Mergers, Acquisitions, and Other Restructuring Activities

Part I

The Mergers and Acquisitions Environment

Outline

Part I. The Mergers and Acquisitions Environment

Chapter 1 An Introduction to Mergers, Acquisitions, and Other Restructuring Activities

Chapter 2 The Regulatory Environment

Chapter 3 The Corporate Takeover Market: Common Takeover Tactics, Antitakeover Defenses, and Corporate Governance

Part I. The Mergers and Acquisitions Environment

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The recovery of the global economy since the devastating effects of the 2008–2009 worldwide recession, Europe’s sovereign debt crisis, and spreading regional geopolitical conflicts continue to restrain corporate executive confidence. Governments struggle to find the right combination of fiscal and monetary policies to restore economic growth. Despite such efforts, the global economic recovery remains uneven. While economic growth in countries such as China continues to outpace most economies, the pace has slowed. Although growth in the United States exceeds most Western European countries, it is still very modest by historical standards.

With revenue growth constrained by a sluggish global recovery, corporations are restructuring aggressively to eke out additional market share. Continued low interest rates and ebullient stock markets are fueling a recovery in corporate restructuring activity with more firms unwilling to take no for an answer pursuing hostile takeovers. Other firms continue to streamline operations to increase product and market focus by divesting or spinning off businesses not considered germane to their corporate strategy. This focus on restructuring is expected to continue through the foreseeable future driven by firms dissatisfied with their current mix of businesses.

The popular media tends to use the term corporate restructuring to describe actions taken to expand or contract a firm’s basic operations or fundamentally change its asset or financial structure. Corporate restructuring runs the gamut from reorganizing business units to takeovers and joint ventures to divestitures and spin-offs and equity carve-outs. Consequently, virtually all of the material covered in this book can be viewed as part of the corporate restructuring process. Part I discusses the context in which mergers, acquisitions, and corporate restructuring occur, including factors often beyond the control of the participants in the mergers and acquisitions (M&A) process.

Chapter 1 provides an overview of M&As by discussing basic vocabulary, the most common reasons why M&As happen, how such transactions occur in a series of somewhat predictable waves, and participants in the M&A process, from investment bankers to lenders to regulatory authorities. The chapter also addresses whether M&As benefit shareholders, bondholders, and society, with conclusions based on recent empirical studies. The labyrinth of regulations that impact the M&A process are addressed in Chapter 2, including recent changes in US federal and state securities and antitrust laws as well as environmental, labor, and benefit laws that add to the increasing complexity of such transactions. The implications of cross-border transactions, which offer an entirely new set of regulatory challenges, also are explored. Viewed in the context of a market in which control transfers from sellers to buyers, Chapter 3 addresses common takeover tactics employed as part of an overall bidding strategy, the motivation behind such tactics, and the defenses used by target firms to deter or delay such tactics. Bidding strategies are discussed for both friendly and unwanted or hostile business takeovers. In hostile transactions, the corporate takeover is viewed as a means of disciplining underperforming management, improving corporate governance practices, and reallocating assets to those who can use them more effectively. While such takeovers occur relatively infrequently, the mere fact that they exist causes the threat of hostile takeovers to encourage incumbent managers to change their behavior. This chapter also addresses the increasingly important role activists are taking in promoting good corporate governance and in disciplining incompetent or entrenched managers.

The reader is encouraged to read about deals currently in the news and to identify the takeover tactics and defenses employed by the parties to the transactions. One’s understanding of the material can be enriched by attempting to discern the intentions of both the acquiring and target firms’ boards and management, if the proposed business combination makes sense, and thinking about what you might have done differently to achieve similar goals.

Chapter 1

An Introduction to Mergers, Acquisitions, and Other Restructuring Activities

In this chapter, you will gain an understanding of the underlying dynamics of mergers and acquisitions (M&As) in the context of an increasingly interconnected world. This chapter begins with a discussion of why M&As act as change agents in the context of corporate restructuring. Although other aspects of corporate restructuring are discussed elsewhere in this chapter, the focus is on M&As, why they happen, and why they tend to cluster in waves. You will also be introduced to a variety of legal structures and strategies that are employed to restructure corporations. Moreover, the role of the various participants in the M&A process is explained. Using the results of the latest empirical studies, this chapter addresses the questions of whether mergers pay off for the target and acquiring company shareholders and bondholders, as well as for society.

Keywords

Mergers; acquisitions; mergers and acquisitions; leveraged buyouts; LBOs; takeovers; spin-offs; equity carve-outs; divestitures; motives for mergers; arbitrage; corporate restructuring; M&As; cross-border deals; M&A transactions; alternative takeover strategies; holding companies; ESOPs

If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a lifetime.

– Lao Tze

Outline

Inside Mergers and Acquisitions: PC Maker Lenovo Moves to Diversify Its Core Business 6

Chapter Overview 8

Why M&As Happen 8

Synergy 9

Diversification 12

Strategic Realignment 14

Hubris and the Winner’s Curse 15

Buying Undervalued Assets: The Q-Ratio 15

Managerialism (Agency Problems) 15

Tax Considerations 16

Market Power 16

Misvaluation 17

Historical Developments in M&As 17

Why M&A Waves Occur 18

Similarities and Differences among Merger Waves 20

Why It Is Important to Anticipate Merger Waves 20

Understanding Corporate Restructuring Activities 20

Mergers and Consolidations 23

Acquisitions, Divestitures, Spin-Offs, Split-Offs, Carve-Outs, and Buyouts 24

Alternative Takeover Strategies 24

The Role of Holding Companies in M&As 26

The Role of Employee Stock Ownership Plans (ESOPs) in M&As 27

Business Alliances as Alternatives to M&As 27

Participants in the M&A Process 28

Providers of Specialized Services 29

Regulators 31

Institutional Investors and Lenders 31

Activist Investors 33

M&A Arbitrageurs (Arbs) 34

The Implications of M&As for Shareholders, Bondholders, and Society 35

Premerger Returns to Shareholders 35

Postmerger Returns to Shareholders 37

Acquirer Returns Vary by Characteristics of Acquirer, Target, and Deal 38

Payoffs for Bondholders 41

Payoffs for Society 42

Some Things to Remember 42

Chapter Discussion Questions 42

Case Study: Microsoft Acquires Nokia 44

Case Study Objectives 44

Discussion Questions 48

Additional Case Study Recommendations 48

Inside Mergers and Acquisitions: PC Maker Lenovo Moves to Diversify Its Core Business

Key Points

• Firms unable to anticipate change often are forced to react to it and to make choices under great duress.

