Actuarial Notes

Mergers and Acquisitions

Mergers and Acquisitions (M&A) are the means of external, or inorganic, growth: a firm combines with or buys another business instead of building the capability itself, which is internal, or organic, growth. An acquisition creates value for the buyer only when the target's stand-alone value plus the present value of the improvements the combination makes possible exceeds everything the buyer pays for it.

V_{AT} = V_A + V_T + \text{PV(synergies)} - \text{Integration costs}

\Delta V_{\text{acquirer}} = V_T + \text{PV(synergies)} - \text{Integration costs} - P

P = \text{MV}_T + \text{Premium}

  • Symbols: V_A and V_T are the stand-alone intrinsic values of the acquirer and the target, and V_{AT} is the value of the combined firm. \text{PV(synergies)} is the present value of the cost savings and revenue gains that the combination makes possible and that neither firm could achieve alone. P is the price paid, the target's market value \text{MV}_T plus the premium for control, and transaction costs are added to it when they are material.
  • Definitions: In Hitt, Ireland and Hoskisson's terms, a merger is two firms agreeing to integrate their operations on a relatively equal basis. An acquisition is one firm buying a controlling interest in another to make it a business in its portfolio, and a takeover is an acquisition the target did not solicit. Horizontal acquisitions buy a competitor, vertical acquisitions buy a supplier or a distributor, and related acquisitions buy a firm in a highly related industry.
  • Organic or inorganic: Organic growth through new products, new markets and internal development avoids a premium and keeps control of the culture, but it is slow and its outcome is uncertain. An acquisition buys an established position and capabilities quickly, at the cost of the premium and the risk of integration. Cooperative strategies, such as alliances and joint ventures, sit between the two.
  • Reasons for acquiring: Hitt lists increased market power, overcoming barriers to entry, avoiding the cost and delay of developing new products, lower risk than internal development, more diversification, reshaping the firm's competitive scope, and learning new capabilities. Koller's value-creating archetypes include improving the target's performance, removing excess capacity from an industry, giving the target's products faster access to market, and buying skills or technology faster than they can be built.
  • Problems in achieving success: Hitt lists integration difficulties, inadequate evaluation of the target, large or extraordinary debt, an inability to achieve synergy, too much diversification, managers who are overly focused on acquisitions, and a firm that becomes too large. Most failures come back to two of them: paying too much, and not delivering the synergies the price assumed.
  • Synergies: Cost synergies, such as combining claims, policy administration or investment operations, are usually more reliable than revenue synergies, which depend on customers' behaviour. Integration costs are spent up front, while synergies take time to arrive and are often smaller than planned.
  • How the deal is paid: In a cash deal the acquirer's shareholders bear the whole risk that the synergies fall short. In a stock deal the target's shareholders become owners of the combined firm and share that risk.
  • In insurance: Insurers grow inorganically by buying other insurers, books of business and distribution, such as brokers and agencies. Buying a closed block competes with reinsurance as a way to transfer a book, and private equity has become a frequent buyer. A divestiture is the same test in reverse: a business should be sold when another owner values it at more than its value to the firm.

Who Captures the Value of an Acquisition An insurer bids for a competitor whose shares trade at $800 million, which is also its stand-alone intrinsic value. Combining the two claims and policy administration operations is expected to produce after-tax cost savings with a present value of $300 million, and the integration will cost $40 million. The insurer pays a 30% premium in cash. How much value does the deal create, and how is it shared?

Answer

\begin{align*}
P &= 800 + 0.30(800) \\
&= 1{,}040 \\
\Delta V_{\text{acquirer}} &= 800 + 300 - 40 - 1{,}040 \\
&= 20 \\
\Delta V_{\text{target}} &= 1{,}040 - 800 \\
&= 240
\end{align*}

The deal creates $260 million of value in total, and the target's shareholders take $240 million of it through the premium, leaving only $20 million for the acquirer. If the savings came in at $250 million instead of $300 million, the acquirer would lose $30 million. This is the usual pattern: sellers capture most of the value, and a small overestimate of synergy turns a modest gain into a loss.

An Earnings-Accretive Deal That Destroys Value An acquirer has 100 million shares at $20, earning $100 million, so its earnings per share are $1.00 and its price-to-earnings ratio is 20. It buys a target earning $30 million, valued at $360 million (a P/E of 12), for a 25% premium paid in new shares. The deal has no synergies. Find the effect on earnings per share and on the value per share.

Answer The price is 1.25(360) = 450, which needs 22.5 million new shares at $20.

\begin{align*}
\text{EPS}_{\text{new}} &= \frac{100 + 30}{100 + 22.5} \\
&= 1.0612 \\
\text{Value per share} &= \frac{2{,}000 + 360}{122.5} \\
&= 19.265
\end{align*}

EPS rises by 6.1%, only because the acquirer used high-P/E stock to buy low-P/E earnings. Value per share falls by $0.735, a loss of $73.5 million to the acquirer's shareholders and an equal gain to the target's. With no synergies, the premium was paid for nothing. Paying in stock meant the target's shareholders bore part of the $90 million premium themselves, because they now own 18.4% of the combined firm.

How it appears on the exam

  • CP-311 learning outcome 1b: Candidates critique and evaluate internal (organic) and external (inorganic) growth strategies. Questions describe a firm and a proposed acquisition and ask which of Hitt's reasons apply, which problems are likely, and whether organic growth or a cooperative strategy would do better.
  • CFE-201 learning outcome 1c: Candidates assess the impact on value creation of acquisitions and divestitures, using Koller's chapter on mergers and acquisitions. The calculation splits the value created between the two sets of shareholders, and the written part judges whether the synergies are credible.
  • Case studies: The CFE-201 case study of Tesla's acquisition of SolarCity supports questions on the financial risks an acquisition brings, such as debt taken on and related-party conflicts.

Exam traps

  • Total value against the acquirer's share: A deal can create value in total and still destroy value for the acquirer, when the premium exceeds the net synergies. State whose value the question asks about before answering.
  • EPS accretion as success: An increase in earnings per share says nothing about value. A deal paid in high-P/E stock is accretive even when it destroys value, and a value-creating deal can be dilutive at first.
  • Gross synergies: Synergies must be counted after tax and net of integration costs, and they arrive with a delay. Using gross, immediate synergies overstates the value the price can absorb.
  • Market value as intrinsic value: The target's share price may already include a takeover premium or expected synergies. Adding the synergies again counts them twice.
  • Merger against acquisition: A merger is an integration on roughly equal terms, while an acquisition makes the target a subsidiary. Using the words interchangeably in a written answer loses the distinction Hitt draws.