Mergers and Acquisitions

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1 Takeovers Takeover: transfers the control right of the firm from one group to another Merger Mergers and Acquisitions Acquisition Acquisition of Stock, 2018 Takeovers Proxy Contest Going Private Acquisition of Assets 2 Acquisitions Merger/Consolidation Bidder Acquiring firm Cash, stock ownership and/or control Target Acquired firm Merger acquiring firm assumes all assets and liabilities of the acquired firm. The acquired firm disappears after merger Consolidation acquiring and acquired firms become a new firm This type of acquisition is less costly since both management teams would like to finish the deal But, each firm has to get the approval from shareholders (two-thirds of shareholders) 3 4 Tender Offer Buy the target stocks in exchange for cash, shares, or other securities No shareholder meeting or vote is required Target firm s managers may oppose the deal, and the acquiring firm can buy stocks directly from the target shareholders Some target shareholders may hold out for more money complete absorption requires a merger Hostile acquisitions of stocks usually replace the incumbent management after the acquisition Acquisition of Assets Buy some or all target assets Needs the vote of shareholders of selling firm to approve No holdout problem, but could be costly 5 6 1

2 Proxy Fight Proxy is the authorization to vote on behalf of shareholders Some (large) shareholders attempts to control the firm and ask all shareholders to vote in the shareholders meeting Proxy Fight and Agency Costs In February 2008, Microsoft offered to buy Yahoo at $31 per share when Yahoo was trading at $ Yahoo rejected the offer, holding out for $37 a share. Billionaire Carl Icahn led a proxy fight to seize control of Yahoo s board and force the firm to accept Microsoft s offer. He lost, and Yahoo stock fell from $29 to $21. Did Yahoo managers act in the best interests of their shareholders? 7 8 Go Dark/Going Private US Financing Pattern The existing management buys the firm from the shareholders and takes it private. If it is financed with a lot of debt, it is a leveraged buyout (LBO). The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners. This reduces the agency costs of equity Junk Bonds LBOs Low-grade bonds, with high default risks, but offer high yield. Prior to 1970, most junk bonds are Fallen Angels. From late 1970, Michael Milken of Drexel Burnham Lambert changed the market by creating the demand and supply of the junk bonds. Junk bonds grew rapidly from 1984 to 1989, changing the corporate finance in 80s. Small firms can get a huge amount of financing through junk bonds, where they were not allowed to do so in the past Threat of hostile takeover, wave of mergers and acquisitions, popularity of share repurchases The acquisition by a small group of investors financed primarily with debt. Going private transaction, usually with very high debt ratio after LBOs. Mega LBOs happened in , and a few in Too much money was chasing too few good deals?

3 The Development US LBOs The increasing defaulted events in late 80s increased the burden of DBL. Milken was charged for securities fraud, and DBL filed bankruptcy in Junk bond market collapsed in 1990, so as the decline of LBOs Global LBOs Do LBOs Create Value? Sources of Gain in LBOs LBO Example Types of Acquisitions HCA (Hospital Corporation of America) LBO in 2007 led by KKR, Bain, Merrill Lynch and Thomas Frist for 33 billion. The investors put 5.3 billion for equity, and borrow the rest for finance the LBO. HCA paid 4.3 billion dividend to LBO investors in In 2011, HCA went to IPO, raising 3.8 billion; LBO investors got 1 billion. After IPO, LBO investors still held 11 billion stock. Horizontal acquisition acquire a firm in the same industry most recent mergers are of this type Vertical acquisition buy firms at different stages of the production process the buyer expands backward toward the source of raw materials (supplier) or forward in the direction of the end consumer (customer) Conglomerate acquisition buy firms in unrelated lines of business it s popular in 60s and 70s, but cools down thereafter

4 Value of Acquisitions History of U.S. Merger Activity Synergies benefits from acquisitions difference between the value of the combined firm and the sum of the acquiring firm (A) and acquired firm (B) Synergy = V AB (V A + V B ) Synergy can be determined from the usual discounted cash flow model, Synergy = Premium Bidder usually pays a premium for the acquired firm Premium = Purchase price V B First Wave: Horizontal Consolidation Second Wave: Increasing Concentration Third Wave: The Conglomerate Era Fourth Wave: The Retrenchment Era Fifth Wave: The Age of the Strategic Mega-merger Sixth Wave: The Rebirth of Leverage U.S. Merger Wave Source: Merrill Lynch Business Brokerage and Valuation, Mergerstat Review, Thompson Securities Financial Data. Similarities among Waves Occurred during periods of sustained high economic growth Low or declining interest rates Rising stock market In addition to economic growth, M&A tend to be caused by regulatory and technological shocks. Discount Cash Flows (DCF) Method DCF discounts future cash flows back to the present. The sum of all discounted future cash flows is the intrinsic value of the project (or the firm) DCF is popular in evaluating projects (capital budgeting) or valuing companies (merger) Generally, we use weighted average cost of capital as appropriate risk-adjusted discount rate

