In recent years, global private equity firms have emerged as a major force in the world of high finance. With the backing of wealthy individuals and funds they have been able to attract to various ventures, they have successfully taken administrative control of billions of dollars in assets. Private equity investments are expected to be $5 trillion or more by 2025.
In a highly competitive business environment, private equity, public and private companies seek every growth opportunity that arises. This includes acquiring other companies, merging with current or potential competitors, or disposing of assets that are no longer of value. These practices have great potential for generating revenue and, in some cases, are even essential for survival.
However, mergers, acquisitions and divestitures are also some of the riskiest and most complex business transactions. Many fail because market conditions change, deals never close, or companies later encounter insurmountable difficulties. Private equity firms face an additional risk – a firm’s institutional shielding may not always protect partners from the financial consequences of ill-advised investment decisions.
Consideration of Transaction Risks
In order to understand the importance of comprehensive and effective risk management, it is first necessary to understand what risks accompany a potential M&A transaction and what costs these can incur. In order to be able to illustrate this better, a value is defined for the risk taken, which is referred to in English specialist literature as “value at risk”. This is made up of both monetary variables, such as the expenses for research and analysis work or consulting costs, as well as intangible elements such as the potential loss of company reputation or loss of time.
The aim of risk management is now to check transactions for their specific value at risk and to minimize this through suitable strategies and measures. A prerequisite for this is detailed knowledge of possible causes and sources of transaction-specific risks, which are to be examined in more detail below using selected examples.
Loss of Value of the Buyer Shares When Carrying Out A “Share-For-Share Deal”
In M&A transactions that are based on an exchange of shares (share-for-share deal), the share price of the buying company determines the actual monetary value of the offer. However, this leads to the problem that fluctuating share prices significantly increase the uncertainty of a transaction based on a share exchange compared to an offer based on a cash payment. A drop in the company’s own share price shortly after the announcement of the takeover bid, a phenomenon that scientific studies have found to occur frequently, can result in the buyer company having to exchange significantly more of its own shares when carrying out the transaction. in order to be able to raise the targeted purchase price than originally planned. In highly volatile markets, this can go so far that, for example, when new shares are issued to finance the transaction, significantly more shares would have to be issued and previous shareholders of the company would have to cope with an enormous loss in value and a reduction in their influence due to the dilution of their shares. In particular, this situation can bring influential major shareholders such as hedge funds, against carrying out the transaction and thus represent a major risk for a successful conclusion. This problem will be addressed in particular in chapters four and five.
Identifying the right price is one of the most complex processes involved in conducting M&A transactions and is controlled by many different factors. The final price of an offer does not necessarily suggest the value that the bidder attaches to the company for which he is bidding. Rather, a skilful and intelligent pricing policy can reduce the risks of an M&A transaction enormously, especially if the bidder is able to determine a fair value for the target through good “due diligence” and then through this secures a high proportion of cash in the takeover bid.However, the price can also become a major risk for the course of an M&A transaction, especially when there are several bidders for a potential target. Ultimately, in such a situation, the final price offered decides who will be given the go-ahead in the takeover. After all, the success or failure of a takeover ultimately depends on how many shareholders accept the price offered and sell their shares to the bidder in return. The temptation for competing bidding companies to outdo the other by outbidding the current offer is correspondingly high. In most cases, however, this “competitive bidding” leads to an overvaluation of the target, which can represent a serious risk for the sustainable success of an M&A transaction. The introductory example of the takeover of ABN Amro by the banking consortium around the Royal Bank of Scotland underscores this risk aspect very clearly, as it is precisely here that the significantly too high valuation of the target led to goodwill write-offs in the billions at the consortium banks.
Intervention by Regulators
Regulatory authorities represent a risk for successful M&A transactions that should not be underestimated, especially in sectors in which only a few companies share the overall market. Here it is particularly important that the preparation of a transaction can sometimes be associated with very high costs, which, as mentioned at the beginning, consist primarily of analysis and consulting costs. The companies have to spend this even before the government authorities have clarified whether the transactions can also be carried out legally. The iron ore industry provides a good example here, as this market is essentially divided between the three mining companies BHP Billiton plc, Rio Tinto plc and Vale. For example, Rio Tinto and BHP are currently planning to merge their iron ore businesses, which some analysts believe would ultimately lead to the formation of an iron ore cartel. Due to the already large market power of the three still independent companies, the antitrust authorities would probably not agree to further consolidation for reasons of competition, but the costs in the run-up to this theoretical transaction would still have to be incurred. As a result, companies would incur high so-called “sunk costs”, i.e. costs without benefit. In this hypothetical example, the starting position is relatively clear, but there are many sectors in which decisions by the competition authorities are very difficult to predict. They therefore represent a large unknown within the M&A transaction process.
Stages of Risk Management
Despite their always very individual design, M&A transactions can essentially be divided into three phases. Each of these phases is characterized by certain risks that must be compensated for by appropriate risk management. It is of great importance to understand the characteristics of the individual stages of the transaction process and the risks they can cause. Building on the knowledge of general risk factors from chapter two, some strategies for reducing risk in the various transaction phases are presented below. This knowledge provides a basis for understanding the different instruments of risk management, which are discussed in chapters four and five of this work.
Pre-Transaction Announcement Phase
In the run-up to a planned transaction, the parties involved will usually prepare themselves for several different process scenarios. This is particularly due to the fact that it is practically impossible to make an exact forecast of the market reaction to the announcement of the transaction. Due to the usually very large free float of the shares of highly capitalized companies, it can be statistically assumed that the transaction will always only appeal to a certain percentage of the shareholders. How high this percentage is in the end depends above all on the average return that the owners of the shares can expect when the transaction is carried out. However, in the run-up to the transaction, one can only speculate about the transaction-related returns, which is reflected in the increased volatility of the shares involved.
In addition to this general risk, which, as already illustrated under 2.1, can have a particularly negative effect on share-for-share deals, there are phase-specific risks both on the part of the buyer company and on the side of the potential targets, which can be offset by strategically well-planned risk management be significantly weakened. With the potential targets, the possibility of a hostile takeover already represents a risk for one’s own company, which can be significantly reduced through the skilful use of anti-takeover tactics. On the other hand, the buyer company has the opportunity to get a first impression of the relevant parameters in the run-up to a planned takeover by acquiring a non-reportable share position of the potential target. The obligation to report share ownership is based on the percentage of shares held in relation to the total number of tradable shares and, for example in Germany, currently applies from a share of three percent. This means that the buying company can own up to 2.99 percent of the potential target’s stock without having to publicly disclose it. This minority interest is referred to in English specialist literature as a “toehold stake” and can prove to be a risk-mitigating element in many respects. In this way, the costs incurred by the buyer company as a result of a lost bidding war can be compensated for by increasing the value of the investment. Since both the improved information situation and the insurance against possible “sunk costs” reduce the risk, the toehold approach represents a very efficient way of risk reduction for potential buyer companies in the run-up to an M&A transaction.