Investment Banking – Part Two – Chapter 7

Buy Side M&A

Disclaimer:
The opinions
expressed herein
are those only of the
presenter (author)
Zaemah Zainuddin
and do not
represent the advice December 2017
or opinion of Dar
Al-Hekma
University.
 Overview
• Mergers and acquisitions (“M&A”) is a catch-all phrase for the purchase, sale,
and combination of companies
• Facilitates a company’s ability to continuously grow, evolve, and re-focus in accordance
with ever-changing market conditions, industry trends, and shareholder demands
• In strong economic times, M&A activity tends to increase as company
management confidence is high and financing is readily available
• In more difficult times, M&A activity typically slows down as financing
becomes more expensive and buyers focus on their core businesses
• M&A transactions tend to be the high profile investment banking activity, with
larger, “big name” deals receiving a great deal of media attention.
• For the companies and key executives, the M&A decision is usually a
transformational event 2
 Overview
• Investment banking advisory assignment for a buying company is referred
to as a “buy-side” assignment
• Core analytical work on buy-side advisory engagements centers on the
detailed financial model
• Banker also advises on key process tactics and strategy, and plays the
lead role in interfacing with the seller and its advisor(s)

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Buyer Motivation
 Buyer Motivation
· Decision to buy another company is driven by numerous factors,
including the desire to grow, improve, and/or expand an existing
business platform
– Growth through an acquisition represents a cheaper, faster, and less risky
option than building a business from scratch
– Greenfielding a new business or product is typically more risky, costly, and
time-consuming than buying an existing company with an established
business model, infrastructure, and customer base

· Successful acquirers are capable of fully integrating newly purchased

companies quickly and efficiently with minimal business disruption.

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 Buyer Motivation
• Acquisitions typically build upon a company’s core business strengths with
the goal of delivering growth and enhanced profitability to provide higher
returns to shareholders

• For acquisitions within core competencies, acquirers seek value creation

opportunities from combining the businesses, such as cost savings and
enhanced growth initiatives

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 Synergies
· Synergies refer to expected cost savings, growth opportunities, and other
financial benefits that occur as a result of the combination of two companies

· Size and degree of likelihood for realizing potential synergies plays an

important role in framing purchase price

· Buy-side deal team must ensure that synergies are accurately reflected in
the financial model and M&A analysis.

· Upon announcement of a material acquisition, public acquirers typically

provide the investor community with guidance on expected synergies

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Acquisition Strategies
 Acquisition Strategies
Companies use various acquisition strategies for growth & enhanced profitability
· Horizontal integration is the acquisition of a company at the same level of
the value chain as the acquirer.
· Vertical integration occurs when a company either expands upstream in the
supply chain by acquiring an existing or potential supplier, or downstream
by acquiring an existing or potential customer
· Conglomeration: Some companies make acquisitions in relatively unrelated
business areas, an a strategy known as conglomeration
– They compile a portfolio of disparate businesses under one management, typically for
providing an attractive investment vehicle for shareholders while diversifying risk

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 Horizontal Integration
· Horizontal integration involves the purchase of a business that expands the
acquirer’s geographic reach, product lines, services, or distribution channels
· Often results in significant cost synergies from eliminating redundancies and
leveraging the acquirer’s existing infrastructure and overhead
· It typically also provides synergy opportunities from leveraging each
respective company’s distribution network, customer base, and technologies
· A thoughtful horizontal integration tends to produce higher synergy
realization and shareholder value than acquisitions of unrelated businesses
· While the acquirer’s internal M&A team or operators take the lead on
formulating synergy estimates, bankers are often called upon to advise
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 Vertical Integration
· Vertical integration seeks to provide cost efficiencies and potential growth
opportunities by affording control over key components of the supply chain
· When companies move upstream to purchase their suppliers, it is known
as backward integration
– An automobile original equipment manufacturer (OEM) moving upstream to acquire an
axle manufacturer or steel producer is an example of backward integration

Raw
Materials Manufacturing/ Distribution End User
Supply Production

Upstream Downstream

Backward Integration Forward Integration

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 Conglomeration
· A strategy that brings together companies that are generally unrelated
in terms of products & services provided under one corporate umbrella

· Conglomerates tend to be united in their business approach and use of

best practices, as well as the ability to leverage a common
management team infrastructure and balance sheet to benefit a broad
range of businesses
· Two most well-known conglomerates are GE” and Berkshire Hathaway

