How Mergers and Acquisitions Impact Investors

Corporate mergers and acquisitions can have a significant impact on the value of stock held by investors. But apart from the potential for sudden price changes for impacted shares, what else do investors need to know about mergers and acquisitions?

What Are M&As?

While they’re generally lumped together and can have similar motivations, mergers and acquisitions are different. A merger occurs when companies combine to create a new entity. Shareholders of the original premerger companies receive shares in the new firm at a predetermined formula. The shares aren’t usually distributed evenly as one company is normally valued higher than the other.

In an acquisition, one firm purchases and absorbs the other, retaining its own corporate structure. Shareholders of the target firm receive shares in the parent—or cash or other compensation—based on the agreed-upon takeover price.

Why Do Companies Engage in M&A Transactions?

There are many reasons why executives might pursue a merger or acquisition, including:

• Increased Market Share – Acquiring a competitor can provide a company with a path to increase its market share in a relatively straightforward manner. 
• Economies of Scale – A company tends to become more streamlined in some areas as it grows. Duplicative jobs, processes and physical assets can often be eliminated or sold, and fixed costs are spread over a larger enterprise. This is a commonly promoted merger benefit.
• Synergies – Combining operations might lead to increased efficiency. For example, each company’s salespeople can begin to sell the other firm’s product lines, increasing revenues. This is a frequent defense of mergers, particularly for companies in similar spaces or with overlapping customer bases.
• Diversification – Buying a company in a different business allows a firm to diversify its operations quicker than starting from scratch.
• Growth – M&A can help grow revenue faster than organic growth, particularly if a company wants to penetrate a new market with high barriers to entry.
• Tax Benefits – The acquiring company sometimes targets a firm with significant tax losses that the buyer could benefit from, potentially for years.
• Acquiring Technology, Knowledge and Talent – There are often limited sources for obtaining these assets in cutting edge industries. Companies can use M&A to enter or catch up to leaders in fast-moving sectors like artificial intelligence (AI) or niche businesses where hard-to-hire, highly skilled employees can jumpstart their plans.
• Vertical Integration – Buying a firm within the acquiring company’s supply chain, such as a supplier or distributor, can create efficiencies and reduce risk. Supply chain risk has become a major global concern since the COVID-19 pandemic.

How Do Companies Approach M&A Targets?

A senior executive at one firm might contact a counterpart at another firm privately to gauge interest in doing a deal. If the second firm is receptive, they could try to negotiate an agreement. They’ll typically keep their discussions private until they reach a preliminary agreement to avoid impacting trading conditions for the shares of either company.

Other times a firm will hire an investment bank to shop itself around for a potential buyer. If and when the news surfaces that a company wants to be purchased, it will likely impact trading.

What If the Target Resists?

A target company might publicly or privately rebuff M&A interest. If the interested party continues its pursuit above these objections, this is known as a hostile takeover attempt. Generally, the would-be acquirer will purchase a large stake of its target’s shares in the open market before announcing its intentions.

While corporate executives have a fiduciary responsibility to try to increase shareholder value, there are reasons that management might refuse an offer above the company’s current share price. Perhaps their growth plans are progressing, and they expect to deliver greater value as an independent company than the hostile bid offers. Or maybe they believe the bid undervalues the company. If the offer is in shares instead of cash, management might question its value given that shareholders would be heavily dependent on the acquiring firm’s future performance.

In fighting off a hostile takeover, the target firm might seek out an alternative purchaser, known as a “white knight,” to offer what the target firm views as more attractive financial terms or a more appealing post-merger operating structure, sometimes including retaining existing management.

Another strategy to fight off an unwanted takeover is for the directors of the target firm to adopt a “poison pill” plan. This can take several forms—such as offering additional share purchases at a steep discount to all shareholders except the would-be acquirer, staggering director elections, or requiring a supermajority on votes to approve a merger or remove a director—but the goal is to make it more difficult for the bidder to complete a transaction in a timely manner.

Whether shareholder approval is required for M&A depends on state law and corporate bylaws.

What’s the Impact of M&As on Investors?

Sudden, unexpected gains can be substantial after a potential deal is publicized. Shareholders can benefit further if a bidding war breaks out between rivals or management holds out for a better offer.

An elevated share price can increase your risk, however. Your gains might evaporate if enthusiasm wanes or no transaction materializes, or a poison pill that appears intended to prevent any deal rather than encourage a higher bid could also bring a stock back to earth. When a stock is “in play,” its share price is heavily dependent upon market psychology, which can shift rapidly. And there’s no guarantee merger speculation will lead to a higher price. If a potential deal is not well-communicated or there are questions about its funding, the target’s shares might struggle.

Some believe M&A offers—both friendly and hostile—are a great way to release untapped value. Others sometimes argue that this activity often enriches bankers and lawyers at the expense of shareholders, employees and even customers.

If you find one of your portfolio holdings involved in merger activity, do your own research and consider consulting an investment professional to determine whether the stock still fits with your investment strategies and risk profile.

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