Mergers and Acquisitions

WHY MERGERS AND ACQUISITIONS?

The different types of mergers and acquisitions. Mergers and acquisitions (often referred to as M&A) help a firm implement a strategy of diversification or vertical integration. In other words, while vertical integration and diversifications are corporate-level strategy options, M&A (along with strategic alliances and internal development) is a vehicle or mode of entry. The M&A activity is the means by which a firm can achieve its growth strategy. WHAT ARE MERGERS AND ACQUISITIONS? The business press uses the terms mergers and acquisitions interchangeably, they are not the same. Acquisition is the purchase of a firm. The purchase does not have to be 100 percent ownership. It could be a majority ownership (greater than 51 percent of the acquired firms stock) or a controlling interest (enough stock ownership to control management and strategic decisions at the acquired firm). Acquisitions can be friendly acquisitions or unfriendly acquisitions. In a friendly acquisition, the management of the acquired firm wants the firm to be acquired. In an unfriendly acquisition (also called hostile takeovers), the management of the target firm does not want the firm to be acquired. Example: Berkshire Hathaway Warren Buffett, the CEO of Berkshire Hathaway, writes very readable and folksy letters to shareholders in his companys annual reports. In the companys annual report for 1995, Buffett recalls how the company acquired Helzbergs Diamond Shops, a Kansas City, Missouri-based jewelry chain. As Buffett was walking down the street in New Yorks Fifth Avenue one day, a woman hailed him by name and proceeded to tell him how she was grateful for having invested her money in Berkshire Hathaway. Upon hearing Warren Buffetts name, another gentleman who was walking by stopped to ask Buffett if he could have a few words with him. The man was Barnett Helzberg Jr. Helzberg wanted Berkshire Hathaway to buy his family firm as he, Barnett Helzberg Jr., was tired of running it and wanted a different parent for the firm. The details of the deal were ironed out during that serendipitous meeting and shortly thereafter Berkshire Hathaway announced this friendly acquisition. bids. The business press is replete with examples of unfriendly acquisitions and acquisition In 2004, cable provider, Comcast, made a bid for Disney, only for Disneys

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management to scuttle the attempt. Oracle has been engaged in an unfriendly bid for PeopleSoft for more than a year. Typically, though not always so, acquisitions are made by larger firms in their quest to buy smaller firms. In contrast, a merger occurs when the assets of two similar-sized firms are combined. In addition, mergers are not typically unfriendly. James Kilts, the CEO of Gillette invited A.G. Lafley, the CEO of Procter and Gamble to merge the two companies. The merged firms may retain the name of one firm (the Gillette business was absorbed by Procter and Gamble and Gillette ceased to exist as an independent entity) or may create a new name (the merger of Newell and Rubbermaid resulted in a new firm called NewellRubbermaid).

Important Point: While a merger may start out as a transaction between equals, it may happen that in the course of time, one firm dominates the other. Thus, the management team at Newell controls the affairs of NewellRubbermaid. A.G. Lafley continues to be the CEO of Procter and Gamble that now includes Gillette. The point is that a merger may end up looking like an acquisition in terms of which firm has control.

THE VALUE OF MERGERS AND ACQUISITIONS

M&A activity presents an interesting question. M&A activity is a common occurrence in the corporate world and the dollar values involved in these transactions amount to trillions. Yet, it is not clear that M&A activity actually generates value for firms implementing these strategies. The instructor has to make this point clear: an M&A strategy makes sense for a firm if the transaction creates value for the firm, whether it be the acquiring firm or the acquired firm. Not all M&As create value. On the other hand, loss of value can be in the billions as the example of the TimeWarner and AOL merger indicates! It is important to direct the class discussion to an examination of the value creation potential of M&A activity. Mergers and Acquisitions: The Unrelated Case Estimate the return to the stockholders of bidding and target firms when there is no strategic relatedness between firms. If a an acquiring firm makes a bid to buy the shares of an unrelated target firm there would be no expectation of value creation because there would be no economies of scope to be exploited. A rational bidding firm would never pay more than the market price for a target if there were no expected economies of scope to be exploited. Therefore, there would be only normal economic returns to the bidder and the acquirer in such a case. About the only expectation of value creation would come from an internal capital market efficiency. Another possibility is that value could be created through the reversal of unrelated diversification. For example, if someone recognizes that the businesses comprising a corporation would actually be worth more if they were under different ownership (a conglomeration discount) then an acquisition of that firm followed by a break up of the businesses could create value. However, for the most part, unrelated M&A activity is unlikely to create value for the bidding firm or for the target firm.

