Profiting together with mergers and acquisitions

By |  October 19, 2018
Divestitures are sometimes required to complete a deal involving crushed stone, sand and gravel operations. Photo: iStock.com/peuceta

Divestitures are sometimes required to complete a deal involving crushed stone, sand and gravel operations. Photo: iStock.com/peuceta

Mergers and acquisitions (M&As) have long played an important role in the lifecycle of many businesses in the aggregate industry.

An M&A can help an operation expand, move into new areas and become more efficient with one simple transaction. For many crushed stone, sand and gravel operations, an M&A is a proven strategy for cutting overhead costs, increasing efficiency and battling a larger competitor.

A number of M&A transactions offer opportunities, such as the U.S. Justice Department requiring CRH to divest Rocky Gap Quarry in Virginia as it attempted to acquire Pounding Mill Quarry Corp., or the two quarries Martin Marietta was required to sell off as part of its planned purchase of Bluegrass Materials Co.

What’s more, consulting firm Deloitte reported in its annual comprehensive look that M&A activity is expected to accelerate this year.

Whether the recent spate of M&As is attributable to last December’s Tax Cuts & Jobs Act (TCJA), the cash it freed up or the new lower corporate tax rate, M&As are on the upswing – with a great deal of the action being smaller deals. The use of warranty and indemnity (W&I) insurance to remove all or a great deal of the risk in M&As is yet another factor in the reported upsurge.

Viva la difference

While often synonymous, the terms “merger” and “acquisition” are separate transactions.

A merger occurs when two separate entities combine to create a new, joint organization in which both, theoretically, are equal partners.

An acquisition refers to the purchase of one entity by another. A new business does not emerge from an acquisition; rather, the acquired business, or “target,” is often consumed and ceases to exist with its assets becoming part of the acquiring business.

The term “M&As” can include a number of other transactions, including:

  • Consolidation. A consolidation creates a new entity where shareholders in both entities approve the consolidation, after which they receive equity shares in the new firm.
  • Tender offer. In a tender offer, one business offers to purchase the outstanding stock of the other business for a specific price. The acquiring business communicates the offer directly to the other business’ shareholders, bypassing the management and board of directors. Obviously, this usually involves larger, often publicly traded businesses.
  • Acquisition of assets. In a purchase of assets, one business acquires only the assets of another business. Asset purchases are common during bankruptcy proceedings, where other businesses bid for various assets of the bankrupt business, which is liquidated after the final transfer of assets to the acquiring business.

Paying for it all

Mergers and acquisitions are on the upswing, with a great deal of the action being smaller deals. Photo: iStock.com/NanoStockk

Mergers and acquisitions are on the upswing, with a great deal of the action being smaller deals. Photo: iStock.com/NanoStockk

Because M&A transactions are expensive, adequate funding is necessary. Fortunately, financing an M&A transaction with stock is a relatively safe option for both parties since both share the risk.

In a typical share-exchange transaction, the buyer will exchange shares in their own business for shares in the selling business. Paying with stock is especially advantageous for a buyer, particularly if their shares are overvalued.

In a merger, shareholders on both sides can reap long-term benefits of a stock swap, as they generally receive an equal amount of stock in the newly-formed operation, rather than simply receiving cash for their shares.

Paying with cash is the most obvious alternative. After all, cash transactions are instant, relatively mess-free and usually don’t require the same kind of complicated management as stock would.

Unfortunately, smaller aggregate businesses without large cash reserves must usually seek alternative financing options in order to fund their M&A transaction. One popular alternative to paying for an M&A with either stock or cash involves agreeing to take on the debt owed by a seller.

Assuming the burden of debt

For many businesses, debt is the reason for the sale. Unfortunately, debt can reduce a seller’s value, often to the point of worthlessness. From a buyer’s point of view, this strategy is often a cheap means of acquiring assets.

Being in control of a large amount of an operation’s debt usually means increased control over management in the event of a liquidation. Owners of the operation’s debt, after all, have priority over shareholders. This can be another incentive for would-be creditors who may wish to restructure the new business or simply take control of assets.