• A common reaction when a firm’s current product focus is in jeopardy is to diversify either into products or services related to or entirely unrelated to their core skills.

• Either choice can be highly risky if the firm’s core skills are becoming obsolete or if the firm is unable to adapt fast enough to the skills required in the new competitive environment.

With the global personal computer market in steady decline, the board and senior management of Lenovo Corporation, the Chinese-based global leader in PC manufacturing, expressed increasing concern about the firm’s future viability. External trends were increasingly shaping the firm’s future. It was clear something had to be done. But what was the appropriate strategy to deal with an accelerating rate of change? In response to this question, Lenovo’s chief executive, Yang Yuanqing, laid out plans to diversify further into the smartphone and tablets’ markets in a strategy he referred to as PC-plus.

The decline in PC demand was worsening with the global PC market falling by 10% in 2013 to 314.5 million units sold according to technology consulting firm IDC. Lenovo was under pressure to implement the new strategy quickly. In rapid fire succession, Lenovo announced on January 14, 2014, that it had reached a deal with IBM to buy its low-end server business and 7 days later that it announced the acquisition of Motorola Mobility’s smartphone business from Google Inc. The $2.3 billion cash deal with IBM gave Lenovo 7.5% of the world market for low-margin servers based on off-the-shelf semiconductors. As a result, Lenovo had positioned itself to compete directly with Dell and HP. While customers are shifting away from the low-end, less powerful servers, demand for these machines is expected to remain in high for years to come ensuring steady cash inflow for the firm.

In contrast, the $2.91 billion Motorola Mobility deal represented a potentially highly significant growth opportunity. The purchase price consisted of $660 million in cash, $750 million in Lenovo shares, and a 3-year promissory note valued at $1.5 billion. Motorola Mobility includes handset technology that Google had acquired for $12.5 billion in 2011. Selling the unit reflected Google’s submission to mounting shareholder pressure to rid itself of the cash hemorrhaging business that many believed provided an unnecessary management distraction from the firm’s core search business.¹ Lenovo is picking up more than 2000 patents, including those necessary to produce smartphones, in addition to the phone handset manufacturing operation.

Lenovo is the third largest smartphone maker in the world behind Samsung and Apple. However, its sales are geographically concentrated, with 90% of its smartphones sold in China. The acquisition of Motorola gives the firm a global brand name and access to the US market where Motorola already has relationships with such major telecommunications carriers as Verizon and AT&T. In total, Motorola has distribution agreements with more than 50 mobile carriers, retail outlets, and resellers. The firm intends to sell both Motorola and Lenovo phones in the United States.

While the US market is large, it is also maturing. With 60% of American cellphone owners having smartphones, future growth is likely to slow from its rapid pace of the past decade. Moreover, the US handset market is highly concentrated with Samsung and Apple having a combined market share of 68% according to NPD Group, a market research firm. The remainder of the handset market is divided among HTC, Motorola Mobility, and Blackberry.

Lenovo had expressed interest in acquiring Motorola in 2012 but was rebuffed by Google management. In November 2013, Google’s executive chairman, Eric Schmidt called Lenovo’s chief executive and asked if he was still interested in a deal. Google was unwilling to sell Motorola to competitors like Microsoft or Samsung. Lenovo was viewed as the ideal buyer for its smartphone business, since the world’s largest PC maker could become a big booster of Android, Google’s mobile operating system. Lenovo began exclusively making Android phones in 2013. For Lenovo, the deal made it a preferred hardware producer for Google putting it in a position to co-market its products with Google and to sell its hardware directly to Google.

The purchase of Motorola Mobility will give the firm a strong brand in the mobile market outside of China and relationships with AT&T and Verizon. Along with Apple, Lenovo will be the only major technology firm with global product lines in PCs, smartphones, and tablets giving Lenovo the opportunity to become a one-stop shop for firms to buy all their devices from the same vendor. Eventually, the firm hopes to become a major player in the global smartphone market.

While mobile phones use different kinds of chips than PCs and servers, many parts and much of the handset assembly is done by the same companies. By increasing their volume of parts purchases, Lenovo may be able to negotiate lower prices from suppliers. With its increased position in the global server market, Lenovo also may hope to experience savings in purchasing microchips for both PCs and servers in greater number.

Lenovo’s highly aggressive acquisition strategy raises questions of whether the firm is moving too fast. Integrating the money-losing Motorola along with the former IBM server business will be a challenge. But the firm believes that speed is critical in implementing successfully its new strategy. In a nod toward déjà vu, Lenovo is hoping that the Motorola deal can propel its smartphone business onto the global stage just as its purchase of IBM’s ThinkPad business in 2005 had catapulted the firm into the thick of the PC industry.

Chapter Overview

Facebook stuns investors by buying mobile messaging business WhatsApp for $21.8 billion, despite the firm’s miniscule $20 million in annual revenue. Google pays $12.5 billion for Motorola Mobility only to sell it less than 3 years later for a fraction of the purchase price. Verizon Communications buys out its partner in Verizon Wireless, Vodafone, for a mind-numbing $130 billion. What explains these seemingly bizarre behaviors?

With its focus on mergers and acquisitions (M&As), this chapter provides insights into why they happen and why they tend to cluster in waves, as well as to a variety of legal structures and strategies that are employed to restructure firms. The roles and responsibilities of the primary participants in the M&A process also are discussed in detail. Subsequent chapters analyze this subject matter in more detail. This chapter concludes with a series of discussion questions, an end of chapter case study, and recommendations for relevant case studies from Harvard Business Publishing.

