Lecture 8: Mergers and Acquisition (Chap 22)

Question 1

Who are the 2 market for corporate control?

Answer 1

1. Acquirer / bidder / buyer

2. Target / seller

Question 2

What are the 2 primary mechanisms of M&A?

Answer 2

1. Mergers: target firm can merge with another firm

2. Acquisition: a corp. or group of individuals acquiring the target firm.

Question 3

What is merger waves?

Answer 3

It is the peaks of heavy takeover activitiy followed by troughs of few transactions.
Merger is normally greater during economic expansion. (reshuffle assets via M&A)

Question 4

What are the 3 types of merger waves?

Answer 4

1. Conglomerate waves: firms acquire firms in an unrelated business
2. Hostile takeovers: acquirer purchase a poorly performing conglomerate and sell off its individual business units for more than the purchase price
3. Strategic / global deals: friendly takeover and to involve companies in related business

Question 5

What are the 3 types of mergers?

Answer 5

1. Horizontal merger: target & acquirer are in the same industry
2. Vertical merger: target’s industry buys or sells to acquirer’s industry (still in the same industry, diff department)
3. Conglomerate merger: target & bidder are both in diff industries (more diff to combine 2 unrelated businesses)

Question 6

How can the M&A take place? (types of consideration paid to target shareholders by the acquiring firm)

Answer 6

1. Stock swap
2. Cash merger / acquisition
3. Combination of stocks and cash

Question 7

What are the items to be negotiated between the acquirer and target firm?

Answer 7

• who’ll run the new co.?
• size & composition of the new BOD?
• location of the new headquarter?
• name of the new co.?

Question 8

What are acquisition premium?

Answer 8

It is when an exisitng shareholders of a target firm are forced to sell their shares, they’ll receive a fair value for their shares by the acquirer co.
Acquirer has to pay a substantial acquisition premium (diff between acquisition price & premerger price of target firm). They cannot acquire for less than its current market value.

On the announcement of M&A, the price reaction for target will enjoy a gain of 15% whereas for acquirer, it’ll see a gain of only 1%.

Question 9

What are synergies?

Answer 9

Synergies are any additional value created as a result of M&A. The acquirer might be able to add economic value as a result of acquisition. (revenue increase, cost decrease)

Question 10

What are the 2 types of synergy?

Answer 10

1. Cost reduction
   - more common & easier to achieve
   - eg: layoffs of overlapping employers & elimination of redundant resources
2. Revenue enhancement
   - eg: expand into new markets or gain more customers

Question 11

What are the reasons to acquire?

Answer 11

1. Economies of scale and scope
   Economies of scale: savings from producing goods in high volume
   Economies of scope: savings from combining the marketing & distribution of related products
2. Vertical integration
   - merger of 2 co. in the same industry tht makes products required at diff stages of production cycle.
   - principal benefit is coordination (putting 2 co. under a central control, management can ensure both co. work towards a common goal)
3. Expertise
   - to compete more efficiently in the market by purchasing a co. for its talent pool tht is ardy a functioning unit
4. Monopoly gains
   - antitrust laws: monopoly power could e very valuable. In the absence of strong antitrust laws, many co. would merge
   - merging / acquiring a major rival enables a firm to susbtantially reduce competition within the industry & thus increase profits
   - share price of other firms in same industry didn’t significantly increase following the announcement of a merger within the industry
5. Efficiency gains
   - elimination of duplication
   - improvement in poor management of target firm enhancing its overall performance
6. Tax savings from operating losses
   - can’t write off tax loss unless there’s a profit elsewhere
   - losses in one division can be offset by profits in another division
7. Diversification (not so solid reason for M&A)
   - risk reduction: combined firm is less risky (cheaper for investors to diversify by themselves)
   - debt capacity & borrowing costs (more diversified firms have lower chances of bankruptcy given the same degree of leverage, increase leverage further & enjoy tax savings w/o incurring significant costs of financial distress)
   - liquidity (target owners can reduce risk exposure by cashing out their investment in the private target reinvesting in a diversified portfolio)
8. Earnings growth
   - 2 co. combined can have a higher EPS than the premerger EPS of either co., even if merger creates no economic value
9. Managerial motives to merge
   - conflicts of interest: managers prefer to run a larger co. due to additional pay & prestige, destroying shareholder value, but managers are gaining from it
   - overconfidence: overconfident CEO pursue mergers tht have low chance of creating value because they believe tht their ability to manage is great enough to succeed
   - managers believe tht they’re doing the right thing for their shareholders, but irrationally overestimates their own ability

Question 12

How does the takeover process works?

Answer 12

Once the acquirer is done with the valuation process, it can now make a tender offer / public announcement of its intention to purchase a large block of shares for a specified price.

Question 13

What is the formula for exchange ratio?

Answer 13

Pt / Pa x (1 + S/T)

Pt = price of target
Pa = price of acquirer
S = synergies

Question 14

What is Merger Arbitrage?

Answer 14

Once a tender offer is announced, there’s no guarantee that the takeover will take place at this price. Acquirers will normally raise the price ot consummate the deal. Due to this uncertainty, market prices generally does not rise by the amount of premium when the takeover is announced.

Question 14

What is Merger Arbitrage?

