In today’s robust M&A environment, there will be no shortage of transactions of either stock deals or cash transactions. But most firms prefer the latter for obvious reasons
Recently, Spencer’s Retail, the retail flagship of the Sanjiv Goenka Group, acquired Nature’s Basket, Godrej’s premium food retailing venture, for Rs 300 crore in an all-cash deal, unravelling possibilities of mutual synergies. Through this acquisition, Spencer’s is planning to gain access into the western India market where it does not have any presence at present. Spencer’s will continue with the Nature’s Basket brand and may even extend it to other markets. Worldwide, acquisition remains the quickest route companies have to new markets and to new capabilities. As markets globalise and the pace at which technologies change continues to accelerate, more and more firms are finding mergers and acquisitions to be a compelling strategy for growth. Like its global counterparts, Indian companies across several sectors are also in consolidation mode. Take the example of the renewable energy sector, Tata Power acquired Welspun Energy’s assets in a deal valued at over Rs 9,000 crore; Kotak Mahindra acquired ING Vysya Bank in an all-stock deal valued at over Rs 15,000 crore in the banking sector; the telecom sector witnessed the acquisition of MTS India from Sistema by Reliance Communications in an all-stock deal, followed by a merger of HDF Life and Max Life in the insurance sector.
As in the case of Spencer’s-Nature Basket deal of paying for an acquisition in cash, acquirers can also pay in stock or can have a combination of cash and stock. A cash merger happens when the acquiring firm buys the target company’s stock with cash. Think of a cash merger as shareholders of the target company being bought out. In a straight cash merger, the acquiring firm will make a tender offer at a price that is acceptable to the shareholders of the target company, who must vote to approve the deal. Often, companies offer stock rather than cash to complete a merger deal by using “conversion ratio” that converts the target company’s shares into shares in the combined firm. For example, if you own 1,000 shares in a target company that received a stock merger offer with a conversion ratio of 1.275, you would receive 1,275 shares in the merged company or 1,000 times 1.275. Some mergers combine a stock-for-stock transaction with a cash portion. For example, a stock merger offering you 0.5 shares plus Rs 10 in cash for every share you own means you’ll have to multiply 0.5 and Rs 10 by the number of shares you hold in the target company. If you owned 400 shares in the old company, you’ll own 200 shares in the merged company plus receive Rs 2,000 in cash or Rs 10 multiplied by 200 shares.
As with most business transactions, cash deals are highly preferred for fairly obvious reasons. Nonetheless, plenty of mergers still happen via stock deals. Although the same thing essentially occurs regardless of whether the deal is completed with a cash payment or a purchase of a certain percentage of shares, there are often differences in the way in which the merger ultimately unfolds. Here are some of the key differences between the two ways to close the deal:
Cash deals show clear ownership: One of the reasons why everyone loves cash transactions is because of its straightforward simplicity, it is faster and people face fewer hurdles in getting the deal closed. While one side hands over cash, the other side transfers its ownership interest in the company. There is rarely any question as to who owns the company and who relinquished ownership. In an analysis for worldwide M&A deals between 1992-2017 by the University of London, it was found that the failure rate for cash transactions was only 2.9 per cent. By way of comparison, all other forms of transactions were likely to fail 4.4 per cent of the time. Another benefit of cash transactions is that they are relatively simple when it comes to what shape the new entity will take. The roles of the two parties, too, are clear-cut and the exchange of money for shares completes a simple transfer of ownership. They go on to note that with this kind of transaction, the roles are pretty cut and dry when it comes to who will control the new organisation, with the purchaser pretty much dictating everything. On the other hand, with a stock deal, the number, type or percentage of shares sold may make it a bit harder to decipher the ownership structure.
Risk allocation is greater in cash deals: Even though cash reigns supreme, there are some potential negatives to this type of deal. The major downside to a cash transaction is that the buyers in the situation are assuming all of the potential risk associated with the merger. In a stock transfer, that risk is at least allocated amongst the shareholders with respect to their proportion of shares. The goal of a merger is obviously to realise an increase in value and, thus, returns. But there are obviously risks to the joining of entities that may get in the way of that, so when paying cash, buyers must be prepared to accept the potential consequences. In addition, there’s the issue of the financing itself. If the financing falls apart, that would certainly doom the deal. Outside of the money risks, there are additional issues, including taxes. One major drawback of an all-cash deal is that shareholders will be on the hook to pay potential capital gains taxes — which are likely to climb from their current levels. For all-stock transactions, these taxes for shareholders would likely be deferred.
With all these positives related to a cash transaction, one might wonder why anyone would consider an alternative. But there are numerous benefits to stock-based transactions where a company uses its stock as currency to purchase another company. Perhaps the biggest perk of all is that the acquiring firm is able to keep its cash reserves around for other functions. Or if they don’t have a significant amount of cash in the first place, they don’t need to borrow money from outside partners to make that deal happen. For shareholders of the acquired company, the benefits are significant as well. As they are paid in stock rather than cash, they can hold on to that stock and as a result, defer any capital gains implications that would result from this buy out. Of course, there is also the potential growth of the new entity and any financial rewards that may result. From a risk standpoint, a stock transaction presents different issues as well. In a stock transaction, the risk is shared proportionately between the acquiring firm and the acquired firm. And for ownership of the acquired firm, a stock transaction also means that you’re ceding control of the direction of the company to the buyer.
However in recent times, in growing economies where access to capital remains relatively inexpensive, stock transactions have been on a decline. In fact, according to Thomson Reuters, 33 per cent of all deals in the second half of 2016 included stock in the transaction. This represents a steady decline from over 50 per cent just two years before. According to Dealogic, 2017 was actually the weakest year since 1995 for US companies when it came to stock-based M&As. However, not all deals are an either/or. Many feature a combination of both cash and stock. There are a variety of reasons for this, including access to capital, share dilution, potential competing offers and payment preferences.
A recently published research by University of London’s Cass Business School found that the type of consideration offered was a significant predictor of the probability of deal completion — for both private and public M&A targets. It was a long-term global study into abandoned acquisitions, ie, deals that are announced but which subsequently fail to complete, by investigating more than 82,500 M&A deals announced over 26 years to identify the significant predictors of failed deals and strategies that acquirers and targets employ to increase the likelihood of successful deal completion. In particular, deals, where cash was the only form of consideration, were less likely to fail than those involving equity or cash/equity hybrids as consideration. Target companies value the certainty that a cash offer brings, both at the time the deal is agreed upon and on completion. By contrast, a deal financed by equity or partly by equity, may become more or less valuable depending on movements in the acquirer’s share price.
In today’s robust M&A environment, there will be no shortage of transactions of both types. The only question that remains is what’s going to be the right type for both companies involved and what value this delivers to their shareholders.
(The writer is Assistant Professor at Amity University)
Writer: Hima Bindu Kota
Courtesy: The Pioneer