Mergers and Acquisitions

Good But for Who?

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

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.

A Brief History of M&A Activity

• M&A 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.

Report Title: Statistical Abstract of the U.S., 2003: Issued By: Bureau of CensusPublication Date: December, 2003, Table on Page: 511.

International Merger Activity 1990-2001

  1990-1994     1998-2001  

All Mergers Cross Border All Mergers Cross Border

$ Val. # $ Val. # $ Val. # $ Val. #

Africa 0.60% 3.27% 0.27% 0.86% 2.07% 9.98% 0.55% 2.39%

Asia 0.37% 1.46% 0.03% 0.48% 1.02% 3.43% 0.15% 0.93%

N. Amer. 2.63% 17.92% 0.45% 2.25% 7.42% 35.12% 1.43% 5.12%

Oceania 2.24% 12.98% 1.05% 5.55% 3.17% 24.05% 1.48% 7.55%

C. & S. Amer. 0.04% 3.92% 0.02% 2.94% 0.84% 8.71% 0.69% 6.47%

W. Eur. – Euro 1.81% 15.55% 0.69% 5.04% 3.97% 15.87% 2.08% 6.09%

W. Eur. - No Euro 1.49% 5.65% 0.96% 3.25% 2.14% 6.77% 0.76% 4.72%

All 1.19% 12.25% 0.27% 2.58% 4.47% 17.82% 1.26% 4.24%

0

100

200

300

400

500

600

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Non-USUS

Figure 1. Number of Acquisitions by Year and RegionThe 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.

Advisor RankingCompleted Acquisitions, World Targets 1995-2003

Financial Advisor Full to

Each Eligible Advisor

Ranking Value inc.Net Debt

of Target ($ Mil) RankMkt.

ShareNumber of

Deals

Goldman Sachs & Co 6,302,786.8 1 34.6 2,428Morgan Stanley 5,044,998.3 2 27.7 2,294Merrill Lynch & Co Inc 4,364,761.1 3 23.9 2,103Credit Suisse First Boston 3,810,234.0 4 20.9 3,240JP Morgan 3,725,925.8 5 20.4 2,607Citigroup 3,260,949.4 6 17.9 2,598UBS 2,237,270.0 7 12.3 2,032Lazard 2,062,914.1 8 11.3 1,301Lehman Brothers 1,759,323.9 9 9.7 1,277Deutsche Bank AG 1,472,016.3 10 8.1 1,754Dresdner Kleinwort Wasserstein 1,267,086.8 11 7.0 804Rothschild 1,136,145.3 12 6.2 1,126Bear Stearns & Co Inc 1,032,622.3 13 5.7 569BNP Paribas SA 483,022.1 14 2.7 535Banc of America Securities LLC 448,977.4 15 2.5 587Societe Generale 368,078.5 16 2.0 700ABN AMRO 368,014.6 17 2.0 914CIBC World Markets Inc 303,636.5 18 1.7 644CreditAgricole-CreditLyonnais 266,713.6 19 1.5 349HSBC Holdings PLC 251,841.8 20 1.4 641ING 240,037.8 21 1.3 543Greenhill & Co, LLC 239,028.5 22 1.3 116RBC Capital Markets 236,195.8 23 1.3 575Houlihan Lokey Howard & Zukin 205,479.2 24 1.1 676Cazenove & Co 190,181.1 25 1.0 160

Subtotal with Financial Advisor 16,289,044.0 - 89.4 33,616Subtotal without Financial Advisor 1,942,090.0 - 10.7 63,028

Industry Total 18,231,133.9 - 100.0 96,644

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.

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.

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.

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 bidder’s stock price around the effective date of the merger.

– Helps insulate target stockholders from volatility in the bidder’s 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)

Estimating Gains and Losses

• On January 1 firm A offers to buy B. On February 1 the acquisition is completed.

• If firm A’s value increased by 2% and B’s value by 15% during the month what was the merger’s impact?

• Answer: It depends on each firm’s beta and how well the market did over the same period.

Abnormal Returns

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

.it it ft i mt ftAR r r r r

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

.b

a

t

it itt t

CAR AR

Interpreting the CAR

• The period ta to tb is called (misleadingly) the “event window.”

• If the CAR > 0 over the event window then the firm’s security did better than expected over that period. If CAR = 0 it did as expected and if CAR < 0 it did worse than expected.

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 security’s value. If negative it was bad, and if zero had no impact.

CAR After the Event Date

• After the event date the CAR should be zero. If not, then the market has incorrectly forecasted the event’s impact on the firm’s value.

• In a large sample, the average CAR across events should average to zero.

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)

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.

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

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20

-113

-106 -99

-92

-85

-78

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-64

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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

CARs for Takeover Targets

Preannouncement information leakage.

Total takeover value to the target.

Value of resolving uncertainty about the takeover.

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

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.

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.

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.

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 (1960’s)

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 wouldn’t have to be in fixed proportions.

– May benefit indirectly.

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.

Diversification: Bondholders

• Maybe the combined firm becomes safer.• But bondholders do not have any decision

power!– The firm’s 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.

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.

Diversification Benefits the Evidence

• Acquirers in diversifying mergers have negative abnormal returns (-2%) in the 80’s.

• Not in the 90’s, instead earn about 0%.• Acquirers in related businesses experience

positive returns of 2%, on average.• Targets of hostile bids in late 80’s are often

broken up and sold to companies in related businesses

• No evidence that there exists a large advantage from diversification.

Conglomerate Mergers: Hubris Hypothesis

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

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?

• 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.

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?

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!

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.

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.

Defenses: Voting Plans

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

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.

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.

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.

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?

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.