may end up better off than the shareholders.

Chapter 12 takes the same story in reverse and looks at how an owner gets out of a business. Chapters 13 and 14 supply the valuation arithmetic that both chapters assume, and Chapter 15 deals with the price finally agreed and what happens after the deal closes.

The two words

A merger is the combination of two companies into a single business. The old shareholders of both become shareholders of the combined entity, and neither company survives as an independent business.

An acquisition (or takeover) is the purchase by one company of enough of another company's shares to give it control. The buyer is the predator (or bidder, or offeror); the company bought is the target (or offeree). The target normally continues to exist as a legal entity — it becomes a subsidiary.

An offer that the target's board recommends to its shareholders is a recommended bid. One the board opposes is a hostile bid. A hostile bid can still succeed, because it is the target's shareholders, not its directors, who decide whether to sell.

In everything that follows the two are treated as one transaction and referred to as M&A, because the financial questions — what is it worth, how do we pay for it, what does it do to our capital structure — are identical.

This recording predates the 2027 syllabus. It is sound on mergers and acquisitions, the types of combination and synergy; carry three things with you.

Regulation: it names the UK’s Competition Commission as the body that reviews acquisitions. That body was abolished in 2014, and F3 applies no national law: learn the principles under How takeovers are regulated.

Tax: it says the tax benefits of an acquisition are unlikely to be examined. The syllabus names taxation implications, and the section of that name teaches them.

Examples: Disney has never combined with NBC — treat it simply as an illustration of a conglomerate — and its other company examples are dated.

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2 Why companies combine

An acquisition is an investment decision like any other, and it is justified in the same way: it must increase the wealth of the predator's shareholders. There are only two ways it can do that.

The target is bought at an undervalue. The predator believes the market price does not reflect what the target is really worth, and pays less than the value it will receive. This argument depends on the predator knowing something the market does not — which, as Chapter 17 explains, is a strong claim to make about a traded share.
The combination is worth more than the two businesses separately. This is synergy: the idea that 2 + 2 = 5.

Synergy comes from four places, and a question that asks you to justify a bid expects you to say which.

Source of synergy	What it is	Typical examples
Revenue	The combined business sells more than the two would separately.	Cross-selling to each other's customers; a wider product range; access to a market or a distribution network that would have taken years to build; greater market power.
Cost	The combined business spends less to produce the same output.	Economies of scale (volume-related savings); economies of scope (complementary resources); one head office instead of two; one finance, HR and procurement function instead of two.
Financial	The combined business raises money more cheaply.	Greater asset backing supports more borrowing; a larger and more diversified cash flow reduces the risk of insolvency and therefore the cost of debt; surplus cash in one business funds investment in the other.
Tax	The combined business pays less tax on the same profits.	Unused tax losses in the target sheltered against profits elsewhere in the group; unrelieved interest or capital allowances brought into use. See the taxation section below.

Synergy is not the same as a good deal. The synergy belongs to whoever captures it. If the predator pays a premium equal to the whole of the expected synergy, the target's shareholders receive all of it and the predator's shareholders receive nothing — for all of the integration risk. The empirical record on takeovers is that most of the measured gain accrues to the target's shareholders.

Diversification is a weak argument on its own. Combining two businesses reduces the total risk of the combined cash flows, but it does not reduce systematic risk, and a shareholder who already holds a diversified portfolio has diversified away the rest for nothing (Chapter 16). Reducing total risk can still create value indirectly — a lower chance of insolvency lowers the cost of borrowing — but the argument has to be made in those terms, not as "we are spreading our risk".

3 Types of combination

Acquisitions are classified by the relationship between the two businesses. The classification matters because it predicts where the synergy will come from and how much attention the deal will attract from a competition authority.

Type	What the predator buys	Where the value is expected to come from
Horizontal	A business at the same stage of the same industry — a competitor.	Economies of scale, removal of duplicated overheads, greater market power. Attracts the closest regulatory scrutiny, because it directly reduces the number of competitors.
Vertical — backward	A business upstream in its own supply chain: a supplier.	Security of supply, control of input cost and quality, capture of the supplier's margin.
Vertical — forward	A business downstream in its own supply chain: a distributor, wholesaler or retailer.	Control of the route to market, capture of the distributor's margin, direct contact with the final customer.
Conglomerate	A business in an unrelated industry.	Financial synergy and the use of surplus cash. Operating synergies are hard to find, which is why conglomerates often trade at a discount to the sum of their parts (Chapter 12).

Classifying a combination

Classify each of the following.

A supermarket group acquires the wholesaler that supplies its stores.
A brewer acquires a chain of bars.
Two airlines combine to form a single group under a new holding company.
An entertainment group acquires a chain of fitness studios.

