FIN 468: Intermediate
Corporate Finance
Topic 10–Mergers and Acquisitions
Larry Schrenk, Instructor
1 (of 22)
Topics

Corporate Control

Mergers

Takeovers

Restructurings
Corporate Control
Corporate Control Defined
What is Corporate Control?
 Monitoring, supervision and direction of a corporation
or other business organization
Changes in corporate control occur through:
 Acquisitions (purchase of additional resources by a
business enterprise):
1. Purchase of new assets
2. Purchase of assets from another company
3. Purchase of another business entity (merger)



Consolidation of voting power
Divestiture
Spinoff
Corporate Control Transactions

Statutory: Acquired firm is consolidated into
acquiring firm with no further separate identity.

Subsidiary: Acquired firm maintains its own
former identity.

Consolidation: Two or more firms combine
into a new corporate identity.
Mergers
6 (of 36)
Merger & Acquisition Transaction
Characteristics
Attitude of target management to a takeover attempt
 Friendly Deals vs. Hostile Transactions
Method of payment used to finance a transaction
 Pure stock exchange merger: issuance of new shares
of common stock in exchange for the target’s
common stock

Cash offer

Mixed offerings: a combination of cash and securities
Mergers by Business Concentration

Horizontal: between former intra-industry competitors




Vertical: between former buyer and seller



Attempt to gain efficiencies of scale/scope and benefit from
increased market power
Susceptible to antitrust scrutiny
Market extension merger
Forward or backward integration
Creates an integrated product chain
Conglomerate: between unrelated firms


Product extension mergers vs. pure conglomerate mergers
Popular in the 60’s as the idea of portfolio diversification was
applied to corporations
History of Merger Waves

Five merger waves in the U.S. history





First wave (1897-1904): period of “merging for monopoly”.



Merger waves positively related to high economic growth.
Concentrated in industries undergoing changes
Regulatory regime determines types of mergers in each wave.
Usually ends with large declines in stock market values
Horizontal mergers possible due to lax regulatory environment
Ended with the stock market crash of 1904
Second wave (1916-1929): period of “merging for oligopoly”



Antitrust laws from early 1900 made monopoly hard to achieve.
Just like first wave, intent to create national brands
Ended with the 1929 crash
History of Merger Waves

Third wave (1965-1969): conglomerate merger wave




Celler-Kefauver Act of 1950 could be used against horizontal
and vertical mergers.
Result of portfolio theory applied to corporations: conglomerate
empires were formed: ITT, Litton, Tenneco
Stock market decline of 1969
Fourth wave (1981-1989): spurred by the lax regulatory
environment of the time




Junk bond financing played a major role during this wave: LBOs
and MBOs commonplace.
Hostile “bust-ups” of conglomerates from previous wave
Antitakeover measures adopted to prevent hostile takeover
attempts.
Ended with the fall of Drexel, Burnham, Lambert
History of Merger Waves

Fifth wave (1993 – 2001): characterized by friendly,
stock-financed mergers




Relatively lax regulatory environment: still open to horizontal
mergers
Consolidation in non-manufacturing service sector: healthcare,
banking, telecom, high tech
Explained by industry shock theory: Deregulation influenced
banking mergers and managed care affected health care
industry.
Sixth wave (2003-Present)


Consolidation continues
Record volume in 2005
Industrial Distribution of Worldwide
Announced Mergers and Acquisitions, Value
in $ Millions, 2004 v. 2003
Motives for Merger
Geographic (internal and international)
expansion in markets with little competition
may increase shareholders’ wealth.


External expansion provides an easier approach to
international expansion.
Joint ventures and strategic alliances give
alternative access to foreign markets. Profits are
shared.
Synergy, market power, and strategic mergers

Operational, managerial and financial mergerrelated synergies
Operational Synergies

Economies of scale: Merger may reduce or eliminate
overlapping resources


Economies of scope: involve some activities that are
possible only for a certain company size.



