Mergers and Acquisitions

Advanced Training Program in Finance Jun Qian Boston College July 7, 2007 1

Outline

Introduction Theoretical reasons for M&As Empirical evidence M&A mechanics Hostile takeovers Stock mergers 2

Mergers and Acquisitions

Mergers:  Friendly, with acquired firm’s executives stay in joined firm    Acquisitions: The bidder (raider) purchases the voting stock of the target, paying target shareholders (SHs) using cash, stock, or a combination Going private transactions: Leveraged buyout (LBOs) Typically completed through a tender offer – the bidder makes a public offer directly to the target SHs: hostile vs. friendly offers Other forms of M&As:   Spinoffs: One firm sells off a division to another firm or to mgmt.

Strategic alliances: Two firms agree to share resources etc.

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Types of Mergers and Acquisitions

Horizontal M&As:  Two firms competing in the same industry  Regulated by anti-trust (monopoly) laws Vertical M&As:  Firms at different stages in the production/sale (supplier and customer) Conglomerate M&As:  Product extension   Geographic market extension / cross-border Unrelated firms 4

Reasons for Mergers

Efficiency  Operating synergy    Financial synergy Market power Diversification Solution to the holdup problem Agency costs  Market for corporate control  Mergers due to agency costs Merger waves  Stock market driven M&As. 5

Operating Synergies

PV (A+B) > PV(A) + PV(B) Economies of scale  Cost savings due to increased size/scale of output Economies of scope   Average cost of producing different products together is lower than the cost when produced separately Cost savings due to overlap in R&D, marketing channels, other sharing of resources Strategic response to changing environment 6

Financial Synergies

Pecking order financing    Matching of cash-rich firms with firms that have investment opportunities Internal capital markets may have less frictions than markets  No informational costs, issuance costs, or regulatory approval But, inefficiencies of internal markets:  Conflict of interests between divisional managers (over-investment);  Allocation of investment capital is a bargaining process rather than “priced” by the markets Increased debt capacity and tax shields Implicit “too big to fail” guarantee  Reduced costs of financial distress costs 7

Diversification-driven M&As?

Diversification thru. merger may create value   Decrease cash flow variability; lower cost of capital Managers can take riskier projects and invest in human capital Diversification may destroy value   SHs can better diversify using capital markets; benefits of taking controlling positions are not available to small SHs Inefficiencies of internal markets and decreasing returns to organizational capitals; higher agency costs Empirical evidence on diversification M&As:    Diversification discount (Berger and Ofek, 1995): diversified firms trade at 15% less than pre-merger levels The above test does not take into account what would have happened to firms if they do not pursue diversifying mergers Redo previous test (by matching diversified and non-diversified firms): discount is much smaller and could be 0 8

Holdup Problem and M&As

Example: Auto company A and tire company B    Assume B is only supplier of tires to A (perhaps only one knows how to produce special tires for A’s new vehicles) Knowing this, B can “holdup” (like hostage) A, and demand that A pays high prices for new tires Expecting this to occur, A loses incentives in producing the new vehicles, so that B also loses Solution: A acquires B (Grossman and Hart, 1986)    Internalizes the supply and holdup problem (if tire division manager threatens to increase price, he will be fired) This is vertical integration: Optimal ownership and control of assets – allowing A, which makes the most use out of the control of tire company’s assets, to own B Similar logic behind horizontal integration 9

Agency Problems and M&As

Separation of ownership and control Managers prefer  Less effort; lower risk (ignores option grants); and shorter horizon Substitute low risk for high risk investments Retain excessive cash reserves   Keep leverage too low Keep dividends too low Perk consumption 10

Corporate Governance Solutions for Agency Problems

Large shareholders as monitors Use of debt Executive compensation Input and product markets competition Capital markets as monitors: markets for corporate control  Managerial teams compete for firms   M&As allow more efficient managers to replace less efficient ones The possibility of a takeover may discipline existing managers 11

Mergers Due to Agency Costs

Jensen’s free cash flow hypothesis   Managers are reluctant to pay out cash Engage in negative NPV merger transactions Roll’s hubris hypothesis  Managers are overly optimistic about the value of targets Empire building   If compensation (or private benefits) is tied to company size, managers have incentives to acquire other firms (even it destroys value); Evidence on cash bonus based on completion of deals (Grinstein and Hribar 2004) 12

History of Merger Waves

First wave (1897-1904) – horizontal mergers Second wave (1916-1929) – vertical mergers Third wave (1960s) – conglomerate mergers Fourth wave (1980s) – hostile takeovers, LBOs and MBOs Fifth wave (1992 - 2000) – stock-based friendly mergers:   Industry-wide consolidations after de-regulation Peak was reached during 2000 – $3.8 trillion, 35,000 announced deals 13

Merger Waves

M&As occur in waves and are clustered in industries Technology shocks and macro-factors Regulations  In the US: M&As must be cleared by Dept. of Justice (e.g., anti-trust laws) and the FTC; many states have anti-takeover laws (solution: Delaware)   Europe: workers have 50% board repres. in Germany and difficult to remove; in France govt. can impose costs on takeovers Japan: role of Keiretsu – firms combine with each other thru. reciprocal shareholdings and trading agreements Deregulation-driven M&A waves?