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there are some examples in which value appears to have been created. Berkshire Hathaway is one such example. Unrelated companies are purchased and then managed with a strict philosophy and ample financial controls. This appears to be a matter of spreading a core competency (Berkshire Hathaways management style) across different businesses. Therefore, in a sense there can be economies of scope even in unrelated M&A activity. Be sure to point out that this is a rare exception to the rule. Mergers and Acquisitions: The Related Case

Important Point: Although unrelated M&A activity will usually not create value,

Types of Strategic Relatedness

The different sources of relatedness between bidding and target firms. M&A activity usually involves bidding and target firms that may be strategically related in a wide variety of ways. Since strategic relatedness is an important and often difficult to grasp issue, it is necessary to look at what relatedness is. Three approaches to defining relatedness are: The FTC categories Michael Lubatkins list Jensen and Rubacks list The Federal Trade Commission (FTC) gets involved in M&A activity because these transactions can affect the level of concentration in an industry that may have implications for competition among the players. Example: The Herfindahl Index The Herfindahl index is a measure of the size of firms in relationship to the industry. Thus, it measures the amount of competition among them. It uses a mathematical formula and reports results from 0 to 10,000. A score of 0 means that the industry has a large number of very small firms (highly fragmented) while a score of 10,000 implies a single monopolistic producer. The FTC uses this index (among other factors) to either approve or reject an M&A transaction. A vertical merger involves a vertical integration move by the bidding company, either backwards in the industry value chain (e.g., a manufacturer buying a supplier) or forwards (e.g., a manufacturer buying a distributor). When Time Warner (a content creator) merged with AOL (a content distributor), it was a vertical (forward) merger. When a firm acquires a former competitor, it engages in a horizontal merger. Johnson & Johnsons proposed acquisition of Guidant is an example of a horizontal merger since both firms produce medical devices. Horizontal mergers come under FTCs scrutiny because such mergers have immense competitive implications. The possibility of antitrust concerns (in other words, the possibility of the acquisition having an adverse impact on customers) may mean that either the acquisition will be disallowed by the FTC, or, as in the

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J&J-Guidant deal, the FTC may insist on J&J divesting some of Guidants activities after the acquisition. In a product extension merger, firms acquire complementary products through the M&A activity. An example would be Unilevers acquisition of Ben & Jerrys Ice Creams. The motivation to access new geographic markets drives firms toward market extension mergers. Cadbury-Schweppes acquisition of 7UP allowed the U.K.-based company to enter the U.S. beverage market. A conglomerate merger is between strategically unrelated firms. In reality, the FTC considers this to be a residual (or catch-all) category, in that, a merger that does not fall within the definition of the four categories above would be classified in this category. Conglomerates were very popular in the 1950s and 1960s (parodied in Mel Brooks Silent Movie, where a conglomerate Engulf + Devour is the subject of much humor!). Since they generally create zero economic value, there are not very many examples of such mergers today. Professor Michael Lubatkin sought to probe deeper into the issue of relatedness in his classification of M&A activity. In his categorization firms may be related on technical economies (in marketing, production, etc. as the example of Procter and Gamble and Gillette indicates), on pecuniary economics (market power, for example, the proposed Oracle-PeopleSoft merger), or on diversification economies (in portfolio management and risk reduction, like Berkshire Hathaway). Jensen and Rubacks sources of strategic relatedness are listed in Table 10.3. These fall into four major categories: reducing production or distribution costs financial motivations gaining market power in product markets eliminating inefficient target management To reiterate: the links between the companies must build on real economies of scope it must be less costly for the merged firm to realize these economies of scope than for outside equity holders to realize on their own Economic Profits in Related Acquisitions Estimate the return to the stockholders of bidding and target firms when there is strategic relatedness between firms. The economic value of a related M&A can be captured by the simple equation 2+2 = 5. In other words, in such M&A activity, the economic value of the two firms combined (i.e., 5) is greater than the economic value of the two firms separately (i.e. 2 and 2). Estimating the returns to the stockholders of the bidding firm is simply a matter of estimating the amount of the value that will be created by the M&A activity minus whatever amount the bidding firm has to pay the target firm. Of course, the amount the bidding firm has to pay for the target is a function of the value other firms recognize in the target firm.

