What Is M&A and How Does it Affect Traders and Investors?

Have you ever heard the term M&A and wondered what it meant? Do you know how M&A affects your investments and whether you should adopt a particular trading strategy around it?

In this article, we’ll be addressing these questions, discussing the drivers and results of M&A and more!

What Is M&A?

M&A is an abbreviation for the term “Mergers and Acquisitions”.

An acquisition is easy to explain; it is the purchase of one company by another. In its simplest form, the acquiring company pays cash to buy all the shares of the company being bought. 

Instead of cash, sometimes a publicly-listed buyer will pay by using its own shares as the acquiring currency. And sometimes a mix of cash and shares is used.

A merger, on the other hand, is the consolidation of two companies into one legal entity. This can be financially and legally structured in a number of different ways, which we will not be looking at in this article. Strictly speaking, mergers in their purest sense are very rare.

Whatever the legal and financial structure behind the transaction, the decision about which term to use is often driven by the relationship between the companies, their attitude towards the proposed deal and the expected outcome after the deal closes.

Merger implies a merger of equals, in which both sides will share control and resources going forward.

The term acquisition tends to be used when one party buys another one but there has been consultation and agreement beforehand.

Takeover, however, implies that one of the companies is being bought; perhaps against its own wishes, and is being placed under the control of the other.

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What is The Motivation Behind Mergers & Acquisitions

In theory, a firm should only decide to buy or merge with another one to improve financial performance and increase value for shareholders. There are several ways in which this can be achieved and we’ll look at some of these below.

In the real world, however, there are suspicions that managers sometimes buy other companies to improve their own status and situation (for example, that being the manager of a larger company allows them to have a larger salary); or to hide problems in their own companies.

In developed markets like the UK, EU and US, mergers and acquisitions get so much scrutiny from financial analysts and the press that only those executives who control their share registers and their boards would be able to execute a large transaction that was not focused on delivering improved performance and shareholder value.

There are several ways in which a merger or acquisition can improve performance, for example:

• Economies of scale: the reduction of costs that come from making more and more of the same items;
• Cross selling: combining two companies whose products can be sold to each other’s client base could lead to increased revenues and profits;
• Increased tax or financial efficiency: for example where a company that generates a lot of cash is merged with a company going through a phase that requires funding;
• Increased pricing power: this can come from effectively eliminating an important competitor from the market.

The gains, or synergies, from mergers and acquisitions are heavily touted by the side that wants to get the deal done.

Synergies can be split into two categories:

• Revenue synergies, for example from cross-selling;
• Cost synergies, for example from combining two firms’ revenues and eliminating costs from back-office, manufacturing or headquarters.

In general, the market is somewhat sceptical about promised revenue synergies and more credulous of cost synergies – as this latter category can be more predictable.

Synergies are very important in mergers and acquisitions. There is no financial gain from combining two companies and leaving everything as it was before. Without improving revenues, cutting some costs, or addressing some new market the two companies are probably better off operating on their own.

It is quite common for managers, in their enthusiasm to get an acquisition done, to overpromise the level of synergies that will be achieved and later to underdeliver.

The M&A Timetable

When one or both of the companies involved in a transaction is a listed company, shareholders need to vote and approve the deal before it can close. This is a process that can take several months.

Other factors can delay a proposed transaction, including rival bids, the involvement of regulators, legal challenges, due diligence, etc. It is important to note that any one of these factors can also prevent a deal from happening altogether.

All of this means that there will be some uncertainty, and a gap of several months between a deal being announced and the deal, hopefully, closing.

In developed markets like the UK, US and EU, there is a strict set of rules and a timetable imposed to make sure that shareholders, both big and small, are treated fairly and that there is enough time to perform everything that needs to be completed; but not so long that the target company is left indefinitely in a state of limbo. In the UK, this complex set of rules is known as theTakeover Code.

During this time, the prices of the two shares will move according to the market’s reaction to the offer and opinions about the likely outcome.

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How Do Share Prices React In Mergers and Acquisitions?

Target Company

In order to buy a listed company, the acquirer needs to offer to pay more that the undisturbedprice of the shares (the price before any announcement is made). This difference is often called the premium. Premiums are usually 20% or more but will depend on the target’s prospects, the likelihood of other bidders and ultimately the acquirer’s desire to get the deal done quickly.

