Mergers and Acquisitions

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Mergers and Acquisitions

• Dr. J.D. Han
• Kings College,
• University of Western Ontario

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Objectives

• Learn the basic concepts
• securities firms, investment banking,
  securities trading and brokerage, M A, etc.
• Find an answer to puzzling questions such as,
• Why are debts, as opposed to equities, getting
  more important in corporate financing?

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I. Two Latest Hand-in-Hand Phenomena in Corporate
Financing

• 1) Surge in Mergers and Acquisitions
• (M A)
• 2) LBO or An Increased Indebtedness(D/E ratio)
• Debts have become more important in corporate
  financing.

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II. Fundamental Driving Forces for the Two
Phenomena

• Principal-Agent Problem Old Problem
• -Information Asymmetry leads to
  Principal-Agent Problem in Equities
• separation of ownership(principalsshareholde
  rs) and management(agentsmanagers)
• Agent often works for his own best interests at
  the expense of the principals
• -The more severe Moral Hazard problem.
• An Increased Legality New Corporate Environment
  of Political Correctness
• makes it virtually impossible to change
  management

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III. Solutions to these Problems

• We will explain that
• An increase in M A combined with
• An Increased Indebtedness
• may resolve or reduce these problems
• of Corporations.
• How?

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1. How does M A help solve Principal-Agent
Problem?

• M A leads to a change to a new and better
  management and thus to an enhanced EFFINCIENCY
• A just credible threat will wake up the existing
  stale management.

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Target for M A Stale ManagementHow do you
know whether a firms management is stale?

• Free Cash Flow (Theory) tells you.
• by Michael C. Jensen at Harvard Business School
• In his paper entitled Agency Cost of Free Cash
  Flow, Corporate Finance and Takeovers, American
  Economic Review (1986)

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Free Cash Flows as a Litmus Test

• He defines Free Cash Flows
• Free Cash Flows
• Cash Receipts - Cash Expenditures - Profitable
  (Constructive) Investment Opportunities
• His Observation
• FCFs are the likely object of the Managements
  abuse and a good indicator of the Principal-Agent
  Problem
• - The larger the FCF of a firm, the more severe
  the Principal-Agent Problem.

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Jensens FCF Theory in Reverse Gear

• Dictum
• The Larger the Free Cash Flow of a Firm, the
  More Severe the Principal-Agent Problem, and thus
  the Larger the Potential Benefits from M A and
  Corporate Restructuring
• Prediction
• We can also identify which firm is likely to be
  a target of M A.

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2. How does a LBO or an Increased Indebtedness
enhance Corporate Efficiency?

• 1) Debt contracts have a better monitoring
  through Restrictive Covenant and thus less moral
  hazards.
• 2) Reduced Equities increase Managements portion
  of Profits
• - Incentive-Compatible
• It enhances Managements work efforts
• - Recall the Dupont System

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Numerical Example of an Increased Indebtedness
enhancing Managements RewardsRestructuring is
Leveraged Buyout (of Shareholders) by Management

• Before Restructuring
• Debt-Equity Ratio 0/1 0
• Capital Profits
• Equity 1 Shareholders share
• 9,000 9,000
• Equity 2 Managers share
• 1,000 1,000
• Total
• 10,000 10,000
• assume
• interest rate 10
• rate of returns on capital 100

• After Restructuring
• Debt Equity Ratio 9
• Capital Profits
• Debts Shareholders share
• 9,000 900
• Equity 2 Managers share
• 1,000 9,100
• Total
• 10,000 10,000
• Note Managers profit share has increased by
  810.

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3. Two Structural Changes as Prerequisites for a
Surge of M A

• Lowering Legal Barriers to M A
• -Weakening of Anti-Trust Act(USA) or Competition
  Act(Canada)
• Development of Financial Institutions, Market
  Debt Instruments
• - Investment Banks, Securities Houses, Junk
  Bonds, (Debt-Equity) Swap, etc.

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Who are the Big Players for M A?

