Corporate Finance #28 - Mergers and Acquisitioins

Question 1

Forms of integration (how firms physically come together from M&A)

Answer 1

LOS 28.a

• statutory merger - acquiring company acquires all of target’s assets and liabilities; target (usually the smaller firm) ceases to exist
• subsidiary merger - target becomes a subsidiary of the purchaser; typical form when target has well-known brand (e.g. P&G buying Gillette)
• consolidation - both companies cease to exist in prior form; common form for same-sized firms

Question 2

Types of mergers (how firms’ business activities relate to one another)

Answer 2

LOS 28.a

• horizontal merger - two firms operate in same/similar industries, often competitors
• vertical merger - acquiring company seeks to move up or down the value chain:
  
  • forward integration - buy a customer
  • backward integration - buy a supplier
• conglomerate merger - two companies operate in completely different industries; few synergies

Question 3

Common motivations behind M&A activitity

Answer 3

LOS 28.b

may be several motivations and may be related

• synergies (cost synergies & revenue synergies)
• achieve more rapid growth
• increased market power
• gain access to unique capabilities
• diversification
• bootstrapping EPS
• personal benefits for managers
• tax benefits
• unlocking hidden value
• achieving international business goals

Question 4

Explain M&A motivation: synergies

Answer 4

LOS 28.b

synergies - “sum is greater than the parts”

• common motivation for merger
• reducing costs or increasing revenues:
  
  • cost synergies - motiviation of a horizintal merger; reduce fixed costs
  • revenue synergies - cross-selling products, increasing market share, or raising prices (reducing competition)

Question 5

Explain M&A motivation: achieving more rapid growth

Answer 5

LOS 28.b

achieving more rapid growth - “make vs buy”

• common motivation in mature industries where organic growth is limited
• faster and less risky to buy resources than to develop them internally

Question 6

Explain M&A motivation: increased market power

Answer 6

LOS 28.b

increased market power - “get bigger”; common in mature industries with few competitors or few suppliers

• horizontal merger - “buy a competitor”; greater pricing power
• vertical merger - “buy a supplier”; eliminate supplier power; gain industry output power and market pricing power; ensures supply and locks out competitors

Question 7

Explain M&A motivation: access to unique capabilities

Answer 7

LOS 28.b

gain access to unique capabilities - “make vs buy”

If company needs a critical unique resources or capabililty (e.g. patents, R&D resources) only way to get it–or cheaper/faster/less risky to buy it.

Question 8

Explain M&A motivation: diversification

Answer 8

LOS 28.b

diversification - “sum is less than the parts”

• managers win; shareholders don’t
• evidence of conglomerate effect

Question 9

Explain M&A motivation: bootstrapping EPS

Answer 9

LOS 28.b

bootstrapping EPS - “bootstrap effect”

• high P/E firm (growing) acquires low P/E firm (not growing) in stock transaction
• acquirer is exchanging high-priced shares for low-priced shares to reduce combined share count
• result is higher EPS, but no synergies
• post-merger P/E should adjust to weighted average of earnings contribution

Question 10

Explain M&A motivation: managers personally benefit

Answer 10

LOS 28.b

personal benefits for managers - “empire building”

• higher pay (i.e. bigger company, bigger pay)
• greater power, prestige; ego trip
• no benefit to shareholders

Question 11

Explain M&A motivation: tax benefits

Answer 11

LOS 28.b

tax benefits - “buying tax carryforwards”

• regulators unlikely to approve merger solely for tax benefits, which can be difficult to prove

Question 12

Explain M&A motivation: unlock hidden value

Answer 12

LOS 28.b

unlock hidden value - “I can do it better”

• acquirer believes it can improve management, add resources, improve org structure, etc.
• acquirer belives it is purchasing assets below their replacement cost i.e. “buying key assets at a discount”

Question 13

Explain M&A motivation: achieve international business goals

Answer 13

LOS 28.b

achieve international business goals - many factors to this motivation:

