MOTIVES FOR MERGERS and MERGER THEORY- HOW
VALUE IS ADDED
a. Efficiency Arguments
1. Differential Managerial Efficiency
Management of a more efficient acquiring firm can bring up
the level of efficiency of the acquired firm, providing both social and
private gain. Implies that firms in similar industries would be potential
acquirers. Acquiring firm’s management complements the management of
the acquired firm through its experience in the industry. Excess managerial
talent by the acquiring firm can be put to use in the acquired firm
(managerial synergy). This talent may be applied by direct entry into a new
market. New entry may be expensive if the firm with excess managerial
capacity does not have other non-managerial organizational capital relevant
to that market. Such capital can be acquired through toehold acquisition
Problem: Implies very few large firms and little specialization.
2. Inefficient management.
In the case of totally inept management, mergers serve as a means of
providing discipline to the managerial markets where the only way to get rid
of inept management is through taking over the company.
Problems:
1) Why aren’t managers replaced after mergers?
2) Why can’t acquired firms be operated as subsidiaries??
3. Operating synergies
Economies of scale allow large firms to operate more efficiently than
smaller firms due to indivisibility of resource inputs.
Management and financial functions may also generate economies of scale.
Vertical integration may also generate economies through more efficient coordination of the production process.
1
4. Financial Synergies.
Internal funds allow a less costly and more efficient means to finance
expansion that reliance on external funds. This would allow cash-rich firms
to provide financing for cash-poor companies. It might also allow for
economies of scale in the financing of projects.
The debt capacity of a combined company may exceed the debt
capacity of its components because the variability of cash flow is reduced.
5. Pure diversification.
For shareholders, diversification at the shareholder level is equivalent
to diversification at the firm level, but should be cheaper, since acquisition
costs are much less. For managers, firm diversification is much preferable
since human capital is concentrated in a specific firm and depends on the
fortunes of that firm. By diversifying, managers gain more job security and
perhaps the firm gains lower labor costs.
Firm diversification also allows protection of firm-specific
information and the firm’s reputation capital against firm liquidation.
Debt capacity can be raised by diversification.
6. Strategic realignment
Change can be effected more quickly by entry into a new product or
market through merger than through direct entry. Where values are
ephemeral, it may pay to acquire rather than to build.
Problem:
The price for timely acquisition may fully reflect value.
7. Undervaluation
The market may not fully reflect the true value of a potential
acquisition, which may be known by competitors and managers in the
industry with access to privileged information.
2
Assets may be acquired more cheaply in the aftermarket than by
building. The allows assets to be acquired whenever market values are lees
than their replacement cost.
Tobin’s q
= market value/replacement cost
A q value less than one implies negative NPV projects or assets that
are worth less than their cost.
Problem:
bringing up value of assets still requires greater efficiency by the
acquirer.
3
b. Agency problems, managerialism, and free cash flow
Overview:
Agency problems in relationships arise whenever the two parties do not
have exactly the same objective function. Then, benefits to one of the
parties can come at the expense of another party. In the context of the
differences between objectives of management and shareholders, agency
problems can lead to inefficiencies, which inefficiencies may be resolve by
means of the market’s discipline of managers through takeovers or the threat
of takeovers.
Examples:
Manager/employees vs. stockholder/owners
Managerial perks are paid for by shareholders
Inefficiency is a form of managerial perk.
Stockholders vs. bondholders
Application of option pricing theory to stock valuation
1. Mergers as a solution to agency problems
If managers have created inefficiencies, then the stock price will not
be as high as possible had such inefficiencies not existed. The presence of
inefficiencies opens the opportunity for an outsider to buy assets at a
discount, resolve the inefficiencies, and bring the assets up to full value.
2. Mergers as an outcome of managerialism
Managers may have incentives to maximize the size of assets
managed rather than maximizing shareholder wealth if their incomes or
economic power is more related to the size of their managerial scope. They
are incented to add assets for their own purposes rather than to make
shareholders better off. The discipline of a merger would strip inefficient or
un-needed assets and reduce the firm to its proper size.
4
3. Conflicts over the distribution of cash flows
Managers and shareholders may have different objectives represented
in preferences for use of the firm’s internally generated cash, with managers
wanting the firm to become larger while shareholders would prefer to obtain
cash through dividends or share repurchases.
4. The rationale for the use of debt.
Interest and principal payments provide discipline for managers in
running a tighter ship to assure that cash is available for fixed financial
charges. Financing associated with Leveraged buyouts or management
buyouts can impose such discipline.
Problem: a merger is not a necessary condition for imposition of debt
discipline. It can be implemented independently of mergers. In Phillips
Petroleum example, the leveraged re-financing serves a very effective
takeover defense, not to make the takeover more costly, but to add value
without a takeover.
5. The Free Cash Flow problem.
Agency problems are heightened when management has financial
flexibility at its disposal in the form of the ability to generate cash from
operations or in pools of liquid assets built up. Buildup of free cash flow in
a) current assets b) pension fund c) borrowing capability can be used by
managers to benefit themselves directly (higher salary) or indirectly (poor
investments) at the expense of shareholders.
