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FIN 468: Intermediate Corporate Finance

Topic 10–Mergers and Acquisitions

Larry Schrenk, Instructor

Topics

Corporate Control

Mergers

Takeovers

Restructurings

Corporate Control

Corporate Control DefinedWhat is Corporate Control?

Monitoring, supervision and direction of a corporation or other business organization

Changes in corporate control occur through: Acquisitions (purchase of additional resources

by a business enterprise):1. Purchase of new assets2. Purchase of assets from another company3. Purchase of another business entity (merger)

Consolidation of voting power Divestiture Spinoff

Corporate Control Transactions

Statutory: Acquired firm is consolidated into acquiring firm with no further separate identity.

Subsidiary: Acquired firm maintains its own former identity.

Consolidation: Two or more firms combine into a new corporate identity.

Mergers

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Merger & Acquisition Transaction CharacteristicsAttitude of target management to a takeover

attempt Friendly Deals vs. Hostile Transactions

Method of payment used to finance a transaction Pure stock exchange merger: issuance of new

shares of common stock in exchange for the target’s common stock

Cash offer

Mixed offerings: a combination of cash and securities

Mergers by Business Concentration

Horizontal: between former intra-industry competitors Attempt to gain efficiencies of scale/scope and

benefit from increased market power Susceptible to antitrust scrutiny Market extension merger

Vertical: between former buyer and seller Forward or backward integration Creates an integrated product chain

Conglomerate: between unrelated firms Product extension mergers vs. pure conglomerate

mergers Popular in the 60’s as the idea of portfolio

diversification was applied to corporations

History of Merger Waves

Five merger waves in the U.S. history Merger waves positively related to high economic growth. Concentrated in industries undergoing changes Regulatory regime determines types of mergers in each wave. Usually ends with large declines in stock market values

First wave (1897-1904): period of “merging for monopoly”. Horizontal mergers possible due to lax regulatory environment Ended with the stock market crash of 1904

Second wave (1916-1929): period of “merging for oligopoly” Antitrust laws from early 1900 made monopoly hard to

achieve. Just like first wave, intent to create national brands Ended with the 1929 crash

History of Merger Waves Third wave (1965-1969): conglomerate merger

wave Celler-Kefauver Act of 1950 could be used against

horizontal and vertical mergers. Result of portfolio theory applied to corporations:

conglomerate empires were formed: ITT, Litton, Tenneco Stock market decline of 1969

Fourth wave (1981-1989): spurred by the lax regulatory environment of the time Junk bond financing played a major role during this

wave: LBOs and MBOs commonplace. Hostile “bust-ups” of conglomerates from previous wave Antitakeover measures adopted to prevent hostile

takeover attempts. Ended with the fall of Drexel, Burnham, Lambert

History of Merger Waves

Fifth wave (1993 – 2001): characterized by friendly, stock-financed mergers Relatively lax regulatory environment: still open to

horizontal mergers Consolidation in non-manufacturing service sector:

healthcare, banking, telecom, high tech Explained by industry shock theory: Deregulation

influenced banking mergers and managed care affected health care industry.

Sixth wave (2003-Present) Consolidation continues Record volume in 2005

Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003

Motives for Merger

Geographic (internal and international) expansion in markets with little competition may increase shareholders’ wealth. External expansion provides an easier

approach to international expansion. Joint ventures and strategic alliances give

alternative access to foreign markets. Profits are shared.

Synergy, market power, and strategic mergers Operational, managerial and financial

merger-related synergies

Operational Synergies

Economies of scale: Merger may reduce or eliminate overlapping resources 1995 merger between Chemical Bank and Chase

Manhattan Bank resulted in elimination of 12,000 positions.

Economies of scope: involve some activities that are possible only for a certain company size. The launch of a national advertising campaign Economies of scale/scope most likely to be realized in

horizontal mergers. Resource complementarities: Merging firms

have operational expertise in different areas. One company has expertise in R&D, the other in

marketing. Successful in both horizontal and vertical mergers

Managerial Synergies and Financial Synergies

Managerial synergies are effective when management teams with different strengths are combined. For example, expertise in revenue growth and

identifying customer trends paired with expertise in cost control and logistics

Financial synergies occur when a merger results in less volatile cash flows, lower default risk, and a lower cost of capital.

Managerial Synergies and Financial Synergies

Market power is a benefit often pursued in horizontal mergers. Number of competitors in industry declines If the merger creates a dominant firm, as in the Office

Depot-Staples merger’s attempt to create market power and set prices

Other strategic reasons for mergers: Product quality in vertical mergers Defensive consolidation in a mature or declining

industry: consolidation in the defense industry

Cross-Border (International) M&A

One company’s acquisition of the assets of another is observed worldwide.

Countries differ not only with respect to how frequently takeover attempts are launched, but also how often these are friendly versus hostile bids how often these are cross-border deals (involving a bidder

and a target firm in different countries) the average control premium offered the likelihood that payment will be made strictly in cash.

Geographic Distribution of WorldwideAnnounced Mergers and Acquisitions, 2004 v. 2003

Methods of Payment

Negotiated Mergers Contact is initiated by the potential acquirer or by target

firm.

