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Chapter 6
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Theories of Mergers and Tender Offers
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Basic Concepts
• Economies of scale — average costs
decline over a broad range of output
• Different from spreading fixed costs
over a larger number of units
• Mergers allow a reorganization of
production processes so that plant scale
may be increased to obtain economies
of scale
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•
•
•
•
Economies of scope
Organization capital
Organization reputation
Human capital resources
– Generic managerial capabilities
– Industry-specific managerial capabilities
– Nonmanagerial human capital
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Free-Rider Problem
• Problem of diffused, small shareholders
– Small shareholders may not expend
resources monitoring management
performance in a diffusely held corporation
– Shareholders simply free-ride on monitoring
efforts of other shareholders and share in
any resulting performance improvements of
the firm
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• Free-rider problem in mergers
– Small shareholders will not tender at any
offer price below the higher expected price
that should result from the merger
– Individual decision to accept or reject
tender offer does not affect success of the
offer
– If offer succeeds, they fully share in the
improvement brought by takeover
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• Possible solutions to free-rider problem
– Allow bidder to dilute value of nontendered
shares of the target firm after takeover
– Two-tier offer
– Make some shareholders pivotal in the
outcome of the bid (Bagnoli and Lipman,
1988)
– Tender offer from a large shareholder or an
outsider who had secretly accumulated a
large fraction of the equity
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Models of the Takeover
Process
•
•
•
•
Economic — competition vs. market power
Auction types — Dutch, English
Forms of games
Types of equilibria — pooling, separating,
sequential
• Types of bids — one, multiple
• Bidding theory — preemptive; successive
bids
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Framework
• Total gains for both target and acquirer
– Positive
• Efficiency improvement
• Synergy
• Increased market power
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– Zero
• Hubris
• Winner's curse
• Acquiring firm overpays
– Negative
• Agency problems
• Mistakes or bad fit
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• Gains to target — all empirical studies
show gains are positive
• Gains to acquirer
– Positive — efficiency, synergy, or market
power
– Negative — overpaying, hubris, agency
problems, or mistakes
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Sources of Value Increases
from M&As
• Efficiency increases
– Unequal managerial capabilities
– Better growth opportunities
– Critical mass
– Better utilization of fixed investments
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• Operating synergy
– Economies of scale
– Economies of scope
– Vertical integration economies
– Managerial economies
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• Diversification motives
– Demand for diversification by
managers/employees because they make
firm-specific investments
– Diversification for preservation of
organization capital
– Diversification for preservation of
reputational capital
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– Diversification and financial synergy
• Diversification can increase corporate debt
capacity, decrease present value of future tax
liabilities
• Diversification can decrease cash flow
variability following merger of firms with
imperfectly correlated cash flow streams
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– Diversification discount
• Studies find that the average diversified firm has
been worth less than a portfolio of comparable
single-segment firms
• Reasons
– External capital markets allocate resources more
efficiently than internal capital markets
– Rivalry between segments may result in subsidies to
underperforming divisions within a firm
– Managers of multiple activities are not well informed
about each segment
– Securities analysts may be less likely to follow multiple
segment firms
– Performance of managers of segments cannot be
adequately evaluated without external market measures
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• Financial synergies
– Complementarities between merging firms in
matching the availability of investment
opportunities and internal cash flows
– Lower cost of internal financing —
redeployment of capital from acquiring to
acquired firm's industry
– Increase in debt capacity which provides for
greater tax savings
– Economies of scale in flotation of new issues
and lower transaction costs of financing
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• Circumstances favoring merger over
internal growth
– Lack of opportunities for internal growth
• Lack of managerial capabilities and other
resources
• Potential excess capacity in industry
– Timing may be important — mergers can
