WCM Educational Recap #3 — Intro to Investment Banking and M&A
Recapped by Naveed Pirouzmand
Hey everyone! This week, we are introduced to the ins and outs of investment banking and M&A. We learn about what investment banking is and the merger model for M&A.
Investment bankers are advisors that act as agents to connect buyers and sellers and/or investors. They help companies raise capital, buy other companies, or sell themselves. Companies can raise capital through an initial public offering (IPO), leveraged financing, or private placement.
IPO: When a company sells equity (ownership in the company) in small, equally sized pieces (shares), to be bought and sold by anyone. Cash raised from IPOs is typically used to fuel accelerated growth.
Leveraged Financing: When a company sells bonds on the open market.
Private Placement: When a private company sells shares to a closed, pre-selected group of investors.
Buying and Selling Advisement
M&A: One of the most common types of transactions that investment banks handle. The buying and selling of companies by other companies.
Divestiture: When a company partially or fully disposes of one of its business units through sale, exchange, closure, or bankruptcy.
Carve-Out: A carve-out is a partial divestiture of a business unit. The company will sell a minority interest of the given business unit through M&A or an IPO.
Bulge Brackets and Boutiques
Bulge Bracket: Bulge bracket banks are full-service financial institutions that offer transaction advisory, retail, wealth management, and commercial banking services. Bulge brackets are organized into product and industry groups. Product groups include equity and debt capital markets, leveraged financing, M&A, financial sponsorship, and restructuring. Industry groups include consumer retail, financial institutions (FIG), healthcare, diversified industrials, energy and power, tech media and telecommunications (TMT), and more.
Boutiques: Boutique banks only offer advisory services and usually target a specific industry or product group.
Investment banks’ management structure in order of increasing seniority is Analyst, Associate, VP, Director, Executive Director, and Managing Director.
Analysts are responsible for building financial models and slide decks and attending meetings with clients. Associates are responsible for building more complex financial models and managing a team of Analysts. Upper management is focused on bigger picture strategy and client coverage.
Skills for Banking
Investment banking is dynamic, so bankers must possess both technical and interpersonal skills to succeed.
Analytical and communication skills are important, as are attention to detail and the ability to take initiative and work hard.
Types of Roles in Banking
When a bank advises a company that is selling itself to another company, they are the sell-side of an M&A transaction. The sell-side advisory process includes the five following phases.
Origination: The seller announces their intent to sell their company. They may be selling because they see value in joining or creating a larger organization or because they want to liquidate their ownership.
Pitching: Investment banks compete for the client’s business. A typical pitch includes an analysis and valuation of the selling company and a rationale for why their bank is best suited to represent the client.
Outreach: The winning bank markets the client to potential buyers with a teaser and a CIM. A teaser is a one-page introduction to a company and a CIM is a full pitch and financial analysis.
Due Diligence: The investment bank researches interested buyers to determine the best fit for their clients.
Bidding: Buyers settle on their final offer for the target and the transaction closes when a final bid is selected by the client and bank. Price and strategic and cultural fit are considered when selecting the right buyer. If the deal closes, the bank receives its advisory fee and starts working on the next deal.
On the other side of an M&A transaction, the buy-side, the bank’s client is a company interested in acquiring another company.
Origination: The buyer announces their intent to buy another company. They may be looking for a target for strategic or value reasons.
Pitching: Banks compete for the buyer’s business. A typical pitch includes the rationale for why their bank is best suited to represent the client and how they will find the perfect target.
Outreach: The bank markets the buyer to potential targets.
Due Diligence: The bank researches interested sellers to determine the best fit for their clients.
Bidding: The bank assists the buyer in submitting a fairly priced offer. If the deal closes, the bank receives its advisory fee and starts working on the next deal.
When a company lists their shares on a stock exchange, they require the advisory services of an investment bank.
Origination: The company announces its intent to IPO.
Pitching: Banks compete for the buyer’s business. A typical pitch includes the rationale for why their bank is best suited to guide the client throughout the IPO process.
Outreach: The outreach phase of the IPO advisory process is called a “roadshow”. On a roadshow, the investment bankers visit other banks, and asset management and investment firms to generate demand for the company’s shares when they list.
IPO: The company’s shares are issued on the open market and the bank receives their advisory fee.
Continuing Coverage: Equity research groups at banks analyze the public company on an ongoing basis. Equity research is separate from investment banking.
