Module I: Investment Banking:
Mergers and Acquisitions
Week 3 –January 26, 2006
J. K. Dietrich - FBE 532 – Spring 2006
Motivation
 Many
companies are in the process of
restructuring
– What are the major forms of restructuring?
– What motivates corporate restructuring?
– What are the consequences for investors and
for firms?
J. K. Dietrich - FBE 532 – Spring 2006
Overview of Restructuring
 Two
Major Forms
– Expansion (Combining assets through M&A)
– Contraction (Breaking-up assets through
divestitures etc.)
– Other Forms
» Changing ownership structure (LBOs, buybacks,
etc.) and retaining control through defensive
strategies (Poison pills etc.)
J. K. Dietrich - FBE 532 – Spring 2006
Expansion: Mergers & Acquisitions
 Merger:
the absorption of one firm by
another
 Acquisitions: purchase of a firm’s voting
stock (tender offer)
 Takeovers: Transfer of control from one
group of shareholders to another
– by merger, stock acquisition, asset acquisition,
proxy contest or by going private
J. K. Dietrich - FBE 532 – Spring 2006
Acquisition or Merger?
 Stock
acquisitions do not require
shareholder meetings or votes, and are
frequently hostile
– The acquirer deals directly with target’s
shareholders, bypassing management
– Minority shareholders may hold out in tender
offers; complete absorption requires a merger
J. K. Dietrich - FBE 532 – Spring 2006
Types of Mergers/Acquisitions
 Horizontal
– Same industry and level of value added
– E.g. petroleum production
 Vertical
– Same industry but different level
– E.g. petroleum production, refining, marketing
 Conglomerate
– Different industries
– E.g. gasoline sales and mini-marts
J. K. Dietrich - FBE 532 – Spring 2006
What Explains M&A Activity?
 The
stated objective of all mergers and
acquisitions is the creation of value
– Other objectives - e.g., managerial hubris - may
also play a role but are usually not the stated
rationale for an acquisition.
 What
are the sources of value? Two types:
– Strategic
– Financial
J. K. Dietrich - FBE 532 – Spring 2006
Strategic Sources of Value
1. Under-managed Target
- Look for strategic and operating errors that can
be corrected by replacing bad management
2. Efficiency Gain or Synergies
- Reduce costs through economies of scale and
scope in production, finance, research,
marketing, and through other indivisibilities
- Increase demand or raise product prices
through gains in market power
J. K. Dietrich - FBE 532 – Spring 2006
Strategic Sources of Value
3. Opportunities for restructurings
– Divest or liquidate businesses with poor fit or
poor results
– Sell unproductive assets that are retained by
managers who cannot or will not shed such
value destroying businesses
J. K. Dietrich - FBE 532 – Spring 2006
Financial Sources of Value
Target is undervalued
– Markets are inefficient
» Forecasted improvements or changes are not
reflected in the stock price
– Unused gains from the use or sale of
accumulated tax losses from net operating
losses
– Unused debt capacity (“Leverage Bargain”)
J. K. Dietrich - FBE 532 – Spring 2006
Dubious Reasons for Acquisitions
 Diversification:
– However, shareholders can diversify their own
holdings at lower cost and greater efficiency
through the financial markets.
 Securing
access to inputs or sales of
output
– This may be valid, but presumes there are
inefficient or uncompetitive markets
J. K. Dietrich - FBE 532 – Spring 2006
Bad Reasons for Acquisitions
 Creating
the Appearance of Growth:
– Growth for its own sake does not create value
 Use
of Excess Cash:
 Increased EPS:
– By buying companies with higher EPS than
your own you raise your EPS. Naive investors
may believe this to be “growth” even if this
destroys value
J. K. Dietrich - FBE 532 – Spring 2006
Example of EPS Growth Strategy
 Company A has
1,000 shares outstanding
and EPS of $1
 Company B has 500 shares outstanding and
EPS of $2
 A buys B and now reports higher EPS of
$1.33
 If A paid more than B was worth, A’s
shareholders lost although A’s EPS rose
J. K. Dietrich - FBE 532 – Spring 2006
Higher EPS Strategy
Company A acquires B
EPS
A
J. K. Dietrich - FBE 532 – Spring 2006
B
Company A’s
reported EPS
after
acquisition of
company B
A
Defenses against Takeovers
 Divestitures
– Sales of assets
– Spinoffs or issuance of tracking stock
 Amendments
to corporate charter
– Supermajority vote needed
– Staggering terms of directors
 Self-tenders,
going private, leveraged
buyouts
 Poison pills, white knights, golden
parachutes, etc.