A firm that attempts to acquire or merge with another company is called an acquiring company, acquirer, or bidder. The target company is the firm being solicited by the acquiring company. Takeovers and buyouts are generic terms for a change in the controlling ownership interest of a corporation. A review of this chapter (including practice questions and answers) is available in the file folder entitled Student Study Guide on the companion website for this book: http://booksite.elsevier.com/9780128013908.

Why M&As Happen

The reasons M&As occur are numerous, and the importance of factors giving rise to M&A activity varies over time. Table 1.1 lists some of the more prominent theories about why M&As happen. Of these theories, anticipated synergy between the acquirer and target firms is most often cited in empirical studies as the primary motivation for M&As.² Each theory is discussed in greater detail in the remainder of this section.

Table 1.1

Common Theories of What Causes M&As

Synergy

Synergy is the value realized from the incremental cash flows generated by combining two businesses. That is, if the market value of two firms is $100 million and $75 million, respectively, and their combined market value is $200 million, then the implied value of synergy is $25 million. The two basic types of synergy are operating and financial.

Operating Synergy

Operating synergy consists of economies of scale, economies of scope, and the acquisition of complementary technical assets and skills, which can be important determinants of shareholder wealth creation.³ Gains in efficiency can come from these factors and from improved managerial operating practices.

Economies of scale often refer to the reduction in average total costs for a firm producing a single product for a given scale of plant due to the decline in average fixed costs as production volume increases. Scale is defined by such fixed costs as depreciation of equipment and amortization of capitalized software, normal maintenance spending, and obligations such as interest expense, lease payments, long-term union, customer, and vendor contracts, and taxes. These costs are fixed since they cannot be altered in the short run. Variable costs are those that change with output levels. Consequently, for a given scale or amount of fixed expenses, the dollar value of fixed expenses per unit of output and per dollar of revenue decreases as output and sales increase.

To illustrate the potential profit improvement from economies of scale, consider the merger of Firm B into Firm A. Firm A has a plant producing at only one-half of its capacity, enabling Firm A to shut down Firm B’s plant that is producing the same product and move the production to its own, underutilized facility. Consequently, Firm A’s profit margin improves from 6.25% before the merger to 14.58% after the merger. Why? Because the additional output transferred from Firm B is mostly profit as it adds nothing to Firm A’s fixed costs (Table 1.2).⁴

Table 1.2

Economies of Scale

aContribution to profit of additional units=$4×500,000–$2.75×500,000=$625,000.

bMargin per unit sold=$4.00–$2.75–$1.00=$0.25.

cMargin per unit sold=$4.00–$2.75–$0.67=$0.58. Note that this illustration does not reflect any costs incurred in closing Firm B’s plant.

Economies of scale may also affect variable costs such as a reduction in purchased material prices due to an increase in bulk purchases and lower production line setup costs resulting from longer production runs. When one company buys another, the combined firms may be able to negotiate lower purchase prices from suppliers because of their increased negotiating leverage. Suppliers often are willing to cut prices because they also realize economies of scale as their plant utilization increases if they are able to produce and sell larger quantities. Setup costs refer to the expense associated with setting up a production assembly line. These include personnel costs in changing from producing one product to another, any materials consumed in this process, and the time lost while the production line is down. For example, assume a supplier’s initial setup costs are $3,000 per production run to produce an order of 2,500 units of a product. Setup costs per unit produced are $1.20. If the order is doubled to 5,000 units, setup costs per unit are cut in half to $0.60 per unit. Suppliers may be willing to pass some of these savings on to customers to get the larger order.

Economies of scope refers to the reduction in average total costs for a firm producing two or more products, because it is cheaper to produce these products in a single firm than in separate firms. Economies of scope may reflect both declining average fixed and variable costs. Common examples of overhead- and sales-related economies of scope include having a single department (e.g., accounting and human resources) support multiple product lines and a sales force selling multiple related products rather than a single product. Savings in distribution costs can be achieved by transporting a number of products to a single location rather than a single product. In 2012, following its emergence from bankruptcy, Hostess Baking achieved significant reductions in distribution costs when its unions allowed the firm to transport both bread and other baked goods to customers in the same truck rather than in separate trucks as had been the case. Economies of scope also include the cost savings realized by using a specific set of skills or an asset currently employed in producing a specific product to produce multiple products. Procter & Gamble, the consumer products giant, uses its highly regarded consumer marketing skills to sell a full range of personal care as well as pharmaceutical products. Honda employs its proprietary know-how (an intangible asset) to enhance internal combustion engines to manufacture, in addition to cars, motorcycles, lawn mowers, and snow blowers.

Complementary technical assets and skills are those possessed by one firm that could be used by another to fill gaps in its technical capabilities. Gaining access to this know-how can be a significant motivation for one firm to acquire another. For example, merger activity is likely to occur between firms pursuing related research and development activities, with certain technologies owned by one firm appearing to be very attractive to the other.⁵ Both firms gain potentially from an increased rate of innovation after the merger because they have access to each other’s technical skills and patent portfolios. Such innovation can accelerate new product development and improved operating efficiency. For example, Pharmacia & Upjohn merged with Monsanto to form Pharmacia. The merger gave Pharmacia & Upjohn access to Monsanto’s Cox-2 inhibitors and Monsanto access to the other’s expertise in genomics. The merger allowed for expanded in-house clinical R&D, resulting in an increase in the average size of R&D projects and a reduction in the time required getting products to market.

