FIN-324 : Financing strategies and corporate governance Lecture 8: Mergers

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FIN 324, Anton Miglo

FIN-324: Financing strategies and corporate governance

Lecture 8: Mergers

Anton MigloFall 2013

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Topics Covered Types of Mergers History of M&A Reasons for Mergers Who benefits/losses? Stock Price Reactions The Free Rider Problem Evaluating Merger Gains and Costs The Mechanics of a Merger Takeover Tactics, Defense and Battles

Poison pills White knight Staggered boards Golden parachutes

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What is merger?

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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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Types of Mergers

Mergers are often categorized as:• Horizontal

– When the merger takes place between firms in the same business, e.g., Air Canada’s acquisition of Canadian Airlines.

• Vertical– When the merger involves acquiring a supplier or

customer, e.g., Pepsi owns Burger King.• Conglomerate

– When the merger involves companies in unrelated businesses, e.g., a manufacturer acquires a bank.

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What is an Acquisition?

In an ACQUISITION, one firm purchases the assets or shares of another.

The acquired firm’s 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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Percentage of Public Companies Taken Over Each Quarter, 1926–2005

Mergers appear to occur in distinct waves, with the most recent waves occurring in the 1960s, 1980s, and 1990s.Source: Jarrad Harford.

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History of Mergers and Acquisitions Activity in United States

The First Wave 1890-1904 - After 1883 depression- Horizontal mergers- Create monopolies The Second Wave 1916-1929- Oligopolies- The Clayton Act of 1914 The Third Wave 1965-1969 - Conglomerate Mergers- Booming Economy The Fourth Wave 1981-1989 - Hostile Takeovers- Mega-mergers- Conglomerates’ “garage sale” Mergers of 1990’s - Strategic mega-mergers

- 2000s? New wave

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1890 – 1905

1) 1890 – 1905 Horizontal, US Perspective

Large mergers of oil, tobacco, steel

Sherman 1890 Act – restraint of trade

Clayton Act – lessen competition

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1916 – 1929

1916 – 1929 Vertical, US perspective

Public Utilities, Banking, Chemical, Mining, Food ProcessingDriven by technology changes and demographic changes Mass Marketing, Market Extensions Radio, Auto

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1960s

1960s ConglomerateMotivation: diversityCapital Asset Pricing Model (CAPM)

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1981 –1989 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.

Deal DecadeMany oil/gas – depressed stock pricesHostile Takeovers/ThreatsMany via LBOs

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1992-1999 1992-1999 Strategic Mergers

Very large in size and number1998: over $1.5 trillion in dealsDriven by: Deregulation, economic forces, technology, globalizationMost done in cash (unlike 1980s)

Examples: Deutsche Bank – Bankers Trust Citicorp – Travelers Insurance (Reigle –Neal 1994, Bliley Act 1999) AOL – Netscape

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Ten Largest Merger Transactions, 1995-2005

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Stock Price Reactions Mergers

Bidders gain 0% Targets gain 20%

Takeovers Bidders gain 4% Targets gain 30%

(Jensen and Ruback, Journal of Financial Economics, 1985)

Premium paid over pre-merged price: 43% Price reaction: Target 15%, Acquirer 1%

(Eckbo, Handbook of Corporate finance, 2008)

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-15 -8 -1 6 13 20 27 34 41 48 55 62 69 76 83 90 97

US TARGETS

UK TARGETS

Return for Takeover Targets

Preannouncement information leakage.

Total takeover value to the target.

Value of resolving uncertainty about the takeover.

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Reasons to acquire

Growth Economies of Scale and Scope Vertical Integration Expertise Monopoly Gains Efficiency Gains Diversification

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Growth

Internal growth may be slow and uncertain. A window of opportunity may pass by. Management and technical personnel may be

difficult to train or hire. Geographical expansion.

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Economies of scale and scope

Economies of scale and scope NPV(A+B) > NPV(A) + NPV(B). Stride Rite acquisition of shoemaker Saucony

in 2005. Smaller cost, larger contracts with China

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Financial Synergy• Financial Synergies: debt capacity, reduced total

risk, liquidity, cost of funds, tax benefits.• Merging to reduce taxes, i.e., if it is possible to

reduce the total taxes of the combined companies, say because one has tax shields it is unable to use. (carefully with IRS)

• Debt becomes safer and cheaper• Liquidity for owners

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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.

Therefore: 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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Monopoly 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 GE and Honeywell, 2000.

