11/11/2012
Mergers & Acquisitions
Transaction Structuring II
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Outline
• Reading market reactions
• Accounting treatment of transactions
• Tax issues
• Antitrust
• Due diligence
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11/11/2012
Reading Market Reactions
• Target price: At least three factors affect the target
price after a deal is announced, but before closing
1. Deal risk: What is the probability that the deal will fall
apart before closing?
• Major obstacles: shareholder dissent, financing, antitrust
• Target shares may therefore sell at a discount.
2. Sweetened bid: An improved offer may follow, either from
the same or a new bidder
• May reduce the discount, or even cause a premium, in the market
price relative to initial offer.
3. In a stock deal where the target also bears pre-closing
risk (e.g., fixed ratio), then the performance of the
acquirer will also affect the target price.
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Reading Market Reactions
• In a fixed ratio stock deal, we can isolate the effects
of the first two components by comparing the
implied exchange ratio (from market prices) to the
agreed upon exchange ratio
• Acquirer price: the acquirer price will be affected by
– The net synergies anticipated by the market
– The premium paid by the acquirer
– Not surprisingly, the market anticipates, more often than
not, a net loss to the acquirer
– The initial market reaction has been shown to be a good
predictor of the long run performance of a deal
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Accounting Issues
• Current practice (since 2001 in U.S., longer elsewhere): Use
purchase accounting for all transactions
– Revalue the identifiable assets of the purchased company to fair
market value (FMV) and put them on your books
– The “step-up” in the basis of these assets will result in a higher
level of depreciation of the assets
– Any excess of the purchase price over the FMV of the
identifiable assets is recorded as goodwill
– Amortize goodwill over a specified period (e.g., 40 years)
– Annually, test whether goodwill has been “impaired” (i.e., is
goodwill less valuable? Note the difficulty of carrying out the
impairment test!)
– If goodwill is “impaired,” (i.e., if the accountants tell you so) write
down goodwill to “fair value” and recognize a loss in current
year.
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Example of the Purchase Method
Bidder purchases target firm’s shares for $1,250 in cash on June 30,
2011.
Current assets
Long-term assets
Goodwill
Total Assets
Current liabilities
Long-term debt
Common stock
Retained earnings
Total Claims
Bidder PreMerger
10,000
6,000
Target Firm
(Book Value)
1,200
800
Target Firm
(Fair Market
Value)
1,300
900
16,000
2,000
2,200
8,000
2,000
2,000
4,000
16,000
800
200
400
600
2,000
800
250
1,250
2,300
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Example of the Purchase Method
Goodwill = Price paid – MV of target firm equity
Acquirer value pre merger + Target firm FMV = Acquirer value post merger
= $1,250 – (MV of target firm assets – MV of target firm liabilities)
= $1,250 – ($2,200 - $1,050)
= $100
Current assets
Long-term assets
Goodwill
Total Assets
Current liabilities
Long-term debt
Common stock
Retained earnings
Total Claims
Acquirer PreMerger
10,000
6,000
Target Firm
(Book Value)
Book
1,200
values
800
16,000
are not
2,000
relevant.
8,000
2,000
2,000
4,000
16,000
800
200
400
600
2,000
Target Firm
(Fair Market
Acquirer Post
Value)
Merger
1,300
11,300
900
6,900
100
2,200
18,300
800
250
1,250
2,300
8,800
2,250
3,250
4,000
18,300
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Origins of the Goodwill “Impairment” Test
• Prior to 2001, all of the world except U.S. used purchase
accounting for virtually all transactions
• The U.S. permitted “pooling-of-interests” accounting (more so
than other jurisdictions), with requirements linked to use of
stock for consideration and ongoing interest of target
shareholders
• Under pooling, the balance sheets of the two companies are
simply combined, with no goodwill, etc.
• CEOs in the rest of the world complained that U.S. firms had
an advantage in M&As because of pooling accounting
– Less amortization expense under pooling = higher future
earnings
• Likewise, U.S. CEOs did not want to lose pooling
– Introducing the impairment test to purchase accounting helped
alleviate some concerns about high levels of goodwill
amortization following a transaction
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Why Might Accounting Methods Matter?
• Previously, firms would often pay higher premiums,
spend substantial amounts to obtain pooling
treatment vs. purchase, or refuse transactions if
they could not obtain pooling treatment
• Why might pooling vs. purchase matter even if it
has no impact on cash flow?
