When an investment banking firm is advising a firm seeking to acquire another company, the investment banking firm is referred to as a buy-side advisor. The buy-side advisor is responsible for
Helping the company identify potential acquisition targets
Performing due diligence on proposed targets
Valuing the proposed benefits of the acquisition
Negotiating with target firms to establish the terms of the deal
Closing the deal
How to identify potential acquisition targets
The buy-side M&A advisor will help identify potential target firms that meet the client's criteria. They will reach out to the potential target firms to gauge their interest and discuss the potential transaction.
The process of courting an M&A target is very confidential, because if it became public that a firm was targeting another publicly traded firm for acquisition — or even if a rumor started that it was happening — market participants would bid up the value of the target firm, making it more expensive to acquire.
In fact, when a firm in a given industry is the target of an acquisition, other firms that fit a similar profile in that industry often see their stock prices bid up, because they may become the next acquisition targets.
Due diligence
Due diligence refers to an in-depth analysis of the target firm in order to gain a true picture of the firm, with particular emphasis placed upon the firm's financial condition. This process involves gathering a great deal of information and analyzing and interpreting that information in order to determine if a deal could be advantageous for the buyer and at what price a deal is reasonable.
Much of this due process focuses on financial modeling in an attempt to determine the incremental value that would likely be created in the acquisition.
The result of this modeling is the creation of pro forma financial statements (projected financial statements that attempt to show the financial performance of the firm if things go “as to form”). These projections are generally made several years out into the future and are used as inputs into the valuation process.
Inherent in the due diligence process is the requirement that the team of investment bankers evaluate the potential synergies of the business combination. Particular emphasis is paid to the target firm's competitive position in the industry, as well as the strategic fit within the acquiring company.
A vital element of accurate due diligence is the necessity to make some key and realistic assumptions regarding the potential synergies in the merger and the risks involved so that when the valuation models are applied, a realistic estimate of the value is obtained.
The due-diligence process should detail the strengths and weaknesses of the proposed transaction and highlight the significant risks of the transaction to the buyer, so that a reasoned decision can be made through consideration of all the relevant facts and conjectures.
Valuing the company
The goal of the due-diligence process should be an unbiased estimate of the true value of the target firm to the buyer. This is where young associates of investment banking firms cut their teeth in the field by applying a wide variety of valuation methods in marathon sessions to determine that value. These associates pore over reams of data and run multiple iterations of financial models.
Several different valuation methods are employed, but the primary method involves a discounted cash-flow analysis, in which the incremental earnings of acquiring the target firm are discounted back (or put) in present value terms. In theory, if the net present value of the acquisition is positive (if the present value of incremental earnings exceeds the purchase price), it should add to the value of the parent firm.
The resulting valuation should not simply be a single point estimate, but should involve a sensitivity analysis that will provide the acquiring firm with a range of potential values, depending upon the realization of some of the key assumptions (such as future sales growth, cost efficiencies realized, and the appropriate risk level of the firm).
In addition, the valuation exercise will make use of relative valuations — price to earnings, price to cash flow, and price to sales, to name a few.
A major portion of the valuation exercise involves the accretion/dilution analysis. This is a part of the analysis that determines whether the earnings per share (EPS) of the buying firm will increase or decrease after the deal is completed.
As you may imagine, shareholders don't like transactions that will lower or dilute the EPS of the firm. In rare occasions, shareholders will support a dilutive acquisition, but only if it appears that the acquisition will result in a long-term increase in EPS.
The terms of the deal
In addition to the price, the investment banking team will negotiate the specific terms of the acquisition with the target firm. This includes negotiating the composition of the board of directors and management team, as well as any necessary employment contracts. There will likely be several rounds of negotiation in any merger situation with a great deal of give and take between the two parties.
With respect to price, a good investment banking firm will tell the client when to stop bidding. In their zeal to complete a deal, many firms lose sight of the necessity to not win at any cost.
Closing the deal
Both the acquirer and the acquired firm's board of directors meet to approve the transaction. In addition, both the buy-side and the sell-side's investment banks deliver a fairness opinion regarding the transaction to their respective clients. The fairness opinion states simply that the deal is fair and that no entity over- or underpaid.
Shareholders of both firms look to the fairness opinion as third-party approval that the deal was, indeed, aboveboard. Finally, in order for the deal to be closed, the shareholders of both parties must approve the transaction.