• Securities Firms
• Banks M A Division of Investment Banking
  Department
• For instance
• - Morgan Stanley
• - Goldman Sachs
• - Salomon Smith Barney
• - Merrill Lynch
• - Donald Trump Drexel Burnham, Campeu Co., T.
  Boone Pickens (Mesa Petrolium)

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Organization of Securities Firm
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Glossaries

• Investment Banking
• -helps issue new securities in the primary
  market
• - Merchant Banking
• Securities Trading and Brokerage
• - helping trade securities in the secondary
  market
• - Dealer versus Broker
• - Discount Brokerage versus Full Service
  Brokerage
• Investment Dealer
• -dealer is principal, not agent
• - applicable for Bought Deal and Securities
  Dealer

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4. Pros and Cons of M A 1) Pros Advocate for M
A

• M A enhances Efficiency of Corporate Management
• Natural Part of Globalization Trend
• Strategy for Survival from International
  Competition
• (evidence)
• Share price of Target Firm goes up by 30-50
  before and after M A

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2) Criticism of M A

• (1) Zero Sum Game for the entire economy gains
  for shareholders come from someones loss
• a) Government Loss of Tax Revenues in LBO
• b) Wage Concessions after M A
• c) Bond holders loss Increased leverage -
  Increased Default Risk - Decreased Bond Price
• d) Consumers loss Increased monopoly power -
  Higher price
• (2) Economic Frailty Increases
• (3) M A could be costly A High Transactions
  Cost

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(3) A Costly M A Shark Repellants

• -Setting up costly barriers against M A
• Green Mail
• -bribe to a raider away
• Scorch Earth
• - make yourself unattractive
• Poison Pills
• - sell stock under market price in case of danger
• Golden Parachute
• - big severance package for leaving executives

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IV. Canadian Context

• M A will continue to increase
• M A take on Globalization trends

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Historical Canadian Mergers Acquisition
Announcements
1,400 1,200 1,000 800 600 400 200 0
210 180 150 120 90 60 30 0
Announcements
Value in Billions
Announcements
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
1998
Source Crosbie Company Inc.
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M A at Canadian Cross-Border
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M A Resulting in Efficiency CanadianCases
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(No Transcript)
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3. Case Studies Case Study I) Excellent
Execution - Onex Corporation

• Classic Study Case of M A
• The Companys objective is to build value for its
  investors through the acquisition of
  underperforming businesses( with a large amount
  of Free Cash Flow) financed largely with debts
  borrowed from third party lenders.
• Performances.
• - Acquired Celestica for C750mm in October,
  1996 which now has a market value of C4.6
  billion.
• - Onex announces a bid for Air Canada and
  Canadian Airlines during a time when the industry
  is struggling.

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Case Study - Excellent Execution - Onex
Corporation
Stock Price Performance September 29, 1994 -
September 30, 1999
May 11/99 Onex purchases
Mar 25/99 Onex announces
American Buildings
30.00
C1.5bn Telecom Fund
Mar 11/99 Onex announces
with Telefonica
that it will sell 23
of its stake in Sky
Chefs to LSG
25.00
Jan 29/99 Onex announces
LCS Industries acquisition
Aug 24/99 Onex
20.00
announces bid
Nov 13/96 ProSource
for Air Canada
completes IPO of US48mm
and Canadian Airlines
15.00
Oct 1/96 Onex acquires
May 29/98 Onex sold
Celestica for C750mm
ProSource Inc. to
10.00
Oct 1/98 Onex
AmeriServe Food
announces
Distribution for
SoftBank acquisition
C123mm
5.00
09/29/1994
04/20/1995
11/07/1995
05/29/1996
12/16/1996
07/08/1997
01/27/1998
08/17/1998
03/09/1999
09/27/1999
Onex Corp Sub Vtg
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Case Study 2) - Disastrous Execution - Extendicare
Stock Price Performance September 29, 1994 -
September 30, 1999
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Case Study 3 - High Yield Debt - Rogers
Communications
Stock Price Performance September 29, 1994 -
September 30, 1999
Sep 9/99 Rogers repurchases
35.00
C1.3bn in debt
Nov 11/95 Rogers Cablesystems
July 12/99 Microsoft makes C600mm
announces two new high yield
investment in Rogers Aug 16/99 Completes
debt issues of US150mm and US125mm
sale of 33 interest of Rogers Cantel to
ATT Corp and BT PLC for C1.4bn
25.00
Jan 25/96 Issues
C75mm high yield debt
July 17/97 Two new high yield
debt issues of US330mm
15.00
and C165mm announced
May 21/98 Rogers sells local
Jan 16/96 Issues US100mm
telephone services to
high yield debt
Metronet for C1bn
5.00
09/29/1994
04/20/1995
11/07/1995
05/29/1996
12/16/1996
07/08/1997
01/27/1998
08/17/1998
03/09/1999
09/27/1999
Rogers Communications Inc Cl B