Solution

Backward vertical integration. The wholesaler is upstream — it sells to the supermarket.
Forward vertical integration. The bars are downstream — they sell the brewer's product to the final customer.
Horizontal. Neither is a supplier or a customer of the other; both operate at the same stage of the same industry. Note also that this is a merger, not an acquisition: two businesses become one new entity.
Conglomerate. Entertainment and fitness are unrelated industries.

Only the third of these is likely to be examined closely by a competition authority, because it is the only one that removes a competitor from a market.

4 How takeovers are regulated

Two quite different bodies of regulation apply to a public takeover, and they protect two different groups.

4.1 Competition control — protecting the customer

A merger or acquisition above a size threshold normally has to be notified to a competition authority, which decides whether it should be allowed to proceed. The authority's concern is not the shareholders of either company; it is whether the transaction leaves customers — households and other businesses — facing a market with less competition in it.

The test applied is broadly whether the transaction would result in a substantial lessening of competition in any market. The typical outcomes are:

Unconditional clearance — the deal proceeds as proposed.
Clearance subject to remedies — the parties agree to conditions, most often the divestment of overlapping businesses or brands (Chapter 12), or behavioural undertakings such as continuing to supply competitors on non-discriminatory terms.
Prohibition — the deal is blocked, or must be unwound if it has already completed.

The regulatory risk is a real commercial risk. A deal can be delayed by many months while an investigation runs, the parties often agree who bears the cost of a prohibition through a break fee, and a forced divestment can remove exactly the part of the target the predator wanted.

4.2 Takeover regulation — protecting the target's shareholders

Most developed markets also operate a takeover code: a set of rules governing the conduct of a bid for a listed company. Codes differ in detail, but they rest on the same general principles.

Equal treatment. All shareholders of the same class must be treated alike and given the same information at the same time. A better price cannot be offered privately to one block of shareholders.
Adequate information and time. Shareholders must be given enough information, and enough time, to reach a properly informed decision on the offer. Timetables are fixed so that a bid cannot be left hanging indefinitely.
No frustrating action. Once an offer has been made or is imminent, the target's directors must not take action that would frustrate it — issuing shares, disposing of key assets, entering unusual contracts — without the approval of the shareholders. The decision to sell belongs to the owners, not the board.
The mandatory offer. A party who acquires control must make an offer to all the remaining shareholders, on no worse terms. This stops control being bought from a few large holders while the rest are left as a minority in a company they cannot influence.

F3 applies no national law. The syllabus names no country's competition authority and no country's takeover code. Learn the principles above: they are what a question will be testing. If a question needs a specific rule — a notification threshold, the percentage that counts as control, a timetable — it will give it to you in the scenario.

5 The predator's decisions

This recording predates the 2027 syllabus. It is sound on the predator’s decisions, the target’s position and the defences; carry two things with you.

Competition authorities: where it says the competition authority works for local government, wants investment and jobs, and is usually quite open to acquisitions, that is wrong. A competition authority acts for customers and asks whether a deal would substantially lessen competition; it can clear it, impose remedies or block it (How takeovers are regulated). The Competition Commission it names was abolished in 2014.

Current events: the bid by PPG for AkzoNobel that it describes as in progress was withdrawn in 2017.

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5.1 The investment decision

How much is the target worth to us? Not what it is worth as it stands, but what it is worth in our hands, including the synergies we expect to realise. Chapters 13 and 14 give the methods.
What assumptions is that valuation resting on? Which economic, industry and company assumptions drive the answer, and how far can each move before the deal stops making sense?
Will the target's shareholders sell at that price? A valuation that nobody will accept is not a deal. The gap between the two is the subject of Chapter 15.

5.2 The financing decision

How the acquisition is paid for is a separate decision from whether to make it, and it is the one that most often causes trouble afterwards.

Question	What to consider
Matching — can we raise it?	Has the predator the surplus cash, the borrowing capacity or the ability to issue shares to fund the offer? Can the combined group service the finance raised — meet the interest and repayments out of the combined cash flows, not just the forecast profits?
Cost — what does it do to our capital structure?	Cash funded from borrowing raises gearing and financial risk; a share issue dilutes the existing shareholders' control and their earnings per share. Chapter 4 supplies the framework for deciding which is worse.
Capital providers — who else has a say?	Will existing debt covenants be breached by the extra borrowing or the change in the group's shape? Would issuing convertibles defer the dilution of control until the acquisition has proved itself? Is the current dividend policy still sustainable after the deal? Will EPS fall — and does that matter, given that EPS is an accounting measure and value is not?

