Mergers: An Introduction GENERALLY ACCESSIBLE Mergers: An Introduction By AV Vedpuriswar June 2008

Introduction Mergers and acquisitions can be a considered a part of the broader topic of restructuring. Restructuring can be of various forms.

Forms of Restructuring Expansion Sell offs Corporate control Changes in ownership structure

Expansion Mergers Tender offers Joint ventures

Mergers New economic unit formed from previous ones. Horizontal mergers Vertical mergers Conglomerate merger Friendly/Bear hug/Hostile takeover

Tender Offer Company approaches shareholders of another firm to tender their shares. Positive response from shareholders leads to a hostile takeover. To avoid being taken over, the company may approach a white knight or opt for poison pills.

Joint Ventures Two parties come together and pool in their expertise/ financial resources.

Sell Offs Spin off Involves creation of new entity; shares distributed on pro rata basis to existing shareholders of the parent company. Divestiture Involves the sale of a portion of the firm to an outside party. Typically the buyer is an existing firm, so no new legal entity is created. Equity carve out Involves the sale of the portion of the firm via an equity offering to outsiders. New shares of equity are sold to outsiders which give them ownership of a portion of the existing firm.

Corporate Control Premium buy back Repurchase of a substantial stockholders ownership interest at a premium above the market price. Standstill agreement A voluntary contract in which the stockholder who is bought out agrees not to make further attempts to take over the company in the future. Anti takeover amendments Provisions to make an acquisition of the company more difficult or expensive. E.g., Super majority voting provisions to approve a merger, staggered terms for directors, golden parachutes Proxy contest Outside groups seek to obtain representation on the firm’s board of directors

Changes in Ownership Structure Exchange offers: Exchange of debt/preferred stock for common stock Share repurchase: Buying back existing shares can help increase control Going private: The entire equity interest in a previously listed company is purchased by a small group of investors. When the transaction is initiated by the incumbent management, it is called management buyout (MBO) When financing from third parties involves substantial borrowing by the private company, it is referred to as Leveraged Buy Out (LBO)

Theory of the Firm Rationale for the existence of a firm Organization forms Organization behaviours

Why does a firm exist? Transaction cost efficiency It will be efficient to substitute firms for markets only if the costs of transacting across markets become larger than the costs of managing the firm. Bounded rationality Complete contingent claims contracts are infeasible/ expensive. Internal organization provides an efficient review and monitoring process, serves to curb opportunism, and relaxes the need for complete contracts The greater the degree of asset specificity, the more likely that transactions will be carried out more efficiently within organizations.

Why does a firm exist? Production cost efficiency – Whether individuals produce independently and transact across markets or cooperate through a multi-person firm depends on the extent of scale economics to management and production as well as transaction costs. Team production makes sense if the team output is sufficiently greater than the sum of output under independent production to justify the costs of organizing and monitoring team members.

An employer with a team in place might achieve superior results, not because of any innate superiority of inputs but because of superior knowledge about the relative productive performance and interaction of inputs within the team. Organization capital consists of information used in assigning employees to tasks they can fulfill, information used in matching employees for formation of teams, information that each employee acquires on other employees and on the organization itself . As organization capital increases, productivity is enhanced.

Merger Types & Characteristics Horizontal mergers Involve firms in same kind of business activity. Vertical mergers Involve firms in different stages of production. Conglomerate mergers Involve firms engaged in unrelated types of business activity. Financial conglomerates Provide flow of funds to different business segments, exercise control and are the ultimate financial risk takers. Financial conglomerates take part in strategic planning but not in operational decisions.

Merger Types & Characteristics (Contd) Management conglomerates Not only assume financial responsibility and control but also play a role in operating decisions and provide staff expertise and staff services to the operating entities. The assumption is that the generic management functions of planning, organizing, directing and controlling are readily transferable to all types of business firms. Concentric mergers If the activities of the business brought together are so related that there is carry over of specific management functions such as research, manufacturing, finance, marketing, personal, the merger can be termed concentric.

Financial Synergy & Pure Conglomerate Mergers A pure conglomerate merger may occur when a firm in an industry with low demand growth relative to the economy acquires a firm which operates in another industry with high expected demand growth. A merger may enable the cost of capital to be lowered and facilitate utilisation of lower cost internal funds of a acquiring firm. In short, the merger facilitates a process of resource allocation in the economy from the acquiring firm’s industry with low demand growth to the acquired firm’s industry with high demand growth. The cost of capital may be lowered if the cash flows of the merged entity are more stable and the probability of bankruptcy is lowered. Moreover, internal funds are cheaper than external funds.

Mergers & Industry Life Cycle Introduction stage Newly created firms may sell to larger firms who sense an opportunity to enter a growing industry. Smaller firms may sell because of the desire to cash out / unwillingness to make huge investments. Exploitation stage The impetus for such mergers is driven by the more visible indications of prospective growth and profit and by the larger capital requirements of a higher growth rate.

Mergers & Industry Life Cycle Maturity stage Mergers may be undertaken to achieve economies of scale in research, production and marketing in order to match the low cost and price performance of other firms. Acquisitions may also happen to provide smaller firms with financial and other resources. Decline stage Horizontal mergers may happen for sheer survival. Vertical mergers may be carried out to increase efficiency and profit margins. Concentric mergers may provide opportunities to tap synergies; conglomerate mergers may facilitate more efficient utilization of cash flows.