Fundamental Characteristics of Financial Industry and Natural Evolution (II) Endogenous Solutions Dr. J.D. Han King’s College, University of Western Ontario

Objectives We have learned stocks (equities) are the most subject to information asymmetry and free rider problems. - Lack of information and monitoring Government intervention is not warranted, at least, for now. It is also not desirable. What are possible endogenous solutions?

Possible Endogenous Solutions for Information Asymmetry in Financial Instudstry 1) Alternative Funding Arrangements with enhanced Monitoring 2) Ultimately, M & As

1. Alternative Funding Arrangements Alternative Funding Arrangements: Private Equity Venture Capital Mezzanine Financing Alternative Financial System, which may allow for an enhanced monitoring by investors eg) Japanese Banks are allowed to be creditors as well as share-holders

2. M & As Recent Surge in Mergers and Acquisitions (M & A) Recent trend statistics: _Global_Finl_Advisory.pdf _Global_Finl_Advisory.pdf M & A means a change in management, and also is usually accompanied with an Increased Indebtedness(D/E ratio): Debts have become even more important in corporate financing.

* Exisiting works miss an important aspect of M & As Too much focus on the Size (growth) issue of M & As as a result of Globalization and Global Competition - by ”big hands” or “rigging the market” True, but there is another very important, and positive, aspect to it – by “invisible hands” or “market forces”

New Kid on the Block: In fact, not a Kid at all. Private Equity Firms have joined M & A through their Pooled Buyout Funds * By now, you have learned about 3 sub-types of Private Equity Private Equity Firms account for One of 4 M & A deals in U.S. in 2006

II. Fundamentals and added problems “Principal-Agent Problem”in the financial market and the corporate world: Old Problem - “Information Asymmetry” leads to “Principal-Agent Problem in Equities * separation of ownership(principals=shareholders) and management(agents=managers) *Agent often works for his own best interests at the expense of the principals’ -The more severe Moral Hazard’ problem. An Increased Legality : an added Problem due toCorporate Environment of Political Correctness makes it virtually impossible to change management

III. Two Phenomena may result from the endogenous, free-market efforts to solve the fundamental information asymmetry problems of the financial market We will explain that An increase in M & A combined with An Increased Indebtedness may resolve or reduce these problems of Corporations. How?

1. How does M & A help solve Principal-Agent Problem? M & A leads to a change to a new and better management and thus to an enhanced EFFINCIENCY A just credible threat will wake up the existing stale management.

* Target for M & A: How do you know whether a firm’s management is stale? Free Cash Flow Theory by Michael C. Jensen at Harvard Business School In his paper entitled “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers”, American Economic Review (1986)

* * Free Cash Flows as a Litmus Test He defines Free Cash Flows: Free Cash Flows = Cash Receipts - Cash Expenditures - Profitable (Constructive) Investment Opportunities His Observation: FCFs are the likely object of the Management’s abuse and a good indicator of the Principal-Agent Problem - The larger the FCF of a firm, the more severe the Principal-Agent Problem.

*** Jensen’s FCF Theory in Reverse Gear Dictum “ The Larger the Free Cash Flow of a Firm, the More Severe the Principal-Agent Problem, and thus the Larger the Potential Benefits from M & A and Corporate Restructuring” Prediction We can also identify which firm is likely to be a target of M & A.

2. How does an Increased Indebtedness enhance Corporate Efficiency? Debt contracts have a better monitoring through Restrictive Covenant and thus less moral hazards. Conversion from Equities to Bonds in the corporate financing increases the amount of information generated about the corporate for the “Principal”.

One more incentive for increased indebtedness for the Agent * Reduced Equities also increase Management’s portion of Profits - “Incentive-Compatible” - It enhances Management’s work efforts

*Numerical Example of an Increased Indebtedness enhancing Management’s Rewards Restructuring is “Leveraged” Buyout (of Shareholders) by Management Before Restructuring Debt-Equity Ratio = 0/1 = 0 CapitalProfits Equity 1Shareholders’ share$9,000 Equity 2Manager’s share$1,000 Total$10,000 *assume interest rate =10%; rate of returns on capital =100% After Restructuring Debt –Equity Ratio = 9 CapitalProfits DebtsShareholders’ share $9,000$ 900 Equity 2Manager’s share $1,000$9,100 Total$10,000 *Note: Manager’s profit share has increased by 810%.

