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Case Study on Risk management in M&A_Anuj Kamble_Veronica Barreda


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Case Study on Risk management in M&A_Anuj Kamble_Veronica Barreda

  1. 1. Case study on Risk management in Mergers & Acquisitions Submitted by: Submitted to: ANUJ KAMBLE (S0555276) Prof. KATARINA ADAM VERONICA BARREDA (S0555505) Corporate Finance & Controlling HTW Berlin MBA&E WS2015
  2. 2. ii Acknowledgement This case study on Risk management in Mergers & Acquisitions is a part of our academic work for the subject of Corporate Finance & Controlling for the Master’s Program at HTW-Berlin. We assure you that the entire report has been prepared by us with the help of several sources whose references have been mentioned in the bibliography section. We would like to take this opportunity to thank our Professor Dr. Katarina Adam, for constantly guiding us through the entire case study preparation period. She has helped us to focus on the finer aspect of this topic & suggested changes wherever necessary which helped us to understand the case in detail and to improve our report. Anuj Kamble Veronica Barreda Berlin/ 21 Dec. 2015
  3. 3. iii Abstract The primary function of this report is to analyze Risks involved in M&A activity and their impact on the involved companies. M&A activities are very complex and there are various risks involved at different stages of M&A process. For our report we have just given overview of financial risks involved in M&A. This report highlights different definitions and types of risk. This report will also help you to understand risk management process and its importance in company’s profitability. This report gives an overview of the M&A and role of risk management in its success. At the end of this report we have done case study on Actavis-Allergan Merger. We have also given an overview of Pharmaceutical companies’ new business model. In the end we have given our recommendation based on risks and opportunities that this new company will have. Keywords: Risk, Risk management, Mergers, Acquisitions, M&A.
  4. 4. 1 Table of Contents 1 Risks and types of risks........................................................................................................3 1.1 What is Risk? .............................................................................................................3 1.2 Types of Risks ..............................................................................................................3 1.3 Inference.......................................................................................................................6 2 Risk management.................................................................................................................7 2.1 What is risk management? ...........................................................................................7 2.2 Why is it important? .....................................................................................................8 2.3 Techniques for identifying Risks...................................................................................8 2.4 Risk Assessment techniques .........................................................................................9 2.5 Inference.......................................................................................................................9 3 Mergers & Acquisitions .....................................................................................................10 3.1 What are mergers & Acquisitions .............................................................................10 3.2 Motives behind M&A ..............................................................................................12 3.3 Classification of mergers & acquisitions .....................................................................13 3.4 Merger Process Stages ...............................................................................................14 3.5 Value at risk when M&A deal fails ............................................................................15 3.6 Risks involved in M&A ............................................................................................15 3.7 Risk management for M&A ........................................................................................17 3.8 Inference.....................................................................................................................18 4 Case study on Actavis and Allergan ...................................................................................19 4.1 Introduction ...............................................................................................................19 4.2 The Actavis-Allergan Merger .....................................................................................21 4.3 New business model ..................................................................................................21 4.4 Evaluation of risks & Opportunities ............................................................................22 4.5 Recommendation ........................................................................................................24 5 Bibliography......................................................................................................................25
  5. 5. 2 List of Exhibits Exhibit No Description Page No. 1 Industry’s portfolio of risks 4 2 A continuous Risk management Process Based on ISO31000 7 3 Selected Financial Data for Actavis 19 4 Selected Financial Data for Allergan 20 5 SWOT Analysis of newly combined company 22