– If accounting data matters to market valuation,
independent of cash flows
• Generally, the accounting literature finds that accounting
differences which are well understood do not have price impacts
– Bond indentures may use accounting data
– Management compensation may be tied to accounting
data
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Impact of Goodwill Accounting (Impairment Test) in a
Negative Environment
Surf’s Up! Wave of M&A Related Write-Offs Seen
• (November, 2008) Reuters notes that with share values
plummeting, companies who have done recent transactions
will likely face large write-offs due to “impairments in
goodwill”
• Possible impacts on covenants, compensation
The Good Will Game
• (August, 2012) WSJ noted that multibillion-dollar write-offs
by Microsoft Corp., (MSFT -1.31%) Hewlett-Packard Co.
(HPQ -2.16%), and Boston Scientific Corp. (BSX -2.59%) for
poorly performing acquisitions prompt the question: Who's
next?
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Tax Issues
• Non-taxable (or tax deferred) transactions
– Personal taxes: No tax to target shareholders on share
portion of consideration until new shares are sold
• The basis to target shareholders is held constant at conversion
(i.e. if the target shareholder original basis is $10 and exchange
ratio is 2:1 then the basis of new shares is $5 each)
– Corporate taxes: The basis of target assets is carried
over to acquirer – no possibility of step-up in FMV of
assets
– Net operating loss (NOL) and tax-credit carryovers, but
with restrictions
• E.g., restrictions on NOL carry forwards (up to 15 years) were
put forward in 1980s to reduce pure tax loss motivations for
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transactions
Taxable Transactions
• In a taxable transaction, the target shareholders pay any
capital gains taxes immediately (depending on their
original basis)
• The acquirer uses as much as possible of the purchase
price over the original book value to step up the
depreciable tax basis of assets
– Asset basis step-up for tax purposes increases future depreciation
and decreases future taxes
– In certain settings, goodwill may be amortizable for tax purposes
(e.g., in U.S. goodwill amortized for tax purposes over 15 years)
– Note that accounting treatment and tax treatment are not
necessarily the same (in fact are often different)
• Cannot carry over NOLs and target tax credits in a taxable
transaction
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11/11/2012
Impact of Tax on a Recent Transaction
• On Tuesday, September 30, 2008, the U.S. Treasury
announced a new interpretation of Sec. 382 of the code
which limited use of NOL carry forwards in an acquisitions.
• The new IRS interpretation focused specifically on bank
mergers, and had an immediate impact on the CitibankWachovia transaction, announced one day earlier link
– Under current estimates, an acquirer of Wachovia will have to write down
approximately $74 billion of losses on the Wachovia loan portfolio
– Prior IRS interpretation would limit use of the NOL’s to approximately $1
billion per year, for a maximum of 20 years.
– The new ruling could remove limits on using the entire amount of NOLs,
producing large potential benefits for a potential acquirer
– Wells Fargo is profitable, Citibank is not
– By the end of the week (Oct. 3) Wells Fargo announced its $15 billion offer
for Wachovia
• The new IRS ruling as a policy tool in encouraging
profitable banks to acquire banks with damaged balance
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sheets
Hypothetical Value of Wachovia
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Tax Status of an Acquisition
• Three basic types of transactions
– Purchases of assets
– Purchases of stock
– Amalgamations (mergers)
• If a transaction is appropriately structured, consideration
received in shares can be tax-deferred to acquirer
shareholders, while cash is immediately taxable.
• In Canada, the acquirer must be Canadian for a
transaction to receive tax-deferred status
– A foreign acquirer will typically set up a Canadian
subsidiary to carry out a transaction if it wants to obtain
tax deferred status
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Tax-Free Acquisitions in U.S.
• Type A Reorganization – statutory merger or
consolidation
– At least 50% of the consideration must be in acquirer’s voting stock
– The “boot” – other consideration such as cash, debt, convertible, may be
taxed immediately on its tax basis
– Capital gain taxes must be paid on those shares that were exchanged for
non-equity consideration
– Includes forward triangular (to be discussed next)
• Type B Reorganization – acquisition of stock
– At least 80% of target stock must be paid for by acquirer’s voting stock
– Cash must constitute no more than 20% of the total consideration
– Includes reverse triangular (to be discussed next)
In both cases, the transaction is viewed as a continuation of
the original corporate entities in a reorganized form
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Triangular Mergers
• Triangular mergers: Variants of basic transaction
structures; the acquirer uses a subsidiary to
purchase or merge with the target
– May help isolate liabilities in the subsidiary
– May help avoid a vote of parent shareholders
• Forward triangular: Subsidiary acquires assets or
stock of target or target merges into subsidiary
• Reverse triangular: Subsidiary merges into target
– e.g., the target acquires the subsidiary, giving parent target
shares and making target a parent subsidiary
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Legal Framework
• Securities Laws
– The Securities Act of 1933
– The Securities Exchange Act of 1934
– The Williams Act of 1968 regulates tender offers
• Antitrust Laws
• State Corporation Law
– Many state antitakeover laws provide protection
against hostile takeover for corporations located
within the state
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Antitrust Laws
Main statutes in the U.S.
