M&A in the global petroleum industry

THE MAIN IDEA

One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A.

This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.

Takeover is a corporate action whereby a company (bidder) acquires a publicly traded company (target) by purchasing its outstanding shares. Takeovers may be classified into friendly and hostile takeovers. A friendly takeover involves direct negotiation with the target management, which in turn recommends its shareholder to approve the transactions. In hostile takeovers, the bid (unsolicited offer) is directly made to the target shareholders either without notice of the management or upon their rejection of the bid. A hostile offer thereby seeks to completely bypass management from direct negotiation. This peculiar nature of such unsolicited offers raises multilateral practical issues of conflicts between the target management and shareholders.

Any attempt to devise a regulatory regime for takeovers encounters an impulsive need of balancing these interacting core issues; fair possibilities of entrenchment motivations of directors in employing defensive strategies, interests of the company and principle of shareholders' freedom to decide upon the merits of the offer. These efforts have led to divergent opinions about the role of directors in hostile takeovers. One hypothesis favors shareholders choice and proposes that directors should not be allowed to take any defensive measures. Another hypothesis argues that those directors should play a central role in deciding company's response to a hostile offer with an objective to maximize shareholder's value.

In general, takeover regulations in the United Kingdom are based on the former hypothesis and the United States follows the latter. In the UK, management is specifically prohibited from taking any action to undermine the shareholder's discretion and to frustrate any tender offer without shareholder approval. On the flip side, the US has adopted a completely different system, wherein the principal decision about the bid is taken by the board of directors without any general requirement of post bid shareholder approval. Although the rigors of business judgment rule and directors' fiduciary duties has helped to regulate this wide discretion of directors, there is still substantial scope for directors to determine the fate of a takeover bid.

A "takeover" is business jargon meaning the purchase of a company (the takeover target) by another company (the bidder or acquirer). Usually, as larger companies are usually public companies listed on a trading stock exchange, takeover also means the acquisition of these types of companies. You can have hostile takeovers, friendly takeovers, and reverse takeovers, i.e. when a private company takes over a public company. This action is usually seen as a back-door strategy or technique for a private company to be floated on the stock market, bypassing the cost of time and money of an Initial Public Offering (IPO).

Companies will take over other companies for a variety of reasons. Small companies may become a takeover target if they fill a niche in the market that the bidder operates within. This is especially true if the smaller company has proven its profitability. The larger company may see synergistic needs or other potential with the smaller such as sharing resources and cutting costs. Taking over other companies may also be an avenue for larger acquiring companies to grow their company.

There are many advantages and disadvantages in a takeover, and perspective plays a role. For example, job cuts may be bad for employees but may benefit the companies involved financially by eliminating redundancies between the two organizations.

Other advantages:

• Increased sales and revenue,
• Increased market share,
• Economies of scale,
• A decrease in competition (assuming the companies are in the same industry),
• And a reduction of overcapacity in the industry.

Disadvantages include:

• Reduced competition and choice for consumers (double-edged sword - good for the company, bad for consumers),
• Job cuts (as explained before),
• Hidden liabilities,
• And the cost of a takeover to the bidding company.

A merger occurs when one firm assumes all the assets and all the liabilities of another. The acquiring firm retains its identity, while the acquired firm ceases to exist. A majority vote of shareholders is generally required to approve a merger. A merger is just one type of acquisition. One company can acquire another in several other ways, including purchasing some or all of the company's assets or buying up its outstanding shares of stock.

An acquisition (often called a "takeover") is the purchase of one business or company by another company or other business entity.

Consolidation occurs when two companies combine to form a new enterprise, and neither of the previous companies survives independently. Acquisitions are divided into "private" and "public" acquisitions, depending on whether the acquiree or merging company (also termed a target) is or is not listed on public stock markets. An additional dimension or categorization consists of whether an acquisition is friendly or hostile.

Achieving acquisition success has proved to be very difficult. Various studies have shown that 50% of acquisitions were unsuccessful. The acquisition process is very complex, with many dimensions influencing its outcome.

Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees, and shareholders. It is normal for M&A deal communications to take place in a so-called "confidentiality bubble" wherein the flow of information is restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the companies cooperate in negotiations. In the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target's board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become "friendly," as the acquirer secures endorsement of the transaction from the board of the target company. This usually requires an improvement in the terms of the offer and/or through negotiation.

HOSTILE ACQUISITIONS

The replacement of poor management is a potential source of gain from acquisition. Changing technological and competitive factors may lead to a need for corporate restructuring. If incumbent management is unable to adapt, then a hostile acquisition is one method for accomplishing change.