J. K. Dietrich - FBE 532 – Spring 2006
Are Mergers Beneficial to Society?
 Mergers
and acquisitions are usually
associated with layoffs and downsizing.
– This may or may not be associated with
increased economic efficiency.
 But
M&A activity may facilitate exit from
an industry where there is overcapacity
J. K. Dietrich - FBE 532 – Spring 2006
Basic Argument
 Suppose
that there are three firms whose
minimum efficient scale is 100 units
Average Cost
Efficient
Production
Zone
Price
J. K. Dietrich - FBE 532 – Spring 2006
67
100
Quantity
Example
 Initially,
industry demand was 300 units, so
there was no over capacity
 Now, demand has fallen to 200 and is not
expected to recover
 Each firm produces 67 units, and makes
economic losses
 The problem: If firm A exits, the benefits
are captured by B and C
J. K. Dietrich - FBE 532 – Spring 2006
Solution
 Since
the benefits from exit do not accrue to
the exiting firm, each firm fights to stay on,
causing losses for all firms
 Solution: If B (or C) were to takeover A,
the shareholders of A would capture the
external benefits from exit
 In this sense, M&A activity is beneficial to
society.
J. K. Dietrich - FBE 532 – Spring 2006
Empirical Evidence
 In
reality, most acquirers fare poorly with
modest declines in value
 Targets receive most of the benefits of the
usually substantial run-up in price
associated with a takeover.
J. K. Dietrich - FBE 532 – Spring 2006
Example: Kodak and Sterling Drug
 January
4, 1988: Hoffman LaRoche offers
$72 per share for Sterling Drug
 January 18: Facing resistance, Hoffman
raises the offer to $81 per share
 January 22: Kodak announces a friendly
bid of $89.50 per share for Sterling Drug
J. K. Dietrich - FBE 532 – Spring 2006
Price Reaction
 Estimate
Kodak’s return net of the return
predicted by CAPM
 The abnormal return is the actual return on
day t less the expected return
 From CAPM, the expected return is
E[rt ]  rf ,t   (rm,t  rf ,t )
J. K. Dietrich - FBE 532 – Spring 2006
Cumulative Abnormal Returns
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
12/2/87
J. K. Dietrich - FBE 532 – Spring 2006
1/22/88
3/18/88
Kodak Paid a High Premium
Value of Kodak’s Bid
$5.1
(in billions)
Less Sterling’s market
capitalization
$3.0
(30 days prior to
announcement)
Equals Kodak’s Premium
J. K. Dietrich - FBE 532 – Spring 2006
$2.1
..But Investors Were Skeptical
 Kodak’s
market decrease was about $2.2
billion, almost the amount of the premium
paid for Sterling
 Clearly, investors did not believe the deal
could add value. Why?
– Kodak’s past acquisitions were failures and it
was ignoring its core business
J. K. Dietrich - FBE 532 – Spring 2006
Why Do Acquires Fare Poorly?
 Overbidding
– Over-optimism or Winner’s Curse
– Managerial hubris
» Mergers increase firm size and hence managerial
compensation, without adding value
 Poor
fit between buyer and seller
– Clash of corporate cultures
 Ignorance
of target’s industry
 Failure to integrate operations carefully and
fast
J. K. Dietrich - FBE 532 – Spring 2006
Example of Winner’s Curse
 Four
companies bid for mineral rights on
Federal land
 True value is $100 million
 Each company estimates value imperfectly
 Valuations are unbiased, but noisy
J. K. Dietrich - FBE 532 – Spring 2006
Valuations
 Company A:
Estimated Value is 80m
 Company B: Estimated Value is 90m
 Company C: Estimated Value is 110m
 Company D: Estimated Value is 120m
– Average estimate is correct
J. K. Dietrich - FBE 532 – Spring 2006
Bidding
 Second
price, sealed bid auction
 The optimal strategy is to bid your
reservation price
 Company D bids $120, and wins, paying
$110
 Winner’s curse: Overpay by 10%
J. K. Dietrich - FBE 532 – Spring 2006
Can this be an explanation?
