Part 7 : M&As, takeovers and buyouts

Question 1

Merger

Answer 1

A merger is a the combination of two firms into a single entity, via

– An acquisition (one firm acquires 100% of the other firm’s equity, the acquired firm ceases to exist, the owners of acquired firm get
equity in the acquirer firm and/or cash, and the acquirer firm takes over the assets and the debt of the acquired firm); or via

– A consolidation (both firms cease, an entirely new entity is formed and takes over the balance sheets of both the merging firms)

Question 2

Takeover

Answer 2

A takeover is the purchase of an entire firm by another firm; the
takeover can be friendly (in which case there is no difference between a takeover and a regular 100% acquisition), or hostile (in which case the main differences with acquisitions concern the motives for and the
procedures of the deal)

Question 3

Buyout

Answer 3

In a buyout, a group of investors purchases an entire public firm or a substantial portion of a public firm (e.g. a division, a main subsidiary), and take it private (the firm lives on as stand-alone entity)

Question 4

Leveraged buyout (LBO)

Answer 4

A leveraged buyout (LBO) is simply a buyout financed in large part by debt; an LBO is effectively a large-scale, debt-financed stock repurchase

Question 5

Management buyout (MBO),

Answer 5

In a management buyout (MBO), the current management of the firm (or some of it) is part of the buyout group

Question 6

Mergers (acquisitions) are also often classified according to the types of operation the merging firms are involved in

Answer 6

• In a horizontal merger, the merging firms operate in the same line of business (e.g. a merger of two newspapers)
• In a vertical merger, the merging firms operate at different stages of production (up- or downstream) within same industry (e.g. an oil firm
  buys refining operations)
• A conglomerate merger is the combination of two firms operating in unrelated industries

Question 7

There are essentially three main possible ways to effect a merger

Answer 7

• To purchase shares in the open market (assuming the target firm is publicly listed)
• To negotiate a deal with the management and board of directors of the intended target firm (the typical procedure for a friendly takeover/acquisition)
• To appeal directly to shareholders via a tender offer (bypassing the target firm’s management and board in this way would typically imply
  that the acquisition attempt is hostile)

Question 8

The main categories of motives for mergers

Answer 8

• Economic (synergies, mar-
  ket power)
• Motives related to various types of market frictions (taxes,
  bankruptcy costs, agency issues, adverse selection)
• A (conglomerate) merger
  can also be have diversification motives (which, in turn, may be related to both economic factors and frictions)

Question 9

Synergies

Answer 9

• The simple logic of synergies is that Va+b − C > Va + Vb, where C is the cost of the merger.
• The merger results in a real NPV gain due to an improvement in operations

-This may be the result of economies of scale and/or scope, asset complementarity, etc

• Synergies are notoriously
  difficult to measure, and often overestimated pre-merger (whereas the cost of the merger and of integrating the organizations is underestimated)
• The “best” type of synergies are tangible cost savings (e.g. branch closings in bank mergers).
• Synergies are most likely to be a main motive in horizontal
  mergers, but may also be relevant in vertical mergers

Question 10

Market-power-motivated mergers

Answer 10

• the economic gain comes from rents from reduced competition.
• there may be legal/regulatory obstacles as mergers that may reduce competition would typically be reviewed (and can be blocked) by competition authorities.

Market-power motives are practically only relevant for horizontal mergers, since for any market power gains to be realized, merging firms have to be direct competitors

Question 11

Tax motivations for mergers

Answer 11

Tax motivations for mergers within a jurisdiction are primarily related to making more efficient use of tax shields. Suppose one firm has a large amount of unused tax shields and not much current income, whereas another firm has high current income and no tax shields. If the firms merge, the merged com-
pany can make full use of the tax shields, reduce tax, and thereby increase total value.

A different type of tax motive is more related to regulatory (tax) arbitrage. In a corporate inversion, a domestic company acquires a foreign company (or lets itself be acquired by a foreign company) and adopts its tax jurisdiction to avoid taxation on repatriated profits. This motive may be particularly relevant for firms with large fractions of their earnings coming from foreign sales, and is a relatively recent phenomenon.

Question 12

What are indirect bankruptcy costs, and how can they lead to substantial value losses for a distressed firm?

Answer 12

Indirect bankruptcy costs include factors like loss of competitiveness, concessions to customers and suppliers, etc. These costs can result in significant value losses for a distressed firm.

Question 13

Why might a target firm choose to engage in a merger, particularly when facing distress? What is the motive related to bankruptcy avoidance?

Answer 13

The motive for a distressed target firm to engage in a merger is to avoid further value losses associated with indirect bankruptcy costs. The target lets itself be acquired to prevent these deadweight costs.

Question 14

In which types of mergers is bankruptcy avoidance by the target firm relatively common? Provide examples of scenarios where this motive is prevalent.

Answer 14

Bankruptcy avoidance is relatively common in consolidating mergers, especially in mature or declining industries with overcapacity. It may also occur in vertical mergers.

Question 15

What factors may influence a target firm’s decision to avoid bankruptcy through a merger? How can market power and synergy play a role in this decision?

Answer 15

Market power or synergy motives for the acquirer, especially in horizontal mergers, can combine with bankruptcy avoidance as reasons for a target firm to engage in a merger.

Question 16

Motives related to managers when it comes to Agency costs of equity/managerial self-interest

Answer 16

• Incentives to increase the size of the firm (overinvestment, empire- building, perk consumption)
• Entrenchment incentives (increase the complexity of the firm to reduce employment risk)
• Risk aversion (diversification to reduce personal exposure)
• “Hubris” (really more of a behavioral bias than an agency cost)
• Agency issues may motivate managers (as acquirers), but also make the com pany a potential target for acquisition, particularly if it is underperforming.

