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Mergers, Acquisitions, and Corporate Control

Mergers, Acquisitions, and Corporate Control

Chapter 24Chapter 24

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24.1: Corporate Control Defined24.1: 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 (LBOs and MBOs)– Divestiture – transfer of ownership of a business unit– Spinoff – Creation of a new corporation

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Methods of AcquisitionsMethods of Acquisitions

Negotiated Mergers

– Contact is initiated by the potential acquirer or by target firm.

– If all parties agree to the terms of the deal, a merger agreement is announced.

Open Market Purchases

– Buy enough shares on the open market to obtain controlling interest without engaging in a tender offer

– Possibly the first step in a “bear hug”

Proxy Fights

– Acquiring corporate control through consignment of other shareholders voting rights

– Proxy for directors: attempt to change management through the votes of other shareholders

– Proxy for proposal: attempt to gain voting control over corporate control or anti takeover proposals or golden parachutes

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Methods of Acquisitions (Continued)Methods of Acquisitions (Continued)

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. Subsequent alternatives:

1. Tender offer for controlling interest and then effect merger

2. Bear hug: approach target with both proposal for merger and threat of proxy fight or hostile tender offer

3. Threaten with tender offer or proxy fight to gain greater access to board of directors or sell shares to target firm at a premium

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Mergers by Mode of IntegrationMergers by Mode of Integration

• 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.

• Going Private Transactions: LBOs (public shares of a firm are bought and taken private through the use of debt) and MBOs (an LBO initiated by the firm’s management)

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Mergers by Business ConcentrationMergers 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

Vertical: between former buyer and seller– Forward or backward integration– Creates an integrated product chain

Conglomerate: between unrelated firms– Creates a “portfolio” of businesses– Product extension mergers vs. pure conglomerate mergers– Popular in the 60’s as the idea of portfolio diversification was

applied to corporations

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Transaction Characteristics Used to Categorize Corporate Control Events:Transaction Characteristics Used to

Categorize Corporate Control Events:

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– Mixed Offerings: a combination of cash and securities

Attitude of target management to a takeover attempt– Friendly Deals vs. Hostile Transactions

Accounting treatment used for recording a merger– Prior to June 30, 2001, two methods: the pooling-of-interest

and purchase method– With the implementation of FASB Statements 141 and 142,

one standard method of accounting for mergers

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Merger and Intangible Assets AccountingMerger and Intangible Assets Accounting

Target firm has 3.2 million shares at $25 per share.– Acquirer pays a 20% premium ($30 per share) to expand in the

geographic area where target firm operates.– Transaction value 3.2 million shares x $30/share = $96,000,000.– Net asset value of target company is $72,000,000.

Current Assets $22,000,000

Restated fixed assets $120,000,000less liabilities $70,000,000

Net Asset Value $72,000,000

Acquirer pays $24,000,000 for intangible assets.

Purchase price paid $96,000,000less Net asset value $72,000,000

Goodwill $24,000,000

Goodwill will remain on the balance sheet as long as the firm can demonstrate that is fairly valued.

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Resource DisintegrationResource Disintegration

Mergers versus divestitures and spin-off:

– Divestiture: Resources of a subsidiary or division are sold to another organization.

– Spin-off and split-off: A new company is created from a division or subsidiary.

Other forms of resource disintegration:– Equity carve-outs: sale of partial interest in a subsidiary

– Split-up: sale of all subsidiaries. Company ceases to exist.

– Bust-up: takeover of a company that is subsequently split-up

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Anti-takeover MeasuresAnti-takeover Measures

• Competing hypotheses to explain anti-takeover measures:– Stockholder interest hypothesis vs. Managerial entrenchment

hypothesis– Stockholder interest hypothesis: Anti-takeover measures

enhance shareholder wealth.– Managerial entrenchment hypothesis: Managers adopt takeover

measures to protect themselves.

• Pre-emptive versus active measures

• Courts usually uphold the legality of anti-takeover measures– Exception: If the measures serves to completely obstruct the

merger, they are deemed illegal.

Active Anti-takeover MeasuresActive Anti-takeover Measures

Measure Anti-takeover Effect

Fair Price Amendments • Preset metric, such as P/E ratio, used to determine the “fair price” of the company in case of takeover

Golden Parachutes • Lucrative termination arrangements for executives in the event of takeover

• Supports managerial entrenchment hypothesisGreenmail • Repurchase at a premium of shares held by

potential hostile bidder

• Declined in popularity after TRA86 imposed a 25% surtax on greenmail payments

Just Say No Defense • No consideration offered is sufficient to give up control

Pac-Man Defense • Initiation of a takeover attempt for the hostile acquirer itself

Recapitalization • Change in capital structure designed to make the target less attractive

Active Anti-takeover Measures (Continued)Active Anti-takeover Measures (Continued)

Measure Anti-takeover Effect

Staggered Term For The Board

• Corporate charter amendments that makes the replacement of board of directors difficult

Standstill Agreements

• Substantial shareholders agree through negotiated contracts to not involve in any takeover attempts.

Supermajority Approvals

• Corporate amendments that require a large majority (67% or 80%) of votes to approve a takeover

White Knight Defense

• Friendly companies bid for a takeover against a hostile acquirer.

• Losses in shareholder wealth due to overbiddingWhite Squire Defense

• Friendly companies acquire a substantial block of shares, but not of controlling interest.

• Can lead to white knight situation with leg-up options which allow the white squire purchase of additional shares at a favorable price

Pre-emptive Anti-takeover MeasuresPre-emptive Anti-takeover Measures

Measure Anti-takeover Effect:Poison Pills

• Flip-overs: Firm issues call options that allow owners to buy the stock at a low price upon a complete takeover of the target.