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Vertical Mergers Upstream firm buys a downstream firm (or vice

versa) Combining complementary resources, i.e., one of the

firms provides the missing ingredient necessary to the other’s success.

Are there efficiency gains from internal rather than external contracting?

Coordination benefits Microsoft vs. Apple

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Conglomerate Mergers

Firms in totally different industries Risk diversification 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 (1960’s)

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Takeovers and Manager Threats

Why takeovers reduce agency costs: Contract negotiation/compensation for senior executives is expensive,

often requires the expensive time of the board of directors The constant threat of being taken over by a better management team

can be enough to ensure that the managers will keep shareholders happy

Thus, the threat of a raider appearing is often enough to keep agency costs relatively lower than otherwise possible when the firm is not the largest in the industry

Result: Compensation committees still exist in the corporate world, but time spent on such issues is not as bad when the company is not the biggest fish in the sea

E.g. Dell would need a compensation committee, but a smaller manufacturer, say, Gateway, would not be worried too much about compensation because the threat of being replaced by the Dell team would be enough for managers to work hard for shareholders

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Other GainsMarketing Gains

Inefficient media/advertising, poor product mix, weak distribution network

Expertise: Cheaper to buy than to makeCapital goods boom, cheaper to make

Strategic Realignment (1990s)Due to economic, technology changes

Regulatory Change Banking in U.S.

Globalization & Freer TradeSignal (information) to market

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Summary

From a policy perspective, gains come from either efficiency gains (good), or from monopolization (bad).

Management shouldn’t 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?

Since corporate control always changes, private benefits of control may be the common factor explaining the gains

Managers of target firms are often fired after the takeover.

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Example: Taxes for a Merged Corporation

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Example Taxes for a Merged Corporation

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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 bidder’s 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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The Takeover Process Valuation The Offer

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.

Defense

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Merger Tactics Unfriendly Takeovers

Shareholders’ rights plan or poison pill.• Measures taken by the target firm to avoid acquisition by an unwelcome

bidder.• For example, giving existing shareholders the right to buy additional

shares at an attractive price if a bidder acquires a significant holding.• Dilutes the value of shares upon purchase by raider

– Recent examples: Indigo and Chapters, Xstrata’s bid for Falconbridge

White knight• Friendly potential acquirer sought by a target company that is threatened

by an unwelcome bidder.– Recent example: Inco placing competing tender for Falconbridge,

ultimately the ideal circumstance for Falconbridge Board of Directors

Both the Inco and Xstrata bids were for cash to shareholders (purchasing 50+%)

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Merger Tactics Staggered board (Shark repellant)

• Amendments to a company charter that make it more difficult for a successful bidder to get control of the Board of Directors.

– For example, staggering the election of the Directors so that 1/3 get elected each year.

– This means the bidder cannot obtain majority control of the Board immediately after acquiring a majority of the shares.

– This would be done when the entrepreneur creates the charter

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Early Warning Systems

Monitoring shareholder trading patterns: Employees Large stakeholders Institutional investors

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Corporate Charter Amendments

Generally require shareholder approval. Generally result in negative stock price

response. Staggered terms for Board of Director. Supermajority Provisions. Fair Price Provisions.

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Greenmail

Targeted stock repurchase back by the company

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Golden Parachutes

Allow payment of lucrative compensation packages to exiting managers.

Rationale: allows managers to exit on favorable terms, thereby reducing desire to resist hostile bids.

Excessive golden parachute provisions have come under a lot of scrutiny.

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Leveraged Recaps

Firm turns into own white knight: pays a huge dividend to shareholders borrows heavily

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Other defenses

Crown Jewel defense Contract to sell attractive assets to a third bidder

contingent on hostile bid Pac Man defense

Counter offer to take over the bidder. Risky and infrequently used. Can result in huge debt for target.

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Shares swap

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Shares swap

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Exchange ratio

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Exchange ratio

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Maximum Exchange Ratio in a Stock Takeover

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Maximum Exchange Ratio in a Stock Takeover

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Total U.S. LBO Volume and Number of Deals

Source: Standard & Poors Leveraged Buyout Review (Volume data not available for the single deal in Q1 ‘09)

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LBO success:http://www.youtube.com/watch?v=4j47RqzGFSk

http://www.youtube.com/watch?v=4j47RqzGFSk

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http://www.youtube.com/watch?v=4j47RqzGFSk&list=PL1342BA42BE109277

http://www.youtube.com/watch?v=4j47RqzGFSk&list=PL1342BA42BE109277

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FIN-324 : Financing strategies and corporate governance Lecture 8: Mergers