Mergers, Acquisitions, and Corporate Control

VENTURE CAPITAL CONSULTANTS

Course VCC / MCCI060107

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Corporate ControlCorporate control: monitoring, supervising and

directing a corporation or other business organization

• Acquisitions (purchase of additional resources by business enterprise):• Purchase of new assets• Purchase of assets from another company• Purchase of other business entity (merger)

• Concentration of voting power (LBOs and MBOs) • Divestiture: transferring ownership of a business

unit• Spin-off: creation of new corporation

Changes in corporate control occur through:

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Corporate Control Transactions

Statutory mergers

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

Subsidiary merger

• Acquired firm maintains its own former identity.

• PepsiCo and Pizza Hut maintained their identities after merger in 1977.

Consolidation

• Two or more firms combine into a new corporate identity.

“Going private”

transactions

• Leverage buyout (LBO): public shares of a firm are bought and taken private through use of debt.

• Management buyout (MBO): an LBO initiated by the firm’s management

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Resource Disintegration

Divestiture: resources of a subsidiary or division are sold to another organization.

Spin-off and split-off: a new company is created from a division or subsidiary.

Equity carve-outs: sale of partial interest in a subsidiary

Split-up: sale of all subsidiaries. Company ceases to exist

Bust-up: takeover of a company that is subsequently split-up

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Corporate Control Transactions

Open market

purchases

• Buy enough shares on the open market to obtain controlling interest

• Regulation in most developed countries prevents this form of acquisition.

Proxy fights

• Gain corporate control through consignment of other shareholders voting rights

Tender offers

• Open and public solicitation for shares

Open market purchases, tender offers and proxy fights can be combined to launch a

“surprise attack.”

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Active Anti-takeover Measures

Measure Anti-takeover Effect

Fair price amendments

• Preset metric, such as P/E ratio, used to determine the “fair price” of the company in case of takeover

Golden parachutes • Lucrative termination arrangements for executives in event of takeover• Supports managerial entrenchment hypothesis

Greenmail • Repurchase at a premium of shares held by potential hostile bidder• Declined in popularity after TRA86 imposed a 25% surtax on greenmail payments

“Just say no” defense • No consideration offered is sufficient to give up control

Pac-man defense • Initiation of a takeover attempt for the hostile acquirer itself

Recapitalization • Change in capital structure designed to make the target less attractive

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Active Anti-takeover Measures, cont.

Measure Anti-takeover EffectStaggered term for the board

Corporate charter amendments that make replacement of board of directors difficult

Standstill agreements

Substantial shareholders agree through negotiated contracts not to participate in any takeover attempts.

Supermajority approvals

Corporate amendments that require a large majority (67% or 80%) of votes to approve a takeover

White knight defense

Friendly companies bid for a takeover against a hostile acquirer.Losses in shareholder wealth due to overbidding

White squire defense

Friendly companies acquire a substantial block of shares, but not of controlling interest.Can lead to white knight situation with leg-up options: allow the white squire purchase of additional shares at a favorable price

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Pre-emptive Anti-Takeover Measures

Measure Anti-takeover Effect:Poison pills Flip-overs: Firm issues call options that allow owners to

buy the stock at a low price upon a complete takeover of the target.Flip-ins: rights can be exercised in case of partial acquisitions as well.Higher takeover premiums (69% higher) for successful takeoversUnless a takeover attempt is successful, poison pills decrease shareholders wealth.

Poison puts

Bonds with put options that can be redeemed with a high premium over face value in case of a takeover.Such bonds can seriously decrease the cash position of the target if a hostile transaction is initiated.

Shark repellents

Amendments to the corporate charter that make hostile takeover more difficult to accomplishRequire shareholder approval, as opposed to poison pills/putsMay be restrained by state laws

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Mergers by Business Concentration

Horizontal mergers

• Between former intra-industry competitors

• Attempt to gain efficiencies of scale/scope and benefit from increased market power

• Susceptible to antitrust scrutiny

Vertical mergers

• Between former buyer and seller• Forward (Disney merger with Capital

Cities/ABC) or backward (Texaco and Getty Oil merger in 1984) integration

• Creates an integrated product chain

Conglomerate mergers

• Between unrelated firms• Creates a “portfolio” of businesses• Product extension mergers vs. pure

conglomerate mergers• For example, merger between GM and

EDS

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Transaction Characteristics

Method of payment used to finance a transaction

Attitude of target management to a takeover attempt

Accounting treatment used for recording a merger

• Pure stock exchange merger: issuance of new shares of common stock in exchange for the target’s common stock

• Mixed offerings: a combination of cash and securities

• Friendly deals vs. hostile transactions

• Prior to June 30, 2001, two methods: pooling-of-interest and purchase methods

• With the implementation of FASB Statements 141 and 142, one standard method of accounting for mergers

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Merger and Intangible Assets Accounting

• Target firm has 5 million shares at $10 per share.• Acquirer pays a 20% premium ($12 per share) to expand in the

geographic area where target firm operates.• Transaction value 5 million shares x $12/share = $60 million.• Net asset value of target company is $45,000,000.