Financial Synergy

Financial synergy refers to the reduction in the acquirer’s cost of capital due to a merger or acquisition. This could occur if the merged firms have cash flows that are relatively uncorrelated, realize cost savings from lower securities’ issuance and transactions costs, or experience a better matching of investment opportunities with internally generated funds. The conventional view holds that corporations moving into different product lines whose cash flows are uncorrelated reduce only risk specific to the firm such as product obsolescence (i.e., business specific or nonsystematic risk) and not risk associated with factors impacting all firms (i.e., systematic risk) such as a recession, inflation, or increasing interest rates.⁶

Recent research suggests that M&As that result in firms whose individual business unit cash flows are uncorrelated can indeed lead to a reduction in systematic risk. Such firms may be better able to withstand the loss of customers, suppliers, employees, or the impact of financial distress than single product firms. Sometimes referred to as coinsurance, the imperfect correlation of business unit cash flows allows resources to be transferred from cash-rich units to cash-poor units as needed. In contrast, the loss of key customers or employees in a single product firm could be devastating. Consequently, multiproduct line firms with less correlated business unit cash flows can have less systematic risk than firms whose business unit cash flows are correlated.⁷

From the perspective of the target firm, financial synergy could be viewed as the elimination of financial constraints. Firms whose investment opportunities exceed their ability to finance them are said to be financially constrained. Theory suggests that financial constraints should lead managers to increase cash holdings due to their limited borrowing capacity and to reduce their levels of investment. There is evidence that financially constrained firms subsequent to being acquired tend to reduce their cash holdings and to increase their investment levels. These results are consistent with the view that financial constraints are reduced for target firms when they are acquired.⁸

Diversification

Buying firms beyond a company’s current lines of business is called diversification. Diversification may create financial synergy that reduces the cost of capital as noted above, or it may allow a firm to shift its core product lines or target markets into ones that have higher growth prospects, even ones that are unrelated to the firm’s current products or markets. The product–market matrix illustrated in Table 1.3 identifies a firm’s primary diversification options.

Table 1.3

The Product–Market Matrix

A firm facing slower growth in its current markets may accelerate growth through related diversification by selling its current products in new markets that are somewhat unfamiliar and, therefore, more risky. Such was the case in 2012 when IBM acquired web-based human resource software maker Kenexa to move its existing software business into the fiercely competitive but fast-growing market for delivering business applications via the web.

A firm also may attempt to achieve higher growth rates by acquiring new products with which it is relatively unfamiliar and then selling them in familiar and less risky current markets. Retailer J.C. Penney’s $3.3 billion acquisition of the Eckerd Drugstore chain (a drug retailer) and Johnson & Johnson’s $16 billion acquisition of Pfizer’s consumer healthcare products line are examples of such related diversification. In each instance, the firm assumed additional risk by selling new products lines, but into markets with which it had significant prior experience: J.C. Penney in consumer retail markets and J&J in retail healthcare markets.

There is considerable evidence that acquisitions resulting in unrelated diversification frequently result in lower financial returns when they are announced than nondiversifying acquisitions.⁹ Firms that operate in a number of largely unrelated industries, such as General Electric, are called conglomerates. The share prices of conglomerates often trade at a discount to shares of focused firms or to their value if broken up.¹⁰ This markdown is called a conglomerate or diversification discount, a measure that sometimes values conglomerates as much as 15% lower than more focused firms in the same industry.¹¹ Investors often perceive conglomerates as riskier because management has difficulty understanding these firms and may tend to underinvest in attractive opportunities.¹² Additionally, outside investors may have trouble in valuing the various parts of highly diversified businesses.¹³ Investors also may be reluctant to invest in firms whose management appears intent on diversifying to build empires rather than to improve firm performance¹⁴; moreover, such firms often exhibit poor governance practices.¹⁵

Other researchers find evidence that the most successful mergers in developed countries are those that focus on deals that promote the acquirer’s core business, largely reflecting their familiarity with such businesses and their ability to optimize investment decisions.¹⁶ Related acquisitions may even be more likely to generate higher financial returns than unrelated deals,¹⁷ since related firms are more likely to realize cost savings due to overlapping functions.

It is important to note that the existence of a conglomerate discount is not universally true. While conglomerates have not fared as well as more focused firms in North America and certain other developed countries, their performance in developing nations has been considerably stronger. Diversified firms in countries having limited capital market access may sell at a premium since they may use cash generated by mature subsidiaries to fund those with higher growth potential.¹⁸ Furthermore, conglomerates in such developed countries as South Korea and Singapore have outperformed their more focused rivals in part due to their ability to transfer ideas and technologies among their various businesses.¹⁹

Strategic Realignment

Firms use M&As to make rapid adjustments to changes in their external environment such as regulatory changes and technological innovation. Those industries that have been subject to significant deregulation in recent years—financial services, healthcare, utilities, media, telecommunications, defense—have been at the center of M&A activity,²⁰ because deregulation breaks down artificial barriers and stimulates competition. Firms in highly regulated industries often are unable to compete successfully following deregulation and become targets of stronger competitors. As such, deregulation often sparks a flurry of M&A activity resulting in a significant reduction in the number of competitors in the formerly regulated industry.²¹

Technological advances create new products and industries and force a radical restructuring of existing ones. The smartphone spurred the growth of handheld telecommunications devices while undercutting the point-and-shoot camera industry and threatening the popularity of wristwatches, alarm clocks, and MP3 players. Tablet computers reduced the demand for desktop and notebook computers, while e-readers reduced the popularity of hardback books. Services such as WhatsApp and Microsoft’s Skype erode a major source of mobile phone company revenue: voice and text messaging. A shift to cloud computing enables businesses to outsource their IT operations.

Hubris and the Winner’s Curse

Acquirers overpay for targets when they overestimate synergies due to excessive optimism. Competition among bidders also is likely to result in the winner’s overpaying because of hubris, even if significant synergies are present. CEOs with successful acquisition track records may pay more than the target is worth due to overconfidence.²² Acquirers overpaying for a target firm may feel remorse at having done so—hence what has come to be called the winner’s curse.

Buying Undervalued Assets: The Q-Ratio

The Q-ratio is the ratio of the market value of the acquirer’s stock to the replacement cost of its assets. Firms can choose to invest in new plant and equipment or obtain the assets by buying a company with a market value less than what it would cost to replace the assets (i.e., a market-to-book or Q-ratio that is less than 1). This theory is useful in explaining M&A activity when stock prices drop well below the book value (or historical cost) of many firms.