3. M & A s as Child of Times Two Structural Changes as Prerequisites for a Surge of M & A Lowering Legal Barriers -Weakening of Anti-Trust Act(USA) Competition Act(Canada) Development of Financial Institutions, Market & Debt Instruments - Investment Banks, Securities Houses, Junk Bonds, (Debt-Equity) Swap, etc.

*Who are the Big Players? Securities Firms Private Equity Firms. Banks’ M & A Division of Investment Banking Department For instance - Morgan Stanley - Goldman Sachs - Salomon Smith Barney - Merrill Lynch - Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium)

**Organization of Securities Firm

***Glossaries Investment Banking -helps issue new securities in the primary market - Merchant Banking Securities Trading and Brokerage - helping trade securities in the secondary market - Dealer versus Broker - Discount Brokerage versus Full Service Brokerage Investment Dealer -dealer is principal, not agent - applicable for Bought Deal and Securities Dealer

4. Pros and Cons of M& A 1) Pros: Advocate for M & A M & A enhances Efficiency of Corporate Management, and reduces problems related to information asymmetry Natural Part of Globalization Trend Strategy for Survival from International Competition (evidence) Share price of Target Firm goes up by 30-50% before and after M & A

2) Criticism of M & A (1) Zero Sum Game for the entire economy: gains for shareholders come from someone’s loss a) Government Loss of Tax Revenues in LBO b) Wage Concessions after M & A c) Bond holders’ loss: Increased leverage - Increased Default Risk - Decreased Bond Price d) Consumers’ loss: Increased monopoly power - Higher price (2) Economic Frailty Increases (3) M & A could be costly: A High Transactions Cost

(3) A Costly M & A: “ Shark Repellants” -Setting up costly barriers against M & A Green Mail -bribe to a raider away Scorch Earth - make yourself unattractive Poison Pills - sell stock under market price in case of danger Golden Parachute - big severance package for leaving executives

IV. Canadian Context M & A will continue to increase M & A take on Globalization trends

Source: Crosbie & Company Inc. Historical Canadian Mergers & Acquisition Announcements Value in $ Billions Announcements 1,400 1,200 1, $210 $180 $150 $120 $90 $60 $30 0 Announcements

M & A at Canadian Cross-Border

M & A Resulting in Efficiency: CanadianCases

Classic Study Case of M & A – The Company’s objective is to build value for its investors through the acquisition of underperforming businesses( with a large amount of Free Cash Flow) financed largely with debts borrowed from third party lenders. Performances. - Acquired Celestica for C$750mm in October, 1996 which now has a market value of C$4.6 billion. - Onex announces a bid for Air Canada and Canadian Airlines during a time when the industry is struggling. 3. Case Studies Case Study I) Excellent Execution - Onex Corporation

Case Study - Excellent Execution - Onex Corporation Stock Price Performance September 29, September 30, /29/199404/20/199511/07/199505/29/199612/16/199607/08/199701/27/199808/17/199803/09/199909/27/1999 Onex Corp Sub Vtg Oct 1/96: Onex acquires Celestica for C$750mm Nov 13/96: ProSource completes IPO of US$48mm Oct 1/98: Onex announces SoftBank acquisition May 29/98: Onex sold ProSource Inc. to AmeriServe Food Distribution for C$123mm Jan 29/99: Onex announces LCS Industries acquisition Mar 11/99: Onex announces that it will sell 23% of its stake in Sky Chefs to LSG Mar 25/99: Onex announces C$1.5bn Telecom Fund with Telefonica May 11/99: Onex purchases American Buildings Aug 24/99: Onex announces bid for Air Canada and Canadian Airlines

Case Study 2) - Disastrous Execution - Extendicare Stock Price Performance September 29, September 30, 1999

Case Study 3 - High Yield Debt - Rogers Communications Stock Price Performance September 29, September 30, /29/199404/20/199511/07/199505/29/199612/16/199607/08/199701/27/199808/17/199803/09/199909/27/1999 Rogers Communications Inc Cl B Nov 11/95: Rogers Cablesystems announces two new high yield debt issues of US$150mm and US$125mm Jan 16/96: Issues US$100mm high yield debt Jan 25/96: Issues C$75mm high yield debt July 17/97: Two new high yield debt issues of US$330mm and C$165mm announced May 21/98: Rogers sells local telephone services to Metronet for C$1bn July 12/99: Microsoft makes C$600mm investment in Rogers; Aug 16/99: Completes sale of 33% interest of Rogers Cantel to AT&T Corp and BT PLC for C$1.4bn Sep 9/99: Rogers repurchases C$1.3bn in debt