• Flip-ins –Rights can be exercised in case of partial acquisitions as well.

• Higher takeover premiums (69% higher) for successful takeovers

• Unless a takeover attempt is successful, poison pills decrease shareholders wealth.

Poison Puts

• Bonds with put options that can be redeemed with a high premium over face value in case of a takeover

• Such bonds can seriously decrease the cash position of the target if a hostile transaction is initiated.

Shark Repellents

• Amendments to the corporate charter that make hostile takeover more difficult to accomplish

• Require shareholder approval, as opposed to poison pills/puts

• May be restrained by state laws

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Motives for Mergers and AcquisitionsMotives for Mergers and Acquisitions

Value-enhancing motives:

– Increasing operating profits

– Gains from restructuring inefficiently run companies

– Creating greater barriers to entry in the industry

Non-value maximizing motives and outcomes:

– Agency problems between managers and shareholders

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Value Maximizing StrategiesValue Maximizing Strategies

Geographic (internal and international) expansion in markets with little competition may increase shareholders’ wealth.– Greenfield (“brick-and-mortar”) entry vs. external expansion– M & A is better alternative for time-critical expansion.– If greenfield expansion risks are considerable, external

expansion is more viable.– 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– Eisner on the Disney and Cap Cities/ABC merger: “1+1=4”– Operational, managerial and financial merger-related synergies

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Operational SynergiesOperational 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

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Managerial Synergies and Market PowerManagerial Synergies and Market Power

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

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

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Financial SynergiesFinancial Synergies

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 costTax-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: Lewellen (1971) and Levy and Sarnatt (1970).

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Non-Value-Maximizing MotivesNon-Value-Maximizing Motives

Agency problems: Management’s (disguised) personal interests are often driver of mergers and acquisitions.– Managerialism theory of mergers, Dennis Mueller (1969):

Managerial compensation is often tied to corporation size.– Free cash flow theory of mergers, Michael Jensen (1986):

Managers invest in projects with negative NPV to build corporate empires.

– Similar theory, managerial entrenchment theory, Shleifer and Vishny (1989): The motive of management is to make themselves indispensable to the firm.

– Hubris hypothesis of corporate takeovers, Richard Roll (1986): Management of acquirer may overestimate their capabilities and overpay for target company in belief they can run it more efficiently.

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History of Merger WavesHistory 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

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History of Merger Waves (Continued)History of Merger Waves (Continued)

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

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Fifth Merger WaveFifth Merger Wave

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.

Merger activity: unprecedented transaction value for both US and non-US mergers– In 2000, aggregate merger value hit $3.4 trillion: $1.8 trillion in

US and $1.6 trillion outside US.– Declined in 2001 to $1.7 trillion and only $1.2 trillion in 2002

Major US Antitrust LegislationMajor US Antitrust Legislation

Legislation (Year) Purpose of LegislationSherman Antitrust Act

(1890)

• Prohibited actions in restraint of trade, attempts to monopolize an industry

• Violators subject to triple damage

•Vaguely worded and difficult to implementClayton 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 mergersHart-Scott-Rodino Act

(1976)• FTC and DOJ can rule on the permissibility of a merger prior to consummation.

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Determination of Anti-competitivenessDetermination 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)

Elasticity tests (“5 percent rule”)is an alternative measure used to determine if merged firm has the power to control prices.

1000 1800 HHI Level

Not Concentrated Moderately Concentrated Highly Concentrated

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The Williams ActThe Williams Act

Enacted in 1968 for fuller disclosure and tender offers regulation– Section 13-d must be filed within 10 days of acquiring 5% of

shares of publicly traded companies.– Raises the issue of “parking” shares

Section 14 regulates tender offer process for both acquirer and target– 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.

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Insider TradingInsider Trading

Regulation for prevention and handling of cases of trading using inside information:– 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, 1984awards triple damages.

– Section 16 of Securities and Exchange Act• Section 16-a requires insiders to report any transaction in

shares of their affiliated corporations.• Section 16-b: “the short swing” rule

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State Antitrust LawsState Antitrust Laws

Regulation of corporate control events at state level– Developing from the genesis of the state of California’s antitrust

governance– Ruled constitutional by the US Supreme Court in 1988

Include anti-takeover and anti-bust up provisions– Supermajority voting: large majorities (usually 67%) to approve

takeovers– 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.

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Empirical Findings in Corporate Control Events

Empirical Findings in Corporate Control Events

Consensus of merger studies: Shareholders of target firm experience significant wealth gains in case of merger.– Jensen and Ruback survey: average 29.1% premiums for

tender offers and 15.9% for mergers

Acquirer returns: On average, positive returns result for tender offers and zero returns for successful mergers.– Negative trend in acquirer returns over time vs. positive trend

for target returns: attributed to adoption of Williams Act– Higher returns for acquirers when larger target firms relative to

acquirer size – Tobin’s

– Acquisition targets have lower q ratios than non-target firms.

assetsof value tnemecalper

assets firm's ofue valmarket q

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Empirical Findings in Corporate Control Events (Continued)

Empirical Findings in Corporate Control Events (Continued)

Mode of Payment: Shareholders gain higher returns in cash transactions than in stock transactions.– Signaling model: Cheapest source of capital is used to finance

mergers. Equity offers signal that acquirer’s stock is overvalued.– Tax hypothesis: Target shareholders require capital gains tax

premium for cash transactions.– Pre-emptive bidding hypothesis: Premium for cash offers

required to deter other potential bidders.

Returns to other stakeholders– Significant wealth gains result for holders of convertible and

nonconvertible bonds.– Layoffs account for 10-20% of hostile takeovers premiums.– Aggregate tax savings, capital expenditure and R&D reductions

are negligible (Shleifer and Vishny, 1997).