Spring 2022 End-of-semester Exam on Financing of Acquisitions- Corporate Finance, University of North Texas

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State and explain the different ways in which an acquiror can consider financing its acquisition.

Exam Solution: There are a number of different ways in which an acquiror can consider financing its acquisition. Sometimes this will require negotiation with the vendors, at others, negotiations will be with third party financiers so that the vendors receive the same type of consideration irrespective of how the acquisition is financed.

1. Cash

Cash has the great merit of being simple, understandable and hard to argue with. The attractions of cash are likely to be most apparent to the seller but some noted takeover exponents consider that cash payment imposes a useful discipline on the buyer also.

2. Deferred terms

As part of the negotiations between buyer and seller, it may be agreed that all or part of payment for an acquisition should be on a deferred basis instead of for immediate settlement. One reason may be because the acquiror cannot afford to put up 100% of the purchase price initially but there are a number of other circumstances in which deferred terms may be appropriate.

3. Exchange of securities

An alternative to payment in cash immediately or on a deferred basis is to offer an exchange of securities. This is only likely to be a practical possibility where the securities being offered are, or will be, listed on a recognized stock exchange and so have a reasonable degree of marketability. The securities offered may be equity, debt or instruments combining both these elements.

An offer which includes an element other than cash can present problems of understanding for the shareholders to whom it is offered. The more elements there are in such an offer, the greater the likely problems become. It is a useful rule not to include more types of security than is really necessary and to ensure that the securities which are offered are as familiar as possible.

When considering cash as the method to use to pay for control in an acquisition, several factors need to be considered. What are some of these factors?

Exam Solution:

1. How can cash be raised?

If an acquiror has sufficient liquid assets, it may simply pay for an acquisition out of its own funds. For an acquisition of a significant size, an acquiror is likely to wish at least to supplement its own resources by external funding.

The most common source of finance is bank lending. Credit lines may have already been negotiated, although they may not necessarily be available or suitable as acquisition finance. As a major acquisition is outside the ordinary course of business, the company should brief its bankers beforehand or, if confidentiality forbids this, at the earliest stage possible Most acquisitions need longer-term finance than the company's normal requirements. The acquiror may wish to negotiate with its bankers for extended maturities.

If bank finance is required, the question of security for the borrowings will arise. In some countries, legal problems can occur if a company could be considered to be giving assistance in the purchase of its own shares. This is a point on which detailed legal advice is required. Unless the acquiror is very lightly geared or the acquisition is a small one, repayments of bank borrowings to fund a cash bid are very likely to come, at least in part, from the cash flow (including asset disposals) of the company being acquired. Even under the strictest interpretation of the legislation, it seems that the company acquired could pay very substantial dividends to its new parent to service loans, provided it has sufficient distributable reserves. Funds can be raised for acquisitions by the issue of securities to institutions and other third parties. The issue of high yielding bonds (junk bonds') has become an important source of financing acquisitions in US Such bonds are attractive to investors as they typically involve high fees and yield considerably more than would be normal for a standard bond issue.

The payment of the high coupons and the repayment of the principal depends significantly on funds being released from disposals of the assets of the company being acquired. If the disposal program does not proceed to schedule, if economic conditions worsen or if the acquiror has misjudged the value of the assets in the first place, the worth of junk bonds' could be brought into question They represent the replacement of a significant part of the acquisition's equity by debt obligations of the acquiror company. This implies that it is possible to run the enlarged group with a significantly lower level of equity than was the case previously. This strategy does not leave much margin for error-

2. Leveraged buy-outs and Management buy-outs (MBOs)

In a leveraged buy-out, a group of parties come together to acquire a company funded principally with loans intended to be repaid out of asset disposals Where- management is involved this type of operation is called a management buy-out. As a practical matter, it is likely that management involvement will be necessary in order to gain the confidence of the lending or other investment institutions Their risk would be extreme if a highly geared group were intended to be run without the assistance of existing management or other people with very similar experience who could develop an informed and detailed plan to show how the loans could be repaid.

