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@sheebakapil

Understanding MERGERS and ACQUISITIONS Learning Objectives: After reading the chapter you will be able to

Understand the concept and rationale for merger and acquisition Understand the types of mergers and the benefits Understanding the major merger waves Understanding the merger motives M&A indices

CONCEPT IN PRACTICE

The world’s first product brand company Procter and Gamble P&G was established in 1837 and it sold candles & soaps. In 1935 the Company expanded its international presence with the acquisition of the Philippine Manufacturing Company to expand the Company's first operations in the Far East. In 1957 P&G entered the consumer paper products business with the acquisition of Charmin® Paper Mills, a regional manufacturer of toilet tissue, towels and napkins. In 1963 P&G entered the coffee business with the acquisition of Folgers Coffee. the company then wanted to expand into new market on the eastern side. In 1973 the Company began manufacturing and selling P&G products in Japan through the acquisition of the Nippon Sunhome Company. The new company was called Procter & Gamble Sunhome Co. Ltd. In 1982 the company entered into over the counter and personal health care business. As a result P&G acquired Norwich Eaton Pharmaceuticals in 1985 the Company significantly expanded its over-the-counter and personal health care business worldwide with the acquisition of Richardson-Vicks, owners of Vicks® respiratory care and Oil of Olay® product lines. By then the company already had a hold in several markets worldwide. The company next planned to expand to European market. In 1987 the Company increased its presence in the European personal care category with the acquisition of the Blendax line of products, including Blend-a-Med and Blendax toothpastes. It was the largest international acquisition in Company history.

The year 1987 and 1988 was a period of consolidation and internal restructuring after a spree of international acquisitions and merger activity by the company. Hence in this period P&G announced several major organizational changes with restructuring to category management and a product supply system that integrated purchasing, manufacturing, engineering and distribution. In 1988 the Company announced a joint venture to manufacture products in China. This was the Company's first operation in the largest consumer market in the world. In 1989 the Company entered the cosmetics and fragrances category with the acquisition of Noxel and its CoverGirl, Noxzema® and Clarion products. Further in 1990 the Company expanded its presence in the male personal care market with the acquisition of Shulton’s Old spice® product line.

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In 1991 P&G opened its first operation in Eastern Europe with the acquisition of Rakona in Czechoslovakia. The acquisitions of Max Factor and Betrix further increased the Company's worldwide presence in the cosmetics and fragrances category. In 1994 P&G entered the European tissue and towel market with the acquisition of the Germany-based company, VP Schickedanz.. In 1995 following the lifting of U.S. sanctions against Vietnam, P&G established a joint venture with the Phuong Dong Company to build a manufacturing plant in the Song Be Province, just outside of Ho Chi Minh City. In 1996 the Company continued to expand its global reach with acquisitions of the U.S. baby wipes brand Baby Fresh — complementing the Company's global diaper business and its strong European Pampers Baby Wipes business — and Latin American brands Lavan San household cleaner and Magia Blanca bleach — providing a solid foundation for P&G growth in this important laundry category. In 1997 P&G expanded its feminine protection expertise into a new global market with the acquisition of Tambrands. Tampax®, its tampon brand, is the market leader worldwide. In 1999 the Company entered the global pet health and nutrition business by acquiring the Iams® Company, a leader in premium pet foods. Further in the same year the acquisition of Recovery Engineering Inc. allowed P&G to utilize its understanding of water treatment by developing home water filtration systems under the ® brand. In 2001 P&G acquired the Clairol® business from Bristol-Myers Squibb Co. Clairol was a world leader in haircolor and hair care products. In the same year P&G and Viacom Plus announced a major multimedia marketing partnership. Further Crest® SpinBrush was brought to market in record time following the acquisition of Dr. John's SpinBrush toothbrushes. Today P&G has more than 15 billion-dollar brands in its portfolio. These brands represent more than half of the Company's sales and earnings and include Pampers®, Tide®, Ariel®, Always®, Pantene®, Charmin®, Bounty®, Iams®, Crest®, Folgers®, Pringles® and Downy®. Almost all of these brands were acquired by the company. The company expanded its product lien, business line, markets through mergers and acquisition. This chapter will help you understand the concept rationale of mergers and acquisitions. It will further help you to understand the issues and various due diligence involved in mergers and acquisitions. CHAPTER OUTLINE INTRODUCTION TYPES OF MERGERS

Mergers Acquisition Horizontal merger Vertical merger Conglomerate merger

MERGER WAVES First wave Second wave

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Third wave Fourth wave Fifth wave Sixth wave

MERGER MOTIVES To eliminate competition and create monopoly To gain market access i.e. geographical expansion. To benefit from efficiency gains in form of synergy To satisfy self ego of managers i.e hubris hypothesis To benefit from undervaluation To diversify across industries To gain access to R&D and technology know-how

INTRODUCTION Value creation and sound growth prospects underlie the basic existence of every business enterprise. Every organization is on the lookout for profitable investment opportunities. Sometimes these opportunities are found within the organization like expansion, modernization, and new product development etc. and sometimes these opportunities are part and parcel of the external environment like investment in another company’s equity, in another company’s project or by acquiring a profitable established brand, capacity, etc. The external process has become very popular in the last few years and has contributed much to the economic development of the countries. The process of acquiring a business, brand or firm is called mergers and acquisition. It is a form of inorganic growth were the company purchases growth. The firm avoids growing through Greenfield and Brownfield projects rather prefers the acquisition mode (see figure 1). Heineken for example in 1999-00, showed a total increase in its net turnover of 14%. Out of this the new acquisitions accounted for 8% increase, enhanced sales accounted for 2%, higher sales price mix accounted for 2%, and improved exchange rates accounted for 2% growth. The contribution of acquisition to firm growth was maximum. Merger and acquisition can take many forms like mergers, acquisition, takeovers, absorption, consolidation etc. In other words we can also call them combination of business enterprises. Figure 1: Expansion of Sabmiller from an African brewery to international giant

