Mergers and Acquisitions

1. Mergers and Acquisitions Advanced Training Program in Finance Jun Qian Boston College July 7, 2007

2. Outline • Introduction • Theoretical reasons for M&As • Empirical evidence • M&A mechanics • Hostile takeovers • Stock mergers

3. Mergers and Acquisitions • Mergers: • Friendly, with acquired firm’s executives stay in joined firm • Acquisitions: • The bidder (raider) purchases the voting stock of the target, paying target shareholders (SHs) using cash, stock, or a combination • Going private transactions: Leveraged buyout (LBOs) • Typically completed through a tender offer – the bidder makes a public offer directly to the target SHs: hostile vs. friendly offers • Other forms of M&As: • Spinoffs: One firm sells off a division to another firm or to mgmt. • Strategic alliances: Two firms agree to share resources etc.

4. Types of Mergers and Acquisitions • Horizontal M&As: • Two firms competing in the same industry • Regulated by anti-trust (monopoly) laws • Vertical M&As: • Firms at different stages in the production/sale (supplier and customer) • Conglomerate M&As: • Product extension • Geographic market extension / cross-border • Unrelated firms

5. Reasons for Mergers • Efficiency • Operating synergy • Financial synergy • Market power • Diversification • Solution to the holdup problem • Agency costs • Market for corporate control • Mergers due to agency costs • Merger waves • Stock market driven M&As.

6. Operating Synergies • PV (A+B) > PV(A) + PV(B) • Economies of scale • Cost savings due to increased size/scale of output • Economies of scope • Average cost of producing different products together is lower than the cost when produced separately • Cost savings due to overlap in R&D, marketing channels, other sharing of resources • Strategic response to changing environment

7. Financial Synergies • Pecking order financing • Matching of cash-rich firms with firms that have investment opportunities • Internal capital markets may have less frictions than markets • No informational costs, issuance costs, or regulatory approval • But, inefficiencies of internal markets: • Conflict of interests between divisional managers (over-investment); • Allocation of investment capital is a bargaining process rather than “priced” by the markets • Increased debt capacity and tax shields • Implicit “too big to fail” guarantee • Reduced costs of financial distress costs

8. Diversification-driven M&As? • Diversification thru. merger may create value • Decrease cash flow variability; lower cost of capital • Managers can take riskier projects and invest in human capital • Diversification may destroy value • SHs can better diversify using capital markets; benefits of taking controlling positions are not available to small SHs • Inefficiencies of internal markets and decreasing returns to organizational capitals; higher agency costs • Empirical evidence on diversification M&As: • Diversification discount (Berger and Ofek, 1995): diversified firms trade at 15% less than pre-merger levels • The above test does not take into account what would have happened to firms if they do not pursue diversifying mergers • Redo previous test (by matching diversified and non-diversified firms): discount is much smaller and could be 0

9. Holdup Problem and M&As • Example: Auto company A and tire company B • Assume B is only supplier of tires to A (perhaps only one knows how to produce special tires for A’s new vehicles) • Knowing this, B can “holdup” (like hostage) A, and demand that A pays high prices for new tires • Expecting this to occur, A loses incentives in producing the new vehicles, so that B also loses • Solution: A acquires B (Grossman and Hart, 1986) • Internalizes the supply and holdup problem (if tire division manager threatens to increase price, he will be fired) • This is vertical integration: Optimal ownership and control of assets – allowing A, which makes the most use out of the control of tire company’s assets, to own B • Similar logic behind horizontal integration

10. Agency Problems and M&As • Separation of ownership and control • Managers prefer • Less effort; lower risk (ignores option grants); and shorter horizon • Substitute low risk for high risk investments • Retain excessive cash reserves • Keep leverage too low • Keep dividends too low • Perk consumption

11. Corporate Governance Solutions for Agency Problems • Large shareholders as monitors • Use of debt • Executive compensation • Input and product markets competition • Capital markets as monitors: markets for corporate control • Managerial teams compete for firms • M&As allow more efficient managers to replace less efficient ones • The possibility of a takeover may discipline existing managers

