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FIN-324: Financing strategies and
corporate governance
Lecture 8: Mergers
Anton Miglo
Fall 2013
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Topics Covered
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Types of Mergers
History of M&A
Reasons for Mergers
Who benefits/losses?
Stock Price Reactions
The Free Rider Problem
Evaluating Merger Gains and Costs
The Mechanics of a Merger
Takeover Tactics, Defense and Battles
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Poison pills
White knight
Staggered boards
Golden parachutes
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FIN 324, Anton Miglo
What is merger?
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What is a Merger?
 In a MERGER, two (or more) corporations
come together to combine and share their
resources to achieve common objectives.
 The shareholders of the combining firms
often remain as joint owners of the combined
entity.
 A new entity may be formed subsuming the
merged firms
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Types of Mergers
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Mergers are often categorized as:
• Horizontal
– When the merger takes place between firms in the
same business, e.g., Air Canada’s acquisition of
Canadian Airlines.
• Vertical
– When the merger involves acquiring a supplier or
customer, e.g., Pepsi owns Burger King.
• Conglomerate
– When the merger involves companies in unrelated
businesses, e.g., a manufacturer acquires a bank.
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What is an Acquisition?
 In an ACQUISITION, one firm purchases
the assets or shares of another.
 The acquired firm’s shareholders cease to be
owners of that firm.
 The acquired firm becomes the subsidiary of
the acquirer.
 Acquisitions usually take the form of a public
tender offer.
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Percentage of Public Companies Taken Over Each Quarter,
1926–2005
Mergers appear to occur in distinct waves, with the most recent waves occurring in
the 1960s, 1980s, and 1990s.
Source: Jarrad Harford.
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History of Mergers and Acquisitions
Activity in United States
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 The First Wave 1890-1904
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After 1883 depression
Horizontal mergers
Create monopolies
 The Second Wave 1916-1929
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Oligopolies
The Clayton Act of 1914
 The Third Wave 1965-1969
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Conglomerate Mergers
Booming Economy
 The Fourth Wave 1981-1989
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Hostile Takeovers
Mega-mergers
Conglomerates’ “garage sale”
 Mergers of 1990’s
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Strategic mega-mergers
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2000s? New wave
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1890 – 1905
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1)
1890 – 1905 Horizontal, US Perspective
Large mergers of oil, tobacco, steel
Sherman 1890 Act – restraint of trade
Clayton Act – lessen competition
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1916 – 1929
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1916 – 1929 Vertical, US perspective
Public Utilities, Banking, Chemical, Mining, Food
Processing
Driven by technology changes and demographic
changes
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Mass Marketing, Market Extensions
Radio, Auto
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1960s
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1960s Conglomerate
Motivation: diversity
Capital Asset Pricing Model (CAPM)
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1981 –1989
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 The increased takeover activity that started in the 1980s can be attributed
to a number of factors:
 The emergence of the high-yield (junk) bond market that was used to
finance a number of that acquisitions.
 The permissive stance toward mergers by the Justice Department
during the Reagan administration.
 Increase in foreign competition, major changes in certain industries
and the deregulation of transportation, communications, and financial
services (especially in Europe) brought about a need for a change in
the way companies did business.
 Deal Decade
Many oil/gas – depressed stock prices
Hostile Takeovers/Threats
Many via LBOs
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1992-1999
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1992-1999 Strategic Mergers
Very large in size and number
1998: over $1.5 trillion in deals
Driven by: Deregulation, economic forces,
technology, globalization
Most done in cash (unlike 1980s)
Examples:
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Deutsche Bank – Bankers Trust
Citicorp – Travelers Insurance
(Reigle –Neal 1994, Bliley Act 1999)
AOL – Netscape
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Ten Largest Merger Transactions, 1995-2005
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Stock Price Reactions
 Mergers
 Bidders gain 0%
 Targets gain 20%
 Takeovers
 Bidders gain 4%
 Targets gain 30%
(Jensen and Ruback, Journal of Financial Economics, 1985)
 Premium paid over pre-merged price: 43%
 Price reaction: Target 15%, Acquirer 1%
(Eckbo, Handbook of Corporate finance, 2008)
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Return for Takeover Targets
Total takeover value
to the target.
