There are several types of payments in the practice of mergers and acquisitions: cash, ordinary shares, bonds or preferred shares, convertible shares, hybrid securities or derivatives, etc. Moreover, either a mixture of the above-mentioned ones or a deferred payment, i.e. obligation to pay in the future according to specified conditions, is possible.
Major types of payment in mergers & acquisitions and corresponding distribution of deals involving certain types of payment in Russian takeovers (total 2,792 deals with the type of payment stated explicitly).
Cash and ordinary stock are considered to be two of the most popular types of payment in the world. . Borrowing (for example, leveraged buy-out or simply LBO, or simple borrowing), preferred stock, derivatives and other types are used less commonly. Stable and relatively high prices of the acquirer’s shares ensure its ability to expand, using stock to pay for a deal. Moreover, equity payments in takeovers make it possible for public companies to defend them from hostile takeovers. It is implemented by means of broad mergers and acquisitions targeted to increase market capitalization.
Considering Russian companies, it should be noted that Russian companies tend to acquire new assets through vertical and horizontal takeovers. That implies acquisition of firms in the same industry and in the subcontracting industry respectively rather than investing in research and development of their own units. Moreover, the strategy of takeovers is a relatively fast way to acquire the needed assets. In many cases, mergers and acquisitions play a key role in strengthening market power and production capacity. Furthermore, the use of internal development would be a crucial failure in being commercially viable.
For instance, in some cases it is less complicated to acquire target through a developed system of distribution and marketing. This statement is strongly exemplified in the field of cellular telephony with “Mobilnye Telesistemy OAO” that has used broad takeover strategy since 2000 and acquired more than 124 companies around the country. They carried out the deals with local cellular operators such as “Sibintertelekom”, “Astrakhan Mobile Zao”, and “Volgograd Mobail Zao”.
In the marketing field, Pivovarnya Moskva-Efes Zao” acquired “Amstar” to expand the range of beer sold and increase the production capacity. Another way to secure the object is using specific technologies and knowledge required for proper functioning of the business. It is applied bysome Internet-based firms, like “Yandeks OOO”. However, in other cases companies tend to develop on their own, since many of them require very specific characteristics of business which are not presented on the market.
Distribution of cash and stock payments. Data from Zephyr (Bureau van Dijk). Country: Russian Federation (Acquirer AND Target), Deal type: Acquisition, Merger (any stake). The sample under consideration includes only deals where the method of payment was indicated explicitly and other methods of payment were not used at all (only cash, stock or both).
The absolute majority of all the deals under consideration in the sample involved cash method of payment (80,22%). As for the stock, it was used individually only in 7,7% of deals and in 1,5% of mixed deals. The low portion of stock financed deals can be accounted for several important reasons. Russia is a developing country with a relatively inefficient capital market. Consequently, the prevalence of cash payments stems from low liquidity and relatively low prices of shares.
Only the so-called blue chips are highly liquid and they account for a major portion in a day-to-day volume of trading. The consequence of the lack of disclosed information about traded firms and uncertainty about future cash flows is that a lot of firms consider their shares to be undervalued by investors. . As a result, low market capitalization of average (or middle) firms directly influences the strategy of takeovers in Russia – it restricts the ability of an acquirer to use its ordinary shares to pay for the acquired company.
However, some reputed big players on the Russian market, like petroleum and raw material producers, use ordinary stock to acquire major stake in other companies. Stock is also frequently used in financial takeovers by thebanks, financial institutions and media companies for provision of telecommunication services and broadcasting.
Moreover, the majority of big stock deals are negotiated to restructure subsidiaries in a certain holding; that is why they are not oriented towards increasing the performance. They mostly target at changing the ownership. Consequently, it reduces the size of an effective sample.
Some major deals involving stock payment. Data from Zephyr (Bureau van Dijk). Country: Russian Federation (Acquirer AND Target), Deal type: Acquisition, Merger (payment by stock).
Generally speaking, only a narrow range of buyers can use their shares as a paying medium in mergers and acquisitions. Conversely, the difference between cash and stock payments is essential for the success of a deal. Use of cash fully ensures that the shareholders of the target do not run any risk associated with future changes in the buyer’s performance on the market. It is crucial for medium and small Russian companies that lack some important information disclosed on the market. Further details of this issue will be discussed in part III. “Cash or stock”.