• capture market inefficiencies - e.g. cheap labor
• overcome government barriers - e.g. tariffs
• leverage technology in new markets
• product differentiation
• expand multinational client relations

Question 14

Explain industry characteristics, merger motiviations, and common types of mergers for Pioneer/development stage

Answer 14

LOS 28.d

Pioneer/development stage

• Industry Charateristics
  
  • unsure of product acceptance
  • large capital needs; not generating profits
• Merger motiviations
  
  • gain access to capital from more mature business
  • share management talent
• Common merger types
  
  • conglomerate
  • horizontal

Question 15

Explain industry characteristics, merger motiviations, and common types of mergers for Rapid growth stage

Answer 15

LOS 28.d

Rapid Growth stage

• Industry Charateristics
  
  • high profit margins; accelerating sales & earnings
  • low competition
• Merger motiviations
  
  • gain access to capital
  • expand capacity
• Common merger types
  
  • conglomerate
  • horizontal

Question 16

Explain industry characteristics, merger motiviations, and common types of mergers for Mature growth stage

Answer 16

LOS 28.d

Mature Growth stage

• Industry Charateristics
  
  • lots of new competitors
  • still opportunities for above average growth
• Merger motiviations
  
  • increase operational efficiencies
  • economies of scale; synergies
• Common merger types
  
  • horizontal
  • vertical

Question 17

Explain industry characteristics, merger motiviations, and common types of mergers for Stabilization stage

Answer 17

LOS 28.d

Stabilization stage

• Industry Charateristics
  
  • competition has reduced growth potential
  • capacity constraints
• Merger motiviations
  
  • economies of scale; reduces costs
• Common merger types
  
  • horizontal

Question 18

Explain industry characteristics, merger motiviations, and common types of mergers for Decline stage

Answer 18

LOS 28.d

Decline stage

• Industry Charateristics
  
  • consumer tastes have shifted
  • overcapacity; shrinking profit margins
• Merger motiviations
  
  • survival
  • operational efficiencies
  • acquire new growth opportunities
• Common merger types
  
  • horizontal
  • vertical
  • conglomerate

Question 19

Key differences between forms of acquisition

Answer 19

LOS 28.e

Stock Purchase

• Payment - made directly to target shareholders in exchange for their shares
• Approval - majority shareholder approval required
• Corp taxes - none
• Shareholder taxes - pay capital gains
• Liabilities - acquirer assumes target’s liabilities

Stock Purchase

• Payment - made directly to target company
• Approval - no shareholder approval needed unless asset sale is substantial
• Corp taxes - none
• Shareholder taxes - pay capital gains
• Liabilities - acquirer avoids assumption target’s liabilities

Question 20

Methods of payment for merger or acquisition

Answer 20

LOS 28.e

Securities offering - quantity of acquirer’s shares received by target shareholders based on the exchange ratio, which is negotiated in advance (e.g. 1.3 shares for each target share)

Total compensation paid by acquirer based on: exchange ratio; number of outstanding shares of target; value of acquirer’s stock on the day the deal is completed

Cash offering - acquirer simply pays an agreed amount of cash for the target’s shares

Question 21

Factors to consider during M&A negotiations

Answer 21

LOS 28.e

Distribution of risk/reward for acquirer & target shareholders

• stock offer - target shareholders share risk of post-merger value with acquirer
• cash offer - acquirer bears all risk of post-merger value; if acquirer is confident of merger synergies it will push for a cash offering

Relative valuations of companies involved

• if acquirer’s stock overvalued, it will push for a stock offer
• investors may interpret a stock offer as acquirer’s shares are overvalued

Changes in capital structure

• acquirer raises cash - will increase acquirer’s financial leverage (D/E ratio) and risk
• acquirer issues new stock - can dilute ownership interest for acquirer’s existing shareholders

Question 22

Describe process of a friendly merger offer

Answer 22

LOS 28.e

Friendly merger offer

• acquirier secretly approaches target management. If parties like the idea of the merger, then they negotiate terms; not public yet
• due diligence process. Each party protects their shareholders by confirming accuracy of merger assertions
  
