3. Special Topics I Mergers and Acquisitions

Mergers and acquisitions are part of what is often referred to as “the market for corpo- rate control.” When one firm acquires another, there is typically a buyer, the acquirer or bidder, and a seller, the target firm. There are two primary mechanisms by which ownership and control of a public corporation can change: Either another corporation or group of individuals can acquire the target firm, or the target firm can merge with another firm. In both cases, the acquiring entity must purchase the stock or existing assets of the target either for cash or for something of equivalent value (such as shares in the acquiring or newly merged corporation). For simplicity, we refer to either mechanism as a takeover.

While we tend to talk about merger waves and mergers in general, the term “merger,” as commonly used, encompasses several types of transactions that vary by the relation between the target and the acquirer and by the method of payment used in the transaction.

If the target and acquirer are in the same industry, the merger is typically called a horizontal merger,

whereas if the target’s industry buys or sells to the acquirer’s industry, it is called a vertical merger.

Finally, if the target and acquirer operate in unrelated industries, the deal is a conglomerate merger. Conglomerate mergers, while popular in the 1960s, have generally fallen out of favour with shareholders because of the difficulty in creating value when combining two unrelated businesses.

Deals also vary based on whether the target shareholders receive stock or cash as payment for target shares. When they receive stock, the deal is often called a stock swap, because target shareholders are swapping their old stock for new stock in either the acquirer or the newly created merged firm. The consideration paid to target shareholders can be very complex, including debt instruments, options, and mixes of any of these with cash and/ or stock. Commonly, however, target shareholders receive stock, cash, or a mix of the two.

While news reports understandably focus on the price and method of payment, the structure of a merger transaction, summarized in a term sheet, can be simple or incredibly complex. The items to negotiate include, among other things, who will run the new company, the size and composition of the new board, the location of the headquarters, and even the name of the new company.

The percentage difference between the acquisition price and the premerger price of the target firm

Such synergies usually fall into two categories: cost reductions and revenue enhancements. Cost-reduction synergies are more common and easier to achieve because they generally translate into layoffs of overlapping employees and elimination of redundant resources. If the merger will create possibilities to expand into new markets or gain more customers, then the merger partners will predict synergies that enhance their revenue.

1. Economies of Scale & Scope

2. Vertical Integration

3. Expertise

4. Monopoly Gains

5. Efficiency Gains

6. Tax savings from operating losses

7. Diversification

8. Earnings Growth

9. Managerial Motives to merge

A large company can enjoy economies of scale, or savings from producing goods in high volume, that are not available to a small company. negotiate superior manufacturing contracts. Larger firms can also benefit from economies of scope, which are savings that come from combining the marketing and distribution of different types of related products

There may also be costs associated with size, small firms are often able to react in a timely way to changes in the economic environment.

Vertical integration refers to the merger of two companies in the same industry that make products required at different stages of the production cycle. A company might conclude that it can enhance its product if it has direct control of the inputs required to make the product. Similarly, another company might not be happy with how its products are being distributed, so it might decide to take control of its distribution channels.

The principal benefit of vertical integration is coordination. By putting two companies under central control, management can ensure that both companies work toward a common goal.

Hiring experienced workers with the appropriate talent might be difficult with an unfamiliar, new technology. A more efficient solution may be to purchase the talent as an already functioning unit by acquiring an existing firm. Such mergers are common in high-tech industries.

It is often argued that merging with or acquiring a major rival enables a firm to substantially reduce competition within the industry and thereby increase profits. Society as a whole bears the cost of monopoly strategies, so most countries have antitrust laws that limit such activity

Another justification acquirers cite for paying a premium for a target is efficiency gains, which are often achieved through an elimination of duplication—for example, as in the SBC/AT&T merger mentioned earlier. Acquirers also often argue that they can run the target organization more efficiently than existing management could.

Once the benefits of the new management team become obvious to investors, the discount for the old management will likely disappear and the acquirer can resell its shares for a profit.5

When a firm makes a profit, it must pay taxes on the profit. However, when it incurs a loss, the government does not rebate taxes. Thus, it might appear that a conglomerate has a tax advantage over a single-product firm simply because losses in one division can be offset by profits in another division

The benefits of diversification are frequently cited as a reason for a conglomerate merger. The justification for these benefits comes in three forms: direct risk reduction, lower cost of debt or increased debt capacity, and liquidity enhancement. We discuss each in turn.

