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Chapter 24 Mergers, Corporate Control, and Corporate Governance. Professor XXX Course Name/Number. Corporate Control Defined. What is Corporate Control? Monitoring, supervision and direction of a corporation or other business organization Changes in corporate control occur through:
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Chapter 24Mergers, Corporate Control, and Corporate Governance Professor XXX Course Name/Number
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
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.
LBOs, MBOs, and Dual-Class Recapitalization • Going Private Transactions • LBOs (public shares of a firm are bought and taken private through the use of debt) • MBOs (an LBO initiated by the firm’s management) • Dual-Class Recapitalization
Methods of Acquisition 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
Methods of Acquisition (Continued) • 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
Divestitures and Spin-Offs • Divestiture - occurs when the assets and/or resources of a subsidiary or division are sold to another organization. • 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
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
Other Concentration Classifications • Degree of overlapping business • Change in corporate focus • Herfindahl Index • demonstrates the relationship between corporate focus and shareholder wealth. • HI is computed as the sum of the squared percentages - the proportion of revenues derived from each line of business
Merger and Acquisition Transaction Characteristics 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 • Mixed offerings: a combination of cash and securities Attitude of target management to a takeover attempt • Friendly Deals vs. Hostile Transactions Accounting treatment used for recording a merger • With the implementation of FASB Statements 141 and 142, one standard method of accounting for mergers • Target liabilities remain unchanged, but target assets are “written up” to reflect current market values, and the equity of the target is revised upward to incorporate the purchase price paid. • The revised values are then carried over to the surviving firm’s financial statements. • Goodwill is created if the restated values of the target lead to a situation in which its assets are less than its liabilities and equity
Merger and Intangible Assets Accounting Target firm has 3.2 million shares at $25 per share. • Acquirer pays a 20% premium ($30 per share) to expand in the geographic area where target firm operates. • Transaction value 3.2 million shares x $30/share = $96,000,000. • Net asset value of target company is $72,000,000. Current Assets $22,000,000 Restated fixed assets $120,000,000less liabilities $70,000,000 Net Asset Value $72,000,000 Acquirer pays $24,000,000 for intangible assets. Purchase price paid $96,000,000less Net asset value $72,000,000 Goodwill $24,000,000 Goodwill will remain on the balance sheet as long as the firm can demonstrate that is fairly valued.
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 • Mode of payment • Cash transactions • Stock transactions • Tax hypothesis: target shareholders must be awarded a capital gains tax premium in cash offers, which is not required in a stock offer. • Preemptive bidding hypothesis: acquirers wishing to ward off other potential bidders for a target offer a substantial initial takeover premium in the form of cash.
Returns to Other Security Holders • Bonds • Convertible • Nonconvertible • Preferred stock • Convertible • Nonconvertible
International Mergers and Acquisitions • 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.
Geographic Distribution of WorldwideAnnounced Mergers and Acquisitions, 2004 v. 2003
Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003
Value Maximizing Strategies 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
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
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.
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
Cash Flow Generation and Financial Mergers • 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
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
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
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
History of Merger Waves (Continued) • 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
Fifth Merger Wave • 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. • Merger activity: unprecedented transaction value for both US and non-US mergers • In 2000, aggregate merger value hit $3.4 trillion: $1.8 trillion in US and $1.6 trillion outside US. • Declined in 2001 to $1.7 trillion and only $1.2 trillion in 2002
Determination of Anti-competitiveness Not Concentrated Moderately Concentrated Highly Concentrated HHI Level 1000 1800 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.
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.
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.
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
Corporate Governance • Law and finance • Efficient capital markets promote rapid economic growth • Privatization’s impact on stock and bond market development