Chapter 1
Introduction to Mergers and Acquisitions
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
Inside M&A: dell moves into information technology services
Dell Computer's growing dependence on the sale of personal computers and peripherals left it vulnerable to economic downturns. Profits had dropped more than 22% since the start of the global recession in early 2008 as business spending on information technology was cut sharply. Dell dropped from number 1 to number 3 in terms of market share, as measured by personal computer unit sales, behind lower-cost rivals Hewlett-Packard and Acer. Major competitors such as IBM and Hewlett-Packard were less vulnerable to economic downturns because they derived a larger percentage of their sales from delivering services.
Historically, Dell has grown “organically” by reinvesting in its own operations and through partnerships targeting specific products or market segments. However, in recent years, Dell attempted to “supercharge” its lagging growth through targeted acquisitions of new technologies. Since 2007, Dell has made ten comparatively small acquisitions (eight in the United States), purchased stakes in four firms, and divested two companies. The largest previous acquisition for Dell was the purchase of EqualLogic for $1.4 billion in 2007.
The recession underscored what Dell had known for some time. The firm had long considered diversifying its revenue base from the more cyclical PC and peripherals business into the more stable and less commodity-like computer services business. In 2007, Dell was in discussions about a merger with Perot Systems, a leading provider of information technology (IT) services, but an agreement could not be reached.
Dell's global commercial customer base spans large corporations, government agencies, healthcare providers, educational institutions, and small and medium firms. The firm's current capabilities include expertise in infrastructure consulting and software services, providing network-based services, and data storage hardware; nevertheless, it was still largely a manufacturer of PCs and peripheral products.
In contrast, Perot Systems offers applications development, systems integration, and strategic consulting services through its operations in the United States and ten other countries. In addition, it provides a variety of business process outsourcing services, including claims processing and call center operations. Perot's primary markets are healthcare, government, and other commercial segments. About one-half of Perot's revenue comes from the healthcare market, which is expected to benefit from the $30 billion the U.S. government has committed to spending on information technology (IT) upgrades over the next five years.
In 2008, Hewlett-Packard (HP) paid $13.9 billion for computer services behemoth EDS in an attempt to become a “total IT solutions” provider for its customers. This event, coupled with a very attractive offer price, revived merger discussions with Perot Systems. On September 21, 2009, Dell announced that an agreement had been reached to acquire Perot Systems in an all-cash offer for $30 a share in a deal valued at $3.9 billion. The tender offer (i.e., takeover bid) for all of Perot Systems' outstanding shares of Class A common stock was initiated in early November and completed on November 19, 2009, with Dell receiving more than 90% of Perot's outstanding shares.
Chapter overview
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. The 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 the chapter, the focus here 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, the chapter addresses questions of whether mergers pay off for the target and acquiring company shareholders and bondholders, as well as for society. Finally, the most commonly cited reasons for why some M&As fail to meet expectations are discussed.
Throughout this book, a firm that attempts to acquire or merge with another company is called an acquiring company, acquirer, or bidder. The target company or target is the firm being solicited by the acquiring company. Takeovers or 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 site for this book (www.elsevierdirect.com/companions/9780123854858). The site also contains a Learning Interactions Library that gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
Mergers and Acquisitions as Change Agents
Businesses come and go in a continuing churn, perhaps best illustrated by the ever-changing composition of the so-called “Fortune 500”—the 500 largest U.S. corporations. Only 70 of the firms on the original 1955 list of 500 are on today's list, and some 2,000 firms have appeared on it at one time or another. Most have dropped off as a result of merger, acquisition, bankruptcy, downsizing, or some other form of corporate restructuring. Consider a few examples: Chrysler, Bethlehem Steel, Scott Paper, Zenith, Rubbermaid, and Warner Lambert.
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. While the focus in this chapter is on corporate restructuring involving mergers and acquisitions, non-M&A corporate restructuring is discussed in more detail elsewhere in this book.
Why Mergers and Acquisitions 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. Each theory is discussed in greater detail in the remainder of this section.