SABMILLER Was

African brewer Company

Became

International Brewery

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Through

International acquisitions

US, EUROPE, AFRICA, ASIA

INDIA 2000: Narang Breweries : Lucknow

2001: Mysore Breweries Ltd, Rochees Breweries Ltd 2003: Shaw Wallace: Beer Division (Strong Brand Haywards)

2006: Foster’s India: Maharashtra 2007 Failed Acquisition Attempt of Mohan Meakin

Merger and acquisition as a strategic tool should result in value creation. It should be able to create or sustain the competitive advantage of the participating firm. The competitive advantage comes from product differentiation, low cost or focus strategy. Competitive advantage is also created when core competence exists in the participating firm. If competitive advantage and core competence exist before merger they should be able to sustain it even after merger. If competitive advantage or core competence does not exist then it has to be created post merger. Competitive advantage puts the merged firm at a superior position relative to its competitors. A firm with competitive advantage earns superior profit than its competitors. It makes its network of suppliers, competitors and customers more meaningful and more productive than without it. The strength of the merged firm should come from the fact that no one in its network of competitors is able to replace it correctly and perfectly. Thus mergers and acquisition is an inorganic strategic tool for corporate restructuring with the objective of value creation. Mergers offer several advantages to companies as they provide several immediate and long term benefits to the participating firms. They creates synergy for the merged entity, Reduce inter trade and intra trade competition, Enhances market potential, Enhances growth potential, Enhances profitability prospects, Diversification of the company, Optimum utilization of resources, Enhances management efficiency, Enhances market value of the company and Increases strategic competitiveness of the company. Thus mergers and acquisitions enhance the long term value of the company thereby increasing the market dominance. Apart from increasing the market share the companies also benefit in the form of operating and financial synergies. For example consolidation may lead to lowering of total running cost for a company. Here the companies merging are able to eliminate overlapping activities in a particular region and within the merged company as a whole.

An economy of scale is also possible when two or more companies merge. Economies of scale in Mergers are about Increase capacity of merged entity, Increase in sales force and reduction in overheads, increase in bargaining power from suppliers and Reduction in production costs due to large volume. Merger should result in decline of the average costs of the company. As volume of sales pick up average unit cost declines thereby lowering

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total cost of the company. Merger also creates economies of scope. Economies of scope is about broadening the existing product lines, providing one stop shopping for all services, and obtaining complementary products. Thus merger leads to value addition to the merged entity meaning thereby the merger creates synergy. Synergy implies that when 2 or more companies combine together they must be able to create more value than they individually do i.e., 2+2 = 5 or more than 5. However, several studies have shown that at most acquisitions don’t create value for acquiring company’s shareholders. But still companies continue to make more deals and bigger deals every year. Recent research shows that acquisitions in the 1990s have an equal poor record as in the 1970s. The reason could be attributed to

a) Irrational hype about strategic importance of the deal. b) Unusually high enthusiasm and excitement built up during negotiation. c) Weak integration of skills and intelligence.

A typical merger and acquisition activity involves proper due diligence i.e. sound homework prior to execution of merger. Due diligence can take various forms like legal due diligence, financial due diligence and technical due diligence. Legal due diligence is concerned with the legal issues of mergers execution. Financial due diligence is concerned with valuation of target firm, valuation of synergy that determines how much the acquirer firm need to pay the target. Financial due diligence also deals with deal structuring i.e. selecting the mode of payment to target company’s shareholders. It can be all cash, all stock or mix of both or simply stock swap or exchange. Technical due diligence is concerned with the technical feasibility integration of the two firms. This is very important in technology driven industry like banking, telecomm, internet etc. Finally some people also focus on human due diligence which is concerned with the human integration post merger i.e. how well to establish the human compatibility with the changed environment. TYPES OF MERGERS Merger and acquisition is a strategic exercise. It is a tool for quick growth. The merger and acquisition may take different forms depending on the nature of the business of the participating companies and mode of payment and deal structuring. Some broad categories of mergers are discussed in the following para. MERGERS Merger is a transaction where two firms agree to integrate their operations on a relatively coequal basis because they have resources and capabilities that together may create a stronger competitive advantage. The merged entity may either take an entirely new name and new identity or the dominant player may completely absorb the smaller players and retained its own identity. In India the word merger is not defined under any act. Rather the term amalgamation is defined in lieu for merger. Section 2(1B) of income tax act defines amalgamation as “Amalgamation”, in relation to companies, means the merger of one or more companies

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with another company or the merger of two or more companies to form one company…….” Here all properties are to be transferred to the amalgamated company. All liabilities to be transferred to the amalgamated company. The Shareholders holding at least 3/4th in value of shares of the amalgamating company should become shareholders of the amalgamated company. In common parlance, merger means combination of two or more commercial organizations into one. It can also take the form of absorption where one of the participating firm survives. Technically Merger can be done by two methods namely,

1. Merger through Consolidation 2. Merger through absorption

Merger through consolidation: It results when two or more companies combine to form an entirely new company. The new combined company is legally a new entity. The companies, which are acquired, transfer their assets, liabilities and shares to the new company (acquiring company) and in return get cash or shares of the acquiring company. Consolidation is generally merger of equals. Here the two firms combine all assets & liabilities and generally take a new name for the new company formed post merger. For example JP Morgan and Chase Manhattan becomes JP Morgan Chase, Exxon and Mobil becomes Exxon-Mobilfor , Guinness and Grand Metropolitan Merge to form entirely new company Diageo, Sandoz Laboratories and Cieba Geigy merged to form Novartis, Hindustan Computers Ltd., Hindustan Instruments Ltd. Indian software Company ltd and Indian Reprographic Ltd. merged to form HCL Ltd, Tata Fertilizer LTD. (TFL) was absorbed by Tata Chemicals Ltd. (TCL). Merger through absorption: Here two or more companies combine into any of the existing participating company. One company is absorbed into another generally in absorption the dominant player completely absorbs the smaller players and retained its own identity. For example Philips carbon black limited (PBCL) and RPG company merged with its wholly owned subsidiary transmission holdings limited (THL), which is an investment company, HDFC absorbed centurion bank of Punjab, RNRL was absorbed by Reliance power