  6. 6. 3 1 Risks and types of risks This year is set to go down as the biggest ever in terms of acquisition deals in the pharmaceutical industry. M&A activities are complex and the results are uncertain. In this chapter we try to give brief definition of risk and explain different types of risks which a company is exposed to. 1.1 What is Risk? 1 2 3 We all have used this word or even felt the anticipation, excitement or anxiety about facing new and unknown event probably every day. We all have our own intuitions about the consequences of our decisions, but the uncertainty of the potential outcome is Risk. The standard deviation from the expected outcome indicates the level of risk. There are many definitions of risk. The definition set out in ISO Guide73 is that “risk is the effect of uncertainty on objectives”.1 In order to assist with the application of this definition, Guide 73 also states that an effect may be positive, negative or a deviation from the expected and that risk is often described by an event, a change in circumstances or a consequence. This definition links risks to objectives. Therefore, this definition of risk can most easily be applied when the objectives of the organization are comprehensive and fully stated. The Chinese symbol for risk (风险-‘Fēngxiǎn’) which means ‘danger-opportunity’ best represents both positive and negative impact of the risk.4 Mergers and acquisition transactions are opportunities that bear considerable risks for a company. 1.2 Types of Risks There are different types of risks according to situations and from where they originate. There are some general risks which an individual or a company has to face which are unavoidable or have any control over. In broader view here we are mentioning some general risks from World Economic Forum’s-2014 global risk report.  Systemic Risk: “It is defined as the breakdowns in an entire system, as opposed to breakdowns in individual parts and components.”5 When risk is shared amongst the different systems and one system’s failure will cause the domino effect which will lead to a bigger failure. Or when a system fails it will be unable to recover from that. 1 Bruner,Applied Mergers and Acquisitions,Wiley 2 A structured approach to Enterprise Risk Management (ERM) and the requirements of ISO 31000 3 AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August 2010 4 Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-Chapter1,Page 5,Para 2 5 World Economic Forum, ‘Global Risks 2014’ 9th edition, Page 9
  7. 7. 4  Global Risk: “It is an occurrence that causes the significant negative impact for several countries and industries over a time frame of up to 10 years.” 5 For example, Economic risks, Technological risks, Societal Risks, Geopolitical Risks and Environmental Risks. Now let’s see risks which are associated with Industries. These are the risks which will have direct or indirect impact on management’s objectives.  Business risk refers to the uncertainties of outcome of management’s decisions. It creates question; whether a company will be able to cover its operating expenses and still generate profit and able to hold its market position? Influencing factors in business risk are cost of goods, profit margins, competition within the industry, bargaining power of the consumers and suppliers, threat of new competitors and substitutes.6 Business risk is often categorized into systematic risk and unsystematic risk. Systematic risk refers to the general level of risk associated with any industry sector, and companies usually have little control over, other than their ability to anticipate and react to changing conditions. On the other hand unsystematic risks refer to the specific level of risks which are associated with specific industry sector. Companies can manage these risks through good management strategies.6 Exhibit1: Industry Portfolio of risks7 6 Investopedia viewed on 21/11/2015 7 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective implementation .2007,Page 5
  8. 8. 5 Amongst Industry’s Portfolio of risks which we came across; we would focus on company’s financial risks. Company’s financial risk is the risk that involves financial loss to the company. It generally arises because of the instability and losses in financial market which are caused by: Fluctuating stock market, changes in interest rates and currency exchange rates.8 Financial Risks can be further categorized as Market risks, Credit risks and Liquidity risks.6  Market risks: This risk has a larger impact as it could affect several firms’ investments at a same time, if not all. For instance when the economy weakens, all firms feel the effects.9  Market Price Risk: It comprises of transactions exposure, Portfolio exposure and Economic exposure. Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date so it will be dependent on currency exchange rate. Portfolio exposure is dependent on interest rate fluctuations. Economic exposure to the real business risk of the company, insofar as it is tied to market interest rates and commodity prices.10  Credit risks: It is the potential risk that the company will fail to meet its obligations according to the previous agreed terms with the bank. This risk is calculated according to company’s credit score which depends on company’s revenue generating ability. Higher the credit score lower is the credit risk. This is why companies try to maintain high credit scores in order to generate future cash flow through debt financing.  Liquidity risk: It is referred to the risk that a company may be unable to meet short term financial demands due to a lack of cash flow as well as when a company tries to generate cash flow by selling a valuable asset but it cannot do so because of bad market conditions. So far we have seen different kinds of risks a company is exposed to. In next chapter we will discuss about how risk management process helps company’s management to decide their strategy against mitigating these risks. 8 Eshna,Financial Risks and its types -article 9 Damodaran,Aswath, “Value and Risk: Beyond Betas” (Nov.2003),Page6 10 Ian Giddy, NYU Stern School of Business, ‘Managing Financial risks’ Page no.34-40
  9. 9. 6 1.3 Inference  While we were searching for the exact definition of the risk we came across the different definitions with some focusing primarily on the likelihood of bad events occurring, some focusing on rewards and some focusing on the downsides and upsides of the risks.  There are many types are risks some are avoidable some are not.  Risk represents threat as well as opportunities.  Company is exposed to various kinds of risks.
