Module%20I:%20Investment%20Banking:%20Mergers%20and%20Acquisitions

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Module I Investment BankingMergers and
Acquisitions

• Week 3 January 26, 2006

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Motivation

• Many companies are in the process of
  restructuring
• What are the major forms of restructuring?
• What motivates corporate restructuring?
• What are the consequences for investors and for
  firms?

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Overview of Restructuring

• Two Major Forms
• Expansion (Combining assets through MA)
• Contraction (Breaking-up assets through
  divestitures etc.)
• Other Forms
• Changing ownership structure (LBOs, buybacks,
  etc.) and retaining control through defensive
  strategies (Poison pills etc.)

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Expansion Mergers Acquisitions

• Merger the absorption of one firm by another
• Acquisitions purchase of a firms voting stock
  (tender offer)
• Takeovers Transfer of control from one group of
  shareholders to another
• by merger, stock acquisition, asset acquisition,
  proxy contest or by going private

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Acquisition or Merger?

• Stock acquisitions do not require shareholder
  meetings or votes, and are frequently hostile
• The acquirer deals directly with targets
  shareholders, bypassing management
• Minority shareholders may hold out in tender
  offers complete absorption requires a merger

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Types of Mergers/Acquisitions

• Horizontal
• Same industry and level of value added
• E.g. petroleum production
• Vertical
• Same industry but different level
• E.g. petroleum production, refining, marketing
• Conglomerate
• Different industries
• E.g. gasoline sales and mini-marts

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What Explains MA Activity?

• The stated objective of all mergers and
  acquisitions is the creation of value
• Other objectives - e.g., managerial hubris - may
  also play a role but are usually not the stated
  rationale for an acquisition.
• What are the sources of value? Two types
• Strategic
• Financial

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Strategic Sources of Value

• 1. Under-managed Target
• - Look for strategic and operating errors that
  can be corrected by replacing bad management
• 2. Efficiency Gain or Synergies
• - Reduce costs through economies of scale and
  scope in production, finance, research,
  marketing, and through other indivisibilities
• - Increase demand or raise product prices
  through gains in market power

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Strategic Sources of Value

• 3. Opportunities for restructurings
• Divest or liquidate businesses with poor fit or
  poor results
• Sell unproductive assets that are retained by
  managers who cannot or will not shed such value
  destroying businesses

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Financial Sources of Value

• Target is undervalued
• Markets are inefficient
• Forecasted improvements or changes are not
  reflected in the stock price
• Unused gains from the use or sale of accumulated
  tax losses from net operating losses
• Unused debt capacity (Leverage Bargain)

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Dubious Reasons for Acquisitions

• Diversification
• However, shareholders can diversify their own
  holdings at lower cost and greater efficiency
  through the financial markets.
• Securing access to inputs or sales of output
• This may be valid, but presumes there are
  inefficient or uncompetitive markets

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Bad Reasons for Acquisitions

• Creating the Appearance of Growth
• Growth for its own sake does not create value
• Use of Excess Cash
• Increased EPS
• By buying companies with higher EPS than your own
  you raise your EPS. Naive investors may believe
  this to be growth even if this destroys value

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Example of EPS Growth Strategy

• Company A has 1,000 shares outstanding and EPS of
  1
• Company B has 500 shares outstanding and EPS of
  2
• A buys B and now reports higher EPS of 1.33
• If A paid more than B was worth, As shareholders
  lost although As EPS rose

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Higher EPS Strategy
Company As reported EPS after acquisition of
company B
Company A acquires B
EPS
A
B
A
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Defenses against Takeovers

• Divestitures
• Sales of assets
• Spinoffs or issuance of tracking stock
• Amendments to corporate charter
• Supermajority vote needed
• Staggering terms of directors
• Self-tenders, going private, leveraged buyouts
• Poison pills, white knights, golden parachutes,
  etc.

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Are Mergers Beneficial to Society?

• Mergers and acquisitions are usually associated
  with layoffs and downsizing.
• This may or may not be associated with increased
  economic efficiency.
• But MA activity may facilitate exit from an
  industry where there is overcapacity

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Basic Argument

• Suppose that there are three firms whose minimum
  efficient scale is 100 units

Average Cost
Efficient Production Zone
Price
100
Quantity
67
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Example

• Initially, industry demand was 300 units, so
  there was no over capacity
• Now, demand has fallen to 200 and is not expected
  to recover
• Each firm produces 67 units, and makes economic
  losses
• The problem If firm A exits, the benefits are
  captured by B and C

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Solution

• Since the benefits from exit do not accrue to the
  exiting firm, each firm fights to stay on,
  causing losses for all firms
• Solution If B (or C) were to takeover A, the
  shareholders of A would capture the external
  benefits from exit
• In this sense, MA activity is beneficial to
  society.

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Empirical Evidence

• In reality, most acquirers fare poorly with
  modest declines in value
• Targets receive most of the benefits of the
  usually substantial run-up in price associated
  with a takeover.