To sum up, the experience of mergers and acquisition in Russia is quite limited; it can be ascribed to the consequence of historical development of the Russian market for capital. In order to analyze both overall picture and specific deals, we should focus on three main subjects. The type of payment is also one of them, but it cannot be considered a crucial one).
Firstly,, companies involved in takeovers have some expectation about the post-deal performance of a combined firm; for a deal to be successful objectives should be achieved. The second part of the question is devoted to the accumulation of capital for shareholders, a target firm or an acquirer. It means determining whether the deals were a financial success? And finally, we are to specify which premises make some takeovers more successful than others. To answer all those questions, the factors of success should be considered first.
II. Factors of success
Most of the studies on mergers and acquisitions conclude that approximately half of the deals are successful. The success is measured by different benchmarks, including the performance of price compared to that of peers or some industry-specific stock price average, ability to generate revenues, operating performance, social factors, etc. Consequently, the variety of “success” indicators results in different explanations of the rationale of the optimal course of things in a good takeover. Causal relationship is established through difficult procedures that are controlled by many factors. In addition, different accounting methods are used merger through absorption or merger through consolidation, purchase vs. pooling accounting.
That makes it difficult to compare the firms’ data. It is sometimes misleading to evaluate the first year performance after a deal because of one-time costs incurred during the process of a takeover. However, the stages of takeover process and efficiency of sub-processes undertaken in each stage embody all the sources of potential benefits to an acquirer and reveal different costs. There is a financial aspect of a deal; it is taken into consideration in order to indicate the key matters of takeovers, since there are many of them. Deals may fail because of competitive reactions, customer dissatisfaction, inadequate due diligence, difficulty of integration, or lack of timely decisions. However, there are three crucial points to note: due diligence, calculation of synergy & pricing and integration.
#1 Screening: looking for potential target, identification of strategy
The decision-making process starts from the identification of potential sources of growth. Takeovers or internal development should have a reason behind. This reason defines the range of opportunities for attaining the objectives of a company. The main issues concern the type of assets it needs and the amount of time it has. The development of a business strategy at this stage protects company from irrational decisions based on mere inspiration. The list of objectives may include different goals, for example:
- Gain access to new markets
- Increase market share
- Gain access to new products
- Reduce operating costs
- Reduce the number of competitors, etc.
It stands to mention that on a large scale, deals aimed at achieving scale economies or developing an existing business meet expectations much more often than those aimed at adding new capabilities or a new business model. Horizontal integrations are more risky and require deep understanding of the reason for the acquisition.
However, economies of scale and scope do not generally prevail; since they are not “strategic” aims. Obtaining scale gains is often not considered as a comprehensive strategy. In addition, many firms cannot undertake mergers to gain such advantages in case their industries are already concentrated. Thus, many deals miss the opportunity to provide scale gains. After the goals are defined, it is time for the screening of market. It is considered to be advantageous when firms select at least two variants for potential acquisition, since the option of choice helps the company to avoid far-fetched illusions.
#2 First financial steps: due diligence process, identification of assets to be acquired and preliminary pricing, synergy
The main aim of due diligence in mergers and acquisition is to provide information about all benefits and liabilities of a target in relation to acquirer’s business. Proper actions at this stage include accurate inspection of all aspects of the firm under consideration, identification of all potential hidden issues and legal procedures, and understanding the target firm’s financials. More than that, the bidder should define whether the target has the same strategic direction, validating the reasons for the deal, and understanding the customer base and their loyalty with the acquirer.
Good acquirers should pay more attention to the mentioned strategic factors. Focus on due diligence raises the chances for success and helps to avoid inappropriate options. More than that, strategic due diligence helps to define post-merger integration issues and sources of synergy, as both play a key role in a successful result.
Synergy reflects the fact that combined company produces extra wealth for shareholders compared to separate entities. There are many different sources of synergy. Two main of them are cost savings and revenue enhancements. Cost savings in scale and scope economies comprise overhead reduction, rationalization of manufacturing premises; in scale economies it is purchasing power and efficiency gains from process improvement; in financial engineering it is tax reduction. Revenue enhancements include all the revenue-side effects like cross-selling, leveraging market power, enhanced new product development, portfolio expansion, transfer of knowledge and skills, and faster time-to-market. Prior to a merger, a bidder cannot be well aware of all the details of the assets he is acquiring in order to predict cost savings accurately. Savings often come from unexpected sources.
