Tracy Tidy
August 08, 2023
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Capital allocation is the most fundamental responsibility of senior management.  A company flush with cash has several options when it comes to deploying capital. It can return some of it to stakeholders through stock buybacks, raising dividends or reducing debt. It can also invest in the business through increased capex, or investments into research & development and working capital or it can engage in M&A. Mergers & acquisitions are the largest use of capital. yet it is widely accepted that over two-thirds of mergers fail despite their goal of increasing value. In fact, studies show most of the value accrues to the seller, not the acquirer in the transaction.  

Despite the risks, a successful merger & acquisition can bring significant benefits to an organization. For example, in fast-growing industries such as technology, it may be cheaper in the long run to buy an existing business than attempt to build similar capabilities from scratch. Three examples of this type of strategic growth acquisition include Google buying Android for its mobile operating system to help it expand its search and ad business beyond the PC platform; Facebook (now Meta) acquiring Instagram with its large user base and advanced mobile strategy; and Disney buying Pixar for its animation technology. Through an acquisition the buyer may also obtain skilled talent, achieve synergies to optimize productivity or reduce costs, eliminate a competitor, or diversity their offerings or market reach.  

1. Optimal timing in the merger cycle

There are four phases of a merger cycle:

• • During phase one, the economy is perceived as being in a recession and investors have little appetite for paying high premiums and they favour deals with payback times of only 1-2 years.

1. • Phase two sees more financing coming on stream. Mergers are still perceived as risky, but the deal volume is increasing.
   • Phase three has the merger boom legitimized and those companies which don’t engage are considered laggards. This spurs “catch up” activity as more companies jump on board which also means premiums are rising and the likelihood of value creation goes down.
   • Finally, phase four is the late cycle of mergers which is marked by a growing number of failed mergers, reduced merger financing, and declining target quality.
2. Reasonable premium paid in both absolute terms and relative to net realizable synergies.
3. The target is smaller and in a related business.
4. Management teams are aligned and incentivized to create value over the long term on a per share basis.
5. The financing is done in cash or mostly cash.
6. There is a good cultural fit.
7. The M&A execution is done well.

Visit our Pender Alternative Arbitrage Hub to learn how investors can benefit from using merger arbitrage as part of a well-diversified, balanced portfolio. The hub provides the latest news, resources and updates to keep you informed on our approach to merger arbitrage investing. Explore articles, podcasts and gain insights with our Invest Education pieces.