The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, visit our website at www.WileyFinance.com Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding M&A A Practical Guide to Doing the Deal Second Edition JEFFREY C HOOKE Cover image: © iStock.com / Vladitto Cover design: Wiley Copyright © 2015 by Jeffrey C Hooke All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data: Hooke, Jeffrey C M & A : a practical guide to doing the deal / Jeffrey C Hooke — [Second edition] pages cm — (Wiley finance series) Includes index ISBN 978-1-118-81699-8 (hardback) — ISBN 978-1-118-81704-9 (ePDF) — ISBN 978-1-118-81701-8 (ePub) Consolidation and merger of corporations—Finance I Title II Title: M and A HG4028.M4H66 2015 658.1′62—dc23 2014024067 CONTENTS Preface Recent Trends Overview of the Contents What’s New in the Second Edition Part One: The Big Picture Chapter 1: The Global M&A Market: Current Status and Evolution An Upward Trend, Interrupted by Booms and Busts M&A Activity by Geography Deal Categories Large versus Small Transactions M&A: No Guarantee of Success Note Chapter 2: U.S M&A History, Trends, and Differences from Other Nations U.S M&A History Advanced M&A Industry in the United States M&A in Wealthy Nations Other Than the United States Emerging Market M&A Notes Chapter 3: The Need for Growth Spurs Acquirers to Buy Other Companies Ten Buyer Motivations The Most Popular of the 10 Motivations Summary Notes Chapter 4: The Three Financial Tactics That Dominate the M&A Business Enterprise Value Earnings per Share Dilution EBITDA Considerations Tactic #1: Cost Cuts/Revenue Gains Tactic #3: Financial Arbitrage Conveying the Three Tactics to Investors Discounted Cash Flow Analysis Supplements the Tactics Summary Notes Part Two: Finding a Deal Chapter 5: The Buyer Must Have a Methodical Plan in Order to Find a Quality Transaction An Active Approach The Acquisition Plan Internal Assessment Summary Chapter 6: To Begin an Acquisition Search, the Buyer First Sets the Likely Parameters of a Deal Defining the Parameters Case Study Summary Chapter 7: The Buyer Starts the Formal Acquisition Search by Alerting Intermediaries and Contacting Possible Sellers Laying the Groundwork Four Steps in Beginning a Search Retaining an Intermediary to Assist in the Search Summary Note Chapter 8: Finding a Deal: Likely Results of a Search Due Diligence Structure the Deal Financing the Deal Closing and Integration Publicly Traded Companies Summary Notes Chapter 9: The Four Principal Risks Facing a Buyer in the M&A Business Overpayment Risk Operating Risk Debt Leverage Risk Macroeconomic Risk Downplaying M&A Risks Summary Notes Part Three: Target Financial Analysis Chapter 10: Sizing Up the M&A Target from a Financial Point of View Starting the Historical Financial Analysis Beginning the Historical Analysis Normalizing Results Absolute Amount Analysis Percentage Changes Common Size Analysis Growth Ratios Ratio Analysis Industry-Specific Indicators Comparable Company Performance Review of P.F Chang’s Financial Analysis Notes Chapter 11: To Facilitate Financial Projections, the Buyer Needs to Classify the Target as a Mature, Growth, or Cyclical Business Company Classifications The Mature Company The Growth Company The Cyclical Company The Declining Company The Turnaround The Pioneer Summary Chapter 12: How Practitioners Forecast an M&A Target’s Sales and Earnings Means of Forecasting Critiquing P.F Chang’s Projection Preparing Projections Three Scenarios Summary Notes Part Four: Acquisition Valuation Chapter 13: The M&A Industry Typically Uses Four Valuation Methodologies Assessing Each Methodology Applying Multiple Methodologies Summary Chapter 14: The Use of Discounted Cash Flow in M&A Valuation Discounted Cash Flow versus Comparables The Discounted Cash Flow Valuation Process Choosing the Right Discount Rate in Valuing a Standalone Business Summary Note Chapter 15: Valuing M&A Targets Using the Comparable Public Companies Approach Real Estate Analogy What’s the Right P/E Ratio? A Word about Value Multiples Summary Chapter 16: Valuing an M&A Target by Considering Comparable Deals and Leveraged Buyouts Control Premium Is Embedded in Comparable Acquisitions Understanding Leveraged Buyouts LBO Mechanics Case Study: Crane Co Summary Note Chapter 17: Valuation Situations That Don’t Fit the Standard Models Sum-of-the-Parts The Cyclical Company Speculative High-Tech Companies Low-Tech, Money-Losing Companies Turnaround Considerations High-Leverage Company Considerations Natural Resources Emerging Market Acquisitions Discounted Cash Flow (DCF) Comparable Public Companies and Comparable Acquisitions in the Emerging Markets Summary Notes Part Five: Combination, the Sale Process, Structures, and Special Situations Chapter 