At Projects RH, our core business is we connect projects & money. One of the ways we do that is by acting as an internal resource to process manage a major change in the business. We understand the challenges of transitions. Our experience and work methods will accelerate the process, optimise the value and minimize the risks.
Mergers, acquisitions and divestments are seen by many people as some of the most exciting parts of corporate finance, but put simply they are swap, buy and sell.
For the purposes of this blog we will define the terms as:
- Mergers are generally said to occur when two organisations, usually companies, join their assets and liabilities. This is generally achieved by one entity buying the shares of a second entity for shares in the first entity. The first entity will then have the combined assets and liabilities of the two companies and their shareholders also as its shareholders. It is important to understand that mergers do not need to be on equal terms and can involve cash payments.
- Acquisitions occur when one company buys something else. It is usually a company and is significant enough that people notice. It is generally achieved by a mix of borrowing and issuing new shares; however, these new shares need not be issued to the existing shareholders of the “target” entity.
- Divestments are the selling of a business or a part of the business it can be for cash or shares. In theory, divestments should occur because the value of a business, or part of the business, is worth more to someone else than it is to the existing shareholder.
Mergers
Examples of mergers include the formation of the National Australia Bank through the merger of the National Bank of Australasia and the Commercial Banking Company of Sydney. About the same time Australia had six private banks which merged into three.
Mergers come with gains and costs; generally mergers have been justified by cost savings arising from savings in management, marketing and development of a national market. In financial theory the present value of the savings should exceed the present value of the costs. Some will ask why the present value of the costs a number of these costs do not emerge for some time down the track as offices are closed and people are made redundant. Despite these costs, value was created and these banks, along with the Commonwealth Bank which is now privatised, have become significant international banks.
The classic reasons for merger are characterised as horizontal, vertical and conglomerate. Horizontal savings emerge from doing more of the same thing such as bank mergers which allow the closure of branches. A vertical merger occurs when electricity generator is bought by a retailer to provide them with long-term supply. It is common now to see companies such as AGL investing in solar power projects to achieve this integration. The more interesting one is where companies have unrelated businesses but where one company believes it can add value to the other potentially to restructure it and resell it. Wesfarmers purchase of and float of Coles is a textbook example. Conglomerates are businesses which operate in different sectors and achieve additional value for shareholders by reducing risk and sharing corporate services. It is argued that this adds shares to shareholder value.
Acquisitions
Acquisitions are often made so that a company can enter a new product or a new market. For example, an Australian confectionery company wanting to enter into United Kingdom market may acquire a small confectionery business in the United Kingdom to give it a platform for growth in that market. Having made the acquisition, it has some sales and a presence in the market and can potentially save years by building on existing business rather than having to start from scratch. The existing business would probably have regulatory compliance as well as a brand but generally would have staff and distribution.
A second reason a company with a good cash flow may seek to acquire a business is for diversification. The company made see the opportunities for growth in its existing business lines as limited and therefore seeks an investment to achieve what it believes to be shareholders expectations. It is often argued that diversification reduces overall risk. For example, a metal mining company that enters into the oil business may be still in resources but has exposures to different risks with the resources sector.
Divestments
Divestments generally occur because the company wishes to focus on other businesses in its portfolio. Often the value of a business within a company portfolio is not recognised by analysts. This is often the case when the market considers that business to be non-core. Increasingly, investors expect companies and their boards to focus on core businesses. So non-core businesses are vulnerable to sale.
In Australia we see a lot of divestments that occur in the property sector. The company will see that it needs a location in a particular area it will develop say a retail complex make itself the anchor tenant and grant itself a favourable lease. It will then acknowledge it has made the development profit and that the ongoing rate of return from owning such an asset will only be 4% after all costs when it’s weighted average cost of capital is 10%. It makes a lot of sense to sell that property as it does not make the required rate of return for the business. Within some companies this idea of creating property and divesting it is part of the business. The internationally acknowledged example of this is McDonald’s which in some circles are said to be more a property and logistics company than a fast food retailer. Another example Woolworths but also this was commonly done by the major oil companies as they expanded their retail franchises around the world.