Managerialism (Agency Problems)

Agency problems arise when the interests of current managers and the firm’s shareholders differ. Managers may make acquisitions to add to their prestige, build their spheres of influence, or augment their compensation or for self-preservation.²³ Further, agency problems may be more pronounced with younger CEOs. Since acquisitions often are accompanied by large, permanent increases in compensation, CEOs have strong financial incentives to pursue acquisitions earlier in their careers.²⁴ Such mismanagement can persist when a firm’s shares are widely held, since the cost of such negligence is spread across a large number of shareholders.

From the target firm’s perspective, agency problems may consist of potential conflicts of interest arising in deals involving the firm’s directors, senior managers, or major shareholders. These problems may be mitigated by the target’s board of directors by using fairness opinions to evaluate the appropriateness of bidder offer prices and special committees consisting of independent directors to represent shareholders. Special committees are subcommittees of a target’s board composed of independent, disinterested directors who are not part of management or a group attempting a buyout of the firm. Special committees are used to evaluate offers in about one-fourth of takeovers.²⁵

A recent example of a potential conflict involves the buyout of Dell Inc. in 2013 by Michael Dell and Silver Lake Partners. Because Michael Dell was both a director and major shareholder, the Dell Inc. board created a special committee of four independent directors to represent shareholders other than Michael Dell. The special committee hired an investment bank and conducted an auction in an effort to obtain a bid higher than that proposed by Michael Dell.

Tax Considerations

Taxes influence corporate decision making.²⁶ Acquirers of firms with accumulated losses and tax credits may use them to offset future profits generated by the combined firms. However, the taxable nature of the transaction often plays a more important role in determining whether a merger takes place than do any tax benefits accruing to the acquirer. The seller may view the tax-free status of the transaction as a prerequisite for the deal to take place. A properly structured transaction can allow the target shareholders to defer any capital gain until the acquirer’s stock received in exchange for their shares is sold.

In recent years, tax considerations have become an increasingly important factor motivating firms in high tax countries that derive a large portion of their income from foreign sources to move their corporate headquarters by acquiring a firm located in a country with more favorable tax rates. Since a firm’s income is taxed both in its home country and abroad, multinational companies are motivated to move to lower tax environments as part of their global financial strategies. So-called corporate inversions have become increasingly popular among US firms that have relocated to such tax friendly environments as Ireland. See Chapters 12 and 18 for more details on inversions.

Market Power

Despite little empirical support, the market power theory suggests that firms merge to improve their ability to set product prices at levels not sustainable in a more competitive market. Many recent studies conclude that increased merger activity is much more likely to contribute to improved operating efficiency of the combined firms than to increased market power (see Do Mergers Pay Off for Society? section). There is, however, evidence that increased industry concentration can force suppliers to lower their selling prices.²⁷

Misvaluation

Absent full information, investors may periodically over- or undervalue a firm.²⁸ Under- or overvaluation is defined as the value of a firm’s shares compared to their true economic value. If a firm’s shares are overvalued, they are likely to decline in the long run to their true value as investors more accurately value such shares based on new information.

Acquirers may profit by buying undervalued targets for cash at a price below their actual value or by using overvalued equity (even if the target is overvalued), as long as the target is less overvalued than the bidding firm’s stock.²⁹ Overvalued shares enable the acquirer to purchase a target firm in a share for share exchange by issuing fewer shares, reducing the dilution of current acquirer shareholders in the combined companies.³⁰ Target firm shareholders may be willing to accept overvalued acquirer shares if they believe the likely synergy resulting from the merger is substantial enough to offset the potential for the overvalued acquirer shares to decline.³¹

The effects of misvaluation tend to be short-lived, since the initial overvaluation of an acquirer’s share price often is reversed in 1–3 years as investors’ enthusiasm about potential synergies wanes.³² Both acquirer and target shareholders often lose in misvalued deals. Acquirers tend to overpay for target firms and often anticipated synergy is insufficient for the acquirer to earn back the premium paid for the target. Target shareholders who hold their acquirer shares see them over time decline to their true economic value.

Historical Developments in M&As

M&As cluster in waves, with public firms more active buyers than private firms due in part to their greater access to financing and their more liquid stock.³³ Insights gained by analyzing these waves help buyers to understand when to make and how to structure and finance deals.

Why M&A Waves Occur

M&As in the United States have tended to cluster in six multiyear waves since the late 1890s. There are two competing explanations for this phenomenon. One argues that merger waves occur when firms react to industry shocks,³⁴ such as from deregulation, the emergence of new technologies, distribution channels, substitute products, or a sustained rise in commodity prices. Such events often cause firms to acquire either all or parts of other firms.³⁵ The second argument is based on misvaluation and suggests that managers use overvalued stock to buy the assets of lower valued firms. For M&As to cluster in waves, goes the argument, valuations of many firms must increase at the same time. Managers whose stocks are believed to be overvalued move concurrently to acquire firms whose stock prices are lesser valued.³⁶ For this theory to be correct, the method of payment would normally be stock. In fact, the empirical evidence shows that less stock is used to finance takeovers during merger waves.

Since M&A waves typically correspond to an improving economy, managers confident about their stocks future appreciation are more inclined to use debt to finance takeovers,³⁷ because they believe their shares are currently undervalued. Thus, the shock argument seems to explain M&A waves better than the misevaluation theory.³⁸ However, shocks alone, without sufficient liquidity to finance deals, will not initiate a wave of merger activity. Moreover, readily available, low-cost capital may cause a surge in M&A activity even if industry shocks are absent.³⁹

While research suggests that shocks drive merger waves within industries, increased M&A activity within an industry contributes to additional M&A activity in other industries as a result of customer–supplier relationships.⁴⁰ For example, increased consolidation among computer chip manufacturers in the early 2000s drove an increase in takeovers among suppliers of chip manufacturing equipment to accommodate growing customer demands for more complex chips. Such consolidation results in a ripple affect across industries.

The First Wave (1897–1904): Horizontal Consolidation

M&A activity reflected a drive for efficiency, lax enforcement of the Sherman Anti-Trust Act, migration, and technological change. Mergers were largely between competitors and resulted in increased concentration in primary metals, transportation, and mining. Fraudulent financing and the 1904 stock market crash ended the boom.