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The winning bid price will likely rise to the point where the winning bidder will realize only normal economic profits. The returns to the stockholders of the target firm depend on the bidding process as well. If the bidding takes the price of the target firm above its current market price, then there will be an above normal return for the target firm. Notice that this has the effect of ensuring that stockholders of the target firm capture the expected value of the M&A activity if there is a bidding process. At this point in the discussion, it is best to stay focused on the logic of value creation, namely the exploitation of economies. Since these concepts have been covered earlier in the course, you probably dont need to spend too much time on this logic. Why Are There So Many Mergers and Acquisitions? The five reasons why bidding firms might still engage in acquisitions, even if on average they do not create value for a bidding firms stockholders. The first motivation to engage in an M&A may be to ensure survival. If all the major competitors are becoming bigger through these transactions, then a firm may engage in an acquisition to ensure competitive parity. This is a defensive reason as the book example of consolidation in the banking industry indicates. Profits left for a firm after investing in all current positive net present value opportunities is the firms free cash flow. As indicated earlier, these can amount to millions or even billions of dollars. For example, Microsoft is reported to have had a free cash flow of $45 billion in 2004! Dominant firms in mature businesses often find themselves in such situations. For firms with free cash flow the obvious decision should be to give it back to stockholders in the form of dividend payments or stock buybacks. Either the firm may choose not to do this or stockholders (because of high marginal tax rates) may prefer the firm invest the money on its own. In such situations, firms may engage in M&A activity because such transactions may at least create competitive parity. In other words, this motivation is akin to saying that there are worse things we could do with the extra money and we are choosing the lesser of all evils. Managers may be motivated to engage in M&As even when such transactions do not benefit the principals the agency problem. These motivations may stem from reducing the risk of the firm going bankrupt (and they losing their jobs) or from increasing their compensation because they are now managing a bigger organization in other words, empire building. It is important to underscore at this point in the discussion that agency issues come to the forefront every time a firm announces an M&A! The dictionary defines hubris as overbearing pride or presumption; arrogance. In the context of M&A activity, this means that managers may engage in an M&A even when evidence is clear on the fact that there is zero economic value for bidding firms. The argument made by managers here is that they can do better in managing the target firm (and thereby produce more profits) than can the current managers of the target firm. Going against the conventional wisdom may be because of overconfidence in their own abilities. The final motivation for M&A activity is the fact that while M&A activity, on average, creates zero economic profits for bidding firms, they dont always do so. The

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notion of average means some M&A activity creates negative economic value while others create positive economic value. The fact that some firms create positive economic value in M&A activity may spur some firms to pursue such transactions.

MERGERS AND ACQUISITIONS AND SUSTAINED COMPETITIVE ADVANTAGE

Three ways that bidding firms might be able to generate high returns for their equity holders through implementing mergers or acquisitions. In the last part of the previous section, one of the motives mentioned for M&A activity was that, while on an average M&A activity does not yield economic profits to bidding firms, the implication was that some bidding firms gain from these transactions. This provides a good segue to this section. The discussion in this section is on imperfectly competitive markets. The market for corporate control (also known as the takeover market) is the market that is created when multiple firms actively seek to acquire one or several firms. Only when the market for corporate control is imperfectly competitive would it be possible for bidding firms to earn above normal returns from M&A activity. The question is: when is the market for corporate control imperfect? Three situations result in an imperfect market for corporate control: when valuable, rare, and private economies of scope exist when valuable, rare, and costly-to-imitate economies of scope exist when unexpected valuable economies of scope between bidding and target firms exist. Valuable, Rare, and Private Economies of Scope When a target is worth more to one bidder than it is to other bidders and this information is not known to the other firms (bidders and targets), an imperfect market for corporate control exists. In such a setting, even when the bidder pays the prevailing price for the target, it stands to gain. When would this happen? The special additional value accruing to the bidding firm (and to it alone) may be from economies of scope stemming from unusual resources and capabilities possessed by the bidding firm. In other words, such capabilities are not just valuable but they are also rare in short, they are private economies of scope not available to other bidders. However, the value of a private economy depends on that economy remaining private. If other bidders or the target become aware of the economy the above normal value of the economy may quickly dissipate. It may be the case that if other bidders knew of the economy they could easily imitate the economy, in which case it would make sense for them to raise the bidding price accordingly. Valuable, Rare, and Costly-to-Imitate Economies of Scope In the previous case, the successful bidding firm had a rare capability that allowed it to create additional economic value in combination with the target firm because that economy remained private. The market was held to be imperfect because one bidding firm knew something other bidding firms did not know (causal ambiguity). It may also be possible that

