ACCA AFM Syllabus C. Acquisitions And Mergers - Reverse Takeovers - Past Papers ^{6 / 6}

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.

(d) 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. (8 marks)

The eight-member board of executive directors (BoD) of Chrysos Co, a large private, unlisted company, is considering the company’s long-term business and financial future. The BoD is considering whether or not to undertake a restructuring programme. This will be followed a few years later by undertaking a reverse takeover to obtain a listing on the stock exchange in order to raise new finance. However, a few members of the BoD have raised doubts about the restructuring programme and the reverse takeover, not least the impact upon the company’s stakeholders. Some directors are of the opinion that an initial public offering (IPO) would be a better option when obtaining a listing compared to a reverse takeover.

Chrysos Co was formed about 15 years ago by a team of five senior equity holders who are part of the BoD and own 40% of the equity share capital in total; 30 other equity holders own a further 40% of the equity share capital but are not part of the BoD; and a consortium of venture capital organisations (VCOs) own the remaining 20% of the equity share capital and have three representatives on the BoD. The VCOs have also lent Chrysos Co substantial debt finance in the form of unsecured bonds due to be redeemed in 10 years’ time. In addition to the BoD, Chrysos Co also has a non-executive supervisory board consisting of members of Chrysos Co’s key stakeholder groups. Details of the supervisory board are given below.

Chrysos Co has two business units: a mining and shipping business unit, and a machinery parts manufacturing business unit. The mining and shipping business unit accounts for around 80% of Chrysos Co’s business in terms of sales revenue, non-current and current assets, and payables. However, it is estimated that this business unit accounts for around 75% of the company’s operating costs. The smaller machinery parts manufacturing business unit accounts for the remaining 20% of sales revenue, non-current and current assets, and payables; and around 25% of the company’s operating costs.

The following figures have been extracted from Chrysos Co’s most recent financial statements:

Profit before depreciation, interest and tax for the year to 28 February 2017

Corporate restructuring programme
The purpose of the restructuring programme is to simplify the company’s gearing structure and to obtain extra funding to expand the mining and shipping business in the future. At present, Chrysos Co is having difficulty obtaining additional funding without having to pay high interest rates.

Machinery parts manufacturing business unit
The smaller machinery parts manufacturing business unit will be unbundled either by having its assets sold to a local supplier for $3,102 million after its share of payables have been paid; or

The smaller machinery parts manufacturing business unit will be unbundled through a management buy-out by four managers. In this case, it is estimated that its after-tax net cash flows will increase by 8% in the first year only and then stay fixed at this level for the foreseeable future. The cost of capital related to the smaller business unit is estimated to be 10%. The management buy-out team will pay Chrysos Co 70% of the estimated market value of the smaller machinery parts manufacturing business unit.

Mining and shipping business unit
Following the unbundling of the smaller machinery parts manufacturing business unit, Chrysos Co will focus solely on the mining and shipping business unit, prior to undertaking the reverse takeover some years into the future.

As part of the restructuring programme, the existing unsecured bonds lent by the VCOs will be cancelled and replaced by an additional 600 million $1 shares for the VCOs. The VCOs will pay $400 million for these shares. The bank overdraft will be converted into a 15-year loan on which Chrysos Co will pay a fixed annual interest of 4·50%. The other debt under non-current liabilities will be repaid. In addition to this, Chrysos Co will invest $1,200 million into equipment for its mining and shipping business unit and this will result in its profits and cash flows growing by 4% per year in perpetuity.

Additional financial information
Chrysos Co aims to maintain a long-term capital structure of 20% debt and 80% equity in market value terms. Chrysos Co’s finance director has assessed that the 4·50% annual interest it will pay on its bank loan is a reasonable estimate of its long-term cost of debt, based on the long-term capital structure above.

Although Chrysos Co does not know what its cost of capital is for the mining and shipping business unit, its finance director has determined that the current ungeared cost of equity of Sidero Co, a large quoted mining and shipping company, is 12·46%. Chrysos Co’s finance director wants to use Sidero Co’s ungeared cost of equity to calculate its cost of capital for the mining and shipping business unit.

The annual corporation tax rate on profits applicable to all companies is 18% and it can be assumed that tax is payable in the year incurred. All the non-current assets are eligible for tax allowable depreciation of 12% annually on the book values. The annual reinvestment needed to keep operations at their current levels is equivalent to the tax allowable depreciation.

Details of the supervisory board
The non-executive supervisory board provides an extra layer of governance over the BoD. It consists of representatives from the company’s internal stakeholder groups including the finance providers, employees and the company’s management. It ensures that the actions taken by the BoD are for the benefit of all the stakeholder groups and to the company as a whole. Any issues raised in board meetings are resolved through negotiation until an agreed position is reached.

Required:
(a) Explain what a reverse takeover involves and discuss the relative advantages and disadvantages to a company, such as Chrysos Co, of obtaining a listing through a reverse takeover as opposed to an initial public offering (IPO). (9 marks)