Mergers and Acquisitions

1. Mergers and Acquisitions Chapter 19

2. Mergers and Acquisitions • Corporations strive to increase their earnings per share over time. • Methods • “Organic” approaches: • Increase sales of existing divisions while maintaining level operating margins • Increase operating margins with constant sales • Mergers and Acquisitions: • Seek to merge or acquire another corporation, with resulting corporation’s size and earnings enhanced by combination

3. A Brief History of Mergers and Acquisitions • M&A transactions date back to 19th century • Horizontal acquisitions: acquiring competitors in the same industry and then systematically reducing costs of acquired company by integrating its operations into acquirer's company • Vertical acquisitions: acquiring companies in own supply chain • Enormous trusts, or business holding companies

4. A Brief History of Mergers and Acquisitions • In the 1920’s, 1960’s, and 1980’s, M&A activity reached historic highs and corresponded to positive performance of the stock market. • 1920’s: combinations of firms within industries • 1960’s: conglomerate approach (e.g. LTV, ITT) • 1980’s: use of large amounts of debt as the means to finance acquisitions of companies with cheaply priced assets through leveraged buyouts

5. A Brief History of Mergers and Acquisitions • In the 2000’s, Wall Street declined due to lower asset values and increased government regulation; strategic horizontal mergers are becoming more common. • Strong banks are absorbing weak ones before/after FDIC seizes them. • Chemical, pharmaceutical and commodities firms are merging in order to increase global reach and reduce cost per unit of production. • Leveraged buyout firms (now private equity firms) have decreased their activity due to losses from 2007/2008 vintage investments and reduction in debt availability. • Completed deals have lower levels of debt and therefore, either a lower price or more equity.

6. How Companies Can Work Together • Article 2 of the Uniform Commercial Code (UCC): set of contractual rules for sale of goods between companies • Vendor-customer relationships are governed by purchase orders (POs): short form of contract, containing standard provisions and blank spaces for price, quantity, and shipment date of goods involved

7. How Companies Can Work Together • Strategic alliance (or teaming agreement): parties work together on a single project for a finite period of time • Do not exchange equity • Do not create permanent entity to mark relationship • Written memorandum of understanding (MOU): memorializes strategic alliance and sets forth how parties plan to work together

8. How Companies Can Work Together • Joint venture: parties work together for lengthy or indeterminate period of time • Form new, third entity • Divide ownership and control of new entity, determine who will contribute what resources • Advantage: two entities can remain focused on their core businesses while letting joint venture pursue the new opportunity • Downside: governance issues and economic fairness issues create friction and eventual disbandment

9. How Companies Can Work Together • Acquisition: acquired company becomes subsidiary of purchasing company • Most permanent • Eliminates governance and economic fairness issues • Forms of acquisitions • Merger • Stock acquisition • Asset acquisition

10. How Companies Can Work Together • Merger: two companies legally become one • All assets and liabilities being merged out of existence become assets and liabilities of surviving company • Stock acquisition: acquired company becomes subsidiary of acquiring company • Asset acquisition: assets but not liabilities become assets of acquiring firm

11. How and Why to do an Acquisition • If acquisition will create positive present value when weighing outflow (acquisition price) versus future inflow (cash flow of acquired company plus any synergies), then transaction makes financial sense. • Difficulty: determine what exactly are the outflows, inflows, and synergies (both revenue/cost synergies)

12. How and Why to do an Acquisition • Common synergies • Cost Savings: • One has lower existing costs due to efficiency, scale, etc. • One has better cost management • Combined company has greater economies of scale • One has better credit rating/balance sheet and therefore cheaper financing costs • Transactions costs eliminated in vertical merger • Reduction in employee costs (layoffs) • Reduction in taxes if acquirer has NOLs and is not limited by Section 382 of IRC

13. How and Why to do an Acquisition • Common synergies (continued) • Revenue enhancements: • Use of each other’s distributors and other channels • “Bundling” opportunities from combined product offering makes company more attractive • Combined company can raise prices (greater market power)

