Overview of Investment Banking Functions In Mergers & Acquisitions By Rohit Bafna and Ananya Pratap Singh

Abstract: Investment banks facilitate flows of funds and allocations of capital. They are financial intermediaries, the critical link between users and providers of capital. They bring together those who need money to invest (e.g., corporations that build factories and buy equipment) with those who have money to invest and they make the markets that allocate capital and regulate price in these financial transactions. Investment bankers seek to optimize price and terms, so that the “best price” may not be the highest price for client sellers (all cash or confidence in closing may be more important) nor the lowest price for client buyers (certainty of getting the deal done may be more vital). Investment banks find, facilitate, price, and finance mergers and acquisitions. Also included in M&A are leverage buyouts by private equity, the restructuring and recapitalization of companies, and the reorganization of troubled companies

Key Points: The Investment bank’s role in mergers and acquisitions falls into one of either two buckets: seller representation or buyer representation (also called target representation and acquirer representation).

  • One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction.
  • Banks will also source deals by studying the market themselves and approaching companies with their own strategic ideas.
  • One of the main roles investment banks play is to introduce new securities to market in order to finance M&A activity.

Introduction & General Terms: With increasing competitive pressures being placed on businesses and the trend towards globalization, companies are engaging more and more in M&A activity. Many companies looking to expand or streamline their business will use investment banks for advice on potential targets and/or buyers. This normally will include a full valuation and recommended tactics. The investment bank’s role in mergers and acquisitions falls into one of either two buckets: seller representation or buyer representation (also called “target representation” and “acquirer representation”). In advising sellers, the investment bank’s work is complete once another party purchases the business up for sale (i.e., once another party buys the client’s company or assets). However, representing a buyer is not always as straight forward. The advisory work itself is simple enough: The investment bank contacts the firm their client wishes to purchase, attempts to structure an acceptable offer for all parties, and make the deal a reality. However, many of these proposals do not work out; few firms or owners are willing to readily sell their business. Because investment banks primarily collect fees based on completed transactions, they are often forced to defend their proposals.

General Terms

  • Investment Banking – A specific division of banking related to the creation of capital for other companies. Investment banks underwrite new debt and equity securities for all types of corporations. Investment banks, such as Barclays (the headquarters for which is pictured here), play a vital role in the mergers and acquisitions process.
  • Valuation – One of the main roles of investment banking in mergers and acquisitions is to establish fair value for the companies involved in the transaction. Investment banks are experts at calculating what a business is worth. They are also able to predict how that worth could be altered (i.e., what happens to the value of a company in a number of different scenarios and what those potential futures would mean financially). Financial models are constructed by investment banks to capture the most important fixed and variable financial components that could influence the overall value of a company. These models, depending upon the proposed transaction, can be extremely complex with special variables being added for special areas (i.e., there are different financial factors to consider in different sectors, countries, and markets when predicting or measuring a company’s value). Because of their expertise in business valuation, investment banks can also provide the service of arbitrage opportunities for their clients. For instance, if a bank has performed valuation on a potential target company that suggests its market value (or the value of its shares in the marketplace) is less than what the business is actually worth, it may facilitate a merger or acquisition of this target company for its client that carries with it substantial profit opportunity
  • Buyers Versus Sellers – Investment banks do not just rely on buyers and sellers approaching them. They will also source deals by studying the market themselves and approaching companies with their own strategic ideas (i.e., they might suggest that two companies merge, or that one company acquires, or sells to, another). An investment bank that represents a potential seller has a much greater likelihood of completing a transaction (and therefore being paid) than an investment bank that represents a potential acquirer. This seller representation, also known as “sell-side work,” is the type of advisory assignment that is generated by a company when it approaches an investment bank and asks it to find a buyer of either the entire company or part of its assets. Generally speaking, the work involved in finding a buyer includes writing a “Selling Memorandum” (a detailed sales document) and then contacting potential strategic or financial buyers.
  • Provision Of Financing – Of course, buying a company will require the funds to do so. Options available to a company wishing to raise funds include selling shares in it or raising debt financing. Investment banks can, yet again, play a role in making this happen. In fact, one of the main roles investment banks play is to introduce new securities to market. Not only can an investment bank determine the best price for new issues–be they equity or debt–by valuing the company and examining the market, but they can also find buyers for those new issues.

