Tuesday, February 16, 2016

Mergers and Acquisitions - Why Companies acquire other companies and why they don't.

The reasons why companies decide to acquire or merge with other companies are manifold and are as follows:


1.     Diversification especially for cyclicality reduction and to ease regulatory pressures: The idea for any business is to inject new blood and diversify. Diversity and product range plays a critical part in any merger or synergy. A buying company therefore may be able to break from a cyclical or seasonal market by acquiring a company outside of its product range, thereby diversifying its product range and evading profitability fluctuations. Similarly a business may operate in a stifling regulatory environment and might want to acquire a company or a business which operates in a relatively relaxed regulatory environment. This would allow greater flexibility in operations.


2.     Business Model: The business model of the company being acquired may be significantly more attractive. It may offer fewer benefits or may not be hindered by unions. The acquiring company may not be in a position to replicate that model and therefore may choose to acquire it altogether.


3.     Intellectual Property, Licenses and Rights: A very good reason for acquisition is usually to acquire intellectual property and/or licenses and rights that the company being acquired might own or enjoy. An example of this would be Mobilink’s recent acquisition of Warid which is being done for the large part to acquire the Warid spectrum which allows for 4G LTE operations, giving Mobilink an edge. Same holds true for trademarks, copyrights and patents in other cases. 


4.     Market Share and Growth: One of the major reasons and usually the riskiest one is the attempt to increase market share through acquisition. This usually happens when the companies are situated in the same market. A variant of this is to achieve market growth by acquiring a company in a market that is growing faster. The first of these is risky because it is open to regulatory challenges including competition challenges.  The second variant is very similar to diversification explained above.


5.     Production Capacity, Product Range and Product Line: Another common reason for merger and acquisition is to either increase production capacity or fill a hole in a product line.  For example a mobile telephony company may seek to acquire a broadband WLL company to ensure that it can also offer a dongle device as part of its product range. Similarly a fixed line telephony company may acquire a mobile telephony company to ensure that it can also cater to the mobile market. Another related example of this is Microsoft’s acquisition of Nokia. Microsoft wanted to take over Nokia to fill a hole in its product line i.e. smartphones. Obviously the acquisition turned out to be a colossal failure in strategy but nevertheless the idea behind it was sound.


6.     Sales Channels and other synergies: Another reason may be that a company might have effective sales channels and the other acquiring company may want to utilize these effective sales channels. It is not unusual for parent companies and subsidiaries to share sales channels. PTCL for example uses the sales channels of PTML Ufone which is its 100 percent owned subsidiary. So synergies in sales channels may actually be a very good reason for two companies to merge or one company to acquire another.


7.     Vertical integration: A company may acquire a supplier to ensure its supply lines are secured. This would be an example of backward vertical integration. In other instances forward vertical integration is also possible where a company may acquire its customer or a distributor.


8.     Local market expertise: A foreign company may want to acquire a local company to enter into the local market. Numerous such examples exist across the border in India, where companies have been acquired by foreign companies to acquire expertise and skills to operate in the Indian market. Such an acquisition or a merger allows a foreign buyer to acquire instantly the local market skill and expertise including knowledge of local customs, laws and obstacles germane to language and other cultural barriers.


9.     Defensive reasons and ulterior motives: Sometimes a company may acquire another company to become so disproportionately large that its acquisition by a third company would render it to challenges under the anti-trust and competition laws of the country. Another reason, usually an ulterior motive would be, that the management thinks having a larger company will mean greater executive compensation. This is usually a bad reason to acquire and often leads to unmitigated disaster.  Corporate greed is never a good reason for a merger or an acquisition.