  • acquirer: make sure target’s assets exist
  • target: ensure acquirer’s capacity to pay
• definitive merger agreement. attorneys draft it; outlines transaction terms and rights of each party
• announce to public once merger agreement is signed; accompanied by endorsement from target to encourage shareholders to vote for the deal.
• proxy statement given to target shareholders; outlines facts of the deal
• approval. once approved by target shareholders and relgulators, payment is made and the deal is done

Question 23

Describe process of a hostile merger offer

Answer 23

LOS 28.e

Hostile merger offer

• acquirier secretly approaches target management. If target management does not like the idea of the merger, then they negotiate terms; not public yet
• acquirer delivers merger proposal to target BoD. Process is called a bear hug. If unsuccessful, then
• acquirer appeals to target shareholders. Two methods:
  
  • tender offer - acquirer offers to buy shares directly from target shareholders; each shareholder either accepts or rejects the offer
  • proxy battle - acquirer seeks to control target with new BoD using a proxy solicitation; if approved by regulators and target shareholders, new board is elected, management is fired so merger can become friendly

Question 24

Describe Pre-Offer Defense Mechanisms against a hostile takeover

Answer 24

LOS 28.f

Note: these are commonly used in combination

Poison pill - very effective; gives shareholders the right to buy additional shares at a deep discount, causing dilution and increases cost to acquirer; pill triggered at a certain equity stake (e.g. 10%); BoD usually allowed to redeem pill before friendly merger offer

• flip-in pill - buy more shares at a discount
• flip-over pill - buy acquirer’s shares at a discount

Poison put - gives bondholders the option to demand immediate bond repayment; adds cash burden for acquirer

Restrictive takeover laws - some states are more target friendly; target may seek to reincorporate in state with strict anti-takeoffer laws (e.g. Ohio or Pennsylvania)

Staggered board - example: BoD terms staggered into 3 groups of 3-year terms; takes at least 2 years for acquirier to gain BoD control

Restricted voting rights - equity ownership above a certain threshold (e.g. 15%) triggers loss of voting rights; effective against a tender offer

Supermajority voting provision for mergers

Fair price amendment - restrict a merger unless a fair price is offered to current shareholders; determined by formula or independent appraisal

Golden parachutes - gives target managers a big payout if fired after a merger; less effective against takeover but eases management concerns of losing their jobs

Question 25

Describe Post-Offer Defense Mechanisms against a hostile takeover

Answer 25

LOS 28.f

Note: these are commonly used in combination

“Just say no” defense - target can publicly appeal to shareholders to decline the offer

Litigation - file lawsuit againt acquirer; long and expensive

Greenmail - payout to acquirer to terminate takeover actions

Share repurchase - target offers to buy its own shares; raises bid price and increases D/E to unattractive levels

Leveraged recapitalization - target assumes debt to finance a share repurchase; increases D/E to unattractive levels

Crown jewel defense - sells an essential asset to a neutral third party; courts could rule the strategy illegal

Pac-Man defense - target make counteroffer to acquire the acquirer; rarely used

White knight defense - friendly third party that offers higher price to create bidding war; Overpaying called “winner’s curse”

White squire defense - friendly third party buys a minority stake in target to prevent acquirer from gaining enough shares; high chance of litigation, especially if target shareholders uncompensated from a dilutive event

Question 26

Calculate and interpret the Herfindahl-Hirschman Index (HHI)

Answer 26

LOS 28.g

As of 1982, the key measure of market power for determining potential antitrust violations

HHI = sum(MS_i * 100)² for (i=1 to n), where

MS_i = market share of firm i

n = number of firms in the industry

Concentration level and likelihood of antitrust challenge:

post-merger Industry d(HHI) Antitrust
HHI Concentration pre/post Action

< 1,000 none any amt none

1,000 < 1,800 moderate 100+ possible

> 1,800 high 50+ highly certain