• Sherman Antitrust Act (1890)
– Sec 1 prohibits all contracts, combinations, and conspiracies in
restraint of trade
– Sec 2 prohibits any attempts or conspiracies to monopolize a
particular industry
• Clayton Antitrust Act (1914)
– Makes transactions that adversely affect competition illegal
• Federal Trade Commission Act of 1914
– Prohibits unfair methods of competition
• Hart-Scott-Rodino Antitrust Improvements Act (1976)
– Requires the Federal Trade Commission and the Antitrust
Division of the Justice Department be given the opportunity to
review proposed M&A deals in advance (30 days for mergers, 15
for tender offers)
– Transactions over $200 million must be reported
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Antitrust Considerations
• The evolution of antitrust theory
–
–
–
–
–
–
–
Concentration ratios (1968)
The Hirschman-Herfindahl index (1982)
The elasticity measure (1984)
Potential competition and barriers to entry (1992)
A trade off between innovation and pricing?
The goal is consumer protection
Globalization and product market convergence have
led to more relaxed standards in recent years
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Concentration Ratios
• Concentration ratio: market shares owned by the top 4
(8) firms in an industry
– 1968 Justice Department merger guideline
– Highly concentrated industry if this ratio >=75%
– The guidelines for horizontal acquisitions that could
give rise to a challenge are given below
Market
Bidder
Target
Highly concentrated
4%
4% +
10%
2% +
15%
1% +
5%
5%+
10%
4%+
15%
3%+
20%
2%+
25%
1%+
Less concentrated
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Hirschman-Herfindahl Index (HHI)
n
HHI   Si2 (Si  market share of ith firm)
i
Consider an industry composed of 8 firms; each firm has a
12.5% market share
n
HHI   Si2  8  12.52 =1250
i
If two of these equal-size firms merge, then new HH is
HHI  6  12.52 +252 =1562.5
HHI perceived to be a better measure than concentration ratio
• Dominated by market weights of large players, but captures
information about structure of entire market
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HHI Framework
• In analyzing competitive effects of a horizontal merger, regulators
consider both post-merger concentration and the change in
concentration
Change in HHI
<100
PostMerger
HHI
<1500
100<∆<200
Unlikely to have adverse anticompetitive effects
1500<HHI<2500
>2500
>200
Raises significant
antitrust concerns
Raises significant
antitrust concerns
Presumed to create or
enhance market power
• The initial analysis of HHI concentration in a market is often
followed by further consideration of additional factors (potential
competition, efficiencies, failing firm concerns, etc.)
• See DOJ/FTC Horizontal Merger Guidelines (August, 2010)
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AT&T Attempted Acquisition of T-Mobile
•
On December 19, 2011, AT&T announced that it would end its $39 billion
attempt to acquire T-Mobile from Deutsche Telekom, after facing stiff
opposition throughout 2011 (the deal first announced on March 20, 2011)
from the Department of Justice, the Federal Communications Commission,
and antitrust groups. The deal's collapse comes with a hefty, multibilliondollar breakup fee that AT&T must pay to Deutsche Telekom, and will have
far-reaching consequences for the entire mobile-phone industry. Here, a brief
rundown of winners and losers:
•
If the deal had gone through, it "might have been fatal to Sprint". Sprint is the
nation's No. 3 carrier, behind AT&T and Verizon. No. 2 AT&T's gobbling of
No. 4 T-Mobile would have created yet another industry powerhouse to
hammer Sprint. "Competing against one hundred-million-subscriber carrier is
hard enough; competing against two would have made things intolerable."
Sprint would have been relegated "to the dungeon occupied by local and
specialty carriers.“
•
The break-up fee is $3 billion consolation prize for T-Mobile's owner
Deutsche Telekom.
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Horizontal Merger Analysis: Five Steps
1.
Define the relevant market or markets where there is current or
potential overlap between merging parties.
• Market defined by product and geography
2.
Carry out the HHI analysis in each market to determine where there
are potential concerns.
