Chapter 46
FINANCIAL MANAGEMENT : Mergers and Demergers

Business combinations, commonly referred to as mergers and acquisitions, can take many forms. The most important distinction among them is the method of payment: (i) cash or cash and shares; (ii) 100% in shares.

All-share deals can take several forms:

• legal merger: two or more companies are combined to form a single company. In general, one company is dissolved and absorbed into the other;

• contribution of shares: the shareholders of Company B exchange their shares for shares of Company A;

• asset contribution: Company B transfers a portion of its assets to Company A in exchange for shares issued by Company A.

The economics of the business combination are independent of the financial arrangements. That said, in an all-share deal the resources of the two entities are added together, increasing the merged company’s financial capacity, compared with what it would have been after the conclusion of a cash deal. Also, in an all-share deal, all the shareholders of the resulting group share the risks of the merger. When the deal is negotiated, the companies are valued and the relative value ratio and exchange ratio are set. The exchange ratio is the number of shares of the acquiring company that will be exchanged for the tendered shares of the acquired company. The relative value ratio determines the position of each group of shareholders in the newly merged group.

The higher a company’s P/E ratio is, the more tempted it will be to carry out acquisitions by issuing shares, because its earnings per share will automatically increase. But be careful! No value is automatically created. The increase in EPS is only a mathematical result deriving from the difference between the P/E ratios of the acquirer and the acquiree. At the same time, the P/E ratio of the new entity declines, because the market capitalisations of the new group should theoretically correspond to the sum of the market capitalisation of the two companies prior to the merger. Sometimes the new company’s P/E ratio stays the same as the acquiring company’s P/E ratio. We call this the “magic kiss” effect, because it implies that the company has only to “wake up” the “sleeping beauty” it has acquired. In each case, the value of the merger synergies is added to the value of the new company. How they are shared by the two groups of shareholders determines the premium the acquiring company will pay to the target’s shareholders to persuade them to participate in the deal.

A demerger is a simple concept. A diversified group decides to separate into distinct compa- nies and to distribute the shares of the new companies to shareholders in return for shares of the parent group. It is often an answer to too low a valuation for a group with too far-flung activities.

The value created by a demerger can be analysed as follows:

• unlocking the value trapped in the conglomerate discount (efficient markets hypothesis);

• increasing the motivation of the managers of the newly independent company (agency theory).

A demerger results in companies being more exposed to takeover bids.