Mergers and Acquisitions

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Mergers and Acquisitions

• Good But for Who?

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What is a Merger?

• In a MERGER, two (or more) corporations come
  together to combine and share their resources to
  achieve common objectives.
• The shareholders of the combining firms often
  remain as joint owners of the combined entity.
• A new entity may be formed subsuming the merged
  firms

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What is an Acquisition?

• In an ACQUISITION, one firm purchases the assets
  or shares of another.
• The acquired firms shareholders cease to be
  owners of that firm.
• The acquired firm becomes the subsidiary of the
  acquirer.
• Acquisitions usually take the form of a public
  tender offer.

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A Brief History of MA Activity

• MA activity has increased substantially since
  the mid-1960s.
• The increased takeover activity that started in
  the 1980s can be attributed to a number of
  factors
• The emergence of the high-yield (junk) bond
  market that was used to finance a number of that
  acquisitions.
• The permissive stance toward mergers by the
  Justice Department during the Reagan
  administration.
• Increase in foreign competition, major changes in
  certain industries and the deregulation of
  transportation, communications, and financial
  services (especially in Europe) brought about a
  need for a change in the way companies did
  business.

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Report Title Statistical Abstract of the U.S.,
2003 Issued By Bureau of CensusPublication
Date December, 2003, Table on Page 511.
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International Merger Activity 1990-2001
        1990-1994 1990-1994       1998-2001 1998-2001 1998-2001  
All Mergers All Mergers All Mergers All Mergers Cross Border Cross Border Cross Border All Mergers All Mergers All Mergers Cross Border Cross Border Cross Border
Val. Val. Val. Val. Val. Val.
Africa 0.60 3.27 3.27 0.27 0.27 0.86 0.86 2.07 9.98 9.98 0.55 2.39 2.39
Asia 0.37 1.46 1.46 0.03 0.03 0.48 0.48 1.02 3.43 3.43 0.15 0.93 0.93
N. Amer. 2.63 17.92 17.92 0.45 0.45 2.25 2.25 7.42 35.12 35.12 1.43 5.12 5.12
Oceania 2.24 12.98 12.98 1.05 1.05 5.55 5.55 3.17 24.05 24.05 1.48 7.55 7.55
C. S. Amer. 0.04 3.92 3.92 0.02 0.02 2.94 2.94 0.84 8.71 8.71 0.69 6.47 6.47
W. Eur. Euro 1.81 15.55 15.55 0.69 0.69 5.04 5.04 3.97 15.87 15.87 2.08 6.09 6.09
W. Eur. - No Euro 1.49 5.65 5.65 0.96 0.96 3.25 3.25 2.14 6.77 6.77 0.76 4.72 4.72
All 1.19 12.25 12.25 0.27 0.27 2.58 2.58 4.47 17.82 17.82 1.26 4.24 4.24
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Figure 1. Number of Acquisitions by Year and
Region The total sample includes all takeover
announcement that take place between January 1,
1990, and December 31, 1999, available in the
Securities Data Corporation Mergers and
Acquisitions database. Only public companies are
considered, and we exclude LBO deals, spinoffs,
recapitalizations, self-tender and exchange
offers, repurchases, minority stake purchases,
acquisitions of remaining interest, and
privatizations. Second and subsequent bids that
occur within a window of four years relative to
an initial announcement are excluded. Non-US data
includes acquisitions from 55 countries.
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Advisor Ranking Completed Acquisitions, World
Targets 1995-2003
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Basic Facts Mergers

• Generally friendly.
• Require the approval of both management
  teams/boards before the stockholders vote.
• Mergers are often done in an exchange of
  securities.
• Common stock of the bidding firm for common stock
  of the target firm.
• They are not taxable events for the target
  stockholders, unless they sell the bidders
  stock.

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Basic Facts Tender Offers

• Generally unfriendly.
• Target management by-passed by asking the
  stockholders to sell their stock, votes, etc.
• Often done for cash.
• Sometimes for new debt securities or stock.
• Are taxable events for the target stockholders
• Strong incentive for the bidding firm to complete
  the acquisition quickly, in order to reduce the
  probability that a competing bidder will come
  along.

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Tender Offer Process

• Start with a public announcement following a 14d
  filing with the SEC.
• The filing must specify the consideration offered
  to the shares of the target firm, the objective
  of the merger (acquisition), and the timeline of
  events.
• The target management has 10 days to respond to
  the offer, via a 14d-9 filing.

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Other Issues

• Tendering shares
• Right to withdraw
• Best price rule (a.k.a. fair price rule)
• Collars
• Provides for certain changes in the exchange
  ratio conditional on the level of the bidders
  stock price around the effective date of the
  merger.
• Helps insulate target stockholders from
  volatility in the bidders stock price by
  promising a cash-like payoff at the end of the
  bid period.
• Competing tender offers
• Contingent payments Earnouts and Contingent
  Value Rights (CVRs)

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Estimating Gains and Losses

• On January 1 firm A offers to buy B. On February
  1 the acquisition is completed.
• If firm As value increased by 2 and Bs value
  by 15 during the month what was the mergers
  impact?
• Answer It depends on each firms beta and how
  well the market did over the same period.