Mezzanine financing

Mezzanine financing is a hybrid of debt and equity financing involving senior debt, such as a bank loan secured by liens on specific assets of the business. Equity is usually in the form of preferred stock but buyers aren’t required to give up as much control to lenders.

The size of the mezzanine finance industry has grown in recent years with quite a few of the mezzanine financing groups sponsored by the U.S. Small Business Administration (SBA). But that’s not the only way the SBA can help in M&A transactions.

The SBA

Many M&As and owner buyouts involve privately, rather than publicly, traded businesses and qualify for SBA loan guarantees. The SBA’s popular 7(a) program provides up to $5 million for refinancing, working capital or to buy a business. Even larger transactions are possible with mezzanine financing or when real estate is included.

The large component of goodwill, along with the lack of tangible assets so common in smaller M&A transactions, isn’t a deterrent. Fortunately, the SBA’s programs focus on lenders where minimal collateral is acceptable, especially when there is strong cash flow and mitigating factors, such as management expertise, involved.

SBA M&A financing is generally through the SBA Preferred Lenders Program, often with additional working capital loans and lines of credit for financing packages in excess of $5 million. Since the SBA has eliminated its personal resource limitations, borrowers and investor groups with high net worth and liquidity are now usually eligible.

Insurance

Much of the risk in an M&A transaction can be eliminated with an often-overlooked type of insurance. W&I insurance has evolved from its introduction in the 1970s into a popular and sophisticated tool for protecting buyers and sellers from financial losses in M&A transactions.

W&I insurance essentially removes the risk, in whole or in part, with the promise that underwriters will be standing behind the warranty claim. However, by offering more protection against downside risk, W&I insurance also negates the requirement for the use of escrow or indemnities, providing certainty and finality to both parties.

With a seller’s W&I policy, the seller gives warranties and indemnities as is customary, but then insures its own risk of a claim. Sellers remain liable to the buyer, but they are indemnified by the insurance underwriter. Thus, when a claim occurs, the buyer would usually claim against the seller for breach of warranty. The seller would look to the insurance company to write a check for all or at least part of the damages being sought.

A buyer’s W&I policy covers damages following breaches and/or fraud, as well as defense costs. If the seller commits fraud, the buyer’s policy would still pay out.

Taxing the M&A’s tax bill

Despite the new, lower 21 percent corporate tax rate, the popularity of tax-free M&A transactions persists. Usually considered “reorganizations” and similar to taxable deals, the buyer uses its stock for a significant portion of the sale price rather than cash or debt.

Reorganizations, while not usually taxable at the entity level, are not completely tax-free to the seller. A reorganization is immediately taxable to the target’s shareholders for any “boot” received. Boot is any consideration received by shareholders in the target entity other than the buyer’s stock.

Other provisions of the TCJA, such as the full expensing of asset costs, may have an impact on an M&A transaction. In reality, the ability to do a taxable asset transaction and take advantage of front-loaded deductions may encourage an aggregate business to complete a taxable deal instead of a tax-free transaction.

Consider a situation where a seller really wants cash while the buyer is pushing for a tax-free acquisition. The tax law’s Section 338 permits the aggregate business to make a “qualified stock purchase” of another business and choose to treat the acquisition as an asset rather than a share acquisition for federal tax purposes. The stepped-up basis in the qualifying assets can be immediately expensed and written off.

On the downside, the interests and objectives of sellers and buyers are all too often discordant. Sellers want the highest price with little or no residual risk or liability. Buyers want the lowest price possible with maximum recovery options.

Recent trends involve more cash-ready buyers but with more aversion to risk. What’s more, buyers are generally unwilling to enter into transactions if the warranty package being offered is too limited or there are concerns over the enforceability of those warranties.

Obviously, these challenges are not insurmountable and deals continue to emerge with and without tax breaks, alternative financing or risk insurance. Obviously, every crushed stone, sand and gravel business owner and manager would be well advised to perform their “due diligence,” as well as seek professional advice.


Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the past 25 years.

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