MF0011 Mergers and Acquisitions Q1. What are the steps for successful mergers?

Steps to a Successful Merger Mergers need careful planning to achieve financial goals, reduce problems and for profit-making. Drop in productivity is expected to be around 50% as people from different workplaces have differences of opinion. Even a successful merger can take three months to three years for the completion of recovery process in an organization. For employees, possibility of changes and uncertainty at workplace can create stress. This affects judgments, perceptions, and interpersonal relationships. Often reduced communication and increased centralisation as part of re-structuring in companies creates space for rumours and insecurity in employees. During these times, employees do not have much access to senior level managers. Active intervention is necessary to maintain the level of productivity and to assure employees. Some suggestions for a smoother restructuring and transition are: Circulate a consistent message in the combining entities from top down. Maintain consistent accountability and compensation throughout the company for similar positions. Find out new ways of structuring the company to bridge corporate culture differences. Establish gauge able objectives, especially in areas, which will for a common goal. Revamp the compensation plan to recognize the additional work required by transition. Plan different ways for people to get to know each other. be working together

Q2. Explain the key approaches to identify acquisition opportunities.

Ans. Identifying takeover opportunities The basic purpose of valuation of target companies is to locate possibilities of takeover. Valuation serves the purpose of identification of target companies for takeover as well as serves the basic purpose of fixing exchange ratio in case the target company is final y selected for acquisition. Some financial experts suggest selection criteria based on two approaches: 1|Page

MF0011 Mergers and Acquisitions 1. Present value analysis 2. Capital assets pricing.
Present value analysis The present value analysis is mostly similar to valuation on the basis of steady-state earnings and/or dividends for listed companies. The earnings or the target firm are projected and discounted at the acquirers cost of capital to obtain a theoretical market price of the shares of the target company. This is then compared with the actual market price to determine the net present value of investment in the target company. The following example gives you an idea of how to calculate theoretical price. Given data: i = k = Acquirer company's cost of capital 10% do = po = target company's payout ratio ` 1 per share. Target Companys market price per share ` 50 Target Company's merger @ 100% basis g = Target company's earnings and dividend expected to grow at 8% p.a. Using above data and the formula for the constant annual growth rate of (1+ g) dividend d0 i( g) as discussed earlier in dividend approach target company's theoretical price is as under: P (1 + g) 1(1.08) 1.08 p+0 (k g) = .10 .08 = .02 = 54 The theoretical price exceeds the market price, i.e., 54 50 = 4. Here, NPV is 4 per share. The result requires reconsideration. This approach does not consider the risk posture of acquisition, i.e., the portfolio effect. The capital assets pricing model considers this aspect as discussed below. Capital assets pricing this approach provide a superior theoretical framework as it also factors the risk. Present value analysis The present value analysis is mostly similar to valuation on the basis of steady-state earnings and/or dividends for listed companies. The earnings or the target firm are 2|Page

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projected and discounted at the acquirers cost of capital to obtain a theoretical market price of the shares of the target company. This is then compared with the actual market price to determine the net present value of investment in the target company. The following example gives you an idea of how to calculate theoretical price. Given data: i = k = Acquirer company's cost of capital 10% do = po = target company's payout ratio ` 1 per share. Target Companys market price per share ` 50 Target Company's merger @ 100% basis g = Target company's earnings and dividend expected to grow at 8% p.a. Using above data and the formula for the constant annual growth rate of (1+ g) dividend d0 i( g) as discussed earlier in dividend approach target company's theoretical price is as under: P (1 + g) 1(1.08) 1.08 p +0(k g) = .10 .08 = .02 = 54 The theoretical price exceeds the market price, i.e., 54 50 = 4. Here, NPV is 4 per share. The result requires reconsideration. This approach does not consider the risk posture of acquisition, i.e., the portfolio effect. The capital assets pricing model considers this aspect as discussed below. Capital assets pricing This approach provides a superior theoretical framework as it also factors the risk. The basic logic behind the model is that if expected rate of return, considering the risk element, exceeds the required rate of return, the target company is a good buy. The required rate of return is calculated by solving the following equation: E(Rj) = Rf + [E(Rm) Rf] (Bj) Where, E(Rj) = Required return 3|Page

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E(Rj) = Expected return E(Rm) = Expected return for market index Rf = Risk-free return Bj = Beta (normally based on past performance) j = Potential merger partner

Q3. Write a note on the five stage model.

