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Reasons For Mergers and Acquisitions

Companies become involved in mergers and acquisitions (M&A) for numerous reasons, with the comprehensive aim of creating more value for shareholders than either company could accomplish independently.

Operating Synergy

1.  Operating synergy

In mergers and acquisitions (M&A), operating synergy is described as the benefits and efficiencies attained when two companies join their operational resources and activities. This kind of synergy aims at improving the joined entity’s performance and value by streamlining processes, eradicating redundancies, and optimizing resources. 

Core Features of operating synergy:

  • Cost Savings

Operating synergies most likely result cost reductions by eradicating repetition of functions, integrating facilities, leveraging economies of scale, and production, and perfecting supply chains.

  • Efficiency Improvements

To effectively reorganize operations, standardizing workflows, and embracing best practices from   both entities can essentially boost operational efficiency and productivity.

  • Revenue Enhancements

Operating synergies can as well enhance risen revenue through cross-selling opportunities (ensuring bundled products or services), expanding into new markets with the combined entity’s broader reach, and advancing new products or services by pooling resources and expertise.

  • Impact on Shareholder Value

By stimulating profitability, fostering competitiveness, and driving efficiency, operating synergies can eventually lead to risen shareholder value for the combined company. 

2.  Financial Synergy

Financial synergy constitutes the extra value created when two firms merge, fundamentally through financial efficiencies that enhance better financial performance for the combined entity, as opposed to when the firms were operating as separate entities. Often, M&A transactions transition into a larger firm, which has a greater bargaining power to achieve a lower cost of capital or enhanced cash flow.

Core Benefits Financial Synergy:

Financial synergy can result in either positive or negative outcome. Positive financial synergy brings about risen benefits in terms of tax, profitability, and debt capacity. Negative synergy occurs when the value of merged companies is lower than the joint value of each separate company.

  • Tax Benefits

Many tax impacts occur when two or more companies merge. Tax benefits can occur from a merger, by taking advantage of existing tax laws and employing net operating losses to shield income. If a profitable firm acquires a loss-making company, it can endeavor to reduce its tax burden by utilizing the net operating losses (NOL) of the target firm. In addition, a company that can rise its depreciation charges after a merger can save on tax costs and rise in value.

Ultimately, company’s unused tax losses, unused debt capacity, surplus funds, and write-up of depreciable assets as well create tax benefits.

  • Increased Debt Capacity

Debt capacity can rise due to two merging of two firms given that their cash flows and earnings may result in more predictable and steadier. A merged company may as well manage to acquire more debt from lenders, which can assist reduce the overall cost of capital. Smaller firms are often required to pay higher interest rates when securing a loan relatively to larger firms.  

Combined companies could get better interest rates on loans as they attain better capital structure and cash flow to get their loan. Given that banks evaluate their interest rates on the liquidity and leverage of a particular firm, a combined company capable of getting loans with a more favorable interest rate.

  • Diversification and Reduced Cost of Equity

Through a reduced cost of equity, a lower cost of capital occurs from diversification. It always occurs when big companies acquire smaller ones, or when publicly traded companies acquire private companies that are in a varied industry. The diversification impact may reduce cost of equity for the combined company. When companies merge, they achieve a broader customer base, which can bring about lower competition. The expanded customer base can as well result in risen revenue, market share, including cash flows. Thus, these competitive advantages can lower the cost of equity. Nevertheless, this is greatly reliant on the size and industry of the business.

3.  Strategic Realignment

In mergers and acquisitions, strategic realignment is referred to as the process of re-evaluating and adjusting a firm’s all-encompassing strategic objectives in view of a merger or acquisition. Strategic changes in M&A can stem from many different sources, such as regulatory environment and technological innovation- these two factors have been key forces in creating chances for growth, and the reverse of it tends to make obsolete company’s line of business.

  • Regulatory Change

The M&A outlook is currently struggling with considerable and rapidly developing regulatory changes across different jurisdictions. These changes effect various perspectives of deals, from the initiation and planning phases to the closing and post-merger integration. Understanding and remedying these regulatory shifts is vital for successful M&A activity in nowadays business environment. These shifts can influence valuations (both downwards and upwards), raise risk and costs, and occasion uncertainty and potential slowness to a transaction.

