FIN 468: Intermediate Corporate Finance

1. FIN 468: Intermediate Corporate Finance Topic 10–Mergers and Acquisitions Larry Schrenk, Instructor

2. Topics • Corporate Control • Mergers • Takeovers • Restructurings

3. Corporate Control

4. Corporate Control Defined What is Corporate Control? • Monitoring, supervision and direction of a corporation or other business organization Changes in corporate control occur through: • Acquisitions (purchase of additional resources by a business enterprise): 1. Purchase of new assets 2. Purchase of assets from another company 3. Purchase of another business entity (merger) • Consolidation of voting power • Divestiture • Spinoff

5. Corporate Control Transactions • Statutory: Acquired firm is consolidated into acquiring firm with no further separate identity. • Subsidiary: Acquired firm maintains its own former identity. • Consolidation: Two or more firms combine into a new corporate identity.

6. Mergers

7. Merger & Acquisition Transaction Characteristics Attitude of target management to a takeover attempt • Friendly Deals vs. Hostile Transactions Method of payment used to finance a transaction • Pure stock exchange merger: issuance of new shares of common stock in exchange for the target’s common stock • Cash offer • Mixed offerings: a combination of cash and securities

8. Mergers by Business Concentration • Horizontal: between former intra-industry competitors • Attempt to gain efficiencies of scale/scope and benefit from increased market power • Susceptible to antitrust scrutiny • Market extension merger • Vertical: between former buyer and seller • Forward or backward integration • Creates an integrated product chain • Conglomerate: between unrelated firms • Product extension mergers vs. pure conglomerate mergers • Popular in the 60’s as the idea of portfolio diversification was applied to corporations

9. 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 • 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

10. History of Merger Waves • Third wave (1965-1969): conglomerate merger wave • Celler-Kefauver Act of 1950 could be used against horizontal and vertical mergers. • Result of portfolio theory applied to corporations: conglomerate empires were formed: ITT, Litton, Tenneco • Stock market decline of 1969 • 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 • Antitakeover measures adopted to prevent hostile takeover attempts. • Ended with the fall of Drexel, Burnham, Lambert

11. History of Merger Waves • Fifth wave (1993 – 2001): characterized by friendly, stock-financed mergers • Relatively lax regulatory environment: still open to horizontal mergers • Consolidation in non-manufacturing service sector: healthcare, banking, telecom, high tech • Explained by industry shock theory: Deregulation influenced banking mergers and managed care affected health care industry. • Sixth wave (2003-Present) • Consolidation continues • Record volume in 2005

12. Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003

13. Motives for Merger Geographic (internal and international) expansion in markets with little competition may increase shareholders’ wealth. • 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

14. Operational Synergies • Economies of scale: Merger may reduce or eliminate overlapping resources • 1995 merger between Chemical Bank and Chase Manhattan Bank resulted in elimination of 12,000 positions. • Economies of scope: involve some activities that are possible only for a certain company size. • The launch of a national advertising campaign • Economies of scale/scope most likely to be realized in horizontal mergers. • Resource complementarities: Merging firms have operational expertise in different areas. • One company has expertise in R&D, the other in marketing. • Successful in both horizontal and vertical mergers

15. Managerial Synergies and Financial Synergies • Managerial synergies are effective when management teams with different strengths are combined. • For example, expertise in revenue growth and identifying customer trends paired with expertise in cost control and logistics • Financial synergies occur when a merger results in less volatile cash flows, lower default risk, and a lower cost of capital.

16. Managerial Synergies and Financial Synergies • Market power is a benefit often pursued in horizontal mergers. • Number of competitors in industry declines • If the merger creates a dominant firm, as in the Office Depot-Staples merger’s attempt to create market power and set prices • Other strategic reasons for mergers: • Product quality in vertical mergers • Defensive consolidation in a mature or declining industry: consolidation in the defense industry

17. Cross-Border (International) M&A • One company’s acquisition of the assets of another is observed worldwide. • Countries differ not only with respect to how frequently takeover attempts are launched, but also • how often these are friendly versus hostile bids • how often these are cross-border deals (involving a bidder and a target firm in different countries) • the average control premium offered • the likelihood that payment will be made strictly in cash.