5.3 Why predators overpay

Targets are frequently acquired for more than they turn out to be worth. Three reasons recur:

Over-optimism about synergy. Cost savings are easier to promise than to deliver, and the costs of achieving them — redundancy, system integration, management time — are routinely underestimated.
The target's share price already anticipates the gains. Once a bid is rumoured or announced, the target's price moves towards the expected offer. A premium measured against the post-rumour price understates what is really being paid.
The auction effect, or the winner's curse. In a contested bid the winner is, by definition, the bidder with the most optimistic valuation — which is precisely the bidder most likely to be wrong.

6 The target's perspective

The target's board faces a different set of questions, and it faces them on behalf of shareholders who may not agree with it.

What is the business worth to the predator? Knowing where the predator's synergies come from is the target's main negotiating asset — it tells the board how much of the gain it can demand.
What is the business worth to us if we keep it? The standalone value is the floor below which the board should not recommend an offer.
Do we want to sell at all? A board that does not is still obliged to put the offer to the shareholders.
What is the offer worth after the shareholders' own tax? A cash offer and a share offer of the same headline value are not worth the same after personal taxation — see below.
If the consideration is shares, are they attractive? Accepting shares means becoming a shareholder in the predator, and taking that company's business risk and share-price risk instead of cash.

It is the target's shareholders who decide. The board can recommend or reject an offer, but it cannot refuse it on the shareholders' behalf. That is why most of the gain on a takeover ends up with the target's shareholders: to succeed, the offer has to be good enough that a majority of them prefer it to keeping their shares.

6.1 Defensive tactics

Where a board opposes a bid, the defences available to it fall into four groups. All of them are constrained by the no-frustrating-action principle above.

Defence	How it works	Its limitation
Contest the offer	Argue publicly that the price undervalues the business, that there is no industrial logic, or that employees and customers would be harmed.	Persuasion only. It works if it convinces shareholders to hold out — and it commits the board to delivering the value it claims is there.
Reveal more value	Revalue assets that are carried below their worth; publish a profit or dividend forecast showing what the business will earn if it stays independent.	A forecast published in a bid is a promise the board will be held to. Advertising and forecasts during an offer period are normally subject to strict verification rules.
Refer the offer	Ask the competition authority to investigate, on the ground that the combination would lessen competition.	The authority acts for customers, not for the target's board. It will not block a deal simply because the directors dislike it.
Find an alternative	Introduce a white knight — a rival bidder the board prefers — or arrange a management buy-out so that the existing team acquires the business (Chapter 12).	It concedes that the company will be sold; it only changes the buyer. A rival bid also starts an auction, which raises the price the shareholders receive.
Poison pill	A right, written into the company's constitution in advance, that is triggered by a change of control and makes the company markedly more expensive to acquire — for example a class of shares that becomes redeemable at a high price the moment control passes.	It must be in place before the bid, because putting one in place during an offer is frustrating action. It also damages the company's own shareholders if it is ever triggered, so its value lies entirely in the threat.

7 Taxation implications

Tax does not usually decide whether an acquisition happens, but it very often decides how it is structured — and it changes what the transaction is worth to each side. The syllabus requires you to discuss the tax implications of an acquisition; it does not require you to compute anyone's tax bill under any particular country's rules.

7.1 Shares or trade and assets?

There are two ways to buy a business, and buyer and seller usually want opposite ones.

	Share purchase — buy the company	Asset purchase — buy the trade and assets
What changes hands	The shares in the target. The company itself is unchanged.	Named assets and liabilities. The selling company survives, holding the proceeds.
Liabilities	The buyer inherits everything, including tax liabilities and obligations that have not yet come to light.	The buyer takes only what is listed in the agreement. Unwanted liabilities stay behind.
Tax losses and allowances	Stay with the company and may survive, but a change of ownership commonly restricts their use, especially if the trade also changes.	Normally stay with the seller. The buyer starts fresh.
Base cost of the assets	Unchanged — the company keeps its existing tax base cost and continues its existing depreciation allowances.	Usually rebased to the price paid, giving the buyer larger future allowances.
Who is taxed on the gain	The shareholders of the target, on the disposal of their shares.	The selling company, on the disposal of the assets — and its shareholders again if the proceeds are then distributed to them.
Usually preferred by	The seller.	The buyer.

7.2 The target's tax attributes

Trading losses. An acquired company may carry unused losses. Whether the group can use them is a central question: many jurisdictions restrict the carry-forward of losses after a change in ownership, or after a major change in the nature of the trade, precisely to stop losses being bought.
Group relief and consolidated filing. Once control is acquired, the target may be able to surrender losses to, or claim them from, other group companies. This is where a genuine tax synergy usually lives.
Deferred tax and unrecognised liabilities. Uncertain tax positions in the target become the buyer's problem in a share purchase. Tax due diligence, indemnities and warranties in the sale agreement exist to deal with this.