Risk Reduction. Like a large portfolio, large firms bear less idiosyncratic risk, so often mergers are justified on the basis that the combined firm is less risky. The problem with this argument is that it ignores the fact that investors can achieve the benefits of diversification themselves by purchasing shares in the two separate firms. Because most stockholders will already be holding a well-diversified portfolio, they get no further benefit from the firm diversifying through acquisition. Moreover, as we have already pointed out, there are costs associated with merging and with running a large diversified firm. Because it may be harder to measure performance accurately in a conglomerate, agency costs may increase and re- sources may be inefficiently allocated across divisions.6 As a result, it is cheaper for inves- tors to diversify their own portfolios than to have the corporation do it through acquisition.

Debt Capacity and Borrowing Costs. All else being equal, larger, more diversified firms have a lower probability of bankruptcy given the same degree of leverage. Consequently, such firms can increase leverage further and enjoy greater tax savings without incurring significant costs of financial distress. Thus, increased tax benefits and reduction in bankruptcy costs from leverage are potential benefits of diversifying mergers. Of course, to justify a merger, these gains must be large enough to offset any disadvantages of running a larger, less-focused firm.

Asset Allocation. A diversified conglomerate may benefit by being able to quickly reallocate assets across industries. For example, the firm may redeploy managerial talent to where it is most needed to exploit emerging opportunities. It may also reallocate capital from less productive divisions to those with a higher return on investment, without having to engage in costly external fundraising. On the other hand, agency costs may lead to the opposite result: profitable divisions may subsidize money-losing ones for longer than is optimal.

Liquidity. Shareholders of private companies are often under-diversified: They have a disproportionate share of their wealth invested in the private company. Consequently, when an acquirer buys a private target, it provides the target’s owners with a way to reduce their risk exposure by cashing out their investment in the private target and reinvesting in a diversified portfolio. This liquidity that the bidder provides to the owners of a private firm can be valuable and often is an important incentive for the target shareholders to agree to the takeover.

It is possible to combine two companies with the result that the earnings per share of the merged company exceed the premerger earnings per share of either company, even when the merger itself creates no economic value.

By acquiring a company with low growth potential (and thus a low P/E multiple), a company with high growth potential (and high P/E multiple) can raise its earnings per share. In the past, people have cited this increase as a reason to merge. Of course, a savvy investor will see that the merger adds no economic value. All that has happened is that the high-growth company, by combining with a low-growth company, has lowered its overall growth rate. As a result, its P/E multiple should fall, which results from its earnings per share rising. Thus, we can draw no conclusion regarding whether a merger was beneficial solely by looking at its impact on the acquirer’s earnings.

Conflicts of Interest. Managers may prefer to run a larger company due to the additional pay and prestige it brings. Because most CEOs hold only a small fraction of their firm’s stock, they may not bear enough of the cost of an otherwise bad merger that increases their personal benefits. Boards typically increase the pay of CEOs along with the size of the firm, even if the size comes at the expense of poorly performing acquisitions.

Overconfidence. Overconfident CEOs pursue mergers that have low chance of creating value because they truly believe that their ability to manage is great enough to succeed. The critical distinction between this hypothesis and the incentive conflict discussed above is that overconfident managers believe they are doing the right thing for their shareholders, but irrationally over-estimate their own abilities. Under the incentive conflict explanation, managers know they are destroying shareholder value, but personally gain from doing so.

The takeover is a positive-NPV project only if the premium it pays does not exceed the synergies created. Although the premium that is offered is a concrete number, the synergies are not—investors might well be sceptical of the acquirer’s estimate of their magnitude.

Once the acquirer has completed the valuation process, it is in the position to make a tender offer—that is, a public announcement of its intention to purchase a large block of shares for a specified price. A bidder can use either of two methods to pay for a target: cash or stock. In a cash transaction, the bidder simply pays for the target, including any premium, in cash. In a stock-swap transaction, the bidder pays for the target by issuing new stock and giving it to the target shareholders. The “price” offered is determined by the exchange ratio—the number of bidder shares received in exchange for each target share—multiplied by the market price of the acquirer’s stock.

