technical factsheet 10 Mergers and Acquisitions

21 July 2008 1. Overview The possible takeover of Yahoo by Microsoft has been in the news since early 2008 but there have been so many twists and turns in the possible deal that its outcome cannot be predicted with reasonable assurance. This is developing into a classic case study in terms of the history of merger and acquisition activity, as all the options, including a no deal, are still very much open. Merger is a statutory combination of two or more companies, in which two approximately equal sized companies merge to combine forces. Merger includes combination, amalgamation, consolidation or joint venture of one corporation with another. An acquisition is when one company acquires another company. It includes take over of management control1 and purchase of assets or common stock of an enterprise by another undertaking. Mergers and acquisitions (M&A) usually aim at creating shareholder value over and above that of the sum of the two (or more) companies. This aim is achieved through synergy of merging companies that takes the form of revenue enhancement and cost savings of the new business. Mergers and acquisition are of three types as illustrated by the following table: Table 1: Types of M&A

Type of M&A
Vertical M&A Horizontal M&A Conglomerate M&A

Purpose
Forward M&A to control distribution Backward M&A to control supply chain To increase market power Diversification

M&A can be financed by one or more of the following sources: Bank borrowings known as leveraged buyouts Issue of shares to existing shareholders An all share deal where bidder issues shares to the shareholders of the company to be acquired, who end up with a majority of shares of the
1

Management Control refers to handing-over of operational decision making powers to the acquirer

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technical factsheet 10 Mergers and Acquisitions

bidding company. The bidding company however keeps the management control rights Loan note alternative which allows the shareholders of target company to take part or all of their consideration in loan notes rather than cash. This makes the offer attractive in terms of tax planning.

Glossary of Commonly Used Terms a) Poison Pill A strategy used by corporations to discourage a hostile takeover by another company. The target company attempts to make its stock less attractive to the acquirer. Flip-in2 and Flip-over3 are the most common types of poison pills. b) Friendly take-over In a friendly take-over, the bidder informs the companys board of directors before making an offer for acquiring its shares. c) Hostile take-over A take-over is considered hostile if: the board rejects the offer but the bidder continues to pursue it, or the bidder makes the offer without informing the board beforehand d) White Knight A white knight is a company that acquires another company with the intention of helping it, e.g. JP Morgan Chase acquired Bear Stearns in 2008, which helped Bear Stearns avoid insolvency after its share price declined to such an extent that its market capitalisation dropped by 92%. e) Reverse take-over A reverse take-over is one where a private company acquires a public company. f) Control premium It is an amount that a buyer is willing to pay over the current market price of a company. The premium is justified by the expected synergies e.g., expected increase in the cash flows resulting from cost savings and revenue enhancements achieved by a merger / acquisition.

2 A flip-in allows existing share-holders (except the acquirer) to buy more shares at a discount rate (as per the by-laws of the targeted company) 3 The flip-over allows stakeholders to buy the acquirers shares at a discounted price after the merger e.g. when shareholders have the right to purchase shares of the acquirer on a 2-for-1 basis in any subsequent merger.

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technical factsheet 10 Mergers and Acquisitions

2. Pakistan and M&A M&A activity has grown in Pakistan in the recent years. The Competition (Merger Control) Regulations 2007 (the regulations) regulate the mergers and acquisitions in Pakistan. For details of Competition Commissions regulation on M&A, please visit: Competition (Merger Control) Regulations 2007 Table 2: M&A in Pakistan

In Pakistan, banks have chosen to acquire / merge with other banks in order to comply with the statutory requirement of raising their paid up capital to at-least Rs.6 billion by the end of 2009. Although, some of the banks have tackled the requirement of capital adequacy by increasing their paid up capital, however M&A has become a business reality in the country. This has involved merger of investments banks with their mainstream banks as well as acquisition of smaller banks by the larger banks. The privatisation policy of the government has resulted in acquisitions of ABL, UBL and PTCL. LINKdotNET also expanded its operations and acquired WOL and DANCOM ONLINE to become the largest ISP in the country, representing the largest horizontal M&A transaction in this sector. Dalda Foods (Pvt) Ltd acquired Wazir Ali Industries, thereby eliminating competitors in the edible oil market of the country by acquiring the famous Tullo brand, which was a horizontal M&A activity. This resulted in increased market share of the edible oil sector for the acquirer.

