Chapter 24 Mergers, Corporate Control, and Corporate Governance

1. Chapter 24Mergers, Corporate Control, and Corporate Governance

2. 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

3. 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.

4. 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

5. 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 • 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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 $22,000,000 Restated fixed assets $120,000,000less liabilities $70,000,000 Net Asset Value $72,000,000 Acquirer pays $24,000,000 for intangible assets. Purchase price paid $96,000,000less Net asset value $72,000,000 Goodwill $24,000,000 Goodwill will remain on the balance sheet as long as the firm can demonstrate that is fairly valued.

12. 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.

13. Returns to Other Security Holders • Bonds • Convertible • Nonconvertible • Preferred stock • Convertible • Nonconvertible

14. 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.

15. Geographic Distribution of WorldwideAnnounced Mergers and Acquisitions, 2004 v. 2003

16. Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003

17. 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 merger-related synergies

18. 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

19. 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.

20. 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

21. 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 non-core 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 carry-forward. • Merging may yield lower borrowing costs for the merged company. • Cash flows of the two businesses are less risky when combined, leading to lower probability of bankruptcy and lower default risk premium

22. 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

23. 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

24. 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” • Antitrust laws from early 1900 made monopoly hard to achieve. • Just like first wave, intent to create national brands • Ended with the 1929 crash

25. 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

26. 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

27. Major US Antitrust Legislation

28. Determination of Anti-competitiveness Not Concentrated Moderately Concentrated Highly Concentrated HHI Level 1000 1800 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) Elasticity tests (“5 percent rule”) is an alternative measure used to determine if merged firm has the power to control prices.

29. 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.

30. 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.

31. 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

32. Corporate Governance • Law and finance • Efficient capital markets promote rapid economic growth • Privatization’s impact on stock and bond market development