For example, transferring learning is a major source of potential synergies, especially in international deals; like in China where the knowledge possessed by the merging organizations may vary considerably. As for the sales, it is even more complicated to do revenue projections for the combined entity. Yet, the study undertaken by Matthias M. Bekier, Anna J. Bogardus, and Tim Oldham in 2001 (McKinsey) indicates that revenue deserves more attention in mergers. Indeed, a failure to focus on this important factor may explain why so many mergers do not pay off. Too many companies lose their revenue momentum as they concentrate on cost synergies or fail to focus on post-merger growth in a systematic manner. “Given a 1 percent shortfall in revenue growth, a merger can stay on track to create value only if a company achieves cost savings that are 25 percent higher than those it had anticipated.”
Therefore, the calculation of synergy should account for a potential in revenue generation alongside with cost saving opportunities. However, prediction of sales for combined company is a challenging task, since that requires large amounts of information concerning customers, distribution of sales, etc. It may be not disclosed at the early steps of negotiations since it is private. Thus, the screening of market and pricing is more difficult. Actually, failures in takeovers are often caused by overestimating the synergies available, overpaying, and inadequate integration planning.
#3 Decision making: pricing, payment method, integration planning
Pricing process is based on the results of due diligence and the value of synergy calculated. The higher the synergy is, the higher is the premium thatmay be paid. That is why there is no single fair price for a deal on a market. Some firms may generate high wealth for shareholders through distribution of positive net acquisition value covering value gap of a deal. However, other firms may be not a successful party for a target. Many studies were conducted to answer whether the size of an acquisition premium is an important determinant of the ultimate success of a deal. For example, G. Alexandridis, K.P. Fuller, L.Terhaar and N.G. Travlos in their study “Deal Size, Acquisition Premia and Shareholder Gains” (2011) state that acquirers of large firms continue to underperform small target acquirers in the long-run in terms of both stock market and operating performance.
It indicates that they fail to deliver the assumed synergies since large deals tend to be too big to succeed, irrespective of the premium paid. Besides there is negative relation between target size and the premium paid in acquisitions. Other studies suggest that the relative size of premium is not significant in determining the success of a deal. The size of the percentage premium was unrelated to the success of the deal (Ernst &Young); however, it is the fact that high premiums limit the financial benefits to acquirer. It will be said further that payment method and the size of a premium are very strong signals to the market. Provided that the stock payment is proposed with a premium that is higher than in equilibrium, the target shareholders may lose considerably high portion of this premium or the situation can get worse.
When price strategy is identified and both parties are ready to conduct a deal, the details of payment are discussed. Those details include the type of instruments to be used, timing of transactions, etc. The focus of the paper is to discriminate between cash and stock payment in Russian environment; specific features of both are discussed in the following parts. There is one more important key to success; that is integration planning at this stage. A good acquirer should sketch decisions concerning feature activities to attain fast integration and overtake the performance. Value creation takes place after the deal if managers ensure that the strategic capabilities of the target are transferred efficiently.
This period is closely connected to intensive work with the market and public. It was noted that in some cases the initial reaction of the stock market to the news of the deals was a reasonably good predictor of later returns. More than a half did badly later in case of poor reaction; while the majority of those that were initially met favorably by the market, later succeeded. However, other studies assume that market was systematically wrong in predicting real values of a deal.
#4 Final stages and Integration: transactions to close the deal, combined company’s activity, customers and workers
At this stage, the company should operate rapidly, since the speed of integration is significantly important. Quick integrations signal positive information to the market and prove the reason for the deal in the eyes of shareholders and workers. There are three leading integration problems at the stage: combination of information systems, different management attitudes and management practices, potential for workers and customer losses. It is evident that the average acquirers’ stock is lower than that of its peers one year after the deal.