Other examples of divestment occur when a conglomerate company recognises that a division or business is probably worth more to someone else and it is to them and that they could reinvest the proceeds in another part of their business and get greater returns for shareholders. BHP began its life as a mining company mining hard rock minerals around Broken Hill. It’s management many years down the track believed what they should do was to add value to the minerals they were mining by building a steel mill, eventually three, then many years down the track they realise their expertise was not in the making of steel and that the risk profile associated with the rest of the business meant that an investment in the steel sector did not provide their investors with returns are expecting from a mining company. Eventually the steel business was divested as part of this BlueScope Steel when it was divested through a float on the Australian Stock Exchange. Within the BlueScope group the steel business was more significant and receive greater attention not only from the analyst from the board and management. It was truly worth more to a different company than it was to a global resources and energy house such as BHP.
In the world of global investment, analysts are looking for sector-specific companies to invest in. In this world conglomerates are constantly challenged as to the best use of their balance sheets and available capital. Equally growth opportunities change. In recent decades the energy majors have exited petrol retail and other downstream all activities including refining. The funds raised by exiting these sectors have been reinvested in what they see as the new business for them as big energy by moving into solar wind and other renewables. These new businesses have more risk and enjoy higher returns.
For Projects RH´s clients
At Projects RH we apply these same principles to the activities of our clients:
Mergers
Working as a corporate advisor, and with our strong network of strategic partners, we often see opportunities with two companies complement each other and there are clear advantages of economies of scale. This this can lead to value creating mergers as a new group is able to offer a more complete service.
In the midmarket, mergers generally occur for companies to achieve scale or for complimentary skills. A company with good technology may readily merge with another which has excellent marketing and financial reporting skills. It may be that the nature of the technical developers of the superior product can acknowledge that they are not marketers and that the market is accept that the other entities product is superior. It really is a matter of being pragmatic and saying 2+2 can equal 5 or more.
Acquisitions
Where a client lacks economy of scale, we work with them to find merger or acquisition opportunities. In these scenarios it is important to find win-win opportunities. We commonly see this as successful with professional services firms such as accountants and engineering but equally applies to parties who market software as a service.
We regularly participate in acquisitions. We often hear the story of a well-established family business where the members of the family really don’t want the business and would rather it be sold. We look for somebody who can afford to buy the business and continue it often by adding it to their own family business. This is common in agriculture and small mining to. So, for one party there has been an acquisition and for the other party there has been a divestment. Hopefully at a fair price where both groups are happy.
We most commonly see mergers in services groups, it may be our client base, increasingly services firms need to have balance sheets and insurance policies which enable them to compete for work. What is said to us is a bigger firm gets more opportunities. We have recently seen an example where a party acquired technology for cash in its own shares. It was a win-win as the purchaser could use the technology and the vendor had been unable to raise the capital to develop the technology any further
Mergers, acquisitions and divestments often get colourful words around them and these are generally set by the context in which they occur. At times there are a very fine line between mergers and acquisitions. Sometimes an acquisition occurs to prevent a company from going into insolvency at such an acquisition may be guided by regulators governments or lenders. I divestments can be forced upon a company because it needs to sell an asset to remain afloat.
Divestments
Most recently Projects RH has been approached by a company with a world-class mining opportunity which has been recognised and not progressed for over a decade. We have been asked to sell the opportunity. Sale is going to be the best way to achieve value.
Sadly, for the founders, divestments is often the pathway for many small to medium family businesses. It is important for us not to be emotional but to accept that for many families the original family business no longer fits in with the aspirations of the family and for that and it is in the best interests of the business that it be sold and the funds realised used father family purposes. This occurs across a number of sectors including agriculture and manufacturing.
Events of 2020
Whilst many of us will remember 2020 as the year we spent much time working from home and not travelling what it should be remembered is how it’s changed the market.
2020 will be recognised as a year of change and the beginning of reconstruction of many firms. This reconstruction will include mergers, acquisitions and divestments. For some it will be sad for many is the beginning of a new lease of life.
We will see companies challenged to ensure that they deliver strong shareholder performance. Some will see opportunity to merge and acquire plus divest, regrettably others will need to divest to reduce their leverage.
A year of opportunities
At Projects RH we work with our clients to achieve their goal. We are excited by what we do and in each stage of the market we see huge opportunities and welcome to share those with our clients.
2020 will be year of change and opportunity in the mergers, acquisitions and divestments area as M&A plus divestments allow companies to shape their form to deliver their destiny.
