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Value Creation Through Mergers & Acquisition

  1. 1.     INTRODUCTION

The corporate sector in India has seen a considerable growth of mergers and acquisitions since the 1990’s & it’s a business strategy today for Indian corporate. The two main objectives behind any Merger & Acquisition (Hereinafter as M&A) transaction, for corporate were found to be: (i) improving revenues and profitability; and (ii) faster growth in scale and quicker time to market. The dynamics involved in the mixture process gives rise to different kinds of uncertainty and ambiguity in the process. Human resource responses arise from three factors. First, intense feeling of “we versus they” in the organization: these results in distrust, misunderstanding and poor organization. Secondly, there are tensions and hostility towards the acquiring company. Thirdly, anxieties on account of the effect it has on career plans through transfers, job loss, relocation, and loss of individual influence and culture clashes arise when dissimilar cultures come into contact with each other. The moments of cultural clashes are considered by employee stress; distrust on the part of members of one firm towards the members of other firm and negative attitudes towards each other. The negative attitudes reduce the commitment of members to successful integration of the organisations and the extent to which they are willing to cooperate with the other organization.

  1. 2.     MERGERS AND ACQUISITIONS: SOME LESSONS

Merger is the combination of two existing companies in which all the assets, liabilities and stock of one company are moved to the other in consideration of payment either through shares, cash or both.

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Acquisition or takeover means the purchase by one company of a controlling interest in the share capital of another existing company. Acquisition is affected through agreement with the persons holding majority interest in the company management.

When merger/acquisition takes place, it affects the values and goals of the new organisation, due to which employees are not able to identify and involve themselves, affecting the individual and organisational commitment.

As the experience of the corporate clearly indicates the root causes of failed mergers represent mainly mismatch of cultures of the two companies. Culture provides meaning, direction and coordination and it influences the top management conduct, organisational practices, strategy formulation and leadership styles. Mergers and acquisitions are seen as the process in which two different cultures come into contact with each other and subsequently, there is accommodation of the companies’ cultures.

Many of the recent mergers and acquisitions have failed to meet expectations in the value creation promise. At the root of these failures of most, if not all, is the fact that managements have failed to address the broader human relations issues during the critical period leading up to or following merger or an acquisition. In the light of these facts, the key issue that the corporate sector is facing today with regard to merger and acquisition is management of human resources. However, these human issues could be handled smoothly with the help of well thought out and planned strategies.

  1. 3.     VALUE CREATION OF VARIOUS MERGERS BY INTERNAL CONSOLIDATION

Horizontal Mergers; In case of horizontal mergers in Indian industry, while the profitability margins had declined marginally following mergers, the return on net worth and return on capital employed had significantly declined in post-merger period.

Vertical Mergers; In case of vertical mergers in Indian industry, mergers had a marginal negative impact on the operating performance of the merging company, as measured by profitability margins and returns on net worth and capital employed.

Conglomerate Mergers; It appears that for merging firms involved in conglomerate mergers in Indian industry, there was a marginal decline in profitability margins and an increase in leverage causing significant decline at the net profit level. The returns on net worth and capital employed were however not affected to a significant extent in the post-merger period.

Horizontal vs. Vertical Mergers; In summary, except for return on capital employed, there are no significant differences in the degree of change of all other operating ratios for the two types of mergers, that horizontal mergers are more effective in improving operating performance of firms/ company  than vertical mergers was rejected.

Vertical vs. Conglomerate Mergers; In summary, there are no significant differences in the degree of change of operating ratios between the two types of mergers; some few ratios were relatively higher for vertical type and few others in case of conglomerate type, that vertical mergers are more effective in improving operating performance of firms than conglomerate mergers was rejected.

Horizontal vs. Conglomerate Mergers; while horizontal mergers seemed to have done better in improving profitability ratios, conglomerate mergers seemed to have done better on the returns ratios. However, none of the differences between the two types of mergers was statistically significant: that horizontal mergers are more effective in improving operating performance of firms/company than conglomerate mergers was rejected.

Mergers and Consolidations; the surviving corporation continues as the entity it was before the merger with the life of the other participant ceasing. Thus, if Corporation X is merged into Corporation Y, Corporation X disappears and Y, the survivor, remains in existence. In a consolidation, the participating corporations combine into a new corporation rather than a surviving participant.[i] For example, if Corporation X and Y are combined in a statutory consolidation, a new corporation is created and X and Y disappear by operation of law. Otherwise, mergers and consolidations are identical and will therefore be treated together in this text unless specific reference is made to a distinguishing characteristic of either transaction.

