1. 1 (of 22) FIN 468: Intermediate Corporate Finance Topic 10–Mergers and Acquisitions Larry Schrenk, Instructor

2. Topics Corporate Control Mergers Takeovers Restructurings

3. Corporate Control

4. Corporate Control Defined What is Corporate Control?  Monitoring, supervision and direction of a corporation or other business organization Changes in corporate control occur through:  Acquisitions (purchase of additional resources by a business enterprise): 1. Purchase of new assets 2. Purchase of assets from another company 3. Purchase of another business entity (merger)  Consolidation of voting power  Divestiture  Spinoff

5. Corporate Control Transactions Statutory: Acquired firm is consolidated into acquiring firm with no further separate identity. Subsidiary: Acquired firm maintains its own former identity. Consolidation: Two or more firms combine into a new corporate identity.

6. Mergers 6 (of 36)

7. Merger & Acquisition Transaction Characteristics Attitude of target management to a takeover attempt  Friendly Deals vs. Hostile Transactions Method of payment used to finance a transaction  Pure stock exchange merger: issuance of new shares of common stock in exchange for the target’s common stock  Cash offer  Mixed offerings: a combination of cash and securities

8. Mergers by Business Concentration Horizontal: between former intra-industry competitors  Attempt to gain efficiencies of scale/scope and benefit from increased market power  Susceptible to antitrust scrutiny  Market extension merger Vertical: between former buyer and seller  Forward or backward integration  Creates an integrated product chain Conglomerate: between unrelated firms  Product extension mergers vs. pure conglomerate mergers  Popular in the 60’s as the idea of portfolio diversification was applied to corporations

9. History of Merger Waves Five merger waves in the U.S. history  Merger waves positively related to high economic growth.  Concentrated in industries undergoing changes  Regulatory regime determines types of mergers in each wave.  Usually ends with large declines in stock market values First wave (1897-1904): period of “merging for monopoly”.  Horizontal mergers possible due to lax regulatory environment  Ended with the stock market crash of 1904 Second wave (1916-1929): period of “merging for oligopoly”  Antitrust laws from early 1900 made monopoly hard to achieve.  Just like first wave, intent to create national brands  Ended with the 1929 crash

10. History of Merger Waves Third wave (1965-1969): conglomerate merger wave  Celler-Kefauver Act of 1950 could be used against horizontal and vertical mergers.  Result of portfolio theory applied to corporations: conglomerate empires were formed: ITT, Litton, Tenneco  Stock market decline of 1969 Fourth wave (1981-1989): spurred by the lax regulatory environment of the time  Junk bond financing played a major role during this wave: LBOs and MBOs commonplace.  Hostile “bust-ups” of conglomerates from previous wave  Antitakeover measures adopted to prevent hostile takeover attempts.  Ended with the fall of Drexel, Burnham, Lambert

11. History of Merger Waves Fifth wave (1993 – 2001): characterized by friendly, stock-financed mergers  Relatively lax regulatory environment: still open to horizontal mergers  Consolidation in non-manufacturing service sector: healthcare, banking, telecom, high tech  Explained by industry shock theory: Deregulation influenced banking mergers and managed care affected health care industry. Sixth wave (2003-Present)  Consolidation continues  Record volume in 2005

12. Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003

13. Motives for Merger Geographic (internal and international) expansion in markets with little competition may increase shareholders’ wealth.  External expansion provides an easier approach to international expansion.  Joint ventures and strategic alliances give alternative access to foreign markets. Profits are shared. Synergy, market power, and strategic mergers  Operational, managerial and financial merger- related synergies

14. Operational Synergies Economies of scale: Merger may reduce or eliminate overlapping resources  1995 merger between Chemical Bank and Chase Manhattan Bank resulted in elimination of 12,000 positions. Economies of scope: involve some activities that are possible only for a certain company size.  The launch of a national advertising campaign  Economies of scale/scope most likely to be realized in horizontal mergers. Resource complementarities: Merging firms have operational expertise in different areas.  One company has expertise in R&D, the other in marketing.  Successful in both horizontal and vertical mergers

15. Managerial Synergies and Financial Synergies Managerial synergies are effective when management teams with different strengths are combined.  For example, expertise in revenue growth and identifying customer trends paired with expertise in cost control and logistics Financial synergies occur when a merger results in less volatile cash flows, lower default risk, and a lower cost of capital.

16. Managerial Synergies and Financial Synergies Market power is a benefit often pursued in horizontal mergers.  Number of competitors in industry declines  If the merger creates a dominant firm, as in the Office Depot- Staples merger’s attempt to create market power and set prices Other strategic reasons for mergers:  Product quality in vertical mergers  Defensive consolidation in a mature or declining industry: consolidation in the defense industry

17. Cross-Border (International) M&A  One company’s acquisition of the assets of another is observed worldwide.  Countries differ not only with respect to how frequently takeover attempts are launched, but also  how often these are friendly versus hostile bids  how often these are cross-border deals (involving a bidder and a target firm in different countries)  the average control premium offered  the likelihood that payment will be made strictly in cash.