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an economy exists between two firms that is costly-to-imitate. For example, a firm may have a location advantage that other firms could not imitate without incurring excessive costs. Much of the grain that is grown in the Northwest is shipped down the Columbia River to Portland, Oregon for export to Pacific Rim countries. Several barge companies provide the shipping down the river. A grain export company (Firm A) that owns a grain loading facility on the water in Portland would have an economy with a barge company (Firm C) that would not exist for an export firm without its own grain loading facility. If the export company with its own grain loading facilities decides to acquire a barge company, other potential bidders (Firm B) will be at a distinct disadvantage. Suppose the barge company (Firm C) has a market value of $1.5 million and that because of the economy of the grain loading facility the barge company is worth $2.0 million to the grain export company possessing these facilities (Firm A). Other bidders (Firm B) for the barge company would not be willing to bid above $1.5 million. Thus, Firm A, the grain export company with the loading facilities, would be able to buy Firm C, the barge company, for $1.5 million and realize an above normal return of $0.5 million. This benefit would accrue to the grain export company (Firm A) regardless of whether this information is public or private. Unexpected Valuable Economies of Scope Between Bidding and Target Firms In the previous two scenarios, the successful bidding firm approached the M&A knowing that it had either a private economy or a costly-to-imitate economy that allowed it to create value in combination with the target firm. While this is possible, in reality the M&A process is typically complex involving numerous unknown and complicated relationships between firms. In such cases, serendipity may place a key role. Since such unexpected events occur after the transaction is complete, the price may not reflect such benefits yielding a windfall to the successful bidder. The example of WPPs acquisition of J. Walter Thompson in the advertising industry cited in the textbook is a good one to use to bring home this point. Needless to say, managers cannot anticipate and prepare for such benefits they just happen after the transaction is completed. Implications for Bidding Firm Managers It is important for the managers of bidding firms to search for rare economies of scope. A good understanding of their own resources and capabilities is the starting point. Managers should then look for synergies between their firms resources and capabilities and those of the target firm. Such an investigation is likely to rule out obvious benefits such as reductions in corporate overhead by combining two firms because they are available to all bidding firms. The second rule for bidding firm managers is to keep information about the bidding process and about the sources of economies of scope as private as possible. While this may be possible when the target firm is privately owned, SEC disclosure requirements may preclude a bidding firm from keeping things private. On the other hand, a firm does not have to reveal complete details about the economies of scope possibilities between the two firms. It is also important to keep proprietary information away from targets, lest the targets pass on this information to other bidders to raise the bid price. To prevent the target firm from holding out for a higher price, the true value of this transaction to the bidding