 Some of the deregulated industries:  Airlines (78), broadcasting (84 & 96), entertainment (84), banks and thrifts (94), utilities (92), and telecommunications (96) 14

Evidence: Announcement effects of M&As

Significant wealth gain for target SHs:  Price runup prior to announcement (-10 days);   Announcement day:   Tender offers: 20% to 30% abnormal return 1 st Stock mergers: Smaller positive effect Firms “similar” to target also get a boost day, Bidder SHs break even or suffer losses:  Depends on method of payment: cash vs. stock  Stock mergers:   Significant negative abnormal returns Show signs of over-valuation (earnings manipulations and insider selling prior to deal announcement) Net effect (bidder plus target) 15

Evidence: Long-run performance Performance of merged firms:

 Stock mergers: negative abnormal returns  Cash acquisitions: positive abnormal returns  Findings robust after correction of Fama French factor of beta, size, book-to-market  Market efficiency: Initial guess correct, but wrong magnitude 16

Merger Mechanics Preliminary actions Proxy fight Tender offer and defensive tactics Friendly (stock) mergers

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Preliminary Actions

Identifying potential targets Bidder may establish a toehold by open market (anonymous) purchase of target shares  Once a certain threshold has been passed, the intentions of the bidder have to be revealed Bear hug (quasi-friendly)  Bidder contacts the target board of directors and threatens with a tender offer if friendly deal is not agreed  Accompanied by public announcement of tender offer intent 18

Proxy Fight

An attempt by a group of SHs to take control through the use of voting by proxy mechanisms  The term “proxy” denotes the ability of a SH to delegate her voting rights to another SH, who can vote by proxy Goals of proxy fights:    Replace portions of the board (and management) Refuse proposed merger agreement To change charter or to approve a merger Frequency of proxy fights   Less frequent in economies with active takeover market (higher frequency of proxy contests in Germany than in the US and UK) Increasing institutional activism over the past decade => proxy fights much more common in the US 19

Proxy Fight (cont’d)

The proxy fight process:    The dissenting party or bidder campaign and solicit vote-proxies from dissatisfied target SHs Collect proxy votes File the proxy documents with the SEC  Call a special shareholder meeting: votes/proxies exercised Evaluation of effectiveness of proxy fight:  Advantage: no need to acquire/purchase equity;  Disadvantage: costly to contact SHs; incumbents tend to have credibility among small SHs;     Attitude and involvement of institutional SHs may be critical Proxy fights are often unsuccessful, but it may change But, they are a cheap alternative to a tender offer Used as a initial step before a tender offer (hostile takeover) 20

Tender Offer

Offer to purchase a pre-specified number of shares directly from target SHs  Method of payment: cash, stock, debentures, warrants, and combination Procedure and important factors:       Active and widespread solicitation of SHs Solicitation for substantial fraction of shares Offer at a premium to current stock price Contingent on tender of a fixed minimum number of shares Tender offer open for a limited period of time Finishing touch: regulatory procedure, cleanup price 21

Types of Tender Offers

Two-tiered (front-end loaded)     Front-end: tender offer price (shares tendered in the 1st step may receive a higher premium); Back-end, clean-up price: effectively a merger offer price (“fair” price/legal problem) Creates incentives for shareholders to tender first instead of wait; coercive but can solve the free-rider problem All partial offers are implicitly two-tiered offers All-or-nothing (conditional offer)  Bid is conditional on a minimum number of shares: usually 50% of all outstanding shares tendered or on success; or nothing Any-or-all (unconditional offer)  Bidder will buy all tendered shares Saturday night special 22

Free-rider Problem Among Target SHs

How to explain the following facts:   Initial bid premium on average 30% Announcement effect for raiders 0 or negative Free-rider problem (Grossman and Hart 1980)     Disperse equity ownership for target; each small SH thinks she is non-pivotal in determining outcome of tender offer To start, assume current target price is $50 per share; assume everyone knows a tender offer by the current raider will increase value to $100 per share What happens if raider bids $50? $75? $99? Smaller shareholders will reject/tend to wait as long as bid < $100 The raider must significantly bid over the current target price in order convince the SHs to tender  But this is very costly to the raider 23

Solutions to Free-rider Problem?