0.4
0.35
Value of resolving
uncertainty about the
takeover.
0.3
0.25
Preannouncement
information
leakage.
0.2
0.15
0.1
0.05
-0.05
US TARGETS
UK TARGETS
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90
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76
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62
55
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0
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Reasons to acquire
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Growth
Economies of Scale and Scope
Vertical Integration
Expertise
Monopoly Gains
Efficiency Gains
Diversification
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Growth
 Internal growth may be slow and uncertain.
 A window of opportunity may pass by.
 Management and technical personnel may be
difficult to train or hire.
 Geographical expansion.
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Economies of scale and scope
 Economies of scale and scope
 NPV(A+B) > NPV(A) + NPV(B).
 Stride Rite acquisition of shoemaker Saucony
in 2005. Smaller cost, larger contracts with
China
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Financial Synergy
• Financial Synergies: debt capacity, reduced total
risk, liquidity, cost of funds, tax benefits.
• Merging to reduce taxes, i.e., if it is possible to
reduce the total taxes of the combined companies,
say because one has tax shields it is unable to use.
(carefully with IRS)
• Debt becomes safer and cheaper
• Liquidity for owners
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Gains: Improved Managerial Efficiency
 Market for corporate control assumes that
managers act in the interest of the
shareholders. Firms that do not maximize
shareholder value are targets for takeover.
 Therefore:
Target share prices experience significant
declines prior to the merger or tender offer.
 Managers of target firms are fired after the
takeover.
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Monopoly Gains: Horizontal Mergers
 Firms producing similar products in similar markets
(i.e., the same industry).
 Monopolistic pricing: could be gains from reducing
competition:
• Reduce output, and increase profits
• Demand curve facing the firm becomes less elastic
 Antitrust Division of the Justice Department & the
Federal Trade Commission worry about horizontal
mergers.
Monopoly pricing makes consumers worse off
 Efficiency increasing mergers make consumers better off:
more output at lower prices
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 GE and Honeywell, 2000.
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Vertical Mergers
 Upstream firm buys a downstream firm (or vice
versa)
 Combining complementary resources, i.e., one of the
firms provides the missing ingredient necessary to
the other’s success.
 Are there efficiency gains from internal rather than
external contracting?
 Coordination benefits
 Microsoft vs. Apple
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Conglomerate Mergers
 Firms in totally different industries
 Risk diversification
 Perhaps there are efficiencies in management
or some centralized service, but is doubtful
today.
 May have been more important when
centralized information systems first came
into being (1960’s)
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Takeovers and Manager Threats
 Why takeovers reduce agency costs:
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Contract negotiation/compensation for senior executives is expensive,
often requires the expensive time of the board of directors
The constant threat of being taken over by a better management team
can be enough to ensure that the managers will keep shareholders
happy
Thus, the threat of a raider appearing is often enough to keep agency
costs relatively lower than otherwise possible when the firm is not the
largest in the industry
 Result: Compensation committees still exist in the corporate
world, but time spent on such issues is not as bad when the
company is not the biggest fish in the sea
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E.g. Dell would need a compensation committee, but a smaller
manufacturer, say, Gateway, would not be worried too much about
compensation because the threat of being replaced by the Dell team
would be enough for managers to work hard for shareholders
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Other Gains
Marketing Gains
Inefficient media/advertising, poor product mix, weak
distribution network
Expertise: Cheaper to buy than to make
Capital goods boom, cheaper to make
Strategic Realignment (1990s)
Due to economic, technology changes
Regulatory
Change Banking in U.S.
Globalization & Freer Trade
Signal (information) to market
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Summary
 From a policy perspective, gains come from either efficiency
gains (good), or from monopolization (bad).
 Management shouldn’t care, except that the probability of
antitrust problems increase if the gains come from monopoly
pricing.
