M&A: Question & Answer - Deal Structuring and Financing

Q&A: Deal Structure & Financing

• Why are terms a very important component of any M&A transaction? How do terms influence price?
• Price can't significantly deliver control, but by implementing terms as subject to negotiations, acquirer could dictate the negotiation situations in order to better deliver control and push target company to accept the deal.
• Terms could influence price by using it as a bargaining chips. For example: 
• Final price bid --> final offer, acquirer's final decisions, price will not going up no more, exit  negotiations if target continue to ask more.
• Deadline: timing of the offer price, not valid any more in certain due date.
• Multiple offer --> increase offer price by stages of bidding.
• Offer reasonable price for more synergies and benefits. Push more target to negotiation table.
• Penalty and limit of the offer.
• Terms can change the offer price. For example: 
• Conditions of the purchase --> Off-market and on-market, whether involve special considerations such as special dividend, stock repurchase, options to sell the stock.
• Timing and proceeding of the purchase --> Whether in the bad or good macroeconomic conditions, final date of acquisition will define how much new share to issue, etc.
• Financing of the purchase --> market and target company dislike acquirer with lots of debt level, considering the cash and liquidity of the acquirer, financing by stock is less desirable.
• Payment forms and contingencies --> is there any liquid cash? is acquirer leave any contingencies clause to target?
• Legal structure of the combined entity after the purchase --> how former target management will involve? Is the new legal form will cultivate more benefits to shareholders and perform well in the longer term?
• Why is stock offer less desirable than cash offer from an acquirer's standpoint? And from a target shareholder's standpoint?
• Acquirer will prefer Cash Offer, because:
• Quick executions, faster to implement, reduce uncertainty about the deal overcome.
• Market reactions: Positive --> buyer stock price will go-up, since market suspect undervalued of buyer's intrinsic firm. Also, thanks to adverse selection, market suspect buyer's optimism about the future value of merger synergies.
• Stock Offer will bring ownership dilution as the acquirer share control and risk with target shareholders.
• But, the negative side effects are: 
• increase leverage/reduce acquirer's liquidity --> raising risk of bankruptcy.
• Increase overpayment risk --> bidder's cash offer usually higher than target's stock price.
• Tax payment directly after the announcement.
• Target will probably prefer Stock Offer, because: 
• Gain from acquirer's overpayment and asking for higher price than current stock price.
• Still have control over a new entity and could earn more profits by selling the stock at better price in the future.
• Deferred tax liabilities, since no cash involvement.
• But, the negative side effects is: 
• If the performance of new entity is worsen thus this could drive slump fall in the stock price and so the potential benefits will loss. 
• Driving uncertainty in the outcome of the deal and often trigger drawn battle due to target's board play for time.
• Due to adverse selection, Stock Offer could trigger Negative Market reactions, since market suspect of buyer's lack of financial capabilities and overvalued buyer's intrinsic value.

• What firm and market conditions predict financing choice? Why?
• Prefer Cash Offer : in high market volatility, strong acquirer's firm capital structure and unused debt capabilities, uncertainty about macroeconomic conditions (negative outlook signal), acquirer prefer for quick executions and save more by reducing time wasting. Strongly offer in the undervaluation of buyer's intrinsic value or uncertainty in the synergies and benefits post-merger. Also, in the small size of target's relative size compare to acquirer.
• Prefer Stock Offer : in good/more stable market conditions (positive outlook signal), acquirer lack of financial strength due to their limitation of cash and unused debt. Short-term profits, due to target could sell their stock in the future with better price. In overall large target's relative size, due to difficulty to fund acquisition with internal funding. 

• Why do acquirers sometimes use contingent payments?
• Uncertainty about the share price and market reaction in the final agreement date (highly volatility).
• Potentially acquirer's share price will fall significantly and so acquirer will issue more shares to maintain the same offer price --> ownership will diluted for something that wasn't the fault of acquirer.
• Wide disagreement about target's current value and benefits/costs of new legal entity after the merger.
• No guarantee about the new entity stock's future value 

• How can acquirers ameliorate target shareholder's risk aversion in stock deals?
• Minimum purchase price guarantee --> buyer gives put option (right to sell stock back to buyer at certain price)
• Purchase price collar --> with a fixed exchange risk, target get a minimum $ purchase price and also maximum $ price.
• Walk away clause --> deal is cancelled if Buyer's stock price falls too far.

M&A: Deal Structuring and Financing

Structuring choice

• Straight merger --> buyer merges with target and target ceases to exist
• Buyer absorbs all target's asset and liabilities.
• buyer shareholders must approve merger
• Triangular merger --> Buyer subsidiary and target merge
• Buyer absorbs all target's asset and liabilities --> cabins all in buyer subsidiary
• Not require buyer's parent shareholder vote.
• Target shareholders receive cash, notes or buyer parent stock
• Forward triangular merger: target ceases to exist.
• Reverse triangular merger: buyer subsidiary ceases to exist.
• Stock acquisition/purchase (including tender offer) --> buyer acquires all (or some of) target's stock for cash, acquirer's debt or stock.
• Target becomes a subsidiary of Buyer (not the case in partial acquisition)
• Target financial liabilities remain in target subsidiary.
• Asset acquisition --> buyer acquires specific target assets for cash, debt or stock
• Buyer only buy target's selected asset, not absorb their liabilities.
• Issues: tax implication --> identify existing double tax-system (from capital gain and dividend payment)
• In general, differences between purchase price and fair value of assets could be allocated as goodwill, of which the amortisation can create tax saving.

