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Advanced Corporate Finance

(Econm 2032)

Mergers and Acquisitions

Piotr Korczak
P.Korczak@bristol.ac.uk

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Outline of the lecture
• Introduction, types
– Strategic, financial, conglomerate
– Some empirical evidence
• Diversification
– Advantages and disadvantages
– Diversification discount
• Levaraged buyouts (LBOs)
– Mechanism, financing
– Sources of gains
• Takeover defence strategies

Source: FT.com, 5 May 2015

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Types of mergers and acquisitions (1)

• Strategic acquisitions
– Operating synergies
– ‘Two firms more profitable combined than separate’
– Usually friendly
– Dominant form of acquisitions

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Types of mergers and acquisitions (2)

• Financial acquisitions
– No operating synergies
– ‘The price of the firm’s stock less than the value of the
firm’s assets’
– Often structured as leveraged buyouts (LBOs)
– Usually hostile
– Popular in the 80’s, increasing popularity up to August
2007

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Types of mergers and acquisitions (3)

• Conglomerate acquisitions
– Diversifying acquisitions
– No apparent potential for operating synergies
– Financial synergies (e.g. lower cost of capital)
– Friendly or hostile
– Popular up to the 80’s, much less popular now
– Trigger LBOs

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Empirical evidence on M&A performance (1)

• Stock price reaction to takeover bids

– Stock prices of the target – positive
• Stock-for-stock mergers: 15-20%
• Cash payment: 25-30%
• Multiple bidders: 5-10 percentage points higher
– Stock prices of the bidder – on average zero or slightly
negative
• More favourable in cash offers
• Lower for bidders with weak corporate governance
– Combined event returns – (slightly) positive

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Empirical evidence on M&A performance (2)
• Long-run performance – mixed evidence
– Significant decline in postmerger profitability (Ravenscraft
and Scherer, 1987)
– Combined target and acquirer operating margins improve
(Andrade, Mitchell and Stafford, 2001)
– Acquirer’s five-year positive abnormal stock price
performance, except for tender offers made with stock
(Loughran and Vikh, 1997)
– Value bidders (low MB) outperform over the subsequent
three years, glamour bidders (high MB) underperform
(particularly in stock mergers) (Rau and Vermaelen, 1998)

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Advantages of diversification

• Internal capital markets avoid some of the

information problems in external capital markets
• Internal capital markets allow access to capital
when external capital is costly
• Reduces the probability of bankruptcy (combines
uncorrelated cash flows)
• Increases the firm’s debt capacity
• Information less exposed to competition
• Larger flexibility of the organisation

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Disadvantages of diversification

• Investors can diversify their portfolio themselves

• Waste and inefficiency when capital is allocated
internally to losing divisions
• Use of excess cash for empire building
• Reduction of the information contained in stock
prices

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Diversification discount puzzle

• Evidence on diversification discount

– Lang and Stulz (1994), Berger and Ofek (1995), Servaes
(1996)
– Firms destroy value when they diversify and create value
when they sell off divisions (Comment and Jarrell, 1995)
• However, after correcting for self-selection bias,
evidence on diversification premium
– Campa and Kedia (2002), Villalonga (2004)

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Leveraged buyouts (LBOs)
• Disciplinary role – see corporate governance
• Often lead to the breakup of large diversified
corporations
– See – extravagant investment, empire building, pet
projects

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LBO mechanism (1)
• Taking a public firm private by buying out old
shareholders by a new group of investors
– Buyout firm / private equity firm
– Old manager(s)
– Banks and public debtholders
• Highly leveraged
– 80’s 20:1, 90’s 5:1, 2007 ~1:1, 2010 ~1:2
– Debt from banks and subordinated public debt (80’s:
‘junk bonds’)
– See: debt as a corporate governance mechanism

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LBO mechanism (2)
• Share ownership
– Management receives 10-30%
– LBO specialist 20%, other partners 80% of non-
managerial shares
– See: concentrated holdings as a corporate governance
mechanism
• Managerial incentives
– Increased managerial ownership
• From a few percent pre-buyout (Kaplan and Stein,
1993)

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LBO mechanism (3)
• Managerial incentives – cont’d
– Increased pay-for performance sensitivity
• LBO: $64 per $1,000 increase in shareholder value
• Avg: $3 per $1,000 increase in shareholder value
• (Jensen, 1989), see also lecture on corporate
governance
– See: the role of managerial incentives in corporate
governance

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LBO mechanism (4)
• Activities
– Often breakup of large diversified corporations
• ‘The parts of a conglomerate are actually worth more
than the whole’
– Productivity improvement
• Reduction in employment, investment/sale of non-
core assets, R&D
• Short-term gains at the expense of long-term gains (?)
• Average investment period of 5-6 years
– Sale to another large investor or taking public

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Typical LBO targets
• Large and steady cash flows – why?
• Examples from the literature
– Oil and gas, mining and chemicals, forest products,
broadcasting, tobacco, food processing, tyres

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The effects of private equity (1)
• Evidence for 28 recent private equity deals in the UK, including
– Allience Boots, Odeon & UCI Cinemas, Debenhams,
Travelodge, AA, NCP, FitnessFirst
– 14 of those already exited by the private equity firm
• Source: British Private Equity and Venture Capital Association,
reported in the Financial Times on 15/01/2009

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The effects of private equity (2)

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The effects of private equity (3)

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Guo, Hotchkiss and Song (2011)
• A thorough description of LBO deals in the most
recent wave (1990-2006)
– Including deal structure, outcomes, changes in operating
performance, returns to LBO capital
• An analysis of the determinants of changes in
operating performance
• An analysis of the sources of value creation in
LBOs

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Guo et al. (2011) – parts of Table VIII (1)

Note: Continued on the next slide

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Guo et al. (2011) – parts of Table VIII (2)

Note: Continued from the previous slide

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Guo et al. (2011) – parts of Table XI

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Takeover defence strategies (1)
• Staggered board terms
– Only a fraction of the board members are up for
reelection in a given year
• Supermajority rules
– x% (as high as 80-90%) rather than 50% of the votes
required to approve an important move (merger,
reorganisation, asset sale etc.)
• Employee Stock Ownership Plans (ESOPs),
differential voting rights, dual-class
recapitalisations

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Takeover defence strategies (2)
• Scorched-earth policies
– To make the firm less attractive to the raider, often
making it less attractive to anybody else as well
– Selling, often at a very low price, assets attractive to the
raider
• Poison pills
– Rights or securities issued to existing shareholders at a
low price if they do not tender their shares, if the raider
acquires a certain fraction of shares

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Takeover defence strategies (3)
• White knight
– Looking for an alternative acquirer with a friendlier attitude
– May discourage the raider and the firm may end up being
sold at a relatively low price to the white knight
• Greenmail
– Targeted block stock repurchase
– Repurchasing the raider’s block of the target’s stock
– Controversial – collusion of the management and the raider
at the expense of shareholders
• Lobbying for antitakeover legislation

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28 Are the defence strategies good for
shareholders?
• They keep entrenched managers in power
– The number of antitakeover provisions is used as a proxy
for the quality of corporate governance (more provisions
= poorer CG)
– Firms with fewer antitakeover provisions have higher
values, higher profits, higher sales growth, lower capital
expenditures and make fewer acquisitions (Gompers,
Ishii and Metrick, 2003)
• But, the bidder may need to make a higher offer

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