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Form of Financing
 Form of Financing
· It refers to sourcing of internal and/or external capital to fund an M&A
· It drives the merger consequences analysis; affecting the amount an acquirer can
to pay for the target
· Sellers may have preference for certain type of consideration (e.g., cash over
stock) that may affect their perception of value
· Form of financing available is dependent upon several factors, including its size,
balance sheet, and credit profile. Acquirer typically chooses based on various
factors, incl. cost of capital, flexibility, rating considerations, and speed
· Cash on hand and debt financing are often viewed as equivalent, and both are
cheaper than equity
· Bankers play an important role in advising companies on their financing options
and optimal structure

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 Cash on Hand (as a form of financing)
· It relates to strategic buyers using excess cash to fund acquisitions
– It is the cheapest as its cost is simply the foregone interest income earned on the
cash, which is minimal in a low interest rate environment

· Generally, companies do not rely upon the maintenance of a substantial

cash position ( “war chest”) to fund sizeable acquisitions

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 Debt Financing
· Issuance of new debt or use of revolver availability to fund an M&A
· Revolving credit facility
· Term loan
– Loan for a specific period of time that requires repayment (“amortization”) according to defined
schedule, typically on quarterly basis
· Bond or note
– Security that obligates the issuer to pay interest at regularly defined intervals and repay the
entire principal at a stated maturity date
· Commercial Paper
– Short-term (typically less than 270 days), unsecured corporate debt instrument issued by
investment-grade companies for near-term use. Typically a zero coupon instrument
· All cost of debt must be viewed on tax basis as interest is tax deductible
· Acquirers are constrained for the amount of debt
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 Equity Financing
· A company’s use of its stock as acquisition currency; backbone of M&A
financing particularly for large-scale public transactions
· Acquirer can either offer its own stock directly to target shareholders as
purchase consideration or offer cash proceeds from an equity offering
· It provides issuers with greater flexibility as there are no mandatory cash
debt service payments (dividends are discretionary) and no covenants
· Acquirers are more inclined to use equity when their share price is high,
both on an absolute basis and relative to that of the target
· Target company shareholders may prefer stock provided the acquirer’s
shares are perceived as high upside potential (including deal synergies)
· Generally, target shareholders view equity as a less desirable than cash
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Deal Structure
 Deal Structure
· As with form of financing, detailed valuation and merger consequences
analysis requires the banker to make initial assumptions regarding structure

· Deal structure pertains to how the transaction is legally structured, such as a

Stock Sale or an Asset Sale

· For the buyer, it is a key component in valuation and merger consequences

analysis, and therefore affects willingness and ability to pay

· For the seller, it can have a direct impact on after-tax proceeds

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 Stock Sale
· Stock sale is most common in M&A deal structure, particularly for C Corp.

· The acquirer purchases the target’s stock from the shareholders for a
consideration

· Target ceases to remain in existence after the stock sale, becoming wholly-
owned subsidiary of an acquirer

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 Stock Sale
Goodwill
· For accounting purposes, if the price exceeds the net identifiable assets the
excess is first allocated to the target’s identifiable (tangible & intangible) assets,
i.e. “written-up” to FMV

· These tangible and intangible asset write-ups are reflected in the acquirer’s
pro forma GAAP balance sheet

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 Stock Sale - Goodwill
· Goodwill is calculated as purchase price minus target’s net identifiable
assets after allocations to the target’s tangible and intangible assets

· Once calculated, goodwill is added to the assets side of the acquirer’s

balance sheet and tested annually for impairment, with certain exceptions
($ in millions)

A graphical
representation of
calculation of
goodwill, including
asset write-up and
DTL adjustments,

Equity Target Net Assumed Assumed Deferred Goodwill 22

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Purchase Identifiable Asset Intangible Tax Liability Created in
Price Assets Write-Up Write-Up Transaction
 Asset Sale
· An acquirer purchases all or some of the target’s assets

· Target legally remains in existence post-transaction, meaning the buyer

purchases specified assets and assumes certain liabilities
– Can help alleviate buyer’s risk, especially from unknown contingent liabilities
– Less attractive for sellers than a stock sale where liabilities are assumed by buyer
– Complete asset sale for a public company is a rare event

· It may provide tax benefits for the buyer if it can “step up” the tax basis of
the target’s acquired assets to FMV, as per the purchase price
· An asset sale often presents problematic practical considerations in terms
of the time, cost, and feasibility involved in transferring title in the individual
assets
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Buy-Side Valuation
 Buy-Side Valuation
· Valuation analysis is central to the acquirer’s view on purchase price
– Primary methodologies used to value a company—namely, comparable companies,
precedent transactions, DCF, and LBO analysis—form the basis for this exercise

· Results of analyses are typically displayed on a graphic “football field”