Hostile acquisitions generally involve poorly performing firms in mature industries and occur when the board of directors of the target is opposed to the sale of the company. When this occurs, the acquiring firm has two options to proceed with the acquisition - a tender offer or a proxy fight. A tender offer represents an offer to buy the stock of the target firm either directly from the firm's shareholders or through the secondary market. In a proxy fight, the acquirer solicits the shareholders of the target firm in an attempt to obtain the right to vote their shares. The acquiring firm hopes to secure enough proxies to gain control of the board of directors and, in turn, replace the incumbent management.

Management in target firms will typically resist takeover attempts either to get a higher price for the firm or to protect their own self-interests. This can be done a number of ways. Target companies can decrease the likelihood of a takeover though charter amendments. With the staggered board technique, the board of directors is classified into three groups, with only one group elected each year. Thus, the suitor cannot obtain control of the board immediately even though it may have acquired a majority ownership of the target via a tender offer. Under a supermajority amendment, a higher percentage than 50% - generally two-thirds or 80% - is required to approve a merger.

Other defensive tactics include poison pills and dual class recapitalizations. With poison pills, existing shareholders are issued rights, which, if a bidder acquires a certain percentage of the outstanding shares, can be used to purchase additional shares at a bargain price, usually half the market price. Dual class recapitalizations distribute a new class of equity with superior voting rights. This enables the target firm's managers to obtain majority control even though they do not own a majority of the shares.

Other preventative measures occur after an unsolicited offer is made to the target firm. The target may file suit against the bidder alleging violations of antitrust or securities laws. Alternatively, the target may engage in asset and liability restructuring to make it an unattractive target. With asset restructuring, the target purchases assets that the bidder does not want or that will create antitrust problems, or sells off the assets that the suitor desires to obtain. Liability restructuring maneuvers include issuing shares to a friendly third party to dilute the bidder's ownership position or leveraging up the firm through a leveraged recapitalization making it difficult for the suitor to finance the transaction.

Other post-offer tactics involve targeted share repurchases (often termed "greenmail") - in which the target repurchases the shares of an unfriendly suitor at a premium over the current market price - and golden parachutes -which are lucrative supplemental compensation packages for the target firm's management. These packages are activated in the case of a takeover and the subsequent resignations of the senior executives. Finally, the target may employ an exclusionary self-tender. With this tactic, the target firm offers to buy back its own stock at a premium from everyone except the bidder.

A privately owned firm is not subject to unfriendly takeovers. A publicly traded firm "goes private" when a group, usually involving existing management, buys up all the publicly held stock. Such transactions are typically structured as leveraged buyouts. LBOs are financed primarily with debt secured by the assets of the target firm.

A merger occurs when one company is legally absorbed into another and the surviving company takes over all of the assets and liabilities of the absorbed company. There cannot be any separate transfer of assets or liabilities to other third parties and a certificate of merger must be filed in the state where the new business will incorporate. The absorbed company shareholders are not "bought out" and therefore the merger is, in essence, treated as a stock transaction for federal tax purposes. The shareholders of both of the merged companies exchange their original stock for new stock in the surviving company. The company's board of directors and shareholders must approve the merger.

Acquisitions can occur in two ways:

• Buy the assets of the company,
• Or, buy the company's shares from the stockholders.

Under the acquisition scenario, the shareholders of the company being bought can, in most instances, take their money and "ride off into the sunset." The terms of the payment can be either in cash or stock of the purchase (which is as good as cash for publicly traded companies). The acquisition is different from a merger in that the selling shareholders do not own stock in a new, combined enterprise. The buyer can select targeted assets or liabilities to take and others to discard which the seller must accommodate. For example, the buyer does not have to assume the debt of the company being bought - although in most cases it does.

In mergers and acquisitions, tax and net income considerations of both the buyer and seller are a major factor in determining how the deal is ultimately structured. The selling shareholders participating in acquisition of asset deals may have to pay significant taxes on gains unless the transaction is structured in a way that allows the taxes to be deferred. Types of tax deferrable transactions include statutory mergers, stock-for-stock swaps, and stock-for-equity swaps.

If the purchase price paid for the assets exceeds its fair market value, the excess payment is treated as goodwill under current accounting rules. The goodwill is then amortized over a period of generally five to seven years, and the annual amortization amount is taken as a charge against the buyer's net income. Consequently, if a buyer's shareholders are very focused on net income growth, purchasing assets in excess of fair market value presents an obstacle. In addition, the goodwill expense is not deductible for federal tax purposes (unlike other items such as depreciation).

One way to bypass the goodwill amortization issue is to structure the transaction as a "pooling of interest." The information below shows the difference between the purchase and pooling structure.