Punishing non-tendering shareholders:  Two-tiered offers Toehold acquisition by raiders:  Shares purchased before bidding for the target  Profitable strategy in takeovers? (Shleifer and Vishny 1986) Disclosure requirements on toeholds and takeovers:   5% threshold in the US and filing of 13d with SEC; More disclosure at the time of the tender offer (e.g, 14d, 14e filings) Evidence on toeholds:   Mean much smaller than 5%; many bidders do not acquire any toehold; Empirical “puzzle”: Goldman and Qian (2005) provide a solution 24

Defense Measures

Preventive defense measures:   Poison pills Corporate charter amendments (shark repellents)  Golden parachutes Reactive defense measures:   Greenmail, standstill, and reverse greenmail White knights     Scorched earth defense Litigation Pac-man defense: Acquiring the acquirer Just say no 25

Defense Measures: Poison Pills

Definition and characteristics:    Represents the creation of special rights to receive extra payments, similar to call options/warrants, issued to (some or all) existing common SHs; to the exclusion and detriment of potential raiders Triggered after takeover-related events: e.g., a bidder acquires 10% of shares; Warrants are exercisable at the triggering of another event (e.g. bidder acquires 100% of the shares) Examples and terminologies:   Share rights plans: current SHs receive right to buy stocks at fixed price, with a “flip over” provision  In the event of M&A, the holders can exercise and receive stock of the merged firm worth twice of the exercise price Other terms: Flip-in – rights to purchase target securities; Back-end plans – exchange stock for cash or senior securities; Poison puts – right to sell bonds 26

Poison Pills (cont’d)

History of poison pills :     Invented in 1982 by Martin Lipton, an M&A attorney First generation: dividend of preferred shares convertible into acquirer’s shares Second generation: flip-over pill (fails to provide protection) Third generation: flip-in pill Example: Conrail’s poison pill   Flip-in pill: Right to buy an additional share at half price when a hostile bidders acquires 10% of Conrail’s shares Background: Conrail – 90.5 million shares at $71; total MV $6,426 million; hostile Bidder buys 10% of shares for a total of $643 million 27

Poison Pills: example (cont’d)

Before poison pill kicks in: Group # Shares % of total Friendly shareholders Hostile bidder Total Per Share 81.45

9.05

90.50

90.0

10.0

100.0

After poison pill becomes effective: Group Friendly shareholders Hostile bidder Total Per Share # Shares

162.90

9.05

171.95

% of total 94.7

5.3

100.0 Value $5,783 $643 $6,426

$71.00

Value $8,827

$490

$9,317

$54.18

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Poison Pills (cont’d)

Conrail’s poison pill:      Purchase triggers poison pill: Conrail issues 81.45 million shares at $35.50 a share, receives $2,891 million Total MV is $9,317, total number of shares is now 171.95 million; share price drops to $54.18

Bidder’s block drops to 5.3% of shares Bidder’s equity value drops from $643 million to $490 million A transfer or $153 million to existing shareholders plus additional voting rights Overall empirical evidence:   Early 1980s – value reducing; Mid- and late-1980s – less negative to value increasing 29

Defense Measures: Charter Amendments

Staggered board of directors  Only a percentage of directors can be replaced on a single annual meeting (e.g. in Conrail 1/3 of directors a year) Supermajority provisions  A merger has to be approved by substantially more than 50% of votes (e.g. 2/3, 80%) Fair price provisions  Acquiring company has to pay minority shares a fair price (precludes two-tiered offers) Dual-class share recapitalization  Issuance of two classes of shares with different voting rights (e.g., Google) 30

Defense measures (cont’d)

Golden parachutes:   Generous lump-sum compensation to target managers in case they are replaced after a takeover Anti-takeover defense: Reduces cash of target; but, makes managers less likely to defend a hostile bid Greenmail and standstill:     “Bribing” bidder to stop tender offer Target repurchase of the shares of a potential bidder at a premium (greenmail payment); extraction of private benefits of control at the expense of small shareholders Reverse greenmail: target repurchase some SHs’ shares at premium, while excluding the potential bidder (financing a dividend out of bidder’s pocket) Standstill: the target pays cash to the bidder to “stand still” ( bidder agrees not to buy more shares for a period of time); 31