Moreover, only one third of the acquired firms maintained their revenue on virtually the same level as the 3-year average one before the deal. Thus, fast transitions matter because they reduce the period of uncertainty. Besides, engaging employees is a key element for firms with intellectual capital. Fast deals bear witness of the stability for the workers; then fewer of them leave the company. In addition, mergers with rapid transitions were found to be more likely to succeed in a financial sense. So, the post-merger integration process is a key to promoting successful deals.
Experience in mergers and acquisitions can be a valuable option, however, different studies produce controversial results. The managers and other personnel are the key to success of a merger, acquisition, joint venture, or strategic alliance by a cooperative (Vandebur, Fulton, Hine, McNamara 2000). Moreover, experienced acquirers outperform the average results (A.T. Kearney 1999). On the other hand, “experience is often not important because firms tend to lose their knowledge as the managers who led previous acquisitions leave the firm” (Cook and Spitzer 2001). If we consider Russian deals with the value of at least 50 million EUR, more than half of them were engaged in takeovers more than once.
To sum up, the success of a deal mainly depends on three generalized issues: understanding of strategy and environment, technical mastery (synergy evaluation, integration planning and strategic due diligence), management and leadership (speed of execution). The violation of key elements in each stage produces poor results. In some cases acquirers are not clear about the rationale behind the deal; the goals of the takeover should account for strategic criteria. Failures often occur, if mergers are undertaken to pioneer new fields of business, being an inherently risky undertaking. On the other hand, consolidations to achieve scale or scope synergies across or within markets are likely to work; that is backed up with average results from worldwide statistics. However, cost reduction is often not the most important goal of a takeover.
III. Cash or stock
The relationship between the type of payment, stock and cash in this case, and success of a deal in financial terms are other other significant questions to consider. Specific features of development of capital market in Russia cause inverse proportion of money and paper financing. The largest Russian “blue chips”, that are listed on the “RTS”-Russian Stock Market and have relatively liquid market for them, are the least likely ones to become the object of a hostile takeover. It will not happen even if their market value is substantially undervalued as compared to the potential. As a consequence, money sources play a significant role in the practice of Russian takeovers. As estimated earlier, they account for approximately 80% of all the transactions (Table #1).
However, some big deals are conducted with stock payment, for example, a well-known scandalous deal withdrawn before completion is a merger of “Yukos Oil” and “Sibneft” announced at 19/01/98. The deal included acquisition of 92% stake in “Sibneft OAO” by “Neftyanaya Kompaniya Yukos OAO” and was planned to be paid by 76% portion in shares and the rest by cash (Shares 9,200,000 th EUR, Cash 2,760,000 th EUR). But the merger was annulled, as “Sibneft’s” shareholders regarded the deal as too risky. Another example is the 100% stake acquisition of “Neftyanaya Kompaniya Rosneft OAO” by “Rosneftegaz OAO” (oil and gas, petroleum products) completed by 08/06/05 (100% paid by Shares 5,266,525 th EUR). As for the recent deals, “Polimetall OAO” (gold and silver mining) in acquisition of “Rudnik Avlayakan OOO” and “Kirankan OOO” used shares as a main method of payment (actually 36,419 of 39,989 th EUR is paid in shares, the rest by debt financing).
Russian takeovers are also characterized by additional obligations (payment of loans, carrying out large-scale investment programs and so on) of an acquiring company. It is attributed to the fact that many of mergers and acquisitions in Russia, like privatization of state enterprises,) are auctions and investment tenders.
Another specific feature of Russian takeovers is the financing of a deal by accumulation of target’s debt and subsequent conversion into shares during the bankruptcy process. It is sometimes quite easy to start the bankruptcy process, since many companies have substantial accrued liabilities; then convert debt into shares and get a company. As a result, there is a merger of a debtor and a lender; for example, “Pskovenergo OAO” paid 72% stake of “Pskov GRES” to “Gazprom OAO” to finance debt valued at 92 mln RUR, as a result the latter actually acquired “Pskov GRES”.
It provides an interesting illustration of stock payments in Russian environment. But it is not a unique experience attributed solely to Russia; many companies in the world use debt conversation, but in Russia they implement plenty of such deals. The reasons include underdeveloped legislation, young market for capital and high amount of debts held by domestic companies, especially owned by the government. As for other means of payments, financing by debentures (Eurobonds) is also the one that takes place. For example, “VimpelCom ltd”, “OJSC «Mobile TeleSystems»” (mobile telecommunications services) used such methods to expand activities in regions in 2002.
