Prof. Ken Shah Seattle University Finc 580

PROF. KEN SHAH SEATTLE UNIVERSITY FINC 580

NOTES ON MERGERS AND ACQUISITIONS

Definition: In M&A, the central event is the transfer of control of assets of a firm from one party to another

Mergers  Mergers are generally friendly. They require the approval of both managements/boards before shareholder vote.  Mergers are often done in an exchange of securities using common stock of bidding firm. They are not taxable events for the target shareholders, unless they sell the bidder's stock.

Tender offer takeovers  Tender offers are generally unfriendly. Target management is by-passed by asking shareholders to sell their stock directly.  Tender offers are often done with cash (or new debt securities). They are taxable events for target shareholders. Strong incentives to complete them quickly to reduce the chance of a competing offer.

Types of M&A:

Horizontal mergers: Firms producing similar products in similar markets (same industry). Monopoly pricing, reducing competition: demand curve for product less elastic; more monopoly profits. Antitrust Division of Justice Dept. worry about horizontal mergers.

Vertical Mergers: Upstream firm buys a downstream firm (or vice versa). If one firm has a monopoly, the merged firm cannot charge monopoly prices at both levels. There could be efficiency gains from internal rather than external contracting. However, there could be transfer pricing problem within the merged firm.

Conglomerate Mergers: Firms in totally different industries. Perhaps there are efficiencies in management or some centralized service. This argument is doubtful today - may have been more important when centralized information systems first were introduced in 1960's.

Possible Sources of Value in M&A:  Efficiency increases o Replace inefficient management  Operational synergy o Scale economies  Diversification motives o Smoothing of earnings – dubious?  Financial synergy o Internal capital market  Strategic realignments o Acquisition of talent, expertise unavailable in-house  Information effects o Arrival of bidder signals firm ‘undervalued’ under existing management  Taxes o Loss carry forwards, stepped-up assets & depreciation/amortization of goodwill Basic stock price evidence: returns to bidders and targets:

Mergers Tender offers Targets Positive 20 – 35% Positive 30 – 40% Bidders Positive 1 – 2% Negative 1 – 2%

Why are premiums smaller in mergers? Taxes. Larger premium in tender offers account for larger tax liability. Could be that some of the 'cost' of the bid is used to buy off target management (to get them to cooperate).

Why are premiums smaller for bidders in mergers? Could be that bidders know that tender offers are more expensive: a higher premium is required; increasing chance of competition; more lawyer/banker fees; hence only persue deals that have large potential gains.

Diversification Gains from mergers: Stockholders do not benefit because they can do it on their own account, and avoid paying a premium. Also, they have greater leeway in investment proportions. Management apparently benefit from reduced volatility of earnings, and prestige related to size.

 Gains must come from internal as against external contracting. DuPont wanted Conoco for access to petroleum as inputs to production process. Couldn't it simply sign a long-term supply arrangement?  Tax credits and offsetting losses: only possible with merger.  Patents, distribution networks, brand name acquisition. Assumes that patents and distribution networks cannot be bought or brand name will extend to other products. E.g. Kodak with Verbatim floppies or batteries.

Gains come from efficiency (good) or monopoly (bad). However, management shouldn't care where the gains come from unless antitrust problems increase. Diversification should not increase firm value

PRACTICAL CONSIDERATIONS

Legal and Regulatory Framework

All Federal securities laws apply The Williams Act: Seeks protection of target company shareholders in three ways: i. By generating more information during the takeover process that target shareholders and management could use to evaluate offers, ii. By requiring a minimum period during which a tender offer must be held open, iii. By explicitly authorizing targets to sue bidding firms

Section 13 requires any person crossing 5% threshold to file 13(d) filing within 10 days

Section 14 regulates terms of the offer: length of time held open 20 days, rights of shareholders to withdraw tendered shares

In general, considerable disclosure is required by all relevant Federal securities laws

In addition, there are state regulations on takeover activities. Delaware acts requires simple 50% majority approval, other states require 2/3rds majority. In addition, state laws regulate two-tier and partial tender offers

Accounting of M&A

Pooling method is discontinued Purchase method results in stepping up of assets and a new basis for depreciation. Any premium must be accounted as goodwill which can be amortized over 20 years.

In purchase method, the leverage of combined firm is affected, unlike earlier pooling method. When stock is used to purchase a company, leverage ratio declines since combined firms equities now reflect actual market values of the purchase price.

Tax Planning:

Acquiring firm Target Firm A. Nontaxable NOL carryover Deferred gains for target reorganizations Tax-credit carryover shareholders Carryover asset basis B. Taxable Stepped-up asset basis Immediate gain recognition by acquisitions Loss of NOLs and tax credits target share holders Depreciation recapture of income

PRACTICAL VALUATION APPROACHES

 Reasonable to assume that pre-M&A announcement target stock price reflects assets under current management

 The premium from pre-announcement target price must be justified by accurately identifying the sources of gains from M&A

 ‘Synergy’ is vague term. Must identify the actual source of gains and estimate their value through DCF methods.

