1. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 1 B40.2302 Class #11  BM6 chapters 12.3, 33, 34  12.3 and non-BM6 material: Agency problems, solutions  33: Mergers, takeovers  34: Corporate control, financial architecture  Based on slides created by Matthew Will  Modified 11/28/2001 by Jeffrey Wurgler

2.  Making Sure Managers Maximize NPV Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will, Jeffrey Wurgler Chapter 12.3 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

3. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 3 Topics Covered  The agency problem  Evidence of its significance  Solutions:  Incentives  Other mechanisms (some not in book)

4. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 4 The Principal-Agent Problem Shareholders = Owners = “Principals” Managers = Control = Shareholders’ “agents” The problem: How do owners get managers to act in their interests? (i.e. to maximize NPV)

5. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 5 The Principal-Agent Problem  Low effort (slacking/shirking)  Expensive perks (corporate jets)  Empire building (overinvestment)  Entrenching investment (to keep job)  Avoiding risk (so as not to lose job) …… How might manager’s interests differ from shareholders’ interests?

6. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 6 Why does agency problem exist?  Agency problem exists because of the separation of ownership and control  Managers do not bear the full costs of their decisions, since they don’t own 100% of firm  Example: Manager owns 10% of firm  Can decide to buy corporate jet for $2 million, which is worth $400,000 to him and $0 to shhs  Will mgr. buy it?  Yes, since doesn’t fully internalize costs of inefficient decisions  Note if mgr owns 100%, then no separation of ownership and control  no agency problem  wouldn’t buy the jet

7. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 7 Why does agency problem exist?  Separation of ownership and control in modern corporation:  Benefits: Limited liability, professional management, shareholder diversification … (allows firm to exist!)  Costs: Agency problems

8. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 8 Evidence on agency problems Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace. -Frederick Taylor The Principles of Scientific Management (New York: Harper, 1929)

9. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 9 Evidence on agency problems  Much evidence on agency problems is from “event studies”  If managers announce actions (the “event”) that investors don’t like – stock price falls  Thus, such actions must not maximize shhr value  (This inference is not justified if the action indirectly conveys some other bad news.)  There are many types of managerial actions that investors don’t like…

10. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 10 Evidence on agency problems  In the mid-1980s, integrated oil producers spent roughly $20 per barrel to explore for new reserves …  Even though could buy proven oil reserves in marketplace for $6 per barrel !!!  Clearly NPV<0, but managers wanted to maintain their large oil exploration activities  At every announcement of a new exploration project, stock price dropped …

11. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 11 Evidence on agency problems  [refer to appendix slide 1] Investors also do not like it when managers adopt “poison pills”  Poison pills are devices to make takeovers extremely costly without target management’s consent  Suggests that managers resist takeovers to protect their private benefits of control, rather than to serve shareholders

12. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 12 Evidence on agency problems  [2] Study of stock market reactions to sudden executive deaths (heart attack, plane crash)  Shareholders often react positively to the news !!!  Especially shareholders of major conglomerates, whose powerful founders built vast empires without returning much to investors  Investors apparently believe the “replacement” manager will be better

13. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 13 Evidence on agency problems  On average, bidder returns on announcement of a takeover are negative  This is especially true in firms whose managers hold little equity  Or when the merger is “diversifying”

14. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 14 Evidence on agency problems  There is a “voting premium”  Consider two shares with equal cash flow rights but different voting rights:  The one with superior voting rights trades at a premium !!!  Indicates that “control” is valuable, i.e. if you have enough shares, you get other benefits of control (private jet…) beyond just dividends  In US, voting premium is small, but is 45% in Israel; 6.5% in Sweden; 20% in Switzerland; 82% in Italy  … suggests managers in Italy have significant opportunities to divert profits to themselves, not share them with nonvoting shhs

15. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 15 Evidence on agency problems  Manufacturing firms in Russia (at time of privatization) were estimated to have market values of 1% of comparable Western firms  Yes, there is more regulation and taxation in Russia  Poor management is also part of the story  But equally important seems to be the ability of managers of Russian firms to divert profits and assets to themselves Stealing from shareholders is the ultimate agency problem!

16. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 16 Potential solutions  Incentives for managers  Equity or stock options can give managers incentives to maximize shareholder value … reduce agency problems  Some believe that CEO incentives are not strong enough One study [3]: CEO pay rises only $3.25 for every $1000 of shareholder value created. Is this enough? Even this amount could generate big swings in CEO wealth (for a big firm)…  Others believe that incentives are poorly designed Why aren’t incentive contracts indexed to stock market?

17. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 17 Potential solutions  Monitor managers  Shareholders delegate monitoring to the board of directors (especially “outside” directors) Auditors also perform monitoring on behalf of shhs Lenders also monitor (to protect their collateral) [4] poorly-performing managers do get fired…  Monitoring may prevent the most obvious agency costs (e.g. blatant perks, manager not showing up for work)  But close monitoring is costly And manager has a lot of specialized knowledge There’s no way to tell if it is being used, just by watching

18. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 18 Potential solutions  Finance with debt  Managers can’t waste money if there is constant pressure to meet interest payments  This commits managers to paying out free cash flow If they don’t, default occurs, managers lose control Dividends, in contrast, are less of a commitment: they can be cut whenever management wants  Thus, agency problems are (like taxes) another reason to favor debt Especially in “cash cow” firms that generate cash but don’t have good investment opportunities

19. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 19 Potential solutions Others:  Takeover pressure If don’t maximize share value, outsider may take over firm, fire management, run firm better, create value  Managerial outside labor market If don’t maximize share value, and subsequently get fired, hard to find a new CEO job, or get lucrative outside directorships  Proxy fights Shareholders organize themselves to fight management

20.  Mergers Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will, Jeffrey Wurgler Chapter 33 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

21. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 21 Topics Covered  Sensible Motives for Mergers  Some Dubious Reasons for Mergers  Estimating Merger Gains and Costs  Takeovers: Unsolicited/hostile mergers

22. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 22 1997 and 1998 Mergers

23. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 23 Merger waves in US history  1893-1904: horizontal mergers to create monopoly  Mergers of companies in same line of business  1915-1929: vertical mergers  Mergers upstream (toward raw material) or downstream (to consumer)  1940s-1950s: “friendly” acquisitions of small, privately-held companies  1935: Roosevelt passed “soak-the-rich” tax laws with high estate taxes; so private firms put up for sale to avoid taxes  1960s-1970s: conglomerate mergers  Mergers across unrelated lines of business  1980s-1990s: still unnamed  Seem to be more underlying logic than conglomerate wave  Deals are much larger, often done in cash, often hostile (especially in 1980s), premia have increased

24. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 24 Sensible Reasons for Mergers Economies of Scale  A larger firm may be able to reduce its per-unit cost by using excess capacity or spreading fixed costs across more units  Motive for horizontal mergers $ $ $ Reduces costs

25. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 25 Sensible Reasons for Mergers Economies of Vertical Integration  Merge with supplier (integrate “backward”) or customer (integrate “forward”)  Control over suppliers may reduce costs  Or control over marketing channel may reduce costs  Motive for vertical mergers

26. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 26 Sensible Reasons for Mergers Combining Complementary Resources  Merging may result in each firm filling in the “missing pieces” of their firm with pieces from the other firm.  A.k.a. “synergies” Firm A Firm B

27. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 27 Sensible Reasons for Mergers Unused tax shields  Firm may have potential tax shields but not have profits to take advantage of them  After Penn Central bankruptcy/reorganization, it had $billions of unused tax-loss carryforwards  It then bought several mature, taxpaying companies so these shields could be used

28. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 28 Sensible Reasons for Mergers To Use Surplus Cash  If your firm is in a mature industry with no positive NPV projects left, acquisition may be a decent use of funds (assuming you can’t/won’t return cash directly to shareholders by dividend or repurchase)

29. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 29 Sensible Reasons for Mergers To Eliminate Inefficiencies in the Target  Target may have unexploited investment opportunities, or ways to cut costs or increase earnings  Replace firm with “better management”  Here, there is no “synergy”  Goal is simply to improve the target  Most likely requires replacing the target management  Many “hostile” deals fall in this category

30. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 30 Sensible Reasons for Mergers To Eliminate Inefficiencies in the Target:  Easier said than done – Warren Buffet says: Many managers were apparently over-exposed in childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess… Consequently, they are certain that their managerial kiss will do wonders for the profits of the target company… We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain confident about the potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.

31. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 31 Dubious Reasons for Mergers  Diversification  Investors should not pay a premium for diversification if they can do it themselves!  “Diversification discount” Diversified firms sell, if anything, at a discount  Makes sense only to the extent that reduces costs of financial distress Which allows merged firm to take on more debt, take advantage of tax shields

32. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 32 Dubious Reasons for Mergers Increasing EPS  Some mergers undertaken simply to raise EPS Acquiring Firm has high P/E ratio Selling firm has low P/E ratio After merger, acquiring firm has short term EPS rise Long term, acquirer will have slower than normal EPS growth due to share dilution.

33. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 33 Dubious Reasons for Mergers Lowers cost of debt  Merged firm can borrow at lower interest rates  This happens because when A and B are separate, they don’t guarantee each other’s debt  After the merger, each one does guarantee the other’s debt; if one part of business fails, bhhs can still get money from the other part  But this is not a net gain  Now, A and B’s shhs have to guarantee each other’s debt  This loss to shhs cancels the gain from the safer debt

34. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 34 Estimating Merger Gains  There is an economic gain to the merger only if the two firms are worth more together than apart  Gain = PV AB – (PV A +PV B ) =  PV AB

35. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 35 Estimating Merger Costs  Calculation of merger cost depends on whether payment is made in cash or in shares.  If A pays for B in cash, then easy:  Cost = cash paid - PV B  Usually shares of B are bought at a “premium,” so this cost is positive

36. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 36 Merger Decision  So merger is a positive-NPV to A if: NPV = Gain – Cost =  PV AB -(cash-PV B )>0  Notice gain is in terms of “total increase in pie”  While cost is concerned with the division of the gains between the two companies

37. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 37 Merger Decision Example  PV A =$200m, PV B =$50m  Merging A and B allows cost savings of $25m  So Gain = PV AB – (PV A +PV B ) =  PV AB = $25m  Suppose B is bought for cash for $65m  a $15m (30%) premium, not unusual  So Cost = cash paid - PV B = 65 – 50 = $15m  Note: B’s gain is A’s cost  NPV to A: Gain – Cost = $10m  Prediction: Upon announcement of merger, B’s stock will rise to $65m, A’s will rise by $10m

38. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 38 Estimating merger costs  When merger is financed by stock, cost calculation is different  Cost depends on value of shares in new company received by shareholders of selling company  If sellers receive N shares, each worth P AB, then:  Cost = N * P AB - PV B  … to illustrate, return to previous example …

39. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 39 Merger Decision Example  PV A =$200m, PV B =$50m, suppose A has 1m shares outsdg.  Gain is still = PV AB – (PV A +PV B ) =  PV AB = $25m  Suppose B is bought for.325m shares (not cash)  Cost to A is not.325*200 – 50  since A’s share price will go up at the merger announcement  Need to calculate post-deal share price of A  New firm will have 1.325m shares outstdg., will be worth $275m  So new share price is 275/1.325=207.55  Cost =.325*207.55 – 50 = $17.45m  NPV to A = Gain – Cost = $25 - $17.45 = $7.55m

40. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 40 Takeover Vocabulary Some useful vocabulary Tender offer: bidder A offers to buy target B’s shares on open market, usually at some premium  Goes “over the head” of B’s management…  Straight to B’s shareholders Hostile takeover: the tender offer is unsolicited Merger/Friendly takeover: agreement between A and B management

41. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 41 Takeover Vocabulary White Knight - Friendly acquirer sought by a target company threatened by an unwanted bidder. Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at a very low price as soon as a bidder acquires 20% Greenmail – Bribe paid to unwanted bidder to get him to go away (a “targeted share repurchase” since target buys back only shares of raider, and usually at a big premium)  Very upsetting to target shareholders!

42. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 42 Takeover Vocabulary Why does B management resist if A is offering B shareholders a premium?  Maybe to hold out for a higher bid  More likely: Agency problem !!!  B managers don’t want to lose job  One solution: pay a bribe to B managers so that they won’t encounter this conflict of interest Golden parachute – generous payoff if manager loses job as result of takeover

43.  Control, Governance, and Financial Architecture Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will, Jeffrey Wurgler Chapter 34 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

44. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 44 Topics Covered  Leveraged Buyouts  Spin-offs and Restructuring  Conglomerates

45. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 45 Definitions  Corporate control – the power to make investment and financing decisions.  Corporate governance –the set of mechanisms by which shhs exercise control over managers  They are the “potential solutions” to agency problems in chapter 12.3  Financial architecture – the whole picture: who has control, what governance mechanisms, what is capital structure, what is legal form of organization, etc.  Financial architectures differ a lot across countries  Partly because agency problems differ across countries

46. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 46 Leveraged Buyouts  LBOs differ from ordinary acquisitions:  A large fraction of the purchase price is financed by debt.  The LBO goes private, so its shares are no longer trade on the open market; they are held by a partnership of (usually institutional) investors  If group includes member of existing management team, called MBO

47. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 47 Leveraged Buyouts  Main sources of value in LBOs  Better incentives Constant debt service forces a focus on cash flows Management often takes a higher equity stake  “Buyout specialist” organizing it will serve as monitor  All the debt generates tax shields  Inefficiencies are cut Capex plans are more closely scrutinized New mgmt. may find it easier to fire unnecessary employees?

48. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 48 Leveraged Buyouts 10 Largest LBOs in 1980s and 1997/98 examples

49. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 49 Spin-offs, etc.  Spin-off – new, independent company created by detaching part of a parent company.  Carve-out – similar to spin offs, except that shares in the new company are not given to existing shareholders but sold in a public offering.  Privatization – the sale of a government-owned company to private investors.

50. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 50 Conglomerates The largest US conglomerates in 1979

51. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 51 The death of U.S. conglomerates  What were they supposed to achieve?  Diversification Which we mentioned is a dubious motive  Creation of internal capital markets Free cash flow in mature industries could be used to fund growing industries But, this avoided discipline of outside markets  Centralized, presumably improved management  Didn’t work  On average, conglomerates have market values 12-15% less than stand-alones

52. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 52 15 years from now You have just seized control of Establishment Industries, a blue-chip conglomerate, after a takeover battle. What advice can I give you to add value? (I.e., how do we use this class to get rich?) 1. Spin off the neglected divisions  Spinoffs go for a premium  Better incentives all around  Avoid mess of internal capital market  Avoid “diversification discount”

53. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 14- 53 15 years from now 2. Perhaps sell mature, cash cows to LBO partnerships.  No growth there for you  Again want to reduce size of internal cap. mkt  But valuable to LBO due to its better incentives 3. Focus on core business  Possible leveraged restructuring (debt-for-equity recapitalization) to improve incentives there  Give employees, managers equity incentives