12. Mergers Due to Agency Costs • Jensen’s free cash flow hypothesis • Managers are reluctant to pay out cash • Engage in negative NPV merger transactions • Roll’s hubris hypothesis • Managers are overly optimistic about the value of targets • Empire building • If compensation (or private benefits) is tied to company size, managers have incentives to acquire other firms (even it destroys value); • Evidence on cash bonus based on completion of deals (Grinstein and Hribar 2004)

13. History of Merger Waves • First wave (1897-1904) – horizontal mergers • Second wave (1916-1929) – vertical mergers • Third wave (1960s) – conglomerate mergers • Fourth wave (1980s) – hostile takeovers, LBOs and MBOs • Fifth wave (1992 - 2000) – stock-based friendly mergers: • Industry-wide consolidations after de-regulation • Peak was reached during 2000 – $3.8 trillion, 35,000 announced deals

14. Merger Waves • M&As occur in waves and are clustered in industries • Technology shocks and macro-factors • Regulations • In the US: M&As must be cleared by Dept. of Justice (e.g., anti-trust laws) and the FTC; many states have anti-takeover laws (solution: Delaware) • Europe: workers have 50% board repres. in Germany and difficult to remove; in France govt. can impose costs on takeovers • Japan: role of Keiretsu – firms combine with each other thru. reciprocal shareholdings and trading agreements • Deregulation-driven M&A waves? • Some of the deregulated industries: • Airlines (78), broadcasting (84 & 96), entertainment (84), banks and thrifts (94), utilities (92), and telecommunications (96)

15. Evidence: Announcement effects of M&As • Significant wealth gain for target SHs: • Price runup prior to announcement (-10 days); • Announcement day: • Tender offers: 20% to 30% abnormal return 1st day, • Stock mergers: Smaller positive effect • Firms “similar” to target also get a boost • Bidder SHs break even or suffer losses: • Depends on method of payment: cash vs. stock • Stock mergers: • Significant negative abnormal returns • Show signs of over-valuation (earnings manipulations and insider selling prior to deal announcement) • Net effect (bidder plus target)

16. Evidence: Long-run performance • Performance of merged firms: • Stock mergers: negative abnormal returns • Cash acquisitions: positive abnormal returns • Findings robust after correction of Fama-French factor of beta, size, book-to-market • Market efficiency: Initial guess correct, but wrong magnitude

17. Merger Mechanics • Preliminary actions • Proxy fight • Tender offer and defensive tactics • Friendly (stock) mergers

18. Preliminary Actions • Identifying potential targets • Bidder may establish a toehold by open market (anonymous) purchase of target shares • Once a certain threshold has been passed, the intentions of the bidder have to be revealed • Bear hug (quasi-friendly) • Bidder contacts the target board of directors and threatens with a tender offer if friendly deal is not agreed • Accompanied by public announcement of tender offer intent

19. Proxy Fight • An attempt by a group of SHs to take control through the use of voting by proxy mechanisms • The term “proxy” denotes the ability of a SH to delegate her voting rights to another SH, who can vote by proxy • Goals of proxy fights: • Replace portions of the board (and management) • Refuse proposed merger agreement • To change charter or to approve a merger • Frequency of proxy fights • Less frequent in economies with active takeover market (higher frequency of proxy contests in Germany than in the US and UK) • Increasing institutional activism over the past decade => proxy fights much more common in the US

20. Proxy Fight (cont’d) • The proxy fight process: • The dissenting party or bidder campaign and solicit vote-proxies from dissatisfied target SHs • Collect proxy votes • File the proxy documents with the SEC • Call a special shareholder meeting: votes/proxies exercised • Evaluation of effectiveness of proxy fight: • Advantage: no need to acquire/purchase equity; • Disadvantage: costly to contact SHs; incumbents tend to have credibility among small SHs; • Attitude and involvement of institutional SHs may be critical • Proxy fights are often unsuccessful, but it may change • But, they are a cheap alternative to a tender offer • Used as a initial step before a tender offer (hostile takeover)

21. Tender Offer • Offer to purchase a pre-specified number of shares directly from target SHs • Method of payment: cash, stock, debentures, warrants, and combination • Procedure and important factors: • Active and widespread solicitation of SHs • Solicitation for substantial fraction of shares • Offer at a premium to current stock price • Contingent on tender of a fixed minimum number of shares • Tender offer open for a limited period of time • Finishing touch: regulatory procedure, cleanup price