7.3 Financing the acquisition

Interest on borrowing raised to fund an acquisition is normally deductible, which makes debt finance cheaper after tax than the coupon suggests. Two cautions:

Many jurisdictions cap the deduction — by reference to a fixed proportion of earnings, or by thin-capitalisation rules limiting the debt a company may carry relative to its equity. Gearing an acquisition heavily can therefore produce interest on which no relief is obtained.
Where predator and target are in different countries, withholding taxes on interest and dividends, and the relief available for them under a double-taxation treaty, affect how much of the target's profit actually reaches the parent.

7.4 The consideration, and the target shareholder's tax

A target shareholder does not compare offers at their headline value; they compare what they are left holding after tax.

Cash is a disposal. The shareholder realises a gain now and is taxed on it now.
Shares in the predator are generally treated as an exchange rather than a disposal. No gain arises at the time; the new shares inherit the base cost of the old ones, and the tax is deferred until they are eventually sold. The shareholder retains an interest in the business — and takes the predator's share-price risk.
Transfer taxes. Many jurisdictions charge a stamp or transfer tax on the transfer of shares. It is usually small relative to the deal, but it is a real cost and it is normally borne by the buyer.

Cash or shares, after tax

J holds 100,000 shares in T, bought some years ago for $1.20 each. P has offered, for each T share, either:

cash of $4.00, or
one P share for every two T shares held. P's shares are currently $8.10.

Gains on the disposal of shares are taxed at 20%. A share-for-share exchange is not treated as a disposal: the new holding takes on the base cost of the old one and the gain is taxed only when the new shares are sold.

Solution

	Cash offer	Share offer
Consideration received	100,000 × $4.00 = $400,000	50,000 P shares × $8.10 = $405,000
Base cost	$120,000	$120,000 (carried over)
Taxable gain now	$280,000	nil
Tax now at 20%	($56,000)	nil
Value in hand today	$344,000	$405,000

If J later sells the P shares at today's price, the gain will be $405,000 − $120,000 = $285,000 and the tax $57,000, leaving $348,000.

So the share offer is worth more on both measures — but it is not risk-free. J is left holding P shares, not money: the value depends on P's share price when J finally sells, and J has swapped a shareholding in T for a shareholding in a different business. The cash offer is certain and immediate, and costs $56,000 of tax to obtain.

This is why a bidder will often offer a choice, or a mix of cash and shares: different shareholders have different tax positions and different appetites for keeping an interest in the combined business.

No national tax law is examined. Rates, thresholds and reliefs vary between countries and the syllabus applies none of them. Every rate in the illustrations above is stated in the scenario, and a question will do the same. What is examinable is the reasoning: why a buyer prefers assets and a seller prefers shares, why losses may not survive a change of ownership, and why a share exchange defers a shareholder's tax where cash does not.

8 Debtholders versus shareholders

An acquisition redistributes wealth inside the combined business as well as between the two sets of shareholders.

When two companies combine, the cash flows available to service the debt of each are pooled. A shortfall in one business can now be met out of the other's surplus. This is the co-insurance effect: each set of debtholders is now, in effect, guaranteed by the other's business, and the probability that either is left unpaid falls.

The existing debt therefore becomes more valuable — and nobody has paid the debtholders anything for that improvement. The gain comes at the expense of the shareholders, whose residual claim is now shared with a larger and better-protected body of lenders. It is a transfer of value from equity to debt.

Shareholders can respond in two ways, and both are examinable points about the design of the deal:

Increase the gearing of the combined group, so that the extra debt capacity created by the combination is used rather than given away — which is one of the reasons an acquisition is often funded by borrowing.
Anticipate it in the covenants. Lenders who understand the co-insurance effect will also understand that it can be reversed by a subsequent demerger, which is why loan agreements commonly contain change-of-control and disposal covenants (Chapter 5).

A merger combines two companies into one; an acquisition buys control of one company for another. Either is justified only by an increase in the predator's shareholders' wealth, which requires the target to be undervalued or the combination to produce revenue, cost, financial or tax synergy — and the synergy is only worth having if the premium paid does not hand all of it to the target's shareholders.

Combinations are horizontal, vertical (backward or forward) or conglomerate. They are regulated twice over: by a competition authority acting for customers, and by a takeover code acting for the target's shareholders, whose general principles are equal treatment, adequate information and time, no frustrating action, and a mandatory offer on acquiring control. No national regime is examinable.

The predator decides what to pay, how to pay for it, and what the payment does to its gearing, covenants, dividend policy and EPS. Tax shapes the structure: a buyer usually prefers to buy assets, a seller to sell shares, and a target shareholder offered cash pays tax today where one offered shares does not. Finally, combining two balance sheets makes each company's existing debt safer — a gain to lenders, paid for by shareholders.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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