· The analysis also typically includes analysis at various prices (AVP) and
contribution analysis (typically used in stock-for-stock deals)
– AVP, aka a valuation matrix, displays the implied multiples paid at a range of
transaction values and offer prices (for public targets) at set intervals
– Contribution analysis examines the financial “contributions” made by acquirer and
target to the pro forma entity prior to any transaction adjustments

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 Football Field
· “It is a commonly used visual aid for displaying the valuation
ranges derived from the various methodologies
($ in millions)

· For public companies, It also typically includes the target’s

Comparable Companies
7.0x – 8.0x LTM EBITDA
6.75x – 7.75x 2012E EBITDA

52-week trading range, along with a premiums paid range in 6.5x – 7.5x 2013E EBITDA

Precedent Transactions

line with precedent transactions in the given sector (e.g., 7.5x – 8.5x LTM EBITDA

25%–40%) DCF Analysis

– May also reference the valuation implied by a range of target 9.5% – 10.5% WACC

prices from equity research reports

7.0x – 8.0x Exit Multiple

LBO Analysis
5.2x Total Debt / LTM EBITDA

· Used to help fine-tune the final valuation range, typically by ~20% IRR and 5-year Exit
25% - 40% Equity Contribution

analyzing the overlap of the multiple valuation methodologies $4,750 $5,000 $5,250 $5,500 $5,750 $6,000 $6,250 $6,500 $6,750

– Certain methodologies receive greater emphasis depending on

the situation
– Valuation range is tested and analyzed within the context of
merger consequences analysis to determine the ultimate price
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 Football Field
This is an illustrative football field; the diagonal line-shaded bar represents the present value of
potential synergies
($ in millions)

Comparable Companies
7.0x – 8.0x LTM EBITDA
6.75x – 7.75x 2012E EBITDA
6.5x – 7.5x 2013E EBITDA

Precedent Transactions
7.5x – 8.5x LTM EBITDA

DCF Analysis
9.5% – 10.5% WACC
7.0x – 8.0x Exit Multiple

LBO Analysis
5.2x Total Debt / LTM EBITDA
~20% IRR and 5-year Exit
25% - 40% Equity Contribution
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$4,750 $5,000 $5,250 $5,500 $5,750 $6,000 $6,250 $6,500 $6,750

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 Analysis at Various Prices (AVP)
· Buy-side M&A
valuation analysis
employs analysis
at various prices
(AVP) to analyze
and frame
valuation

· Displays implied
multiples paid at a
range of offer
prices (for public
targets) and
transaction values
at set intervals 28

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 Contribution Analysis
Contribution
Analysis depicts
the financial
“contributions”
that each party
makes to the
pro forma entity
in terms of
sales, EBITDA,
EBIT, net
income, and
equity value,
typically
expressed as a
percentage

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Merger Consequences Analysis
 Merger Consequences Analysis
· Merger consequences analysis measures the impact on EPS in the form of
accretion/(dilution) analysis, as well as credit statistics through BS effects
· Enables strategic buyers to fine-tune the ultimate purchase price, financing
mix, and deal structure
· Requires key assumptions regarding purchase price and target’s financials
· For this analysis, first construct standalone operating models for both the
target and acquirer
– These models are then combined into one pro forma financial model that incorporates
various transaction-related adjustments
· The next slide displays the key merger consequences analysis outputs as
linked from the merger model
– Outputs include purchase price assumptions and various required details
– Format allows team to quickly review and spot-check the analysis & make adjustments 31
Merger Consequences Analysis Transaction Summary

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 Merger Consequences Analysis
Purchase Price Assumptions

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 Merger Consequences Analysis
Purchase Price Assumptions

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34
 Merger Consequences Analysis
Goodwill Created

35
 Merger Consequences Analysis
Goodwill Created

36
Merger Consequences Analysis

Balance Sheet
Effects

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Merger Consequences Analysis

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 Merger Consequences Analysis
Accretion/(Dilution) Analysis
($ in millions, except per share data)

Acquirer
Target
Combined

Acquirer
Fully Diluted
Shares


Outstanding
+
New Shares
=
Issued in
Transaction

Acquirer Target Synergies Depreciation Amortization Acquirer Additional Income Pro Forma Pro Forma Standalone
EBIT EBIT Write-Up Write-Up Standalone Acquisition Taxes Net Income EPS EPS
Interest Exp. Interest Exp.

Step I Step II Step III Step IV Step V Step VI Step VII Step VIII Step IX Step X
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Merger Consequences Analysis

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Thank you….