  10. 10. 7 2 Risk management 2.1 What is risk management? 11 12 As we have already seen in previous chapter that risk has various definitions and it is directly linked to the objectives of a company’s management. Therefore, this definition of risk can most easily be applied when the objectives of the organization are comprehensive and fully stated. Risk management is the continuous process which involves identifying and evaluating risks and taking preventative action to mitigate impacts of risks on management’s objectives and set strategy objectives accordingly. Risk management is more than risk hedging as it is all about identifying those risks which have opportunities for an organization by exploring and mitigating them rather than just avoiding them. Exibit2: A continuous Risk management Process Based on ISO31000 13 11 Damodaran,Aswath, “Strategic Risk Taking- A Framework of risk management”-Chapter1,Page 5,Para 2 12 AS/NZS ISO 31000:2009, Risk management Principles and Guidelines, August 2010,Page 1 13 A structured approach to Enterprise Risk Management (ERM) and the requirements of ISO 31000 Page No.9
  11. 11. 8 2.2 Why is it important? 14 “Risks affecting organizations can have consequences in terms of economic performance and professional reputation, as well as environmental, safety and societal outcomes. Therefore, managing risk effectively helps organizations to perform well in an environment full of uncertainty.”15 As we have mentioned earlier in Exibit1. The organization is exposed to various types of risks. By using risk management, companies can determine the overall exposure to the particular type of risk under consideration. Company’s Risk management drivers can be external or internal. For example, for company’s financial risk management internal drivers could be: internal control, fraud, liabilities, liquidity and cash flow. External drivers could be exchange rates, interest rates. 2.3 Techniques for identifying Risks16 There are many risks and identifying the risks which would affect the company is the most important task in risk management. Now we know that risk is not a sudden event or just bad luck so... identifying the risk that the company is exposed to and taking actions in controlling it in advance can potentially lead to the mitigation of the risk. For example company A has taken steps to mitigate the systematic risk the industry is exposed to and its competitor company B has not then in such scenario; Company A has advantage over company B who has failed to do that. Company A could use this opportunity as a bonus for its strategy against the mitigated risk. There are various risk identifying techniques such as Brainstorming, Event inventories and loss event data, Interviews and self-assessment, Facilitated workshops, SWOT analysis, Risk questionnaires and risk surveys, Scenario analysis, the use of technology and other techniques. We would like to describe SWOT analysis in brief as we also going to use this technique for our case study.  SWOT Analysis:17 SWOT (strengths-weaknesses-opportunities-threats) analysis is a technique often used in the formulation of strategy. Internal factors which company’s management can have control over like: company structure, culture, financial and human resources decide company’s strength and weaknesses. And external factors which company’s management doesn’t have any control over such as: political, environmental and systematic industrial risks decide opportunities and threats for the company. 14 Adam, Corporate finance-KW 2-3,Risk management, Page 18-23 15 ISO 30001: , Visited on 15/12/2015 16 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective implementation .2007,Page 7 17 Haupt,Denny, Stratergy Marketing and HR management- ‘Analysis of industry-Part3’.pdf , 24/11/2015, Page 145
  12. 12. 9 By using SWOT analysis management can identify risks which are internally driven like if company has some department or product as a weakness management can take appropriate actions against them. By analyzing threats management will come to know about the external risks which are there and which will affect their business so that they can plan the best strategy accordingly. 2.4 Risk Assessment techniques18 19 After the identification of risks it is necessary for the management to know the probability and impact of the identified risks so that the management can have a consistent approach towards risk assessment, evaluation and monitoring. “It helps management understand and quantify the likelihood and consequences of the risk.”18. By using risk assessment techniques management can categorize risks according their nature and prioritize them accordingly. There are three types of approaches to risk assessment: Qualitative, Quantitative and both.  Qualitative risk assessment techniques: FMEA (Failure mode analysis), HAZOP (Hazard and operability study), Risk map with likelihood and impact, risk rankings, identification of risk correlation.  Quantitative risk assessment techniques: VAR (Value at risk)  Qualitative/quantitative risk assessment techniques: Tornado charts, Benchmarking, NPV, Scenario analysis, Risk corrected revenues etc. In next chapter we will talk about the M&A process which is internal driver for the strategic risk management process. We will see how risk management process plays an important role while dealing with financial risks in M&A activity. 2.5 Inference  Risk management plays an important role in identifying and evaluating risks. Using qualitative risk assessment technique management can prioritize risks according to their likelihood and impact.  Risk management helps management to develop their strategy to reach company’s objective successfully.  Looking at the importance of the risk management ISO30001:2009 has developed a frame work for implementing risk management into organizations. This frame work is based on 11 principles of risk management.  After 2008 financial crisis companies have realized the importance of risk management. Now companies have started to integrate risk management in their organizational processes. 18 Adam, Corporate finance-KW 2-3,Risk management, Page 27-35 19 Institute of Management Accountants. Enterprise risk management: Tools and Techniques for effective implementation .2007,Page 7
  13. 13. 10 3 Mergers & Acquisitions In Previous chapters, we have seen definition and types of risks, how risk management process can identify which risks a company’s management should take to reach the set objectives. As a part of company’s strategic risk management process a company’s management could decide to increase their business through M&A activity. But M&A as itself is a very complex process and has lots of risks involved in it. In this chapter we try to give brief definitions of Mergers and acquisitions, explain their types, the M&A process and various risks involved at various stages of this process. We will mainly focus on financial risks and their impacts on the companies involved in the M&A and how risk management plays an important role in the success of M&A. 3.1 What are mergers & Acquisitions20 21 22 23 A merger or an acquisition can be defined as the combination of two or more companies into one new company or corporation. The main difference between a merger and an acquisition lies in the way in which the combination of these two companies happens.  