Module I: Investment Banking: Mergers and Acquisitions

1. Module I: Investment Banking:Mergers and Acquisitions Week 4 –September 16 and 18, 2002

2. Motivation • Many companies are in the process of restructuring • What are the major forms of restructuring? • What motivates corporate restructuring? • What are the consequences for investors and for firms?

3. Overview of Restructuring • Two Major Forms • Expansion (Combining assets through M&A) • Contraction (Breaking-up assets through divestitures etc.) • Other Forms • Changing ownership structure (LBOs, buybacks, etc.) and retaining control through defensive strategies (Poison pills etc.)

4. Expansion: Mergers & Acquisitions • Merger: the absorption of one firm by another • Acquisitions: purchase of a firm’s voting stock (tender offer) • Takeovers: Transfer of control from one group of shareholders to another • by merger, stock acquisition, asset acquisition, proxy contest or by going private

5. Acquisition or Merger? • Stock acquisitions do not require shareholder meetings or votes, and are frequently hostile • The acquirer deals directly with target’s shareholders, bypassing management • Minority shareholders may hold out in tender offers; complete absorption requires a merger

6. What Explains M&A Activity? • The stated objective of all mergers and acquisitions is the creation of value • Other objectives - e.g., managerial hubris - may also play a role but are usually not the stated rationale for an acquisition. • What are the sources of value? Two types: • Strategic • Financial

7. Strategic Sources of Value 1. Under-managed Target - Look for strategic and operating errors that can be corrected by replacing bad management 2. Efficiency Gain or Synergies - Reduce costs through economies of scale and scope in production, finance, research, marketing, and through other indivisibilities - Increase demand or raise product prices through gains in market power

8. Strategic Sources of Value 3. Opportunities for restructurings • Divest or liquidate businesses with poor fit or poor results • Sell unproductive assets that are retained by managers who cannot or will not shed such value destroying businesses

9. Financial Sources of Value Target is undervalued • Markets are inefficient • Forecasted improvements or changes are not reflected in the stock price • Unused gains from the use or sale of accumulated tax losses from net operating losses • Unused debt capacity (“Leverage Bargain”)

10. Bad Reasons for Acquisitions • Diversification: • However, shareholders can diversify their own holdings at lower cost and greater efficiency through the financial markets. • Securing access to inputs or sales of output • This may be valid, but presumes there are inefficient or uncompetitive markets

11. Bad Reasons for Acquisitions • Creating the Appearance of Growth: • Growth for its own sake does not create value • Use of Excess Cash: • Increased EPS: • By buying companies with higher EPS than your own you raise your EPS. Naive investors may believe this to be “growth” even if this destroys value

12. Example of EPS Growth Strategy • Company A has 1,000 shares outstanding and EPS of $1 • Company B has 500 shares outstanding and EPS of $2 • A buys B and now reports higher EPS of $1.33 • If A paid more than B was worth, A’s shareholders lost although A’s EPS rose

13. Higher EPS Strategy Company A’s reported EPS after acquisition of company B Company A acquires B EPS A B A

14. Are Mergers Beneficial to Society? • Mergers and acquisitions are usually associated with layoffs and downsizing. • This may or may not be associated with increased economic efficiency. • But M&A activity may facilitate exit from an industry where there is overcapacity

15. Basic Argument • Suppose that there are three firms whose minimum efficient scale is 100 units Average Cost Efficient Production Zone Price 67 100 Quantity

16. Example • Initially, industry demand was 300 units, so there was no over capacity • Now, demand has fallen to 200 and is not expected to recover • Each firm produces 67 units, and makes economic losses • The problem: If firm A exits, the benefits are captured by B and C

17. Solution • Since the benefits from exit do not accrue to the exiting firm, each firm fights to stay on, causing losses for all firms • Solution: If B (or C) were to takeover A, the shareholders of A would capture the external benefits from exit • In this sense, M&A activity is beneficial to society.

18. Empirical Evidence • In reality, most acquirers fare poorly with modest declines in value • Targets receive most of the benefits of the usually substantial run-up in price associated with a takeover.

