This sub-section expands on the economics of mergers and acquisition (under Resources - Harvest Options) by considering the structuring and financing options for M&A deals. The attached presentation discusses how risk is distributed between the buying and selling shareholders when M&A purchase consideration is paid either in cash or in shares, and the basic forms of combination structures.
Synergies and merger value
In order for mergers and acquisitions to create value, cash flow of the combined entities must exceed the sum of cash flows of the individual entities before the combination. In other words, there must be synergistic cash (value) gains through the combination. From the perspective of the acquiring entity, the synergistic value gain must exceed the acquisition (takeover) premium in order that the M&A makes economic sense.
Two main types of synergy are operating synergy and financial synergy. Operating synergy comes in two forms: revenue enhancements and cost reductions. They may be derived in horizontal or vertical mergers. Financial synergy refers to the possibility that the cost of capital may be lowered by combining one or more companies.
Revenue-enhancing operating synergy may be more difficult to achieve than cost reduction synergies. It is defined as a newly created or strengthened product or service that is formulated by the fusion of two distinct attributes of the merger partners and which generates immediate and/or long-term revenue growth. They may come from sharing of marketing opportunities by cross-marketing each merger partner’s products. It may arise from a strong brand name, or a strong distribution network. They are more difficult to achieve, to quantify and build into valuation models.
Cost-reduction synergies may come as a result of economies of scale – decreases in per-unit costs that result from an increase in the size or scale of a company’s operations. Per-unit costs may decline because of “spreading overhead’ via increases in output levels, from increased specialization or labour and management and more efficient use of capital equipment, which might not be possible at low output levels. Diseconomies of scale may arise as the firm experience higher costs and problems associated with coordinating a large scale operation. Economy of scope is the ability of a firm to utilize one set of inputs to provide a broader range of products and services.
Financial synergy refers to the impact of a corporate merger or acquisition on the costs of capital to the acquiring firm or the merging partners. The extent to which financial synergy exists in corporate combinations, the costs of capital should be lowered.
The combination of two firms may reduce the risk if the firms’ cash flow streams are not perfectly correlated. If the acquisition or merger lowers the volatility of the cash flows, suppliers of capital may consider the firm less risky. Known as debt coinsurance, the offsetting earnings of the firm in good condition might be sufficient to prevent the combined firm from falling into bankruptcy and causing creditors to suffer losses. The problem with debt-coinsurance effect is that the benefits accrue to debt holders are at the expense of equity holders. Debt holder’s gain by holding debt in a less risky firm, and these gains come at the expense of stockholders, who lose in the acquisition, given that total returns that can be provided by a combined firm are assumed to be constant. In other words, the debt-coinsurance effect does not create any new value but merely distributes gains among the providers of capital to the firm.
Financial economies of scale are also possible in the form of lower flotation and transaction costs. A larger company has certain advantages that may lower the cost of capital to the firm as it enjoys better access to financial markets because it is considered to be less risky than a smaller firm. Costs of borrowing or raising equity are therefore lower for larger issues than for smaller issues as well.