Lecture 11

TODAY Mergers and Acquisitions

Required Reading:
Chapter 30 Other references: Takeover, Restructuring and Corporate Governance, by Weston, Siu, and Johnson, Prentice Hall 2001.
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Mergers and Acquisitions

1. 2. 3. 4. 5. 6. 7. 8. Background: The Basic Forms of Acquisitions Theories of M&A Accounting for Acquisitions Determining the Synergy from an Acquisition Calculating the Value of the Firm after an Acquisition The NPV of a Merger Defensive Tactics Some Evidence on Acquisitions

Mergers and Acquisitions

Merger, Acquisition , Buyout, Spin-off activity is a prominent feature of the market for corporate control in the US and the UK. Until recently this activity has not been such as pronounced in most other parts of the world, and in particular hostile bids are rare outside the US and UK. Recently there has been an increasing level of international mergers eg between motor manufacturers, drugs companies, telecommunications companies and food manufacturers. Also there has been an increase in consortium arrangements for manufacture of high value capital goods.
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Types of combination
1.Vertical Integration A combination between businesses at different levels of production - eg manufacturer taking over a distributor. (eg TSB and Hill Samuel) 2. Horizontal Integration A combination of businesses at the same level of production - eg a merger between two manufacturing or two financial firms. (eg Guinness and Distillers) 3. Conglomerate mergers/takeovers Mergers motivated by risk pooling. For example, tobacco companies taking over frozen food or financial firms.
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Merger Waves
UK immediately after 1st WW late 1920s late 1960s, and early 1970s just after mid-1980s late 1990s

US
turn of 19th - 20th century

late 1920s
late 1960s 1980s late 1990s

Merger Waves

1895 to 1904 (horizontal mergers):

High concentration in many industries Period of economic expansion It followed:
1. the completion of the transcontinental railroad system. 2. The advent of electricity 3. Major increase in the use of coal

1 resulted in the development of national economic markets, thus the merger activity represented to a certain extent the transformation of regional firms into national firms
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Merger Waves
1922-1929 (Vertical Mergers)
Public utilities and banking industries were among the most active 60% (food processing, chemicals, and mining sectors) Product extension mergers (e.g. IBM, General Foods, Consumers became more mobile (new transportation system- the use of motor vehicles) Development of advertising and brand recognition

Merger Waves
1960s (Conglomerate mergers)
Booming economy The merger activity peaked during 19671969 Most acquirers were small to medium-sized Diversification strategy into other business activities Acquired firms were also small to mediumsized
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Merger wave of the mideighties

Globalization of markets Strong economy Rising stock market Junk bonds Hostile takeovers Deregulation Antitrust policy more accommodating
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Merger wave of the mideighties

Firms became aware of a focus on core business ... Ill run firms were taken over by aggressive corporate raiders, financing take-overs using junk bonds and they stripped the assets that generated no shareholder wealth

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Merger wave of the mideighties

Firms tended to be self supporting (in-sourcing) Probably because
ill-developed infrastructure ill-developed contracting mechanisms, or weak/corrupt enforcement system and ignorance about the correct way of doing business

Focus was on increasing ROI, but not on increasing value RESULT (Managers ran firms inefficiently)

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Merger wave of the mideighties

But around the mid eighties things started changing Some smart guys discovered that a focus on core business was a smarter way of doing business (must have read and understood Modigliani and Miller) They engaged in aggressive hostile takeovers Paying high take-over premiums Financed using junk bonds
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Merger wave of the mideighties

Firms were stripped from their unproductive assets Ill performing management was sent home Firms started focusing on core business, they started engaging in outsourcing
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The Current WAVE 1992 to ?? Strategic

Major forces

Mergers

Technology Globalization Deregulation The economic environment The method of payment Share repurchases, and Stock options

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M&As pace-around the end of the 20th Century

Global M&As activities between Jan 87 and Dec 99.

