The process of merging or acquiring companies is known as mergers and acquisitions (M&A). A company mergers a transaction with investor interest in which two or more businesses together with operations and assets similar to those of the combined company are sold to a strategic buyer. In the United States, mergers and acquisitions are subject to a variety of significant legal and tax issues. To facilitate M&A transactions, there are three essential elements that must be addressed by the acquirer or the acquiree, these elements include: cash flow, debt ratio, and exit value. This article highlights the significant differences between M&A and leveraged buyouts (LBO).
Cash flow is one of the most crucial and essential factors for an M&A deal. Many factors come into play when calculating the cash flow during an acquisition. Among these factors are the amount of money needed to purchase the acquired firm, whether any existing debts of the acquired firm may need to be repaid, potential investors’ financing needs, and the duration of the acquisition. In addition, cash flow is an ongoing concern during an acquisition, as losses or damages could be assessed against the acquired firm.
On the other hand, debt to equity and retained earnings comprise the other two components of the equation of M&A. The difference between these two components is that the debt-to-equity ratio of an acquisition is much less than the total debt of the acquired firm. The reason for this is that the acquisition is not considered a traditional leveraged buyout. The combination of cash and equity significantly increases the liquidity of the acquiring company.
As previously mentioned, the key investor interest in M&A is the potential return on investment. The primary driver of this return is the price of the acquired firm. The other driver is the retained earnings of the acquired firm. One important consideration is that while earnings is a good thing, it can be very detrimental if the business cannot generate enough interest or cash flow from the acquired firm. This is why the primary driver of M&A is the price of the enterprise.
One way to ensure that the primary driver of an M&A deal underperforms the secondary drivers is to manage the deal during its development. If the deal is expected to generate low returns, then the deal must be bought out at a price far below the true value. However, this is only one way to manage the deal during development; in all actuality, it is usually easier and more effective to keep the acquisition price low until it starts to generate positive cash flows.
The third driver of M&A deals is capital structure. Capital structure is not typically a consideration during the transaction development process because the acquisition is focused on either adding a new buyer or providing resources to the existing buyer. However, many companies that acquire other companies will convert these assets into working capital before they make any bids on specific deals. By converting the purchased equity into working capital, the M&A provider can fund projects, increase working capital, and reduce financial risk.
The fourth and final driver is the secondary market. A secondary market exists when an existing, nontraditional buyer of a business is unable to obtain financing from a primary dealer or bank. In this scenario, buyers from the secondary market are more likely to compete with sellers in the primary market, resulting in higher prices and more aggressive bidding. This scenario results in higher cash flows and greater value for the acquisition deal.
Because an M&A acquisition is more complicated than a typical purchase in the secondary market, it is critical that the primary dealers that will be involved in the transaction understand the process completely. They must know the legal risks associated with the acquisition, the likely pricing environment, the ultimate outcome of the deal, and the timing of the closing. While the primary dealers typically have years of experience in negotiating mergers and acquisitions, they also have financing risks, expansion risks, and operational risk. Any of these factors could result in the inability of the primary dealers to realize a profit on the acquisition. When they commit their resources to an acquisition and the transaction does not close in a timely manner, the investment could turn into a loss.