Comparison of pre- and post-merger for all the three types of mergers showed that horizontal mergers had caused the highest decline in the operating performance of the merging companies, followed by conglomerate and vertical mergers, in that order. The declines are more prominent in terms of returns on net worth and capital employed, and to a lesser extent on net profit margin (primarily because of an increase in leverage, and consequently, interest costs after merger). The declines in profitability margins at the operating and gross level were not significant. Comparison of post- vs. pre-merger operating ratios, for the different types of mergers suggested that horizontal mergers had caused the highest decline in the operating performance of the merging companies, followed by conglomerate and vertical mergers, in that order.

  1. 4.     DO ACQUISITIONS SERVE MANAGERS OR SHAREHOLDERS

Ironically, the literature that focused on takeovers as devices to eliminate non-value-maximizing behavior has almost completely forgotten the bidders, despite the fact that acquisitions may be the most important decisions about the allocation of corporate wealth that managers make. Acquisitions, especially friendly ones, may provide managers their greatest opportunity for expressing their non-value-maximiz­ing preferences.

The acquisition process is probably the most important vehicle by which managers enter new lines of business. But value maximization is not the only objective of the manager.

For example, if the company operates in a declining industry, the CEO might want to start moving into faster growing industries. Many corporate acquisitions seem to be governed by this desire of managers to switch into businesses with long term growth potential even when the managers have no special expertise in running such businesses and when the value- maximizing strategy is to distribute free cash flows to shareholders. Since in choosing the acquisition targets the manager is guided by a number of objectives other than value maximization, he is likely to overpay relative to what the acquisition is worth to shareholders. For in addition to the value gained for share­holders, the manager is also paying for increasing the size of the firm, the opportunity to diversify, and for making himself less replaceable.

Examples of acquisitions that were probably motivated by non-value considerations include U.S. Steel’s white knight acquisition of Marathon Oil, Mobil’s acquisition of Montgomery Ward, Exxon’s acquisition of Reliance Electric, and GM’s acquisition of Hughes Aircraft. Of course, some managers may raise profitability of companies they acquire even when value-maximization is not their main motivation. Even managers interested only in entrenching themselves will enter businesses to which they have something to add, since this would increase their own value to shareholders.

The implication of our story is that friendly mergers can (though they need not) create value, but that in many cases more than 100 percent of these gains will accrue to target shareholders. Shareholders of the target company gain and those of the acquiring company lose, since the latter end up paying the former for the benefits going to acquiring managers. But more than just a transfer between acquiring and target shareholders is likely to be involved here. Acquisition choices based on managerial objectives will not lead to the optimal allocation of managers to busi­nesses. For example, managers of cash cows in declining industries will end up buying businesses that could be run more efficiently by other potential acquirers.

In interpretation of the acquisition process, non-value-maximizing behavior of bidders plays a central role. The willingness of the managers of the bidder to pay for benefits to themselves that are of no value to their shareholders explains negative returns to acquiring firms. This interpretation suggests that before stressing the role of takeovers in eliminating non-value-maximizing behavior by managers of target com­panies, it is important to remember the managers of bidding firms. For them, the purchase of other companies at inflated prices may be the grandest deviation from value maximization. Just as improvements in acquisition techniques of the 1980s have pressured some managers to maximize value, they have enabled others to deviate from doing so on a previously impossible scale.

Typically, for each corporation that is to be merged, after the shares that are to be converted into shares[S1] , obligations or other securities of the survivor or any other corporation or into cash or other property are converted; the former holders of those shares are entitled only to the rights provided in the articles of merger or to dissenters’ rights.[ii]

  1. 5.     WHEN AND WHY DO MERGERS & ACQUISITIONS OCCUR

The happening of mergers came to the conclusion that mergers take place at times of positive conditions in the capital markets.

Sometimes mergers occurred be­cause of discrepancies in evaluations of the firm between the selling and the buying parties. These discrepancies were more likely to exist in times of rapid technological change and when there were speculative capital markets, that “forces which generate discrepancies in valuation are decisive in determining varia­tions in merger rates both among industries and over time”. The technical personnel ratio, productivity change, growth, and the con­centration ratio were each correlated with the merger rate.