22. Types of Tender Offers • Two-tiered (front-end loaded) • Front-end: tender offer price (shares tendered in the 1st step may receive a higher premium); • Back-end, clean-up price: effectively a merger offer price (“fair” price/legal problem) • Creates incentives for shareholders to tender first instead of wait; coercive but can solve the free-rider problem • All partial offers are implicitly two-tiered offers • All-or-nothing (conditional offer) • Bid is conditional on a minimum number of shares: usually 50% of all outstanding shares tendered or on success; or nothing • Any-or-all (unconditional offer) • Bidder will buy all tendered shares • Saturday night special

23. Free-rider Problem Among Target SHs • How to explain the following facts: • Initial bid premium on average 30% • Announcement effect for raiders 0 or negative • Free-rider problem (Grossman and Hart 1980) • Disperse equity ownership for target; each small SH thinks she is non-pivotal in determining outcome of tender offer • To start, assume current target price is $50 per share; assume everyone knows a tender offer by the current raider will increase value to $100 per share • What happens if raider bids $50? $75? $99? Smaller shareholders will reject/tend to wait as long as bid < $100 • The raider must significantly bid over the current target price in order convince the SHs to tender • But this is very costly to the raider

24. Solutions to Free-rider Problem? • Punishing non-tendering shareholders: • Two-tiered offers • Toehold acquisition by raiders: • Shares purchased before bidding for the target • Profitable strategy in takeovers?(Shleifer and Vishny 1986) • Disclosure requirements on toeholds and takeovers: • 5% threshold in the US and filing of 13d with SEC; • More disclosure at the time of the tender offer (e.g, 14d, 14e filings) • Evidence on toeholds: • Mean much smaller than 5%; many bidders do not acquire any toehold; • Empirical “puzzle”: Goldman and Qian (2005) provide a solution

25. Defense Measures • Preventive defense measures: • Poison pills • Corporate charter amendments (shark repellents) • Golden parachutes • Reactive defense measures: • Greenmail, standstill, and reverse greenmail • White knights • Scorched earth defense • Litigation • Pac-man defense: Acquiring the acquirer • Just say no

26. Defense Measures: Poison Pills • Definition and characteristics: • Represents the creation of special rights to receive extra payments, similar to call options/warrants, issued to (some or all) existing common SHs; to the exclusion and detriment of potential raiders • Triggered after takeover-related events: e.g., a bidder acquires 10% of shares; • Warrants are exercisable at the triggering of another event (e.g. bidder acquires 100% of the shares) • Examples and terminologies: • Share rights plans: current SHs receive right to buy stocks at fixed price, with a “flip over” provision • In the event of M&A, the holders can exercise and receive stock of the merged firm worth twice of the exercise price • Other terms: Flip-in – rights to purchase target securities; Back-end plans – exchange stock for cash or senior securities; Poison puts – right to sell bonds

27. Poison Pills (cont’d) • History of poison pills: • Invented in 1982 by Martin Lipton, an M&A attorney • First generation: dividend of preferred shares convertible into acquirer’s shares • Second generation: flip-over pill (fails to provide protection) • Third generation: flip-in pill • Example: Conrail’s poison pill • Flip-in pill: Right to buy an additional share at half price when a hostile bidders acquires 10% of Conrail’s shares • Background: Conrail – 90.5 million shares at $71; total MV $6,426 million; hostile Bidder buys 10% of shares for a total of $643 million

28. Group Group # Shares # Shares % of total % of total Value Value Friendly shareholders Friendly shareholders 162.90 81.45 90.0 94.7 $8,827 $5,783 Hostile bidder Hostile bidder 9.05 9.05 5.3 10.0 $643 $490 Total Total 90.50 171.95 100.0 100.0 $6,426 $9,317 Per Share Per Share $54.18 $71.00 Poison Pills: example (cont’d) • Before poison pill kicks in: • After poison pill becomes effective:

