So, let's establish an understanding of exactly what's going on when we talk about mergers, acquisitions, and takeovers. Firstly, some definitions of the fundamentals. A bidder firm is one that seeks to acquire control of a target firm by purchasing the voting shares that have been issued by that target firm. The convention in many markets is to distinguish between different types of acquisition activity on the basis of whether the deal is a friendly or negotiated one. Or alternatively, whether the deal is a hostile transaction which typically involves the target firm actively defending itself against the bid. The former, the negotiated bids we refer to as a merger, and the latter, the hostile bids as a takeover. Most of the concepts that we'll come across in this module are common to both mergers and takeovers and so we'll tend to use the terms interchangeably. Finally, an important concept for us to understand at the outset is the control premium. The control premium represents the extra amount that the bidder has to pay over and above the current market value of the target firm, in order to gain control of the target firm. The next step is for us to be able to differentiate between alternative types of acquisitions. Firstly, a horizontal acquisition is where both the bidder and the target firms are operating in the same line of business. For example, in February, 2010, US snack foods company, Kraft, successfully acquired UK chocolate company, Cadbury, for a lazy 11.5 billion pounds. The stated rationale at the time, revenue synergies from instant consumption channels. That is, Kraft felt that the acquisition would enable them to sell more Kraft products to Cadbury customers while cutting costs in the combined organization. We'll come back to a critical analysis of reasons for acquisition activity, a little bit later on. The next category relates to vertical acquisitions. This is when both the bidder and the target firm operate in the same industry but in different points in the production process. For example in May 2015, telecommunications company Bell Canada, successfully completed its acquisition of mobile phone retailer Glentel for $594 million. As we can see from this quote from senior management at Bell, this vertical acquisition seemed motivated by a desire to gain control over the distribution channels for its product. The third and final category consists of conglomerate acquisitions. Conglomerate acquisitions occur where the bidder and the target firm operate in completely different industries. A classic example of a firm with a long history of conglomerate acquisition activity, is GE. The firm, itself, founded in 1892 from a merger between the Edison General Electric Company and the Thomson-Houston Company. Over the years, these power companies, diversified operations along many different lines, including oil and gas, financing, aviation, healthcare, and transportation. The rationale for conglomerate acquisitions is not nearly as clear as that for horizontal or vertical acquisitions. But we get a bit of a hint of the style of thinking from GE's 2011 Annual Report, where they highlight that the diversified groups cash flows are characterized by greater diversification and lower volatility. We'll come back to this claimed benefit of diversification with a critical eye a little bit later on. So how does the bidding firm pay for the target firm? Well there are three alternatives, cash, shares, that is, shares in the after-merger entity, or a mixture of the two. Factors that will impact upon the decision made include the cost, the possible dilution in the ownership and control of the merged entity, which may be an issue if the bidder issues shares to target shareholders. Tax may be important, particularly where the tax paid on cash consideration differs to that levied on shares received. And finally, and perhaps most importantly, from the bidder's perspective, is that there is evidence that shareholders may have a preference for a particular form of consideration. Which then directly impacts upon the likelihood of the bid being successful. So let's illustrate each of these alternative forms. We start with two distinct separate companies, Bidder Ltd and Target Ltd, each 100% owned by their own shareholders. Under a cash bid we see the bidding company exchanging cash for the shares of the Target. And if the bid is successful, the Target firm will be delisted. Its shares canceled and all of the target firm's assets rolled into the bidder company's existing operations. One of many examples of this occurred in June 2013 when Warren Buffett's company, Berkshire Hathaway, together with an investment fund successfully acquired the HJ Heinz Company. In a 28 billion dollar transaction that equated to a cash bid of $72.50 per share. Of note, Heinz was trading at only $60.48 the day before, implying that the bidders had paid a control premium of about 19.9%. Now let us consider acquisitions that use shares in the combined entity as the currency for consideration. In exchange for their shares in the target company, target share holders will receive shares in the bidder company, but, and this is a very important but, they are shares in bidder company as it will exist after the acquisition. An example of this type of deal, from November 2013, is when the two billion dollar merger between the two office supply companies Office Depot and OfficeMax was completed. The terms of the deal were that for every share held in OfficeMax, an OfficeMax shareholder would receive 2.69 shares in Office Depot. Following the merger, OfficeMax shareholders own 45% of the shares in the new Office Depot with the remainder held by the original Office Depot shareholders. Finally, there are cases where Target shareholders are offered either a mixture of cash and shares or sometimes even a choice between cash and shares in the merged entity. To illustrate, in July 2014, the multinational pharmaceutical company Actavis completed its $25 billion acquisition of Forest Labs. Shareholders in Forest Labs were offered a choice between cash, shares, or a specific mixture of cash and shares. Now, this type of deal is typically structured in such a way as to try to ensure that each method of payment provides about the same value of consideration as each other method. But in reality this can be difficult to achieve. In this session we've established the meaning of some of the common terms used in the analysis of merger and acquisition activity. We've distinguished between alternative categories of acquisitions, and we've demonstrated the different methods of payment between bidder and target companies. Next up we establish a framework for the economic evaluation of merger and acquisition activity. As you'll see, this is an absolutely essential tool, as without it we won't be able to answer the question, is this a good deal?