Merger is the combination of two or more companies in formation of a new company. Usually in a merger there are negotiations involved between the two companies before the combination takes place. For example, assume that Companies A and B are existing automobile companies. Company A has a renowned brand name and a large commercial customer base. Company B is innovative car maker for domestic market. Both companies may consider that a merger would produce benefits to the combined company as there are some obvious potential synergies available. For example, company A can use innovative ideas from company B and produce innovative cars under its brand name and sale them globally. In this way Company B will also able to reach foreign markets. The two companies may decide to initiate merger negotiations. When the negotiations are successful both companies will merge and will form a new company. They can have new brand name for the new company or they can simply combine their brand names or they can choose to operate under acquirer’s brand name. Generally in case of mergers the management can get shareholders’ approval easily if they are successful to show that the potential merger will be profitable for shareholders. The acquirer may offer either cash or share in merger transaction. Cash transactions will give immediate profit for shareholders whereas share may give long term investment opportunity for shareholders. Shareholders will make profit if potential merger is creating value for the combined company. The value of share will increase faster when market is up than when it is stagnant. 20 Damodaran,Aswath, “Acqusitions and tekeovers” Page1-8 21 Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” , 2010,Page 2-4 22 International Journal of BRIC Business Research (IJBBR) Volume 3, Number 1, February 2014 23 Hoang, Thuy Vu Nga- Lapumnuaypon, Kamolrat, “Critical Success Factors in Merger & Acquisition Projects”- Page 3
  14. 14. 11  Acquisition is the process when one company purchases the shares or assets of another company to have control over the other company with or without mutual agreement. In an acquisition the negotiation process does not necessarily take place. Rules about the ownership changes according to countries in which the acquisition is taking place. Countries have different laws and regulation for M&A activities. In acquisitions the company who wants to acquire another company is referred to as the acquirer and the company which will get acquired referred to as the potential target for acquisition. In most cases the acquirer acquires the target by buying its shares. Achieving ownership may require purchase of all of the target shares or a majority of them. For example in an acquisition company A buys company B. Company B becomes wholly owned by company A. Company B might be fully absorbed and cease to exist as a separate entity, or company A might retain company B in its pre-acquired form. With this limited absorption there is a possibility that Company A might sell company B in future for a profit. There are two types of acquisitions friendly and hostile. In the case of a friendly acquisition the target is willing to get acquired. The target may view the acquisition as an opportunity to develop into new areas and use the resources offered by the acquirer. This happens particularly in the case of small successful companies or startups that wish to develop and expand but don’t have sufficient capital. The smaller company may look for a bigger company who is ready for such investments. In case of hostile acquisition the target is opposed to the acquisition. Hostile acquisitions are sometimes referred to as hostile takeovers. In hostile takeovers the acquirer may attempt to buy large amounts of the target company’s shares from the share market. But when sudden large purchase of shares of the target company is visible in share market there will be increase in share price of the target company. To avoid this scenario the acquirer may attempt to buy as much shares as possible in the shortest possible time, preferably as soon as the markets open. Sometimes the target company may seek opportunity of potential merger or acquisition by a favorable buyer who will rescue the target company from the hostile acquisition by an unsuitable acquirer. If the target company is managed to stop hostile acquisition with the help from his new acquirer then the acquirer is called as ‘The White Knight’. We will see example for white knight in our case study. In both friendly and hostile acquisitions the decision on whether or not to sell shares in the target lies with the shareholders. If all or a large proportion of target shareholders agree to sell their shares, ownership will be transferred to the acquirer.
  15. 15. 12 3.2 Motives behind M&A 24 25 26  Financial synergy: With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital. This can be achieved by-  When a large company with higher cash combines with a smaller company with high return projects can yield a payoff in terms on higher value for the combined firm. The increase in value comes from doing the high return projects which were possible due to excess cash provided by the large company to the smaller company.  When two companies are merged together; their earnings and cash flow may become stable and predictable hence the debt capacity of the combined company increases. This allows companies to borrow more than they could have when they were separate entities. Companies can have better cash flow due to tax benefits from the debt that merged companies have.  Tax benefits due to lower corporate tax rates: Sometime a company merges with a company from another country where corporate tax is lower than the country in which it is currently operating. This we will discuss later in chapter-4.  Operating synergy: Companies merge to have operating synergy which will allow them to increase operating income, growth or both. This can be achieved by-  Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable.  Greater pricing power due to reduced competition and higher market share which gives higher profit margins and operating income.  Combination of different functional strength. For example when firm with good product line acquires firm with good marketing team.  Higher growth in new or existing market. For example when company acquires a new company in an emerging market which has a good distribution network and recognized brand name which can be used as strength to increase sales of its product.  Diversification: Companies may use merger or acquisition for diversification-  To reduce risk- For example if a company is operating in a volatile industry it may merge with another company from different industry to hedge itself against fluctuations in its own market.  To have diverse product portfolio-For example company may merge or acquire company with new product or services from same or different industry to have a diverse product portfolio. 24 Damodaran,aswath, 25 Brealeay/Myers/Markus Fundamentals of Corporate Finance, Page 588-591 26 Berk,DeMarzo Corporate finance, Page 934-937