A stock-swap merger is a positive-NPV investment for the acquiring shareholders if the share price of the merged firm (the acquirer’s share price after the takeover) exceeds the premerger price of the acquiring firm.

For example, if the value of synergies equals 20% of the value of the target, you would be willing to pay an exchange ratio 20% higher than the current price ratio

Because of this uncertainty about whether a takeover will succeed, the market price generally does not rise by the amount of the premium when the takeover is announced.

This uncertainty creates an opportunity for investors to speculate on the outcome of the deal. Traders known as risk arbitrageurs, who believe that they can predict the outcome of a deal, take positions based on their beliefs. While the strategies these traders use are sometimes referred to as arbitrage, they are actually quite risky, so they do not represent a true arbitrage opportunity in the sense we have defined in this book.

The potential profit described above arises from the difference between the target’s stock price and the implied offer price, and is referred to as the merger-arbitrage spread. However, it is not a true arbitrage opportunity because there is a risk that the deal will not go through. If the takeover did not ultimately succeed, the risk arbitrageur would eventually have to unwind his position at whatever market prices prevailed. In most cases, these prices would have moved against hum, so he would face losses on the position.

Any cash received in full or partial exchange for shares triggers an immediate tax liability for target shareholders. They will have to pay a capital gains tax on the difference between the price paid for their shares in the takeover and the price they paid when they first bought the shares. If the acquirer pays for the take-over entirely by exchanging bidder stock for target stock, then the tax liability is deferred until the target shareholders actually sell their new shares of bidder stock.

If the acquirer purchases the target assets directly (rather than the target stock), then it can step up the book value of the target’s assets to the purchase price. This higher depreciable basis reduces future taxes through larger depreciation charges. Further, any goodwill created could also be amortized for tax purposes over 15 years. The same treatment applies to a forward cash-out merger, where the target is merged into the acquirer and target share-holders receive cash in exchange for their shares.

While the method of payment (cash or stock) affects how the value of the target’s assets is recorded for tax purposes, it does not affect the combined firm’s financial statements for financial reporting. The combined firm must mark up the value assigned to the target’s assets on the financial statements by allocating the purchase price to target assets according to their fair market value. If the purchase price exceeds the fair market value of the target’s identifiable assets, then the remainder is recorded as goodwill and is examined annually by the firm’s accountants to determine whether its value has decreased

For a merger to proceed, both the target and the acquiring board of directors must approve the deal and put the question to a vote of the shareholders of the target (and, in some cases, the shareholders of the acquiring firm as well).

In a friendly takeover, the target board of directors supports the merger, negotiates with potential acquirers, and agrees on a price that is ultimately put to a shareholder vote. Although it is rare for acquiring boards to oppose a merger, target boards sometimes do not support the deal even when the acquirer offers a large premium. In a hostile takeover, the board of directors (together with upper-level management) fights the takeover attempt. To succeed, the acquirer must garner enough shares to take control of the target and replace the board of directors. When a takeover is hostile, the acquirer is often called a raider.

If the shareholders of a target company receive a premium over the current market value of their shares, why would a board of directors ever oppose a takeover? There are a number of reasons. The board might legitimately believe that the offer price is too low. In this case, a suitor that is willing to pay more might be found or the original bidder might be convinced to raise its offer. Alternatively, if the offer is a stock-swap, target management

may oppose the offer because they feel the acquirer’s shares are over-valued, and therefore that the value of the offer is actually less than the stand-alone value of the target. Finally, managers (and the board) might oppose a takeover because of their own self-interests, especially if the primary motivation for the takeover is efficiency gains. In this case, the ac- quirer most likely plans to undertake a complete change of leadership of the corporation. Upper-level managers could view opposing the merger as a way of protecting their jobs (and the jobs of their employees). In fact, this concern is perhaps the single biggest reason for the negative associations that hostile takeovers generate. Bear in mind that if substantial efficiency gains are indeed possible, current management is not doing an effective job. A takeover, or threat thereof, might be the only recourse investors have to fix the problem.