ACQUISITION

Acquisition is a business transaction where one firm buys another firm with the intent of more effectively using a core competence by making the acquired firm a subsidiary within its portfolio of businesses. In takeover the acquiring firm taking possession of another business either through share purchase or asset purchases. It is characterized by the purchase of a smaller company by a much larger one. This results when a company acquires the ownership/stake in other companies without any combination of the companies. The acquiring company controls other companies by acquiring their assets or management. Thus by acquisition the acquiring company takes a hold of the working of another company. An acquisition becomes a hostile takeover if the target firm does not solicit the bid of the acquiring firm. For example IBM’s acquisition of Lotus in 1995 and Oracle’s bid for PeopleSoft in 2003.

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In India the word acquisition is not used rather we use the term takeover. According to the earlier monopolies and restrictive trade practices ( now the MRTP act has been replaced by competition act 2002) takeover means acquiring at least 25% of the voting power in a company. Sometimes acquisition of even 10% of the subscribed capital can result in takeover/control of the company, hence Indian Companies Act states that if a company intends an acquisition of 10% or more in another company, it has to seek approval in the shareholders’ general meeting and also by the central government. Generally a hostile acquisition is called a takeover. A takeover is always resisted by the acquired company. Thus unwilling, induced, and forced acquisitions are termed as takeovers. A holding company is the company that owns around 50% or more of the share value in a company (subsidiary company). But holding company as well as subsidiary company are different entities and maintain separate accounting reports.

Business snapshot

On November 18th 2001. Grasim bought 2-5 crore shares of Larsen and Tourbo (L&T). From Reliance (RIL) at Rs. 306.60 per share amounting to 10% of equity capital of L&T. `On 24th November 2001 Kumar Birla and Mrs. Rajshree Birla are inducted on board of L&T. On 27th December, 2001 SEBI asked for details of Grasim and RIL deal on L&T. On 13th October 2002. Grasim made an open offer rom 20% of L&T stake at Rs. 190 per share. On 20th October 2002 SEBI took note of investors Complaining on the offer price by Grasim. On 18th November 2002. Sebi directed NV Birla Group to put open offer on hold. In the first major consolidation in the Rs. 700 crore Nylon. Yarn industry, Thapar Group Company JCT Limited is expected to take over nylon yarn plant of Baroda Rayon in Surat. After this take over JCT will become the largest nylon textile yarn manufacturers in India. JCT has entered into a long term agreement with Baroda Rayon to run its nylon plant shut for over 2 years now. JCT will run the plant on a conversion basis (i.e., run the plant and pay a fee). The RM, FGs will be JCT’s. The Assets and liabilities will continue to remain with Baroda Rayon (for Baroda Rayon the plant will start running, earning a fee). Merger can be categorized into following types:- 1. Horizontal Merger 2. Vertical Merger 3. Conglomerate Merger. Horizontal merger A typical Horizontal merger involves two firms that operate in same business line and compete each other in the same industry. In a horizontal merger the merging companies are engaged in same type of business, distribution of business. For example merger of HP and COMPAQ, Vodafone and hutch etc. it results in the consolidation of firms that are direct rivals i.e. competitors. i.e. sell substitutable products within overlapping geographical markets. Horizontal mergers result in increase in market power of the acquiring firm as well as increase in efficiency gain through economies of scale,

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economies of scope and rationalization. For example BP & Amoco expected to save $2 bn p.a. from operations. However in a typical horizontal merger there exists huge challenge of integration like in Exxon & mobile, Helene-Curtis and unilever. Electrolux acquired Voltas’ white goods division for Rs. 160 crore. Voltas had a manufacturing capacity of 50,000 refrigerators and 2, 00,000 washing machines per annum along with 2 brands namely Voltas & Allwyn. Electrolux Further Acquired Kelvinator (see figure 2). Figure 2: Electrolux M&A Horizontal mergers realize economics of scale. It expands the existing business geographically into new territories by offering similar products and services to layer customer base. It does not involve additional products or services. When markets reach saturation point the best option for the firm is to expand through horizontal merger. Organic growth in a saturated market like hiring sales force and managers, developing efficient sales and marketing channel and developing effective, customer relationship

Electrolux AB

Position Allwyn in low end segment, phase out Voltas brand, rebuild Kelvinator brand.

55% Maharaja International

74% Intron 80% Electrolux Voltas

Manufacture only Kelvinator fridges & import high-end Electrolux fridges

Manufacture front loading Electrolux machines (washing)

Manufacture Voltas, Allwyn, Kelvinator fridges & Electorlux W.M.

