Secret Education

Chapter 9 Merger and Acquisition

Merger and Acquisition (M&A):

Merger is the combination of two or more companies into one, where they unite to form a new
entity or one absorb the other.
Acquisition is when one company takes over another by purchasing a majority stake or all of its
assets, gaining control of that company.

Rationale for Mergers and Acquisitions

Mergers and acquisitions are driven by various strategic and financial motives aimed at
enhancing business value. The basic motives are as follows:
1. Synergy:
Combined companies create greater value together than separately—leading to higher
revenue, lower costs, and improved efficiency.
2. Economies of Scale:
M&A helps reduce costs by eliminating duplicate functions and optimizing operations,
especially in horizontal mergers.
3. Strategic Motives:
o Positioning: Strengthen future market opportunities.
o Gap Filling: Address weaknesses by combining complementary strengths.
o Organizational Competence: Acquire talent and innovation.
o Market Access: Expand into new or global markets.
4. Business Motives:
o Bargain Purchase: Acquire assets cheaper than building new ones.
o Diversification: Enter new industries to stabilize earnings.
o Short-Term Growth: Boost performance in slow-growth periods.
o Undervalued Target: Acquire firms at low cost for potential value gains.

Types of Mergers
Mergers are primarily classified into three types: Horizontal, Vertical, and Conglomerate.
Additionally, there are hybrid forms like Congeneric and Market-Extension mergers.
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1. Horizontal Merger
• Definition: Merger between firms in the same industry and stage of production.
• Purpose: Increase market share, reduce competition, achieve economies of scale, cut
costs, and expand market reach.
• Example: Merger between National Finance Ltd. and Narayani Finance Ltd.
• Concerns: May reduce competition, increase market power, and promote market
coordination among remaining firms.

2. Vertical Merger
• Definition: Merger between firms at different stages of the supply chain (e.g., supplier
and manufacturer).
• Purpose: Improve coordination, monitor performance, reduce transaction costs, and
increase profitability.
• Forms:
o Forward Integration: Merging with a customer/distributor.
o Backward Integration: Merging with a supplier.
• Example: Merck (manufacturer) merging with Medco (distributor).
• Risk: May limit market access for new entrants.

3. Conglomerate Merger
• Definition: Merger between firms in unrelated businesses or industries.
• Purpose: Diversification, stable earnings, long-term growth, and reduced risk.
• Example: General Electric entering financial services and media.
• Types:
o Pure: Completely unrelated industries.
o Geographical/Product Line Extension: Different products or markets but
similar consumer base.

Other Types
• Congeneric Merger: Firms offer related products to the same customers (e.g., TV
manufacturer merging with a cable company).
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• Market-Extension Merger: Firms serve different geographical areas or customer

segments (e.g., furniture and home appliance company merging).

Hostile vs. Friendly Takeovers

Acquiring Firm: The company that seeks to acquire another firm.
Target Firm: The company being acquired.
Friendly Takeover
• Occurs with the consent of the target firm's management.
• The acquiring firm proposes a merger; both management teams negotiate terms (price,
payment, etc.).
• If agreed, shareholders are informed, and ownership is transferred through formal
procedures.
• Target firm shareholders often become shareholders in the acquiring firm.
Example: ABC Ltd. (a commercial bank) acquires XYZ Ltd. (a finance company) through
mutual agreement.

Hostile Takeover
• Happens without approval of the target firm's management.
• Target’s management may resist due to reasons like low offer price or job security
concerns.
• Acquiring firm bypasses management and makes a tender offer directly to shareholders,
encouraging them to sell their shares.
• If enough shareholders agree, the acquiring firm gains control despite resistance.

Merger Analysis
Merger analysis is the process used to evaluate a target firm before a merger. It includes:
1. Valuing the target firm
2. Setting the bid price
3. Settling post-merger issues
1. Valuing the Target Firm
Valuation helps determine how much the acquiring firm should offer. The target firm also
evaluates the offer to decide whether to accept it, based on:
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• Its own independent value

