1. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - - - - Chapter 6 - - - - - - - - Theories of Mergers and Tender Offers

2. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Basic Concepts Economies of scale — average costs decline over a broad range of output Different from spreading fixed costs over a larger number of units Mergers allow a reorganization of production processes so that plant scale may be increased to obtain economies of scale

3. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3 Economies of scope Organization capital Organization reputation Human capital resources –Generic managerial capabilities –Industry-specific managerial capabilities –Nonmanagerial human capital

4. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Free-Rider Problem Problem of diffused, small shareholders –Small shareholders may not expend resources monitoring management performance in a diffusely held corporation –Shareholders simply free-ride on monitoring efforts of other shareholders and share in any resulting performance improvements of the firm

5. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 Free-rider problem in mergers –Small shareholders will not tender at any offer price below the higher expected price that should result from the merger –Individual decision to accept or reject tender offer does not affect success of the offer –If offer succeeds, they fully share in the improvement brought by takeover

6. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6 Possible solutions to free-rider problem –Allow bidder to dilute value of nontendered shares of the target firm after takeover –Two-tier offer –Make some shareholders pivotal in the outcome of the bid (Bagnoli and Lipman, 1988) –Tender offer from a large shareholder or an outsider who had secretly accumulated a large fraction of the equity

7. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7 Models of the Takeover Process Economic — competition vs. market power Auction types — Dutch, English Forms of games Types of equilibria — pooling, separating, sequential Types of bids — one, multiple Bidding theory — preemptive; successive bids

8. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 Framework Total gains for both target and acquirer –Positive Efficiency improvement Synergy Increased market power

9. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 –Zero Hubris Winner's curse Acquiring firm overpays –Negative Agency problems Mistakes or bad fit

10. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 Gains to target — all empirical studies show gains are positive Gains to acquirer –Positive — efficiency, synergy, or market power –Negative — overpaying, hubris, agency problems, or mistakes

11. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11 Sources of Value Increases from M&As Efficiency increases –Unequal managerial capabilities –Better growth opportunities –Critical mass –Better utilization of fixed investments

12. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12 Operating synergy –Economies of scale –Economies of scope –Vertical integration economies –Managerial economies

13. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13 Diversification motives –Demand for diversification by managers/employees because they make firm-specific investments –Diversification for preservation of organization capital –Diversification for preservation of reputational capital

14. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 –Diversification and financial synergy Diversification can increase corporate debt capacity, decrease present value of future tax liabilities Diversification can decrease cash flow variability following merger of firms with imperfectly correlated cash flow streams

15. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15 –Diversification discount Studies find that the average diversified firm has been worth less than a portfolio of comparable single-segment firms Reasons –External capital markets allocate resources more efficiently than internal capital markets –Rivalry between segments may result in subsidies to underperforming divisions within a firm –Managers of multiple activities are not well informed about each segment –Securities analysts may be less likely to follow multiple segment firms –Performance of managers of segments cannot be adequately evaluated without external market measures

16. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 Financial synergies –Complementarities between merging firms in matching the availability of investment opportunities and internal cash flows –Lower cost of internal financing — redeployment of capital from acquiring to acquired firm's industry –Increase in debt capacity which provides for greater tax savings –Economies of scale in flotation of new issues and lower transaction costs of financing

17. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17 Circumstances favoring merger over internal growth –Lack of opportunities for internal growth Lack of managerial capabilities and other resources Potential excess capacity in industry –Timing may be important — mergers can achieve growth and development of new areas more quickly –Other firms may be competing for investments in traditional product lines

18. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 Strategic realignments –Acquire new management skills –Less time to acquire requisite capabilities for new growth opportunities or to meet new competitive threats

19. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19 The q-ratio –Ratio of the market value of the firm's securities to the replacement costs of its assets High q-ratio reflects superior management Depressed stock prices or high replacement costs of assets cause low q-ratios –Undervaluation theory Acquiring firm (A) seeks to add capacity; implies (A) has marginal q-ratio > 1 More efficient for (A) to acquire other firms in industry that have q-ratios < 1 than building a new facility

20. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20 Information –New information generated during tender offer process causes target firm share to be permanently revalued upward even if offer is unsuccessful –Two information hypotheses ”Sitting on a gold mine" — tender offer disseminates information that target shares are undervalued ”Kick in the pants" — tender offer forces target firm management to implement more efficient business strategies –Synergy explanation — upward revaluation in unsuccessful offer merely reflects likelihood that other bidders may surface with specialized resources to apply to target

21. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21 Signaling –Information — an outside event not initiated by the firm conveys information –Signaling — particular actions by the firm may convey other significant forms of information, e.g., that management does not tender at the premium price in a share repurchase signals that the company's shares are undervalued

22. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22 Winner's Curse and Hubris Winner's Curse: The winning bid in a bidding contest for an object of uncertain value will typically pay in excess of its true value One cause of the winner's curse phenomenon in M&As is hubris, defined as overweening pride and excessive optimism

23. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23 Agency Problems Agency problems arise when managers own only fraction of the ownership shares of the firm –Managers may work less (shirk) and/or overconsume perks –Individual shareholders have little incentive to monitor managers –Dealing with agency problems give rise to monitoring and controlling costs

24. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24 Solutions to agency problem –Organizational mechanisms –Compensation arrangements tied to performance –Market mechanisms Market for managers External monitoring through stock market Takeovers — external control device of last resort

25. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25 Managerialism –Mergers are a manifestation of agency problems –Managers are motivated to increase the size of their firms because their compensation is a function of firm size, sales, or total assets –Theory may not be valid if managers' compensation is based on profitability or value increases

26. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26 Free Cash Flow Hypothesis (FCFH) Jensen (1986, 1988) Free cash flows (FCF) are cash flows in excess of the amount needed to fund all positive net present value projects

27. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27 Payout of free cash flow to reduce agency costs –Reduces amount of resources under control of managers –Prevents managers from investing in negative NPV projects –Outside financing is subject to monitoring by capital markets

28. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28 Bonding mechanism –Forces managers to pay out future cash flows by debt creation without retention of the proceeds of the issue –Discipline to be efficient to meet debt obligations –Prevents unsound investments

29. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29 Theory prediction –Positive stock price reaction to unexpected increases in payouts –Increased tightness of constraints requiring the payout of future FCF will result in positive stock price reaction –Predictions do not apply for Firms that had more profitable projects than cash flows to fund them Growth firms If agency costs cannot be resolved perfectly, takeovers can help reduce them

30. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30 LBOs –Bonding effects of high debt ratios undertaken by LBOs cause increase in share price –Successful LBOs also involve a turnaround, an improvement in the firm's performance –Strong incentives provided by large ownership stakes of managers

31. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31 Redistribution Gains to target shareholders represent redistribution from other stakeholders –Tax gains — redistribution from the government or public at large –Market position — mergers may increase market power and redistribution from consumers –Redistribution from bondholders — account for only a small percentage of gains to shareholders –Redistribution from labor — Is it forced recontracting or is it recognition of changed industry conditions? –Pension fund reversions — not a major source of takeover gains

32. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32 Patterns of Restructuring in the Chemical Industry Change forces –Technological change –Globalization of markets –Favorable financial and economic environments

33. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33 Characteristics of the chemical industry –U.S. chemical industry accounts for 2% of U.S. GDP –Diverse and complex –Many distinctive segments; some overlap with oil and other energy industries, pharmaceutical and life science products –Two major types of firms "All-around" companies operate in many areas "Focused" firms operate in downstream specialized segments

34. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34 –Commoditization of products –"Keystone" industry — building blocks at every level of production in major industries –Economic trends Chemical shipments not keeping up with growth in economy Increase in service industries relative to major users of chemicals has caused a decline in growth of chemical shipments –Easy entry

35. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35 M&As in the chemical industry –Chemical and related industries occupy one of the top ranking areas in M&A activity –Include a wide range of adjustments and adaptations to changing technologies, changing markets, and changing competitive thrusts

36. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36 –Roles of M&As Strengthen existing product line by adding capabilities or extending geographic markets Add new product line Foreign acquisitions to obtain new capabilities or needed presence in local markets Obtain key scientists for development of particular R&D programs Reduce costs by eliminating duplicate activities and shrinking capacity to improve sales to capacity relationships Divest activities not performing well

37. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37 Harvest successful operations in advance of competitor programs to expand capacity and output Round out product lines Strengthen distribution systems Move firm into new growth areas Attain critical mass required for effective utilization of large investment outlays Create broader technology platforms Achieve vertical integration Revise and refresh strategic vision

38. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38 –Disadvantages of M&As Buyer may not have full information of acquired assets Implementation may be difficult –Considerable executive talent and time commitments –Different organization cultures –Wide use of joint ventures and strategic alliances Combine different expertise and capabilities of different companies Reduce size of investments and risks

39. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39 –Include changes in financial policies and effectiveness Considerable use of highly leveraged restructuring such as leveraged buyouts (LBOs) and management buyouts (MBOs) Share repurchases

40. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40 Concentration trends –US chemical industry HHI in 1980 was 178, declined to 148 in 1990 and to 102 in 1998 HHI is far below critical 1,000 specified in anti-trust guidelines HHI has declined while M&A activity has increased –Intense competition –New entrants –Reduced firm size inequalities –New firms as a result of divestitures –World chemical industry Significantly below critical 1,000 level HHI declining for the same reasons as in US market

41. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41 Measurement of Abnormal Returns Residual analysis — tests whether returns to common stock of individual firms or groups of firms is greater or less than that predicted by general market relationships between return and risk

42. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42 Calculation of residuals –Event period Identify event and its announcement day, t 0 Define event period from day T 1 to T 2 usually centered on announcement date

43. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 43 –Predicted (or normal) return,, for each day t and for each firm j Represents return that would be expected absent of event Estimated using "clean" period (C 1 to C 2 ) that does not include event period –Three methods Mean adjusted return –Predicted return is mean of daily returns for firm j during clean period

44. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 44 Market model –Predicted return for firm j in day t in event period –Estimates for  and  are obtained from a regression using returns during clean period –Takes explicit account of both risk associated with market and mean returns Market adjusted return –Predicted return is return on market index for that day –Approximate market model where  = 0 and  = 1 for all firms

45. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 45 Measures –Residual Actual return minus predicted return Represents abnormal return — part of return that was unexpected as a result of event –Average residual returns Average across N firms for each event day t Averaging across large number of firms mitigates noisy component of returns

46. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 46 –Cumulative average residuals (CAR) Cumulate average residual returns for successive days over event period Represents average total effect of event across all firms over event period

47. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 47 Absolute gains and losses –Absolute dollar gain or loss at time t due to abnormal return during event period CAR t = cumulative average residual returns (%) to date t for firm MKTVAL 0 = market value of firm at date m 0 previous to event window interval

48. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 48 Statistical significance of event returns –Test whether estimated cumulative average residuals, CAR, is significantly different from zero with a specified level of confidence Null hypothesis presumed true unless statistical tests establish the contrary Alternative hypothesis H 0 : CAR = 0 (event does not affect returns) H 1 : CAR  0 (event does affect returns)

49. ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 49 –Test statistic is ratio of value of cumulative average residuals, CAR, to its estimated sample standard deviation –If absolute value of t-stat ratio is greater than specified critical value, reject null hypothesis with some degree of confidence |t-stat | > 1.96, CAR is significantly different from zero at 5% level |t-stat | > 2.58, CAR is significantly different from zero at 1% level