1995 merger between Chemical Bank and Chase Manhattan
Bank resulted in elimination of 12,000 positions.
The launch of a national advertising campaign
Economies of scale/scope most likely to be realized in
horizontal mergers.
Resource complementarities: Merging firms have
operational expertise in different areas.


One company has expertise in R&D, the other in marketing.
Successful in both horizontal and vertical mergers
Managerial Synergies and
Financial Synergies

Managerial synergies are effective when management
teams with different strengths are combined.


For example, expertise in revenue growth and identifying
customer trends paired with expertise in cost control and
logistics
Financial synergies occur when a merger results in
less volatile cash flows, lower default risk, and a lower
cost of capital.
Managerial Synergies and
Financial Synergies

Market power is a benefit often pursued in horizontal
mergers.



Number of competitors in industry declines
If the merger creates a dominant firm, as in the Office DepotStaples merger’s attempt to create market power and set
prices
Other strategic reasons for mergers:


Product quality in vertical mergers
Defensive consolidation in a mature or declining industry:
consolidation in the defense industry
Cross-Border (International) M&A
 One company’s acquisition of the assets of another
is observed worldwide.
 Countries differ not only with respect to how
frequently takeover attempts are launched, but also
 how often these are friendly versus hostile bids
 how often these are cross-border deals (involving a bidder
and a target firm in different countries)
 the average control premium offered
 the likelihood that payment will be made strictly in cash.
Geographic Distribution of Worldwide
Announced Mergers and Acquisitions, 2004 v.
2003
Methods of Payment
Negotiated Mergers

Contact is initiated by the potential acquirer or by target firm.
Open Market Purchases

Buy enough shares on the open market to obtain controlling
interest without engaging in a tender offer
Proxy Fights


Proxy for directors: attempt to change management through the
votes of other shareholders
Proxy for proposal: attempt to gain voting control over corporate
control, antitakeover amendments (shark repellents, golden
parachutes, white knights, poison pills
Methods of Payment

Tender Offers: an open and public solicitation
for shares

Open Market Purchases, Tender Offers and
Proxy Fights could be combined to launch a
“surprise attack”

Acquirer accumulates a number of shares
(‘foothold”) without having to file 13-d form with
SEC
Takeovers
21 (of 36)
Friendly vs. Hostile Takeovers

Friendly mergers are negotiated

Hostile takeovers are opposed by
management



Bear hug – go to board
Tender offer – direct to shareholders
Proxy fight – vote by shareholders
Hostile Takeover Defenses

Pre-offer (shark repellants)
 Poison pills – increase shares
 Poison puts – bondholders
 Charter amendments




Staggered board
Voting provisions
Fair price amendments
Golden parachutes
Hostile Takeover Defenses

Post-offer
 “Just Say No” defense



Litigation
Greenmail
Share repurchase





LBO
Leveraged recap
“Crown Jewel” defense
“Pac-Man” defense
White Knight/Squire defense
Major US Antitrust Legislation
Legislation (Year)
Sherman Antitrust Act
(1890)
Clayton Act
(1914)
Federal Trade Commission Act
(1914)
Celler-Kefauver Act
(1950)
Hart-Scott-Rodino Act
(1976)
Purpose of Legislation
 Prohibited actions in restraint of trade, attempts to
monopolize an industry
 Violators subject to triple damage
Vaguely worded and difficult to implement
 Prohibited price discriminations, tying arrangements,
concurrent service on competitor’s board of directors
 Prohibited the acquisition of a competitor’s stock in order to
lessen competition
 Created FTC to enforce the Clayton Act
 Granted cease and desist powers to the FTC, but not
criminal prosecution powers
 Eliminated the “stock acquisition” loophole in the Clayton
Act
 Severely restricts approval for horizontal mergers
 FTC and DOJ can rule on the permissibility of a merger prior
to consummation.
Concentration Classifications