MINORITY VS MAJORITY EQUITY POSITION

The percentage equity ownership that a buyer takes in a target company can have material effect on its reported financial statements. The nature of the impact varies according to the following:

• Less than 20% ownership
• Greater than 20% ownership, but less than 50%
• Greater than 50% ownership

At the less than 20% equity ownership level, the buying company is not required to consolidate any portion of the revenue or net income of the selling company to its financial statements. This can be a very important consideration if the selling company is expected to experience losses at once and in the near future as it grows its business. The buying company does not need to dilute its earnings because of its obligation to consolidate its share of the losses since its investment is a relatively small minority.

However, there is an exception to this rule. If the buying company, as a condition of its investment, has significant veto power over key business decisions made by the selling company, then they are deemed to have operating control and would act more like a majority investor.

If the acquirer has an equity interest between 20% and 50%, they are required to consolidate their share of profits or losses from the target company regardless of whether they have veto rights over key operating plans. Most buyers who take this level of equity ownership usually structure the deal to give them a path to control at a later date. This can be the right of first refusal to buy additional equity or a guaranteed future majority share at an agreed upon price or method to calculate the price.

An equity position of greater than 50% most often means the buyer has control of the day-to-day running of the business and, therefore, will consolidate the total revenue of the target company to its financial statements as well as its portion of profits and losses. However, as discussed above, if the minority shareholder(s) are given veto rights that clearly prevent the majority shareholder from exercising full control over the operations of the business, then revenue consolidation is disallowed but the percentage of earnings is not.

Merger and acquisition transaction types are normally executed in one of the following formats:

• Statutory merger
• Exchange of stock for stock
• Purchase of assets for stock
• Purchase of stock for cash
• Purchase of assets for cash

A statutory merger involves two companies merging their businesses and generally the shareholders receive payment in stock. The deal is non-taxable and can be done as either a purchase or a pooling of interest.

Exchange of stock for stock deals occur when the selling shareholders sell their company to the buyer and receive shares in the buyer's company as the security for payment. The transaction is usually non-taxable and can be done as a purchase or pooling of interest.

Purchase of assets for stock. In this type of transaction, an asset or a group of assets (such as selected plants or reserves) and not the entire company of the seller is purchased. In some cases, only the corporate shell of the seller remains which can be liquidated at a later date. The currency used to fund the purchase is stock of the buyer's company. This transaction is also non-taxable and can be treated as a purchase or pooling of interest.

Purchase of stock for cash. This type of transaction is fairly common and occurs when the shareholders sell their stock for cash to a buyer. The buyer will then have majority or full control depending on the number of shareholders who sell. This type of deal is taxable to the shareholders of the selling company if they realize a gain from selling their shares. This type of transaction is treated as a purchase only and pooling of interest benefits does not come into play.

Purchase of assets for cash. This transaction is similar to a purchase of assets for stock, except that the assets are paid for with cash and not stock. This transaction is also taxable to the selling shareholders and can only be done as a purchase and not a pooling of interest.

A freeze-out merger is a technique by which one or more shareholders who collectively hold a majority of shares in a corporation gain ownership of remaining shares in that corporation.

The majority shareholders incorporate a second corporation, which initiates a merger with the original corporation. The shareholders using this technique are then in a position to dictate the plan of merger. They force the minority stockholders in the original corporation to accept a cash payment for their shares, effectively "freezing them out" of the resulting company.

DISTINCTION BETWEEN MERGERS AND ACQUISITIONS

Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition mean slightly different things.

When one company takes over another and clearly establishes itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business, and the buyer's stock continues to be traded.

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.

In practice, however, actual mergers of equals don't happen very often. Usually, one company will buy another and, as part of the deal's terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it's technically an acquisition. Being bought out often carries negative connotations. Therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable.

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly -that is, when the target company does not want to be purchased - it is always regarded as an acquisition.

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees, and shareholders.

ABOUT THE AUTHOR

Eugene M. Khartukov is Professor of Economics at the Moscow State University for International Relations, General Director of the Center for Petroleum Business Studies, Chief of the World Energy Analysis & Forecasting Group, and Vice President (for Eurasia) of Petro-Logistics SA. Prof. Khartukov is an international expert on Russian and ex-Soviet oil and gas issues. Since 1980, he has taught world oil and energy markets research at Moscow State University for International Relations. Since 1984, he has consulted on oil and gas economics and policies, including energy pricing, to various Soviet/Russian ministries, international agencies, foreign governments, private oil and gas companies, consulting firms and financial institutions, as well as to the Gorbachev, Yeltsin, and Putin administrations. He can be reached at [email protected].