In theory, the duty of the target board of directors is to choose the course of action that is in the best interests of the target shareholders. In practice, the courts have given target directors wide latitude under what is called the “business judgment rule” to determine the best course for their companies, including spurning a premium offer if the directors can rea- sonably argue that more value will eventually be realized for their shareholders by remaining independent. The premise of this rule is that absent evidence of misconduct or self-dealing, the court will not substitute its judgment for that of the elected, informed directors.

1. Poision Pills

2. Staggered Boards

3. White Knights

4. Golden Parachutes

5. Recapitalization

6. Other Defensive Strategies

7. Regulatory Approval

A poison pill is a rights offering that gives existing target shareholders the right to buy shares in the target at a deeply discounted price once certain conditions are met. The acquirer is specifically excluded from this right. Because target shareholders can purchase shares at less than the market price, the rights offering dilutes the value of any shares held by the acquirer. This dilution makes the takeover so expensive for the acquiring shareholders that they choose to pass on the deal.

Because the original poison pill goes into effect only in the event of a complete takeover (that is, a purchase of 100% of the outstanding shares), one way to circumvent it is to not do a complete takeover. by adopting a poison pill, a company effectively entrenches its management by making it much more difficult for shareholders to replace bad managers, thereby po- tentially destroying value. Financial research has verified this effect. A firm’s stock price typically drops when it adopts a poison pill. Furthermore, once adopted, firms with poison pills have below-average financial performance.16

Not surprisingly, companies adopting poison pills are harder to take over, and when a takeover occurs, the premium that existing shareholders receive for their stock is higher. Therefore, because a poison pill increases the cost of a takeover, all else being equal, a target company must be in worse shape (there must be a greater opportunity for profit) to justify the expense of waging a takeover battle.

Poison pills also increase the bargaining power of the target firm when negotiating with the acquirer because they make it difficult to complete the takeover without the coopera- tion of the target board. If used effectively, this bargaining power can allow target share- holders to capture more of the takeover gains by negotiating a higher premium than they would get if no pill existed. Numerous studies on the impact of anti-takeover provisions on takeovers have found that such provisions result in higher premiums accruing to exist- ing shareholders of the target company.17

Get its own slate of directors elected to the target board, which it can submit at the next annual shareholders meeting. If the target shareholders elect those candidates, then the new directors can cancel the poison pill and accept the bidder’s offer. To prevent such a coup from hap- pening, about two-thirds of public companies have a staggered (or classified) board. In a typical staggered board, every director serves a three-year term and the terms are stag- gered so that only one-third of the directors are up for election each year. Thus, even if the bidder’s candidates win board seats, it will control only a minority of the target board. A bidder’s candidate would have to win a proxy fight two years in a row before the bidder had a majority presence on the target board.

When a hostile takeover appears to be inevitable, a target company will sometimes look for another, friendlier company to acquire it. This company that comes charging to the target’s rescue is known as a white knight. The white knight will make a more lucrative offer for the target than the hostile bidder. Incumbent managers of the target maintain control by reaching an agreement with the white knight to retain their positions.

One variant on the white knight defense is the white squire defense. In this case, a large investor or firm agrees to purchase a substantial block of shares in the target with special voting rights. This action prevents a hostile raider from acquiring control of the target. The idea is that the white squire itself will not choose to exercise its control rights.

A golden parachute is an extremely lucrative severance package that is guaranteed to a firm’s senior managers in the event that the firm is taken over and the managers are let go.

An adoption of a golden parachute actually creates value. If a golden parachute exists, management will be more likely to be recep- tive to a takeover.

This means the existence of golden parachutes lessens the likelihood of managerial entrenchment. Researchers have found that stock prices rise on average when companies announce that they plan to implement a golden parachute policy, and that the number of firms bidding against one another for the target and the size of the takeover premium are higher if a golden parachute agreement exists.

Another defense against a takeover is a recapitalization, in which a company changes its capital structure to make itself less attractive as a target. For example, a company with a lot of cash might choose to pay out a large dividend. Companies without a lot of cash might instead choose to issue debt and then use the proceeds to pay a dividend or repurchase stock.