Exceeded USD 11,000 Billion. USD 2,700 bil 1998. USD 3,400 bil. 1999.
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M&As pace-around the end of the 20th Century

15% 33% Europe USA Other 52%

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M&As pace-around the end of the 20th Century

5% 21% 42% 1% 5% 26%

F in a n c ia l M a n u fa c tu rin g N a tu ra l R e s o u rc e s O th e r S e rvic e s Tra d e

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M&As Theories
Motivations for M&A
Value-Maximisation motives:
Extract product market rents (market power) Efficiency Increases Operating Synergy

Non-value maximisation motives

Agency Problems Free Cash flow Hypothesis Winners curse and Hubris.

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Accounting for M&A

Pooling versus Purchase Purchase Method
Assets of the target firm are re-valued to their fair value. Both the re-valued assets and the purchased goodwill should be amortised For US firms, amortisation should be done in less than 40 years Consequence: unfavourable ratios: lower profits, higher asset values
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Accounting for M&A

Pooling of interest method
Firms basically merge balance sheets No goodwill, no revaluation of assets Less than 10% settlement by cash (ie a share exchange is the norm). Usually involves the creation of a new holding company. In the UK, accounting standards FRS6 & FRS7 limit the use of the merger method. In the US Pooling Method is no longer allowed starting the beginning of 2001.

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Determining the Synergy from an Acquisition

For a takeover to be viable, it should provide benefits to the ordinary shareholders of both companies. Consider the takeover case: A + B = AB

Equity Valuations: VeA VeB VeAB Maximum price A will pay = VeAB -VeA Minimum price B will accept = VeB For a takeover to be feasible, it is necessary that: Max Price > Min Price This implies that: VeAB > VeA + VeB

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Determining the Synergy from an Acquisition

Define S as the total value of synergy effects to the shareholders.

S = VeAB - VeA

+ VeB Synergy therefore is the incremental value created from the merger, i.e the incremental cash flow generated every year.

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Calculating the Value of the Firm after an Acquisition

Avoiding Mistakes
Do not Ignore Market Values Estimate only Incremental Cash Flows: Tax gains, Operating efficiencies, strategic fit etc. Use the Correct Discount Rate Dont Forget Transactions Costs, and/or restructuring charges

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The NPV of a Merger: Gains to each set of shareholders

Gains to each set of shareholders:
Suppose that the agreed settlement price is X. GA is the gain to As shareholders and GB is the gain to Bs.
NPV of merger to acquirer = Synergy Premium

Premium = X - VB Therefore NPV to acquirer or GA = VeAB - VeA - X AND GB = X - VeB

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Are mergers profitable?

If there are gains from mergers, how big are they? how are they divided between acquiror and acquiree? how far in advance does market anticipate mergers? what is implication for pricing of acquisitions? do acquiring companies make abnormal gains from pre-merger purchases of shares? can investors devise profitable trading rules?

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What would we expect?

some mergers profitable (some of above reasons valid); gains go to party in stronger position; eg for merger gains arising from offsetting tax losses, then gain goes to tax loss firms when shortage of latter; market efficiency suggests no abnormal returns from merger related trading strategies by firms or individual investors.

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The evidence
Most commonly used technique (cumulative abnormal residual) involves measuring return on shares of acquiree and of acquiror and adjusting for market movements. This is done by assuming returns for share i (over given period) satisfy Ri = ai + biRM + i (the market model) where ai, bi constant over time for i; use past data to obtain best estimates for ai, bi.

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The evidence
Author period sample size % gains to acquiree 30% 36.9% 29.1% 15.9% 14% % gains to acquiror 7% -3% 3.8% 1.4% 3.0%
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Franks, Harris (UK) Firth (UK) Jensen, Ruback(US) Jensen, Ruback(US) Mandelker (US)

1955-85 1973-74 1956-81 1962-79 1948-67

1800 190 653 457 241

The evidence
ACCOUNTING STUDIES
Rare evidence of improved profitability, except Cosh, Hughes and Singh (1980), Healy, Palepu and Ruback (1992), Cornnet and Tehranian (1992)

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