A board sees a target trading at $40 with synergy claims of $8 per share. The offer climbs to $52 and dilution wipes out the premium. Restructuring lives or dies on whether synergy cash flows clear the price paid.
A horizontal merger combines competitors (two regional banks), capturing scale and market share. A vertical merger combines a firm with its supplier or distributor, securing inputs or channels. A conglomerate merger combines unrelated industries, diversifying cash flows but rarely creating operating synergy.
In an leveraged buyout (LBO), the acquirer (often a PE sponsor or management) uses 70 to 90% debt collateralized by target assets. Debt service runs off target free cash flow. The equity sliver is thin, so modest enterprise-value gains produce outsized equity returns. Good LBO candidates have stable cash flow, low existing leverage, hard assets, and non-cyclical revenue.
KEY: LBO economics work when the cost of debt is below the unlevered return on assets and cash flow covers interest with margin.
Common mistakes
- Confusing horizontal and vertical. Horizontal = competitors in the same industry. Vertical = supplier or distributor. A steelmaker buying an iron-ore miner is vertical.
- Treating synergy gross, not net. Subtract integration costs and apply taxes. A $10M gross cost saving at a 25% tax rate is $7.5M after-tax.
- Using cost of equity for FCFF. FCFF is unlevered; discount at WACC. Cost of equity pairs with free cash flow to equity (FCFE).
Bottom line
- Horizontal = competitors in the same industry; vertical = supply-chain links (supplier or distributor); conglomerate = unrelated industries.
- LBO = acquisition funded 70 to 90% with debt collateralized by target assets and serviced by target cash flow; ideal targets have stable cash flow and low leverage.
- Defenses: poison pill (rights plan), staggered board (about two annual meetings to flip majority), golden parachute, leveraged recap (debt-funded special dividend or buyback).
- Divestitures: spin-off (pro-rata stock, tax-free under §355), split-up (parent dissolved), equity carve-out (cash-raising IPO of subsidiary), tracking stock (segment-linked equity, parent keeps assets).
Exam shortcut
When a stem says "same industry," answer horizontal; "supplier" or "distributor," answer vertical; "unrelated," answer conglomerate. For maximum bid in a synergy problem, compute standalone equity value + PV of after-tax synergies − integration costs. Anything below that is value-accretive.
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Learning objectives
- 2B5
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