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Abnormal Returns

• The abnormal return (AR) for a security i in
  period t is defined as

• The cumulative abnormal return (CAR) for a
  security i in n period interval ta to tb is
  defined as

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Interpreting the CAR

• The period ta to tb is called (misleadingly) the
  event window.
• If the CAR gt 0 over the event window then the
  firms security did better than expected over
  that period. If CAR 0 it did as expected and
  if CAR lt 0 it did worse than expected.

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CAR Prior to Event Date

• If the CAR is not zero prior to the public
  announcement of the event date (t0) this implies
  information leaked into the market prior to its
  public announcement.
• If the CAR up to the event date (ex. t-60 to t0)
  is positive the event was good for the securitys
  value. If negative it was bad, and if zero had
  no impact.

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CAR After the Event Date

• After the event date the CAR should be zero. If
  not, then the market has incorrectly forecasted
  the events impact on the firms value.
• In a large sample, the average CAR across events
  should average to zero.

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Stock Price Reactions

• Mergers
• Bidders gain 0
• Targets gain 20
• Tender Offers
• Bidders gain 4
• Targets gain 30
• (Jensen and Ruback, Journal of Financial
  Economics, 1985)

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Target Premium

• Why are premiums smaller for targets in mergers?
• Larger premium in tender offers to make target
  stockholders as well off after taxes
• Could be that some of the cost of the bid is
  used to buy off target management (to get them to
  cooperate), so the gains to stockholders are
  smaller.
• Both of the stories imply that the pie is being
  divided in different ways, with target
  shareholders getting a smaller piece.

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CARs for Takeover Targets
Total takeover value to the target.
Value of resolving uncertainty about the takeover.
Preannouncement information leakage.
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Bidder Premium

• Why are premiums smaller for bidders in mergers?
• Could be that bidders know that tender offers are
  more expensive, higher premia required.
• Greater chance of competition.
• Higher legal/investment banking fees.
• So they only pursue deals that are likely to have
  large potential gains.
• There are some deals that remain profitable as
  mergers that would not be as hostile tender
  offers, so the samples are not comparable

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Gains Improved Managerial Efficiency

• Market for corporate control assumes that
  managers act in the interest of the shareholders.
  Firms that do not maximize shareholder value are
  targets for takeover.
• Prediction
• Target share prices experience significant
  declines prior to the merger or tender offer.
• Managers of target firms are fired after the
  takeover.

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Synergy Gains Horizontal Mergers

• Firms producing similar products in similar
  markets (i.e., the same industry).
• Monopolistic pricing could be gains from
  reducing competition
• Reduce output, and increase profits
• Demand curve facing the firm becomes less elastic
• Antitrust Division of the Justice Department
  the Federal Trade Commission worry about
  horizontal mergers.
• Monopoly pricing makes consumers worse off
• Efficiency increasing mergers make consumers
  better off more output at lower prices.

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Synergy Gains Vertical Mergers

• Upstream firm buys a downstream firm (or visa
  versa)
• If one firm has a monopoly, can the merged firm
  increase profits by charging monopoly prices at
  both levels?
• NO.
• Are there efficiency gains from internal rather
  than external contracting?
• It depends there is still an important transfer
  pricing problem.

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Synergy Gains Conglomerate Mergers

• Firms in totally different industries
• Perhaps there are efficiencies in management or
  some centralized service, but is doubtful today.
• May have been more important when centralized
  information systems first came into being
  (1960s)

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Conglomerate Mergers Diversification

• At first sight diversification may create value.
• Who benefits from diversification?
• Not stockholders (at least directly). They could
  do it on their own account by buying the stock of
  the two companies, avoiding paying a premium.
  Better yet, their holdings wouldnt have to be in
  fixed proportions.
• May benefit indirectly.

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Diversification Employees

• Other stakeholders
• They are forced to hold undiversified portfolios
  of the stock of the bidder/target firm.
• It is hard for them to diversify on their own
  accounts.
• Employees cannot diversify their human capital.
• They may be willing to accept a lower salary
  and/or have a larger commitment to the company if
  they take less risk.
• May ultimately benefit shareholders.

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Diversification Bondholders

• Maybe the combined firm becomes safer.
• But bondholders do not have any decision power!
• The firms debt capacity will be increased if
  the firm is more diversified.
• Lenders care about total risk, not just
  systematic beta risk.
• To the extent that there are advantages with debt
  financing, shareholders will benefit.