achieve growth and development of new
areas more quickly
– Other firms may be competing for
investments in traditional product lines
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• Strategic realignments
– Acquire new management skills
– Less time to acquire requisite capabilities
for new growth opportunities or to meet
new competitive threats
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• The q-ratio
– Ratio of the market value of the firm's
securities to the replacement costs of its
assets
• High q-ratio reflects superior management
• Depressed stock prices or high replacement costs
of assets cause low q-ratios
– Undervaluation theory
• Acquiring firm (A) seeks to add capacity; implies
(A) has marginal q-ratio > 1
• More efficient for (A) to acquire other firms in
industry that have q-ratios < 1 than building a new
facility
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• Information
– New information generated during tender offer
process causes target firm share to be permanently
revalued upward even if offer is unsuccessful
– Two information hypotheses
• ”Sitting on a gold mine" — tender offer disseminates
information that target shares are undervalued
• ”Kick in the pants" — tender offer forces target firm
management to implement more efficient business
strategies
– Synergy explanation — upward revaluation in
unsuccessful offer merely reflects likelihood that
other bidders may surface with specialized
resources to apply to target
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• Signaling
– Information — an outside event not initiated
by the firm conveys information
– Signaling — particular actions by the firm
may convey other significant forms of
information, e.g., that management does not
tender at the premium price in a share
repurchase signals that the company's
shares are undervalued
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Winner's Curse and Hubris
• Winner's Curse: The winning bid in a
bidding contest for an object of uncertain
value will typically pay in excess of its
true value
• One cause of the winner's curse
phenomenon in M&As is hubris, defined
as overweening pride and excessive
optimism
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Agency Problems
• Agency problems arise when managers
own only fraction of the ownership
shares of the firm
– Managers may work less (shirk) and/or
overconsume perks
– Individual shareholders have little incentive
to monitor managers
– Dealing with agency problems give rise to
monitoring and controlling costs
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• Solutions to agency problem
– Organizational mechanisms
– Compensation arrangements tied to
performance
– Market mechanisms
• Market for managers
• External monitoring through stock market
• Takeovers — external control device of last
resort
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• Managerialism
– Mergers are a manifestation of agency
problems
– Managers are motivated to increase the size
of their firms because their compensation is
a function of firm size, sales, or total assets
– Theory may not be valid if managers'
compensation is based on profitability or
value increases
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Free Cash Flow Hypothesis
(FCFH)
Jensen (1986, 1988)
• Free cash flows (FCF) are cash flows in
excess of the amount needed to fund all
positive net present value projects
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• Payout of free cash flow to reduce
agency costs
– Reduces amount of resources under
control of managers
– Prevents managers from investing in
negative NPV projects
– Outside financing is subject to monitoring
by capital markets
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• Bonding mechanism
– Forces managers to pay out future cash
flows by debt creation without retention of
the proceeds of the issue
– Discipline to be efficient to meet debt
obligations
– Prevents unsound investments
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• Theory prediction
– Positive stock price reaction to unexpected
increases in payouts
– Increased tightness of constraints requiring
the payout of future FCF will result in positive
stock price reaction
– Predictions do not apply for
• Firms that had more profitable projects than cash
flows to fund them
• Growth firms
• If agency costs cannot be resolved
perfectly, takeovers can help reduce them
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• LBOs
– Bonding effects of high debt ratios
undertaken by LBOs cause increase in
share price
– Successful LBOs also involve a turnaround,
an improvement in the firm's performance
– Strong incentives provided by large
ownership stakes of managers
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Redistribution
• Gains to target shareholders represent
redistribution from other stakeholders
– Tax gains — redistribution from the government or
public at large
– Market position — mergers may increase market
power and redistribution from consumers
– Redistribution from bondholders — account for only a
small percentage of gains to shareholders
– Redistribution from labor — Is it forced recontracting
or is it recognition of changed industry conditions?