Mergers and acquisitions (M&A) is the consolidation of two companies. A merger is the combination of two companies of similar size to create a new company, and an acquisition is the purchase of a smaller company by a larger company. M&A transactions are completed for either strategic or sponsorship reasons.
Types of M&A
Strategic: Strategic M&A occurs between two companies that are projected to be more powerful and profitable operating together rather than separately.
Sponsorship: The acquisition of a company by a private equity (PE) or venture capital (VC) firm. The sponsor generates growth by streamlining the target’s operations, replacing management, or completing tuck-in acquisitions, and later sells the target for a profit.
Financial: The conclusion that the value of two companies operating together is greater than the sum of the values of the same companies operating separately. The increased value is created by synergies. Types of synergies include revenue, cost, leverage, and tax. Revenue synergies occur when the combined businesses cross-sell and upsell their products to realize increased revenues. Cost synergies occur when the combined companies eliminate redundant processes, staff, or assets, lowering costs and increasing net income. Leverage synergies occur when a buyer takes on the seller’s debt, increasing their interest expense and lowering their taxes.
Strategic: Integration, access to unique resources, and undervaluation are some of the strategic reasons for M&A transactions. Horizontal integration allows firms in the same industry to capture additional market share and vertical integration allows companies to control multiple parts of the supply chain, lowering supply costs. Access to unique resources allows companies to share patents, people, proprietary technology, and special assets. When the buyer believes that another company is undervalued. They may acquire them to later sell them and generate a profit.
Fuzzy Motivations: Acquisitions driven by non-business-related desires and egos of management.
Quaker Oats Acquires Snapple
In 1994, Quaker Oats, a food conglomerate known for selling oatmeal and cereal, acquired Snapple, an alternative soft drink manufacturer known for selling ice tea and juice at convenience stores. Quaker had previously completed a successful acquisition of Gatorade and wanted to replicate the same success with Snapple and capitalize on the anticipated growth in the alternative drinks market. Quaker acquired Snapple for $1.7Bn, $1Bn of which, in retrospect, was estimated to be goodwill. At the same time, PepsiCo and Coca-Cola entered the alternative drinks market and the demand for alternative drinks flatlined. This dangerous combination of increased competition and lagging demand forced Quaker to sell Snapple in 1996 for only $300mm, an 82% loss.
67% of all M&A transactions destroy value. Common reasons for failed M&A include incorrect merger model assumptions, operational and cultural integration issues, and overpayment.
Facebook Acquires Instagram
In 2012, Facebook acquired Instagram for $1Bn to eliminate competition, move into the mobile space, and increase ad revenue. In nine years, Instagram grew its user base by 3,233% from 30mm to 1Bn users. Now, Instagram generates ¼ of Facebook’s total top line.
How to Evaluate M&A (Merger Model)
Estimating the value of M&A transactions is an important part of an investment banker’s job. Earnings per share (EPS) is the core metric by which the value of acquisitions is measured.
EPS = Net Income / Shares Outstanding
When post-transaction EPS is higher than pre-transaction EPS, the transaction generated value, and is “accretive”; when it is lower, the transaction destroyed value, and is “dilutive”. Buyers only follow through with acquisitions that are projected to be accretive.
To estimate post-acquisition EPS, combine both companies’ net income, and adjust for synergies that will increase net income and adjust for M&A transaction fees. Divide this sum by the sum of the shares of both firms adjusted for changes in shares outstanding to get the consolidated company net income.
Paying for Acquisitions
Companies pay for acquisitions using either cash, debit, stock, or a combination of these methods.
If a company has enough cash on its balance sheet and no better investment opportunities, cash can be used to pay for an acquisition.
If a company takes on debt to complete the deal, they need to ensure that their return earned on the new business is higher than the interest rate on the debt.
Sometimes, companies pay for acquisitions with their own shares, trading a piece of their business for another business.
- The function of investment banks is to advise clients on financing and M&A transactions
- The M&A advisory process has five stages: Origination, pitching, outreach, due diligence, and bidding
- The IPO advisory process has five stages: Origination, pitching, outreach (roadshow), IPO, and continuing coverage
- The two types of M&A buyers are strategic buyers and sponsors
- Financial, strategic, and fuzzy reasons motivate M&A transactions
- EPS is the core metric used to value M&A transactions