Open Market Purchases Buy enough shares on the open market to obtain

controlling interest without engaging in a tender offer

Proxy Fights Proxy for directors: attempt to change management

through the votes of other shareholders Proxy for proposal: attempt to gain voting control over

corporate control, antitakeover amendments (shark repellents, golden parachutes, white knights, poison pills

Methods of Payment

Tender Offers: an open and public solicitation for shares

Open Market Purchases, Tender Offers and Proxy Fights could be combined to launch a “surprise attack” Acquirer accumulates a number of shares

(‘foothold”) without having to file 13-d form with SEC

Takeovers

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Friendly vs. Hostile Takeovers

Friendly mergers are negotiated

Hostile takeovers are opposed by management Bear hug – go to board Tender offer – direct to shareholders Proxy fight – vote by shareholders

Hostile Takeover Defenses

Pre-offer (shark repellants) Poison pills – increase shares Poison puts – bondholders Charter amendments

Staggered board Voting provisions Fair price amendments Golden parachutes

Hostile Takeover Defenses

Post-offer “Just Say No” defense Litigation Greenmail Share repurchase

LBO Leveraged recap “Crown Jewel” defense “Pac-Man” defense White Knight/Squire defense

Major US Antitrust LegislationLegislation (Year) Purpose of Legislation

Sherman Antitrust Act (1890) Prohibited actions in restraint of trade, attempts to

monopolize an industry Violators subject to triple damageVaguely worded and difficult to implement

Clayton Act(1914) Prohibited price discriminations, tying arrangements,

concurrent service on competitor’s board of directors Prohibited the acquisition of a competitor’s stock in order to lessen competition

Federal Trade Commission Act(1914) Created FTC to enforce the Clayton Act

Granted cease and desist powers to the FTC, but not criminal prosecution powers

Celler-Kefauver Act(1950) Eliminated the “stock acquisition” loophole in the Clayton

Act Severely restricts approval for horizontal mergers

Hart-Scott-Rodino Act(1976)

FTC and DOJ can rule on the permissibility of a merger prior to consummation.

Concentration Classifications

Herfindahl-Hirschman Index Demonstrates the relationship

between corporate focus and shareholder wealth

HHI is computed as the sum of the squared percentages - the proportion of revenues derived from each line of business

Determination of Anti-competitiveness

Since 1982, both DOJ and FTC have used Herfindahl-Hirschman Index (HHI) to determine market concentration HHI = sum of squared market shares of all

participants in a certain market (industry)

1000 1800 HHI Level

Not Concentrated Moderately Concentrated Highly Concentrated

The Williams Act (1968)

Ownership disclosure requirements Section 13-d must be filed within 10 days of acquiring

5% of shares of publicly traded companies. Raises the issue of “parking” shares

Tender offer regulations Shareholders of target company have the opportunity

to evaluate the terms of the merger. Section 14-d-1 for acquirer and section 14-d-9 by target

company (recommendation of management for shareholders regarding the tender offer)

Minimum tender offer period of 20 days All shares tendered must be accepted for tender.

Other Legal Issues

Sarbanes-Oxley Act of 2002 primarily targeted accounting practices, it also

mandated significant changes in how, and how much, information companies must report to investors.

Laws Affecting Corporate Insiders SEC rule 10-b-5 outlaws material misrepresentation of

information for sale or purchase of securities. Rule 14-e-3 addresses trading on inside information in

tender offers. The Insider Trading Sanctions Act, 1984 awards triple

damages. Section 16 of Securities and Exchange Act

Requires insiders to report any transaction in shares of their affiliated corporations.

Other Legal Issues

State Antitrust Laws Include anti-takeover and anti-bust up

provisions Fair price provisions disallow two-tiered tender

offers. All shareholders receive the same price for their shares, regardless of when they are tendered.

Cash-out statutes forbid partial tender offers. Provisions usually used in conjunction

with each other

Merger Analysis

Acquirer sees target undervalued. Many junk bond-financed deals of the 1980s had one of

the following two outcomes: “Busting up” the target for greater value than acquisition price Restructuring the target to increase corporate focus. Sell non-core

businesses to pay acquisition cost

Tax-considerations for the merger: Tax loss carry-forward of the target company used to

offset future taxes; resulting in increased cash flow. 1986 change in tax code limits the use of tax loss

carry-forward. Merging may yield lower borrowing costs for the

merged company. Cash flows of the two businesses are less risky when

combined, leading to lower probability of bankruptcy and lower default risk premium

Non-Value-Maximizing Motives

Agency problems: Management’s (disguised) personal interests are often driver of mergers and acquisitions. Managerialism theory of mergers: Managerial

compensation often tied to corporation size

Free cash flow theory of mergers: Managers invest in projects with negative NPV to build corporate empires.

Hubris hypothesis of corporate takeovers: Management of acquirer may overestimate capabilities and overpay for target company in belief they can run it more efficiently.

Agency cost of overvalued equity

Non-Value-Maximizing Motives

Diversification Coinsurance of debt: the debt of

each combining firm is now insured with cash flows from two businesses

Internal capital markets: created when the high cash flows (cash cow) businesses of a conglomerate generate enough cash flow to fund the “rising star” businesses

Shareholder Wealth Effects and Transaction Characteristics

Target returns – stockholders almost always experience substantial wealth gains

Acquirer returns – less conclusive than those for target shareholders

Combined returns – slightly positive

Restructuring

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Corporate Restructuring

Divestiture - occurs when the assets and/or resources of a subsidiary or division are sold to another organization.

Equity carve-out - partial sale to outsiders

Spin-off - a parent company creates a new company with its own shares by spinning off a division or subsidiary. Existing shareholders receive a pro rata distribution

of shares in the new company.

Split-off - similar to a spin-off, in that a parent company creates a newly independent company from a subsidiary, but ownership of company transferred to only certain existing shareholders in exchange for their shares in the parent