Increase the capacity of the company

Increase the capacity of the company

Increase the capacity of the company

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management practices does not seem a lucrative business decision. However, the basic strategy for growth is a saturated market is to organize a competing firm in some market or in distant geographic markets. Organic expansion involve large amount of money and time to hire and train people for new markets, new system and new processes. Sometimes it may become an added burden on the organization. Acquiring a firm in distant geographic market does away with such establishment and set up costs. It is an established business already running operation and delivering goods or services. Hence buying firm starts earning from day one. Horizontal merger between two large players has large effect on confirmed firm as well as market. When horizontal merger is between two small players the impact may be very little. Large horizontal mergers are generally considered anti-competitive. Large consolidation through horizontal merger may lead to unfair market practices by the involved players to take advantage over its competitors. Horizontal mergers are more common than vertical and conglomerate mergers. Generally, the players are involved in same industry and in same stage of production. Horizontal mergers create consolidation in the industry. Horizontal merger achieves economies of scale in the production process through doing away with duplicate resources, decreasing working capital and certain fixed expenses, reducing advertising and promo expense, eliminating competition. Economics of scale in simple microeconomics terms refer to cost advantage that a firm derives due to expansion (merger) (figure 3). The average cost per unit falls as scale of output increase. The horizontal merger enhances capacity and scale of output by

1) Reducing cost of purchase due to back buying of inputs and hence enhanced bargaining power with suppliers.

2) Reducing cost of advertising & promotion over complete set of products, brand combined together.

Average cost in long run Average Cost minimum cost Output Figure 3: economies of scale Horizontal merger also enhances economies of scope. Where economies of scale means reduction in average cost per unit due to increase in scale of production economies of scope implies reduction in average cost of producing multiple products. The portfolio of products and brands becomes more efficient as number of products promoted increases along with increase in people reached due to cross selling of the product bundle into the market of new players and effective combination of distribution

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channel. Example of Horizontal Merger; Lipton India and Brook Bond merge to form Brook Bond Lipton India Ltd., Bank of Mathura with ICICI Bank, HDFC Bank and Centurion Bank of Punjab, Bombay Suburban Electric Supply Ltd. (BSES) Ltd. with orissa Power Supply Co., ACC (Associated Cement Companies Ltd.) with Damodar Cement. Vertical merger Vertical Merger happens when two companies in different stages of production or distribution or value chain combine. Generally, it involves companies upstream and another is downstream. Vertical mergers neither change market shares in a relevant market nor eliminate a direct source of competition. Vertical mergers make the merged firm cost-efficient by streamlining its distribution and production costs. It ideally leads to optimal utilization of resources. Thus Vertical merger takes two forms namely Backward vertical merger When a firm integrates with its supplies it is known as backward integration. Here post merger the company controls inputs used in its production operations. For example a steel industry may acquire iron ore mines, Sugar Mill acquires sugarcane farm, automobile company acquires tire or spare part manufacturer, coca cola integrated vertically backward when it bought its franchises and bottlers and Merck-medco Forward vertical merger When the company acquires a firm forward like distribution dealer and , retailers it is known as forward vertical integration. For example Chevron’s oil- gulf oil, America online- map quest. Reliance Petroleum could integrate forward if it decides to sell its entire output through its own petrol pumps instead of through Indian Oil, Disney’s acquisition of American Broadcasting Company. (ABC). Vertical integration reduces transportation costs of production, supplies and distribution system are in close proximity and at the same time enhances supply chain activity coordination. It may also leads to creation or expansion of core competency and competitive advantage of firm vertical merger does not directly create monopoly but creates entry barriers to new players and competitors. Conglomerate merger Here the merging companies are engaged in diverse business activities. Thus merger happen between companies that have no common business link and are completely unrelated. The participating firms may sell related products, share marketing & distribution channels & production processes, or they may be wholly unrelated. Pure diversified mergers, diversify the risk of business portfolio of the parent firm. Diversification of a firm into different business lines that are having low or negative correlation tends to reduce the overall risk of the conglomerate grant firm (parent firm). The diversification helps the firm to diversify away the business specific risk and hence reduce the fluctuation in operating profit (EBIT) of the parent firm. The volatility in operating profits (EBIT) i.e. business risk is high in individual business and hence

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diversification across low or uncorrelated business us reduced in a portfolio of business for parent firm. Parent firm’s volatility in operating profit reduces due to diversification. This helps the parent firm to go for greater diversification. For example, diversified firms like Reliance Industries, Aditya Birla Group, NUVO. Kelso’s acquisition of Nortek Where Nortek Inc. is a international designer manufacturer and marketer of building products while Kelso & Company LP is a private equity firm For example Reliance Industries Ltd. merged with Reliance Petroleum Ltd, aditya birla group acquired idea cellular , Ciba-Geigy (contact lens, Ritalin, Maalox) and Sandoz(Gerber Baby Food, Ovaltine) merged to form Novartis, US steel- marathon oil merged to form USX, AOL merged with time Warner, PepsiCo merged with pizza hut, Citicorp merged with travelers insurance, P&G merged with clorox and Cardinal healthcare merged with allegiance, AT&T merged with Hartford insurance, Bankcorp of America merged with Hughes electronics, R J Reynolds merged with burmah oil & gas. Business Snapshot Savlon was sold by Imperial chemical Industry, as a part of over the counter - OTC product sell off to Johnson and Johnson. Savlon was clinically proven to be better antiseptic than Dettol and hence there were few doubts regarding the success of Savlon in India. In India Dettol is produced and marketed by Reckitt & Benckieser- Piramal (A joint Venture between Reckitt & Benckieser and Nocholas Piramal ). In 1998 Hindustan lever acquired all rights to savlon brand in the medicated soap segment From J&J. In turn they agreed to pay a fixed percentage on brand turnover. HLL with Savlon soap intended to compete in medicated soap category against its rival Dettol soap. After four years of the marketing alliance with J&J HLL called it off in 2003. It decided to launch Lifeboy soap to fight against Dettol.