3.
Consider the impacts of potential entrants, and how they could
minimize anticompetitive impacts.
• Relevant question: In the event of a significant increase in prices (5%),
would new entry be “timely, likely, and sufficient” (enough to deter the
price increase in the first place).
4. Are the economic efficiencies to be gained from the merger sufficient
to outweigh competitive concerns?
• How large are the efficiencies? Will they be passed on to consumers?
Are there other ways of achieving these efficiencies besides a merger?
5. “Failing firm” defense: Will one of the firms disappear anyway if this
merger does not occur
• Need to show real economic losses and no alternatives
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Potential Outcomes
• A preliminary merger analysis might lead to the conclusion that there
are no significant problems, in which case the merger can proceed.
• The agency may, on the other hand, ask for more information
(“second request”), which substantially delays the consummation of
the merger
• Ultimately, the agency may decide to
– Let the merger proceed.
– Negotiate with the parties conditions under which the deal may proceed
(“remedies”, e.g., asset sales / divestitures in problem markets, licensing
agreements with competitors, etc.).
– Block the deal.
• The parties have legal rights to contest agency decisions in courts,
which is both time-consuming and costly
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Horizontal Merger Analysis Example
• In 1996, Staples proposed to acquire Office Depot.
• The FTC carried out an analysis showing that prices were
substantially higher in areas covered by only one “office
superstore” relative to markets where competition existed.
• The agency concluded that after the merger Staples
would have been able to raise prices an average of 13%.
• Ultimately, the agency decided to block the merger, and
their decision was upheld in U.S. District Court.
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The RJR Reynolds, Inc/Brown and Williamson Merger
•
•
•
•
•
•
The 2004 merger between cigarette makers RJR Reynolds (#2) and Brown
and Williamson (#3) is a useful case to highlight the fact that simple market
shares can be of limited benefits when analyzing the antitrust ramification of
a merger
The Federal Trade Commission (FTC) concluded that the deal would not
result in a damaging increase in the combined company’s market power
There were several rapidly growing upstarts who had made inroads into
certain parts of this industry including the discount segment
Both had suffered market share losses in the premium and discount
segments. Brown and Williamson total market share fell from 15% to 10%
while RJ Reynolds from 24% to 20% over 1998-2004
In citing the Horizontal Merger Guidelines, the FTC concluded that the
industry was highly concentrated by simply looking at the market share of the
top four; such “market share and concentration data provide only the starting
point for analyzing the competitive impact of a merger”
The merger was to try to halt the merging firms’ declining positions rather
than gaining competitive advantages or exercise market power at consumers’
expense
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Vertical and Conglomerate Mergers
• Vertical mergers occur within the value chain.
– Example: U.S. Steel and Tennessee Coke and Coal.
• Antitrust concerns:
– Theory of potential competition: combination of a current player
with a potential player.
– Barriers to entry from vertical mergers: If two markets are tightly
linked, the need to enter both simultaneously could create barriers
to entry (product tying, exclusivity arrangements, etc.).
• Conglomerate mergers occur among firms unrelated by
value chain or peer competition (e.g., GE).
– Generally do not raise anticompetitive concerns (but also do not
generally have obvious economic synergies).
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Events in Antitrust
1. (Oct. 17, 2008) DoJ / FCC expected to clear wireless deals
– Verizon acquiring Alltel for $28.1 billion, creating largest cell company in North America,
closes on January 9, 2009
– $14.5 billion wireless broadband pact involving Sprint Nextel Corp., Clearwire Corp.,
Google Inc., Intel Corp. and three cable providers.
2. Policy differences seem to appear between DoJ and FTC
enforcement another link
– DoJ perceived as soft
– “Antitrust enforcement has been a low priority for the Bush
administration. How low? Until recently, the Department of Justice
hadn't challenged a single case in court.”
– FTC (another agency jointly responsible for enforcement) wants a
more aggressive approach, previously attempted to block merger of
Whole Foods and Wild Oats Markets, blocked a hospital merger, etc.
3. Microsoft raises antitrust concerns about Google-Yahoo
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Competition Policy in Canada/Worldwide
•
Competition policy in Canada and Europe is similar in principle to U.S.
•
In Canada, governed by the Competition Act and implemented by the
Commissioner of Competition.
o Challenges may be brought prior to or within three years following a
transaction.
o Pre-merger notification of Competition Commissioner is required.