Most analyses of merger behaviour have at­tempted to demonstrate that merger-active firms either were more profitable or were not more profitable than firms that did not engage in as much merger activity. If the goal of profit maximization, common in economic theory, is assumed, the issue of whether or not mergers enhance profitability becomes a central one.

The pattern of mergers among industrial companies has been analyzed as a response to organizational interdependence. It has been shown that there exist statistically sig­nificant associations between patterns of re­source exchange and patterns of merger ac­tivity and that these associations are able to account for about one-half of the variation in merger behaviour. Merger, when thought of as a response to organizational interde­pendence, is a strategy to be examined along with other strategies that can be utilized in managing the organization’s environment. It is also a strategy that can be analyzed in a consistent conceptual framework across types of organizations. The task also remains to examine growth, apart from merger, as a strategy for managing the environment and to specify the environmental conditions that will tend to produce strategies of diversifica­tion or integration.

Many reasons have been given for the trend towards growth by acquisition, including the increasing complexity of modern technology, the shortage of capable managerial talent, the expense and uncertainty of expanding internally into new fields, the inability of small and medium-sized firms to meet competition, the tax advantages that accrue to the sellers of successful businesses, and the economies that are expected to result from the combination of complementary enterprises. Purchaser’s reasons for acquiring other companies; to increase its earnings per share by adding other companies’ earnings to its own.[iii]

  1. 6.     EFFECT OF EUROPEAN INTEGRATION ON THE NINETIES; MERGERS & ACQUISITIONS

International economists will think of the late nineties as a period of considerable interest. Thus, according to the OECD, the world-wide number of cross- border M&As rose from 8,587 in 1990 to 24,113 in 1999. Over the same period, the number of European cross-border M&As almost tripled. Indeed, according to the OECD, the value of cross-border M&As amounted to 91 percent of the value of all FDI flows in 1999.

In India, reasonably though, mergers and amalgamations are taking place at comparatively faster rate in the pharmaceuticals and fine chemicals. In the other lines, mergers have followed only when the foreign principal of the Indian counterparts have merged abroad. Thus the merger path of the Indian companies is forced by what is happening to the collaborators abroad and not necessarily because the conditions of operations are favourable to such mergers. The evidence suggests that the new economic environment of the 1990’s has facilitated M&A’s between companies under domestic or foreign ownership.

To draw parallels at the international level, an examination of the effect of mergers on profitability in six countries showed that mergers had no effect on profitability or led to minor increases in Belgium, Germany and uk, whereas it had declined slightly or re­mained unchanged in France, Holland and Sweden observed that merging firms had improved their performance during the post-merger period in the Japanese manufacturing industry in the period 1959-77. It is evi­dent that the profitability of 64 per cent of the acquired firms in crisis-hit countries rose after acquisition. Further it is observed that profitability improved in those acquired firms in Asia and Latin America where Japanese executives replaced the old man­agement in more than one half of the cases. An appropriate competition policy needs to be designed so as to address the possible anti-trust implications of overseas merg­ers for India, as well as to regulate M&As among Indian enter­prises. This needs to be done keeping in view the need to develop productive capacities and generate employment within the coun­try, providing for adequate “promotional measures” and safe­guards to small and medium entrepreneurs.

This paper could not deal with aspects such as the impact of M&A’s on capital formation, balance of payments, employment generation, managerial and marketing skills, quality of services and prices. These are also issues that need careful scrutiny espe­cially, in the case of cross-border M&A’s.

  1. 7.     VALUATION FACTORS; ACQUISITION

It is widely accepted principle that all factors relevant to a determination of fair value of a dissenter’s shares are to be taken into account by the court.[iv]Although the methods by which the courts apply these factors to the valuation process vary & generally are not set out by statute, and the weight accorded the factors in determining the total value of the shares will necessarily change with the jurisdiction & factual situation, some consistent conclusions may be reached.[v]

First, it is generally held that the value given by the court should not include any appreciation or depreciation that comes about as a result of the proposed corporate action.[vi] This Principle is statutorily mandated in many jurisdictions through the requisite use of the day prior to shareholder authorization as the basis upon which share value must be computed.

The valuation process may begin and end with the price of the stock if a regular market exists, leaving aside any price change due to the action in question;[vii] or, as has been noted, the market price may simply be deemed of special importance.

Circumstances surrounding the trading of the stock will generally have an effect on the importance placed on the market value element. Factors considered include: whether the shares are listed on a national stock exchange;[viii] frequency of trading in the stock; market price in relation to asset value; and the presence and effect of any unusual purchases prior to the corporate action. Note that in certain situations market value has been deemed totally irrelevant with regard to valuating the shares.

