Mergers and Acquisitions

FINC 361 Fall 2016

Professor Mahdi Mohseni

Agenda
1.

Types of Mergers and Acquisitions (M&A)

2.

Merger waves

3.

4.

Reasons for M&A

A. Good reasons (increasing shareholder value)
B. Dubious reasons (not always increasing shareholder value)
C. Bad reasons (most probably destroying shareholder value)
Premium paid and valuation

Types of Mergers and Acquisitions

1.

M&A can be friendly

Most mergers

Simply need at least 50% approval in shareholder vote

2.

M&A can be hostile

A.

Tender offer (typical)

Make an offer directly to shareholders

Usually for at least 50% of the shares outstanding

1.
> 90% shares tendered: Bidder can squeeze out remaining shareholders
2.
< 90% but > 50%: Bidders needs a shareholder vote at target firm to close the deal
3.
< 50%: Deal is over as is (it needs to be revised)

(+): Fast and allows to bypass management

(-): Detailed due diligence not allowed to perform

B.

Alternatives

Buy enough shares on the open market first

Creeping tender offer

Proxy fight

Get enough votes from shareholders to replace the current board and management, with people
favorable to the bid being made

Merger waves

1. Hot markets = Peaks of heavy M&A activity

2. Cold markets = Quiet periods
Often linked to deregulation or shock to industry:
1.
2.
3.

1960s (conglomerate wave)

1980s (hostile takeovers wave)
1990s (strategic or global wave)

Merger waves in 2000's

Quarterly M&A Deal Value ($ Billions)

Deal Value (Billions)

$500.00

Very cyclical
1. Hot markets

2000: Dot.com bubble

2006-07: Private equity/real estate bubble

2. Cold markets

2001-2002: Bursting of dot.com bubble

2008-2009: Financial crisis

8/1/10

3/1/10

5/1/09

10/1/09

7/1/08

12/1/08

2/1/08

9/1/07

4/1/07

6/1/06

11/1/06

1/1/06

8/1/05

3/1/05

10/1/04

5/1/04

7/1/03

12/1/03

2/1/03

9/1/02

4/1/02

6/1/01

11/1/01

1/1/01

8/1/00

3/1/00

$50.00

Beware of buying in hot

markets!!
Multiple buyers
Buying fever
Lack of discipline
Winners curse:
You win the contest but
you end up overpaying!

Twenty Largest merger transactions, 2000-2013

Most cited reasons for M&A

but not necessarily the right reasons!

Good reasons for M&A:

Operational Synergies

Good reasons for M&A:

Operational Synergies
1. Economies of scale
Lower average production costs
with higher volumes
Elimination of overlapping
resources

2. Economies of scope
Shared marketing campaigns
Shared distribution channels
Etc.

Good reasons for M&A:

Gaining market power

Less competition!

Good reasons for M&A:

Gaining market power
Advantage:

Risk:

Less competition
Regulatory concerns: Antitrust
1. U.S. DOJ (Department of Justice)
More power over
2. FTC (Federal Trade Commission)
customers and suppliers
3. EC (European Commission)
Can charge more for
its products
Can get its input
cheaper

Famous examples
1. AT&T and T-Mobile
2. GE and Honeywell

Two U.S. firms blocked by EC!!

Good reasons for M&A:

More operational synergies

1. Horizontal mergers

Combination of competitors in same industry

Benefits:
All the ones listed in the previous slides

2. Vertical mergers

Combination between
A. Upstream firm (supplier)
B. Downstream firm (distributors)
Benefits:
1.

2.

Guarantees product quality and procurement

Better monitoring and coordination
Guarantees access to better distribution network
Better monitoring and coordination

Example: Disney buying ABC TV networks

Disney CEO, Michael Eisner: 1+1 = 4!

Safeway and Albertsons:

Classic horizontal merger
What are the gains to be had
in this industry when merging?