Many leveraged buy-out operations begin to look like a controlled liquidation, at least of a part of the business. Indeed, the main logic underlying such transactions is that there exists a profitable core of businesses to which a group can be stripped down, freeing up significant, perhaps not fully productive assets.

The same logic suggests that at least one party to the transaction has under- valued the assets involved. The vendor may be a large conglomerate who during a period of growth acquired a series of businesses without subsequently being able to manage them actively or understand them properly Management can become frustrated that administrative controls deprive them of the flexibility to make decisions and of the availability of funds for expansion. This may lead to a decline in the business and the demoralization of management which results in under- performance. Indeed, once management begins to contemplate a buy-out there is little incentive to improve performance in advance of it.

Freed of the shackles of an unsympathetic parent, the business may indeed recover. II the problems are more deep-seated than appears, a resurgence of management enthusiasm may not be sufficient by itself to restore the company to health. The natural pride of a management in its own business can lead them to over-value it. Institutions who support such an operation with finance may be inclined to regret the persuasiveness management can bring to bear in such circumstances

3. Taxation

Acceptance of cash by the vendors can give rise to tax liabilities. They will be considered to have disposed of their shares and any capital gain will be realized at that point. This may simply be the penalty of having made a successful investment. However, there may be some advantage in offering vendors the alternative of taking shares or other paper. In this way, they may be able to 'roll- over their investment so that no taxable gain will arise until they dispose of the securities they receive in exchange for their original holding.

4. Cosmetic advantages of a paper alternative

The fact that cash is simple also means that there is no disguising that a sale is actually being made. It is not possible to suggest to vendors that they retain any kind of stake in the future of the business. If some alternative, even partial, can be offered in paper in addition to the cash, this not only gives the vendors another option but may also make them feel they are not being forced to part with their investment in the company altogether.

What are the circumstances where using deferred terms to pay for control in an acquisition is considered appropriate?

Exam Solution:

1. As vendor finance

Deferred payment may be considered to be mainly to the advantage of the purchaser. It may be offered by the vendors if they realize that to demand cash is likely to restrict the chances of a sale. In some cases, the assets being purchased may not be acceptable as security for conventional bank borrowing Vendor finance not only makes the transaction possible but gives the purchaser an indication of the vendors' confidence in the quality of the assets and the price being paid. For the vendors, provided security is retained over the asset, the worst outcome would be to take back the asset and retain the deposit.

Vendor finance is most suitable where a relatively straightforward asset such as a property is being sold. In the case of a business, the damage done by the changes of control can make this structure undesirable.

2. As part of negotiation on price

Payment by instalments can be a useful negotiating device where a seller insists on the amount he must receive and the purchaser's best offer falls short. A compromise can be achieved through a series of deferred payments. These may add up to the nominal sum the vendor has in mind but have a discounted present While this may seem purely cosmetic, it is surprising how frequently a vendor is value (allowing for interest) equal to the price the purchaser is prepared to pay. While this may seem purely cosmetic, it is surprising how frequently a vendor is concerned to claim he has achieved a particular figure, perhaps to avoid a book loss.

3. To provide for a period of investigation

 The purchaser will investigate an acquisition at the time of the transaction to find out what problems may exist. Without being in full control of the business, a purchaser cannot be entirely confident he has identified all the potential pitfalls Difficulties may not become apparent for some period of time. If the whole purchase price is paid on completion, the purchaser may have to sue the vendor to recover any damages due. If, on the other hand, the purchaser retains some portion of the purchase price, he has the option to refuse to pay the balance if he feels the terms of the sale and purchase agreement have been broken. The vendor must then prove that the purchaser is withholding money unfairly. No question arises as to whether the vendor can actually repay the sum in dispute. If the vendor's business proves to have some financial weaknesses, it is likely that the purchase price, once paid over, will prove difficult to recover.

4. To allow for variations in price

The price for an acquisition may vary depending on future performance. It is sometimes useful to have a performance-related element in the consideration so as to give management an incentive and to allow vendors to share in future growth. In such cases, payment has to be by instalments as the amounts due cannot be known at the outset.

