FIN-324 : Financing strategies and corporate governance Lecture 8: Mergers

1. FIN-324: Financing strategies and corporate governance Lecture 8: Mergers Anton Miglo Fall 2013

2. Topics Covered • Types of Mergers • History of M&A • Reasons for Mergers • Who benefits/losses? • Stock Price Reactions • The Free Rider Problem • Evaluating Merger Gains and Costs • The Mechanics of a Merger • Takeover Tactics, Defense and Battles • Poison pills • White knight • Staggered boards • Golden parachutes

3. What is merger?

4. What is a Merger? • In a MERGER, two (or more) corporations come together to combine and share their resources to achieve common objectives. • The shareholders of the combining firms often remain as joint owners of the combined entity. • A new entity may be formed subsuming the merged firms

5. Types of Mergers • Mergers are often categorized as: • Horizontal • When the merger takes place between firms in the same business, e.g., Air Canada’s acquisition of Canadian Airlines. • Vertical • When the merger involves acquiring a supplier or customer, e.g., Pepsi owns Burger King. • Conglomerate • When the merger involves companies in unrelated businesses, e.g., a manufacturer acquires a bank.

6. What is an Acquisition? • In an ACQUISITION, one firm purchases the assets or shares of another. • The acquired firm’s shareholders cease to be owners of that firm. • The acquired firm becomes the subsidiary of the acquirer. • Acquisitions usually take the form of a public tender offer.

7. Percentage of Public Companies Taken Over Each Quarter, 1926–2005 Mergers appear to occur in distinct waves, with the most recent waves occurring in the 1960s, 1980s, and 1990s. Source: Jarrad Harford.

8. History of Mergers and Acquisitions Activity in United States • The First Wave 1890-1904 • After 1883 depression • Horizontal mergers • Create monopolies • The Second Wave 1916-1929 • Oligopolies • The Clayton Act of 1914 • The Third Wave 1965-1969 • Conglomerate Mergers • Booming Economy • The Fourth Wave 1981-1989 • Hostile Takeovers • Mega-mergers • Conglomerates’ “garage sale” • Mergers of 1990’s • Strategic mega-mergers • 2000s? New wave

9. 1890 – 1905 • 1890 – 1905 Horizontal, US Perspective Large mergers of oil, tobacco, steel Sherman 1890 Act – restraint of trade Clayton Act – lessen competition

10. 1916 – 1929 1916 – 1929 Vertical, US perspective Public Utilities, Banking, Chemical, Mining, Food Processing Driven by technology changes and demographic changes • Mass Marketing, Market Extensions • Radio, Auto

11. 1960s • 1960s Conglomerate Motivation: diversity Capital Asset Pricing Model (CAPM)

12. 1981 –1989 • The increased takeover activity that started in the 1980s can be attributed to a number of factors: • The emergence of the high-yield (junk) bond market that was used to finance a number of that acquisitions. • The permissive stance toward mergers by the Justice Department during the Reagan administration. • Increase in foreign competition, major changes in certain industries and the deregulation of transportation, communications, and financial services (especially in Europe) brought about a need for a change in the way companies did business. • Deal Decade Many oil/gas – depressed stock prices Hostile Takeovers/Threats Many via LBOs

13. 1992-1999 • 1992-1999 Strategic Mergers Very large in size and number 1998: over $1.5 trillion in deals Driven by: Deregulation, economic forces, technology, globalization Most done in cash (unlike 1980s) • Examples: • Deutsche Bank – Bankers Trust • Citicorp – Travelers Insurance • (Reigle –Neal 1994, Bliley Act 1999) • AOL – Netscape

14. Ten Largest Merger Transactions, 1995-2005

15. Stock Price Reactions • Mergers • Bidders gain 0% • Targets gain 20% • Takeovers • Bidders gain 4% • Targets gain 30% (Jensen and Ruback, Journal of Financial Economics, 1985) • Premium paid over pre-merged price: 43% • Price reaction: Target 15%, Acquirer 1% (Eckbo, Handbook of Corporate finance, 2008)

16. Return for Takeover Targets Total takeover value to the target. Value of resolving uncertainty about the takeover. Preannouncement information leakage.

17. Reasons to acquire • Growth • Economies of Scale and Scope • Vertical Integration • Expertise • Monopoly Gains • Efficiency Gains • Diversification

18. Growth • Internal growth may be slow and uncertain. • A window of opportunity may pass by. • Management and technical personnel may be difficult to train or hire. • Geographical expansion.

19. Economies of scale and scope • Economies of scale and scope • NPV(A+B) > NPV(A) + NPV(B). • Stride Rite acquisition of shoemaker Saucony in 2005. Smaller cost, larger contracts with China

20. Financial Synergy • Financial Synergies: debt capacity, reduced total risk, liquidity, cost of funds, tax benefits. • Merging to reduce taxes, i.e., if it is possible to reduce the total taxes of the combined companies, say because one has tax shields it is unable to use. (carefully with IRS) • Debt becomes safer and cheaper • Liquidity for owners

21. Gains: Improved Managerial Efficiency • Market for corporate control assumes that managers act in the interest of the shareholders. Firms that do not maximize shareholder value are targets for takeover. • Therefore: • Target share prices experience significant declines prior to the merger or tender offer. • Managers of target firms are fired after the takeover.

22. Monopoly Gains: Horizontal Mergers • Firms producing similar products in similar markets (i.e., the same industry). • Monopolistic pricing: could be gains from reducing competition: • Reduce output, and increase profits • Demand curve facing the firm becomes less elastic • Antitrust Division of the Justice Department & the Federal Trade Commission worry about horizontal mergers. • Monopoly pricing makes consumers worse off • Efficiency increasing mergers make consumers better off: more output at lower prices • GE and Honeywell, 2000.

