Around seven years ago, Opao Co, a private conglomerate company involved in many different businesses, decided to obtain a listing on a recognised stock exchange by offering a small proportion of its equity shares to the public. Before the listing, the company was owned by around 100 shareholders, who were all closely linked to Opao Co and had their entire shareholding wealth invested in the company. However, soon after the listing these individuals started selling their shares in Opao Co, and over a two-year period after the listing, its ownership structure changed to one of many diverse individual and institutional shareholders.
As a consequence of this change in ownership structure, Opao Co’s board of directors (BoD) commenced an aggressive period of business reorganisation through portfolio and organisational restructuring. This resulted in Opao Co changing from a conglomerate company to a company focusing on just two business sectors: financial services and food manufacturing. The financial press reported that Opao Co had been forced to take this action because of the change in the type of its shareholders. The equity markets seem to support this action, and Opao Co’s share price has grown strongly during this period of restructuring, after growing very slowly initially.
Opao Co recently sold a subsidiary company, Burgut Co, through a management buy-in (MBI), although it also had the option to dispose of Burgut Co through a management buy-out (MBO). In a statement, Opao Co’s BoD justified this by stating that Burgut Co would be better off being controlled by the MBI team.
Opao Co is now considering acquiring Tai Co and details of the proposed acquisition are as follows:
Proposed acquisition of Tai Co
Tai Co is an unlisted company involved in food manufacturing. Opao Co’s BoD is of the opinion that the range of products produced by Tai Co will fit very well with its own product portfolio, leading to cross-selling opportunities, new innovations, and a larger market share. The BoD also thinks that there is a possibility for economies of scale and scope, such as shared logistic and storage facilities, giving cost saving opportunities. This, the BoD believes, will lead to significant synergy benefits and therefore it is of the opinion that Opao Co should make a bid to acquire Tai Co.
Financial information related to Opao Co, Tai Co and the combined company
Opao Co
Opao Co has 2,000 million shares in issue and are currently trading at $2·50 each.
Tai Co
Tai Co has 263 million shares in issue and the current market value of its debt is $400 million. Its most recent profit before interest and tax was $132·0 million, after deducting tax allowable depreciation and non-cash expenses of $27·4 million. Tai Co makes an annual cash investment of $24·3 million in non-current assets and working capital. It is estimated that its cash flows will grow by 3% annually for the foreseeable future. Tai Co’s current cost of capital is estimated to be 11%.
Combined company
If Opao Co acquires Tai Co, it is expected that the combined company’s sales revenue will be $7,351 million in the first year and its annual pre-tax profit margin on sales will be 15·4% for the foreseeable future. After the first year, sales revenue will grow by 5·02% every year for the next three years. It can be assumed that the combined company’s annual depreciation will be equivalent to the investment required to maintain the company at current operational levels. However, in order to increase the sales revenue levels each year, the combined company will require an additional investment of $109 million in the first year and $0·31 for every $1 increase in sales revenue for each of the next three years.
After the first four years, it is expected that the combined company’s free cash flows will grow by 2·4% annually for the foreseeable future. The combined company’s cost of capital is estimated to be 10%. It expected that the combined company’s debt to equity level will be maintained at 40:60, in market value terms, after the acquisition has taken place.
Both Opao Co and Tai Co pay corporation tax on profits at an annual rate of 20% and it is expected that this rate will not change if Opao Co acquires Tai Co. It can be assumed that corporation tax is payable in the same year as the profits it is charged on.
Possible acquisition price offers
Opao Co’s BoD is proposing that Tai Co’s acquisition be made through one of the following payment methods:
(i) A cash payment offer of $4·40 for each Tai Co share, or
(ii) Through a share-for-share exchange, where a number of Tai Co shares are exchanged for a number of Opao Co shares, such that 55·5% of the additional value created from the acquisition is allocated to Tai Co’s shareholders and the remaining 44·5% of the additional value is allocated to Opao Co’s shareholders, or
(iii) Through a mixed offer of a cash payment of $2·09 per share and one Opao Co share for each Tai Co share. It is estimated that Opao Co’s share price will become $2·60 per share when such a mixed offer is made.
Similar acquisitions in the food manufacturing industry have normally attracted a share price premium of between 15% and 40% previously.
Required:
Distinguish between a management buy-out (MBO) and a management buy-in (MBI), and discuss why Opao Co’s board of directors (BoD) might have sold Burgut Co through an MBI.
A management buy-out (MBO) involves the purchase of a company by the management running that company. Hence Burgut Co’s current management team would be buying Burgut Co from Opao Co. A management buy-in (MBI) involves selling Burgut Co to a management team brought in from outside the company.