19. Example: Kodak and Sterling Drug • January 4, 1988: Hoffman LaRoche offers $72 per share for Sterling Drug • January 18: Facing resistance, Hoffman raises the offer to $81 per share • January 22: Kodak announces a friendly bid of $89.50 per share for Sterling Drug

20. Price Reaction • Estimate Kodak’s return net of the return predicted by CAPM • The abnormal return is the actual return on day t less the expected return • From CAPM, the expected return is

21. Cumulative Abnormal Returns 12/2/87 1/22/88 3/18/88

22. Kodak Paid a High Premium Value of Kodak’s Bid $5.1 (in billions) Less Sterling’s market capitalization $3.0 (30 days prior to announcement) Equals Kodak’s Premium $2.1

23. ..But Investors Were Skeptical • Kodak’s market decrease was about $2.2 billion, almost the amount of the premium paid for Sterling • Clearly, investors did not believe the deal could add value. Why? • Kodak’s past acquisitions were failures and it was ignoring its core business

24. Why Do Acquires Fare Poorly? • Overbidding • Over-optimism or Winner’s Curse • Managerial hubris • Mergers increase firm size and hence managerial compensation, without adding value • Poor fit between buyer and seller • Clash of corporate cultures • Ignorance of target’s industry • Failure to integrate operations carefully and fast

25. Example of Winner’s Curse • Four companies bid for mineral rights on Federal land • True value is $100 million • Each company estimates value imperfectly • Valuations are unbiased, but noisy

26. Valuations • Company A: Estimated Value is 80m • Company B: Estimated Value is 90m • Company C: Estimated Value is 110m • Company D: Estimated Value is 120m • Average estimate is correct

27. Bidding • Second price, sealed bid auction • The optimal strategy is to bid your reservation price • Company D bids $120, and wins, paying $110 • Winner’s curse: Overpay by 10%

28. Can this be an explanation? • Winner’s curse can explain over bidding in this simple one-shot game • But in a repeated game, firms will recognize this problem or learn from other’s bids • However, if takeovers are isolated events, the winner’s curse may still hold

29. II. Contractions • In the 1980s and 1990s, firms that operate in fewer numbers of industries do better than widely diversified firms. • Restructurings that result in more focus are rewarded by higher stock prices • Example: Dun & Bradstreet, a major information provider, split in three. The stock price reaction was positive, with a subsequent rise of 8%

30. Why is Re-Focusing in Vogue? • Corporations made several errors including • Expanding into industries they didn't know • Overestimating the gains from synergy and diversification • Complex structures allowed mistakes to go undetected • Internal conflicts arose over the allocation of capital and direction of future projects

31. Types of Contractions • Spin-offs: Creates a new legal entity; shares are distributed on a pro rata basis to parent’s shareholders: • Separation of control over time without cash flows. Example: In 1995, US West spun off its cable and cellular businesses. • Split-off: some shareholders get stock in a subsidiary in exchange for parent stock • Immediate separation of control

32. Previous shareholders Original Firm New Firms Spin-Offs A Spin-Off does not yield cash inflows

33. Motivations for Spin-Offs • In recent years, spin-offs and split offs have become increasingly popular as companies try to “refocus” on their core business • Example: • ATT split up into three entities in 1995; NCR, Lucent Technologies and ATT

34. Contraction: Divestitures • Divestitures: Sale of part of the firm to outsiders • Equity Carve-outs: Sale of stock in subsidiary to outsiders • In both cases, there is an immediate separation of ownership and control • The parent also receives cash inflows

35. Assets Original Owners New Owners Divestitures Firm Cash Divestiture is a Sale of part of the Firm

36. Example: VLSI and Compass • In 1997, VLSI Technology, a San Jose based semiconductor firm had a wholly-owned subsidiary, Compass. • Compass developed CAD/CAM-type software to design new computer chips • Compass licenses its software for profit; the parent company, VLSI, receives a substantial price discount

37. Example: VLSI and Compass • VLSI argues that divesting compass would result in higher input costs for itself, putting it at a competitive disadvantage. • But Compass executives believed that as an independent company, it could license its software to many other chip manufacturers who are currently unwilling to pay a subsidiary of their rival

38. What Should VLSI Do? • If Compass is correct, a split-off would have the following effects: • Compass’ value would increase • It could charge VLSI more • It could sell more to other chip makers • The new VLSI would be worth less • It would have to pay Compass market prices for software products

39. Case: Outcome • Since the extra costs paid by VLSI upon divestiture are equal to the extra revenues of Compass, shareholders are no better or worse off • But since Compass will have new sales, shareholders would benefit from divestiture VLSI sold Compass in 1997

40. Conclusions • Corporate restructurings can take many forms. • Restructurings are motivated by the creation of value • But in practice, evidence suggests that strategic and financial motives for acquisition rarely produce value gains.

41. Next Week – September 23 and 25 • Allocate tasks associated with group write-up and do necessary work • Hand in Red October case write-up at the beginning of class on September 23, 2002 • Review contents of Chapter 19 • Read and begin to identify critical financial issues in the John Case Case discussed in week 6