Steven Wevodau - Insurance Mergers & Acquisitions

Let’s talk mergers… - Steven Wevodau

Bhavana Acharya

The spotlight is now on mergers, with the RIL-RPL deal just around the corner, but despite the deluge of news updates and analysis, mergers may still make little sense if the concepts and terms involved are not clear. Here’s taking a look at mergers and their underlying dynamics, so you can understand why and how they happen.

To begin with, a merger is when two companies combine voluntarily, as opposed to an acquisition where one company takes over the other. It’s an easy form of what is called ‘inorganic’ expansion, as a company skips over the many years it otherwise may have taken to grow on its own. Theoretically, mergers are meant to be between equals, with the individual companies ceasing to exist in favour of the new entity. However, in reality, mergers rarely create a wholly new entity. Instead, one company is usually merged into another.

Take the RIL-RPL merger for instance. The smaller entity RPL will be merged into the bigger RIL — no new entity is formed, but RPL ceases to exist.

Merger motives: What gives?

The idea behind any merger is to create synergy — making one and one add up to three! That is to say, the value of the merged entity, by virtue of the merger itself, becomes greater than the sum of the independent values of the merging companies. Merger benefits may accrue from, say, acquisition of new technology, or when smaller, specialised companies merge with larger companies, in which case they not only profit from the technology but also gain competitive advantage. Benefits can also be cloaked as market share increases or wider geographical reach, which is especially the case in cross-country mergers. Staff benefits may be amassed through a management shake-up or the talent pool in the merging company. And since the size of the newly merged company also increases with mergers, advantages by virtue of size in terms of cost of production, bargaining power and so on may also be a significant driver of mergers.

Strategic benefits may also stem from a pre-emptive strike against competition, or by becoming big enough to overcome competition. In case of vertical mergers, wherein a company merges with its suppliers or customers, the benefits accrue by way of a greater control over the supply chain, reduced costs, and assured supply, improved coordination and much more.

These apart, tax advantages may be the other force behind mergers. If the one of the merging entities enjoys an SEZ status, that benefit may be passed on to the newly merged company. A firm with accumulated losses or a huge unabsorbed depreciation merging with a profitable firm erects tax shields which neither company may be in a position to enjoy independently.

That said, achieving synergies is easier said than done, and may not necessarily pan out as intended. In the impending RIL-RPL merger, creating a behemoth and RPL’s SEZ advantage may be the discernible benefits from the merger.

Merger money: What’s at stake?

So once a merger and its synergies are decided, the question of financing it pops up. Merger financing may be by way of cash, stock, or both. In cash payouts, the shareholders of the merged company give up their shares in exchange for cash. This, however, leans more towards acquisitions rather than mergers.

Where mergers involve purely stock payments, swap ratios come into play. Shares in one company (merged entity) are exchanged for shares in the other (merging company). The ratio in which the shares are exchanged is termed the share swap or exchange ratio. For example, in the merger of HDFC Bank and Centurion Bank of Punjab (CBoP), 29 shares of the latter were exchanged for a single share in HDFC Bank, bringing the exchange ratio to 29:1.

The ratio is worked out based on the valuation of the two companies. Metrics used to work out valuation may be the market price per share, the book value per share or the share values derived through discounted cash flows. If market price is being used, it may be more prudent to consider the prices after the merger announcement. The exchange ratio determines two key points — the degree of control shareholders of both entities will have in the new one and the distribution of the synergies.

A range of the maximum and minimum ratios acceptable to shareholders of both companies is eked out, bound by the maximum ratio permitted by the merging company, and the minimum expected by the merged company. The ratio where the two ranges meet becomes the swap ratio.

However, as far as shareholders are concerned, the prime concern in any share swap is the fate of their holding. Though generally prices are expected to go up post any merger, it is not sacrosanct.

Shareholder interests

Wondering what then happens to the shareholders of the merging entities? Where mergers are through cash, the shareholders of the merged company simply relinquish control of their company and do not own a stake in the new entity. They may even be taxed for the consideration so received. However, in a share swap, they get partial ownership in the merging entity. In our above example, shareholders of CBoP found themselves part owners of HDFC Bank. However, in the merging entity, the stake owned by the shareholders becomes diluted.

A higher swap ratio indicates greater dilution. For instance, continuing the above example, had the swap ratio been, say, 1 share for every 20 held, instead of 29, HDFC Bank would have to give out more of its shares, diluting the stakes further. Promoter holding too diminishes, and sometimes, the extent of dilution may decide the swap ratio more than actual share values.

Shareholders aside, the assets and liabilities of the companies also need to be incorporated. There may be two ways to do this — one is to simply aggregate the lot and add it in the new balance sheet.

The other may be that the merging company ‘purchases’ the assets and liabilities from the other at the fair market price, the difference between the book value and the price paid being either goodwill (asset) or a capital reserve (liability).

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