SAVLON

Clinically proven better antiseptic than

Dettol

Imperial Chemical Industry ltd (ICI ltd)

Johnson & Johnson (J&J) Sold OTC brands

HLL (1998) Savlon soap marketing rights from J&J

HLL (2003) Called off the alliance

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MERGER WAVES Merger activity started from the mid 80s and has since evolved along with industry growth and capital market growth. Merger activity has shown specific cycle patterns along with capital market and industrial production cycles. For a better understanding we group merger acquisition activity into six cycles called waves (table 1). Table 2: characteristic of the merge waves Merger waves Period Particulars First wave 1893-1904 Horizontal merger Second wave 1916-1929 Vertical merger Third wave 1950-1970 Diversified mergers Fourth wave 1980-1989 Hostile mergers, corporate

raider, LBOs Fifth wave 1990-2000 Cross border mega mergers Sixth wave 2003-2008 Private equity, shareholder

awareness Source : york university First wave: 1898-1904 The first merger wave occurred between 1989-1904. this merger wave witnessed peak M&A activity across united states in US economy Also witnessed consolidation across sectors during the period. Evolution of railroad transportation system fuelled the consolidation spree. Firms merged horizontally creating monopoly, eliminating competition and became leading market shareholders. From individual units of ownership giant firms emerged like US steel, Du Pont, standard electric, Eastman Kodak etc. The urge to consolidate was so strong among companies that on an average 300 firms disappeared annually during the period (table 2). Merger activity was concentrated in the industry where transportation cost was high relative to the price of the product . Majority of mergers activity occurred in eight industries namely food products, chemical products, petroleum products, primary metals metal products, transportation equipment and coal mining. The economy moved towards monopoly. Major industries that saw consolidation were capital and labour intensive that had high fixed costs. Table 2: Firm disappearance by merger and merger capitalization 1895-1920 Year Firm disappearance

by merger Merger capitalization

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(million $usd) 1895 43 40.8 1897 69 119.7 1898 303 650.6 1899 1208 2262.7 1900 340 442.4 1901 423 2052.9 1902 379 910.8 1905 226 243 1906 128 377.8 1910 142 257 1911 103 210.5 1916 117 470 1919 171 981.7 1920 206 1088.6 Ralph nelson, the merger movements in American industry, 1895-1956; national bureau of economic research, UMI, 1959, ISBN 0-87014-065-5 During demand decline period and price competition that followed the great depression in US these firms readily absorbed each other to become giants in their respective sectors . As sectors consolidated giants were created from small widely distributed firms. Consolidation helped firms take advantage of economies of scale and economies of scope. .Horizontal consolidation of such mega nature witnessed in the first wave lead to reduced production costs and manipulation of prices to strengthen sales and create demand. Simultaneous development of the capital market augmented the consolidation spree. The growing capital market provided the much required support in the form of large size securities issue that financed the deals. Although the first merger wave is symbolic to US however Great Britain experienced simultaneous merger wave. The divers for the first merger wave were economic depression of US, new state legislations on incorporations, development of stock exchange (NYSE). Main reasons for the consolidation were reduction of price competition and cost reduction. This wave ended with crash of equity market. Second wave: 1916- 1929 The second wave began with World War II and ended with stock market crash of 1929. Enactment of antitrust laws created ground for second merger wave. This period also marked consolidation and emergence of new giants like general motors, IBM, union carbide etc. The period witnessed emergence of oligopoly rather than monopoly. Along with merger activity the stock prices also gained momentum running parallel with industrial production and growth. However when stock market crashed in 1929 the merge activity suffered a decline. To discourage monopoly creation as witnessed in first wave merger Sherman antitrust act was created and enforced with vigour. It lead to discouragement of monopoly creation

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lead to creation of oligopoly. Clayton act 1914 discouraged monopolies and uncompetitive mergers hence the period witnessed more vertical mergers occurred relative to horizontal mergers. Cost reduction though economies of scale and scope were main motives for the merger. Third merger wave ( 1946-1970) This period began a decade after World War II and was marked by economic surplus and growth in US economy. Merger happened in unrelated businesses. The M&A activity was more concentrated around 5 years 46, 47, 54, 55, 56. In 1968 around 25000 merges took place and declined in latter part. Unlike the fist and second merger waves this period was marked by diversified mergers that happened amongst unrelated businesses and gave birth to an era of creation of conglomerate business empires. The strong regulatory reforms that discouraged monopoly and anticompetitive sprit along with strong antitrust policy lead to diversification. In US during the period the M&A activity focused on diversification and conglomerate creation while In UK the M&A activity focused on horizontal integration. Third merger wave ended with the oil crisis followed by global recession Fourth wave (1980-1989) This era was highlighted by friendly as well as hostile mergers. The term corporate raider was coined. This wave gave birth to the concept of leverage buyouts LBOs and more and more companies were bought by debt financing. This period was also market by foreign takeovers across countries especially hostile mergers. However few mega hostile deals like RJ Nabisco bought by KK ( Kohlbeg, Kavis, & Roberts) for $25 million, indictment of Michael Milken and his investment bank Drexel Burnham Lambert shook the financial world. This wave of LBOs reached an end as markets for junk bonds which is used for financing LBOs collapsed. The period saw enactment of anti-takeover code of conduct. The main divers fo M&A activity during this period were deregulation of financial service sector, creation of new financial instruments and advancements in technology know how. Taking lessons from the third merger wave the companies diversified and focused on core competencies rather than on non core assets. Fifth merger wave ( 1990-2000) This was an era of bill Clinton. The world economies flourished especially India and china. This wave also marked revival of LBOs although not of the magnitude as witnessed in 4th wave. This period was marked by overvaluation and overpayment, high profile mega mergers, dominance of equity deals over LBOs and wealth transfer from acquirer to target company shareholders. The merger activity was more pronounced by control mania where acquirer pursued companies aggressively for control and created overpayment. For example BP and amco, Exxon/ Mobil, Citicorp/ travelers, chase Manhattan and J P Morgan, Compaq and digital equipment, HP and Compaq, Mannesmann and Vodafone, Daimler Benz and Chrysler etc.