– Pension fund reversions — not a major source of
takeover gains
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Patterns of Restructuring in
the Chemical Industry
• Change forces
– Technological change
– Globalization of markets
– Favorable financial and economic
environments
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• Characteristics of the chemical industry
– U.S. chemical industry accounts for 2% of
U.S. GDP
– Diverse and complex
– Many distinctive segments; some overlap
with oil and other energy industries,
pharmaceutical and life science products
– Two major types of firms
• "All-around" companies operate in many areas
• "Focused" firms operate in downstream
specialized segments
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– Commoditization of products
– "Keystone" industry — building blocks at
every level of production in major industries
– Economic trends
• Chemical shipments not keeping up with growth
in economy
• Increase in service industries relative to major
users of chemicals has caused a decline in
growth of chemical shipments
– Easy entry
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• M&As in the chemical industry
– Chemical and related industries occupy
one of the top ranking areas in M&A
activity
– Include a wide range of adjustments and
adaptations to changing technologies,
changing markets, and changing
competitive thrusts
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– Roles of M&As
• Strengthen existing product line by adding
capabilities or extending geographic markets
• Add new product line
• Foreign acquisitions to obtain new capabilities
or needed presence in local markets
• Obtain key scientists for development of
particular R&D programs
• Reduce costs by eliminating duplicate activities
and shrinking capacity to improve sales to
capacity relationships
• Divest activities not performing well
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• Harvest successful operations in advance of
competitor programs to expand capacity and
output
• Round out product lines
• Strengthen distribution systems
• Move firm into new growth areas
• Attain critical mass required for effective
utilization of large investment outlays
• Create broader technology platforms
• Achieve vertical integration
• Revise and refresh strategic vision
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– Disadvantages of M&As
• Buyer may not have full information of acquired
assets
• Implementation may be difficult
– Considerable executive talent and time commitments
– Different organization cultures
– Wide use of joint ventures and strategic
alliances
• Combine different expertise and capabilities of
different companies
• Reduce size of investments and risks
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– Include changes in financial policies and
effectiveness
• Considerable use of highly leveraged
restructuring such as leveraged buyouts
(LBOs) and management buyouts (MBOs)
• Share repurchases
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• Concentration trends
– US chemical industry
• HHI in 1980 was 178, declined to 148 in 1990 and to
102 in 1998
• HHI is far below critical 1,000 specified in anti-trust
guidelines
• HHI has declined while M&A activity has increased
–
–
–
–
Intense competition
New entrants
Reduced firm size inequalities
New firms as a result of divestitures
– World chemical industry
• Significantly below critical 1,000 level
• HHI declining for the same reasons as in US market
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Measurement of Abnormal
Returns
• Residual analysis — tests whether
returns to common stock of individual
firms or groups of firms is greater or
less than that predicted by general
market relationships between return and
risk
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event window
C1
C2
m0
T1
t0
T2
t (time)
“clean” period
“event”
• Calculation of residuals
– Event period
• Identify event and its announcement day, t0
• Define event period from day T1 to T2 usually
centered on announcement date
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– Predicted (or normal) return, R̂ jt , for each
day t and for each firm j
• Represents return that would be expected
absent of event
• Estimated using "clean" period (C1 to C2) that
does not include event period
– Three methods
• Mean adjusted return
– Predicted return is mean of daily returns for firm j
during clean period
Rˆ jt  R j
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• Market model
– Predicted return for firm j in day t in event period
Rˆ jt  ˆ  ˆ j Rmt
– Estimates for  and  are obtained from a regression
using returns during clean period
R jt   j   j Rmt   jt
– Takes explicit account of both risk associated with
market and mean returns
• Market adjusted return
– Predicted return is return on market index for that day
Rˆ jt  Rmt
– Approximate market model where  = 0 and  = 1 for
all firms
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• Measures
– Residual
• Actual return minus predicted return
rjt  R jt  Rˆ jt
• Represents abnormal return — part of return that
was unexpected as a result of event
– Average residual returns
• Average across N firms for each event day t
ARt 
r
jt
j
N
• Averaging across large number of firms mitigates
noisy component of returns
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– Cumulative average residuals (CAR)
• Cumulate average residual returns for
successive days over event period
T2
CAR   ARt
t T1
• Represents average total effect of event across
all firms over event period
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• Absolute gains and losses
– Absolute dollar gain or loss at time t due to
abnormal return during event period
Wt  CARt  MKTVAL0
CARt = cumulative average residual returns (%)
to date t for firm
MKTVAL0 = market value of firm at date m0 previous
to event window interval
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• Statistical significance of event returns
– Test whether estimated cumulative average
residuals, CAR, is significantly different from
zero with a specified level of confidence
• Null hypothesis presumed true unless statistical
tests establish the contrary
H0: CAR = 0 (event does not affect returns)
• Alternative hypothesis
H1: CAR  0 (event does affect returns)
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– Test statistic is ratio of value of cumulative
average residuals, CAR, to its estimated
sample standard deviation
CAR
t-stat 
Ŝ ( CAR )
– If absolute value of t-stat ratio is greater than
specified critical value, reject null hypothesis
with some degree of confidence
• |t-stat | > 1.96, CAR is significantly different from
zero at 5% level
• |t-stat | > 2.58, CAR is significantly different from
zero at 1% level
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