• In a global environment, merging two large multinational corporations
may require numerous simultaneous reviews in different jurisdictions
o Example: In 2001, the merger of GE and Honeywell – both U.S.
corporations – was blocked by the E.U.
o European Commissioner for Competition: “The merger between GE and
Honeywell … would have severely reduced competition in the aerospace
industry and resulted ultimately in higher prices for customers, particularly
airlines.”
o GE: “We strongly disagree with the commission‘s conclusions… This
acquisition would have clearly benefited consumers in terms of quality,
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service and prices.”
Antitrust Remedies
• Two broad types of remedies for economic
conditions that regulatory authorities find
anticompetitive:
• Structural: Required divestiture of an acquired division
that had anticompetitive effects. E.g., when Perrier was
purchased by Nestle, they had to transfer one of
Perrier’s brands, Volvic, to a competitor
• Behavioral: focus on specific business practices. E.g.,
when UK’s Vodafone and Germany’s Mannesmann
merged, they had to granted competitor mobile
operators access to their networks
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Due Diligence
• Due Diligence: The process of thoroughly investigating
the value of a transaction to shareholders.
o A fiduciary duty of managers and directors
• Who carries out due diligence, acquirers or targets?
o In general, both
o For targets, especially important if stock consideration
is involved
• When does the process begin and end?
o Begins with first negotiations, does not end until
closing
o A process of continually increasing the level of
scrutiny, negotiating for greater access, etc.
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The Due Diligence Process
• Due diligence is much more difficult for a buyer in a hostile
situation than in a friendly setting.
o Access to information is more difficult: Citigroup complained about
having less access to information than Wells Fargo during their
dispute over Wachovia
• Negotiating the specifics of due diligence to be
facilitated/allowed by the other party is an important part of
the transaction structuring process in a friendly transaction.
o Analogy to placing “inspection” conditions on a real estate
purchase.
o In a common scenario
• The buyer wants as much information as possible before closing.
• The seller wants to receive consideration quickly, with as few
conditions as possible.
• Both sides are sensitive to prematurely allowing access to
competitively sensitive information.
• Due diligence complexity is one reason for lengthy closing periods.
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How Due Diligence Fits with Deal Structuring?
• Ideally, the due diligence process is about closing
gaps in information asymmetries, while protecting
the interests of both parties
o A well-structured merger agreement should allow
economically beneficial agreements to close.
o At the same time, a merger agreement should provide
a way out for deals that are found during the due
diligence process to have negative economic
consequences
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Due Diligence in Practice
• Laundry lists: Legal; accounting; tax; IT; risk and insurance;
environmental; market presence and sales; operations;
property; intellectual and intangible assets; finance; crossborder; organization and HR; culture; ethics
• Specific concerns: inventories, pension plan assets, debt
guarantees and covenants, threatened litigation, tax delinquencies,
warranties and defects, severance payments, uncollected
receivables, etc.
• Sources: SEC filings, 8-K, 10-K, 10-Q; DEF 14A (proxy
statements); auditor’s work; management letters; operating
budgets; cash flow projections; consultant opinions;
interviews with employees, customers, and analysts, etc.
• The ideal is complete and thoughtful probing of the
business model…
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11/11/2012
Due Diligence as an Excuse
• In the Wachovia battle, Citigroup publicly maintained a
commitment to completing the deal at all times, but in
unattributed comments, as the tide favored Wells Fargo,
Citigroup insiders expressed to the financial press the idea
that they backed off the deal because of due diligence
findings.
• “While Citigroup insisted publicly that it still was willing to buy most
of Wachovia, people close to the company said that additional due
diligence uncovered questions that made executives uncomfortable
about proceeding with the deal. An important sticking point was the
valuation of Wachovia assets, particularly the bank's large securities
portfolio.”
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More on Citigroup, Wells Fargo, and Wachovia
$60 B Lawsuit
The exclusivity agreement: “Wachovia shall not …encourage
any other Acquisition Proposal…”
• “The parties agree that in any breach, the parties
would be irreparably harmed, and could not be made
whole by monetary damages.”
• Compare with the idea of a breakup fee.
$2.2 B
$15 B
Citigroup: our shareholders have been unjustly and illegally deprived
of the opportunity the transaction created.
Wachovia: We look forward to completing our merger with Wells Fargo,
which is in the best interest of shareholders, employees, creditors and
retirees as well as the American taxpayers.
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11/11/2012
Related Events
• Buffet bids for Burlington
– Berkshire Press Release (great transaction structuring issues)
•
EU objects to Oracle’s takeover of Sun
–
EU says US comment on Oracle Sun deal “unusual”
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