Price versus Terms

Price is the headline of M&A transactions, but secondary to terms
If one of the terms changes, price will changes. Both of them is subject to intense negotiation.
Bidding sends stronger signal than talking. Better by using the time limits, withdrawals, threats and other bargaining chips.

• M&A Terms:
• Condition of the purchase.
• Timing and proceeding of the purchase.
• Financing of the purchase.
• Payment forms and contingencies.
• Legal structure of the combined entity after the purchase.

Main concern of M&A participants --> to negotiate on terms

• Objectives / desirable:
• value creation.
• control and incentives
• financing flexibilities
• minimising transaction risks and adverse market signals
• enhancing governance, social responsibility.
• Constraints:
• Counter party objectives / desirables --> Zone of potential agreement (ZOPA)
• Owner's collective action: free-rider problems.
• Other stakeholders interests --> cost pay to lawyers, consultant, or government regulations.
• Contracting and financing costs.
• governance and tax regulations.
• Adverse selection:
• Outside investors cannot ascertain the true value of the firm.
• But suspect: managers issue shares --> if the firm is currently overvalued.
• Issue shares are "bad" signal --> high cost, share ownership of the firm, or as last resort (the firm cannot borrow any debt).

Payment choice

• Fixed payment: 
• often in the form of cash or debt securities.
• resolving uncertainty about the transaction.
• Semi-fixed payment:
• often in the form of junk bonds (very low credit worthiness), preferred stock and common stock.
• value may change upon the announcement of the deal --> different time of announcement date and arrival of other news?
• uncertainty about the realisation of the deal.
• may reveal negative investors reaction.
• Contingency payment:
• in the form of: earn-outs (additional payment to be made to target depend on performance in the future), warrants (a right, without obligation, to buy or sell something at an agreed price), convertible debts (the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value).
• value may change depending on the future target performances.
• Side payment:
• payments parties other than target owners
• Example: parties that influence in design & consummation of transaction to success of post-merger. Payment to union, guarantee of work rules, job security, government.

Financing choice (bidder financing decisions):

• New debt or reduce cash
• Effect: increase leverage, raising risk of bankruptcy and raise target taxes.
• Increase overpayment risk --> usually target's market share price is lower than the bidder's cash offer, thus no real measurement about under or overpayment.
• quick conclusion, reduce uncertainty about the deal overcome.
• Market reactions --> POSITIVE (buyer stock price will go up) due to market suspect: buyer's optimism about the future value of merger synergies and undervalued buyer's intrinsic firm value.
• Requires buyer financial strength --> must have sufficient excess of liquid assets or unused debt capacity.
• New debt will influence management discipline and increase monitoring of performance.
• Faster executions.
• Avoid buyer shareholder vote to approve deal.
• New equity
• Effect: dilute ownership, share deal risk with target (reflected in future share price, performance low --> share price decrease), raise stock liquidity (how easy it is to buy and sell shares without seeing a change in price).
• Floatation costs --> paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees.
• Drawn out battle --> lots of effort, more difficulty and time consuming.
• Market reactions --> NEGATIVE (buyer stock price will go down) due to market suspect: buyer's lack of internal financial capabilities (last resort) and overvalued buyer's intrinsic firm value. 
• Reduce buyer's risk of overpaying for a target. Performance of target decreasing --> stock price will decrease as well, target sharing risk of lower stock price between announcement of takeover and final due date.
• Buyer shareholders may have right to vote on the deal (because have a large block share  which meet the criteria to vote).
• Floatation exchange rate: adjusting the ratio price the acquirer decrease by 35%, thus price M&A will decrease by 35% (always remaining the same proportion).
• Risk bearing impact of financing choice
• Cash Deal:
• Buyer shareholders bear all deal risk --> overpayment risk (unrealised expected synergies & operating improvement)
• Target: no risk
• Stock Deal:
• Target shareholders bear short-term purchase price risk --> acquirer stock price will change up/down until deal completion date.
• Target overpayment shortfalls cause acquirer share price will fluctuate as investors learn about the true value of synergies & control benefits.
• What are potential problems if Buyer's share price falls substantially?
• Acquirer will issue more share to maintain the same offer price --> ownership will diluted for something that wasn't the fault of acquirer.
• Solution?
• Minimum purchase price guarantee --> buyer gives target owners put options on its stock (right to sell stock back to buyer)
• Purchase price Collar --> with a fixed exchange rate, target owners get a minimum $ purchase price, but they also accept a maximum $ price.
• Walk away clause --> deal is cancelled if Buyer's stock price falls too far.
• Special dividend --> shareholder is happy because excess of imputation credit --> get back to shareholders as dividend and also transferring tax credit.
• Equity-linked contingent Financing:
• M&A payments are contingent on Buyer or Target stock price or on Target asset value or profitability after deal completion.
• Contingent contract mechanisms are often used when:
• wide disagreement exists about a Target's current value & target will be operated as a separate subsidiary or division of Buyer.
• Target shareholders retain a minority interest in Target --> than fear expropriation by Buyer (ex: buyer purchase only 50.1% control)
• In stock deals where Buyer stock is highly risky, Buyer can offer a long term price guarantee on it's stock future value.