Difficulties can arise with this structure. The new controlling shareholder may wish to change the accounting policies of the company. This will affect the reported profits in a way which may not reflect the performance of the business. In addition, disputes may arise over policies which are good for the business but may depress short-term profits. The new controlling shareholder may wish to establish a conservative base for growth for the future. The vendors will wish to maximize profits in the period during which the variable consideration is calculated.

What are some of the securities that can be offered as a form of payment for control in an acquisition?

Exam Solution:

1. Ordinary shares

The most obvious choice is ordinary shares of the acquiror which rank in all respects equally to shares which are already in issue. The acquiror must weigh up the percentage in the equity of the enlarged group which is being allocated to the shareholders of the company being acquired. The acquiror must expect that shareholders of a target company may not necessarily see the merits of the acquiror's paper as clearly as the acquiror itself.

The provision of a cash alternative by underwriting or some other method will establish the worth of the securities being offered. Firm arrangements are desirable to deal with a large number of shares being issued to investors who may not be long-term holders. In the absence of such proposals, the announcement of the bid may trigger a period of price weakness in the acquiror's shares. This can play havoc with calculations of the worth of the bid based on market prices before the announcement.

2. Shares with different rights

Despite additional complications, it may be advantageous to offer shares with different rights from the existing ordinary shares. If the target company pays a high dividend, it may be necessary to offer shares carrying preferred dividend rights in order to be able to offer an attractive increase in income to the target's shareholders. An alternative might be for the acquiring company to raise its own dividends to match that of the target. However, this requires the higher dividend to be paid on all the issued shares of the acquiror, which may not be practicable. As well as shares with improved rights, shares with restricted rights may be utilized in acquisitions.

Shares which do not, for the moment, carry any rights to dividends may be acceptable to vendors as consideration for an asset which does not currently generate income. An example is a property for development where the development period might typically be two to three years. In this case, shares could be issued which carry no rights to dividend during the development period, after which they would rank equally with the other shares. Until they do, they are unlikely to be freely tradable in the market.

Shares can also be issued with rights linked to the particular business being acquired. This is a useful device where the acquiring company is very large with a different major activity to that of the target company. The target company shareholders may feel little interest in being shareholders of a company so dissimilar to their original investment. To counter this, the dividend of the new shares may be linked to the performance of the business being acquired and not to the group as a whole. Accounting problems may arise but an acquiror may feel this is a fair price to pay where in any case it is intended that the acquisition should be run independently.

3. Debt

Shareholders of the target company may also be offered debt obligations of the acquiring company. They may see an advantage in ranking ahead of shareholders in a company with which they are not familiar. The coupon on debt should provide a higher current income than dividends on an equivalent value of ordinary shares which should attract investors valuing high yields. The acquiror on the other hand can offer a higher nominal value without surrendering equity in the enlarged group. Where the company being acquired is asset rich, inclusion of some debt may seem appropriate to both sides. The vendors feel due consideration is being given to the assets contributed by their company, while the purchasers' equity is not diluted. The debt issued is prudently backed by assets and may be serviced by income from or disposals of such assets. The inclusion of debt increases the debt/equity ratio of the enlarged group in the same way as a cash payment. However, depending on the repayment schedule

of the debt, the impact on cash flow will be significantly reduced. Debt may be issued on terms which enable it to be converted into ordinary shares. This allows the issuer and the holder to hedge their bets. If the underlying equity does not perform well, the debt will still hold its value to a considerable extent. If the company does well, holders of the convertible will benefit from conversion. The dilution effect to the issuing company's shareholders will be delayed until increased earnings can compensate for the larger number of shares in issue.

As an alternative to conversion rights, warrants to subscribe for the acquiror's company's securities (usually ordinary shares) may be included in the package. Warrants have proved rather difficult to value and may not be regarded as having much importance in the eyes of the target company's shareholders. They are viewed more as a general sweetener to the proposals. In volatile and rising markets, warrants can have significant market worth. They may also prove useful to the issuing company. At the end of the warrant period, providing the underlying share price is above the warrant exercise price, new funds should be received by the issuing company through subscription of the warrants.