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 Stock Sale - Deferred Tax Liability (DTL)
· DTL is created due to the fact that the target’s written-up assets are
depreciated on a GAAP book basis but not for tax purposes
– While depreciation expense is netted out from pre-tax income on GAAP income
statement, company does not receive cash benefits from tax shield
– Perceived tax shield on the book depreciation exists for accounting purposes only
– In reality, company must pay cash taxes on pre-tax income amount before the
deduction of transaction-related depreciation and amortization expense

· DTL line item on the balance sheet remedies this accounting discrepancy
between book basis and tax basis
– Serves as a reserve account that is reduced annually by the amount of the taxes
associated with the new transaction-related depreciation and amortization
– Annual tax payment is a real use of cash and runs through cash flow statement

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 Stock Sale - Deferred Tax Liability (DTL)
The DTL is calculated as the amount of the asset write-up multiplied by the company’s tax rate
($ in millions)

Tax
X Rate =
38%

Tangible Intangible Total Deferred

Asset Asset Asset Tax Liability
Write-Up Write-Up Write-Up

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 Asset Sale - Taxation
· First level of taxation occurs at the corporate level, where taxes on the
gain upon sale of the assets are paid at the corporate income rate

· Second level of taxation takes place upon distribution of proceeds to

shareholders in the form of a capital gains tax on the gain in the
appreciation of their stock

· Upfront double taxation hit to the seller in an asset sale tends to outweigh
the tax shield benefits to the buyer, which are realized over an extended
period of time
– Hence, stock deals are the most common structure for C Corps

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 Asset Sale - Taxation
· In deciding upon an asset sale or stock sale from a pure after-tax
proceeds perspective, the seller also considers the tax basis of its assets
(also known as “inside basis”) and stock (also known as “outside basis”)

· If the company has a lower inside basis than outside basis, which is
commonplace, the result is a larger gain upon sale
– This would further encourage the seller to avoid an asset sale in favor of a stock sale
due to the larger tax burden
– Asset sales are most attractive for subsidiary sales when the parent company seller
has significant losses or other tax attributes to shield the corporate-level tax
– Eliminates double taxation for the seller while affording the buyer the tax benefits of
the step-up

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 Overview
• For day-to-day execution, the advisory team liaises with a point person(s),
a key executive(s) at the client company
– Client point person is charged with coordinating internal resources as appropriate to
ensure a smooth and timely process
– Company input is essential for performing mergers consequences analysis, incl.
synergies, EPS accretion/(dilution) and balance sheet effects.

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 Synergies
• Successful and timely delivery of expected synergies is extremely important
for the acquirer and, in particular, the management team
• Synergies tend to be greater, and the degree of success higher, when
acquirers buy targets in the same or closely-related businesses
• Cost synergies, more quantifiable (i.e. staff reduction & facility consolidation
etc.) tend to have a higher success than revenue synergies
• Other synergies may include tangible financial benefits such as target’s net
operating losses (NOLs) for tax or a lower cost of capital due to the
increased size, diversification, and market share of the combined entity

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 Cost Synergies
· Traditional synergies include headcount reduction, consolidation of
overlapping facilities, and ability to buy key inputs at lower prices due to
increased purchasing power

· Increased size enhances a company’s ability to leverage its fixed cost

base (e.g., selling & general exp.) across existing and new products, as
well as better terms from suppliers due size, aka “purchasing synergies”

· Another common cost synergy is the adoption of “best practices”

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 Revenue Synergies
· Revenue synergies refer to the enhanced sales growth opportunities
presented by the combination of businesses

· Typical revenue synergy is the acquirer’s ability to sell the target’s

products though its own distribution channels without cannibalizing
existing acquirer or target sales

· An additional revenue synergy occurs when the acquirer leverages the

target’s technology, geographic presence, or know-how to enhance or
expand its existing product or service offering

· Revenues synergies tend to be more speculative than cost synergies

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 Vertical Integration
• When companies move downstream to purchase their customers, it is
known as forward integration
– An example of forward integration would involve an OEM moving
downstream to acquire a distributor

• Vertical integration is motivated by a multitude of potential advantages

– Increased control over key raw materials and other essential inputs
– Ability to capture upstream or downstream profit margins
– Improved supply chain coordination
– Moving closer to the end user to “own” the customer relationship

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 Asset Sale

• An asset sale often presents problematic practical considerations in

terms of the time, cost, and feasibility involved in transferring title in
the individual assets
– This is particularly true for companies with a diverse group of
assets in multiple geographies
– In a stock sale, by contrast, title to all the target’s assets is
transferred indirectly through the transfer of stock

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