29. Poison Pills (cont’d) • Conrail’s poison pill: • Purchase triggers poison pill: Conrail issues 81.45 million shares at $35.50 a share, receives $2,891 million • Total MV is $9,317, total number of shares is now 171.95 million; share price drops to $54.18 • Bidder’s block drops to 5.3% of shares • Bidder’s equity value drops from $643 million to $490 million • A transfer or $153 million to existing shareholders plus additional voting rights • Overall empirical evidence: • Early 1980s – value reducing; • Mid- and late-1980s – less negative to value increasing

30. Defense Measures:Charter Amendments • Staggered board of directors • Only a percentage of directors can be replaced on a single annual meeting (e.g. in Conrail 1/3 of directors a year) • Supermajority provisions • A merger has to be approved by substantially more than 50% of votes (e.g. 2/3, 80%) • Fair price provisions • Acquiring company has to pay minority shares a fair price (precludes two-tiered offers) • Dual-class share recapitalization • Issuance of two classes of shares with different voting rights (e.g., Google)

31. Defense measures (cont’d) • Golden parachutes: • Generous lump-sum compensation to target managers in case they are replaced after a takeover • Anti-takeover defense: Reduces cash of target; but, makes managers less likely to defend a hostile bid • Greenmail and standstill: • “Bribing” bidder to stop tender offer • Target repurchase of the shares of a potential bidder at a premium (greenmail payment); extraction of private benefits of control at the expense of small shareholders • Reverse greenmail: target repurchase some SHs’ shares at premium, while excluding the potential bidder (financing a dividend out of bidder’s pocket) • Standstill: the target pays cash to the bidder to “stand still” (bidder agrees not to buy more shares for a period of time);

32. Defense measures (cont’d) • White knight: • Target solicit another bidder after receiving a hostile bid; • The white knight is friendly to target managers, and usually overpays (bad for white knight SHs) • White esquire – a large shareholder that is friendly to managers • Scorched earth defense: • Make target less attractive: increase leverage, use money to pay dividends; scorched earth – sell off the best assets (crown jewels) • Change distribution of voting rights: issue more shares to friendly shareholders (dilutes bidders voting rights), repurchase shares

33. Effects for Defense Measures • Actions taken by managers: retain control (entrenchment); increase offer price • “Mild” resistance causes restructuring of bid; “severe” resistance deters bid • Reduce probability of takeover bids; but increase premium given a takeover bid/success • Allow managers and large shareholders to expropriate small shareholders (private benefits of control) • Empirical evidence is mixed

34. Top 10 M&As up to 1995

35. More Recent Mergers

36. Stock Market Driven M&As • Shleifer & Vishny (2003): • Markets inefficient, managers take advantage through M&As • When do we expect to see cash offers? • Undervalued acquirers tend to use cash to acquire targets; they will earn positive long-run returns after acquisitions; • Wave can occur if market- or industry-wide valuations are low; • Targets earn low returns prior to acquisitions; high, short-run returns after M&A but long run return can be flat • What about stock mergers? • Acquirers are likely to be (relatively more) over-valued; • Wave occurs when market- or industry-wide valuations are high; • Long-run returns to acquirers after M&As tend to be negative, but M&As still serve the interests of long-term acquirer shareholders

37. Agency Problems of Overvalued Equity • Jensen (2004): • Shock (tech sector) in the market increases equity value in 1990s; • Firms’ managers realize that their equity is over-valued: • Correction? Yes, otherwise investors and market will have (overly optimistic) expectations that cannot be fulfilled by firms; • But, no one wants to be the “party pooper” • More importantly, managers’ compensation tied to stock pricesHow to correct (lower) expectations on your own equity value? • Series of (stock-based) acquisitions: • If market does not “get the message,” large scale acquisition, or, • (After all other means fail) accounting frauds • Overall lessons: • Important for mgmt./board to correct over-valuation of equity early; • Otherwise they may engage in activities that will destroy value.

38. Insider Trading around M&As: All Acquirers (86-00)(from Song 2005)

39. Insider Trading by “Pure Seller” Acquirers around M&As

40. Insider Trading by “Pure Buyer” Acquirers around M&As

41. Summary and Concluding Remarks • Good M&As, and bad M&As • Empirical evidence: announcement effect and long-run performance • Tender offers: techniques, free-rider problem and solutions, defense measures • Stock mergers: (over-) valuations; risk and uncertainty; method of payment; due diligence