Opao Co may have sold Burgut Co through a MBI for the following reasons. Opao Co’s BoD may have felt that Burgut Co’s current management team lacked fresh ideas and strategies which could have driven Burgut Co forward successfully. Instead, it may have felt that a fresh team, with skills and expertise gained externally, would have had the required innovative ideas and skills. It may be that the external team of managers may have had the finance available to move quickly, whereas the internal team of managers may not have had the finance in place to purchase Burgut Co at that time. It is also possible that the management teams within Burgut Co and Opao Co had disagreements in the past, and Opao Co’s BoD may have believed the two management teams would not be able to work together in the future, if needed. Thus, the BoD may have felt that a fresh management team was the better option going forwards.
Explain what portfolio restructuring and organisational restructuring involve, and discuss possible reason(s) why the change in the type of shareholders may have made Opao Co change from being a conglomerate to one focusing on just two business sectors.
Portfolio restructuring involves the acquisition of companies, or disposals of assets, business units and/or subsidiary companies through divestments, demergers, spin-offs, MBOs and MBIs. Organisational restructuring involves changing the way a company is organised. This may involve changing the structure of divisions in a business, business processes and other changes such as corporate governance.
The aim of either type of restructuring is to increase the performance and value of the business.
Opao Co, in going from a conglomerate business to one focusing on just two business areas, can be seen as restructuring its portfolio, as businesses and assets which are not part of financial services and food manufacturing are disposed of, and businesses focusing on these areas are acquired. Financial markets may take the view that focusing on food manufacturing and financial services has enabled Opao Co’s senior management to concentrate on areas in which they have expertise. Whereas other businesses in which the senior management are not experts are disposed of. This activity leads to the maximisation of business value.
Shareholders are interested in maximising returns from their investments, which companies achieve through maximising business value, whilst minimising the risks inherent in their investment activity. Shareholders who are closely linked to a particular business do not hold diversified investment portfolios, and therefore benefit from diversification of risk undertaken by a company, investing in many different areas. On the other hand, institutional shareholders and other shareholders, who hold diversified portfolios, would not benefit from a company undertaking risk management through diversification by becoming a conglomerate. Instead, such companies would increase value by focusing on areas in which they have relative expertise, as Opao Co seems to do. So Opao Co’s changing owner clientele has forced it to change its overall strategy. This strategy change was implemented through portfolio restructuring.
Prepare a report for the board of directors of Opao Co which:
(i) Estimates the value of equity of Opao Co and of Tai Co before the acquisition, and of the combined company after the acquisition;
(ii) Estimates the percentage gain in value for each Opao Co share and Tai Co share, under each of the cash, the share-for-share, and the mixed offers;
(iii) Evaluates the likely reaction of Opao Co’s and Tai Co’s shareholders to the acquisition offers.
Professional marks will be awarded in part (c) for the format, structure and presentation of the report.
Report to the board of directors (BoD), Opao Co
Introduction
This report provides an estimate of the additional value created if Opao Co were to acquire Tai Co, and the gain for each company’s shareholders based on a cash offer, a share-for-share offer and a mixed offer. It evaluates the likely reaction of the two companies’ shareholders to each payment method.
Summary of the estimates from the appendices
From appendix 1
Opao Co equity value pre-acquisition: $5,000m
Tai Co equity value pre-acquisition: $1,000m
Combined company equity value post-acquisition: $6,720m
From appendix 2
Therefore, additional value based on synergy benefits is $720m or 12% ($720m/$6,000m)
Estimated percentage gain in value
Opao Co Tai Co
Cash offer 11·2% 15·8%
Share-for-share offer 6·4% 40·0%
Mixed offer 9·7% 23·4%
Likely reactions
Tai Co’s shareholders are likely to consider all the offers made, because they all fall within the range of premiums paid in previous acquisitions of 15% to 40%. The cash offer is at the lower end of the range, the share-for-share offer at the top end of the range and the mixed offer in between. It is likely that Tai Co’s shareholders will be more attracted to the share-for-share offer as it maximises their return. However, this offer is reliant on the fact that the expected synergy benefits will be realised and Tai Co will probably need to analyse the likelihood of this. Cash payment, although much lower, gives a certainty of return. The mixed offer provides some of the certainty of a cash payment, but also offers a higher return compared to the cash offer. This return is roughly in the middle of the premium range. It may therefore prove to be the better option for Tai Co’s shareholders.