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Example Kodak and Sterling Drug

• January 4, 1988 Hoffman LaRoche offers 72 per
  share for Sterling Drug
• January 18 Facing resistance, Hoffman raises
  the offer to 81 per share
• January 22 Kodak announces a friendly bid of
  89.50 per share for Sterling Drug

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Price Reaction

• Estimate Kodaks return net of the return
  predicted by CAPM
• The abnormal return is the actual return on day t
  less the expected return
• From CAPM, the expected return is

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Cumulative Abnormal Returns
12/2/87
1/22/88
3/18/88
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Kodak Paid a High Premium
Value of Kodaks Bid 5.1 (in billions) Less
Sterlings market capitalization 3.0 (30
days prior to announcement) Equals Kodaks
Premium 2.1
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..But Investors Were Skeptical

• Kodaks market decrease was about 2.2 billion,
  almost the amount of the premium paid for
  Sterling
• Clearly, investors did not believe the deal could
  add value. Why?
• Kodaks past acquisitions were failures and it
  was ignoring its core business

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Why Do Acquires Fare Poorly?

• Overbidding
• Over-optimism or Winners Curse
• Managerial hubris
• Mergers increase firm size and hence managerial
  compensation, without adding value
• Poor fit between buyer and seller
• Clash of corporate cultures
• Ignorance of targets industry
• Failure to integrate operations carefully and fast

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Example of Winners Curse

• Four companies bid for mineral rights on Federal
  land
• True value is 100 million
• Each company estimates value imperfectly
• Valuations are unbiased, but noisy

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Valuations

• Company A Estimated Value is 80m
• Company B Estimated Value is 90m
• Company C Estimated Value is 110m
• Company D Estimated Value is 120m
• Average estimate is correct

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Bidding

• Second price, sealed bid auction
• The optimal strategy is to bid your reservation
  price
• Company D bids 120, and wins, paying 110
• Winners curse Overpay by 10

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Can this be an explanation?

• Winners curse can explain over bidding in this
  simple one-shot game
• But in a repeated game, firms will recognize this
  problem or learn from others bids
• However, if takeovers are isolated events, the
  winners curse may still hold

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II. Contractions

• In the 1980s and 1990s, firms that operate in
  fewer numbers of industries do better than widely
  diversified firms.
• Restructurings that result in more focus are
  rewarded by higher stock prices
• Example Dun Bradstreet, a major information
  provider, split in three. The stock price
  reaction was positive, with a subsequent rise of
  8

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Why is Re-Focusing in Vogue?

• Corporations made several errors including
• Expanding into industries they didn't know
• Overestimating the gains from synergy and
  diversification
• Complex structures allowed mistakes to go
  undetected
• Internal conflicts arose over the allocation of
  capital and direction of future projects

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Types of Contractions

• Spin-offs Creates a new legal entity shares
  are distributed on a pro rata basis to parents
  shareholders
• Separation of control over time without cash
  flows. Example In 1995, US West spun off its
  cable and cellular businesses.
• Split-off some shareholders get stock in a
  subsidiary in exchange for parent stock
• Immediate separation of control

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Spin-Offs
A Spin-Off does not yield cash inflows
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Motivations for Spin-Offs

• In recent years, spin-offs and split offs have
  become increasingly popular as companies try to
  refocus on their core business
• Example
• ATT split up into three entities in 1995 NCR,
  Lucent Technologies and ATT

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Contraction Divestitures

• Divestitures Sale of part of the firm to
  outsiders
• Equity Carve-outs Sale of stock in subsidiary
  to outsiders
• In both cases, there is an immediate separation
  of ownership and control
• The parent also receives cash inflows

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Divestitures
Firm
Cash
Divestiture is a Sale of part of the Firm
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Example VLSI and Compass

• In 1997, VLSI Technology, a San Jose based
  semiconductor firm had a wholly-owned subsidiary,
  Compass.
• Compass developed CAD/CAM-type software to design
  new computer chips
• Compass licenses its software for profit the
  parent company, VLSI, receives a substantial
  price discount

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Example VLSI and Compass

• VLSI argues that divesting compass would result
  in higher input costs for itself, putting it at a
  competitive disadvantage.
• But Compass executives believed that as an
  independent company, it could license its
  software to many other chip manufacturers who are
  currently unwilling to pay a subsidiary of their
  rival

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What Should VLSI Do?

• If Compass is correct, a split-off would have the
  following effects
• Compass value would increase
• It could charge VLSI more
• It could sell more to other chip makers
• The new VLSI would be worth less
• It would have to pay Compass market prices for
  software products

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Case Outcome

• Since the extra costs paid by VLSI upon
  divestiture are equal to the extra revenues of
  Compass, shareholders are no better or worse off
• But since Compass will have new sales,
  shareholders would benefit from divestiture
• VLSI sold Compass in 1997

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Conclusions

• Corporate restructurings can take many forms.
• Restructurings are motivated by the creation of
  value
• But in practice, evidence suggests that strategic
  and financial motives for acquisition rarely
  produce value gains.

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Next Week February 2

• Allocate team tasks associated with group
  write-up and do necessary work
• Hand in Red October case write-up at the
  beginning of class on February 2, 2006
• Review contents of Chapter 19
• Read and begin to identify critical financial
  issues in the John Case Case discussed in week 4