Why does increasing leverage make a firm less attractive as a target? In many cases, a sub- stantial portion of the synergy gains that an acquirer anticipates from a takeover are from tax savings from an increase in leverage as well as other cost reductions. By increasing leverage on its own, the target firm can reap the benefit of the interest tax shields. In addition, the need to generate cash to meet the debt service obligations provides a powerful motivation to managers to run a corporation efficiently. In effect, the restructuring itself can produce efficiency gains, often removing the principal motivation for the takeover in the first place.

A firm can…

… Require a supermajority (Someties as much as 80%) of votes to approve a merger

… Restrict the voting rights of very large shareholders

… Require that a “fair” price be paid for the company, where the determination of what is “fair” is up to the board of directors or senior management

In most jurisdictions, large mergers must be approved by regulators to satisfy antitrust rules.

In the United States, all mergers above a certain size (approximately $60 million) must be approved by the government before the proposed takeovers occur.

In the European Union, there is a similar process.

You might imagine that the people who do the work of acquiring the corporation and replacing its management will capture the value created by the merger. Based on the average stock price reaction, it does not appear that the acquiring corporation generally captures this value. Instead, the premium the acquirer pays is approximately equal to the value it adds, which means the target shareholders ultimately capture the value added by the acquirer. To see why, we need to understand how market forces react to a takeover announcement.

The free-rider problem in the M&A (mergers and acquisitions) process refers to a situation where certain shareholders or stakeholders of a company benefit from the merger or acquisition without contributing their fair share of costs or efforts.

When a merger or acquisition is announced, shareholders of the target company often expect a premium on their shares as the acquiring company offers to purchase their holdings at a higher price. However, some shareholders may adopt a "free-rider" mentality, hoping to benefit from the transaction without actively participating or contributing to the process.

The problem here is that existing shareholders do not have to invest time and effort, but they still participate in all the gains from the takeover that T. Boone Icon generates—hence the term “free rider problem.” By sharing the gains in this way, T. Boone Icon is forced to

give up substantial profits and thus will likely choose not to bother at all.

1. Toeholds

2. Leveraged Buy-Outs

3. Freezeout Merger

One way for T. Boone to get around the problem of shareholders’ reluctance to tender their shares is to buy the shares in the market anonymously. However, SEC rules make it difficult for investors to buy much more than about 10% of a firm in secret.21 After T. Boone acquires such an initial stake in the target, called a toehold, he would have to make his intentions public by informing investors of his large stake.

A number of legal mechanisms exist that allow acquirers to avoid the free rider problem and capture more of the gains from the acquisition. We describe the two most common, the leveraged buyout and the freezeout merger, next.

Assume an investor group announces a tender offer for half the outstanding shares of a firm.

• Instead of using its own cash to pay for these shares, the investor group borrows the money through a shell corporation and pledges the shares themselves as collateral on the loan.

• Because the only time the investor group will need the money is if the tender offer succeeds, the banks lending the money can be certain that the investor group will have control of the collateral.

If the tender offer succeeds, the investor group has control of the target company.

• Now, the acquirer merges the target and the shell company, thus attaching the loans directly to the corporation—that is, it is as if the corporation, and not the investor group, borrowed the money.

• At the end of this process the investor group still owns half the shares, but the corporation is responsible for repaying the loan.

• The investor group has effectively acquired half the shares without paying for them!

SoSe 2023 | Finanzen III | Prof. Dr. Helmut Gründl 56

The laws on tender offers allow the acquiring company to freeze existing shareholders out of the gains from merging by forcing non-tendering shareholders to sell their shares for the tender offer price.

• The bidder gets complete ownership of the target for the tender offer price.

• The freezeout tender offer has a significant advantage over a leveraged buyout because an acquiring corporation need not make an all-cash offer. Instead of paying the target’s shareholders in cash, it can use shares of its own stock to pay for the acquisition.

• Stock exchange ratio set so that the value in the acquirer’s stock exceeds the premerger market value of the target stock: fair value for the shares of non-tendering target shareholders