You just found out that one of your long-time portfolio stocks was part of an acquisition and now, you’re suddenly saddled with shares of a different company. If you’re not someone who checks their investment accounts often, it can be startling to see the results of an acquisition. What is an acquisition? It’s when one company purchases the assets of another, and it can have rippling effects for investors.
Acquisitions come in all different varieties, ranging in complexities, for a variety of reasons. When they happen, the market tends to react to them in several predictable ways. There are opportunities to capitalize on an acquisition, whether you have a position in the acquirer, the acquirer or neither.
What Happens During an Acquisition?
During an acquisition, one company acquires the assets of another. This usually happens through a cash deal, stock deal or a combination of both—and occasionally via debt, called a leveraged buyout. The acquirer can choose to operate the acquired company as a subsidiary, absorb it into the primary business or liquidate it entirely.
From a shareholder standpoint, an acquisition can mean several things for your portfolio. Depending on the terms of the buyout, you may see one of the following actions:
- Possibly receive the cash-out value of shares if the company goes private
- You may receive shares of the acquirer equivalent to the value of the acquired company
- You may have the option to choose whether you want cash or stock from the deal
Stock-for-stock, cash-for-stock and hybrid deals are all defined by the terms of the buyout. Investors typically have no say, which can make acquisitions somewhat turbulent for your portfolio.
Why do Companies Acquire Other Companies?
One of the first things analysts look at when dissecting an acquisition is motive. Why is Company A acquiring Company B? Understanding motive sets a precedent for evaluating the efficacy of the acquisition and understanding the value involved. Some of the primary reasons behind a company decision to acquire another include:
- Diversification. Acquisitions are a great way for companies to gain exposure in peripheral industries, without starting up a new division or line of business from scratch.
- Growth. Bringing another company in-house means gaining access to established revenue streams that allow the company to grow its top line in new ways.
- Reduce Competition. Acquiring competitors means owning more of a specific market share. It can also help companies increase the barrier to entry in a sector.
- Bring IP In-House. Bringing another company’s critical assets and intellectual property in-house serves to strengthen the main brand’s capabilities.
Keep in mind that these reasons don’t always justify the terms of an acquisition. If analysts think Company A overpaid for Company B, the market may react accordingly. It all comes down to how investors justify the cost vs. value of an acquisition.
How Does the Market Respond?
Generally, stock of the acquiring company and the target company react inversely. As a general rule of thumb, the price of the acquirer’s stock will fall because it’s implied that they paid a premium to buy out the target company. Likewise, the target company’s stock will rise because it’s now benefitting from the bullish sentiment of investors.
The target company’s shares tend to rise to the price of the premium the acquirer pays. For example, if Company A pays a $10 per-share premium for Company B, which currently trades at $50, the share price will likely rise to $60 very quickly. Likewise, shares of Company A will likely fall by a percentage.
Acquisition vs. Merger vs. Takeover
There’s often confusion about what constitutes an acquisition vs. a merger vs. a takeover. There are distinctions that make each situation unique, and a relative level of amicability associated with them:
- Acquisitions tend to represent a positive agreement by both companies. They require board of director approval, and there are usually stipulations that ensure benefits for both parties involved.
- Mergers are similarly amicable, but represent the formation of a totally new entity. Two companies decide to effectively “join forces” and marry their strengths and weaknesses. It’s common in cases of diversification.
- Takeovers are hostile and usually unwelcome. They occur through more nefarious means, such as gaining a controlling interest in the company or uniting activist investors to vote on the takeover.
The media often confuses these terms, so it’s best to pay attention to press releases issued by the company to determine the nature of the event.
An Example of an Acquisition
To better-understand an acquisition, it’s important to look at how one might shape up. Here’s a very simple example:
Company A wants to acquire Company B to capitalize on its great leadership and access to a peripheral market. Company B is worth $100 billion, and Company A decides to pay a 10% acquisition premium. The board of directors approves the acquisition and announces it to the public. Analysts believe it’s a fair and mutually beneficial transaction. Company A’s stock falls 2% on the news, while Company B’s stock rises 10% to mirror the premium. The acquisition is successful and in two years, Company A breaks even.
Acquisitions are rarely this simple and smooth, but that’s certainly what companies look to get out of the process. Low premium, fast ROI and value-add benefits are the cornerstones of a successful acquisition.
Investors Can Capitalize on Acquisitions
What is an acquisition without a little opportunity attached to it? For many investors, acquisitions are a chance to act favorably for their portfolio. You might choose to cash out shares of an acquired stock while they’re at a premium. Or, you might buy shares of the acquirer anticipating big growth in the long term. Many traders even straddle trade announcements to capitalize on market sentiment.
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Even if you choose not to participate in an acquisition as a shareholder, it’s still important to understand how they affect the market or the sector. Understanding these ripple effects can put you on the path to smarter, more informed decisions about where and how you invest your money.