5 Beta with Leverage Beta of the firm is weighted average of betas of debt and equity Since debt is very low in practice, we assume it s zero and get Sources of Synergy CF = Revenues - Costs - Taxes - CapExp Revenue Enhancement Cost Reduction Tax Gains Reduction of cost of capital For all equity firm, With corporate taxes, Revenue Enhancement Marketing gains Broader distribution network Balanced product mix Strategic benefits Enter a related industry, and gain the niche of the market Monopoly power Acquire firms to reduce competition, and then increase profits Cost Reduction Economies of scale Reduce the average cost by increase the level of production Consolidate operations and eliminate redundant costs Example: banking industry: Chase and Chemical oil industry: BP and Amoco, Chevron and Texaco Economies of vertical integration Make coordination of closely related operating activities easier Example: Disney merge with ABC Cost Reduction Technology transfer New technology in target firm improves product quality Complementary resources enhance usage of existing resource, provide missing ingredients Example: Utah power (peak demand in summer for air condition) and PacifiCorp (peak demand in winter for heating) Fire inefficient management There are firms with unexploited opportunities to cut costs and increase sales and earnings through better management Many incumbent managers are replaced after acquisitions. Example: oil industry in late 70s and early 80s Tax Gains Net operating loss firms need taxable profits to take advantage of potential tax losses Unused debt capacity debt capacity increases as firms merge, leading to unused tax shields Surplus funds not pay cash to investors (dividends or share repurchases), but to acquire other firms Jensen s agency costs of free cash flows

6 Reduction of Cost of Capital Larger firms usually have lower issuing costs of equity Bad Reasons for Mergers Earnings growth create illusion of earnings growth to fool investors Diversification Diversification per se cannot increase value, though diversification may reduce risks Earnings Growth Diversification Firm A and B have same earnings and # of shares, but Firm A has better future growth prospects. No synergy for the merger, so the market value of combined firm should be the sum of market values of two separate firms However, if the market is fooled and thinks that the combined firm has better growth potential (EPS increase 43%), its market value will increase at the same rate of return as well. Diversification is easier and cheaper for the stockholder than for the corporation. In fact, investors pay discount, rather than premium, for diversified firms. Example: Kaiser Industries was a holding company of Kaiser Steel, Kaiser Aluminum, and Kaiser Cement for diversification purpose Kaiser Industries was traded at a significant discount from the sum of these three firms values The discount vanished when Kaiser Industries revealed its plan to sell its holdings and distributed the proceeds to its stockholders Survey on Motives Characteristics of Acquisitions Method of payment Cash offer Stock offer: issuance of new shares of common stock in exchange for the target s common stock Mixed: a combination of cash and securities Attitude of target management Friendly vs. Hostile Source: Tarun K. Mukherjee, Halil Kiymaz, and H. Kent Baker, Merger Motives and Target Valuation: A Survey of Evidence from CFOs, Journal of Applied Finance,

7 NPV of a Merger Firm A and B have values of $500 and $100, respectively. The merged firm AB will have value of $700 due to synergies of $100 Firm B will be sold to whoever offers cash of $150 NPV of Cash Merger Value of firm A after acquisition = V AB cash paid = $700 - $150 = $550 Since V A = $500 prior to acquisition, the NPV to firm A s shareholders is $550 - $500 = $50 Alternatively, NPV of a merger to acquirer = Synergy Premium = $100 - $50 = $ Stock Merger Firm A acquires B by giving A s stocks to B s shareholders Suppose we use A s prior value to compute number of shares distributed to B, then B will get $150 / $20 = 7.5 shares, suggesting an exchange ratio of 0.75:1 However, the cost of this way is more than $150 NPV of a merger to acquirer = $100 - $61 = $39 What is the number shares giving to B so that the cost is $150? Choice between Cash and Stock Sharing gains target stockholders do not participate in stock price appreciation with a cash acquisition Taxes cash acquisitions are generally taxable Control cash acquisitions do not dilute control N = Defensive Tactics Corporate charter Classified board (i.e., staggered elections) Supermajority voting requirement Golden parachutes top management receive a huge compensation when a takeover occurs Poison pill Target shareholders can buy shares of combined firm with a low price White knight A friendly acquirer invited by the target facing hostile takeover Recapitalization and repurchase (greenmail) Exclusionary self-tenders: exclude the bidder Asset restructurings Staggered Board In many public companies, a board of directors whose three-year terms are staggered so that only one-third of the directors are up for election each year. A bidder s candidate would have to win a proxy fight two years in a row before the bidder had a majority presence on the target board

