In 2019, International Business Machines (IBM) announced that it would acquire another company known as Red Hat. Red Hat was an enterprise provider of open source software and was valued at more than $20 billion (IBM will pay more than $34 billion for the company).
IBM on the other hand was once the largest IT company in the world. Its star faded when competition from companies like Amazon, Google, and Microsoft heated up. In these years, it is a shadow of its former self.
This article will explain the concept of Mergers and Acquisitions and what it means for traders.
What is merger and acquisition?
A merger refers to a situation where two companies join forces.
They do this for a number of reasons: for example, an insurance company in the East Coast can merge with another one in the West Coast. By so doing, the companies will have be at a position to reach more customers.
An acquisition on the other hand is a situation where a larger company acquires another one outright. The M&A industry is a very large one. This year alone, deals worth more than $3.3t trillion have been made globally.
Types of setups under M&A
Other than the typical merger or acquisition, there are several dealings that a company can engage in under the broader M&A structure. This includes:
Under this arrangement, one firm gains ownership of another’s assets. It is crucial to note that for such a transaction to take place, a company requires its stakeholders’ consent before handing over its possessions.
Such deals are common when a company is facing bankruptcy. The affected firm can sell its assets to the highest bidder in order to settle its debts.
A consolidation occurs when two companies form a new entity by combining their core businesses and deserting their individual structures. Just like in asset acquisition, shareholders have to approve the proposed setup.
Besides, the investors acquire shares in the newly formed entity. A good example of a consolidation is the one between Bell Atlantic and GTE to form Verizon.
A tender offer is when a company contacts a particular firm’s stakeholders directly with the proposal to purchase the entity’s stock. The offer is usually on a set price as opposed to the market price. In most cases, a tender offer culminates in a merger.
This arrangement can also be referred to as management-led buyout (MBO). As a way of transforming a firm into a private entity, executives in another company can buy a controlling stake. For instance, Michael Dell, the CEO of Dell Corporation used this approach in 2013 to acquire the company.
Why companies do M&A
Companies conduct M&A for various reasons.
Acquiring a Competitor
First, they buy companies with the goal of acquiring a competitor. A good example of this is what Google and Facebook have done.
Google acquired YouTube for about a billion dollars. Today, YouTube is worth more than $200 billion. Similarly, Facebook acquired Instagram for about a billion dollars, and it is now worth more than $100 billion.
Second, companies do M&A to create synergies. For example, if a software development company has 5000 employees and another software company has 4000 employees, merging the two into one can lead to synergies.
For example, the combined company can have just 5000 employees who will be doing the same thing (like United Technologies and Raytheon).
Third, companies do M&A to accelerate growth. The Facebook example mentioned above is a good one. Facebook realized that its legacy platform will start seeing reduced growth. To accelerate its growth, it acquired Instagram and Whatsapp.
It also sought to acquire Snapchat before it became a public company.
How to trade M&A News
A good way to explain this is the IBM’s acquisition of Red Hat. At its close after the news, Red Hat was trading at $116. IBM will acquire it at $190 per share.
Therefore, when the market opens, the likely scenario is that IBM’s stock declined sharply while Red Hat increased to near $190. This is because IBM has already agreed to pay $190 for the stock.
IBM, instead, dropped for a number of reasons:
- Investors will flee the stock for dilution purposes. They believe that the money would have been better elsewhere.
- The deal will likely increase IBM’s debts.
- Historically, mergers and acquisitions have not worked out as expected. In fact, they have been value destroyers. A good example of this is the acquisition of Monstanto by Bayer. After the deal was closed, Monsanto lost a major lawsuit that threatens its existence.
Therefore, when a deal is announced, the best way to trade is to go long the company being acquired and shorting the one doing the acquiring. In fact, this has created a large group of investors who specialize in what is known as merger arbitrage.
Where to find M&A news
How do stocks perform during a merger/acquisition?
In the event of a merger or acquisition, the share prices of the two companies usually move in opposite directions. This situation is usually on a short-term basis before the operations stabilize.
On the one hand, the shares of the acquiring firm fall. This is because the company may have used a substantial amount of its funds or even entered into debt that the shareholders think was too high.
In contrast, the stock price of the acquired firm is likely to rise. This is after the acquiring corporation pays a substantial amount to entice the shareholders.
External Useful Resources
- List of largest mergers and acquisitions - Wikipedia