  16. 16. 13  Investment motives: Sometimes as an investment opportunity a company may acquire an undervalued company who has future growth potential but it is undervalued by financial markets. If the acquiring company has sufficient funds to carry out the acquisition then it can gain the difference between the value and purchase price as surplus.  Managerial motives: Usually M&A activities are carried out by managers and their motives can be different-  Empire Building- In this case management motive for M&A is to make their company the largest or most dominant company in their industry.  Managerial Ego- some acquisitions start battle of bidding especially when multiple companies are trying to acquire a same firm and which nobody wants to lose because it could hurt manager’s ego or it will harm management reputation.  Compensation & side benefits: Sometimes management’s compensation contracts are restructured after M&A. “If the potential M&A brings private gains to the managers from the transactions are large it might blind them to the costs created for their own stockholders.”27 3.3 Classification of mergers & acquisitions28 Classification based on previously mentioned motives behind M&A.  Horizontal M&A: When two competing companies from a same industry merge or when the acquirer acquires the target company from the same industry then such M&A is known as the Horizontal M&A. This trend is usually observed in industries like pharmaceuticals, automobile and petroleum. For example the merger of two giant pharmaceutical companies, Glaxo and SmithKline Beecham. As CEO of Smith Kline Beecham mentioned that the aim of this merger was the R&D synergies to drive revenues since in pharmaceutical industry new technologies and inventions of new drugs result in enormous opportunities for revenue creation.29  Vertical M&A: Vertical M&A is usually the combination of companies which are client or suppliers of each other. Vertical M&A has two types based on integration. Forward vertical integration and backward vertical integration. For example when an OEM acquires raw material supplier of its product then it is a backward integration. And when an OEM merges or acquires its product retailer then it is forward integration. Using this OEM can control the whole supply chain of its product. The best example of this vertical 27 Damodaran,Aswath, 28 Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” 2010,Page 7-9 29 Referred for horizontal integration example, plc.html,Viewed on 12/12/2015
  17. 17. 14 integration is Ford’s River Rouge plant. Henry Ford adapted this vertical integration for production of the famous Model-T.30  Conglomerate M&A: When companies operate in unrelated businesses involved in M&A transactions then it’s a conglomerate M&A. Being a conglomerate company can diversify its risks and attain economies of scope. For example ThyssenKrupp AG is the German conglomerate which has 670 companies under its brand name operating worldwide. ThyssenKrupp operates in Steel industry, Elevator business and also as a supplier to automotive industry.31  Cross-border M&A: When two companies operating in two different countries or economies involved in M&A want to have transactions then it is a cross border M&A. For example to avoid high tax regulations and gain tax benefits a US based company will merge with company where tax regulations are lower than the US. 3.4 Merger Process Stages32 33 We just want to give an overview of the merger process. In reality, merger processes are more complex, to have control over them; these stages are subdivided into various small stages and timely activities.  Pre-Merger planning stage: This phase is also called as inception phase in which the management of a company initiates the process; Business and growth strategies are defined and then companies identify the potential target companies for a merger. After initiating the process feasibility stage comes which includes detail analysis of the financial characteristics of the proposed merger with time scale for the activity, synergy generation and other variables. Once all the factors are evaluated the management decides to proceed for a merger commitment and allocates necessary funding’s and resources.  Merger implementation stage: Then usually Letter of intention is submitted to the target company and the management of the target company is invited for the merger activity. After receiving Target Company’s acceptance on the Letter of intention then the management commits to proceed with the merger activity. This followed by negotiation phase which involves managements of the both companies that are involved in the merger. Both the managements negotiate with each other to reach agreement on the structure and format of the newly combined company. Usually in these negotiations both companies involve their experienced lawyers and M&A advisory firms. The merger contract sets out the rights and obligations of each company under the terms of the deal. 30 Referred for vertical integration example, Henry Ford, “My life & Work” 31 Referred for conglomerate example, Viewed on 12/12/2015 32 Bruner,Applied Mergers and Acquisitions,Wiley 33 Alexander Roberts, William Wallace, Peter Moles, “Mergers and Acquisitions” 2010,Page 7-9
  18. 18. 15 Merger contracts can be extremely complex and are usually developed and finalized by specialist external consultants working with in-house specialists.  Post-Merger integration stage: The implementation process starts as soon as both the companies agree with the terms and obligations of the merger contract. Usually merger integration activities are taken as a separate project. Companies assign their respective project teams for the successful integration of both the organizations in a merger. Companies may include outside project teams from M&A advisory firms like Goldman Sachs and McKenzie. These project teams plan, monitor and executes the integration activities for the new organization. This helps newly combined company adapt to the new organizational structure. This phase is usually referred to as commissioning. In some cases the commissioning phase may continue for several years. 3.5 Value at risk when M&A deal fails 34 M&A deals are exposed to various risks starting from the deal to the finalizing of the deal. The value before consummation of deal includes research expenses which company has spent to find the potential target and financial fees to various firms like legal firms, advisory firms and auditing firms; management time & reputation; and the cost of lost opportunity. The value at risk grows over the time period of a deal transaction, and reaching its maximum at the closing. The opportunity cost will be massive where there are solid synergies or strategic options that might have been created. Strategic options, synergies and other opportunity costs amplify the value at the risk. Moreover if the buyer company is a frequent participant in M&A activity, reputation consideration will amplify the value at risk. 3.6 Risks involved in M&A 35 36 Company’s financial risks in M&A exist at different phases of the process: In the course of value evaluation, transaction, financing, payment and company integration.  The Financial Risk before M&A:  Risk in value evaluation of Target Company: This risk mainly occurs when there is a problem with the financial statements, and the value assessment of the target company. From the perspective of value assessment of target enterprise, when making decisions in M&A, the acquirer must correctly assess its merged capacity. The risks of M&A mainly appear in over estimating or underestimating capacity of the target enterprise. The target enterprise manipulates the financial statement or conceals the actual accounting information. Because of this it is hard for the acquirer to assess the real asset value and profitability of the target enterprise, which will probably make the acquirer over estimate 34 Bruner,Applied Mergers and Acquisitions,Wiley, Pages 637-640 35 Deng, Analysis of Financial Risk Prevention in Mergers and Acquisitions 36 Damodaran,Aswath, “Acquisitions and takeovers” Pages 45-58