The undertaking with which a corporation is involved generally will affect the weight accorded investment value in computing the total valuation. For example, a commercial business the aim of which is to create and maximize earnings, as opposed to a company dedicated to the holding of assets for appreciation will have the investment value accorded it by the court given great weight; and such value will therefore make up a great proportion of the total valuation. Another factor which can affect the investment or earning valuation of stock is a corporation’s accounting practices. These practices may include: the choice of inventory valuation; the method used to calculate depreciation; treatment of accrued expenses and income; allocation of corporate overhead; valuation of intercompany transfers; and valuation of assets acquired by merger.

The crucial factor which the financial expert must consider in choosing a valuation method is whether the method chosen is one that is generally considered acceptable in valuing a stockholder’s proportional interest in a comparable business. One common modern method of valuation is the discounted cash flow or “DCF” analysis. Used generally by financial analysts to value stocks, the DCF approach considers all assets, including securities, bonds, real estate and machinery, valuable in their potential to provide future benefits to the corporation.

  1. 8.   COMPARTIVE STUDY; US, UK, JAPAN & INDIA

8.1 UNITED STATESIn the US, the CEO usually runs the company. Negotiations are much more likely to succeed if they begin with the CEO. But be careful about trying to eliminate investment bankers from negotiations; they may become highly motivated to cause an increase in price or to find an alternative deal.

The US acquisition market is very competitive and sellers and their advisers judge quickly who is a serious acquirer and who is not. An acquirer able to make up its mind and carry out the transaction with speed is more likely to obtain exclusive negotiating rights and safeguard the acquisition against competition. If the main assets in the target business are people, an acquirer should have a reasonable theory as to why the key people will remain with the new owners and how to remain them. For a foreign acquirer, this consideration may be an ongoing one. In acquisitions of private companies, there is no legal or practical way to protect the acquisition completely from competing bidders until a binding ‘no shop’ or binding acquisition agreement will not bar competition. An acquirer’s main ally against competition is speed. Acquisitions of public companies in the US are very public and very expensive. In making a minority investment, the acquirer is unlikely to obtain meaningful control of the investment. Negotiating an exit, therefore, becomes very important.

8.2 UNITED KINGDOM

A public company may be a ‘listed’ company and have its shares traded on the London Stock Exchange. The Financial Services Authority (FSA), as the UK’s Listing Authority (UKLA) publishes the Listing Rules which govern, inter alia, admission to listing and the continuing obligations of listed companies and which must be observed in any private company acquisition where either the acquiring or the target company is a listed company or a member of a group where one company in the group is a listed company. In addition, where the target company is a public company (listed or unlisted) and in the case of certain types of private company considered to be resident in the UK, the Channel Islands or the Isle of Man, there must also be compliance with the City Code on Takeovers and Mergers (City Code). The City Code will not apply on an asset purchase.

8.3 JAPAN

The majority of large-scale businesses in Japan are as in other jurisdictions, undertaken through companies. There are four types of company in Japan: the Kabushiki Kaisha (company limited by shares, ‘KK’), the Yugen Kaisha (company limited by units, ‘YK’), the Goshi Kaisha (limited partnership company) and the Gomei Kaisha (partnership company).

The KK is the most common type of company for business purposes and most closely resembles a company whose liability is limited by shares in jurisdictions such as the United Kingdom. It is the business form in Japan which carries the greatest aura of stability and respectability.

The KK must be registered with local Legal Affairs Bureau in the district in which its head office is located. There is no requirement to file the KK’s Articles of Incorporation (teikan), although information must be filed on the KK’s objects, trade name, directors, representative directors, representative directors, statutory auditors, types and number of issued share and authorized share capital. Secondly, a report (or notification) must be filed on the acquisition of shares in the KK with the Ministry of Finance via the Bank of Japan under the Foreign Exchange and Foreign Trade Law of Japan.

8.4 INDIA

With the liberalization of the Indian economy and the removal of restrictive arrangements such as monopolies and restrictive trade practices, corporate India is advancing more towards a merger culture. In India, the real reasons for a merger are not purely economic. Legislation having a bearing on acquisitions and mergers includes the Companies Act 1956, the Sick Industrial Companies (Special Provisions) Act 1985 and the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 2011.

