These deals usually happen between two companies operating in the same industry, in the pursuit of growth, efficiency, and competitive advantage. They can be voluntary, or involuntary.
Sometimes, “M&A” can refer to corporate finance departments that provide financial and legal advice, or structure, manage, and facilitate deals. In some cases, regulators like the Federal Trade Commission (FTC) and the Department of Justice (DOJ) must also approve of a deal for it to take place. The process can therefore involve a wide range of actors: companies, investment banks, attorneys, accounting firms, government agencies, and shareholders.
What is the difference between a merger and an acquisition?
The terms “merger” and “acquisition” have distinct meanings. Each deal is unique and may include elements of both. Shareholders must vote to approve the deals.
A merger is when two companies combine to form one. This generally occurs between two companies of similar size and stature, and both companies end up with shared control over the resulting conglomerate.
An acquisition is when a larger company buys or acquires a smaller one through a majority stake. The buyer absorbs the target company or a certain portion of its assets.
M&A activity in the company lifecycle
M&A deals can occur at different stages in a company’s lifecycle. Let’s explore these stages and how they influence M&A activity.
Development is when a company is new and generates little to no revenue, such as a startup. Companies in this phase are often acquired for their innovative ideas. These purchases are cheap and offer upside potential.
Growth is when the company grows and sells more. Larger companies will acquire these for growth potential. An M&A in a case like this one can also be a defensive measure, absorbing competition or preventing a rival from acquiring the target company first.
Maturity is when the business becomes very profitable, and competition increases. Since mature companies have a lot of cash, they tend to be the ones that acquire other companies. This is a cheaper way for them to gain access to a new product or market than researching and building it from scratch.
Decline is when a company loses market share to more innovative competitors. Companies in this phase are struggling and need to be turned around. They are subject to takeovers or being purchased on the cheap by companies that view them as undervalued.
Why companies pursue M&As
Companies competing within the same industry gain an advantage by offering innovative products and cutting costs. It can make sense for a company to simply acquire its competitors and their innovative ideas, or team up with a competitor and combine business activities. That way, they can gain access to a new section of the market, new customers, new product lines, and new intellectual property, all while eliminating the threat of competition. If the investment is worth it, the deal will allow the company to cut costs, be more efficient, and increase growth by gaining a competitive advantage.
Combining two businesses can lead to operational benefits. They can become more efficient and save money by eliminating duplicate costs of production and workforce. They can also unite the best of both companies to offer a more attractive product. For example, a TV service provider and an internet provider can offer both as a package.
M&As can help companies grow faster by quickly absorbing already operational facilities and multiplying their output. They can also slash costs by becoming more independent. When a company buys a distributor, for example, it can take care of its own distribution rather than having to pay another business for it.
Furthermore, when a company buys or assimilates another, it is getting rid of a rival. The target business becomes no longer a source of competition, but a source of value.
What are the types of mergers and acquisitions?
Horizontal mergers
Two direct competitors in the same industry come together to create a bigger, more powerful company. This can be two airline companies, for example.
Vertical mergers
Two companies that operate at different levels in the same supply chain, such as a supplier and a distributor, merge.
Market extensions
A company acquires a similar business that operates in a different geographical location, gaining access to a wider market.
Product extensions
Two companies that sell different products to the same consumer base merge.
Reverse mergers or takeovers
A private company acquires a publicly traded shell company with no operations. The private company then folds into the public one, rather than the other way around. This is a quicker and cheaper way for the private company to go public, bypassing the initial public offering (IPO).
Conglomerate mergers
Two companies that operate in completely unrelated industries combine to put excess capital to work, provide diversification, reduce exposure to risk related to a specific industry, and tap into new markets without having to start from scratch.
Hostile takeovers
An acquisition is proposed without the target company’s approval or consent. The acquiring company bypasses the board of directors and appeals directly to its shareholders. It can make a tender offer to purchase a certain amount of shares (enough to have a controlling stake in the company) at a certain price (a premium, to get shareholders to sell their stock) by a certain date. It can also try a proxy vote, which is when an acquiring company tries to convince the target company’s shareholders that they should vote out its board of directors, making it easier for the acquiring company to take over.
Challenges of M&A deals
Sometimes, the two merging company cultures don’t align and are so different that the resulting friction hinders management and morale, leading to higher turnover, layoffs, and a decline in long-term productivity.
The target company can reject an offer or bid. This can motivate acquiring firms to launch a hostile takeover.
Merging the two companies can create enormous costs. It can also be very difficult to combine the businesses and their individual systems, teams, technologies, and production lines. This can result in missed financial goals and a decline in share prices, with the M&A generating more costs and fewer savings than expected.
M&A activity is heavily regulated and monitored by government agencies like the FTC and DOJ to ensure deals don’t result in monopolies. They want to ensure that competition still exists in a particular industry to maintain a healthy and fair capitalist environment. Preventing companies from controlling an entire industry ensures competition and forces businesses to keep prices fair for consumers. That is why very big M&A deals will require regulatory approval.
What M&As mean for investors and traders
As a trader, staying informed about potential and ongoing M&A deals can give you a heads up on large-scale corporate activity that will cause volatility and impact an industry or the broader market.
When a company places a bid to purchase another, it offers to buy that company’s stock for more than what it is currently trading for. The target company’s share price will therefore rise, or even soar. Timing this right can be lucrative.
Keep in mind, though, that an offer doesn’t guarantee a deal will go through. A target company or regulators can reject the deal. If you believe this will be the case, you can opt to short the shares of the soaring stock, in the hopes that this optimism will prove misplaced and stock prices will reverse. Shareholders of an acquiring company may also feel they are paying too much of a premium to acquire another company, and sell the stock.
If you already own the stock when an M&A is announced, you can vote to approve or reject it, or sell it once the stock price has risen.
