THEORIES OF MERGERS AND TENDER

OFFERS

REASONS FOR MERGERS

1) Size And Returns To Scale

 Benefits of size are usual source of
‘synergies’
 Economies of scale
 Average costs decline with larger
size
 Lower required investment in
inventory
 Large firms more able to implement
specialization
 Improved capacity utilization
 Economies of scope – firm can
produce additional products due to
experience with existing products

2) Transaction costs
 Technological factors do not guarantee
a merger will enhance profit
  Specialization gains suggest reasons
mergers should not occur
 If supplier can produce input more
cheaply, will not profit a firm to merge
 Coase framework
 Firm must decide between
internal or external production
 Transaction costs within and
outside firm determine decision on firm
size and merger

VALUE EFFECTS OF M&AS

(A) VALUE INCREASING THEORIES

1) Transaction costs
 Organization of firm is reaction to
appropriate balance of internal
operations and external markets
2) Mergers create synergies
 Economies of scale
 More effective management
 Improved production techniques
 Combination of complementary resources
 3) Takeovers are disciplinary
 Can be used to remove poor managers
 Facilitate competition between
different management teams

(B) VALUE REDUCING THEORIES

1) Agency costs of free cash flow
 Free cash flow is a source of value reducing
mergers
 Firms with FCF are those where internal
funds exceed investment required for
positive NPV projects
2) Managerial entrenchment
 Managers hesitant to distribute cash to
shareholders
 Investments may be in form of acquisitions
where managers over pay but reduce
likelihood of their own replacement

(C) VALUE NEUTRAL THEORY – HUBRIS

1) Merger bids result from managerial hubris –
managers are prone to excessive self-
confidence
2) Winner’s curse
 Competitive bidding has a distribution of
value estimates
 Manager with most optimistic forecast wins
bidding process
 Cursed by fact that bid likely overvalues
target
3) Mergers can occur even when no value
effects: target sells when bid is higher than
target value

Principle Theory
Value  Transaction cost efficiency
Increasing – mergers optimise
transaction costs
 Synergy – scale, best
practices, etc.
 Disciplinary – takeovers
can be used to replace
poor management
Value  Agency costs of free cash
Reducing flow – managers reinvest
FCF inefficiently back into
firm
 Management
entrenchment – firm
invests to increase
managers’ value to
shareholders

Value Neutral  Hubris – winner of

takeover contest is firm
that most overvalues
target

Theory Combine Gains to Gains to

d Gains Target Bidder
Efficiency/ Positive Positive Non-
Synergy Negative

Agency Negative Positive More

Costs/ Negative
Entrenchme
nt

Hubris Zero Positive Negative

EXAMPLES OF THE MERGER PROCESS

(A) HP-COMPAQ
Reasons given for the merger
 Economies of scale in PC industry
 Projected synergies of $2.5 billion
 Strategic response to conditions in
computer and information technology
sectors

Market reaction to 3/9/01 announcement

 Hewlett-Packard declined 19%
 Compaq fell by 10%

Major events in the merger process

 CEOs initiated discussion in June 2001 –
firms then undertook extensive due
diligence
 Consulting firms McKinsey and Accenture
were involved in the analysis of the merger
 Goldman Sachs (HP) and Salomon Smith
Barney (Compaq) were engaged in July
2001, to provide financial advice
  Members of Hewlett and Packard families
threatened to vote against the merger
 Shareholders approved in May 2002
(B) NORTHROP GRUMMAN AND TRW
 Deal began as a hostile bid by Northrop
and evolved into merger

Reasons given for the merger

 Economies of scale in defence industry
 Complementary product mix

Market reaction to initial announcement

(22/2/02)
 TRW increased 26.4% (speculation that
there may be more potential bidders, or
that TRW would get a higher price from
NG)
 NG dropped by 6.7%

Major events in the merger process

 22/2/02 – Northrop releases letter sent to
TRW proposing a merger
 3/3/02 – TRW rejected $47 stock offer
  TRW sought other bidders and considered
implementing a split-up
 Northrop increased offer
 2/7/02 – announced merger agreement for
$60 stock

EXAMPLE OF THE BIDDING PROCESS:

SAVANNAH FOODS (A SUGAR REFINER)

 Merger process began in March 1996

 SF’s board of directors requested
management develop a plan to improve
shareholder value
 Plan: maximize value of core sugar
business and consider acquisitions in
related areas
 Discussions with acquisition candidates
and merger partners in summer 1996
produced no formal actions

 Savannah discussed merger with two

possible partners in late 1996
 Flo-Sun reached deal to buy SF (15/7/97)
  Shareholders of SF to own 41.5% of
new entity
 SF price fell 15.7% to $15.75 at
announcement
 Shareholder lawsuits arose over terms
 Imperial Holly, a sugar refining
company, made a competing bid
 IH contacted investment-banking
firm, Lehman Brothers, to develop
acquisition strategies
 IH made competing offer for SF for
$18.75 per share (70% in cash and 30% in
stock)

 Flo-Sun upped bid on 4/9/1997

 SF would own 45% of new firm
 Shareholders would also receive $4 in cash
 SF asked both bidders to submit
final offers on 8/9/97
 IH upped bid to $20.25 per share
 Flo-sun stood by most recent offer
 SF executed merger agreement
with IH on 12/9/97
 Ended previous agreement with Flo-Sun
 Paid $5 million termination fee to Flo-Sun

THE MERGER PROCESS:

COMPLEXITIES IN NEGOTIATING DEALS

1) Bidder considerations:
 Pay cash or stock
 Deal with management or shareholders
 May buy initial stake
2) Target considerations:
 Decision to sell
 Decision to seek competing bids or seek
termination fee in initial bid
MODELS OF TAKEOVER BIDDING

(A) The Winner’s Curse

 Bidders can shade bids lower –
but risk losing possible deals
 Alternatives
 If concerned about value of
target, can offer stock
 Shares risk of combined
firm between bidder and target

(B) Bidder costs

 Pre-emptive bid
 Bidder decides to make bid
that precludes other bidders from
making competing offer
 Target may receive higher
price if there is a pre-emptive bidder
 Termination fee – bidder
making formal offer often requires a
termination fee in agreement
 Toehold
 Use of toehold helps to
recoup bidding costs
  Size of toehold is a function
of expected synergies from the merger

(C) Seller decisions

 Effects of bidder using toehold
 May deter other firms from
making competitive bids
 But, seller can counteract
by designing a favourable auction
 Effects of costly bidding
 Selling firm bears most of
bidding costs
 Implies that seller may gain
by limiting the number of bidders
EXAMPLE OF TAKEOVER AUCTION:
OUTLET COMMUNICATIONS

 Owned and operated television stations

 Board engaged Goldman Sachs to aid in
sale via auction (auction began 2/95)
 80 firms contacted GS
 45 signed confidentiality agreements and
received non-public information
 By 5/95, 12 firms submitted preliminary
bids ranging from $32 to $38
 8 firms invited to perform extensive due
diligence
 By 6/95, 5 had submitted definitive
proposals

 Highest bid was $42.25 by Renaissance

Communications – OC and RC signed a
merger agreement
 Before deal completed, NBC offered bid of
$47.25 – OC approved competing bid
 Example illustrates:
Complexity of bidding process
 Sequential reduction of number of
bidders
 Advantages of encouraging multiple
bids