Mergers&

Acquisitions

Introduction

Another firm should be acquired only if doing so generates a positive NPV. However, the NPV of an acquisition candidate can be difficult to determine. As such, acquisitions are an investment made under uncertainty.

IntroductionHistorically, there are distinct, systematic patterns to the returns various security-holder classes earn during corporate control transactions (mergers and acquisitions).The strongest and most consistent regularity is that the target firm shareholders earn large, positive abnormal returns in virtually all transactions, while bidder shareholder results are mixed.

Introduction

Target shareholder returns are larger:1. For leveraged buyouts (by incumbent

management) than external takeovers.

2. In contested bids than single bidder transactions.

3. In recent years than during the 1960s.

IntroductionBidder shareholder returns are more mixed, in that:1. Bidder shareholders earned significantly

positive abnormal returns during the 1960s, but these have decreased over time.

2. Bidding firm shareholders on average break even in those takeovers where cash is used, but lose when stock is the form of payment.

3. Bidder shareholders lose when their firm acts as a white knight.

Legal Forms Of Acquisitions

1. Acquisitions through Merger or ConsolidationMerger - the complete absorption of one firm by another; after the merger, the acquired firm ceases to exist as a separate business entity.Consolidation - is the same as a merger except a new firm is created; after the merger, both the acquiring firm and the acquired firm terminate their previous legal existence and became part of a new firm.

Legal Forms Of Acquisitions2. Acquisition of Stock

A second way to acquire another firm is to simply purchase the firm’s voting stock in exchange for cash, shares of stock, or other securities. A tender offer (ie. public offer to buy shares) is made by one firm directly to the shareholders of another firm. If the shareholders choose to accept the offer, they tender their shares by exchanging them for cash or securities (or both), depending on the offer. A tender offer is usually contingent on the bidder’s obtaining some percentage of the total voting shares. 

Legal Forms Of Acquisitions3. Acquisition of Assets

A firm can effectively acquire another firm by buying most or all of the assets. However, the target firm does not necessarily cease to exist unless its shareholders choose to dissolve it. This type of acquisition requires a formal vote of the shareholders of the selling firm.The acquisition may involve transferring titles to individual assets, a legal process that can be costly.

Legal Forms Of AcquisitionsA Note on Takeovers

A takeover occurs when one group takes control from another. Three forms include:

1. Acquisitions (merger or consolidation) – occurs when the bidding firm makes a tender offer or acquires the assets of the target firm.

2. Proxy contest – occurs when a group attempts to gain controlling seats on the B of D by voting in new directors.

3. Going private – all the equity shares of a public firm are purchased by a small group of investors through a leveraged buyout (LBO). The shares are then delisted from stock exchanges.

Legal Forms Of Acquisitions

A Note on Takeovers

Acquisition

Proxy contest

Going private

Merger or consolidation

Acquisition of stock

Acquisition of assetsTakeovers

Taxes And AcquisitionsIf one firm buys another firm, the transaction may be taxable or tax-free. In a taxable acquisition, the shareholders of the target firm are considered to have sold their shares and they have capital gains or losses that are taxed; it is a taxable acquisition if the buying firm offers the selling firm cash for its equity. In a tax-free acquisition, since the acquisition is considered an exchange rather than a sale, no capital gain or loss occurs at that time; the general requirements for tax-free status are that the acquisition involves 2 corporations from same country, subject to same corporate tax and that there be a continuity of equity interest.

Taxes And Acquisitions

In addition, there are two tax-related factors to consider when comparing acquisition alternatives:

1. The capital gains effect – in a taxable acquisition, shareholders may demand a higher price as compensation, thereby increasing the cost of the merger.

2. The write-up effect – in a taxable acquisition, the assets of the selling firm are revalued or “written-up” from their historic book value to their estimated current market value.

Gains From AcquisitionsAcquiring another firm makes sense only if there is some concrete reason to believe the target firm is somehow worth more in our hands than it is worth now. Some reasons include:

1. Synergy “The whole is worth more than the parts.” Synergy is measured as the difference between the value of the combined firm and the sum of the values of the firms as separate entities – it is the incremental net gain from the acquisition.

Gains From Acquisitions

2. Revenue EnhancementMarketing gains: improved promotion, distribution and/or product mix; cross-marketing.Strategic benefits: enhances management flexibility with regard to the company’s future operations – the process of entering a new industry to exploit perceived opportunities.Market power: increased market share and market power – profits can be enhanced through higher prices and reduced competition.

Gains From Acquisitions

3. Cost ReductionsEconomics of scale: the sharing of central facilities spreads fixed overhead more thinly.Economics of vertical integration: makes coordinating closely related activities easier.Complementary resources: to make better use of existing resources or to provide the missing ingredient for success.

Gains From Acquisitions

4. Tax GainsNet operating losses: the combined firm would have a lower tax bill than the two firms considered separately.Unused debt capacity: adding debt can provide important tax savings and many acquisitions are financed using debt.Surplus funds: the tax problem associated with paying dividends is avoided.Asset write-ups: in a taxable acquisition, the assets of the acquired firm can be revalued.

Gains From Acquisitions

5. Changing Capital RequirementsAll firms must make investments in working capital and fixed assets to sustain an efficient level of operating activity. A merger may reduce the combined investments needed by the two firms. For example, a firm that is producing at capacity can either build new or merge with a firm that has excess capacity.

Gains From Acquisitions6. Inefficient Management

There are firms whose value could be increased with a change in management. These firms are poorly run or otherwise do not efficiently use their assets to create shareholder wealth.

Gains From Acquisitions

7. Going GlobalEntering new markets may be more viable buying existing operations and infrastructure in the foreign country.Government restrictions, consumer confidence in foreigners, and entry barriers play key roles in foreign market expansion decision-making.