Herfindahl-Hirschman Index

Demonstrates the relationship between
corporate focus and shareholder wealth

HHI is computed as the sum of the squared
percentages - the proportion of revenues
derived from each line of business
Determination of Anti-competitiveness
Since 1982, both DOJ and FTC have used
Herfindahl-Hirschman Index (HHI) to
determine market concentration

HHI = sum of squared market shares of all
participants in a certain market (industry)
Not Concentrated
Moderately Concentrated
1000
Highly Concentrated
1800
HHI Level
The Williams Act (1968)

Ownership disclosure requirements



Section 13-d must be filed within 10 days of acquiring 5% of
shares of publicly traded companies.
Raises the issue of “parking” shares
Tender offer regulations




Shareholders of target company have the opportunity to
evaluate the terms of the merger.
Section 14-d-1 for acquirer and section 14-d-9 by target
company (recommendation of management for shareholders
regarding the tender offer)
Minimum tender offer period of 20 days
All shares tendered must be accepted for tender.
Other Legal Issues

Sarbanes-Oxley Act of 2002


primarily targeted accounting practices, it also mandated
significant changes in how, and how much, information
companies must report to investors.
Laws Affecting Corporate Insiders




SEC rule 10-b-5 outlaws material misrepresentation of
information for sale or purchase of securities.
Rule 14-e-3 addresses trading on inside information in tender
offers.
The Insider Trading Sanctions Act, 1984 awards triple
damages.
Section 16 of Securities and Exchange Act

Requires insiders to report any transaction in shares of their affiliated corporations.
Other Legal Issues
State Antitrust Laws

Include anti-takeover and anti-bust up
provisions



Fair price provisions disallow two-tiered tender
offers. All shareholders receive the same price for
their shares, regardless of when they are tendered.
Cash-out statutes forbid partial tender offers.
Provisions usually used in conjunction with
each other
Merger Analysis

Acquirer sees target undervalued.

Many junk bond-financed deals of the 1980s had one of the
following two outcomes:



Tax-considerations for the merger:



“Busting up” the target for greater value than acquisition price
Restructuring the target to increase corporate focus. Sell non-core businesses to pay
acquisition cost
Tax loss carry-forward of the target company used to offset
future taxes; resulting in increased cash flow.
1986 change in tax code limits the use of tax loss carryforward.
Merging may yield lower borrowing costs for the
merged company.

Cash flows of the two businesses are less risky when
combined, leading to lower probability of bankruptcy and lower
default risk premium
Non-Value-Maximizing
Motives

Agency problems: Management’s (disguised) personal
interests are often driver of mergers and acquisitions.

Managerialism theory of mergers: Managerial compensation
often tied to corporation size

Free cash flow theory of mergers: Managers invest in projects
with negative NPV to build corporate empires.

Hubris hypothesis of corporate takeovers: Management of
acquirer may overestimate capabilities and overpay for target
company in belief they can run it more efficiently.

Agency cost of overvalued equity
Non-Value-Maximizing Motives

Diversification


Coinsurance of debt: the debt of each
combining firm is now insured with cash
flows from two businesses
Internal capital markets: created when the
high cash flows (cash cow) businesses of a
conglomerate generate enough cash flow to
fund the “rising star” businesses
Shareholder Wealth Effects and
Transaction Characteristics

Target returns – stockholders almost always
experience substantial wealth gains

Acquirer returns – less conclusive than those
for target shareholders

Combined returns – slightly positive
Restructuring
35 (of 36)
Corporate Restructuring

Divestiture - occurs when the assets and/or resources of a
subsidiary or division are sold to another organization.

Equity carve-out - partial sale to outsiders

Spin-off - a parent company creates a new company with its
own shares by spinning off a division or subsidiary.
 Existing shareholders receive a pro rata distribution of shares
in the new company.

Split-off - similar to a spin-off, in that a parent company creates
a newly independent company from a subsidiary, but ownership
of company transferred to only certain existing shareholders in
exchange for their shares in the parent