Upon the announcement of the offer, the share price of the target company will likely jump up and, typically, settle slightly below the offer price. The difference between the offer price and the normally lower market price reflects the possibility that a deal may not take place, de-railed by shareholder votes, regulators or some other factor.

Occasionally, the share price will go higher, beyond the offer price. This happens when the market as a whole believes that:

1. Other potential acquirers will be prompted to make their own higher offers and bid up the price of the target; or
2. The board of the target company will negotiate a higher offer from the acquirer.

Acquiring Company

Typically, the share price of the acquiring company will fall on the announcement due to one, or a combination of the following reasons:

• Shareholders perceive risks in the integration of the two companies;
• Perception that the acquisition will lead to additional operational risks;
• The price of acquisition is judged to be too high;
• The acquisition price demands loading more debt on the acquirer’s balance sheet, adding financial risk;
• Increased regulatory risk.

In general, the less risky, more logical and conservatively priced the acquisition is judged to be, the more favourably the market will react – and this will be reflected in the acquirer’s share price.

Positive reaction can go as far as pushing the acquirer’s share price higher. When US financial giant Charles Schwab announced at the end of 2019 that it planned to acquire rival TD Ameritrade, the industrial logic behind the deal and the restrained price of the acquisition caused a 9% rise in Charles Schwab’s share price.

The opposite is also true. When Tesla announced in June 2016 that it was planning to acquire Solarcity for a premium of around 25%, Tesla’s own share price fell by 13% in after-hours trading.

Should I Trade Around M&A?

Some traders base their entire trading strategy around Mergers & Acquisitions, in what is sometimes called merger arbitrage. Different tactics are used, some of which we will explore in the following sections.

Buying into potential targets, before any announcement

As we have seen, target companies often end up selling at a premium to their undisturbed share prices.

Some traders and investors analyse industries hoping to establish which companies are likely to end up being acquired by rivals; then taking long positions in these.

Getting this judgement right can result in benefiting from premiums that can be 20% or higher. When Microsoft bought LinkedIn in 2016, it paid a 50% premium over LinkedIn’s undisturbed share price.

Following this strategy exposes a trader to the risk that an offer never comes along or that, if it does, the transaction does not close due to one of the reasons discussed earlier.

Buying into announced targets

As we have seen, target shares normally trade slightly below the offer price.

Traders confident that the deal will close or, even better, that other bidders will be flushed out and offer even higher prices for the target, will buy into the shares of the target and hope for a deal to close.

Doing this leaves a trader exposed to the risk that the transaction fails to take place and that the target’s share price falls back towards the original undisturbed price.

For example, when Ares Capital announced that it was dropping its proposed acquisition of Australian financial group AMP in February 2021, AMP’s share price instantly fell by 10% and fell towards its previous undisturbed price.

The chart below also shows how AMP’s price jumped by 30% in two days following AMP’s announcement, at the end of October 2020, that it was in merger talks with Ares.

Shorting announced targets

A trader who thinks there is a large probability that the deal will not go through could elect to short the target’s stock, hoping that, once this becomes clear to the rest of the market, the target’s stock price falls back towards the undisturbed price.

This tactic leaves the short-seller exposed to the risk that the deal closes, which would result in the trader making a loss. 

Trading in both the acquirer and the target’s shares

Some traders will go all-in, for example, going long on the target’s shares and short of the acquirer’s shares if the deal is expected to succeed.

For deals where the acquirer uses its own shares as payment, some will decide what to buy and what to short, and in what ratios, depending on the relationship between the two share prices and the ratio of shares being offered.

This area is largely the domain of hedge funds and other specialist investment firms. The critical job for these investors is to successfully predict which announced deals will close and which won’t. To improve their chances of getting this right, hedge funds employ experienced lawyers and industry experts to evaluate deals and analysts with a good understanding of the real value of the companies involved.

Conclusion

Hopefully, you now have a better understanding of M&A, the logic behind it and some of the potential outcomes.

These, sometimes predictable, outcomes help to explain the reasons behind some common trading strategies used by merger arbitrageurs and illustrate how careful analysis can lead to potentially profitable trading outcomes.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.