Gains From Acquisitions

Some general rules in evaluating an acquisition are:

1. Do not ignore market values.2. Estimate only incremental cash flows to

your firm.3. Use the correct risk-adjusted cost of

capital.4. Be aware of transaction costs including

merger implementation costs.5. Understand corporate culture and the

impacts this will have on the “marriage”.

Myths of Acquisitions

DiversificationDiversification is commonly mentioned as a benefit to a merger – it reduces unsystematic risk. However, given the value of an asset depends on only its systematic risk, shareholders will not pay a premium for a merged company just for the benefit of diversification. Stockholders can get all the diversification they want simply by buying stock in different companies.

Myths of Acquisitions

EPS Growth An acquisition can create the appearance of growth in EPS. This may fool investors into thinking the firm is doing better than it really is. Astute financial managers will look beyond the accounting numbers in valuing the net impacts of an acquisition.

The Cost of an Acquisition (Cash or Common Stock)

All other things being the same, if common stock is used, the acquisition cost may be higher because the target firm’s shareholders must share the acquisition gains with the shareholders of the bidding firm. If cash is used, the cost of an acquisition may not depend on the acquisition gains.

The Cost of an Acquisition (Cash or Common Stock)

Whether to finance an acquisition by cash or by shares of stock depends on several factors, including:

1. sharing gains2. taxes3. control

Corporate RaidersWhile most would agree that corporate raiders can deliver benefits to shareholders and society, there is increasing concern over whether the cost is too high.That is, when plants close or move, workers and equipment can be turned to other uses only at a cost to society – usually paid for by taxpayers. In addition, critics argue that they reduce trust between management and labor thus reducing efficiency and increasing costs.Corporate raider – usually refers to the person or firm that specializes in the hostile takeover of other firms.

Defensive TacticsTarget firms frequently resist takeover attempts; resistance usually starts with press releases and mailings to shareholders presenting management’s viewpoint. It can eventually lead to legal action and solicitation of competing bids. Managerial action to defeat a takeover attempt may make target shareholders better off if it elicits a higher offer premium from the bidding firm or another firm. However, management resistance may simply reflect pursuit of self-interest at the expense of shareholders.

Defensive TacticsThe Control Block and the Corporate

CharterIf an individual or group owns 51% of a company’s common stock, this control block makes a hostile takeover virtually impossible. The corporate charter refers to the articles of incorporation and corporate by-laws that establish the governance rules of the firm. Firms can amend their charter to make acquisitions more difficult by, for example, requiring a merger to be approved by 80% of the shareholders of record.

Defensive TacticsRepurchase/Standstill AgreementsStandstill agreements are contracts where the bidding firm (or individual) agrees to limit its holdings in the target firm; these agreements usually lead to the end of the takeover attempt. Standstill agreements often occur at the same time that a targeted repurchase is arranged. In a targeted repurchase, a firm buys a certain amount of its own stock from unwanted investor(s), usually at a substantial premium (known as greenmail). These premiums can be thought of as payments to potential bidders to eliminate unfriendly takeover attempts.

Defensive Tactics

Greenmail – refers to the practice of paying unwanted suitors who hold an equity stake in the firm a premium for their shares over the market value, to eliminate the potential takeover threat.

Defensive Tactics

Poison Pills and Share Rights PlansA poison pill is a financial device designed to make unfriendly takeover attempts unappealing if not impossible.

A share rights plan, a type of poison pill, are provisions allowing existing stockholders to purchase stock at some fixed price should an outside takeover bid take place, discouraging

hostile takeover attempts.

Defensive Tactics

Poison Pill – is an amendment to the corporate charter granting the shareholders the right to purchase shares at little or no cost in the event of a hostile takeover, thus making the acquisition prohibitively expensive for the hostile bidder.

Defensive Tactics

Going Private and Leveraged BuyoutsIn a sense, a LBO can be a takeover defense. However, it is only a defense for management. From the stockholder’s point of view, a LBO is a takeover because they are bought out. In a LBO, the selling shareholders are paid a premium on the market price of their stock, just as they are in a acquisition.

Defensive Tactics

Does a LBO create value? There are generally two reasons given for the ability of a LBO to create value:

1. The extra debt creates a tax deduction which (may) lead to an increase in firm value.

2. The LBO usually turns the previous managers into owners, thereby increasing their incentive to work hard.

Defensive Tactics

Since the mid-1980s, ongoing experience with LBOs has revealed some weaknesses both in the concept and the financing vehicle – high-yield junk bonds.

Further, LBOs sometimes lead to spinoffs of assets to pay down debt.

Defensive Tactics

Other Defensive Tacticsa. Golden Parachutes

Some target firms provide compensation to top-level management if a takeover occurs. This can be viewed as a payment to management to make it less concerned for its own welfare and more interested in the shareholders who are considering the bid.

Defensive Tactics

b. Crown jewelsFirms sometimes sell major assets when faced with a takeover threat.

c. White knightTarget firms sometimes seek a competing bid from a friendly bidder who promises to maintain the jobs of existing management and to refrain from selling the target firm’s assets.

In-Conclusion

Shareholders of successful target firms achieve substantial gains as a result of a takeover.Shareholders of bidding firms earn significantly less from takeovers. In fact, studies have found that the acquiring firms actually lose value in many mergers.

In-ConclusionRules of thumb for merger success?

Don’t rush the wedding - do your homework carefully to prevent morning-after surprises.Know what you’re buying - not just the financials, but the corporate culture.Adopt each partner’s best practices - don’t assume the bigger company or the acquirer has all the answers.Be honest with employees about how a merger will affect them - start early and communicate honestly with them.Take the time to do internal recruiting - make sure the managers you want to keep don’t go wandering off to a competitor.