 Always ask yourself whether it is necessary to merge to
capture the efficiency/pricing gains. Are other contracting
methods better than paying a premium to buy control?
 Since corporate control always changes, private benefits of
control may be the common factor explaining the gains
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Managers of target firms are often fired after the takeover.
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Example: Taxes for a Merged Corporation
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Example Taxes for a Merged Corporation
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Basic Facts – Mergers
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 Generally friendly.
 Require the approval of both management
teams/boards before the stockholders vote.
 Mergers are often done in an exchange of securities.
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Common stock of the bidding firm for common stock of
the target firm.
 They are not taxable events for the target
stockholders, unless they sell the bidder’s stock.
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Basic Facts – Tender Offers
 Generally unfriendly.
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Target management by-passed by asking the stockholders
to sell their stock, votes, etc.
 Often done for cash.
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Sometimes for new debt securities or stock.
 Are taxable events for the target stockholders
 Strong incentive for the bidding firm to complete the
acquisition quickly, in order to reduce the
probability that a competing bidder will come along.
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The Takeover Process
 Valuation
 The Offer
Start with a public announcement following a 14d filing
with the SEC.
 The filing must specify the consideration offered to the
shares of the target firm, the objective of the merger
(acquisition), and the timeline of events.
 The target management has 10 days to respond to the
offer, via a 14d-9 filing.
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 Defense
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Merger Tactics
 Unfriendly Takeovers
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Shareholders’ rights plan or poison pill.
• Measures taken by the target firm to avoid acquisition by an unwelcome
bidder.
• For example, giving existing shareholders the right to buy additional
shares at an attractive price if a bidder acquires a significant holding.
• Dilutes the value of shares upon purchase by raider
– Recent examples: Indigo and Chapters, Xstrata’s bid for
Falconbridge
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White knight
• Friendly potential acquirer sought by a target company that is threatened
by an unwelcome bidder.
– Recent example: Inco placing competing tender for Falconbridge,
ultimately the ideal circumstance for Falconbridge Board of
Directors
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Both the Inco and Xstrata bids were for cash to shareholders
(purchasing 50+%)
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Merger Tactics
 Staggered board (Shark repellant)
• Amendments to a company charter that make it more
difficult for a successful bidder to get control of the
Board of Directors.
– For example, staggering the election of the Directors
so that 1/3 get elected each year.
– This means the bidder cannot obtain majority
control of the Board immediately after acquiring a
majority of the shares.
– This would be done when the entrepreneur creates
the charter
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Early Warning Systems
 Monitoring shareholder trading patterns:
Employees
 Large stakeholders
 Institutional investors
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Corporate Charter Amendments
 Generally require shareholder approval.
 Generally result in negative stock price
response.
 Staggered terms for Board of Director.
 Supermajority Provisions.
 Fair Price Provisions.
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Greenmail
 Targeted stock repurchase back by the
company
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Golden Parachutes
 Allow payment of lucrative compensation
packages to exiting managers.
 Rationale: allows managers to exit on
favorable terms, thereby reducing desire to
resist hostile bids.
 Excessive golden parachute provisions have
come under a lot of scrutiny.
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Leveraged Recaps
 Firm turns into own white knight:
pays a huge dividend to shareholders
 borrows heavily
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Other defenses
 Crown Jewel defense
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Contract to sell attractive assets to a third bidder
contingent on hostile bid
 Pac Man defense
Counter offer to take over the bidder.
 Risky and infrequently used.
 Can result in huge debt for target.
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Shares swap
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Shares swap
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Exchange ratio
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Exchange ratio
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Maximum Exchange Ratio in a Stock
Takeover
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Maximum Exchange Ratio in a Stock
Takeover
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Total U.S. LBO Volume
and Number of Deals
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Source: Standard & Poors Leveraged Buyout Review (Volume data not available for the single deal in Q1 ‘09)
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LBO success:
http://www.youtube.com/watch?v=4j47RqzGFSk
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http://www.youtube.com/watch?v=4j47RqzGFSk&list=PL1342BA42BE109277
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