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technical factsheet 10 Mergers and Acquisitions

In Pakistan there have been instances of conglomerate mergers for example, Fatima Group and Arif Habib Group acquiring 51% stakes in Pakarab Fertiliser Ltd and Azgard Nine Ltd acquiring Pak-American Fertiliser Ltd. 3. Benefits of M&A M&A results in a number of benefits including revenue enhancement, cost reductions, diversification of business activities, access to a wider range of markets, transfer of talents and resources as well as the following: Tax Benefits M&A result in following tax benefits: The Income Tax Ordinance, 2001 allows amalgamating companies to set off their business losses against the profits of the other company4, provided that the amalgamating companies continue their operations for at least five years from the date of amalgamation. Any unabsorbed depreciation of the amalgamating companies is also treated as an allowable expense of the merged entity Similarly, group companies have the option to be taxed as one unit5. The group companies can also surrender their assessed losses for the year (except the capital loss), which may be claimed by a company in the group for set off against its income in the tax year and the next two tax years6 The finance bill 2008 has also proposed to allow banking companies, nonbanking financial companies, modarabas and insurance companies to adjust accumulated losses against the income of the group during a tax year. Any un-used loss will also be allowed to be carried forward for six tax years following the tax year in which the loss arises Transfer pricing means the pricing of transactions between two or more related parties or between two or more segments of a company7. In Pakistan, income tax authorities can apportion / allocate income and expenses relating to transactions between group companies in such a manner which truly reflects the essence of the transaction8.

4 Section 57A, Income Tax Ordinance 2001 5 Section 59AA, Income Tax Ordinance 2001 6 Section 59B, Income Tax Ordinance 2001 7 Part 1 of Fourth Schedule, Companies Ordinance 1984 8 Section 109, Income Tax Ordinance 2001

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technical factsheet 10 Mergers and Acquisitions

4. Accounting Challenges A business combination brings about changes in accounting and reporting requirements of the combined entities, which usually depend on the following (See Table 3): Table 3: Accounting treatments for group companies Type of Investment Accounting Treatment Subsidiary Full consolidation Associate Equity accounting Joint Venture Proportional consolidation / Equity accounting The accounting of M&A covers following areas: Goodwill accounting ascertainment of fair value and capitalisation Minority interest calculation Treatment of pre / post acquisition profits Elimination of inter-group transactions In piece meal acquisitions, the accounting treatment usually changes with the change in shareholding structure of the acquirer. But, despite having 53% voting rights and the right to appoint five out of nine directors of PTCL, Etisalat is accounting for its investment as an associate using the Equity method, due to some control impediments involving financial and operating decision making of PTCL9. Enron remains a classic case study where Enron used equity accounting to report its off-shore special purpose entities (SPEs) which were used for tax avoidance, borrowing money and hedging. At the time of creation of these SPEs, Enron carefully drafted their capitalisation in such a manner that they would not have to be consolidated into its financial statements. This negated the basic accounting concept of substance over form which requires an entity to emphasise the economic substance of an event although its legal form may provide a different result. 5. Conclusion If you fail to plan, you plan to fail This saying seems appropriate for M&A like any other business transaction. Otherwise, history is full of examples of failed business combinations involving business giants e.g. Mercedes Benz and Chrysler Corporation. To make a business combination a success, the right balance between the strengths and weaknesses of the entities needs to be created in terms of their cultures and intrinsic values.
9 http://etisalat.ae/assets/docs/financial/2007Flash/Flash2007/pdfs/english/notes.pdf

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