1. MERGERS AND ACQUISITIONS
Chapter 10
MERGERS AND ACQUISITIONS
Behavioral Corporate Finance
by Hersh Shefrin

2. Traditional Approach To M&A
In the traditional approach to M&A, prices are efficient.
The market prices of both the acquiring firm and the target firm coincide with their fundamental values, under the assumption that both remain stand alone firms.
A merger between the acquiring firm and the target firm holds the potential for synergy.

3. Cont..
In theory, the shareholders of the acquiring firm will capture the synergy through the acquisition of the target, by paying the current market value for the target.
Managers of the acquiring firm will only go forward wit the acquisition if the value of the synergy is positive.
Shareholders will be indifferent to the combination of cash and equity used to finance the acquisition.

4. The Winner’s Curse
When the winning bid in an auction leads the winner to overpay, the winner is said to experience the winner’s curse.
Overconfident managers suffer from hubris, winner’s curse in acquisition stemming from overconfidence is known as hubris hypothesis.

5. Example
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 2001.
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.

6. Optimistic, Overconfident Executives
Excessively optimistic, overconfident CEOs
Are described as such in the press, and
Wait too long before exercising options.
Firms whose executives qualify as excessively optimistic and overconfident are more likely to have completed an acquisition.
Tendency compounded when firm is generating positive cash flow, but mitigated when board size less than 12.

7. Cont..
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.

8. Theory
Suppose that an acquiring firm is considering the purchase of a target firm.
Assume that the market value of the acquiring firm is $2mill and the market value of the target firm is $1mill, where both are valued as stand alone firms.
However, let there be $ in synergy from a merger of the two firms, so that the value of the combined firms is $3,850,000 (=2000,000+1,000, ,000).

9. Symmetric Information, Rational Managers, and Efficient Prices
If the acquirer is the only firm bidding for the target firm and all managers are rational, then the acquirer can obtain both the target by paying a hair more than the market value of $1 mill.
The acquirer managers will do the shareholders of their firm a service by acquiring the target as long as the synergy value is greater than zero.
Maximum amount willing to pay is $1.85mill and least amount is $1mill.

10. Excessive Optimism and Overconfidence, When prices are efficient
People tend to be excessively optimistic when they believe they exert a lot of control over the outcome.
An overconfident managers will typically overestimate the fundamental value of both the acquiring firm’s share and the amount of synergy in the merger.
The value that acquirers believe that the target’s shareholders receive because the acquiring firms stock is undervalued in the market is called dilution cost.

11. Cont..
Reasons that may lead to the acquiring firm’s shareholders not being able to capture the entire synergy:
If the acquirer has a competitor who is also interested in acquiring the firm.
If the managers of the target themselves are overconfident, they may demand more than the market value.
EPS may lead the managers of the acquiring firm to agree to pay more than they would otherwise.

12. Inefficient Prices and Acquisition Premium
Managers perceive their firm to be over-valued.
Managers of the acquiring firm would want to engage in market timing and purchase the target firm using over-valued equity in its own firm, rather than cash.

13. Cont..
If the target firms managers are overconfident, they will be prone to overvalue their firm value to the market.
They may require a premium above the market value before being willing to accept the acquiring firm’s bid.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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%.

19. 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.”

20. 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.
enterprise computing and services for businesses, losing to IBM.
personal computers (PCs), losing to Dell.
imaging and printing,
118% of H-P's overall operating profits.

21. Psychological Basis for the decision to acquire Compaq
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?

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

23. 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?

24. Valuation Before and After

25. H-P’s Board accepts reality
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.

26. The End