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Stock market boom supported the wave and ran parallel to the wave. Further deregulation, globalization and liberalization of banking and telecom industry marked the wave peak of 98-2000. Revival of equity financing was witnessed as LBOS took a back seat. Consolidation of industries and globalization was the key buzzword. This wave ran parallel to the IT Boom. Many high profile mergers failed like AOL-Time Warner, While Pfizer’s Acquisition of Lambert (lipitor) for $100 bn and Exxon Mobil were mega successful deals (table 3). However in early 2000 as stock market bust and dot.com era sagged the M&A spree came to a halt. Sixth merger wave ( 2003-2008) This wave started three years post IT bubble bust. IT bubble bust that marked the end of fifth wave lead to credit crunch, global liquidity tightness and loss of investor trust. Fear prevailed in capital market. Gradually as economies revived general macro and micro economic scenarios eased. With evolution of corporate governance practices and strengthening of capital market yielded more fundamental valuation figures. These drivers lead to growth in M&A activity. It peaked in 2006 when M&A deals crossed around 1$ trillion mark. In mid 2007 the financial crisis started and liquidity crunch creped in which had rippling effect across markets worldwide. Unlike the 5th wave in the sixth wave along with equity payment cash payment formed substantial part of the deals. The cash surplus of corporate and high liquidity in the market was instrumental in creating the sixth merge wave. The corporate control mania that emerged in the 5th wave subsided in this merger wave and overpayments educed thus reducing the acquisition premium and wealth transfer. Managerial hubris softened paving way to more fundamental strategic reasons for acquisitions. Enactment of Sarbanes Oxley act created improved corporate governance practice resulting in improved valuations and better premium justifications. Sixth wave predominantly streamlined the acquisition process in terms of fewer premiums, premium justification, less wealth transfer clear-cut strategic rationale for acquisitions and fading of myopic vision of acquirers acquisition bid. Emergence of sixth wave was driven by cheap funds. The deals were debt financed and cash financed. The wave was marked by more friendly takeover in America and more hostile side in Europe and Asia. Asia witnessed deregulation liberalization and globalization and Europe integration ( euro), low interest rates and weak dollar were drives of the fourth merger wave. Sixth wave ended with subprime mortgage crisis and credit crunch that lead to high costs of funds. The first two merger waves were unique to US third wave incorporated merger wave of UK as well. The fourth wave included merger wave of Europe. Fifth and sixth merger wave was more a global phenomenon.. Many reasons have been cited by academicians

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and researchers justifying the occurrence of such waves. We now discuss the major reasons for mergers across globe.

Table 3: Top 20 deals by value in the last decade ($USD BN)

1999 Vodafone AirTouch PLC Mannesmann AG 202.80

2000 America Online Inc Time Warner 164.70

2007 Shareholders Philip Morris Intl Inc 107.60

2007 RFS Holdings BV ABN-AMRO Holding NV 98.20 1999 Pfizer Inc Warner-Lambert Co 89.20

1998 Exxon Corp Mobil Corp 78.90

2000 Glaxo Wellcome PLC SmithKline Beecham PLC 76.00

2004 Royal Dutch Petroleum Co Shell Transport & Trading Co 74.60

2006 AT&T Inc BellSouth Corp 72.70

1998 Travelers Group Inc Citicorp 72.60 2001 Comcast Corp AT&T Broadband & Internet Svcs 72.00

2009 Pfizer Inc Wyeth 67.30

1998 SBC Communications Inc Ameritech Corp 62.60

1998 NationsBank Corp,Charlotte,NC BankAmerica Corp 61.60

2006 Gaz de France SA Suez SA 60.90

1999 Vodafone Group PLC AirTouch Communications Inc 60.30

2004 Sanofi-Synthelabo SA Aventis SA 60.20

2008 InBev NV Anheuser-Busch Cos Inc 52.20

1999 Total Fina SA Elf Aquitaine 50.10

2000 Pacific Century CyberWorks Ltd Cable & Wireless HKT 37.40 REASONS FOR M&A Firm merge for several reasons. But all reasons culminate in creating strategic benefit to the merged entity in the long run. The merger of the resources owned by the companies are required to yield competencies that create advantage to the acquiring firms in the long run. The acquired should be placed at an advantageous position post M&A in the industry structure vis-à-vis its peers. The merger and acquisition process for whatever reasons leads to combination of the complimentary and supplementary resources of the two companies. The acquirer gets new supplementary resources that create added advantage for the merged entity. At the same time the acquirer combines its resources effectively with the acquired resources similar in nature i.e. complimentary resources. The resources include all tangible and intangible assets, firm processes, firm attributes and capabilities

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and the knowledge and information the firm controls and generates1. These resources combine to generate competencies that yield advantage to the merged entity in the industry structure vis-à-vis its peers. The acquirer should derive strength and gains by acquiring the target company. Post M&A the acquirer should be better placed in the industry structure as compared to its peers. The M&A should yield competencies in form of competitive advantage through physical resources2 like plant equipment, geographical location, technology know-how etc, though human resources3 like experience, judicious judgment, intelligence , foresight and skills of managers. Also though organizational resources4 like hierarchical structures, span of control, divisional boundaries and product diversification etc. The broad reasons for M&A across sectors and economies can be listed as follows.