18. Geographic Distribution of Worldwide Announced Mergers and Acquisitions, 2004 v. 2003

19. Methods of Payment Negotiated Mergers  Contact is initiated by the potential acquirer or by target firm. Open Market Purchases  Buy enough shares on the open market to obtain controlling interest without engaging in a tender offer Proxy Fights  Proxy for directors: attempt to change management through the votes of other shareholders  Proxy for proposal: attempt to gain voting control over corporate control, antitakeover amendments (shark repellents, golden parachutes, white knights, poison pills

20. Methods of Payment Tender Offers: an open and public solicitation for shares Open Market Purchases, Tender Offers and Proxy Fights could be combined to launch a “surprise attack”  Acquirer accumulates a number of shares (‘foothold”) without having to file 13-d form with SEC

21. Takeovers 21 (of 36)

22. Friendly vs. Hostile Takeovers Friendly mergers are negotiated Hostile takeovers are opposed by management  Bear hug – go to board  Tender offer – direct to shareholders  Proxy fight – vote by shareholders

23. Hostile Takeover Defenses Pre-offer (shark repellants)  Poison pills – increase shares  Poison puts – bondholders  Charter amendments Staggered board Voting provisions Fair price amendments Golden parachutes

24. Hostile Takeover Defenses Post-offer  “ Just Say No” defense  Litigation  Greenmail  Share repurchase LBO  Leveraged recap  “Crown Jewel” defense  “Pac-Man” defense  White Knight/Squire defense

25. Major US Antitrust Legislation Legislation (Year)Purpose of Legislation Sherman Antitrust Act (1890)  Prohibited actions in restraint of trade, attempts to monopolize an industry  Violators subject to triple damage  Vaguely worded and difficult to implement Clayton Act (1914)  Prohibited price discriminations, tying arrangements, concurrent service on competitor’s board of directors  Prohibited the acquisition of a competitor’s stock in order to lessen competition Federal Trade Commission Act (1914)  Created FTC to enforce the Clayton Act  Granted cease and desist powers to the FTC, but not criminal prosecution powers Celler-Kefauver Act (1950)  Eliminated the “stock acquisition” loophole in the Clayton Act  Severely restricts approval for horizontal mergers Hart-Scott-Rodino Act (1976)  FTC and DOJ can rule on the permissibility of a merger prior to consummation.

26. Concentration Classifications Herfindahl-Hirschman Index  Demonstrates the relationship between corporate focus and shareholder wealth  HHI is computed as the sum of the squared percentages - the proportion of revenues derived from each line of business

27. Determination of Anti-competitiveness Since 1982, both DOJ and FTC have used Herfindahl-Hirschman Index (HHI) to determine market concentration  HHI = sum of squared market shares of all participants in a certain market (industry) 10001800 HHI Level Not ConcentratedModerately ConcentratedHighly Concentrated

28. The Williams Act (1968) Ownership disclosure requirements  Section 13-d must be filed within 10 days of acquiring 5% of shares of publicly traded companies.  Raises the issue of “parking” shares Tender offer regulations  Shareholders of target company have the opportunity to evaluate the terms of the merger.  Section 14-d-1 for acquirer and section 14-d-9 by target company (recommendation of management for shareholders regarding the tender offer)  Minimum tender offer period of 20 days  All shares tendered must be accepted for tender.

29. Other Legal Issues Sarbanes-Oxley Act of 2002  primarily targeted accounting practices, it also mandated significant changes in how, and how much, information companies must report to investors. Laws Affecting Corporate Insiders  SEC rule 10-b-5 outlaws material misrepresentation of information for sale or purchase of securities.  Rule 14-e-3 addresses trading on inside information in tender offers.  The Insider Trading Sanctions Act, 1984 awards triple damages.  Section 16 of Securities and Exchange Act Requires insiders to report any transaction in shares of their affiliated corporations.

30. Other Legal Issues State Antitrust Laws Include anti-takeover and anti-bust up provisions  Fair price provisions disallow two-tiered tender offers. All shareholders receive the same price for their shares, regardless of when they are tendered.  Cash-out statutes forbid partial tender offers. Provisions usually used in conjunction with each other

31. Merger Analysis Acquirer sees target undervalued.  Many junk bond-financed deals of the 1980s had one of the following two outcomes: “Busting up” the target for greater value than acquisition price Restructuring the target to increase corporate focus. Sell non-core businesses to pay acquisition cost Tax-considerations for the merger:  Tax loss carry-forward of the target company used to offset future taxes; resulting in increased cash flow.  1986 change in tax code limits the use of tax loss carry- forward. Merging may yield lower borrowing costs for the merged company.  Cash flows of the two businesses are less risky when combined, leading to lower probability of bankruptcy and lower default risk premium

32. Non-Value-Maximizing Motives Agency problems: Management’s (disguised) personal interests are often driver of mergers and acquisitions.  Managerialism theory of mergers: Managerial compensation often tied to corporation size  Free cash flow theory of mergers: Managers invest in projects with negative NPV to build corporate empires.  Hubris hypothesis of corporate takeovers: Management of acquirer may overestimate capabilities and overpay for target company in belief they can run it more efficiently.  Agency cost of overvalued equity

33. Non-Value-Maximizing Motives Diversification  Coinsurance of debt: the debt of each combining firm is now insured with cash flows from two businesses  Internal capital markets: created when the high cash flows (cash cow) businesses of a conglomerate generate enough cash flow to fund the “rising star” businesses

34. Shareholder Wealth Effects and Transaction Characteristics Target returns – stockholders almost always experience substantial wealth gains Acquirer returns – less conclusive than those for target shareholders Combined returns – slightly positive

35. Restructuring 35 (of 36)

36. Corporate Restructuring Divestiture - occurs when the assets and/or resources of a subsidiary or division are sold to another organization. Equity carve-out - partial sale to outsiders Spin-off - a parent company creates a new company with its own shares by spinning off a division or subsidiary.  Existing shareholders receive a pro rata distribution of shares in the new company. Split-off - similar to a spin-off, in that a parent company creates a newly independent company from a subsidiary, but ownership of company transferred to only certain existing shareholders in exchange for their shares in the parent