B40.2302 Class #11

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

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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

Making Sure Managers Maximize NPV

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 12.3



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Topics Covered

The agency problem Evidence of its significance Solutions:

Incentives Other mechanisms (some not in book)


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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)


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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?


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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


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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


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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 TaylorThe Principles of Scientific Management (New York: Harper, 1929)


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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…


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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 …


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[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


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[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


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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”


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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


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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!


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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?


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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


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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


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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

Mergers


Slides by


Chapter 33



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Topics Covered

Sensible Motives for Mergers Some Dubious Reasons for Mergers Estimating Merger Gains and Costs Takeovers: Unsolicited/hostile mergers


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1997 and 1998 Mergers

Selling Company Acquiring Company Payment, billions of dollars

NYNEX Bell Atlantic 21.0McDonnell Douglas Boeing 13.4Digital Equipment Compaq Computer 9.1Schweizerischer Union Bank of Swiz. 23.0Energy Group PCC Texas Utilities 11.0Amoco Corp. British Petroleum 48.2Sun America American Intl. 18.0BankAmerica Corp. Nationsbank Corp. 61.6Chrysler Daimler-Benz 38.3Bankers Trust Corp. Deutsche Bank AG 9.7Netscape America Online 4.2Citicorp Travelers Group Inc. 83.0


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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


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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 costsReduces costs


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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


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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


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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


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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)


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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


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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.


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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


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Dubious Reasons for MergersIncreasing 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.


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Dubious Reasons for MergersLowers 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


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Estimating Merger Gains

There is an economic gain to the merger only if the two firms are worth more together than apart

Gain = PVAB– (PVA+PVB) = PVAB


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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 - PVB

Usually shares of B are bought at a “premium,” so this cost is positive


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Merger Decision

So merger is a positive-NPV to A if:NPV = Gain – Cost = PVAB-(cash-PVB)>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


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Merger DecisionExample PVA=$200m, PVB=$50m Merging A and B allows cost savings of $25m So Gain = PVAB– (PVA+PVB) = PVAB = $25m

Suppose B is bought for cash for $65m a $15m (30%) premium, not unusual

So Cost = cash paid - PVB = 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


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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 PAB , then:

Cost = N * PAB - PVB

… to illustrate, return to previous example …


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Merger DecisionExample PVA=$200m, PVB=$50m, suppose A has 1m shares outsdg. Gain is still = PVAB– (PVA+PVB) = PVAB = $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


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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


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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!


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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

Control, Governance, and Financial Architecture


Slides by


Chapter 34



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Topics Covered

Leveraged Buyouts Spin-offs and Restructuring Conglomerates


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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


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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


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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?


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Leveraged Buyouts

Acquirer Target Year Price ($bil)

KKR RJR Nabisco 1989 24.72$ KKR Beatrice 1986 6.25$ KKR Safeway 1986 4.24$ Thompson Co. Southland 1987 4.00$ AV Holdings Borg-Warner 1987 3.76$ Wing Holdings NWA, Inc. 1989 3.69$ KKR Owens-Illinois 1987 3.69$ TF Investments Hospital Corp of America 1989 3.69$ FH Acquisitions For Howard Corp. 1988 3.59$ Macy Acquisition Corp. RH Macy & Co 1986 3.50$ Bain Capital Sealy Corp. 1997 0.81$ Citicorp Venture Capital Neenah Corp. 1997 0.25$ Cyprus Group (w/mgmt) WESCO Distribution Inc. 1998 1.10$ Clayton, Dublier & Rice North Maerican Van Lines 1998 0.20$ Clayton, Dublier & Rice (w/mgmt) Dynatech Corp. 1998 0.76$ KKR. (w.mgmt) Halley Performance Products 1998 0.20$

10 Largest LBOs in 1980s and 1997/98 examples


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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.


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Conglomerates

Sales Rank Company Numebr of Industries

8 ITT 3815 Tenneco 2842 Gulf & Western Industries 4151 Litton Industries 1966 LTV 1873 Illinois Central Industries 26

103 Textron 16104 Greyhound 19128 Marin Marietta 14131 Dart Industries 18132 U.S. Industries 24143 Northwest Industries 18173 Walter Kidde 22180 Ogden Industries 13188 Colt Industries 9

The largest US conglomerates in 1979


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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


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15 years from nowYou 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”


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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

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