To eliminate competition and create monopoly To gain market access i.e. geographical expansion. To benefit from efficiency gains in form of synergy To satisfy self ego of managers i.e hubris hypothesis To benefit from undervaluation To diversify across industries To gain access to R&D and technology know-how

To eliminate competition and create monopoly Horizontal and vertical integration eliminate competition. Typically horizontal mergers eliminates direct competitors and consolidate the industry. Horizontal merger of firms in same business line, in same geographical location and close substitute products call for consolidation. As markets become slimmer and players reduce the merged entity enjoys the monopoly status. Anti-competitive laws across globe aim at reducing the monopoly creation through horizontal mergers. Horizontal mergers directly hamper the competition and eliminate weak players that are acquired (figure 4). Vertical merger creates foreclosure of rivals by blocking supplier or distributor for competitors. The supplier may force the firm ( vertical backward integration) to buy all its inputs from the supplier. In vertical merger competition may be blocked by tying as well. In tying the customers are required to buy all inputs with the one they want from the supplier. In tying the supplier agrees to sell its customer one product (tying item) only if the customer buys remaining items from the supplier. This creates anti competitive environment in the industry structure.

1 Daft R 1983 organizational theory and design new york west. 2 Williamson O 1975, markets and hierarchies , new york : free press. 3 Tomer J F 1987 organizational capital, the path to higher productivity and well being, new York: praeger. 4 Becker G S 1964, human capital, new york: Columbia.

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figure 4: monopoly creation in horizontal and vertical merger To gain market access i.e. geographical expansion. Companies choose merge and acquisition for expansion in new markets. Geographical expansion through M&A involves better understanding of market as the local target is operating in that market. For example coke came to India it bought thums up, limca and gold spot owned by Mr AMESH Chauhan. All three strong brands holding about 70% of the soft beverage market in India was sold to coke which received a readymade market in India. Till date thums up contributes more to the bottom line of coke India than coke itself. Similarly Vodafone entered India by acquiring hutch., daiichi entered Indian pharma sector by acquiring ranbaxy etc.out-bound deals help companies expand in new markets, new geographic locations and hence garner new revenues though new customers. Acquirers get a readymade market and readymade product and distribution system all at one place. Geographical expansion pursued to add new brands, products and business lines to that of existing ones. This adds directly to the existing revenues and gives synergy gains to the acquirer. The acquirer can now cross sell and take advantage of multiple, brands, product portfolios. Geographical expansion benefits from local specialization , higher utilization of capacity and more technical efficiency gains. However new geographical expansion also poses risk which is domestic country specific. In any geographical expansion the acquirer takes time to adjust to local benefits and the market. To benefit from efficiency gains in the form of synergy

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All mergers and acquisition are pursued with an ulterior motive of synergy gains. The acquirer understands that post acquisition the acquirer would not only get the target but also added value derived from integration of the two. Synergy gains occur both in horizontal as well vertical merges. Synergy gains are derived from combination of supplementary and complimentary resources. Typically Horizontal mergers result in elimination of competitor. The industry gets consolidated with horizontal mergers. Large scale consolidation lead to monopoly creation as competition is eliminated and acquirers dominance on pricing and distribution enhances. As Horizontal mergers occur between firms engaged in similar business, similar markets, close substitute products, it provides greater market power to the acquirer. Incentive to merge horizontally not only eliminates competition but also creates large cost savings for the acquirer. The cost savings come from economies of scale and economies of scope. An economy of scale is derived by larger production output leading to reduced fixed costs as well as variable production costs. Post merger acquirer is in a position to manage the vendor(s) better and that helps to reduce cost of inputs as the acquirer gets into a better bargaining position with large purchase orders. The large combined production facilities help in elimination of overlapping resources and activities thus lowering the fixed costs. Elimination of duplicate, overlapping and redundant resources saves time, effort and money thus reducing overall costs. In the post merger scenario the merged entity may shift or reallocate production processes among facilities that were owned separately pre-merger with the aim of reducing marginal cost of production. At the same time large capacities may result in specialization in processes, division of labour resulting in reduced costs. The merged entity gains from combining their complementary and supplementary resources, technology, know-how, skills and even administrative abilities. Economies of scope occur as cost of production for the combined portfolio of brands and products reduces post merger. The combined entity has a widely diversified bouquet of brands, product offerings with lesser cost associated with their production, marketing and distribution. After merger the cross selling happens across the client base of both the companies. After adjusting for cannibalization the cross selling of brands and products across the two markets help in enhancing revenues and reducing distribution costs. Large firms as a result of merger benefits from spreading their advertisement and promotional budget over larger bouquet of brands and products. Large firms with broader array of assets are able to borrow more funds and maybe at lower costs if the quality of assets improve post merger. Apart from horizontal mergers, vertical mergers also create efficiency gains. The vertical merger combines firms which operate in different stages of value chain activity of the firm. Backward vertical integration helps in streamlining procurement process thereby reducing the cost of inputs and backward supply chain. For example when steel industry purchases iron ore mines, sugar manufacturer purchases sugarcane farms, flour and baking company purchases wheat farms etc reduce their cost of raw material and

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procurement. Forward vertical mergers happen when firms purchase entity involved with distribution of the end product and services. This again helps the acquirer to reduce the distribution cost and enjoy efficiency gains from such front end loaded deals. To satisfy self ego of managers i.e hubris hypothesis Many merger and acquisition happen due to the self ego of the acquirer. The CEO self concept and his ego. Hubris implies that the acquirer lands up paying too much for the acquisition of the target. This is mainly linked to the ego and overconfidence of the acquirer. The overvaluation and overpayment due to aggressive biding leads to wealth transfer from acquirer to target shareholders, and also high debt financing raising the cost of money to eth acquirer. Ideally target should have same value to all bidders. The winner is the one who overvalues the target. Managers pay huge premium with the impression that they are correct in their judgments of spotting the synergy gains and future growth opportunities5. This is due to their overconfidence and rigidity. And later post merger the whole company pays a price and looses on value in the long run due to overpayment. Technically hubris hypothesis discusses the myopic vision of the acquirer during bidding process and final acquisition. To benefit from undervaluation M&A is pursued by firms when the target company is available at undervalued price. The undervaluation is in context of the fundamental value of the target company’ assets. Such companies may be termed as sick or poor in performance. Sometimes undervaluation is also in context of the market share price. A stock may loose more than 50% of its value and remain at its new low price consistently like Satyam, Bear Stearns etc. This eroded market value may be due to investors distrust, loss of market confidence or erosion of brand value. The main issue is that the acquirer should be able to spot the undervaluation in time and the cost of integration should not be more than the benefit of undervaluation. Otherwise the benefit of undervaluation buyout is defeated. The acquisition premium is generally not paid when the target is bought with undervaluation as motive. To diversify across industries M&A is pursued across unrelated business and sectors when the acquirer intends to diversify and become a conglomerate. A conglomerate operates in multiple businesses 5 Mukherjee TK, Kiymaz H, Baker HK. 2004. Merger Motives and Target Valuation: A Survey of Evidence from CFO’s. Journal of Applied Finance 14: 7-24.

