Investing 101: Mergers and Acquisitions – Part 1

Updated: Jun 21, 2020

NB: This is Part 1 of a several part introduction to Mergers and Acquisitions. Stay tuned for further instalments!

If you’ve read any of my previous posts, you’ve probably noticed that the term Mergers and Acquisitions or M&A’s, has appeared several times. It is a frequently used term in the financial world, and one that is really important to understand. So, without further a do, let’s get into the nitty gritty of what a Merger and Acquisition really is…

A Merger and Acquisition (M&A) generally occurs when a large company wants to buy a smaller one. The reason behind this is to create value and growth. The larger company (acquirer) can more effectively and efficiently achieve growth if it buys a pre-existing company, rather than organically creating growth. Behind all M&A’s is the idea that there is a type of synergy that is established when two firms combine. Synergy is explained as 1+1=3 (i.e. two firms combined together are worth more than either firm is worth alone).

That might be pretty hard to get your head around, so let’s break it down! Typically in an M&A, a larger company wants to strengthen a part of its business. In this example, we will use the supermarket chain, Sainsbury’s.

Sainsbury’s does everything, from food and groceries, to homeware and sports equipment. However, recently it decides that it wants to improve its electronics department to keep up with its rivals. Now, Sainsbury’s has a choice:

A) It can try and bolster its electronics department organically. This would mean that it would have to hire a team of people to build up the electronics department, some to design products, some to build sales strategies, some to do market research, finance experts to determine how much it should sell its kindles and cameras for, marketing employees to attract customers to buy their products, and operations staff to be able to source the products in the first place. So, if Sainsbury’s wants to strengthen and grow its electronics department organically, it will require hiring lots of staff, thus costing lots of money. Makes sense so far? I hope so.

B) It can buy a smaller company that already works in electronics, saving themselves lots of money and work. This would be an M&A.

So, why might a company want to buy another one in an M&A transaction? Below is a list of several reasons:

  1. For synergy. As previously mentioned, synergy can be defined as 1+1=3. What this means is as follows – Starbucks Coffee one day decides to buy Café Nero (a smaller company). There are lots of Starbucks branches all around the country, and lots of Café Nero’s in similar locations. If Starbucks buys Café Nero, it maintains the same customers, and also has lower costs, because it can close down some of the branches of Café Nero when there is already a Starbucks in that area, meaning it can employ less staff (less wages to pay), pay less rent, tax, etc. Synergy doesn’t always materialise, but it is definitely a driving force behind an M&A deal.

For Speed. Growing organically requires a lot of time and patience. A car dealership company may not be able to predict how long it will take to achieve its sales and revenue targets if it grows organically, but if it decides to buy an already established, successful car dealership, it knows that it will have a guaranteed boost. It could take years for Sainsbury’s to develop their electronics department, but if it buys Curry’s/PC World, it knows that it will instantly be able to grow from the success of its acquisition.

For Increased Market Dominance. If Domino’s Pizza decides to acquire Papa John’s Pizza, it has removed its biggest rival from the market. It also gains the power and success of Papa John’s, and together they could have complete dominance over the UK pizza takeaway market. With both companies joined together, it would be very difficult for another pizza company to come along and take away all of their customers (or to find a better stuffed crust recipe!)

To access foreign markets. Brazil’s TAM Airline wanted to grow, to attract more customers. But how? It already was the largest airline in Brazil, and due to regulatory reasons and cultural concerns, could not easily operate in different Latin American countries. Well, that was until Chile’s LAN Airline came along and the companies decided to merge in 2012 into the current LATAM Airlines Group. Now, they can both fly across Latin America and so have access to a wider market of customers.

To satisfy the interests of the management team. Sometimes, an M&A takes place for the wrong reasons. A CEO generally gets paid more at a bigger company, so sometimes, they put their interests above those of the shareholders and acquire a smaller company, to increase the size of their empire. The bigger the empire, the bigger the pay-check for the CEO.

For Greater Control. Sometimes, a large company will see potential in a smaller one that they believe is being mismanaged. If they were to buy this smaller company, they’d be able to manage it better, unlock its true potential, and the hidden value of its assets can be realised through a change in leadership and control. For example, online shopping website ASOS may see that Boohoo, another online shopping company, has a great product. However, due to Boohoo’s poor management, it isn’t doing as well as it should be. Therefore, ASOS makes an offer to Boohoo to acquire it. Under ASOS’ leadership and control, it can help maximise the value of Boohoo and be successful.

These are just some reasons as to why an M&A might happen. However, there are plenty more, but these will be covered in future blog posts.

Thanks for reading!