Where M & A pays and. where it strays Where M & A pays and where it strays Based on the article by Robert Bruner, Journal Of Applied Corporate Finance, Fall 2004 By A.V. Vedpuriswar

Introduction Cynicism about M & As is not justified. Shareholders of buyers and sellers combined, earn significant returns. The world of M&A is not homogeneous. Each M&A is contextual. Deals differ in various ways. These differences should be appreciated. Looking at the buyer’s stock price before and after the deal, may not tell the full story. It fails to take into account factors unrelated to the deal, that could have triggered a price change.

Measuring Success Looking at the firm’s returns and comparing with a benchmark is more useful, but this may still be imperfect. An even better test is: Are shareholders better off after the deal than they would have been, if the deal had not occurred? Event studies examine the abnormal returns to shareholders in the period surrounding the announcement of a transaction. Event studies indicate: - abnormal returns to shareholders of target firms - abnormal returns to shareholders of buyer firms The poor performance of companies following acquisitions is often the result of economic turbulence in the industry rather than the acquisition itself. When managers see trouble approaching, in the form of deregulation, technological change, demographic shift or other forms of turbulence, they take action (including M&A) to mitigate the trouble. So the subsequent problems have more to do with the foreseen turbulence than with the acquisitions themselves.

What the data indicates M&A does pay on average M&A clearly pays off for shareholders of target firms If buyers and targets are considered together, value is created If bidders are considered alone, value is preserved if not created. If industry and general economic turbulence drive M&A, then success or failure is likely to be determined in significant part by the context of the deal.

Focus Focus and relatedness probably pay off better as an acquisition strategy than does unrelated diversification, all else equal. A strategy of unrelated diversification can pay when there are unusual skills such as running an LBO association or value investing. Industries are dynamic. Their attractiveness changes over time. A mindless strategy of focused and related acquisitions is no guarantee of success. The fundamental bet on industry attractiveness trumps the need for strategic linkage.

Which deals are better? Investors seem to welcome M&As when they are -aligned with some strategic objective -focused on restructuring -clearing synergies that appear to be credible. Value acquiring (targeting companies with a low market to book value ratio) pays off. Segments that tend to be profitable to buyers are privately owned targets and underperforming targets Privately owned companies may be attractive for the following reasons: -Lack of information on private companies -Lack of marketability of private securities -Bargaining advantages for pubic buyers of private firms -Absence of competitive bidding that keeps prices low

Stock Vs Cash deals Several studies report that stock based deals are associated with negative returns to the buyer’s shareholders at deal announcements. Cash deals are neutral or highly positive. This is probably because managers time the issuance of shares to occur at a high point in the cycle of the company’s fortunes or in the stock market cycle. In cases where the payment is in cash, target shareholder returns are considerably higher. When payment is in stock, target shareholder returns are significantly positive, but materially lower than for cash deals. When payment is in stock, buyer returns are significantly negative. Tender offers often generate more returns, compared to friendly deals. In tender offers, the higher returns may reflect bargain prices as well as the expected economic benefits from replacing management and redirecting the strategy of the firm. Target shareholders also receive higher premiums in hostile deals than in friendly deals. Tender offers amplify the stock-cash effect. Stock tends to be used when a deal is friendly, the buyer’s stock price is relatively high, ownership in the buyer is not concentrated, deals are larger in size and the buyer has less cash.

LBOs and contingent payment structures Those M&As are viewed positively by markets where managers tend to commit a significant portion of their own net worth to the success of the transaction. LBOs often lead to efficiencies and greater operational improvements. Shareholders of target companies in LBOs, earn large abnormal returns. The returns to buyers are higher when the payment is structured to be contingent on meeting some future performance benchmarks. Earnouts and other contingent payment structures can be viewed as providing stronger performance incentives for selling managers as well as a risk management device for the buyer.

Mergers of equals Premiums in mergers of equals are typically much smaller than those in other deals. Target shareholders earn positive abnormal returns that, although significantly positive, are also smaller than those in other deals. It is possible that in mergers of equals, CEOs trade power for premium. By signaling an absence of dominance of one side over the other, mergers-of-equals help reduce resistance in the target company. This increases the probability of the deal being consummated. It also builds a general sense of teamwork that can facilitate faster post merger integration.

Corporate governance Firms with stronger governance practices are more highly valued. Those M&As should generate higher returns, which provide greater protection for shareholders. When a target successfully rejects a hostile bidder, the target’s share price falls but typically to a price level higher than prevailed before. This is partly because unsuccessful takeover attempts often lead to restructurings that unlocks value for shareholders. Anti takeover defenses can help shareholders of well governed companies by enhancing the bargaining power of management, enabling them to attract higher prices from bidders. But defenses harm shareholders of poorly governed firms. When the board of directors is strong and independent, and when the CEO’s interests are strongly aligned with shareholder returns, the reaction tends to be positive.

When do M&As fail? The organization enters a fundamentally unprofitable industry or refuses to exit from one. The organization steps far away from what is known. They key strategic drivers of profitability have less to do with focus and relatedness and more to do with knowledge, mastery and competencies. The economic benefits of the deal are improbable. Success is less likely when there are many competitive bids (public companies) as opposed to less competitive segments of the market like private firms and assets. Poor structuring of the deal – the use of cash, debt financing, tax shields, staged payments, merger of equals terms and earnout incentive structures are all associated with higher buyer returns. Poor governance – oversight and delegation of decision making authority within the firm.