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and business lines that are not related to each other. Diversification happens when the acquirer and target are on unrelated businesses and post Merger the acquirer is diversified into businesses that are having low correlation with each other. Due to low correlation the businesses are able to reduce the business risk of fluctuating operating profit. The fluctuation in the operating profit of the acquirer reduces as the M&A adds unrelated businesses and becomes stable. Stable operating profits call for high debt repaying capacity and hence more debt and less cost of capital. However there are no distinct synergy benefits in pure diversified merger and hence ideally acquisition premium is not justified. Diversified mergers into new products new business lines yield less synergy gains. as witnessed in the third wave which was dominantly known as diversified merger wave, Almost all deals that created conglomerate gains in this wave reported weak performance in the long run. Many could not survive and were sold off. They were found to destroy shareholders value in the long run6. Diversified mergers lead to high control and coordination costs from the acquirer7, information asymmetries and production inefficiencies. The managerial bottlenecks magnify with diversification and destroy value in the long run. To gain access to R&D and technology know-how Firm with lucrative R&D investment are tempting targets. R&D does not assure revenue till it is in the process. Only when R&D yield innovations which garner a market and create surplus it is termed commercially successful. Acquiring company high on R&D assures control over future innovation market. R&D intensive industries would call for more M&A as R&D are secretive in their research initiative and activities and innovations of new products. M&A grants directs control over &D and hence more dominance in the market. Several firms pursue M&A to acquire firms with strong innovation centres. These are R&D intensive firms that reap on commercial success of their r&d developments. Microsoft is a company that has aggressively pursued smaller entrepreneurial ventures based on r&d and innovation like forethought which had developed a presentation software now known as PowerPoint. P&G acquired innovation based firm Gillette and so on. In March 2009 a pharmaceutical giant Roche completed its acquisition of biotechnology firm Genentech for $ 46.8 billion8. Roche had earlier acquired a substantial stake in Genentech in 1999 bys pending $2.1 billion due to TPA a clot busting drug developed by Genentech. Genentech established in 1976 carries a legacy of innovative culture and strong R&D laboratory (gRED). Roche agreed to provide the autonomy to R&D at Genentech to retain its strong culture of highly successful innovation. Roche’s best

6 Weston FJ, Mitchell ML, Mulherin HJ. (2004) Takeovers, Restructuring and Corporate Governance. Pearson Prentice Hall: Upple Saddle River, New Jersey 7 Rajan, R., H. Servaes, L. Zingales, 2000, The Cost of Diversity: The DiversificationDiscount and Inefficient Investment, The Journal of Finance, Vol 55, Issue 1, pp 35-80 8 http://www.nytimes.com/2009/03/13/business/worldbusiness/13drugs.html

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selling drugs – cancer medicines avastin, herceptin, rituxan came from Genentech9. In 2012 july Roche faced problems with its R&D cell ( Roche pharma research and early development laboratory pRED). As a result Roche initiated drastic job cuts and shutting down of the Nutley NJ research site. Roche lab faced several high profile expensive failures like heart drug dalcetrapib. Genetech’s R&D successes are several and have outshined the Roche’s lab performance since the merger. This has forced Roche to retain the autonomy of the target firm i.e. Genetech’s R&D lab. Post merger as competition reduces and industry consolidates the players tend to invest less in R&D. Synergies in R&D take longest time to realize. The creativity, innovation, and free thinking gets curbed which coupled with licensing procedures and regulatory requirements In R&D testing and commercialization de-motivated the acquirer to pursue R&D. Pfizer was founded in 1849 in USA and became household name by 1942 with its blockbusting drug penicillin. It entered into merger fro the first time in 2000 by acquiring Warner Lambert due to its drug lipitor for $100 billion. Lipitor became blockbusting drug and Pfizer has grown since. In 2003 added pharmacia to become one of the leading R&D oriented pharmaceutical company. It diversified itself by acquiring Wyeth in 2009 to become world’s leading biopharmaceutical company. However post expiry of patent of lipitor its best selling drug contributing significantly to its bottom-line, Pfizer has shunned away from R&D investment. Pfizer is cutting down its costs by cutting R&D investment. The R&D spend of Pfizer was about USD$ 9.4 billion in 2010 and has reduced to USD$ 7 billion in 2012. Pfizer has closed its R&D sites in catama, italy, Aberdeen, Gasport UK. It closed down its R&D site Ann Arbor which was most productive R&d lab and where Lipitor was discovered. Pfizer seems to have shifted its corporate strategic focus away from R&D. and with this shift it calls for aggressive pursuit of M&A fro growth. If Pfizer cannot make it it should buy it. Further Pfizer is also selling off non-core non-pharmaceutical businesses like capsugel (gelatin capsule manufacturing unit to KKR) and nutrition business unit to Nestle. KEY TERMS Due diligence Merger Acquisition Takeover Consolidation Amalgamation Subsidiary Conglomerate Horizontal Vertical Backward integration Forward integration

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