Roles of Investment Bankers in Mergers & Acquisition: The investment bankers play an important role in Mergers and Acquisitions in number of ways. Needless to mention, that these activities accrue substantial profits to investment banking firms. According to a survey made by Thomson Financials[1], financial advisors received nearly $16 billion in fees solely from their services in Mergers & Acquisitions in first half of 2008.  Investment Bankers help both (transferor and transferee) companies in number of ways such as:

  • They are the major organizers of Merger and Acquisitions.
  • They help the transferee companies to combat the hostile techniques of transferor companies by helping them in developing defensive tactics.
  • One of their major roles is to establish fair value for the companies involved in the transaction.
  • It helps the transferor company to raise funds either by selling shares or through debt financing.
  • Sometimes they make investments in the stock of either transferor or transferee company which are likely to merge.

Various Roles of Investment Bankers Are:

  • Arranging Merger – In today’s corporate market, investment banking firms have their separate mergers and acquisition section that functions within their Corporate finance departments. The primary function of this section is to undergo marker search and figure out firms having excess cash which may enable them to buy other firms which are willing to sell their entities due to variety of reasons such as dissolution of firms, bankruptcy etc. In many such cases, the dissident stockholders of such diminishing firms join hands with investment bankers in arranging the merger of their own companies due to poor track records. The Investment bankers around the world are now adapted a new tactic in which they offer package for financing the entire process of mergers from designing the securities to be used in tender offer to combining the shareholders and transferee company who will be the prospective purchasers of stocks in Target Company. The greed of some investment bankers has taken them one step further. One of the examples of such corrupt practice is Parked Stock in which the investment banker purchases stock in Target Company for their client under a guaranteed buy-back agreement indirectly helping their client to accumulate 5% stock in Target Company without disclosing the position. This is illegal form of business practice and some of the investment bankers have been penalized for implementing such corrupt practices. Merrill Lynch[2] was fined $100 million for using such illegal practice.

Developing Defensive Tactics – The Target firms which can be made an easy prey of hostile merger, takeover or acquisition or otherwise take the recourse of an investment banking firm and a law firm which specializes in mergers. The investment bankers then guide the Target Company to adopt such tactics which can prevent them from mergers. Some of the examples of such tactics are:

  • Changing the Article of Association of the company to so that the final decision making power of electing directors and allowing mergers remain in the hands of majority;
  • Taking measures to make the shareholders of the Target Company believe that offered price is reasonably low;
  • Bring up the issues of Competition law with increasing the possible intervention by respective government instrumentality.
  • Buy back of Target Company in open market with intent to raise the price that has already being offered by potential buyer and stockholders of such buyer company.
  • Getting White Knight[3] acceptable by Target’s firm’s management to compete with potential acquirer.
  • Getting a White Squire[4] with a view to buy substantial amount of shares in Target Company which is friendly with current management.
  • Taking Poison Pill[5]. It is tactic which is of tently termed as suicidal tactic. In Poison Pill Tactic borrowing is done with precedent condition that the loan will be immediately paid in case acquisition takes place. The most popular Poison pill is giving stock purchase rights to its own shareholders of a company which subsequently allows them to purchase the stock of acquiring company at half price.
  • Employee Stock Ownership Plan (ESOP)[6] it a profit sharing plan to allocate ownership stake to lower level employees with an ultimate aim to enjoy tax benefits provided by the Tax laws for providing such incentives to the employees. Procter and Gamble executed an ESOP in which it has assigned 20% ownership stake in the company in addition to profit sharing plan. ESOP can be an effective tool to combat hostile takeover since it satisfies the management of the company and 85% of votes are required for merger. ESOP is a dual phase plan with two fold objectives first to get tax benefits and second to provide retirement security to employees.