Answer 14

Once a tender offer is announced, there’s no guarantee that the takeover will take place at this price. Acquirers will normally raise the price ot consummate the deal. Due to this uncertainty, market prices generally does not rise by the amount of premium when the takeover is announced.

Question 15

Who are Risk Arbitrageurs?

Answer 15

Traders, who once a takeover offer is announced, they speculate the outcome of the deal.

Question 16

What is Merger Arbitrage Spread?

Answer 16

It is the difference between target’s stock price and implied offer price. It’s not truly arbitrage as there’s still a risk that the deal will not go through.

Question 17

What are the tax accounting issues in a takeover process?

Answer 17

• form of payment affect taxes of target shareholders & combined firm
• cash received triggers immediate tax liability (capital gains tax on target shareholders on the diff between the price paid for their shares in the takeover & the price paid when they first bought the shares)
• stock swaps defer taxes until shares have been sold

Question 18

Board & shareholder approval

Answer 18

For a takeover to proceed, target & acquiring BOD must approve the deal & let the shareholders of target firm vote.

Friendly takeover: target BOD supports the merger, negotiates w/ potential acquirers & agrees on a price tht is ultimately put to a shareholder vote
Hostile takeover: BOD fights the takeover attempt. Acquirer must garner enough shares to control target & replace BOD. The acquirer here is called a corporate raider.

Sometimes, BOD may not approve even if a premium if offered:

• offer price is too low
• in a stock swap, acquirer is overvalued
• self-interest (agency problems) ; sometimes the entire management team is changed

Target BOD duty: act in the best interest of shareholders using the business judgement rule.
Revlon duties: seek the highest value if a change of control is going to occur
unocal: when BOD takes defensive actions, they’re subject to extra scrutiny, defenses must not be coercive or designed to preclude a deal

Question 19

What is proxy fight as part of a takeover defense?

Answer 19

Proxy fight: acquirer trys to convince target shareholders to use proxy votes to support acquirer’s candidates for election to the target BOD

How to stop this proxy fight?

• force a bidder to raise the bid
• entrench management more securely

Question 20

What are the different types of takeover defenses?

Answer 20

1. Poison pills (strongest & most effective)
   - acquirer is excluded from this right
   - rights offering tht gives existing target shareholders the right to buy shares in target at a deeply discounted price
   - makes it more diff to replace managers as stock price drops and the co. will have a below average financial performance
   - only effective in the event of a complete (100%) takeover
   - increases the cost of takeover, and the bargaining power of target firm when negotiating w/ acquirer
2. Staggered Boards
   - BOD’s terms are staggered so tht only 1/3 of the directors are up for election each year
3. White Knights
   - target looks for a friendlier co. to acquire it
   - make more lucrative offer for the target than the hostile bidder
   - managers of target maintain control by reaching an agreement w/ the white knight to retain their position
4. White Squire
   - large, passive investor or firm agrees to purchase a substantial block of shares in a target w/ special voting rights
   - prevents hostile raider from acquiring control of the target firm
5. Golden Parachutes
   - management receive compensation package for the takeover if the firm is taken over & managers are let go
   - value increasing bcs management is more likely to be receptive to a takeover
6. Recapitalization
   - co. changes capital structure to make itself less attractive
   Eg: pay out large div (increase leverage to reap the benefit of interest tax shield
   - produce efficiency gains, managers run the operation more efficiently
7. Other defensive strategies
   - supermajority of votes to approve a merger
   - restricted voting rights for large shareholders
   - fair price is to be paid for the co. which is determined by the BOD
8. Regulatory Approval
   - Sherman Act: prohibits mergers tht’d create a monopoly/ undue market control
   - Clayton Act: prohibits co. from acquiring the stock of another co. if it’d adversely affect competition
   - Hart-Scott Rodino Act: puts the burden of proof on the merging parties

Question 21

Does the acquiring firm actually capture the value created by the merger?

Answer 21

No, it doesn’t actually because the premium the acquirer pays is approximately equal to the value it adds (target shareholders ultimately capture the value added by the acquirer)

Question 22

Free-Rider Problem

Answer 22

Management isn’t doing a good job, thus shares trade at a deep discount. Raider gives up profits, exisitng shareholders don’t have to invest any time & effort “free-rider”.

Question 23

Toeholds

Answer 23

Initial ownership stake in a firm tht a corporate raider can use to initiate a takeover attempt.

Question 24

Leveraged Buyout

Answer 24

low cost mechanism for corporate raiders to takeover a co. & fire underperforming managers.

Question 25

Freezout Merger

Answer 25

allow acquiring co. to freeze existing shareholders out of the gains from merging by forcing non-tendering shareholders to sell their shares for the tender offer price.
Acquiring co. makes a tender offer at a slight premium (higher than the current stock price)
If offer succeeds, acquirer gains control & merges into a new corp ; bidder gets complete ownership of the target for the tender offer price.
Non-tendering shareholders get the right to receive the tender offer price. (lose their share bcs the target cop. no longer exists)
Freezeout merger has a significant advantage over the LBO bcs an acquiring corp. need not make an all-cash offer.

Question 26

Competition

Answer 26

Most of the benefit to the merger goes to the target shareholders. If premium isn’t high enough, another co. will submit a higher bid. (target is sold at a higher bid)