18. Geographic Distribution of WorldwideAnnounced Mergers and Acquisitions, 2004 v. 2003

19. Methods of Payment Negotiated Mergers • Contact is initiated by the potential acquirer or by target firm. Open Market Purchases • Buy enough shares on the open market to obtain controlling interest without engaging in a tender offer Proxy Fights • Proxy for directors: attempt to change management through the votes of other shareholders • Proxy for proposal: attempt to gain voting control over corporate control, antitakeover amendments (shark repellents, golden parachutes, white knights, poison pills

20. Methods of Payment • Tender Offers: an open and public solicitation for shares • Open Market Purchases, Tender Offers and Proxy Fights could be combined to launch a “surprise attack” • Acquirer accumulates a number of shares (‘foothold”) without having to file 13-d form with SEC

21. Takeovers

22. Friendly vs. Hostile Takeovers • Friendly mergers are negotiated • Hostile takeovers are opposed by management • Bear hug – go to board • Tender offer – direct to shareholders • Proxy fight – vote by shareholders

23. Hostile Takeover Defenses • Pre-offer (shark repellants) • Poison pills – increase shares • Poison puts – bondholders • Charter amendments • Staggered board • Voting provisions • Fair price amendments • Golden parachutes

24. Hostile Takeover Defenses • Post-offer • “Just Say No” defense • Litigation • Greenmail • Share repurchase • LBO • Leveraged recap • “Crown Jewel” defense • “Pac-Man” defense • White Knight/Squire defense

25. Major US Antitrust Legislation

26. Concentration Classifications • Herfindahl-Hirschman Index • Demonstrates the relationship between corporate focus and shareholder wealth • HHI is computed as the sum of the squared percentages - the proportion of revenues derived from each line of business

27. Not Concentrated Moderately Concentrated Highly Concentrated HHI Level 1000 1800 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)

28. The Williams Act (1968) • Ownership disclosure requirements • Section 13-d must be filed within 10 days of acquiring 5% of shares of publicly traded companies. • Raises the issue of “parking” shares • Tender offer regulations • Shareholders of target company have the opportunity to evaluate the terms of the merger. • Section 14-d-1 for acquirer and section 14-d-9 by target company (recommendation of management for shareholders regarding the tender offer) • Minimum tender offer period of 20 days • All shares tendered must be accepted for tender.

29. Other Legal Issues • Sarbanes-Oxley Act of 2002 • primarily targeted accounting practices, it also mandated significant changes in how, and how much, information companies must report to investors. • Laws Affecting Corporate Insiders • 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 • Requires insiders to report any transaction in shares of their affiliated corporations.

30. Other Legal Issues State Antitrust Laws • Include anti-takeover and anti-bust up provisions • Fair price provisions disallow two-tiered tender offers. All shareholders receive the same price for their shares, regardless of when they are tendered. • Cash-out statutes forbid partial tender offers. • Provisions usually used in conjunction with each other

31. Merger Analysis • Acquirer sees target undervalued. • Many junk bond-financed deals of the 1980s had one of the following two outcomes: • “Busting up” the target for greater value than acquisition price • Restructuring the target to increase corporate focus. Sell non-core businesses to pay acquisition cost • Tax-considerations for the merger: • Tax loss carry-forward of the target company used to offset future taxes; resulting in increased cash flow. • 1986 change in tax code limits the use of tax loss carry-forward. • Merging may yield lower borrowing costs for the merged company. • Cash flows of the two businesses are less risky when combined, leading to lower probability of bankruptcy and lower default risk premium

32. Non-Value-Maximizing Motives • Agency problems: Management’s (disguised) personal interests are often driver of mergers and acquisitions. • Managerialism theory of mergers: Managerial compensation often tied to corporation size • Free cash flow theory of mergers: Managers invest in projects with negative NPV to build corporate empires. • Hubris hypothesis of corporate takeovers: Management of acquirer may overestimate capabilities and overpay for target company in belief they can run it more efficiently. • Agency cost of overvalued equity

33. Non-Value-Maximizing Motives • Diversification • Coinsurance of debt: the debt of each combining firm is now insured with cash flows from two businesses • Internal capital markets: created when the high cash flows (cash cow) businesses of a conglomerate generate enough cash flow to fund the “rising star” businesses

34. Shareholder Wealth Effects and Transaction Characteristics • Target returns – stockholders almost always experience substantial wealth gains • Acquirer returns – less conclusive than those for target shareholders • Combined returns – slightly positive

35. Restructuring

36. Corporate Restructuring • Divestiture - occurs when the assets and/or resources of a subsidiary or division are sold to another organization. • Equity carve-out - partial sale to outsiders • Spin-off - a parent company creates a new company with its own shares by spinning off a division or subsidiary. • Existing shareholders receive a pro rata distribution of shares in the new company. • Split-off - similar to a spin-off, in that a parent company creates a newly independent company from a subsidiary, but ownership of company transferred to only certain existing shareholders in exchange for their shares in the parent