Ans. To examine the issues that may contribute to the failure of acquisition and value destruction, a five-stage model of mergers and acquisitions was developed by the author Sudi Sudarsanam. This model advocates a view of M & A as a process rather than a transaction. The process is considered as a multi-stage one and a holistic view of the process is required to appreciate the links between different stages and develop effective value creating M & A strategies. The five stages comprise: corporate strategy evolution organising for acquisition deal structuring and negotiations post-acquisition integration post-acquisition audit and organisational learning Stage 1: Corporate strategy evolution The goal of M & A is to achieve corporate and business strategic objectives. Corporate strategy aims to achieve ways to optimise the portfolio of businesses that a firm has and how that portfolio can be modified in the interest of the shareholders. Business strategy aims to enhance the firms competitive positioning on a sustainable basis in its chosen markets. Both the objectives can be met by M & A but is only one of several alternatives including, for instance, strategic alliances, outsourcing, organic growth, etc. Generally, acquisitions are made by companies due to one or more of the following strategic intents: to gain market power to achieve economies of scale to internalise vertically linked operations to save cost on dealing with markets 4|Page

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to acquire complementary resources. The acquirer looks for capabilities that can be leveraged to enhance the competitive advantage of both the firms post-merger. Achievement of the objectives depends both on the conceptual and empirical validity of the strategy. M & A generally seeks to create value through: enhancement of revenue while maintaining the existing cost base reduction in cost while maintaining the existing revenue levels generation of new resources and capabilities, thus leading to revenue growth or cost reduction or both. Stage 2: Organizing for acquisition It is important to understand the decision process of acquisition because it has a bearing not only on the quality of the decision and its value creation logic but also on the ultimate success of the post-merger integration. There are two primary perspectives here: The rational perspective: This view is based on hard economic, strategic and financial evaluation of the acquisition proposal and the potential value creation. The acquisition is basically a matter of measurement of expected costs and benefits. The acquisition decision is assumed to be a unified view which requires commitment from all managers within the firm. The process perspective: This is based on soft human dimension. In this view the process of decision-making is more politically complex and has to be carefully managed so that the required clarity and commitment of managers is achieved, which is taken for granted in the rationalist approach. The authors contention is that the M & A five-stage process model ensures that the risk involved in value damage are potentially. structural in their foundation, and managing this risk effectively should be crucial while the acquisition is being considered. Stage 3: Deal structuring and negotiation The result of the processes described in Stages 1 and 2 is the specific target selection. Once the selection has been made by the firm, the merger transaction has to be negotiated or a takeover bid to be made. The dealmaking takes place in this stage.The deal structuring and negotiation process is complex and involves many interconnected steps including: 5|Page

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valuing the target company choosing experts like investment bankers, lawyers and accountants as advisors to the deal obtaining and evaluating maximum intelligence possible about the target company performing due diligence negotiating the senior management positions of the both firms in the post-merger context developing the appropriate bid and defense strategies and tactics within the regulatory and other parameters. Stage 4: Post-acquisition integration The objective of this important stage is to make the merged organisation operational so that the strategic value expectations can be delivered which drove the merger in the first place. Integration of two organisations is not just about making changes in the organisational structure and instituting a new hierarchy of authority. It involves integration of processes, systems, strategies, reporting systems, etc. Above all, it also involves integrating people and changing organisational culture of the merging firms, possibly to develop a new hybrid culture. Integration of organisations may require change in the mindset and behaviour of the people. It is, therefore, necessary to address cultural issues during the integration process. Since it involves redistributing the power between the merging firms, it is also a politically sensitive stage. Conflicts of interest and loyalty wil certainly come into play. This stage of the acquisition process is, therefore, a major factor which determines the success of the acquisition. The extent of integration depends upon the degree of strategic interdependence required between the two firms as a precondition for value creation and capability transfer. The value creation logic behind the acquisition dictates the extent to which the capabilities of the two firms need to be merged into a single organisation. The diagram below il ustrates the dimensions of need for interdependence vis--vis need for autonomy. The taxonomy results in four types of post-acquisition integration

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Preservation: There is a great need for autonomy so that the capabilities of the acquired firm are nurtured by the acquirer with judicious and limited intervention such as financial control while allowing. the acquired firm to develop and exploit its capabilities to the full. Holding company: This refers to involving no interaction between portfolio companies, with passive investment by parent more in the nature of a financial portfolio motivated by risk reduction and reduction in capital costs Symbiosis: This refers to two firms initially co-existing but gradual y becoming independent. Symbiosis-based acquisitions need simultaneous protection and permeability of the boundary between the two firms. Absorption: This means full consolidation of the operations, organisation and culture of both the firms over time. Stage 5: Post-acquisition audit and organisational learning Companies trying to grow through acquisitions need to develop acquisition making as a core competence and excel in it. Companies possessing the right growth strategy through acquisition and the necessary organizational capabilities to manage their acquisitions efficiently and effectively can sustain their competitive advantage far longer and create sustained value for their shareholders. For acquisition-making to become a firms core competence, possessing robust organisational learning capabilities is a 7|Page

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must. Developing such learning capabilities is thus integral to the M & A core competence of building effort by multiple or serial acquirers. It is, or should be, part of their competitive strategy.