 Winner’s
curse can explain over bidding in
this simple one-shot game
 But in a repeated game, firms will recognize
this problem or learn from other’s bids
 However, if takeovers are isolated events,
the winner’s curse may still hold
J. K. Dietrich - FBE 532 – Spring 2006
II. Contractions
 In
the 1980s and 1990s, firms that operate
in fewer numbers of industries do better
than widely diversified firms.
 Restructurings that result in more focus are
rewarded by higher stock prices
– Example: Dun & Bradstreet, a major
information provider, split in three. The stock
price reaction was positive, with a subsequent
rise of 8%
J. K. Dietrich - FBE 532 – Spring 2006
Why is Re-Focusing in Vogue?
 Corporations
made several errors including
– Expanding into industries they didn't know
– Overestimating the gains from synergy and
diversification
– Complex structures allowed mistakes to go
undetected
– Internal conflicts arose over the allocation of
capital and direction of future projects
J. K. Dietrich - FBE 532 – Spring 2006
Types of Contractions
 Spin-offs:
Creates a new legal entity;
shares are distributed on a pro rata basis to
parent’s shareholders:
– Separation of control over time without cash
flows. Example: In 1995, US West spun off its
cable and cellular businesses.
 Split-off:
some shareholders get stock in a
subsidiary in exchange for parent stock
– Immediate separation of control
J. K. Dietrich - FBE 532 – Spring 2006
Spin-Offs
Previous shareholders
Original Firm
New Firms
A Spin-Off does not yield cash inflows
J. K. Dietrich - FBE 532 – Spring 2006
Motivations for Spin-Offs
 In
recent years, spin-offs and split offs have
become increasingly popular as companies
try to “refocus” on their core business
– Example:
» ATT split up into three entities in 1995; NCR,
Lucent Technologies and ATT
J. K. Dietrich - FBE 532 – Spring 2006
Contraction: Divestitures
 Divestitures:
Sale of part of the firm to
outsiders
 Equity Carve-outs: Sale of stock in
subsidiary to outsiders
– In both cases, there is an immediate separation
of ownership and control
– The parent also receives cash inflows
J. K. Dietrich - FBE 532 – Spring 2006
Divestitures
Firm
Original
Owners
Assets
Cash
New
Owners
Divestiture is a Sale of part of the Firm
J. K. Dietrich - FBE 532 – Spring 2006
Example: VLSI and Compass
 In
1997, VLSI Technology, a San Jose
based semiconductor firm had a whollyowned subsidiary, Compass.
 Compass developed CAD/CAM-type
software to design new computer chips
 Compass licenses its software for profit; the
parent company, VLSI, receives a
substantial price discount
J. K. Dietrich - FBE 532 – Spring 2006
Example: VLSI and Compass
 VLSI
argues that divesting compass would
result in higher input costs for itself, putting
it at a competitive disadvantage.
 But Compass executives believed that as an
independent company, it could license its
software to many other chip manufacturers
who are currently unwilling to pay a
subsidiary of their rival
J. K. Dietrich - FBE 532 – Spring 2006
What Should VLSI Do?
 If
Compass is correct, a split-off would
have the following effects:
– Compass’ value would increase
» It could charge VLSI more
» It could sell more to other chip makers
– The new VLSI would be worth less
» It would have to pay Compass market prices for
software products
J. K. Dietrich - FBE 532 – Spring 2006
Case: Outcome
 Since
the extra costs paid by VLSI upon
divestiture are equal to the extra revenues
of Compass, shareholders are no better or
worse off
 But since Compass will have new sales,
shareholders would benefit from divestiture
VLSI sold Compass in 1997
J. K. Dietrich - FBE 532 – Spring 2006
Conclusions
 Corporate
restructurings can take many
forms.
 Restructurings are motivated by the creation
of value
 But in practice, evidence suggests that
strategic and financial motives for
acquisition rarely produce value gains.
J. K. Dietrich - FBE 532 – Spring 2006
Next Week – February 2
 Allocate
team tasks associated with group
write-up and do necessary work
 Hand in Red October case write-up at the
beginning of class on February 2, 2006
 Review contents of Chapter 19
 Read and begin to identify critical financial
issues in the John Case Case discussed in
week 4
J. K. Dietrich - FBE 532 – Spring 2006