Firms with good investment opportunities have greater need for
financial slack (free cash flow) and are less likely to waste free cash. Firms
with poor investment opportunities may be inclined to invest anyway simply
because ample cash is available.
Example: Cash-rich oil companies with poor investment opportunities being
the subject of and the subject of takeover battles in the 1980’s. Takeovers
prevented oil companies from wasting cash in negative NPV investment
because of managerialism.
5
Empirical Evidence on Free Cash Flow problems
Investments (McConnell and Muscarella)
Regular Dividends (Lang and Litzenberger, Denis, Denis, and Sarin)
Special Dividends (Howe, He, and Kao; Gombola and Liu)
Stock Repurchases (Porter, Roenfeldt and Sicherman)
6
c. Information and signaling arguments
Basic Concept:
Information is not shared equally between parties in a transaction.
Sellers and job applicants know more about the item offered or skills
available than buyers or employers. Managers know more abut the condition
of the firm than investors or the managers of an acquiring firm.
Pooling Equilibrium
When individual characteristics are unknown then group
characteristics are assigned rather than individual characteristics.
Example:
All used cars are classified as “lemons”.
Graduates of prestigious universities are considered smarter and
harder-working
Resolution
Costless signaling is worth what it costs. Costly signaling is difficult
to signal falsely.
Empirical Research :
Stock offerings (Asquith and Mullins, Brous)
Regular dividend increases and decreases (asymmetry)
Stock repurchases (Comment and Jarrell, Jain)
Investment Announcements (McConnell and Muscarella, John and
Mishra)
Divestment Announcements (Blackwell, Marr, and Spivey, Gombola
and Tsetsekos).
7
1. Information implications of merger activity.
Investors learn information about a company when it goes in play as a
takeover target. Its value is revised upward. The revision may be due to a
combination of two explanations.
\
Explanation #1. - “Sitting on a gold mine”
The target shares and assets may be undervalued because of their
higher value for an alternative owner who may place assets at a higher and
better use. If one outsider can add value, then other potential new owners
may also add value.
Explanation #2 - "Kick in the pants"
When managers learn of the potential for the discipline of a merger,
they institute pre-emptive steps to initiate the discipline by themselves.
2. Signaling implications
The form of mergers can be used to glean information about bidders
and targets. A bidder that uses common stock rather than cash may signal
that the bidder’s own stock may be overvalued, or it may signal that the
bidder is unsure of the target’ value and wishes target shareholders to share
in the risk of potential mis-estimation of the target’s value.
8
d. Market Power considerations
1. Market Share
Any merger will increase market share, but market share may not be
translated into higher profits and higher share value.
Problem: Legal problems associated with “undue concentration” in an
industry. Old guidelines implied concentration when the four largest firms
accounted for 40 percent or more of sales. Herfindahl index takes into
account the relative share of all firms in the industry as
H = of industry)2
where N is the number of firms at any percentage of industry sales.
2. Monopoly and monopsony power.
9
e. Wealth Redistribution
1. Shareholders versus bondholders.
Mergers are often, but not necessarily, accompanied by opportunities
to change capital structure in a manner that disciplines management.
Substitution of debt for equity applies such discipline, but also provides
shareholders with an opportunity to transfer bondholder wealth to
themselves. Losses by bondholders will increase the wealth of shareholders,
even with no change in the value of assets.
Viewing the equity as an option on underlying firm assets produces
the same implications.
Sale of assets to generate cash also undercuts the value of bonds since
fewer assets reduces the cash flow available for paying interest and
principal.
Examples:
In the KKR takeover of RJR assets sales of $5 billion and sale of junk
bonds that produced a net loss after interest of $976 million.
In Phillips Petroleum defense against takeover, the leveraged
refinancing hurt the value of existing bonds. Equity was reduced from $6.6
billion in 1984 to $1.6 billion in 1985, while long-term debt increased from
$2.8 billion in 1984 to $6.5 billion in 1985. (Notice that takeover was
averted by management pre-emption of takeover strategies).
2. Shareholders versus other stakeholders.
A. Employees
In a merger, the acquiring firm and its new management may not feel
as responsible for the welfare of employees or other stockholders. The result
can be much of the “efficiencies” of mergers.
Example: Acquisition of TWA by Icahn produced cost savings of
$200 million per year by means of wage reductions forced on employees.
10
It can be argued whether this is the result of a “breach of trust” or an
end to regulation.
B. Government
Greater leverage and reduced tax payments may transfer wealth from
society to shareholders.
11
II.
The Free Rider Problem
Source of the problem:
1. Outside acquirer pays a premium that incorporates much of the
benefits of the merger
2. All of risk is borne by acquirer
3. Most of benefits of the merger are enjoyed by inside stockholdersyet they do nothing to add value to the firm.
4. Merger can fail because original shareholders have no incentive to
tender
Resolving the problem:
Transferring merger benefits from acquired-firm shareholders to
acquiring firm.
1. Dilutive activity
2. Two-tier offer
12