Sections 391-396 of the Companies Act 1956, deal with the merger and acquisition of companies. Section 394 of the Companies Act 1956 is the main section dealing with the reconstruction and amalgamation of companies. This section requires companies to make application to the court under section 391, which empowers the court to sanction the compromise or arrangement proposed by the companies. Section 392 further empowers the High Court to enforce a compromise or arrangement ordered by the court under section 391 of the Companies Act. Section 393 provides supporting provisions for compliance with the provisions or directions given by the court. Sections 395, 396 and 396A are supplementary provisions relating to amalgamation. Section 395 deals with the power to amalgamate without going through the procedure of the court.

  1. 9.     CONCLUSION

The design of mergers & acquisitions among industrial companies has been studied as a response to organizational interdependence. Many of the recent mergers and acquisitions have failed to meet expectations in the value creation promise. At the root of these failures of most, if not all, is the fact that managements have failed to address the broader human relations issues during the critical period leading up to or following merger or an acquisition. However, an exchange of shares takes place between the entities involved in such a proc­ess. No fresh in­vestment is made through this process. The immediate effect of a merger is to increase the degree of concen­tration as it reduces the number of firms/company. Another effect of merg­ers on competition is on the generation of barriers to entry. An ac­quiring firm might decide to go in for an international merger in order to take advantage of cheap raw materials and labour, to capture profits from exchange rates, or to invest its surplus cash. The interna­tional mergers should be encouraged when demand uncertainty is large and market competition is intense as they are privately unprofitable but socially desirable.

In the light of these facts the key issue the corporate sector is facing today with regard to merger and acquisition is management of human resources. However, these human issues could be handled smoothly with the help of well thought out and planned strategies.

About the Author(s)

Ms. Soumya Kanti Sinha,
LL.M., NALSAR, Hyderabad,
Lecturer, Delhi Institute of Rural Development School of Law,
GGS Indra Prastha University, Delhi

Mrs. Anupam Sharma,
H.O.D., Delhi Institute of Rural Development School of Law,
GGS Indra Prastha University, Delhi

End Notes


[i]Id. See Del. Code Ann., tit. 8, $ 251 (a); N.Y. Bus. Corp. Law $ 901 (a) (2) (McKinney).

[ii]See Model Bus. Corp. Act $ 11.07 (a) (8) (b).

[iii]The Purchaser must carefully identify its reason for wanting to acquire a particular company. This reason may control whether or not the deal will be made. For example, if the prospective seller demands a premium price for the company, and the reason for the acquisition is to save time in developing new products or additional technical capability, it may be worthwhile for the buyer to pay the seller’s price. If, however, the acquisition is made for a less compelling purpose, the asking price may be too high.

[iv]See Walter S. Cheesman Realty Co. V. Moore, 770 P.2d 1308 (Colo. Ct. App. 1988); See generally Ferdinand S. Tinio, Annotation, “Valuation of Stock of Dissenting Shareholders in Case of Consolidation or Merger of Corporation, Sale of its Assets, or the Like,” 48 A.L.R.3d 430 (1973).

[v]“Methods” as used here refers to the combination of the particular factors a court will consider determining a fair value & the way in which the factors are weighed against each other.

[vi]See Murdock, The Evolution of Effective Remedies for Minority Shareholders & Its Impact upon Valuation of Minority Shares, 65 Notre Dame L. Rev. 425 (1990); kanda & Lev more, The Appraisal Remedy & the Goals of Corporate Law, 32 UCLA L. Rev. 429 (1985); Note Corporate Law- Chipping Away at the Delaware Block: A Critique of the Delaware Block Approach to the Valuation of Dissenters’ Shares in Appraisal Proceedings, 8 West. New Eng. L. Rev. 191 (1986); But see Cede & Co. V. Technicolor, Inc., 684 A.2d 289 (Del. 1996) (holding minority shareholder is entitled to value added during the interim period in a two-step takeover); Wine-burgh, Comment, Appraising Dissenters Shares: The “Fair Value” of Technicolor, 22 Del. J. Corp. L. 293 (1997).

[vii]See, e.g., Armstrong v. Marathon Oil Co., 32 Ohio St. 3d 397, 513 N.E. 2d 776(1987) (fair cash value of stock was deemed to be the actual market was reasonably suitable & active).

[viii]Some courts have considered market value to be the most accurate method of valuing stock which is traded regularly on a national securities exchange. See, e.g., In re Olivetti Underwood Corp., 246 A.2d 800 9Del. Ch. 1968).

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July 19, 2016

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