The Second Wave (1916–1929): Increasing Concentration

Activity during this period was a result of the entry of the United States into World War I and the postwar economic boom. Mergers also tended to be horizontal and further increased industry concentration. The stock market crash of 1929 and the passage of the Clayton Act that further defined monopolistic practices brought this era to a close.

The Third Wave (1965–1969): The Conglomerate Era

Firms with high P/E ratios learned to grow earnings per share (EPS) through acquisition rather than reinvestment by buying firms with lower P/E ratios but high earnings growth to increase the EPS of the combined companies. This in turn boosted the share price of the combined companies—as long as the P/E ratio applied to the stock price of the combined companies did not fall below the P/E ratio of the acquiring company before the deal. To maintain this pyramiding effect, though, target companies had to have earnings growth rates that were sufficiently attractive to convince investors to apply the higher multiple of the acquiring company to the combined companies. In time, the number of high-growth, relatively low P/E ratio companies declined, as conglomerates bid up their P/E multiples. The higher prices paid for the targets, coupled with the increasing leverage of the conglomerates, caused the pyramids to collapse.

The Fourth Wave (1981–1989): The Retrenchment Era

The 1980s was characterized by the breakup of many major conglomerates by so-called corporate raiders using hostile takeovers and leveraged buyouts (LBOs). LBOs involve the purchase of a company financed primarily by debt, often resulting in an increased concentration of ownership. Conglomerates began to divest unrelated acquisitions made in the 1960s and early 1970s. For the first time, takeovers of US companies by foreign firms exceeded in number and dollars the acquisitions by US firms of foreign companies. Foreign buyers were motivated by the size of the market, limited restrictions on takeovers, the sophistication of US technology, and the weakness of the dollar against major foreign currencies. Toward the end of the 1980s, the level of merger activity tapered off in line with a slowing economy and widely publicized LBO bankruptcies.

The Fifth Wave (1992–1999): The Age of the Strategic Megamerger

The longest economic expansion and stock market boom in US history was powered by a combination of the information technology revolution, continued deregulation, reductions in trade barriers, and the global trend toward privatization. Both the dollar volume and number of transactions continued to set records through the end of the 1990s before contracting sharply when the Internet bubble bursts, a recession hit the United States in 2001, and global growth weakened.

The Sixth Wave (2003–2008): The Rebirth of Leverage

US financial markets, especially from 2005 through 2007, were characterized by a proliferation of highly LBOs and complex securities collateralized by pools of debt and loan obligations of varying levels of risk. Much of the financing of these deals, as well as mortgage-backed security issues, has taken the form of syndicated debt (i.e., debt purchased by underwriters for resale to the investing public). Lenders have an incentive to increase the volume of lending to generate fee income by accepting riskier loans.⁴¹ Once loans are sold to others, loan originators are likely to reduce the monitoring of such loans. These practices, coupled with exceedingly low interest rates (which substantially underpriced risk) made possible by a world awash in liquidity and highly accommodative monetary policies, contributed to excessive lending and encouraged acquirers to overpay significantly for target firms. However, limited credit availability, as banks attempted to rebuild their capital following substantial asset write-downs, not only affected the ability of private equity and hedge funds to finance new or refinance existing transactions but also limited the ability of other businesses to fund operations. These conditions were exacerbated by European sovereign debt concerns and escalating oil prices that triggered a global economic downturn in 2008. Mirroring the global malaise, M&A activity languished during this period.

Similarities and Differences among Merger Waves

M&As commonly occur during periods of sustained high rates of economic growth, low or falling interest rates, and a rising stock market. Historically, each merger wave has differed in terms of a specific development (such as the emergence of a new technology), industry focus (such as rail, oil, or financial services), degree of regulation, and type of transaction (such as horizontal, vertical, conglomerate, strategic, or financial deals discussed in more detail later in this chapter). Table 1.4 compares the six US merger waves. Merger waves also occur in cross-border M&As, with European waves following those in the United States with a short lag.⁴²

Table 1.4

US Historical Merger Waves

Why It Is Important to Anticipate Merger Waves

The stock market rewards firms acting early and punishes those that merely imitate. Firms pursuing attractive deals early pay lower prices for targets than followers. Late in the cycle, purchase prices escalate as more bidders enter the takeover market, leading many buyers to overpay.⁴³ Reflecting this herd mentality, deals completed late in M&A waves tend to show lower acquirer returns than those announced prior to an upsurge in deal activity.⁴⁴

Understanding Corporate Restructuring Activities

Corporate restructuring often is broken into two categories. Operational restructuring entails changes in the composition of a firm’s asset structure by acquiring new businesses or by the outright or partial sale or spin-off of companies or product lines. Operational restructuring could also include downsizing by closing unprofitable or nonstrategic facilities. Financial restructuring describes changes in a firm’s capital structure, such as share repurchases or adding debt either to lower the company’s overall cost of capital or as part of an antitakeover defense. The focus in this book is on business combinations and breakups rather than on operational downsizing and financial restructuring. Business combinations can be known as mergers, consolidations, acquisitions, or takeovers and can be characterized as friendly or hostile.

Mergers and Consolidations

Mergers can be described from a legal perspective and an economic perspective.

A Legal Perspective

A merger is a combination of two or more firms, often comparable in size, in which all but one ceases to exist legally. A statutory or direct merger is one in which the acquiring or surviving company assumes automatically the assets and liabilities of the target in accordance with the statutes of the state in which the combined companies will be incorporated. A subsidiary merger involves the targets becoming a subsidiary of the parent. To the public, the target firm may be operated under its brand name, but it will be owned and controlled by the acquirer. A statutory consolidation—which involves two or more companies joining to form a new company—is technically not a merger. All legal entities that are consolidated are dissolved during the formation of the new company, which usually has a new name, and shareholders in the firms being consolidated typically exchange their shares for shares in the new company.