• The offer from the acquiring firm
• Potential offers from other bidders
A target firm accepts an offer only if:
• The offer price exceeds its standalone value
• The offer price is higher than any competing bids
Two Common Valuation Methods:
a) Discounted Cash Flow (DCF) Analysis
• Projects future free cash flows of the target firm post-merger
• Uses a discount rate (cost of equity) to find present value of those cash flows
• Two types of mergers considered:
o Financial Merger: Firms operate independently; no synergy expected.
o Operating Merger: Firms integrate; synergy benefits expected.
• Interest expenses are included (unlike in capital budgeting) to reflect debt impacts.
Steps:
1. Estimate post-merger cash flows
2. Subtract interest expenses
3. Discount cash flows at the cost of equity
4. Sum the discounted values = Equity value of the target firm
b) Market Multiple Analysis
• Uses valuation multiples like P/E ratio, EV/EBITDA, etc.
• Compares the target firm to similar firms in the industry
• Example:
o Similar firm: Market Price = Rs 100; EPS = Rs 10 → P/E = 10
o Target firm's net income = Rs 500 million → Value = 10 × Rs 500m = Rs 5,000
million
• Other bases can include:
o Sales
o Book value
o Customers and cash flow per customer (used in telecom, cable, media sectors)
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2. Setting the Bid Price

After estimating value, the acquiring firm must decide the price it is willing to offer.
• If bid price > value, acquiring firm loses value (value dilution)
• If bid price < value, acquiring firm gains value
• Firms aim to set bid price below appraised value, but above current market price
Example:
• Appraised value of XYZ Ltd. = Rs 500 million
• Market value = Rs 450 million
• Synergy = Rs 50 million
• Bid price = Set between Rs 450m and Rs 500m

3. Post-Merger Control
Post-merger issues include management roles and employee retention. These must be negotiated
before finalizing the merger.
• Target firm's management may demand job security and retention
• Resistance may arise if employment is not guaranteed
• To gain support, acquiring firms often agree to retain key employees and management

Summary Table

Step Key Focus

Valuation DCF or Market Multiple method

Bid Price Setting Price between market value and appraised value

Post-Merger Control Employment, management roles, and integration issues

The Role of Investment Bankers in Mergers

Investment bankers play a central role in merger and acquisition (M&A) activities. They assist
both acquiring and target companies in various aspects of the transaction, making M&A a
profitable line of business for investment banks.
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1. Arranging Mergers
Investment bankers often act as matchmakers between firms with:
• Excess capital looking for investment opportunities
• Willingness to be acquired
• Strategic attractiveness (e.g., strong assets, technology, or market share)
• Dissident shareholders dissatisfied with current management
M&A groups within investment banks proactively identify and connect such firms to facilitate
potential mergers.

2. Developing Defensive Tactics (for Target Firms)

When a merger is hostile (i.e., unwanted by the target firm’s management), investment bankers
help target companies defend against takeovers using a range of strategies:
Common Defensive Tactics:
• Amending by-laws to require a supermajority for board decisions, making takeovers
harder
• Convincing shareholders the offer price is below the true value of the firm
• Share repurchases to raise the market price above the offer price
• White Knight strategy: Encouraging a friendly firm to acquire the company instead
• White Squire strategy: A friendly entity purchases a block of shares to block the hostile
bid
• Poison Pills: Strategic financial actions that make the firm less attractive to acquirers
(e.g., allowing existing shareholders to buy shares at a discount if a hostile takeover is
attempted)
• Employee Stock Ownership Plans (ESOPs) to increase insider ownership and voting
control
Investment bankers guide the target firm through choosing and implementing these tactics
effectively.

3. Establishing Fair Value

In friendly mergers, both firms typically engage investment bankers to conduct independent
valuations of the target company. This ensures both sides agree on a fair offer price, reducing
conflicts and expediting the deal.
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4. Financing Mergers
While some acquiring firms finance mergers with excess cash, others may need additional funds.
Similarly, target firms may require financing to implement defensive strategies.
Investment banks help by:
• Structuring financial packages
• Raising capital through equity or debt issuance
• Providing bridge financing or syndicated loans

5. Arbitrage Operations
What is Arbitrage?
Arbitrage involves buying an asset at a low price in one market and selling it at a higher price in
another.
In M&A Context:
• Investors speculate on takeover targets
• They buy shares of the target firm before a merger is announced, expecting the stock
price to rise after the announcement
• Sell shares post-announcement for a profit
This strategy, known as merger arbitrage, requires significant capital and market insight.
Investment banks often fund these arbitrageurs or engage in these activities themselves.

Summary Table

Function Description

Connects buyers and sellers; identifies strategic targets and

Arranging Mergers
opportunities

Defensive Tactics Helps target firms block hostile takeovers through strategic actions

Establishing Fair
Provides valuation services to ensure fair pricing in friendly deals
Value

Financing Mergers Structures financial solutions for both acquiring and target firms

Arbitrage Operations Engages in or funds speculative trading based on merger expectations

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Corporate Alliances
Corporate alliances refer to collaborative arrangements between companies where they operate
together to achieve common objectives but maintain separate ownership. Unlike mergers, which
involve full integration of assets and ownership, corporate alliances allow firms to benefit from
each other’s strengths while retaining independence.
Key Features of Corporate Alliances:
• Separate Ownership: Companies involved in corporate alliances retain individual
ownership but cooperate on shared goals.
• Shared Resources: The main goal is to share resources, information, capabilities,
innovation, and technology.
• Synergistic Effect: Companies aim to leverage each other's strengths to achieve a greater
outcome than they could independently.