Managerially motivated mergers can be horizontal, vertical or conglomerate

Question 17

Information asymmetry/undervaluation motive

Answer 17

An undervalued company may be the target for a takeover or buyout, assuming that the bidder has private information about the true value of the firm.
The firm’s own management is probably most likely to have such private info, suggesting that undervaluation may motivate management buyouts

Bidders in the same line of business may also have private information (or at least be
more knowledgeable than the general public about the business), suggesting
undervaluation may also motivate horizontal mergers

Question 18

diversifivation motive

Answer 18

Diversification motives are relevant primarily for conglomerate mergers.

Diversification alone cannot be relied upon to argue for a value-increasing effect of a merger (as per standard finance theory), but because the primary effect
is reduced cashflow volatility, the rationales for mergers with diversification as primary motive coincide with general reasons for reducing/managing risk
at the firm level (all related to various frictions):

• Tax advantages (losses can be offset against gains, tax shields can be used more efficiently, debt capacity can be increased)
• Reduction in expected distress costs via reduced cashflow volatility (increased debt capacity and tax shield)
• Reduction in expected inefficiency costs of external finance (more stable
  earnings, less risk of having to pass up investments due to temporary drop in slack)
• Agency costs of equity (managerial private benefits, risk aversion, over investment; value-decreasing from shareholders’ perspective)

Any potential value gain to shareholders will be counteracted by the so-called
co-insurance effect – i.e., diversifying mergers always increase the value of
debt at the expense of shareholder

Question 19

Takeover motives

Answer 19

• Target underperformance (combined with management self-dealing) is a main motive for hostile takeovers and buyouts
• The threat of a takeover (if credible) may be effective in disciplining management even if there is no actual successful takeover attempt made
• The market for corporate control is an important governance mecha-
  nism primarily for firms with diffuse ownership

Question 20

Takeover motive evidence

Answer 20

Evidence:
- Takeover attempts are more likely in industries with abnormal executive compensation

• Target CEOs are more likely to be replaced if the bid succeeds
• Target CEOs earn negative abnormal compensation post takeover

Question 21

Takeover defenses

Answer 21

• Corporate charter defenses (“shark repellants”)
  Staggered board (only a fraction of the board can be replaced at
  a time), supermajority rules, fair price amendments, differential
  voting rights
• Poison pills
  Call options exercisable in case of a hostile takeover (allowing
  insiders/existing shareholders to acquire shares at substantial dis-
  count); covenants or “poison put” making all debt payable upon change of control
• Post-bid repellants
  White knight (identify alternative friendly bidder), “greenmail”
  (repurchase bidder’s stock at a premium), “Pacman” (launch counter- bid for the hostile bidder), “scorched-earth policies” (sell off strate-
  gic assets)
• Other resorts, e.g. litigation, media campaign, lobby with regulators

Question 22

There are three possible methods of payment in mergers

Answer 22

• the shareholders of
  the target firm get paid in (newly-issued) acquirer-firm stock
• cash (possibly borrowed)
• a mix of cash and stock

Question 23

The determinants of the choice
of payment method

Answer 23

Agency costs and Asymmetric information

Question 24

Agency costs of equity

Answer 24

• Poor incentive alignment may make management more likely to overinvest using stock, since issuing new stock to pay for an acquisition is detrimental to shareholders (via dilution), but does not hurt managers. Cash payment/debt financing, on the other hand, disciplines management
• If a sufficient amount of stock has to be issued to pay for the target, shareholder would typically have a say (i.e., method of payment is not completely at management’s discretion)
• Empirical evidence tends to suggest that higher managerial ownership in the acquirer firm makes it more probable that cash payment is used
  in acquisitions (insider ownership in the firm aligns management’s incentives with those of outside shareholders).

Question 25

Asymmetric information/signaling

Answer 25

• In analogy with new equity issues in general, a stock offer may signal that the acquirer firm’s management has private information that its
  stock is overvalued (an acquisition is essentially an investment project, so the pecking-order reasoning applies)
• A cash offer, on the other hand, signals a higher degree of confidence in the value of the target. Alternatively, low-value bidders use cash (slack) to avoid issuing undervalued stock and face the inefficiency cost
  of external financing
• The evidence from event studies on merger announcements suggests
  that acquirers paying cash earn higher abnormal returns (see below). The evidence on whether overvaluation plays a role for the decision to
  pay with stock, on the other hand, is very mixed

Question 26

Example

Answer 26

ppp. 14-15

Question 27

Do mergers create value for shareholders , and – if so – how are these gains distributed
between acquirer and target shareholder

Answer 27

Large part of M&A literature: do mergers create value for shareholders?

Mostly (short-term) event studies (AR for merger announcements)

General
- Target shareholders capture large gains from tender offers
- Acquirers neither gain nor lose from mergers
- Weighted sum of target and acquirer gains is positive on average

Determinants
- Contestation reduces average gain to acquirers and increases gain to targets
- Merger class: Horizontal mergers most likly to realize synergies, mixed results for other classes for merger
- Payment method matters: mergers paid cash perform better
- Results strongly dependent on time period due to merger waves (and very skewed distributions)

pp. 16-19. There is more

Question 28

Determinants of value creation from mergers include

Answer 28

• Whether or not the bid is contested: bids initially refused and competing bids from multiple prospective acquirers reduce the average gain to
  acquirers and increase the gain to targets
• Merger class: horizontal mergers are most likely to realize synergies; overall value gains for other classes of mergers are mixed
• Payment method: mergers paid in cash perform better than equity financed mergers
• Time period: mergers tend to occur in waves, and return distributions in different periods are very skewed

19-24