 Ask the question: what can the bidder management do differently than the current target management?

 ‘Marginal’ valuation: Assuming pre-announcement value is the base price, identify and using DCF methods value the incremental changes that would be brought about by changing the control of assets. These well-identified changes (e.g. in operations, in cost of capital, risk reduction, etc.) must be well thought, well identified, and properly valued individually. The sum of these values on a per share bases gives the maximum premium that can be paid.

 The actual offer price is a bargaining process subject to the upper limit on the premium offered.

 Overpaying is common place and probably reflects the zero or negative returns to bidder. Management hubris is a serious problem in M&A - successful offer at any price? FURTHER EVIDENCE ON MERGERS AND ACQUISITIONS

MERGERS: Evidence discussed below based on Dodd (1980) published in the Journal of Financial Economics. A study of announcement returns of 151 targets, 126 bidders in merger proposals:

Days -1, 0

Bidders Targets Successful -1.9% (60, -3.0) 13.41% (71, 23.8) Unsuccessful -1.24% (66, 12.73% (80, -2.6) 19.1)

Days -10 to +10:

Bidders Targets Successful -7.22% (60, 33.96% (71, 7.7) -2.5) Unsuccessful -5.50% (66, 3.86% (80, 1.0) -2.1)

Do bidders pay too much? Egos of CEOs get involved and they pursue NPV<0 takeovers just to show they can win. Mergers are more often financed with equity. Is this a reaction to the financing decision? Is the decision to merge a signal about the quality of internal investment opportunities? There are substantial costs to not being successful. Perhaps a reflection on competence of management?

Who cancels unsuccessful mergers? Bidders should cancel if, when they get access to inside info about the target, they learn negative things Targets should cancel if, when they learn more about the terms of the deal, they learn that it will not be a good deal for their shareholders.

Days -1, 0:

Bidders Targets Target Cancels 0.86% -5.57% Bidder Cancels 1.38% -9.75%

Days -10 to +10:

Bidders Targets Target Cancels -3.12% 10.95% Bidder Cancels -6.47% 0.18%

The one who has the second thoughts is rewarded. The overall effect is best for both targets and bidders if the target pulls out Better for bidders than if the bid is successful (-7%) or if the bidder pulls out (-6.5%). Is it relatively good news that the bidder was trying to strike a hard bargain?

TAKEOVERS:

SUCCESSFUL TENDER OFFERS: Evidence is from Bradley, Desai and Kim (JFE 1988) of 236 successful tender offers over the period 1963 - 1984 with matched bidders and targets. Announcement effects: (3-day)

Bidders Targets Total Sample 0.00% 21.6% Single Bidder 0.65% 22.0% Multiple Bidders -1.45% 20.8%

Total weath effects (5-days before first offer to 5-days after last offer by winning bidder)

Bidders Targets Total* 7/1963 - 12/1984 1.0% 31.8% 7.4% *percent change in combined value of target and bidder

Total wealth effects to winning bidder (5-day before first offer to 5-days after last offer by winning bidder)

Single Bidder Multiple Bidders Total 7/1963 - 12/1984 2.0% -1.3% 1.0%

Unsuccessful Tender offers: Management has no veto power. Must convince shareholders not to tender. Bidder management has stronger commitment. It is hard, but not impossible to cancel a tender offer before it expires. Don't usually get access to inside info during hostile tender offer Would lose credibility with financing sources, investment bankers, and arbitrageurs if frequently cancels bids.

UNSUCCESSFUL TENDER OFFERS:

Evidence is from Bradley, Desai & Kim (JFE, 1983): 353 targets: 241 bids successful, 112 unsuccessful; 94 bidders who were unsuccessful. Period is 1980-83.

Abnormal returns to target stock from one month before announcement to month K:

Period Total Subsequently Subsequently Taken Over NOT Taken Over -1, +1 40.2% 46.3% 20.2% -1, +12 42.2 56.9 7.0 -1, +24 40.9 60.2 1.9

Cumulative abnormal returns to bidder stock from month before announcement (-20 days) to day K:

Period Total Subsequently Subsequently Taken Over NOT Taken Over -20, +1 2.3% 1.9% 3.4% -20, +140 -5.9 -7.9 0.7

SUMMARY: Market reacts negatively to bidder in mergers, not in tender offers. Bidder is defined as the company that is offering a premium for other company's stock. At the initial announcement of merger, it is hard to tell which deals will be successful. Unsuccessful tender offers have lower announcement returns. Tender offers that are followed by other bids have higher announcement returns. Market can tell which are likely to succeed. Targets that are not taken over within 5 years lose all of the tender offer premium. Bidders for those firms also lose value. Reflects on competence of management? Multiple bidder auctions lead to higher target returns and negative bidder returns. You don't want to be a 'white knight'. For example, DuPont in Conoco takeover.