Green Mountain Coffee and Keurig:

Classic vertical merger
Has risen in value from $30 million in 2000 to $6 billion
Catalyst: Purchase of Keurig for $119 million

Good reasons for M&A:

Financial synergies
Beyond operational synergiesfinancial synergies!
1. Taxes
A.

B.

Tax Inversion

U.S. has global system of taxation + high corporate tax rate

Profits earned abroad are taxed by U.S. government
Hurts competitiveness of large multinationals earnings profits mostly abroad
Tax Inversion: Strategy used by U.S. firms since the 1980s (very popular in recent years)
Merge with foreign partner, and then reincorporate the firm abroad where tax regime is
more advantageous
Example:
Medtronics acquisition of Covidien Plc
Reincorporates from Minneapolis to Dublin
U.S. government loses lots of revenues
Tried to impose new laws in September 2014 to slow down the movement

Unused tax shields

Firm may have tax shields but not the profits to take advantage of them
Recall:
You cannot use tax carryforwards with a change of ownership so you cannot be acquired
for that reason.
What M&A activity could still be done?
Example: Penn Central
After its restructuring, it had billions of unused tax-loss carry forwards
Bought several mature taxpaying companies so that these shields could be used

Good reasons for M&A:

Financial synergies
Beyond operational synergiesfinancial synergies!
2. Debt capacity

More stable and greater cash flow generation for combined firm
Firm can now issue relatively more debt
Greater tax shield benefit of debt
Lower cost of capital

More dubious reasons for M&A

1. Eliminate Inefficiencies in the Target

Target may have unexploited investment opportunities, or ways to cut

costs or increase earnings
Replace current management with better management

In this case: No synergies are invoked!

Goal: Simply improve the target Value of control

Many hostile / LBO deals fall in this category
Carl Icahn is a big player in this market

It could make sense, but

Beware: Over-optimism with regards to benefits of restructuring

More dubious reasons for M&A

1. Eliminate Inefficiencies in the Target
Example Carl Icahn and TWA
Icahn paid a premium of $400 million
But he also cut salaries and benefits for

3,000 pilots earning 90K by 30%

9,000 machinists earning $38K by 15%
6,000 flight attendants earning $35K by 28%
Total labor savings $193 million

Icahns comparative advantage: Ruthless bargaining!

Not everybody has his talent

More dubious reasons for M&A

2. Use Excess Cash
If your firm is in a mature industry with no positive NPV projects
left, acquisition may be a decent use of funds
Seeking new positive NPV projects

You have to wonder:

Does it have the know-how to run that new business?

Is it going away from its core competence?

Better use of excess cash (potentially)

Dividends or stock repurchases

Let shareholders decide what they want to do with their excess cash

Bad reasons for M&A

1. Diversification
Investors can diversify their portfolio by themselves!!
One click on Etrade!
Much cheaper than buying another firm. Why?
No need to pay a premium!

Additional problems:
In-fighting for the money within the conglomerate
Poor allocation of resources across the divisions

Bad reasons for M&A

2. Managerial self-interest
1. Empire building
2. Managerial ego
Over-optimism in terms of capacity to turn firm around
If multiple bidders: Will fight to win!
Winners curse

3. CEO compensation
Often tied to size of firm

Reasons for M&A: Recap

1. Good reasons
i. Operational synergies + gaining market power
ii. Financial synergies

2. Dubious reasons
i. Eliminate inefficiencies in the target
ii. Use excess cash

3. Bad reasons
i. Diversification
ii. Managerial self-interest

Anti-takeover defenses
Firms can defend themselves in many ways
1. Poison pill (only in US):
If potential acquirer goes above a threshold of ownership (for example
20%), it triggers a massive dilution whereby existing shareholders can
buy new shares at massively discounted price, except the shareholder
who has more than the threshold ownership!
Ultimate deterrent!

2. Staggered boards
Staggered reelection process of board members
Takes a few years to replace entire board

3. Scorched-earth strategy
Threaten to sell prized assets (crown jewels), load up on debt, etc.

Are these shark repellents good or bad corporate

governance measures?