10.  Target company’s reasons for being acquired: Equally important are the reasons for a target company or business (i.e. company that is being acquired) to allow itself to be acquired. These are:


a.     Anemic Profits and Survival: Usually if a company has little or no profits it would want to be acquired so as to survive.

b.     Competitive environment and Patent expiration:  A company may want to be acquired because it cannot face the aggressive competition by its competitors without extra help.  Another reason may be that a company may find itself in a situation where its exclusive patent is expiring and it may not be able to compete without extra help.

c.     Rapid growth or conversely stalled growth: In both cases a company may want to be acquired. In the event of rapid growth, to sustain working capital and in the event of stalled growth to further maximize profits.

d.    Shareholder pressure:  Shareholders may press for acquisition where a buyer is willing to offer complete liquidity to a group of shareholders.

e.     Technological obsolescence:  The technology used by a company may be obsolete or nearing obsolescence. It may want to be acquired so that the buyer may use it to convert it to new technology. In some ways we have seen such acquisitions in the print media market where newspapers have been taken over by technology companies who then convert existing newspapers into online portals.


The aforesaid reasons do not constitute an exhaustive list.


There are many reasons, administrative, legal and others, which may deter a company from acquiring or being acquired. These are as follows:


1.     Competition law concerns:  A merger may lead to anti-competitive and anti-trust challenges. The newly merged entity may become too big for its own good and such a merger may not be approved by the competition body or regulator. An excessively large market share or in Pakistan’s case any inhibition of competition when the merging parties cross thresholds defined by the Competition Act 2010 may automatically be challenged and may not be approved after the two review process.


2.     Regulatory concerns:  In certain industries, such as telecommunication in Pakistan, the regulator plays an important role in determining pricing structure and the role of a significant market player. For example the on cards merger/acquisition of Warid by Mobilink is still going to have to overcome regulatory hurdles and approvals.  Failure to get regulatory approvals for mergers can lead to 


3.     Surprises resulting from poor due diligence: This happens quite often in mergers and acquisitions. Nasty surprises such as an incomplete audit or failure to get an undertaking or overlooking a key balance sheet can have its own impact. Accurate due diligence would usually show the financial and legal health of an entity. An acquiring concern should not touch an encumbered target with a ten foot pole. It is not in a buyer’s interest to assume any liabilities which it is unaware of. 


4.     Lack of common vision: A lack of common vision between two managements may be a big deal breaker. A lack of common vision would mean that a convergence between the two managements would be impossible and therefore the merger or acquisition would be doomed from the start.


5.     Complex, Costly and Convoluted: Mergers and acquisitions are often very complex, are definitely very costly and extremely convoluted with regulatory codes and rules involved. The entire process requires a commitment and a spirit of fairness which is often lacking between two aggressive negotiating entities working at cross purposes. 


6.     Value reduction risk: Empirical evidence suggests that acquisition transaction often destroys value i.e. the acquiring entity or the merged entity is ultimately valued less than the two entities previously were in sum. Ultimately it is the opportunity cost of advantages gained from the merger or acquisition. Would that opportunity cost be acceptable?  Would it be offset by significant gains?  This is ultimately the call a merging or acquiring entity has to make.


7.     Seller’s acquisition risks: By putting itself out there for acquisition, a selling target exposes itself. For example a competitor may enter the bidding process only to be able to conduct due diligence on key and significant parts of the seller’s operations. It can obtain pay rates, HR data, proprietary information, key operating and engineering information, and product ranges both current and in pipeline.  Usually a confidentiality agreement is used to protect against this eventuality but their effectiveness is limited.


8.     Misdirected objectives:  An acquiring company may fail to pinpoint exactly what it wants out of the target acquisition. It may want the HR culture or work ethic but that may not happen simply because it takes over an entity. HR culture is not acquired but is embraced.


9.     Alternative of building instead of buying: An acquiring company may be acquiring a target because it wants to buy innovation and news ideas. However it may be cheaper for the acquiring company to actually invest in its own research and development which would lead to more organic innovation and add value to the company.


10.  Poor Governance, confusion and lack of leadership: In either merger or acquisition, there comes an extended period of poor governance because new management is slow in implementation of the plan or is unable to cope with fast changing situation on the ground. Poor governance causes confusion and is usually coupled with a lack of leadership. This is one of the major reasons to avoid a merger or acquisition situation because the risk is that residual benefits of any such acquisition would be squandered by either poor governance, infighting or confusion about the chain of command.

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