Unit 12: Mergers and Acquisitions

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Unit 12 Mergers and Acquisitions
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Mergers vs. Acquisitions

• Merger Two companies become one via a
  stock-for-stock exchange.
• Chrysler-Daimler
• Acquisition One company (or individual) buys
  substantially all of the outstanding shares of
  another.
• The distinction is not necessarily one of size.
• Did one group of shareholders receive cash or not?

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Hostile vs. Friendly

• Management does not need to approve of any MA
  deal, but they may be able to fight it (mechanism
  discussed later)
• This is the hostile vs. friendly distinction
• A merger requires the approval of 50 of
  stockholders.
• Acquisitions can be accomplished via the open
  market, or through a tender offer.
• Tender offer direct cash offer to all of
  shareholders.

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Taxable vs. Tax-free

• Do the investors in the acquired firms have to
  pay taxes?
• If cash acquisition, yes.
• If stock merger, generally no.
• The IRS considers this continuity of ownership
  interest. Since you didnt sell, then you
  didnt realize your gain (yet).
• The exception is if the purpose of the merger
  appears to be to avoid taxes (e.g. a profitable
  company acquires a bankrupt firm to use their
  losses).

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Accounting for Acquisitions

• Pooling of interests balance sheets are simply
  added together.
• Purchase Accounting
• Assets of acquired firm put on the balance sheet
  at fair market value
• Goodwill is created difference between purchase
  price and estimated fair market value of net
  assets
• Currently, US firms must use purchase accounting

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Goodwill

• Goodwill no longer has to be amortized assets
  are essentially marked-to-market annually and
  goodwill is adjusted and treated as an expense if
  the market value of the assets has decreased

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Sensible Reasons for Mergers

• Vertical Integration
• Efficiency in dealing with suppliers may reduce
  costs.
• Over integration can cause the opposite effect.

Company
Company
S
S
S
S
S
S
S
S
Pre-integration (less efficient)
Post-integration (more efficient)
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Sensible Reasons for Mergers

• Horizontal Integration Economies of Scale
• A larger firm may be able to reduce its per unit
  cost by using excess capacity or spreading fixed
  costs across more units.
• This may also create market power.

Reduces costs


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Sensible Reasons for Mergers

• Combining Complementary Resources
• Merging may result in each firm filling in the
  missing pieces of their firm with pieces from
  the other firm.

Firm A
Firm B
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Sensible Reasons for Mergers

• Combining Complementary Resources
• Merging may result in each firm filling in the
  missing pieces of their firm with pieces from
  the other firm.

Firm A
Firm B
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Example of Mergers

• Getty Oil merged with Texaco. Getty had oil
  reserves and Texaco had excess capacity.
• Complementary resources / vertical int.
• Daimler merged with Chrysler
• Economies of scale / horiz. int. / market power

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Dubious Reasons for Mergers

• Diversification
• Investors should not pay a premium for
  diversification since they can do it themselves.
• This intuition follows from the CAPM
• Access to cheap capital for smaller target
• Careful! Target probably uses a high rate for
  good reasons their assets are risky. This can
  be a reasonable justification if and only if the
  target is somehow missed by financial markets.
  In that case, acquirer is acting like a
  financier.

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Conclusion

• To justify a merger we need to show that
• PV(A B) PV(A) PV(B)
• If so, there are synergies.
• Economies of scale or scope
• Monopoly power
• Diversification is not a synergy.

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Merger Valuation

• Step 1 Estimate the stand-alone value of the
  target. Estimate the stand-alone value of the
  acquirer.
• If the market does not anticipate the offer,
  market prices are probably the best estimate for
  these.
• If the offer is anticipated, then the market has
  probably bid up the target. For this reason, the
  target is often tricky to value.

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Target stand-alone valuation

• DCF
• Discount at WACC. This yields enterprise value
  (i.e. the entire value of the assets), so
  subtract off debt value.
• Book value of the debt is probably a reasonable
  approximation of market value unless the credit
  risk of the target has changed since issuance.
• Multiples for current traded companies (P/S, P/E,
  P/B, etc.) But are these really comparables?
• Multiples for comparable transactions.
• Smaller sample set, but also gives info as to the
  premium demanded by the market. We can also see
  ex-post whether there was overpayment.

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Step 2 Value synergies

• Where do the synergies come from?
• Ex 1 Acquirer cost savings due to economies of
  scale in a horizontal merger.
• Estimate these after-tax cost savings per year
  (annuity, perpetuity, growing perpetuity) and
  discount them at the acquirers cost of capital.
• Ex 2 Additional revenue to target due to
  complementarities.
• Estimate the incremental cash flows associated
  with these increased revenues, and discount them
  at the targets cost of capital.

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Example

• A merger should result in the following nominal
  cost savings for the acquirer in its core
  business (economies of scale). The usual
  discount rate is 12 for this firm.
• T0 0
• T1 15 million
• T2 22 million
• T3 60 million
• The cost savings are expected to fall at 3 per
  year thereafter. The tax rate is 35.
• What is the NPV of synergies?

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Step 3 Allocate Synergies

• Regardless of the form of the offer stock or
  cash targets implicitly capture some of the
  synergies.
• Worst case scenario for acquirer is that all
  synergies will be allocated to target.
• Let S total dollar value of synergies
• XT target stand-alone value per share.
• NT number of shares for target
• Then
• Minimum cash offer XT
• Maximum cash offer XT S/NT
• In general the cash offer should be somewhere
  between these two extremes.