Premium paid
Bidders (acquirers) almost always pay a premium to
acquire the target firms
1. Why do they have to pay a premium?
2. How much premium should they pay?
3. Are all the profits going to target shareholders?

Biggest premiums paid over 2001-2011

M&A: Paying a Premium

Texas Instruments to buy National

Semiconductor for 78% premium

Massive premium

Rationale?

Push National Semiconductors product

through TIs 10x larger salesforce
Massive economies of scope

Paying 21x earnings

Faster growing competitors trade at 14x earnings

Dell bought EqualLogic for 10x revenues in 2007

Three years later EqualLogic revenue has grown by
factor of 8

TI stock up 1% at announcement

However, little room for error to make it a positive NPV

endeavor!

Valuation
Recall:
M&A = Biggest CAPEX project you can have!

Must put into numbers your reasons for doing it:

Target value = Stand-alone value + merger benefits
Be carefulthis is finance:
Mergers bring costs and benefits with them
You often hear: the synergy gains are too hard to estimate
If you cannot quantify gains: Do not go and spend billions!

Valuation tools

Those two transaction-based numbers will include the

benefits of control and synergies found in previous deals

DCF approach
Step 1: Compute target firm DCF as a stand-alone
Step 2: Compute target firm DCF assuming all the
benefits of the merger
For instance:
i. Lower WACC (due to increased debt capacity)
ii. Higher sales (due to better distribution network)
iii. Lower SG&A (due to reduction in overhead costs)
iv. Lower COGS (due to shared facilities)
v. Etc

Step 3: The difference = Net benefits of merger

Golden rule: Premium paid < Net benefits of merger

Is a takeover a value increasing

proposition for the bidding firm?
Conventional wisdom:

Most acquisitions turn out to be a mistake for the bidders

Most of the gains end up with target shareholders!

Empirical evidence:
1. Stock return at announcement for target firm
Average: 20% to 40% depending on the study
Reflects premium paid

2.

Stock return at announcement for bidding firm

Average: -2% to 4% depending on the study

Overall:

On average, bidding firms do not make mistakes (see next slide however)
On average, most of the gains do end up with target shareholders!

Heterogeneity in gains for bidding firms

1.

Better to focus than to diversify

Only diversify if core business is dying

2.

Better when synergies are more credible

3.

Better when market power is gained

4.

Better when cash is not squandered

5.

Dont buy in hot markets!

Buy private firms! Why?

Better when deals are structured efficiently

Tax benefits, contingent payments based on performance, use of debt

(LBOs), etc.

All these features lead to better stock price reactions at

announcement for the bidders!

M&A deals and method of payment

Typical: Mix of cash and equity
Bidders use more equity when richly
valued

Trends in % of stock used

relative to total deal value
1. 2012: 51.6%
2. 2013: 64.6%
3. 2014: 83.6%
What do you take from this overall
trend?
Target firm: Why accept a currency
that may be inflated?

Combined returns
Overall gains:
On average: 2% to 7% depending on the study
Efficient markets
Assets are priced fairly
So what should the combined returns correspond to?

But beware, even when deal makes sense:

Risk of poor post-merger performance

Business failures in general

which also apply to M&A deals!

See Deals from Hell by Prof. R. Bruner

A failure usually has more than one cause

Multiple drivers increasing risk of failure:
1.
2.
3.
4.
5.
6.

Complexity

Larger firms more at risk

Tight coupling

When there is a low margin for error to start with

Managerial choices that increase risk

Too fast in pushing for integration initiatives

Cognitive biases

Sunk cost fallacy, overconfidence, etc.

Business not as usual

Sudden downturn in underlying business

Inappropriate response by operating team

Miscommunication, culture shock, bickering, etc.

Conclusion
There are good and not so good reasons for M&A!
On average, M&A earns returns at or slightly
above cost of capital
Reflects synergies
But: Most benefits accrue to target firm

Like any business decision, many pitfalls to avoid!

We have seen many of them in this lecture

Thank you for a great semester!