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firm should be kept private. This advice comes with a caveat, though. For an M&A to be successful and create value, the two firms must be integrated to exploit the economies. Keeping things hidden from the target firm may make it difficult for the bidding firm to successfully integrate the two firms. The key is to strike the right balance between disclosing information for competitive advantage and facilitating integration of the two companies. Economists have a term winners curse -- to refer to the situation when the winner scores a Pyrrhic victory (a victory that comes at a cost so high that the victory loses its value). An example: suppose a number of publishing houses bid for the rights to publish a potential bestselling book. The competitive bidding process raises the bid price and the winner gets the bid at an enormous price. This high price takes away all the possible profits from the book. In the M&A context, managers of bidding firms should not get into a bidding war so that the price of the target reduces the profit to the bidder. Note that firms possessing rare and costly-to-imitate economies do not face such bidding wars because competing bidders will not rationally bid above the market value of the target. A rule of thumb for managers of bidding firms is to close the deal quickly. When the process is quickly done, there is less possibility for information leakage and dissipation of value. Many firms often make pre-emptive bids. Such bids are at a significant premium over the target firms prevailing market price and the target firm is likely to accept such a sweetheart deal. The key, though, is not to hurry the due diligence process. M&A decisions must be carefully made and firms should take their time in the preparatory work. However, once the target is identified, the firm should move quickly to consummate the deal. A thinly traded market is one where only a small number of buyers and sellers exist, and where information about opportunities in this market is not widely known. The industry is likely to be fragmented or it may be out of the radar screen of stock analysts. For bidding firms, target firms in thinly traded markets are attractive because they can capitalize on information asymmetries. A highly public M&A (such as the Oracle-PeopleSoft transaction which, at times, seem to take on a soap operatic tone) leads to a competitive market where bidding firms are not likely to gain. However, in thinly traded markets, there may be greater opportunities because of a lack of publicity. Example: Quest Diagnostics Quest Diagnostics started its corporate life by being a division of Corning, Inc. The division made over 70 acquisitions of small, locally-owned medical laboratories to become the leading player in the industry. It was spun off as a separate company in 1996 and continued the strategy of acquiring small local players. Most of these small targets were traded in thinly traded markets, allowing Quest to buy them at attractive prices. Today, Quest is the largest player in the $35 billion medical testing market. Strategic Rollups: Overhauling the multi-merger machine, Strategy + Business, Second Quarter 2000.

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Implications for Target Firm Managers So far the discussion has focused on what managers of bidding firms can do to maximize the value creating potential of M&A activity for their firms. It is important for the instructor to reiterate that target firms are not passive onlookers in this whole process. They can take proactive steps to maximize the value to their stockholders. They can do this in a variety of ways and typically, theses moves mirror those of the bidding firms, except in the opposite way. Bidding firm managers were implored to keep information away from target firms for fear of dissipation of value. The argument is that target firms are likely to hold out for more if they know the true value of their firm to the bidder. Managers of target firms can increase the value of the transaction to their stockholders if they seek additional information from bidding firms. They should keep themselves informed of their value to bidding firms. Creating a competitive market for the transaction helps the target get greater value for their firm. Inviting more firms to bid for them helps create this competitive market. Finally, delaying the transaction helps the target firm. Just as the bidding firm is motivated to quicken the process so that information leakage is at a minimum, target firms stand to benefit when the process is delayed. However, target firms should not stop the acquisition as this would result in their equity holders not getting the value.

Important Point: Target firms have a number of ways to delay or prevent an M&A. These are discussed in detail in the Research Made Relevant box. This is often an interesting topic to discuss in class because it has a lot of cloak-and-dagger type of symbolism attached. Besides, students are likely to be intrigued by terms such as greenmail, poison pills, and the Pac Man defense. This is also a good time to discuss the ethical implications of such practices.

ORGANIZING TO IMPLEMENT A MERGER OR ACQUISITION

The major challenges that firms integrating acquisitions are likely to face.

Important Point: Acquiring firms have latitude as to how much the target should be integrated into the existing firm. The target firm could be left to operate fairly autonomously or it could be integrated completely and lose all former identity.
There are specific issues associated with implementing an M&A, though. These issues center on one thing: the bidding firm and the target firm have led a separate existence up till this point. They have had separate histories, separate management philosophies, and separate strategies. The challenge is to integrate these very disparate entities. Tangible or codifiable differences like: different production systems different technologies

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different human resource policies, etc. can usually be integrated with consistent effort. However, the more difficult integration issue is typically the different cultures of the two firms. These different cultures are marked by intangible elements such as risk propensity, communication style, etc. They are usually much more difficult to integrate than the tangible elements. The problem is likely to be compounded when the acquisition is unfriendly and there is a distinct victor vanquished mentality. As a case in point, when Quaker Oats acquired Snapple, a number of cultural problems arose. Quaker Oats was a large company and was quite formal in the way it operated. In contrast, Snapple was a small company that thrived on its folksy image. Quaker Oats found it very difficult to integrate the two cultures, leading to the eventual failure of this transaction. Some acquirers regard implementation problems as an additional cost of the transaction. The cost of integration is sometimes factored in to the bid price of the acquisition to the extent that the acquiring firm is aware of the cost.