Q4. Explain the role of industry life cycle.

Ans. Role of Industry Lifecycle Industry lifecycle has a crucial impact on mergers and acquisitions. The different stages of industry lifecycle are: Fragmentation Stage: The first stage of the new industry is referred to as fragmentation. In this stage, the new industry develops the business. The entrepreneur plans on how to introduce new products or services into the market. The twin problems of innovation and invention are overcome by the entrepreneur at this stage. Shake-out: In the industry lifecycle, the second stage is the shake-out stage. A new industry emerges in this stage and it is at this stage, competitors begin realising business opportunities in the emerging industry. There is a rapid rise in the value of the industry as well. To gain benefits of the growing opportunities, many firms enter this stage through mergers and acquisitions. Maturity: The third stage of the lifecycle is maturity. At this stage, the dominant business models efficiency gives companies a competitive advantage over competition (Kotler, 2003). Due to the presence of many competitors and product substitutes, the competition in the industry is rather aggressive. Cooperation, competition and price take a complex form (Gottschalk & Saether, 2006). To gain competitive advantage, some firms may shift some of their production overseas. Decline: The final stage of the industry lifecycle is the decline. It is a stage at which there is possibility of a war of slow destruction between businesses resulting in the failure of those with heavy bureaucracies. In addition, the market demand may be fully met or suppliers may have a shortage. In this stage many companies leave the market and many other try to take the advantage by acquiring companies which are performing low. Many companies also try to merge with other companies in the decline stage.

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MF0011 Mergers and Acquisitions Q5. What are the important forces contributing to mergers and acquisitions?
Ans. 1. Improved ASK financial performance. We are seeing more centers that are doing very well, with high revenues, profits and earnings before interest, taxes, depreciation and amortization (EBITDA) margins. It is not unusual now to see physician-managed centers that have EBITDA margins of 40 percent or more. Many centers have added ancillary services to improve their financial performance and have attended seminars, Such as those sponsored by the Ambulatory Surgery Center Association and ASK Communications, and have implemented the recommendations discussed. However, many have also seen their profit growth slowing and are seeking a sale to take some money off the table; at the same time, they attract a professional management company that will keep their distributions growing. 2. Diversification opportunity. The nation's economic difficulties and the impact this has had on investment assets such as stocks and real estate have increased an awareness of the importance of asset allocation. Many surgeons are overweight in the investments they have in their ASK business and real estate and realize that selling a portion of their interest will help them diversify their assets. This becomes accentuated for senior physicians who are planning their retirement and want to make sure their nest egg is adequately diversified. It is far better to sell an interest well before retiring to avoid significant discounting of a retiring partner's value to the center. 3. Increased deal flow. With more successful centers and more than 30 companies competing to acquire ASK interests, many centers are being bombarded with opportunities to sell a minority or majority share to a corporate partner. There are many good companies willing to buy minority interests and this makes a sale more attractive to many physicians as it allows them to retain a majority interest. For groups that want to take more money off the table, there is strong competition to buy majority interests as well. While it may be increasingly difficult for physicians to make a short list of the best 3-4 companies for them to solicit because of the growing number of companies, firms that specialize in ASK mergers and acquisition consulting can assist them to partner with the best companies and get the highest price. 9|Page

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4. Higher prices. Competition for good quality centers with growth potential has driven multiples higher. It is now common to see multiples for multi-specialty Asics in the 7-8 times EBITDA (less debt, plus cash) range. We are now seeing offers only slightly below this range offered for single-specialty Asics with significant cash flow and good growth opportunities. Minority interests are being valued in the 5-6 times EBITDA range. Buyers have money (some with credit lines of $200 million) and the credit crunch has not slowed their deal making. 5. Incentives to sell: Capital gains taxes, adverse legislation. We have seen a spike in ASK physician owners wanting to make a sale now because of an expectation those capital gains taxes will increase in 2009 to pay for wars, Wall Street bailout, etc. This anticipation of an increase in the capital gains tax rate is providing a strong incentive to seek the sale of interests in Asics prior to the enacting of new tax laws. Additionally, the fear of adverse legislation that could prohibit or restrict physician referrals to physician owned Asics, which could significantly reduce the value of all Asics, is also a factor. 6. Real estate sales. Many physicians who own their medical office building (MOB)/ASK real estate are interested in further diversification by selling their real estate as well as their ASK. We have advised and assisted clients to obtain some very attractive sale/leaseback deals offered by medical real estate investment trusts and private equity firms. These sales are sometimes done at the same time as the sale of the ASK or separately, albeit to completely different buyers.