  19. 19. 16 the value of the target enterprise. The value estimation risk of M&A embodies the expected deviation of future earnings and time needed to show benefit. The falsified information and corrupt behavior during the course of M&A would result in financial risk and financial crisis for the acquirer.  The Financial Risks during the Course of M&A:  Financing Risk: The financing risk of M&A refers to the risk of financial security and funding resources required for M&A. The financing method includes internal financing and external financing.  Risks of using Internal Financing: Internal financing method would tie up most of the cash flow of the acquirer which will endanger the company’s liquidity. The acquiring company may fail to pay its short-term debt and eventually fail to finish the financing for the M&A activity.  Risk of using external financing: In case of external financing such as debt financing if bad management is involved in the M&A it will reduce the ability of an acquiring company to pay back the principle interest and eventually the acquiring company may go bankrupt.  Payment Risk: The mode of payment will bring risk to the pricing which involves capital liquidity and stock dilution. The payment methods involved in M&A mainly include cash payments, equity payments, leverage payments, and mixed payments. Different payment methods will produce different financial risks.  Risks of paying cash: It is the most convenient method of payment and it allows acquirer to gain control over the target company with fastest speed, however the increasing pressure on company’s cash flow will harm corporate liquidity and meanwhile will slow the reaction ability of the enterprise to adapt to its external environment. Furthermore, this mode of payment increases the enterprise’s debt burden, and consequently produces the risk of debt and bankruptcy.  Risk of equity payment: In this mode of the payment acquirers share are dominant and the deal is dependent on it. However acquirer’s share price is not fixed and it is dependent on how market reacts with the news of new merger or acquisition so it may go down and eventually the acquirer will have to settle the deal by overpaying for the target company’s share value.  Risk of Preemption of Competing Bidder: This risk happens usually in case of hostile acquisitions where the target company may decide to merge with or get acquired by a favorable buyer. This can provoke a competing bid and the acquirer ultimately loss the opportunity to acquire the target company.  Risk of Litigation by competitors: Sometimes competitors could claim that the result of the possible merger would eliminate competition in various products and on basis of this they might file a lawsuit against the merging companies. Merging companies have to deal with the lawsuit which will ultimately cost money.
  20. 20. 17  Financial Risk After M&A: Integration Risk:  Liquidity Risk: Liquidity risk refers to the possibility of payment difficulty due to heavy debt burden after M&A. This may affect company’s ongoing projects and ultimately cash flow. If the company is unable to pay its short term debts then eventually it will affect company’s creditability and it will also affect the company’s image.  Operational risks: Operational risk refers to the financial risk resulting from the loss of enterprise funds. The deviation of actual income from expected returns results from the contradiction of the financial management system and the setting of the financial institution, financial fault, or financial behavior.  Loosing of key customers: There is a possibility that a customer is not happy with the newly integrated company and chooses to go with the company’s competitor for future projects.  Loosing important personnel: There is a possibility that some important people are unhappy with the new organization structure and that they feel uncertainty about their future with the new company and eventually they may decide to leave the company. Loosing important people will ultimately affect company’s business.  Technological Synergic risks: There is a risk that companies may fail to create technological synergies for example both companies were using different IT systems for their operations earlier and now they have to invest money for the integration of their different IT systems. In some cases companies may have to invest in developing new technology which will be suitable for both the companies.  Social Risks: There is a risk of the working culture differences between the two companies. For example newly integrated product development team is working on new product but both the teams have their own way of handling this kind of projects because of which they fail to launch new product on time which will ultimately generate cost to the company. 3.7 Risk management for M&A37  Pre-M&A  Confirming own competencies for potential M&A: Management should first evaluate and analyze their own strengths and weaknesses especially financial strengths rather than just focus on the strategic objectives. Management can involve external M&A advisory firms and auditing firms in Pre- M&A phase. . 37 International Business Research, Vol 3,January 2010
  21. 21. 18  Evaluating the real value of target company: Main cause of valuation risk in evaluating the real value of the target company is asymmetric information’s between the two companies. Before any M&A activity company should do due diligence for the potential M&A. Management should include institutions like investment banks that could evaluate potential outcome of the M&A and reasonably predict the future profit for the combined company.  Between M&A Process  Adopting various financing & Payout methods: Once the value of the target company is confirmed the acquirer should adapt various financing and payout methods such as cash, equity financing and debt financing, in this way the acquirer can reduce the financial risks by diversifying in financing & payout for M&A.  Involvement of the insurance firm in M&A: As precaution against the financial risks involved in M&A, companies should involve insurance firms in M&A deals.  Post M&A  Establishing the financial alarm management system: For the survival and development of the newly integrated company after M&A, the new company could establish a financial alarm management system which will take precautions against financial risks and potential financial crisis induced by the financial management mistakes during the M&A activity and the financial process fluctuation during integration. This financial alarm system could evaluate, predict, pre-control and continually remedy bad financial development tendency. 3.8 Inference  Even though M&A activities are look like short cut for a company to increase shareholder value they are very complex and there are lot of risks involved.  There are various motives behind M&A activities.  M&A activities are classified on the basis of the motives behind them.  Risk management plays an important role in M&A activity.