14. How and Why to do an Acquisition • Companies will hire a group of advisors to assist in evaluating and consummating transaction  investment bank, law firm with expertise in mergers and acquisitions, accounting firm, valuation firm

15. How and Why to do an Acquisition • Investment bank • Primary financial advisor • Puts together financial model to analyze cash flows of combined company on pro forma basis • Evaluates comparable transaction in order to render advice on price • Offers advice on tax and accounting structure for transaction • Helps raise capital needed to complete transaction

16. How and Why to do an Acquisition • Law firm • Responsible for drafting and negotiation of transaction documents • Reviews appropriate tax, employment, environmental, corporate governance, securities, real property, and other applicable international, federal, state and local laws • Advise Board of Directors on fulfilling its fiduciary duties of care and loyalty to shareholders

17. How and Why to do an Acquisition • Accounting firm • Advise company on proper tax and accounting treatment of transaction • Assist in valuing certain specific assets • “Comfort letter” on certain accounting issues • Consent letter needed if publicly registered securities offering is made in connection with transaction

18. The Politics and Economics of Acquisitions • Key political elements of a transaction • Which entity will survive or be parent company • What will new company’s board of directors look like • Who will manage company day-to-day

19. The Politics and Economics of an Acquisition • Smaller company will typically become subsidiary of larger company • Smaller company may have token representation on Board of Directors of parent • Management of smaller company will typically either remain at subsidiary or exit

20. The Politics and Economics of an Acquisition – Merger of Equals • Board positions often allocated 50/50 • “Office of the Chairman” or “Office of CEO”: formed to share management authority • Murky lines of authority or shared power can lead to difficulty and conflict

21. The Politics and Economics of an Acquisition • Buyer will offer price based on whether transaction will be accretive: increases earnings per share of acquiring company • Seller will seek premium over its existing stock price (if public) or price in line with public traded comparables or recent public disclosed M&A transaction multiples based on price to earnings, price to EBITDA or price to sales (if private)

22. LBOs, Hostile Takeovers and Reverse M&A • Leveraged Buy Outs (LBOs): purchases of stock of company where a significant percentage of purchase price is paid for with proceeds of debt • Became prominent in 1970’s and 1980’s with rise of LBO shop • Debt financing to fund: • High yield (junk) bonds • Hostile takeovers: acquisition in which “target’s” board of directors does not consent to transaction • Tender offer: Potential buyer or “raider” makes cash offer directly to shareholders, thereby bypassing board of directors

23. LBOs, Hostile Takeovers and Reverse M&A • Three major events altered landscape to reduce incidence of hostile takeovers: • Creation of poison pills: companies issued convertible preferred stock to exiting shareholders with provisions which made a potential tender offer prohibitively expensive • State of Delaware passed new provision of Delaware General Corporate Law, Section 203: requires hostile buyer to acquire at least 85% of target company in order to consummate hostile takeover • U.S. Congress passed revision of tax code: limited tax deductibility of certain high yield debt (HYDO rules), thus reducing attractiveness of junk bonds as means of financing acquisitions

24. LBOs, Hostile Takeovers and Reverse M&A Reverse M&A (add value through divestiture) • Four forms of reverse M&A: • Simple sale of division or subsidiary: asset sale, stock sale, or merger

25. LBOs, Hostile Takeovers and Reverse M&A 2. Spin-off: corporation issues dividend of shares of subsidiary to be spun-off corporation’s shareholders • Shareholders of parent participate in spin-off on pro rata based on their ownership percentage in parent • Prior to spin-off, parent may extract cash from subsidiary • “19.9% IPO”: subsidiary is taken public and all or large portion of proceeds are then allocated to parent • Transfer certain debts to subsidiary so that parent ends up with less leveraged balance sheet post spin-off • Parent has subsidiary dividend to parent a portion of subsidiary’s cash

26. LBOs, Hostile Takeovers and Reverse M&A • Split-off: shareholder in parent corporation elects to take shares in subsidiary being split-off, but ends up with fewer shares of parent corporation • Split-up: shareholder elects to take shares in one part of split company or other • Less common than spin-offs and split-offs because most shareholders like having parts of both parent and entity divested