Establishing a Fair Value – The most crucial and important role played by investment banking in Merger and Acquisition to determine the fair value between the transferor and the transferee. The investment banks expertise in calculating the worth of business. They are also responsible to forecast the alteration that is to be made in such worth.[7] They also draft the financial models for determining the values of different financial variables that will have an impact on the overall value of the company. These financial models require special knowledge of variables such as financial factors depending on the required transactions proposed by the service taker. It is due to this expertise that enables the investment banks to provide arbitrage opportunities. If the merger is friendly then it is important that the price agreed upon is fair and even if it the merger is not a friendly, the investment banker will play its role in establishing a fair price. In case of surprise tender offer, the acquiring firm is entitled to know the lowest quoted price at which acquisition can take place at the same time the Target Company can take help of investment banker to prove that quoted price is actually too low.

Financing Merger – The main source of finance in a merger is generally the excess cash available with acquiring company. In cases where the acquiring company has no such excess cash, another source of fund is required.  Corporate finance is the traditional aspect of investment banks which also involves helping customers raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. Product coverage groups focus on financial products – such as mergers and acquisitions, leveraged finance, public finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt – and generally work and collaborate with industry groups on the more intricate and specialized needs of a client.

Conclusion:This paper looked at the role of investment banks in providing merger advisory services. In this area, unlike some areas of investment banking, commercial banks have always been allowed to compete directly with investment banks. In their dual role as lenders and advisors to firms that are the target or the acquirer in a merger, banks can be viewed as serving a certification function. However, banks acting as both lenders and advisors face a potential conflict of interest that may mitigate or offset any certification effect. Overall, we find evidence supporting the certification effect for target firms. In contrast, conflicts of interest appear to dominate the certification effect when banks are advisors to acquirers.

In particular, the target earns higher abnormal returns when the target’s own bank certifies the (more information ally opaque) target’s value to the acquirer. In contrast, we do not find a certification role for acquirers. There are two possible reasons for these different outcomes. First, it is the target firm, not the acquirer,  that must be priced in a merger. Second, acquirers predominantly use commercial bank advisors to obtain access to bank loans that may be used to finance the merger.

Recommendations: We find that acquirers tend to choose their own banks (those with prior lending relationships to the acquirer) as advisors in mergers. However, this choice weakens any certification effect and creates a potential conflict of interest because the acquirer’s advisor negotiates the terms of both the merger transaction and future loan commitments. Moreover, the advising bank’s recommendations may be distorted by considerations related to credit exposure incurred in both past and future lending activity. The market prices these conflicts of interest; we find significantly negative abnormal returns for bank advisors when they advise their own loan customers in acquiring other firms.

By: Rohit Bafna and Ananya Pratap Singh, BBA.LLB SEM-VIII SLS- NOIDA

[1] Thomson Financial was an arm of The Thomson Corporation, which was one of the world’s leading information companies, focused on providing integrated information solutions to business and professional customers.

[2] Merrill Lynch Wealth Management is the wealth management division of Bank of America

[3] A white knight is an individual or company that acquires a corporation on the verge of being taken over by forces deemed undesirable by company officials (sometimes referred to as a “black knight”). While the target company doesn’t remain independent, a white knight is viewed as a preferred option to the hostile company completing their takeover.

[4] A white squire defence is where a friendly company or investor purchases a large enough share of the target company to stop an unwelcome bidder from achieving its aim of taking over the target company.

[5] A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make its stock less attractive to the acquirer.

[6] An employee stock ownership plan (ESOP), also known as a stock purchase plan, is a defined contribution plan whereby an employer invests the fund’s assets in its own stock.

[7] To determine the different scenarios that may arose in case of restructuring.

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