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Realities of MA

• Consider Buffets view
• Many managements apparently were overexposed in
  impressionable childhood years to the story in
  which the imprisoned handsome prince is released
  from a toad's body by a kiss from a beautiful
  princess. Consequently, they are certain their
  managerial kiss will do wonders We've observed
  many kisses but very few miracles.
• http//www.wallstraits.com/buffett/buffett_quote26
  .html

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Buffet is right!

• In practice, targets almost always capture
  synergies.

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Step 3 for Stock Offers

• Heres how to allocate synergies with stock
  offers.
• Let the offer ratio be R (shares in the new
  combined company obtained per share in the
  target)
• Shareholders in the acquirer will retain one
  share of the new company per share they own now.
• The exchange ratio is trickier than you might
  think, since some synergies go to the acquirer in
  general.

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Stock Offers cont.

• R offer ratio (1 target share converts into R
  shares in the combined firm
• SA dollar value of synergies allocated to
  acquirer (some fraction of S).
• XA acquirer price per share
• NA acquirer number of shares
• Post-merger market cap XANA XTNT S
• Post-merger price per share XA SA/NA
• Post-merger price x Post-merger number of shares
  Post merger market cap
• Solve this equation for post-merger number of
  shares. From this, we can back out how many
  shares need to be created, and therefore what the
  exchange ratio must be.

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Dilution

• An MA transaction is called
• dilutive if EPS goes down for the acquirer.
• Accretive if EPS goes up for the acquirer.
• This is different from term dilution used for
  seasoned equity offerings
• Reminder if the SEO price is too low, we issue
  too many shares (for a given sized investment).
  The old shareholders stake is diluted.
• Does EPS dilution matter? No! The thing that
  matters is did we acquire the target at a
  favorable price.

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Case Problem

• Pick your own firm, and estimate the value of
  target, acquirer and synergies.
• Since your acquisition is unanticipated, its
  safe to use market values for the first two. For
  the target, also find a couple of comparables
  and see if the multiples give answers similar to
  the market value. Explain any discrepancy.
• Estimate the value of synergies using the DCF
  method. Explain your discount rate choice.
• Explicitly show me the forecasted cost savings
  (in total dollars) for the next five years, and
  make an assumption regarding what happens after
  that.

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• Allocate the synergies based on your sense of the
  market situation. Are there other potential
  bidders? If so, most of the gains will go to
  target.
• Calculate the offer ratio (assuming stock merger)
  and find the effect of the transaction on the
  EPS, P/E and leverage of the acquirer.
• Useful way to check your answer
• You calculate the offer ratio solely based on the
  synergies allocated to the acquirer.
• Check the outcome to shareholders in the target
  firm. You should find that
• (New shares given to target shareholders )x
• Post-merger share price
• Synergies allocated to target
• target stand-alone price

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First Bancorp and OFG

• Ill do a reduced version of your case in class.
• I will not look at comparables (to see if the
  value of OFG is reasonable) or value the
  synergies.
• I will assume that the synergies to the deal are
  250 million, and that the target captures 100
  million of this.
• Find the offer ratio, and post-merger leverage.
• I will not find P/E or EPS because I did not say
  where synergies came from. In your case, you
  will have an estimate of just how much E rises.

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Hostile Takeover Defenses

• Staggered Board only one third of the board of
  directors is elected each year.
• Supermajority can raise the 50 required vote
  to 80.
• Poison Pill if a large block of stock is
  purchased, existing shareholders have a right to
  buy discounted shares.

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Effect of Takeover Defenses

• May be a way to extract a higher final price from
  potential acquirer.
• Insulates management from the market for
  corporate control.
• Good or bad?
• The market for corporate control is virtually
  absent in Japan and Germany. Very active in the
  U.S. for certain periods.

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Corporate Structure in Japan

• Keiretsu A group of manufacturing firms with
  interlocking boards of directors, and
  cross-holdings.
• At the center of each Keiretsu is a large bank,
  which provides financing for the team.
• Because of these cross-holdings, it would be
  virtually impossible to do a hostile takeover in
  Japan.

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Daimler-Benz
Kuwait Government
Mercedes Auto Holding
Deutsche Bank
Widely Held
Widely Held
Widely Held
Stella Automobil Beteiligungsges
Stella Automobil Beteiligungsges Holding
Komet Automobile
Bayerische Landesbank
Robert Bosch
Dresdner Bank
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LBO

• A leveraged buyout is a type of acquisition in
  which
• Most of the acquisition financing is debt. Debt
  financing dwarfs equity financing, and is
  speculative grade i.e. junk bonds.
• After acquisition, the company goes private.
• The company is bought by a group of investors
  specifically formed for that purchase.
• When management participates, it is an MBO.

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Barbarians at the Gate

• When RJR Nabisco was LBOd the selling
  shareholders received 109 for stock that had
  traded previously for 56.
• KKR sold off the RJR Air Force, cut
  bureaucracy, sold off European operations that
  were not being run well.
• Large amount of debt to service means the drive
  for cost-cutting and selling off assets is high.
• Winners Old stockholders, raiders.
• Losers Old bondholders, government, employees.

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Why the bad name?

• Between 1981 and 1987, junk bond financing went
  from 3.7 of the bond market to 23. Over half
  of this business was done by Drexel Burnham
  Lambert.
• From 1989 to 1991, about 10 of these issuers
  went bankrupt and the market collapsed.
• Drexel went bankrupt. Michael Milken plead
  guilty to securities fraud, paid over a billion
  dollars in fines, and was sentenced to ten years
  in prison.
• http//www2.uchicago.edu/alumni/alumni.mag/9510/Oc
  tober95Investig.html