Chapter 24
Mergers, Corporate Control, and
Corporate Governance
Professor XXX
Course Name/Number
© 2007 Thomson South-Western
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
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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.
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LBOs, MBOs, and Dual-Class
Recapitalization
Going Private Transactions
LBOs (public shares of a firm are bought
and taken private through the use of debt)
MBOs (an LBO initiated by the firm’s
management)
Dual-Class Recapitalization
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Methods of Acquisition
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
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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 Acquisition (Continued)
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
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Divestitures and Spin-Offs
 Divestiture - occurs when the assets and/or
resources of a subsidiary or division are sold to
another organization.
 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
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Mergers by Business Concentration
 Horizontal: between former intra-industry competitors
 Attempt to gain efficiencies of scale/scope and benefit from
increased market power
 Susceptible to antitrust scrutiny
 Market extension merger
 Vertical: between former buyer and seller
 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
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Other Concentration Classifications
Degree of overlapping business
Change in corporate focus
Herfindahl Index
demonstrates the relationship between
corporate focus and shareholder wealth.
HI is computed as the sum of the
squared percentages - the proportion of
revenues derived from each line of
business
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Merger and Acquisition Transaction
Characteristics
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
 Mixed offerings: a combination of cash and securities
Attitude of target management to a takeover attempt
 Friendly Deals vs. Hostile Transactions
Accounting treatment used for recording a merger
 With the implementation of FASB Statements 141 and 142, one
standard method of accounting for mergers
 Target liabilities remain unchanged, but target assets are “written
up” to reflect current market values, and the equity of the target is
revised upward to incorporate the purchase price paid.
 The revised values are then carried over to the surviving firm’s
financial statements.
 Goodwill is created if the restated values of the target lead to a
situation in which its assets are less than its liabilities and equity
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Merger and Intangible Assets
Accounting
Target firm has 3.2 million shares at $25 per share.
 Acquirer pays a 20% premium ($30 per share) to expand in the
geographic area where target firm operates.
 Transaction value 3.2 million shares x $30/share = $96,000,000.
 Net asset value of target company is $72,000,000.
Current Assets
Restated fixed assets
less liabilities
Net Asset Value
$22,000,000
$120,000,000
$70,000,000
$72,000,000
Acquirer pays $24,000,000 for intangible assets.
Purchase price paid
less Net asset value
Goodwill
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$96,000,000
$72,000,000
$24,000,000
Goodwill will remain on the balance sheet as long as the firm can
demonstrate that is fairly valued.
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
 Mode of payment
Cash transactions
Stock transactions
Tax hypothesis: target shareholders must be awarded a
capital gains tax premium in cash offers, which is not required
in a stock offer.
Preemptive bidding hypothesis: acquirers wishing to
ward off other potential bidders for a target offer a substantial
initial takeover premium in the form of cash.
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Returns to Other Security Holders
Bonds
Convertible
Nonconvertible
Preferred stock
Convertible
Nonconvertible
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International Mergers and Acquisitions
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.
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Geographic Distribution of Worldwide
Announced Mergers and Acquisitions, 2004 v. 2003
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Industrial Distribution of Worldwide Announced
Mergers and Acquisitions, Value in $ Millions,
2004 v. 2003
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Value Maximizing Strategies
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
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Operational Synergies
 Economies of scale: Merger may reduce or eliminate
overlapping resources
 1995 merger between Chemical Bank and Chase Manhattan
Bank resulted in elimination of 12,000 positions.
 Economies of scope: involve some activities that are
possible only for a certain company size.
 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
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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.
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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 Depot-Staples 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
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Cash Flow Generation and Financial
Mergers
 Acquirer sees target undervalued.
 Many junk bond-financed deals of the 1980s had one of the
following two outcomes:
 “Busting up” the target for greater value than acquisition price
 Restructuring the target to increase corporate focus. Sell noncore businesses to pay acquisition cost
 Tax-considerations for the merger:
 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.
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 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
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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
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History of Merger Waves
 Five merger waves in the U.S. history
 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
 First wave (1897-1904): period of “merging for
monopoly”.
 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”
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 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 (Continued)
 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
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Fifth Merger Wave
 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.
 Merger activity: unprecedented transaction value for
both US and non-US mergers
 In 2000, aggregate merger value hit $3.4 trillion: $1.8 trillion in
US and $1.6 trillion outside US.
 Declined in 2001 to $1.7 trillion and only $1.2 trillion in 2002
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Major US Antitrust Legislation
Legislation (Year)
Sherman Antitrust Act
(1890)
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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
Clayton Act
 Prohibited price discriminations, tying
arrangements, concurrent service on
(1914)
competitor’s board of directors
 Prohibited the acquisition of a competitor’s
stock in order to lessen competition
Federal Trade Commission  Created FTC to enforce the Clayton Act
Act
 Granted cease and desist powers to the FTC,
(1914)
but not criminal prosecution powers
Celler-Kefauver Act
 Eliminated the “stock acquisition” loophole
in the Clayton Act
(1950)
 Severely restricts approval for horizontal
mergers
Hart-Scott-Rodino Act
 FTC and DOJ can rule on the permissibility of
(1976)
a merger prior to consummation.
Determination of Anticompetitiveness
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
Elasticity tests (“5 percent rule”) is an alternative measure used to
determine if merged firm has the power to control prices.
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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.
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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.
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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
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Corporate Governance
Law and finance
Efficient capital markets promote rapid
economic growth
Privatization’s impact on stock and bond
market development
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