Current assets $10,000,000Restated fixed assets $65,000,000Less liabilities $30,000,000Net asset value $45,000,000

• Acquirer pays $15 million for intangible assets ($60 million - $45 million).

Goodwill will remain on the balance sheet as long as the firm can demonstrate that it is

fairly valued.

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Returns to Target and Bidding Firm Shareholders

Shareholders of target firm experience significant wealth gains in case of merger.

Jensen and Ruback survey: average 29.1% premiums for tender offers and 15.9% for mergers

On average, positive returns result for tender offers and zero returns for successful mergers.

Negative trend in acquirer returns over time attributed to adoption of Williams Act.

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Empirical Findings in Corporate Control Events

Mode of payment

• Shareholders gain higher returns in cash transactions than in stock transactions.

• Signaling model: Equity offers signal that acquirer’s stock is overvalued.

• Tax hypothesis: Target shareholders require capital gains tax premium for cash transactions.

• Preemptive bidding hypothesis: premium for cash offers required to deter other potential bidders.

Returns to other

stakeholders

• Significant wealth gains result for holders of convertible and nonconvertible bonds.

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Value-Maximizing Motives for Mergers and Acquisitions

Geographic (internal and international) expansion

• Greenfield (internal) entry vs. external expansion• M & A is better alternative for time-critical expansion.• 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

• Eisner on Disney and Cap Cities/ABC merger: “1+1=4”

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Value-Maximizing Motives for Mergers and Acquisitions

Operational synergies

• Economies of scale:• Merger may reduce or eliminate overlapping resources.

• Economies of scope:• Involve activities that are possible only for certain company

size• The launch of national advertising campaign• Economies of scale/scope most likely to be realized in

horizontal mergers

• Resource complementarities: • One company has expertise in R&D, the other in marketing.• Successful in both horizontal and vertical mergers

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Value-Maximizing Motives for Mergers and Acquisitions

Managerial synergies and market power

• Managerial synergies are effective when management teams with different strengths combine.

• Market power is a benefit often pursued in horizontal mergers.• Number of competitors in industry declines.

Other strategic reasons for mergers

• Product quality in vertical merger• Defensive consolidation in a mature or declining industry• Tax-considerations for the merger

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Non-Value-Maximizing Motives

Agency problems: management’s (disguised) personal interests are often drivers of mergers and

acquisitions.

Managerialism theory

• Dennis Mueller (1969)• Managerial compensation is often tied

to corporation size

Free cash flow theory

• Michael Jensen (1986)• Managers invest in projects with

negative NPV to build corporate empires

Hubris hypothesis

• Richard Roll (1986)• Acquirer’s management overestimate

their capabilities and overpay for target company in belief they can run it more efficiently

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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

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History of Merger Waves

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

Third wave (1965-1969)

• Conglomerate merger wave• Celler-Kefauver Act of 1950 could be

used against horizontal and vertical mergers.

• Stock market decline of 1969

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History of Merger Waves, cont.

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

• Ended with the fall of Drexel, Burnham, Lambert

Fifth wave (1993 – 2001)

• Friendly, stock-financed mergers• Relatively lax regulatory environment• Consolidation in non-manufacturing

service sector• Explained by industry shock theory

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Major U.S. Antitrust Legislation

Legislation (Year) Purpose of LegislationSherman Antitrust Act

(1890)

• Prohibited actions in restraint of trade, attempts to monopolize an industry• Violators subject to triple damage•Vaguely 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

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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)

• Elasticity tests (“5 percent rule”)is an alternative measure used to determine if merged firm has the power to control prices.

1000 1800 HHI Level

Not Concentrated Moderately Concentrated Highly Concentrated

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The Williams Act

Enacted in 1968 for fuller disclosure and tender offers regulation

Section 13-d must be filed within 10 days of acquiring 5% of shares of publicly traded companies.

Section 14 regulates tender offer process for both acquirer and target.

Section 14 provides structural rules and restrictions on the tender offer process in addition to disclosure

requirements.

Section 14-d-1 for acquirer and section 14-d-9 by target company

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Insider Trading

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 establishes a monitoring facility for corporate

insiders.

Merging firms may be integrated in a number of ways.

Target shareholders almost always win, but acquirers’ return are mixed.

Managers have either value-maximizing or non-value maximizing motives for pursuing mergers.

Merger activity occurs in waves.

Mergers, Acquisitions, and Corporate Control