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Diversification Executives

• Managers in small firms may be undiversified for
  control purposes, and become too risk averse.
• Hence, both inside and outside shareholders may
  benefit through diversification.
• A merger always changes control in at least one
  of the firms.
• Good or bad depending on who is losing out and
  why.
• Fired Bad if you are the one being dismissed.
• Retired Good if you are the one being bought
  out.

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Diversification Benefits the Evidence

• Acquirers in diversifying mergers have negative
  abnormal returns (-2) in the 80s.
• Not in the 90s, instead earn about 0.
• Acquirers in related businesses experience
  positive returns of 2, on average.
• Targets of hostile bids in late 80s are often
  broken up and sold to companies in related
  businesses
• No evidence that there exists a large advantage
  from diversification.

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Conglomerate Mergers Hubris Hypothesis

• Managers commit errors of over-optimism in
  evaluating merger opportunities due to excessive
  pride, animal spirits or hubris.

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Summary

• From a policy perspective, gains come from either
  efficiency gains (good), or from monopolization
  (bad).
• Management shouldnt care, except that the
  probability of antitrust problems increase if the
  gains come from monopoly pricing.
• Always ask yourself whether it is necessary to
  merge to capture the efficiency/pricing gains.
  Are other contracting methods better than paying
  a premium to buy control?
• Diversification by itself should not increase
  firm value.
• Since corporate control always changes, this may
  be the common factor explaining the gains
• Managers of target firms are often fired after
  the takeover.

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Takeover Defenses

• Successful takeovers
• Target Stockholders gain 20-35 or more
• Unsuccessful takeover
• Target stockholders gain little if not eventually
  taken over.
• Why defend a firm from a takeover?

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Defense Entrenchment or What?

• Why it might not be entrenchment.
• Target management may try to get a higher bid
  from bidder.
• Sometimes such negotiations cause a deal to fail.
• Target management may defend the firm while
  searching for another bidder willing to pay more.
• The delay may inadvertently cause the deal to
  fail.
• Why it might be entrenchment.
• You know what they say about ducks!

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Takeover Defenses Charter Amendments

• Supermajority Rules.
• 67 or more of votes necessary to approve control
  change can be avoided by board.
• However, it can be avoided by board ("board out")
• Fair-Price supermajority clause can be avoided
  if price is high enough (P/E or P/B).
• Staggered Board.
• Only 1/K of board is elected each year, so it
  takes K years to turnover board completely.

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Charter Amendments Poison Pills

• Securities that provide shareholder (except
  acquirer) with special rights, following the
  occurrence of a triggering event such as a tender
  offer.
• They 'poison' the acquirer if it swallows the
  pill.
• Poison pills do not have to be approved by
  shareholders.
• Flip over plans
• Shareholders have the right to buy the shares of
  the target at a premium above the market.
• In case of a merger they flip-over the
  shareholders have then the right to buy the
  shares of the bidder at a substantial discount
  below market.
• Ownership flip-in plans
• If the bidder acquires a threshold, shareholders
  (except the bidder) have the right to purchase
  shares of the target firm at a discount.
• Back-end right plans
• If the bidder acquires a threshold, shareholders
  (excluding bidder) can exchange a right plus a
  share for cash equal to a back-end price set by
  the board of directors of the issuing firm.
• Thus, back-end price will then becomes the
  minimum effective bid price.

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Defenses Voting Plans

• If a party acquires a substantial block of the
  firm's stock, the other shareholders receive more
  voting rights.

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Legal/Regulatory Defenses

• State corporation/anti-takeover laws impose rules
  that are similar to stringent charter amendments
  for all corporations chartered in that state.
• Inter-firm litigation can be effective.
• Target charges that bidder failed to disclose
  something material in SEC filings.

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Asset Restructuring Defense

• Crown Jewel defense
• Contract to sell attractive assets to a third
  bidder contingent on hostile bid
• Pac Man defense
• Make competing tender offer for shares of bidder.

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Other Defenses

• Leverage Recapitalization.
• Partial LBO leaving equity holders with much
  riskier claims.
• ESOPs
• Employees get equity claim in the firm, but
  management votes the shares of the stock in the
  ESOP.
• Golden Parachutes
• Lump sum payments to target management if fired
  due to takeover.
• Usually small relative to size of deal, so
  probably not much deterrence effect.
• Aligns the interests of target management with
  shareholders.

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Other Defenses Continued

• Greenmail
• Buy back stock (at a premium above the market
  price) from large stockholders who may pose a
  threat.
• Often liked with standstill agreements.
• Shareholders bought out (through greenmail) agree
  not to make further investments in the target
  company.
• Should greenmail be outlawed?

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Valuing Acquisitions

• Evaluating a potential acquisition is similar in
  most respects to analyzing the NPV of any other
  investment project a firm may be considering.
• Some subtle differences
• The value of potential synergies must be added to
  the value of the target firm's cash flows.
• The target firm's stock price will exceed the
  present value of the firm's future cash flows, if
  it reflects the possibility that the firm may
  eventually be taken over at a premium.