McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 MERGERS AND ACQUISITIONS Behavioral Corporate Finance by Hersh Shefrin

1 The Winner's Curse in M&A  Between 1991 and 2001, shareholders of acquiring firms lost $216 billion, thereby experiencing the winner's curse.  Disproportionate share traced to very large losses by a few acquirers during the period 1998 through Many of the large loss acquirers had been active acquirers prior to their large loss acquisitions, and the market values of their firms had been increasing.

2 Optimistic, Overconfident Executives  Hubris hypothesis.  Excessively optimistic, overconfident CEOs 1.Are described as such in the press, and 2.Wait too long before exercising options.  More likely to have completed an acquisition.  Tendency compounded when firm is generating positive cash flow, but mitigated when board size less than 12.

3 Cash Flow  Financially constrained firms run by excessively optimistic, overconfident CEOs choose not to go to the capital markets in order to secure the funds needed to conduct an acquisition.  They act as if the market undervalues the equity and/or risky debt issued by their firm.

4 AOL Time Warner  In January 2000, America Online (AOL) announced its intention to acquire the media conglomerate Time Warner.  Goal was to create a distribution channel whereby Time Warner’s media products would be delivered via Internet broadband.  The purchase price, $165 billion in AOL stock, set an acquisition record.

5 Valuation  The combination of AOL and Time Warner occurred at the height of the technology stock bubble. In January 2000, the market capitalization of AOL was $185.3 billion, over twice as large as the $83.7 billion market capitalization of Time Warner.  The market’s judgment of the overall merger was favorable, with the shareholders of Time Warner benefiting at the expense of the shareholders of AOL.

6 Steve Case Market Timing  Case judged that dot-com stocks, including AOL, were overpriced, and he sought to exploit the overpricing through market timing.  He expected that Internet stocks would collapse in the not too distant future, and sought to protect AOL shareholders by acquiring a more mature firm.

7 Gerald Levin Trusted Market Prices Gerald Levin trusted market prices. During a press conference to announce the merger Levin stated: Something profound is taking place. I believe in the present valuations. Their future cash flow is so significant, that is how you justify it.

8 Asset Writedown  In April 2002, AOL Time Warner wrote down $54 billion in goodwill, to reflect the decline in the value of the combined firm.  In the previous 12 months, the operating profit for most AOL Time Warner businesses experienced positive growth.  But its AOL business fell 30%.

9 Hubris  The adjective “hubris” has frequently been applied to Steve Case in the press.  The New York Times did not paint a flattering picture of the executives at Time Warner, stating: “If Case was guilty of hubris, then the Time Warner management team was guilty of ignorance and credulity, industry analysts and academics say.”

10 H-P and Compaq  In May 2002, H-P acquired Compaq Computer.  In 1999, H-P was involved in three broad business segments, two of which were in decline. 1.enterprise computing and services for businesses, losing to IBM. 2.personal computers (PCs), losing to Dell. 3.imaging and printing, 118% of H-P's overall operating profits.

11 Proposed Merger  On July 19, 2001, Fiorina raised the merger issue with the other eight members of H-P’s board.  Only three expressed interest, most were resistant. H-P director Sam Ginn raised doubts about becoming more deeply involved in the PC business. Patricia Dunn noted that history has produced many unsuccessful technology mergers and asked what would make the odds of this one any better?

12 Three Questions Posed by Fiorina 1.Do you think the information-technology industry needs to consolidate and, if so, is it better to be a consolidator or a consolidatee? 2.How important is it to our strategic goals to be No. 1 or No. 2 in our chief product categories? 3.Can we achieve our strategic goals without something drastic?

13 Behavioral Issues  Did Carly Fiorina’s questions appeal to the directors’ natural tendency to be overconfident?  Did she frame the issue for them in a way that placed them in the domain of losses?  In speaking about drastic action, did she induce them to be risk-seeking?

14 Valuation Before and After

15 Dismissal  In February 2005, The Wall Street Journal characterized H-P’s business services group as second-tier, relative to industry leader IBM, and noted that its computer division was losing its battle against Dell.  That month, H-P’s board dismissed Carly Fiorina as CEO of H-P, and named independent director Patricia Dunn as nonexecutive chair.