  22. 22. 19 4 Case study on Actavis and Allergan 4.1 Introduction 38 Actavis: Actavis (formerly known as Actavis Limited) was incorporated in Ireland on May 16, 2013 as a private limited company and re-registered effective September 18, 2013 as a public limited company. Actavis is a leading integrated global specialty pharmaceutical company engaged in the development, manufacturing, marketing, sale and distribution of generic, branded generic, brand name, biosimilar and over-the-counter pharmaceutical products. Actavis also develops and out- licenses generic pharmaceutical products primarily in Europe through its third-party business. Actavis has operations in more than 60 countries throughout North America and the rest of world, including Europe, Middle East, Africa, Australia, Asia Pacific and Latin America. Exibit3: Selected Financial Data for Actavis (Source: Merger Prospectus, 2014, Published on: January 26, 2015, Page no. 48) 38 Merger Prospectus, 2014,Published on January 26, 2015, Page-67 Operating Highlights as on 30 Sept 2014 (In million, except per share amount) Net revenue $ 9,005.4 Operating income $638.1 Earnings per share $4.39 Weighted average ordinary shares outstanding 204.4 Balance sheet Highlights as on 30 Sept 2014 (In million USD, except per share amount) Current Assets $6252.3 Total Assets $53,467.4 Total Debt $15,537.1 Total Equity $29,145.0
  23. 23. 20 Allergan: Allergan was incorporated in Delaware in 1950. Allergan is known for its famous anti-wrinkle drug BOTOX. Allergan is a multi-specialty health care company focused on developing and commercializing innovative pharmaceuticals, biologics, medical devices and over-the-counter products. Allergan discovers, develops and commercializes a diverse range of products for the ophthalmic, neurological, medical aesthetics, medical dermatology, breast aesthetics, and urological and other specialty markets in more than 100 countries around the world. Operating Highlights as on 30 Sept 2014 (In million, except per share amount) Net revenue $ 5,327.4 Operating income $1,382.6 Earnings per share for Allergan Stockholders $3.32 Weighted average ordinary shares outstanding 297.5 Balance sheet Highlights as on 30 Sept 2014 (In million) Current Assets $6103.8 Total Assets $11,645.8 Long term Debt, excluding current portion $2088.6 Total Equity $7110.7 Exibit4: Selected Financial Data for Allergan (Source: Merger Prospectus, 2014,Published on: January 26, 2015,Page no. 51)
  24. 24. 21 4.2 The Actavis-Allergan Merger39 40 We have mentioned in previous chapter about the hostile acquisition and the White Knight term related to it. Actavis-Allergan merger case is good example to understand the concept. Valeant made $180 a share acquisition offer to acquire Allergan. Allergan wanted to slip from this hostile acquisition offer as Valeant was not the best suitor for Allergan. Allergan’s management then approached Actavis with a merger proposal. Looking at the future growth opportunities for both the companies Actavis agreed to the merger and offered a combination of $129.22 in cash and 0.3683Actavis shares for each share of Allergan common stock, Valuing the target $219 a share or $ 70.5 billion. That offer exceeded Valeant’s $180 a share takeover proposal for Allergan and eventually Valiant stepped backed from its hostile takeover attempt. Actavis played a role of ‘White Knight’ and rescued Allergan from Valeant’s long running takeover attempt. On 22 Jan 2015 Actavis made public announcement regarding the merger. The newly combined company is known as Allergan and is listed at New York stock exchange under AGN. This merger helped Allergan saving millions of dollar by shifting its corporate headquarter from the US to Ireland where corporate tax is 17%. This cost saved through tax benefits will help newly combined company to fund its R&D and produce new products in their R&D pipeline. 4.3 New business model 41 42 Every business has its own business model. To keep the market share and to be competitive in market companies invests a lot in R&D for development of new product or innovation in technology. Companies try to be innovative in technology and try to increase their market share by launching new product every year and keep on growing their revenues to keep their investors happy. Many leading pharmaceutical companies feel pressure to cut costs as they approach their expiring date for patents. Once a patent expires, other companies may begin producing generic versions of the medicines which will considerably affect their price. According to Forbes the study indicates that it costs $2.5 billion on average to bring a new drug to the market. New drug has to go through long approval process from government agencies like FDA. These government agencies have authority to discontinue the new drug and which affects pharma companies badly as they have invested a lot of money in developing this new drug. 39 Jonathan D. Rockoff,The Wall Street Journal,Article dated 17/11/2015 40 Antonie Gara, Forbes,Article dated 17/11/2014 41 Amy Nordrum, International business Times,Article dated 27/7/2015 42 Jen Wieczner, Fortune,Article dated 28/07/2015