Joint Ventures:
A joint venture is a specific type of corporate alliance where two or more companies come
together to achieve a specific objective, often for a limited time. The key characteristic of a joint
venture is that it involves shared management and decision-making from the parent companies.
• Short-Term vs Long-Term Alliances: Some corporate alliances are formed for short-
term projects (e.g., construction of a specific infrastructure), while others, like many in
the tech and pharma sectors, are long-term.
• Example of Joint Ventures: Commercial banks in Nepal often form joint ventures,
where management is shared between parent firms.

Private Equity Investment

Private equity (PE) refers to equity capital invested in companies that are not listed on public
exchanges. PE firms raise capital from wealthy individuals, pension funds, insurance firms, and
endowment funds to invest in businesses that have strong growth potential.
Key Features of Private Equity:
• Capital Sources: PE firms source funds from institutional investors and high-net-worth
individuals.
• Investment Objective: They target businesses that are poised for growth or can be turned
around to generate higher value.
• Not Publicly Traded: PE firms invest in private companies or buy out publicly traded
companies and take them private.
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Leveraged Buyouts (LBOs):

One of the most common strategies used by private equity firms is the Leveraged Buyout (LBO).
In an LBO, the PE firm acquires a company primarily using debt (leverage) rather than equity.
• Financing via Debt: The acquisition is largely financed by debt and repaid with the
profits generated by the acquired company.
• Sale of Assets: In some cases, a PE firm may sell off parts of the acquired company to
generate capital and realize synergies.
• Potential for Profit: Private equity firms aim to boost a company’s sales and
profitability, then either sell the company or take it public again to realize profits.
• High Risk: LBOs are high-risk ventures due to the heavy reliance on debt.

Summary Table

Type Key Feature Example/Use

HP & Disney, Apple &

Corporate Collaboration without ownership integration;
Motorola, Eli Lilly’s various
Alliances share resources, innovation, and capabilities
alliances

Joint Companies come together for a specific Joint venture commercial banks
Ventures objective and share management in Nepal

Invests in private companies or takes public

Private Leveraged Buyouts (LBOs),
companies private, often through leveraged
Equity Private Equity Firm investments
buyouts

Acquisition through debt financing, often with

PE firms using LBOs to acquire
LBOs the goal of improving profitability or selling
and resell companies at a profit
off assets

These strategies, corporate alliances, and private equity investments, allow firms to leverage
external resources, expertise, and capital to grow, innovate, or improve their market position.

Merger Activities in Nepal

Overview:
Mergers and acquisitions (M&A) in Nepal, especially within the banking and financial
institutions (BFIs) sector, gained momentum after financial liberalization in 1990. The NRB’s
Merger and Acquisition Byelaw (2011) and capital requirements in 2015 led to an increase in
M&As to strengthen institutions.
Key Dates:
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• 1990: Financial liberalization boosts BFI growth.

• 2011: NRB introduces Merger and Acquisition Byelaw.
• 2015: NRB increases paid-up capital requirements for BFIs, encouraging M&As.

M&A Trends (2004-2022):

• 2004-2011: Only 5 M&As.
• 2016-2017: Surge to 30 M&As after new capital rules.
• 2020-2022: Continued consolidation in BFIs.
By mid-2023, the number of commercial banks dropped from 31 in 2011 to 21, while
development banks and finance companies also decreased.

Notable M&As:
• 2022: M&As included Nabil Bank acquiring Nepal Bangladesh Bank and Global IME
Bank merging with Bank of Kathmandu.
Impact of M&As:
• Economies of scale and better management have been the primary drivers.
• Non-performing loans initially increased but improved in subsequent years.
• Public confidence, technology upgrades, and service expansions were notable benefits.
Other Sectors:
M&As also occurred in hydropower and insurance sectors, such as Himalayan Distillery merging
with Jawalakhel Distillery and several insurance firms merging to meet capital requirements.

Conclusion:
M&As have helped strengthen Nepal’s banking and financial sectors, improve efficiency, and
restore public trust. The NRB’s policies have been pivotal in driving consolidation, with more
M&As expected in the future.