18: Combining the Buyer’s and Seller’s Financial Results for the M&A Analysis Combining the Buyer’s and Seller’s Projections Reality Check Financing Sources Summary Notes Chapter 19: When Is the Best Time for an Owner to Sell a Business? Seller Categories Timing Considerations Making the Decision Confronting Reality Selling the Business versus an Initial Public Offering IPO versus Sale Partial Sale/Leveraged Recapitalization Summary Notes Chapter 20: The Sale Process from the Seller’s Vantage Point Retaining a Financial Adviser Setting the Stage for the Sale The Buyer’s List Approach Tactics Confidentiality, Operational, and Personnel Issues Due Diligence Visits Coming Up with a Bid Final Due Diligence and Legal Documentation Summary Chapter 21: A Review of Legal and Tax Structures Commonly Used in Transactions Acquisition Legal Structures Legal Considerations Triangular Merger Simplified Tax Structures Legal Documents Summary Note Chapter 22: Unusual Transaction Categories Tax-Free Deal DEMERGER Reverse Merger Special Purpose Acquisition Corporation (SPAC) Hostile Takeover Summary Note Chapter 23: Final Thoughts on Mergers and Acquisitions About the Author Index End User License Agreement List of Tables Chapter Table 1.1 Chapter Table 3.1 Table 3.2 Chapter Table 4.1 Table 4.2 Table 4.3 Table 4.4 Table 4.5 Table 4.6 Table 4.7 Table 4.8 Chapter Table 6.1 Table 6.2 Chapter Table 9.1 Table 9.2 Table 9.3 Table 9.4 Table 9.5 Table 9.6 Table 9.7 Table 9.8 Chapter 10 Table 10.1 Table 10.2 Table 10.3 Table 10.4 Table 10.5 Table 10.6 Table 10.7 Table 10.8 Table 10.9 Table 10.10 Table 10.11 Table 10.12 10 applying appropriate multiple calculating value multiples control premium decision process discounted cash flow (DCF) analysis versus example interpreting range of value multiples popular value ratios pros and cons real estate analogy selecting comparable public companies for speculative high-tech companies steps target valuation in emerging markets Compound annual growth ratios Confidentiality Conflicts of interest Conglomerate transactions Constant growth model Consultants See Intermediaries for buyers; Intermediaries for sellers Continucare Control premium in comparable acquisitions valuation approach in comparable public companies valuation approach Convertible securities Cooper Industries Corporate appraisal firms, as intermediaries Cost of Capital (Pratt and Grabowski) Cost reductions buyer motivation for M&A financial tactics based on Countrywide Financial Crane Co Crash of 1929 Credit rating agencies Credit ratios Crocs CTC Currency risk Cyclical companies Deal categories Debt leverage risk 252 Declining companies Definitive agreements Dell, Inc De-mergers Diabetes America DiCenza, Mike Digital Management Discounted cash flow (DCF) valuation approach Capital Asset Pricing Model (CAPM) comparables versus constant growth model discount rate Equity Buildup Method per share value on standalone basis pro forma analysis projections pros and cons for speculative high-tech companies steps to supplement basic financial tactics synergies target valuation in emerging markets terminal value Discount rate, in discounted cash flow (DCF) approach Diversification, in buyer motivation for M&A Done Deals Dot-com bubble Due diligence Duff & Phelps Duke Energy DuPont Dynergy Earnings dilution Eaton Economies of scale See Synergies/economies of scale Economist Intelligence EDF Egypt El Paso Emerging markets defined family business model 253 historical M&A trends local finance practices as limitation M&A activity seller attitudes structural issues target valuation Energies Nouvelles Energy Future Holdings Engagement letter Engility, Inc Enterprise value (EV) Equity Buildup Method Equity Residential Escrow accounts Estate taxes EV/EBITDA ratio in arbitrage in comparable public companies approach considerations in transactions debt leverage risk earnings per share dilution enterprise value (EV) financial tactics based on in high-leverage company valuation in leveraged buyout (LBO) valuation approach projecting target results sum-of-the-parts in holding companies Swan effect in turnaround company valuation Everett, Ron EV/Sales Exclusivity Exxon Facebook Family business model Fidelity Healthcare Financial advisors See Intermediaries for buyers; Intermediaries for sellers Financial analysis See also Forecasting sales and earnings; Projections; Target financial analysis buyer's audit combining buyer and seller financial results in forecasting sales and earnings pro forma analysis 254 Financial tactics See also Structuring deals; Target financial analysis arbitrage conveying to investors cost cuts/revenue gains discounted cash flow analysis to supplement Swan effect FlatWorld Capital Fleetmatics Group, plc