Defense measures (cont’d)

White knight:  Target solicit another bidder after receiving a hostile bid;  The white knight is friendly to target managers, and usually overpays (bad for white knight SHs)  White esquire – a large shareholder that is friendly to managers Scorched earth defense:  Make target less attractive: increase leverage, use money to pay dividends; scorched earth – sell off the best assets (crown jewels)  Change distribution of voting rights: issue more shares to friendly shareholders (dilutes bidders voting rights), repurchase shares 32

Effects for Defense Measures

Actions taken by managers: retain control (entrenchment); increase offer price “Mild” resistance causes restructuring of bid; “severe” resistance deters bid Reduce probability of takeover bids; but increase premium given a takeover bid/success Allow managers and large shareholders to expropriate small shareholders (private benefits of control) Empirical evidence is mixed 33

Top 10 M&As up to 1995

Year Acquirer Target 1989 Kohlberg, Kravis & Roberts 1995 Walt Disney Co.

1995 Glaxo PLC 1990 Time Inc.

1988 Philip Morris Inc 1984 Standard Oil Inc 1989 Squibb Co.

1984 Texaco Inc 1995 Lockheed Corp 1995 Chemical Bank RJR Nabisco Capital Cities/ABC Wellcome PLC Warner Comm.

Kraft Inc Gulf Inc Bristol-Myers Co.

Getty Oil Co Martin Marietta Corp Chase Manhattan Bank Value $billion 25.1

19.0

15.0

14.1

13.4

13.4

12.1

10.1

10.0

10.0

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Year 1999 1999 1999 1999 1999 1999 1999 1999 1998 1998 1998 1998 1998 1998

More Recent Mergers

Buying Company Selling Company MCI WorldCom Viacom AT&T Travelers Exxon TotalFina (France) Olivetti (Italy) Vodafone (UK) Telecom Italia (Italy) Air Touc Comm.

British Petroleum (UK) Amoco Corp.

Daimler-Benz (Germany)Chrysler Zeneca (UK) Nationsbank Corp.

Astra (Sweden) BankAmerica Corp.

WorldCom Inc.

Norwest Corp.

Sprint CBS MediaOne Group Citicorp Mobil Elf Aquitaine (France) MCI Communications Wells Fargo & Co.

Payment ($bil) 115 35 54 83 80 55 58 61 48 38 35 62 42 34 35

Stock Market Driven M&As

Shleifer & Vishny (2003):  Markets inefficient, managers take advantage through M&As When do we expect to see cash offers?

   Undervalued acquirers tend to use cash to acquire targets; they will earn positive long-run returns after acquisitions; Wave can occur if market- or industry-wide valuations are low; Targets earn low returns prior to acquisitions; high, short-run returns after M&A but long run return can be flat What about stock mergers?

   Acquirers are likely to be (relatively more) over-valued; Wave occurs when market- or industry-wide valuations are high; Long-run returns to acquirers after M&As tend to be negative, but M&As still serve the interests of long-term acquirer shareholders 36

Agency Problems of Overvalued Equity

Jensen (2004):  Shock (tech sector) in the market increases equity value in 1990s; Firms’ managers realize that their equity is over-valued:    Correction? Yes, otherwise investors and market will have (overly optimistic) expectations that cannot be fulfilled by firms; But, no one wants to be the “party pooper” More importantly, managers’ compensation tied to stock pricesHow to correct (lower) expectations on your own equity value?

Series of (stock-based) acquisitions:   If market does not “get the message,” large scale acquisition, or, (After all other means fail) accounting frauds Overall lessons:   Important for mgmt./board to correct over-valuation of equity early ; Otherwise they may engage in activities that will destroy value.

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Insider Trading around M&As: A ll Acquirers (86-00) (from Song 2005) All Acquirers Purchase Sale 300,000 250,000 200,000 150,000 100,000 50,000 0 -6 -5 -4 -3 -2 -1 Month 1 2 3 4 5 6 38

Insider Trading by “Pure Seller” Acquirers around M&As Pure Seller Group Purchase Sale 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0 -6 -5 -4 -3 -2 Month -1 1 2 3 4 5 6 39

Insider Trading by “Pure Buyer” Acquirers around M&As Pure Buyer Group Purchase Sale 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 -6 -5 -4 -3 -2 Month -1 1 2 3 4 5 6 40

Summary and Concluding Remarks

Good M&As, and bad M&As Empirical evidence: announcement effect and long-run performance Tender offers: techniques, free-rider problem and solutions, defense measures Stock mergers: (over-) valuations; risk and uncertainty; method of payment; due diligence 41