8 Golden Parachutes An extremely lucrative severance package that is guaranteed to a firm s senior management in the event that the firm is taken over and the managers are let go Perhaps surprisingly, the empirical evidence suggests that the adoption of a golden parachute actually creates value. If a golden parachute exists, management will be more likely to be receptive to a takeover, lessening the likelihood of managerial entrenchment. Poison Pill It is a rights offering that gives the target shareholders the right to buy shares in either the target or an acquirer at a deeply discounted price. Because target shareholders can purchase shares at less than the market price, existing shareholders of the acquirer effectively subsidize their purchases, making the takeover so expensive for the acquiring shareholders that they choose to pass on the deal White Knights & White Squire White Knight A target company s defense against a hostile takeover attempt, in which it looks for another, friendlier company to acquire it White Squire A variant of the white knight defense, in which a large, passive investor or firm agrees to purchase a substantial block of shares in a target with special voting rights Recapitalization With recapitalization, a company changes its capital structure to make itself less attractive as a target. For example, companies might choose to issue debt and then use the proceeds to pay a dividend or repurchase stock Regulatory Approval Disappearing Defenses All mergers must be approved by regulators In the United States, all mergers above a certain size (approximately $60 million) must be approved by the government before the proposed takeovers occur. The European Commission has a similar process

9 US Firms Taken Over Geographic Distribution of M&A Industrial Distribution of M&A Largest M&A, International M&A, Do Acquisitions Create Value? In short-run returns? In long-run returns? Can short-run returns predict long-run returns? What are factors affecting acquisition value?

10 Empirical Evidence: Short-Run Empirical Evidence: Short-Run Target shareholders experience significant gains in mergers, if they are successful This benefit is larger for tender offers than for mergers Acquirers seem to have little gain in acquisitions Acquirers are usually larger than target Over-valuation of the acquired firm or managerial hubris Agency problem of equity (conflict of interests) Takeover market may be competitive. Announcement may not contain new information about the bidding firm Short-Run Returns Short-Run Return Variation Typical M&A announcement had a slightly negative impact on acquirer s stock price Empirical Evidence: Long-Run Long-Run Returns 5-yr abnormal returns from the date of acquisition Shareholders of acquiring firm on average lose money Cash deals outperform while stock deals underperform Equity offers signal that acquirer s stock is overvalued Premium for cash offers required to deter other potential bidders Mergers underperform while tender offers outperform

11 Predict M&A by Short-Run Return Factors of M&A Value? Acquisitions performed well over short windows continued to perform very well over the two-year Market initial view could be the indicator of longterm success Source: Todd Hazelkorn, Marc Zenner, and Anil Shivdasani, Creating Value with Mergers and Acquisitions, Journal of Applied Corporate Finance, Method of Financing Cash vs. Stock 5-yr abnormal returns from the date of acquisition The market reaction in both short- and long-term was more favorable for cash-financed transactions Send a positive signal acquirer s confidence in ability to replenish its cash balance Cash-financed transactions involve significant debt issuance, pressure to repay Takeover arbitrageur tend to buy target firms and sell acquiring firms Shareholders of acquiring firm on average lose money Cash deals outperform while stock deals underperform Equity offers signal that acquirer s stock is overvalued Premium for cash offers required to deter other potential bidders Mergers underperform while tender offers outperform Target Firm Status Why Private Firms Better? Acquirer had positive excess returns when the target was a private company or a business unit 1. Private company 2. Asset or business unit of public company Less trouble in integration Do not need to pay premium Typically paid for in cash Publicly traded company

12 Target Earnings Growth Forecast Focus vs. Diversified Acquisition Short-term: reaction were similar Long-term: - focused transactions outperformed by 2% - diversifying transactions underperformed by 3% Excess acquirer returns were higher when the target had low projected earnings-growth rates Low projected growth rate are often in mature industry, and mergers can create value for mature firms Companies tend to overpay for growth Focused transactions may be more successful in realizing synergies; strategic objectives may be similar Cross-industry transactions might face cultural and social issues Foreign vs. Domestic acquisition Percentage and Dollar Return In U.S., foreign acquisitions are more successful. Reach a broader geographic market Access local technological expertise Provide a lower cost production platform Aggregate Dollar Gain (Loss) of Acquirers Corporate Finance 71 12