  25. 25. 22 Now day’s pharmaceutical companies believe that acquisitions are the only way to keep their revenues growing fast as investors expect. That’s why pharmaceutical companies are now looking for merger and acquisitions instead of investing only in R&D. In the first half of this year around 221 billion dollars were involved in pharmaceutical M&A transactions. This M&A trend is also indicative of a new business model that has emerged within the pharmaceutical industry. More often, major drug companies are leaving the research and development up to smaller biotech firms and startups. Forbes describes it as a sort of pyramid, with a handful of large drug manufacturers at the top purchasing the rights to make promising drugs developed by many smaller companies. By consolidating, pharmaceutical companies save on expenses and acquire companies which have new products in their pipelines, which ensure them to have strong new drugs to bring to the market and to compensate for their losses. 4.4 Evaluation of risks & Opportunities43 Exibit5: SWOT Analysis of newly combined company44 43 Actavis Client Report.pdf by Sontag Solutions 44 SWOT analysis derived from the Actavis 10K 2014 Strengths  More products in R&D pipeline  Enhanced Commercial Opportunities across Global Markets.  Potential to create top 10 pharmaceutical company with diverse product portfolio  Industry leading supply, Distribution capabilities  Many drugs in FDA’s phase3 clinical trials Weakness  Uncertainty in paying off debt  Low margins on generics Opportunities  Merger with Pfizer  Synergies in distribution from expanding their product portfolio  Expansion into Branded Pharmaceuticals Threats  Failure to Integrate Acquisitions and Dealing with the Explosive Growth  Medicine not making it through clinical trials  Approval of competitor’s generic pharmaceutical products that compete with Actavis branded drugs.  Increasing Buyer (Wholesaler) Power
  26. 26. 23  Risks for the newly combined company based on SWOT analysis.  Risk of integrating companies: The newly combined company has to integrate its operations with new businesses while conducting their own day to day activities. The other difficulties with the integration and which could delay this process include: an inability to achieve synergies as planned, incompatibility of corporate cultures, distracting management from day-today operations, costs and delays in implementing system and procedures, and the difficulty of managing the additional international locations of the company.  Risk of not getting approvals on new drugs: The newly combined company has many new drugs at phase 2 and phase 3 of clinical trials which is crucial step for them towards receiving FDA approval. Study shows that only less than 50 % of new drugs pass through these clinical trials. Failure of these drugs to receive approval will significantly affect company’s future sales.  Risk of not producing competitive revenues: The study shows that there is growth in generics drugs this gives wholesaler’s ability of lowering prices on purchases of generic drugs. This may affect company’s revenue through generic drugs business as due to wholesaler’s pressure company keeps low profit margins on generic drugs.  Risk of reduction in sale for branded drug business: The newly combined company has large number of branded drugs in their portfolio. Branded products comprise major percentage of total revenue. Generic equivalents for branded pharmaceutical products are cheaper than the branded products. If competing generic product has been introduced then it will affect sale of branded products. This will ultimately lower the total revenue of the newly combined company.  Opportunities for newly combined company based on SWOT analysis.  Expansion into Branded Pharmaceuticals: Previously Actavis was known for its generic pharmaceutical business. This merger has created a global brand pharmaceutical business with leading positions in key therapeutic categories. The new company has six blockbuster franchises with combined revenue of approximately $ 15 billon expected.45  Possible Merger with Pfizer: Pfizer Inc. and Allergan Plc announced that their board members have approved and companies have entered into a merger agreement. And the deal is valued approximately $160 billion.45 45 Allergan Plc website
  27. 27. 24 4.5 Recommendation By looking at the risks and opportunities this new company has, we would like to give the following recommendations:  The new company should focus on the successful integration of both, the companies and their other subsidiaries.  Both management teams should work as an effective team and integrate same corporate culture throughout all the organizations.  The new company should focus on getting their new products clear through FDA’s clinical trials.  The new company should combine their separate teams of physicians to use their R&D synergies more effectively.  The new company should focus on investing in R&D and its current drug pipeline while setting a firm plan to integrate its recent acquisitions.  The new company should develop a strategy against increasing revenues in generic drug business by overcoming wholesalers bargaining power.  The new company should focus on their firm strategy for successfully completing the coming merger opportunity with Pfizer.
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