An Economic Perspective

Business combinations may also be defined depending on whether the merging firms are in the same (horizontal) or different industries (conglomerate) and on their positions in the corporate value chain (vertical). Figure 1.1 illustrates the different stages of value chain. A simple value chain in the basic steel industry may distinguish between raw materials, such as coal or iron ore; steel making, such as hot metal and rolling operations; and metals distribution. Similarly, a value chain in the oil and gas industry would separate exploration activities from production, refining, and marketing. An Internet value chain might distinguish between infrastructure providers such as Cisco, content providers such as Dow Jones, and portals such as Google. In a vertical merger, companies that do not own operations in each major segment of the value chain backward integrate by acquiring a supplier or forward integrate by buying a distributor. When paper manufacturer Boise Cascade acquired Office Max, an office products distributor, the $1.1 billion transaction represented forward integration.⁴⁵ PepsiCo backward integrated through a $7.8 billion purchase of its two largest bottlers to realize $400 million in annual cost savings.

Figure 1.1 The corporate value chain. Note: IT stands for information technology.

Acquisitions, Divestitures, Spin-Offs, Split-Offs, Carve-Outs, and Buyouts

An acquisition occurs when a company takes a controlling interest in another firm, a legal subsidiary of another firm, or selected assets of another firm, such as a manufacturing facility. They may involve the purchase of another firm’s assets or stock, with the acquired firm continuing to exist as a legally owned subsidiary. In contrast, a divestiture is the sale of all or substantially all of a company or product line to another party for cash or securities. A spin-off is a transaction in which a parent creates a new legal subsidiary and distributes shares in the subsidiary to its current shareholders as a stock dividend. A split-off is similar to a spin-off, in that a firm’s subsidiary becomes an independent firm and the parent firm does not generate any new cash. However, unlike a spin-off, the split-off involves an offer to exchange parent stock for stock in the parent firm’s subsidiary. An equity carve-out is a transaction in which the parent issues a portion of its stock or that of a subsidiary to the public (see Chapter 15). Figure 1.2 provides a summary of the various forms of corporate restructuring.

Figure 1.2 The corporate restructuring process.

Alternative Takeover Strategies

The term takeover is used when one firm assumes control of another. In a friendly takeover, the target’s board and management recommend shareholder approval. To gain control, the acquiring company usually must offer a premium to the current stock price. The excess of the offer price over the target’s premerger share price is called a purchase premium or acquisition premium and varies widely by country,⁴⁶ reflecting the perceived value of obtaining a controlling interest (i.e., the ability to direct the activities of the firm) in the target, the value of expected synergies (e.g., cost savings) resulting from combining the two firms, and any overpayment for the target firm. Overpayment is the amount an acquirer pays for a target firm in excess of the present value of future cash flows, including synergy.⁴⁷ The size of the premium fluctuates widely from 1 year to the next. During the 30-year period ending in 2011, US purchase price premiums averaged 43%, reaching a high of 63% in 2003 and a low of 31% in 2007.⁴⁸ The premium size also varies substantially across industries, reflecting their different expected growth rates.⁴⁹

A formal proposal to buy shares in another firm made directly to its shareholders, usually for cash or securities or both is called a tender offer. Tender offers most often result from friendly negotiations (i.e., negotiated tender offers) between the boards of the acquirer and the target firm. Cash tender offers may be used because they could represent a faster alternative to mergers.⁵⁰ Those that are unwanted by the target’s board are referred to as hostile tender offers. Self-tender offers are used when a firm seeks to repurchase its stock.

A hostile takeover occurs when the offer is unsolicited, the approach was contested by the target’s management, and control changed hands. The acquirer may attempt to circumvent management by offering to buy shares directly from the target’s shareholders (i.e., a hostile tender offer) and by buying shares in a public stock exchange (i.e., an open market purchase). Friendly takeovers are often consummated at a lower purchase price than hostile deals, which may trigger an auction for the target firm. Acquirers often prefer friendly takeovers because the postmerger integration process is usually more expeditious when both parties are cooperating fully and customer and employee attrition is less. Most transactions tend to be friendly, with hostile takeovers usually comprising less than 5% of the value of total deals.

The Role of Holding Companies in M&As

A holding company is a legal entity having a controlling interest in one or more companies. The key advantage is the ability to gain effective control⁵¹ of other companies at a lower overall cost than if the firm was to acquire 100% of the target’s shares. Effective control sometimes can be achieved by owning as little as 30% of the voting stock of another company when the firm’s bylaws require approval of major decisions by a majority of votes cast rather than a majority of the voting shares outstanding. This is particularly true when the target company’s ownership is highly fragmented, with few shareholders owning large blocks of stock. Effective control generally is achieved by acquiring less than 100% but usually more than 50% of another firm’s equity. Because it can gain effective control with less than 100% ownership, the holding company is left with minority shareholders, who may not always agree with the strategic direction of the company. Implementing holding company strategies may become very contentious. Also, holding company shareholders may be subject to an onerous tax burden, with corporate earnings potentially subject to triple taxation.⁵²

The Role of Employee Stock Ownership Plans (ESOPs) in M&As

An ESOP is a trust fund that invests in the securities of the firm sponsoring the plan. Designed to attract and retain employees, ESOPs are defined contribution⁵³ employee pension plans that invest at least 50% of the plan’s assets in the sponsor’s common shares. The plans may receive the employer’s stock or cash, which is used to buy the sponsor’s stock. The sponsor can make tax-deductible contributions of cash, stock, or other assets into the trust.⁵⁴ The plan’s trustee is charged with investing the trust assets, and the trustee often can sell, mortgage, or lease the assets. Stock acquired by the ESOP is allocated to accounts for individual employees based on some formula and vested over time. ESOP participants must be allowed to vote their allocated shares at least on major issues such as selling the company. However, there is no requirement that they be allowed to vote on other issues such as choosing the board of directors.