Percentage of total number of deals in Russian mergers and acquisitions (including cross-border deals).
Absolute majority of deals were conducted solely with the use of cash type of payment. Besides, stock payments account only for 3% of total value among domestic deals with the value of at least 50 mil EUR.
Reasons for the choice of payment method between cash or stock, or mixed deals, vary greatly subject to a certain deal. Many of them are summarized below.
As previously stated, in cash transactions all the risk is run by the buyer. Target shareholders are isolated from all negative movements in stock returns and prices after the deal is completed. Cash payment is a signal of confidence of the acquirer in its motives. However, if the deal is paid entirely in cash, target stockholders are guaranteed against the risk of losing the opportunity to share some gains in synergy above the premium as a result of a takeover. So, there is a problem of asymmetric information at the market: investor concern with adverse selection produces a negative market reaction to the news of a stock deal rather than a cash deal. In general, risk-averse target shareholders would likely prefer cash. Actually, announcement-induced abnormal stock returns are lower for stock offers than for cash bids (Travlos, 1987).
Travlos finds that, on average, acquirers experience negative excess returns at the announcements of stock-financed acquisitions and normal returns at the announcements of cash-financed acquisitions. He concludes that “the findings are consistent with the signaling hypothesis”, which implies that financing a takeover through exchange of common stock conveys the negative information that the bidding firm is overvalued. Myers and Majluf (1984) show that in case of information asymmetry between managers and shareholders, managers have the incentive to issue stock when they perceive it to be overvalued. It should be noted that competition produces positive results. If there are multiple bids, then final agreement between a target and a bidder would include optimal amount of cash that increases with competition and stock. Thus, the bidder would signal its true value by the amount of cash paid in equilibrium.
Furthermore, the final agreement may be made under the fixed number of shares or fixed value of shares. In the first case, acquirer pays a fixed number of shares irrespective of stock price at the time of transaction. This releases the bidder from uncertainty about ownership as a result. In the second case, the bidder issues some amount of stock corresponding to a fixed value, and the number of share paid depends on the stock price when a deal is closed and transactions are made. Then the acquiring company bears all the pre-closing market risk on its share and also faces another problem, the identification of final stake. It also characterizes the confidence of a buyer in the ability to realize all the expected synergies from the deal as well as bidder’s opinion about market’s valuation of its shares. If it insists on a payment by stock, then the management is likely to think that stock is overvalued by market. Consequently, it may produce negative effect in stock price movements after announcement and closing.
Consistent with this argument, numerous studies document that the average market reaction to the announcement of equity offerings is significantly negative. Empirical evidencefurthermore shows a significantly higher announcement return to the shares of the target company for cash offers than for share offers. Erickson and Wang (1999) recognize the possible incentives for firms that conduct stock-financed acquisitions to manage earnings by aggressively utilizing discretionary accruals to inflate the purchasing power of their stock temporarily.
Firms conducting stock-financed acquisitions manage their earnings upward prior to their acquisitions. As a result, if there is a significant amount of earnings management before stock-financed acquisitions, a decline in the operating performance reported by these firms after their acquisition is expected. To sum up, theory implies that acquiring firms prefer to pay for their acquisitions with stock when it is overvalued and cash when the stock is undervalued.
If a mixed type of a deal was proposed, then the existing shareholders would expect control dilution in a merged company. In this case, some acquiring companies give preference to cash over stock as payment method in order to avoid problems connected with uncertainty over final stake hold in a merged entity. As far as the capital structure is considered, it should be noted that in considering stock and cash the payment method matters alongside with the source of financing.
Deals may be fully paid by cash. However, the source of cash is mainly one of the following: retained earnings, debt, or previously issued stock. Some researches state that in case of cash payments, debt and retained earnings significantly influence positive returns, while previously issued shares do not outperform market or even produce in negative market reactions (Toffanin, 2005). Besides, tax questions are also considered when the payment method is chosen. In case of cash transactions, selling shareholders face immediate capital gain taxes. There is a common rate of tax on income in Russia – 20% (since 1st January 2009). So, all those factors influence the final decision whether to pay by stock or cash.