Over the years you may have heard the terms ‘merger’ or ‘M&A’ thrown about in conversation and wondered, `What on earth is that?’ Well today is your lucky day because we’re going to take you through the ins and outs of mergers, hostile takeovers and joint ventures and give you a few tips on the way.
What is a merger/acquisition?
A merger is an agreement between two companies to create one larger company by joining the two companies together where one company is bought out by the other. An acquisition on the other hand is when a c0mpany simply obtains the majority stake in the firm without enacting any legal or name-based changes. The process is typically handled by merger and acquisition experts in an investment bank. So if you were wondering what investment bankers do all day that makes them so wealthy, then here’s your answer!
There are a number of ways that companies can complete a merger or acquisition and even more reasons for doing so.
Horizontal: Companies are from the same industry, producing the same product or services. The merger acts as a consolidation between the two or more firms with the goal of creating a larger business with more market share.
Vertical: Companies are from the same industry, but produce different products. They then team up to produce an entirely new product that uses a blend of both companies’ expertise. The goal here is to create or enter a new market more effectively by using a greater pool of resources and a wider distribution network.
Conglomeration: Companies are from completely unrelated industries or parts of the world. They typically occur when a firm wishes to expand its geographic reach or product range . These mergers are less common today, but were extremely popular in the 1960’s/
Consolidation: This creates an entirely new company where both companies are purchased and joined under the banner of the new entity. Here, the assets and liabilities of both companies merge to become the property of the new company.
Hostile takeover: This is another kettle of fish entirely and involves acquiring a company by approaching its shareholders directly for takeover approval without the consent of the company’s board of directors. While these are not particularly common, they attract a lot of media attention and cause aggressive spikes in the companies’ share prices.
Joint-ventures: This does not actually fall under the mantle of M&A, but often when a target company’s shareholders torpedo an acquirer’s advances, they often settle on doing a joint venture together. This is simply a collaborative project using both companies’ resources to maximise efficiency and profits, but does not involve any official merging of assets.
But what happens in the markets?
The immediate, and most common, effect of a merger announcement is a sharp rise in the share price of the target company and a drop in the acquiring company’s price. The size of the move depends on how surprising and how much of an impact the merger will make in terms of market share and overall performance for the companies.
It is not uncommon to see price changes in a range of 10%-70% for certain mergers that come as a shock to the market. So listening for merger whispers is always important and can be incredibly lucrative, if done right.
Why do prices move like this?
The reason this happens is simple. The acquiring company needs to pay a premium for the target company in order to entice the shareholders into approving the merger. These shareholders only benefit from the transaction if the company’s stock price rises and are unlikely to approve a deal that comes in below the current market price. Hence, an above market offer causes the price of the target company to rise.
On the other side of the equation, the acquiring company’s stock price falls temporarily due to the fact that it had to pay a premium for the target company and may have exhausted its cash reserves or used debt to pay for the merger. This would reflect badly on the balance sheet in the short term, but eventually equal out once the company realised the benefits of the acquisition.
The acquirer’s stock price can also fall if:
- Investors think that it overpaid for the target company
- The integration process between the two companies becomes messy or it runs into regulatory issues
- There is a slowdown in productivity as a result of friction between the management teams of the two companies
- There are unforeseen developments or costs that could impact negatively on the company’s performance
Companies that embark on M&A crusades are often great investment targets as they are typically in a growth phase or trying to re-invent their businesses structure to offset a decline in performance. Investing in an acquiring firm once the news has broken and sent its price lower can often be a very productive long term strategy that pays dividends once the company has put the newly-acquired resources to good use and offset the cash spent in the purchase.
How can I know about a potential merger?
Unfortunately, knowing when these mergers are going to happen is extremely difficult because companies like to keep them secret. Sometimes news will be leaked, but most often nobody will know for sure until the news comes directly from the source. By law, public companies must declare their intentions to acquire or merge with another company, but private companies have no such obligation.
Your best course of action would be to invest during the process, once the news has broken in response to developments in the merger timeline. If you do hear via the grapevine, however, that a merger is imminent, then buying into the target company quickly could make it your lucky day!
A general rule of thumb, however, is that Merger activity tends to increase in a low interest rate environment when money can be raised for ambitious ventures.
The Invstr feed is often a great source of inspiration for the latest movements in the news and markets. Articles from respected market news providers, such as Reuters, Bloomberg and CNBC also provide excellent merger-related news, which you can look out for in the feed and structure your portfolio accordingly!
Even though it is very difficult to pre-empt mergers, they offer an excellent opportunity to invest in growing companies. By keeping abreast of the news surrounding any M&A activity, you can often supplement your portfolio with promising companies that have the potential to add that additional X-factor to make your portfolio either outperform in the short term or grow consistently in the long term.