23. Vertical Mergers • Upstream firm buys a downstream firm (or vice versa) • Combining complementary resources, i.e., one of the firms provides the missing ingredient necessary to the other’s success. • Are there efficiency gains from internal rather than external contracting? • Coordination benefits • Microsoft vs. Apple

24. Conglomerate Mergers • Firms in totally different industries • Risk diversification • Perhaps there are efficiencies in management or some centralized service, but is doubtful today. • May have been more important when centralized information systems first came into being (1960’s)

25. Takeovers and Manager Threats • Why takeovers reduce agency costs: • Contract negotiation/compensation for senior executives is expensive, often requires the expensive time of the board of directors • The constant threat of being taken over by a better management team can be enough to ensure that the managers will keep shareholders happy • Thus, the threat of a raider appearing is often enough to keep agency costs relatively lower than otherwise possible when the firm is not the largest in the industry • Result: Compensation committees still exist in the corporate world, but time spent on such issues is not as bad when the company is not the biggest fish in the sea • E.g. Dell would need a compensation committee, but a smaller manufacturer, say, Gateway, would not be worried too much about compensation because the threat of being replaced by the Dell team would be enough for managers to work hard for shareholders

26. Other Gains Marketing Gains Inefficient media/advertising, poor product mix, weak distribution network Expertise: Cheaper to buy than to make Capital goods boom, cheaper to make Strategic Realignment (1990s) Due to economic, technology changes Regulatory Change Banking in U.S. Globalization & Freer Trade Signal (information) to market

27. Summary • From a policy perspective, gains come from either efficiency gains (good), or from monopolization (bad). • Management shouldn’t care, except that the probability of antitrust problems increase if the gains come from monopoly pricing. • Always ask yourself whether it is necessary to merge to capture the efficiency/pricing gains. Are other contracting methods better than paying a premium to buy control? • Since corporate control always changes, private benefits of control may be the common factor explaining the gains • Managers of target firms are often fired after the takeover.

28. Example: Taxes for a Merged Corporation

29. Example Taxes for a Merged Corporation

30. Basic Facts – Mergers • Generally friendly. • Require the approval of both management teams/boards before the stockholders vote. • Mergers are often done in an exchange of securities. • Common stock of the bidding firm for common stock of the target firm. • They are not taxable events for the target stockholders, unless they sell the bidder’s stock.

31. Basic Facts – Tender Offers • Generally unfriendly. • Target management by-passed by asking the stockholders to sell their stock, votes, etc. • Often done for cash. • Sometimes for new debt securities or stock. • Are taxable events for the target stockholders • Strong incentive for the bidding firm to complete the acquisition quickly, in order to reduce the probability that a competing bidder will come along.

32. The Takeover Process • Valuation • The Offer • Start with a public announcement following a 14d filing with the SEC. • The filing must specify the consideration offered to the shares of the target firm, the objective of the merger (acquisition), and the timeline of events. • The target management has 10 days to respond to the offer, via a 14d-9 filing. • Defense

33. Merger Tactics • Unfriendly Takeovers • Shareholders’ rights plan or poison pill. • Measures taken by the target firm to avoid acquisition by an unwelcome bidder. • For example, giving existing shareholders the right to buy additional shares at an attractive price if a bidder acquires a significant holding. • Dilutes the value of shares upon purchase by raider • Recent examples: Indigo and Chapters, Xstrata’s bid for Falconbridge • White knight • Friendly potential acquirer sought by a target company that is threatened by an unwelcome bidder. • Recent example: Inco placing competing tender for Falconbridge, ultimately the ideal circumstance for Falconbridge Board of Directors • Both the Inco and Xstrata bids were for cash to shareholders (purchasing 50+%)

34. Merger Tactics • Staggered board (Shark repellant) • Amendments to a company charter that make it more difficult for a successful bidder to get control of the Board of Directors. • For example, staggering the election of the Directors so that 1/3 get elected each year. • This means the bidder cannot obtain majority control of the Board immediately after acquiring a majority of the shares. • This would be done when the entrepreneur creates the charter

35. Early Warning Systems • Monitoring shareholder trading patterns: • Employees • Large stakeholders • Institutional investors

36. Corporate Charter Amendments • Generally require shareholder approval. • Generally result in negative stock price response. • Staggered terms for Board of Director. • Supermajority Provisions. • Fair Price Provisions.

37. Greenmail • Targeted stock repurchase back by the company

38. Golden Parachutes • Allow payment of lucrative compensation packages to exiting managers. • Rationale: allows managers to exit on favorable terms, thereby reducing desire to resist hostile bids. • Excessive golden parachute provisions have come under a lot of scrutiny.

39. Leveraged Recaps • Firm turns into own white knight: • pays a huge dividend to shareholders • borrows heavily

40. Other defenses • Crown Jewel defense • Contract to sell attractive assets to a third bidder contingent on hostile bid • Pac Man defense • Counter offer to take over the bidder. • Risky and infrequently used. • Can result in huge debt for target.

41. Shares swap

42. Shares swap

43. Exchange ratio

44. Exchange ratio

45. Maximum Exchange Ratio in a Stock Takeover

46. Maximum Exchange Ratio in a Stock Takeover

47. Total U.S. LBO Volume and Number of Deals Source: Standard & Poors Leveraged Buyout Review (Volume data not available for the single deal in Q1 ‘09)

48. LBO success: http://www.youtube.com/watch?v=4j47RqzGFSk

49. http://www.youtube.com/watch?v=4j47RqzGFSk&list=PL1342BA42BE109277http://www.youtube.com/watch?v=4j47RqzGFSk&list=PL1342BA42BE109277