Key takeaways:

• Mergers and acquisitions are different types of corporate transactions, driven by various types of reasons including but not limited to synergies, asset control, and market expansion

• Premiums are commonplace for takeovers, enticing shareholders to accept a bid, and reflecting the additional value that comes with owning 100% of a business

• Takeover targets tend to see their share prices increase, whereas the price action for an acquiring company or merger companies will largely depend on the proposed deal

With high-profile companies like Newcrest Mining (ASX: NCM), Allkem (ASX: AKE), and Invocare (ASX: IVC) just a few of the names caught up in merger and acquisition (M&A) activity lately, it an opportune time to look at the mechanics behind these corporate transactions.

Although every transaction is different, and the reasons for said transaction can vary significantly, there are some common principles that apply to M&A activity as a rule of thumb. 

Let take a look at how mergers and acquisitions affect stock prices.

What is the Difference Between a Merger and an Acquisition?

While many investors tend to think of mergers and acquisitions as being one and the same, they are different types of transactions. 

A merger occurs when two or more separate companies agree to join in order to create a single organisation. In most cases, this will be a mutual decision between the companies. 

Although it is not always the case, a merger typically involves two or more companies that are similar in size, whereby a new legal entity is formed, but the brand of one company will be retained.

On the other hand, an acquisition is where one company acquires the other. You may have also heard of the term takeover', which refers to an acquisition.

In an acquisition, one company purchases another outright and absorbs that business into its operations. Generally speaking, one of the companies will hold more influence over the other by way of size, capital, or industry positioning. As such, the acquisition may not always be a mutual decision - an event referred to as a hostile' takeover. 

In either case, mergers and acquisitions can be paid for by cash, equity, or a combination of the two. If a target company was publicly-listed, that stock will generally be removed from trading. However, sometimes merging entities or an acquiring company will already be listed, or may seek a dual-listing to afford the expanded shareholder register more liquidity.

What are the Reasons for M&A Activity?

The list of reasons as to why companies might engage in a merger or acquisition is extensive. After all, the rationale will depend on the sector, the industry, the size of the two companies, and many other factors.

Nonetheless, as far as general convention, there are some typical reasons that emerge depending on whether the transaction is a merger or acquisition. Common reasons cited include:

• Synergies - M&A activity is often viewed as a way for companies to realise economies of scale and optimise their operating expenses

• Diversification - a transaction might give rise to cross-selling opportunities or the chance to diversify a product or service offering

• Asset control - sometimes a deal may be done in order to gain access to valuable IP, property, or other assets

• Market Share Expansion - building scale is commonly seen as a way to expand market share

• New Markets - a deal can help expand a company footprint, especially in terms of geographical reach into overseas markets 

• Competitive forces - a merger or acquisition might be brought on as a response to a third-party competitor, or to effectively lessen competition by taking a competitor out of the market

What Happens to the Target Company?

In the overwhelming majority of cases, a company that is the subject of a takeover bid will generally receive an offer that is at a premium'. 

A premium is the difference between the last trading price or market value for the stock, and the actual price according to the bid.

The purpose of a premium is to entice and compensate the target company - and by extension, its shareholders - for the additional value that comes with owning 100% of the business. 

If a company were to try and acquire all the shares in a business on-market, it would likely lead to the share price rapidly increasing. This way, the acquirer can stipulate what it is prepared to pay.

In the short-term, the trading price for a target company tends to rise towards the bid price, but will usually sit below that price. This reflects uncertainty as to whether the deal proceeds and is approved. 

What Happens to an Acquiring Company or Merger Companies?

Whereas the price trend for a target company is much more straightforward, it is a different proposition for acquiring or merger companies. There is a belief that acquiring companies tend to see their share prices decline, but nowadays that is a bit of a misconception.

Ultimately, the immediate reaction of the market will depend on shareholders' views of the target or merger companies, as well as the terms of the deal. The long-term price action will depend on a number of variables, not least of which includes the combined entity operating performance

If the market believes the acquiring or merger companies might realise synergies or other benefits that could unlock earnings growth, and the transaction is on at least fair value' terms, share prices may find some support.

In contrast, if the market views the proposal as too risky, too expensive, out of step with a company strategy or debt profile, or a merger company is giving up too much control, the share price of said company may come under selling pressure. 

Sometimes an acquirer will need to conduct a capital raise to complete a takeover, which could further weigh on the share price. 

These rules are far from written in stone, and while it may seem unrealistic, it is certainly possible for win-win outcomes in the mergers and acquisitions space.