Q6. What is leveraged buyout? Explain the different modes of LOB Financing.
Leveraged Buyouts (LOB) In the realm of ever-increasing globalization, mergers and acquisitions have assumed significance both within the country and across borders. Such acquisitions need huge amounts of finance. In search for an ideal mechanism to finance an acquisition, the concept of Leveraged Buyout (LOB) has emerged. LOB is a financing technique of purchasing a private company with the help of borrowed or debt capital. Leveraged buyouts are cash transactions where cash is borrowed by the acquiring firm and the 10 | P a g e

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debt financing represents 50% or more of the purchase price. Generally the tangible assets of The target company is used as security for borrowing by the acquiring Firm. Sometimes a part of the requirement is secured with the fixed assets of the firm and to raise the balance amount unrated or low-rated debt known as junk bond financing is utilized. 7.2.1 Modes of LBO Financing There are many types of financing used in an LBO. These include the following (in order of their risk): 1. Senior debt: The debt that is at the topmost rank amongst all the other debts and equity capital in the business is the senior debt. A typical structure of a bank loan is up to three trenches: A, B and C. Specific assets of the company generally secure the debt, which implies that if there is a breach in the obligations under the loan agreement, The lender automatically y takes over the assets; therefore the cost of debt Is lower. Usual y the obligations are quite stringent. A syndicate of banks and specialized funds generally hold the bank loans. Most of the times, the terms of senior debt in an LBO requires debt repayment over a period of 7 years approximately through equal annual installments. 2. Subordinated debt: In the order of priority in any liquidation, subordinated debt is ranked after senior debt. In this debt, the terms are less stringent compared to the senior debt. At the end of the term, repayment is required in the form of one bulet payment. Lending costs are typically higher in this debt as it offers less security to the Lender than in senior debt. The high yield bond, which is often listed in the Indian markets, is an increasingly significant form of subordinated debt. High yield bonds that are publicly handed over to institutional investors can either be senior or subordinated securities. Although they have stringent reporting requirements, they are fixed rate, can be publicly traded and offer long term securities with a looser covenant package In comparison to senior debt. 3. Mezzanine finance: It is an alternative to high yield bonds and is considered as a type of intermediate financing between debt and equity. It is usually high risk subordinated 11 | P a g e

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debt. The lenders can opt for an enhanced return which is made available to them by the grant of an equity kicker (e.g. warrants, shares and options) that can be Crystallized upon an exit. PICK is a form of this and reflects interest Pain in Kind, Or rolled up into the principal. It usually includes an attached equity warrant for larger financings. 4. Loan stock: It can be regarded as a form of equity financing once it is convertible into equity capital. An investigation should be carried out with the companys advisers whether or not loan stock is tax deductible. 5. Preference share: It is a part of the companys share capital. It gives a fixed dividend and fixed share of the companys equity which depends on the availability of adequate profits. 6. Ordinary shares: It is the riskiest among the parts of a LBOs capital structure. However, if the company is successful, majority of the upside wil be enjoyed by ordinary shareholders. 7.2.2 Governance aspects of LBOs Every restructuring programmer must generate some additional value for The business and for its stakeholders. The sources of value generation of An LBO are as follows: (a) Reduction in agency cost: An LBO privatizes a public corporation. In case of a public corporation, the management is different from owners. Management may take suboptimal decisions without approval of the owners, for their personal benefit. These are costs of agency that are avoided. (b) The second source of value gain is associated with efficiency. A private firm is arguably quicker in decision-making, and this is needed in a fast changing environment. A public corporation is inevitably bound by elaborate approval systems and documentary support for every decision. The cutting-out of this red tape can create value for an LBO. (c) Thirdly the tax benefit of leveraging, in view of tax deductibility of interest expense, is a distinct benefit. The concept of stepping up of assets for depreciation as an ingredient of LBO calls for additional tax advantages. (d) Final y, it is understood that management or investors in an LBO deal have more information on the value of the firm than the ordinary shareholders. Because of this 12 | P a g e

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information, a buyout proposal gives indication to the market that the post buyout scenario would certainly provide more operating incomes than previously expected or that the firm is less risky than perceived by the public at present. It is this asymmetric information, which adds value to an LBO and because of this value; the buyout investors do not mind paying large premiums on such deals. The values so created through an LBO exercise are exclusively meant for shareholders of the restructured firm and partly for the specialists engaged in such an operation. Basically, this is considered as a wealth transfer mechanism in a sense that because of the financial leverage, the Gain achieved by the shareholders came at the expense of the firms debt holders. 7.2.3 Leveraged buyouts and corporate governance Today, LBO firms are attempting to create value in acquired companies by enhancing profitability, pursuing growth that includes roll-up strategies (where the acquired company is used as the platform for more acquisitions of related businesses in order to gain critical mass and create economies of scale), and improving corporate governance to create a better.

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