Key areas of regulatory change significant to M&A are: (i) Antitrust and Competition Law  {expansion of regulatory powers, focus on new theories of harm, and emphasis on structural remedies (e.g., divestitures due to violation)}; (ii) Foreign Direct Investment (proliferation of FDI screening mechanisms).

These regulatory shifts render M&A transactions more awkward and requiring: (i) early and comprehensive due diligence; (ii) proactive engagement with regulators; and (iii) strategic deal structuring.

  • Technical Change

Technological change advancements create new services, products and industries. These have substantially reshaped the outlook of mergers and acquisitions, affecting each phase stage of deal-making process. Key effects of technology on M&A are: (i) enhanced due diligence (e.g., machine learning, Virtual Data Rooms that provide real-time access to information; (ii) improved target identification (facilitates appropriate acquisition target, market trends, competitor performance, & customer behavior); (iii) enhanced valuation accuracy (Big data analytics, real-time market data, etc.); (iv) smoother post-merger integration (with ERP and CRM systems).

Challenges against M&A

1. Hubris and the “Winner’s Curse

This occurs when acquirers are inclined to overpay for targets, having been overoptimistic when assessing synergies. Competition among bidders tend to bring about overpayment for an acquisition due to hubris.

In an auction scenario with bidders, the scope of bids for a target firm tends to be rather broad given that senior managers are likely to highly competitive and occasionally too proud. They can be too desirous not to lose, thereby drive the purchase price of an acquisition over and above its actual economic value. (i.e., cash-generating capability).

2. Mismanagement

Mismanagement in M&A is referred to substandard strategic planning, mistaken due diligence, and insufficient integration, resulting in failure and value destruction. Core aspects of mismanagement encompass  overpaying for a target, under-assessing integration complications, unsuccessful alignment of cultures, inadequate communication, and weak leadership, all of which can considerably destroy the success of the combined firm.

3.  Managerialism

Managerialism in M&A defines the theory that managers are probable of pursuing acquisitions at the expense of shareholders and company wealth, by maximizing their own utility, such as empire-building, personal power, and risen compensation. This theory is as well known as the “Managerialism Hypothesis or Empire Building Theory”, as opposed to the Synergy Hypothesis, which posits M&A creates value; and the Hubris Hypothesis, where managers commit mistakes in evaluating targets.

Key Features of Managerialism:

  • Self-Interest Vs. Shareholder Value

Managerialism suggests that managers’ personal objectives can drive M&A activity, regardless of the acquisitions are value-destroying for the firm’s shareholders (owners).

  • Empire Building

Managers are likely to expand the size and scope of the company through M&A to improve their own power, prestige, and compensation.

  • Personal Biases

Managers’ personal prejudice or biases, motivations, and as well cultural differences can affect M&A decisions, occasionally resulting in suboptimal outcome for the company.

  • Shareholder-Value Destruction

When driven by managerial self-centeredness, M&A can result in decreased shareholder wealth, as managers’ personal gains take precedence over the company’s financial performance.

  • Ineffective Use of Resources

In place of strategic growth for the firm, M&A initiated owing to managerialism can result in wasteful use of corporate resources.

  • Tax Implications

M&A entails many tax considerations that can essentially affect the financial outcomes for both sellers and buyers. Painstaking tax planning and structuring are vital to mitigate tax burdens and maximize the gains of transaction.

  • Tax Basis and Depreciation

Amid an asset acquisition, the  to step up the tax basis of acquired assets create crucial future tax benefits through risen depreciation deductions. Contrarily, a share purchase holistically restrains the buyers’ ability to enhance the asset basis, affecting depreciation and amortization deductions.

  • Tax Losses

Using the target firm’s tax losses can render considerable benefits in favour the combined entity. Nevertheless, specific rules and restraints regulate the carry-forward of tax loses, specifically in case entailing a change of control or a drift in the kind of the business activities.

  • Market Power

In the context of M&A, market power refers to the ability of companies to advantageously affect market conditions, such as prices (pricing power), output, market entry barriers, to their benefits, with encountering substantial competitive constraints. Mergers, specifically horizontal mergers (between companies in the same industry), possess the potential to upscale market power by lowering the number of competitors and strengthening market share.

  • Misvaluation

In M&A, misvaluation happens when the valuation of either the acquiring or target firm, or the combined entity, is inexact, with high likelihood of resulting in overpaying and underpaying, and affecting the long-term triumph of the deal.