ESOPs may be used to restructure firms. If a subsidiary cannot be sold at what the parent firm believes to be a reasonable price and liquidating the subsidiary would be disruptive to customers, the parent may divest the subsidiary to employees through a shell corporation. A shell corporation, as defined by the U.S. Securities and Exchange Commission in 2005, is one with no or nominal operations, and with no or nominal assets or assets consisting solely of cash and cash equivalents.⁵⁵ The shell sets up the ESOP, which borrows the money to buy the subsidiary; the parent guarantees the loan. The shell operates the subsidiary, whereas the ESOP holds the stock. As income is generated from the subsidiary, tax-deductible contributions are made by the shell to the ESOP to service the debt. As the loan is repaid, the shares are allocated to employees who eventually own the firm. ESOPs may be used by employees in LBOs to purchase the shares of owners of privately held firms. This is particularly common when the owners have most of their net worth tied up in their firms. ESOPs also provide an effective antitakeover defense, since employees who also are shareholders tend to vote against bidders for fear of losing their jobs.

Business Alliances as Alternatives to M&As

In addition to M&As, businesses may combine through joint ventures (JVs), strategic alliances, minority investments, franchises, and licenses. The term business alliance is used to refer to all forms of business combinations other than M&As (see Chapter 15 for more details).

Joint ventures are business relationships formed by two or more separate parties to achieve common objectives. While the JV is often a legal entity such as a corporation or partnership, it may take any organizational form desired by the parties involved. Each JV partner continues to exist as a separate entity; JV corporations have their own management reporting to a board of directors. A strategic alliance generally does not create a separate legal entity and may be an agreement to sell each firm’s products to the other’s customers or to co-develop a technology, product, or process. Such agreements may be legally binding or largely informal.

Minority investments, those involving less than a controlling interest, require little commitment of management time for those willing to be so-called passive investors. Such investments are frequently made in firms which have attractive growth opportunities but lack the resources to pursue them.⁵⁶ Investors often receive representation on the board or certain veto rights in exchange for their investment. A minority investor can effectively control a business by having veto rights over such issues as changes in strategy, capital expenditures over a certain amount of money, key management promotions, salary increases applying to senior managers, the amount and timing of dividend payments, and when the business would be sold.

Licenses enable firms to extend their brands to new products and markets by permitting others to use their brand names or to gain access to a proprietary technology. A franchise is a specialized form of a license agreement that grants a privilege to a dealer from a manufacturer or franchise service organization to sell the franchiser’s products or services in a given area. Under a franchise agreement, the franchiser may offer the franchisee consultation, promotional assistance, financing, and other benefits in exchange for a share of the franchise’s revenue. Franchises represent a low-cost way for the franchiser to expand.⁵⁷

The major attraction of these alternatives to outright acquisition is the opportunity for each partner to gain access to the other’s skills, products, and markets at a lower overall cost in terms of management time and money. Major disadvantages include limited control, the need to share profits, and the potential loss of trade secrets and skills to competitors.

Participants in the M&A Process

In addition to the acquirer and target firms, the key participants in the M&A process can be categorized as follows: providers of specialized services, regulators, institutional investors and lenders, activist investors, and M&A arbitrageurs. Each category plays a distinctly different role.

Providers of Specialized Services

The first category includes investment banks, lawyers, accountants, proxy solicitors, and public relations personnel. Not surprisingly, the number and variety of advisors hired by firms tends to increase dramatically with the increasing complexity of the deal.⁵⁸

Investment Banks

Investment banks provide advice and deal opportunities; screen potential buyers and sellers; make initial contact with a seller or buyer; and negotiation support, valuation, and deal structuring guidance. The universal or top-tier banks (e.g., Goldman Sachs) also maintain broker–dealer operations, serving wholesale and retail clients in brokerage and advisory roles to assist with the complexity and often-huge financing requirements of mega-transactions.⁵⁹

Investment bankers derive significant income from writing so-called fairness opinion letters—written and signed third-party assertions that certify the appropriateness of the price of a proposed deal involving a tender offer, merger, asset sale, or LBO. They often are developed as legal protection for members of the boards of directors against possible shareholder challenges of their decisions.⁶⁰ Researchers have found that fairness opinion letters reduce the risk of lawsuits associated with M&A transactions and the size of the premium paid for targets if they result in acquirers’ performing more rigorous due diligence and deal negotiation.⁶¹

In selecting an investment bank, acquirers and target firms focus far more on a bank’s track record in generating high financial returns for their clients than on its size or market share.⁶² Smaller advisors may generate higher returns for their clients than the mega-investment banks because of proprietary industry knowledge and relationships. About one-fourth of merging firms tend to hire so-called boutique or specialty investment banks for their skill and expertise as their advisors, especially in deals requiring specialized industry knowledge.⁶³ However, size and market share do matter in certain situations. Contrary to earlier studies that report a negative or weak relationship between bidder financial advisor size and bidder returns,⁶⁴ bidders using top-tier investment banks as advisors report on average a 1% improvement in returns in deals involving public targets.⁶⁵ Top-tier investment banks are better able to assist in funding large transactions, which typically involve public companies, because of their current relationships with lenders and broker networks. Public company takeovers often are more complex than private firm takeovers due to their greater bargaining power, need for greater disclosure, and regulatory issues.

Longstanding investment banking relationships do matter. However, their importance varies with the experience of the acquirer and target firm. Targets, having longstanding relationships with investment banks, are more likely to hire M&A advisors⁶⁶ and to benefit by receiving higher purchase price premiums.⁶⁷ Frequent acquirers are more likely to use the same investment advisor if they have had good prior outcomes. Otherwise they are very willing to switch to a new investment advisor. Investment banking relationships are significant for inexperienced acquirers. They are more likely to hire as their financial advisors in deals that are financed by issuing new equity investment banks with which they have had a longstanding underwriting relationship.⁶⁸

Investment banks often serve as advisors for firms undergoing extensive restructuring involving asset sales. Such firms are more likely to utilize investment banks when they are in a different industry from the potential buyer and the asset to be sold is large. Buyers of divested assets are more likely to use investment banks when the target is large relative to the buyer (i.e., they have more at stake), is a foreign firm, is in the technology industry, or is in a different industry from the buyer.⁶⁹