MERGERS AND ACQUISITIONS IN AN INTERNATIONAL CONTEXT

Unique challenges to merger and acquisition strategies in an international context. Cross border M&A activity is quite common. For example, Unilever (a Dutch company) acquired the U.S.-based Ben & Jerrys. Ford Motor Company acquired the U.K.-based Jaguar. In general, issues related to domestic M&A activity (both the acquisition process and the implementation process) are relevant in an international context as well. The implications for acquirers and the implications for targets apply in the international context just as they do in the domestic context. Host governments may present additional challenges and opportunities in the international context. Managers of firms that enter foreign countries through their M&A strategies need to be aware of these issues. Governments tend to protect their national interests when dealing with foreign-owned firms. For example, in the United States an airline cannot have more than 25% foreign ownership. Governments may have currency laws that prevent a foreign-owned firm from taking money out of the country. Labor laws may be different from those in a firms domestic market. Such differences may be rooted in culture and tradition that may prove to be difficult to recognize and/or understand. Managers would do well understand what the differences in government involvement are as they enter foreign markets. The major issue in cross-border M&A activity is that the cultural differences between the firms are likely to be exacerbated by deep-seated country cultural differences. In other words, when firms A and B are in the U.S., they are likely to have some cultural differences, but all the participants share a common culture outside the respective firms. The cultures within the two firms, although different, are based on this common national culture. On the other hand, if a firm acquires another firm in a foreign country, the cultural differences could be even wider because of differences in the underlying national cultures. Geert Hofstedes cultural dimensions are likely to be familiar to students who have had a Principles of Management class or an International Management class. Hofstede identified 5 dimensions upon which cultures differ:

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social orientation (individualism vs. collectivism) power orientation (power respect vs. power tolerance) uncertainty orientation (uncertainty acceptance vs. uncertainty avoidance) goal orientation (aggressive goal behavior vs. passive goal behavior) time orientation (long-term outlook vs. short-term outlook) For example, compensation practices are impacted by the countrys social orientation. Titles and organizational chart may mean more in a power respect culture than in a power tolerance culture. Firms engaged in international M&As must recognize that there is an added degree of difficulty involved in such transactions that make the whole process more challenging. A Chinese shipping company has established an office in the western U.S. This office was initially staffed with Chinese managers and U.S. employees. When the Chinese managers were ready to promote a U.S. employee, they would give the U.S. employee the additional job responsibilities that accompanied the promotion without giving the employee the additional pay that went with the promotion. This was difficult for the U.S. employees to accept because in the U.S. culture the pay for a promotion is usually received at the same time the additional responsibilities are received. This example highlights a difference in the time orientation between the Chinese and U.S. cultures. The U.S. employees had a short term time orientation compared to the Chinese managers who wanted to see if the U.S. employee could handle the additional responsibilities before bestowing the higher pay on the U.S. employees.

SUMMARY OF ISSUES IN MERGERS AND ACQUISITIONS

On a regular basis they read about these transactions and some may have worked in an organization that was involved in M&A activity. One of the most important things for students to understand is that M&A activity is part of a firms corporate level strategy. As such, M&A activity should generate value for the firm that stems from economies that shareholders could not get by simply diversifying their individual portfolios. The popularity of M&A activity runs contrary to the research on the value created by these transactions. The essence of the research findings is that stockholders of target firms gain while those of bidding firms do not. However, the popularity of M&A activity is not so perplexing when the long term results of the strategy are considered. Remind students that the outstanding long term results of Wells Fargo were the result of Wells Fargo pursuing an M&A strategy with attention to detail and spreading its core competencies to its targets. Another key takeaway from this chapter should be the importance of post-merger integration. The long-term success of an M&A strategy depends heavily on a firms ability to recognize the challenges of integration and respond with the appropriate structure, controls, and compensation policies. Although M&A activity is popular, perhaps even glamorous in the business world, at the end of the day the ability of an M&A strategy to generate competitive advantage and above normal returns comes down to the basic logic of the VRIO model. If the economies being exploited are valuable, rare, costly-to-imitate, and the firm is organized to exploit the economies, then competitive advantage is likely. An M&A strategy can create significant

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long term value for a firm. In fact, some firms with aggressive growth goals must rely on M&A activity to achieve that growth. Such firms cannot afford to fail at M&A activity.