Focus, LLC Forecasting sales and earnings causal forecasting combining buyer and seller projections critiquing projections historical information in preparing projections qualitative forecasting scenarios time series forecasting Forward integration Fraga, Arminio Free cash flows Full-blown auctions GDF Suez Genzyme Geographical distribution of deals George Weston Glencore Global financial crisis (2007/2008) Goldman Sachs Capital Partners Google Grabowski, Roger Growth compound annual growth ratios financial ratios financial tactics based on forecasting target sales and earnings growth company classification importance strategies to promote Grupo Industrial Bimbo Grupo Modelo Gunther, Andrew 255 Healthtran Hertz Rent-A-Car Hewlett-Packard High-leverage companies, valuation methods High-technology company valuation Hilton Hotels History of M&A cyclicality waves of activity Holding companies Horizontal transactions Hostile takeovers Humana Hurson, Dan Ibbotson India Indocement Indonesia Industry-specific indicators Information memorandum Information risk Initial public offerings (IPOs) Instagram Integration process Interline Brands Intermediaries for buyers downplaying M&A risks due diligence fees initiating target search with legal documents retaining in target search process types Intermediaries for sellers approach tactics bidding process and offers confirming valuation range conflicts of interest dressing up sales candidate due diligence of buyers and fees 256 information memorandum legal documents list of buyers retaining Internal rate of return (IRR) International Exchange Group (ICE) International Power Investment banking engagement letter Investment banks downplaying M&A risks as intermediaries Japan J.P Morgan Junk bonds Keiretsu Kelly Services Kforce Kinder Morgan Kroger's L-3 Corporation LaFarge Ciments LaMota, Antonio Large transactions Law firms, as intermediaries LBOs See Leveraged buyouts (LBOs) Legacy Oil & Gas Legal issues acquisition legal structures documentation of deal due diligence of buyer law firms as intermediaries regulation of M&A retaining intermediaries in sale process retaining intermediaries in search process structuring the deal Lehman Brothers Lender credit ratio tests Letter of intent (LOI) Leveraged buyouts (LBOs) See also Private equity managers basic principles buyer motivation for M&A capital structure versus normal companies 257 Crane Co example EV/EBITDA ratio mechanics partial sale/leveraged recapitalization private equity fund time limits pros and cons in target company valuation trends in M&A market Leveraged recapitalization Lightyear Low-tech, money-losing companies Macroeconomic risk Mature companies MaxIT McQuade, Brian MergerMarket Mergers, statutory legal considerations nature of triangular Mergerstat Metro Health MetroPCS Mexico Mittal Modified auctions Morocco Motorola Mrs Baird's Murray, Paul Natural resources capturing through M&A in target valuation NBC Universal Nestle Neur, Fred New markets, buyer motivation for M&A New products, avoiding risks through M&A Nexen Nextel Nielsen Corporation Nondisclosure agreement (NDA) 258 “Normalizing” financial results NYSE Euronext Corp Oligopoly power, buyer motivation for M&A On Assignment Onyx Operating risk Opportunism Overpayment risk Paccar, Inc Par Pharmaceuticals Partial sales Pentair Corporation Pepsi Percentage change analysis Perella Weinberg Permira Advisors Per share value, in discounted cash flow (DCF) approach P.F Chang's Bistro Pfizer Nutrition Pioneer companies Political risk Pratt, Shannon Price/book ratio Price/earnings (P/E) ratio, in comparable public companies approach Private equity managers See also Leveraged buyouts (LBOs) in advanced M&A industry in U.S buyer motivation for M&A capital structure versus normal companies downplaying M&A risks Profitability ratios Pro forma analysis Projections combining buyer and seller in discounted cash flow (DCF) approach of free cash flow historical information in Rock-Term Packaging Company example structuring future finances of target results Proxy fights Publicly traded companies See also Comparable public companies valuation approach acquisition campaigns 259 in driving M&A activity regulation of U.S Quadra FNX Qualitative forecasting Rajbhandary, Sujan Ratio analysis activity ratios credit ratios growth ratios profitability ratios Recapitalization, leveraged Recapture tax Recessions, macroeconomic risk Reinvestment focus Retirement of seller Revenue synergies Reverse mergers “Rifle shot” approach tactic Risk of buyer in M&A transaction currency debt leverage downplaying of entering new country executing Swan effect through lowering information macroeconomic of new product introduction no guarantee for M&A success operating overpayment