Opao Co’s shareholders benefit less from the acquisition compared to Tai Co’s shareholders. In each case, they get less than the additional value created of 12%, with the cash payment offering the highest return of 11·2%, which is just below the 12% overall return. The share-for-share offer gives the least return at just over half (6·4%) of the overall return of 12%. Nevertheless, with this option, cash is retained within Opao Co and can be used for other value creating projects. Opao Co’s shareholders may also prefer the mixed offer, because the return they are expecting to receive is between the cash and share-for-share offers. Also, less cash resources are used compared to the cash offer, and they still benefit from a significant proportion of the additional value created.
Conclusion
Based on the benefits accruing to both sets of shareholders, it is not possible to conclusively say that one method of acquisition payment would be acceptable to both sets of shareholders. However, both sets of shareholders may be persuaded that the mixed offer provides a reasonable compromise between the wholly cash and the wholly share-for-share prices. Given that synergy benefits are shared (even if not equally), both companies’ share prices should increase if the acquisition proceeds, as long as the estimates when estimating the valuations are reasonably accurate.
Report compiled by:
Date
APPENDICES:
Appendix 1 (Part (c) (i)):
Equity value of Opao Co prior to acquisition
$2·50/share x 2,000m shares = $5,000m
Equity value of Tai Co prior to acquisition
Free cash flows to firm = $132·0m + $27·4m – $24·3m – ($132·0m x 0·2) = $108·7m
Company value = $108·7m x 1·03/(0·11 – 0·03) = $1,399·5m, say $1,400m
Equity value = $1,400m – $400m = $1,000m
Equity value of combined company post acquisition
All amounts in $ millions
Following the MBI, the BoD of Burgut Co announced that its intention was to list the company on a recognised stock exchange within seven years. The BoD is discussing whether to obtain the listing through an initial public offering (IPO) or through a reverse takeover, but it does not currently have a strong preference for either option.
Required:
Distinguish between an IPO and a reverse takeover, and discuss whether an IPO or a reverse takeover would be an appropriate method for Burgut Co to obtain a listing.
The initial public offering (IPO) is the conventional way to obtain a listing where a company issues and offers shares to the public. When doing this, the company will follow the normal procedures and processes required by the stock exchange regarding a new issue of shares and will comply with the regulatory requirements.
Undertaking a reverse takeover enables a company to obtain a listing without going through the IPO process. The BoD of Burgut Co would initially take control of a ‘shell’ listed company by buying some shares in that company and taking over as its BoD. The ‘shell’ listed company was probably a normal listed company previously, but is no longer trading. New equity shares in the listed company would then be exchanged for Burgut Co’s shares, with the external appearance that the listed company has taken over Burgut Co. But in reality Burgut Co has now effectively got a listing, having taken control of the listed company previously. Normally, the name of the original listed company would then be changed to Burgut Co.
Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is cheaper, takes less time and ensures that Burgut Co will obtain a listing on a stock exchange. An IPO can cost between 3% and 5% of the capital being raised because it involves investment banks, lawyers, and other experts. A marketing campaign and issuing a prospectus are also needed to make the offering attractive and ensure shares to the public do get sold. A reverse takeover does not need any of these and therefore avoids the related costs. The IPO process can typically take one or two years to complete due to hiring the experts, the marketing process and the need to obtain a value for the shares. Additionally, the regulatory process and procedures of the stock exchange need to be complied with. With a reverse takeover, none of these are required and therefore the process is quicker. Finally, there is no guarantee that an IPO will be successful. In times of uncertainty, economic downturn or recession, it may not attract the attention of investors and a listing may not be obtained. With reverse takeover, because the transaction is an internal one, between two parties, it will happen and Burgut Co will be listed.
However, obtaining a listing through a reverse takeover can have issues attached to it. The listed ‘shell’ company may have potential liabilities which are not transparent at the outset, such as potential litigation action. A full due diligence of the listed company should be conducted before the reverse takeover process is started. The IPO process is probably better at helping provide the senior management of Burgut Co with knowledge of the stock exchange and its regulatory environment. The involvement of experts and the time senior management need to devote to the listing process will help in this regard. Due to the marketing effort involved with an IPO launch, it will probably have an investor following, which a reverse takeover would not. Therefore, a company which has gone through an IPO would probably find it easier to raise extra funds, whilst a company which has gone through a reverse takeover may find it more difficult to raise new funding.
Overall, neither option of obtaining a listing has a clear advantage over the other. The choice of listing method depends on the company undertaking the listing and the purpose for which it is doing so.
(Note: Credit will be given for alternative valid areas of discussion)