political securities in lieu of cash target valuation in emerging markets Robert Half Robinson, Steve Rock-Term Packaging Company Rodgers, Doug Rosneft Nexen Russia SAIC Sanofi 260 Sara Lee Scenario analysis Screening targets factors in in-house approach intermediaries in SDC Platinum Search process for targets See Acquisition campaigns Sears Seller considerations approach tactics bidding process and offers business appraisal/valuation (See also Target valuation) categories of sellers confidentiality decision process due diligence of buyer legal issues leveraged recapitalization list of buyers operational issues partial sale personnel issues reasons for selling retaining a financial advisor selling versus initial public offering (IPO) setting stage for sale steps in business sale process timing issues Shell companies “Shotgun” approach tactic Siam Cement Sicker, John Sino-Forest Small transactions Softbank Special purpose acquisition corporations (SPACs) Speculative high-tech companies Spin-offs Split-offs Sprint Sprint Nextel 261 Standard Oil “Step up” tax basis Stock options Stock purchases legal considerations nature of Strategic transactions Structuring deals acquisition legal structures debt leverage risk de-mergers financing choices in hostile takeovers legal documents overpayment risk pro forma analysis reality checks in reverse mergers securities in lieu of cash setting price for target special purpose acquisition corporations (SPACs) tax considerations Subway Sum-of-the-parts Swan effect executing through lowering risk nature of understanding math Synergies/economies of scale buyer motivation for M&A in combining buyer and seller projections in discounted cash flow (DCF) approach “Tail” provisions Target financial analysis See also Target valuation absolute amount analysis accurate financial statements buyer's audit combining with buyer financial analysis common size analysis company classifications comparable public companies performance credit ratings 262 dressing up the sales candidate forecasting sales and earnings growth analysis historical analysis industry-specific indicators “normalizing” results percentage changes P.F Chang example ratio analysis review Target search process See Acquisition campaigns Target valuation See also Target financial analysis comparable acquisition approach comparable public companies approach confirming valuation range cyclical companies discounted cash flow (DCF) approach in emerging markets forecasting sales and earnings high-leverage companies leveraged buyout (LBO) approach low-tech, money-losing companies natural resources in reality in seller business appraisal seller considerations speculative high-tech companies sum-of-the-parts in holding companies turnaround companies Tax considerations buyer capital gains tax for mergers recapture tax seller “step up” tax basis for stock purchases tax-free deals Tax-free deals Teasers Technical expertise buyer motivation for M&A 263 valuation of speculative high-tech companies Telebras Telefonica de Argentina Telmex Tenet Healthcare Terminal value, in discounted cash flow (DCF) approach Texas Roadhouse Thailand Thomson Financial 3-D Systems 3G Capital Time series forecast techniques Time Warner Timing considerations, for seller TMobile TNK-BP Torah Portland Towers Watson TPG Capital Trends in M&A market advanced M&A industry in U.S cyclicality deal categories deal size emerging markets geographical distribution growth in transactions historical private equity participants size of deals wealthy nations other than U.S Triangular mergers Turnaround companies Turner, Gerald Tyco Flow Control International Corporation UCI Medical United Airlines United States advanced M&A industry “cash flow” loans history of mergers and acquisitions regulation of securities industry 264 U.S Steel Universal Valeant Pharmaceuticals Valuation See Target valuation Vanguard Health Systems Venture capital pricing, for speculative high-tech companies Vertical transactions Wall Street (film) Warranties Western Europe Xstrata Yahoo! Yang, Bob Yang, Luo Yook, Ken 265 WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA 266 ... superior arbitrage investments, and assess relevant regulatory matters M &A: A Practical Guide to Doing the Deal provides a practical, well-rounded view of the M &A business and enables you to make sound... Notes Part Three: Target Financial Analysis Chapter 10: Sizing Up the M &A Target from a Financial Point of View Starting the Historical Financial Analysis Beginning the Historical Analysis Normalizing... Chapter 11: To Facilitate Financial Projections, the Buyer Needs to Classify the Target as a Mature, Growth, or Cyclical Business Company Classifications The Mature Company The Growth Company The