Table 1.1. Common Theories of What Causes Mergers and Acquisitions
| Theory | Motivation |
| OPERATING SYNERGY | |
| Improve operating efficiency through economies of scale or scope by acquiring a customer, supplier, or competitor | |
| FINANCIAL SYNERGY | LOWER COST OF CAPITAL |
| Diversification | Position the firm in higher-growth products or markets |
| Strategic Realignment | Acquire capabilities to adapt more rapidly to environmental changes than could be achieved if the capabilities were developed internally |
| Hubris (Managerial Pride) | Acquirers believe their valuation of the target is more accurate than the market's, causing them to overpay by overestimating synergy |
| Buying Undervalued Assets (q-Ratio) | Acquire assets more cheaply when the equity of existing companies is less than the cost of buying or building the assets |
| Mismanagement (Agency Problems) | Replace managers not acting in the best interests of the owners |
| Managerialism | Increase the size of a company to increase the power and pay of the managers |
| Tax Considerations | Obtain unused net operating losses and tax credits, asset write-ups, and substitute capital gains for ordinary income |
| Market Power | Increase market share to improve ability to set prices above competitive levels |
| Misvaluation | Investor overvaluation of acquirer's stock encourages M&As |
Synergy
Synergy is the rather simplistic notion that the combination of two businesses creates greater shareholder value than if they are operated separately. The two basic types of synergy are operating and financial.
Operating Synergy
Operating synergy consists of both economies of scale and economies of scope, which can be important determinants of shareholder wealth creation.1 Gains in efficiency can come from either factor and from improved managerial practices.
Economies of scale refer to the spreading of fixed costs over increasing production levels. 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 in that they cannot be altered in the short run. By contrast, 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 is assumed to have 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 (Table 1.2).
Table 1.2. Economies of Scale
| Period 1: Firm A (Premerger) | Period 2: Firm A (Postmerger) |
| ASSUMPTIONS | ASSUMPTIONS |
| Profit = price × quantity – variable costs – fixed costs = $4 × 1,000,000 – $2.75 × 1,000,000 – $1,000,000 = $250,000 |
Profit = price × quantity – variable costs – fixed costs = $4 × 1,500,000 – $2.75 × 1,500,000 – $1,000,000 = $6,000,000 – $4,125,000 – $1,000,000 = $875,000 |
| Profit margin (%)a = 250,000/4,000,000 = 6.25% Fixed costs per unit = $1,000,000/$1,000,000 = $1.00 |
Profit margin (%)b = 875,000/6,000,000 = 14.58% Fixed cost per unit = $1,000,000/1,500,000 = $0.67 |
a Margin per $ of revenue = $4.00 – $2.75 – $1.00 = $.25
b Margin per $ of revenue = $4.00 – $2.75 – $.67 = $.58
Economies of scope refer to using a specific set of skills or an asset currently employed in producing a specific product or service to produce related products or services, which are found most often when it is cheaper to combine multiple product lines in one firm than to produce them in separate firms. For example, 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 knows how to enhance internal combustion engines, so in addition to cars, the firm develops motorcycles, lawn mowers, and snowblowers. Citigroup uses the same computer center to process loan applications, deposits, trust services, and mutual fund accounts for its banks' customers.
Assume Firm A merges with Firm B and combines the data processing facilities such that a single center supports both firms' manufacturing operations. By expanding the scope of a single data processing center to support all of the manufacturing facilities of the combined firms, significant cost savings can be realized in terms of lower labor, telecommunications, leased space, and overhead costs (Table 1.3).
Table 1.3. Economies of Scope
| Premerger | Postmerger |
Financial Synergy
Financial synergy refers to the impact of mergers and acquisitions on the cost of capital of the acquiring firm, or the newly formed firm, resulting from the merger or acquisition. The cost of capital is the minimum return required by investors and lenders to induce them to buy a firm's stock or to lend to the firm. In theory, the cost of capital could be reduced if the merged firms have cash flows that do not move up and down in tandem (i.e., so-called coinsurance), realize financial economies of scale from lower securities issuance and transactions costs, or result in a better matching of investment opportunities with internally generated funds.
Combining a firm that has excess cash flows with one whose internally generated cash flow is insufficient to fund its investment opportunities may result in a lower cost of borrowing. A firm in a mature industry that is experiencing slowing growth may produce cash flows well in excess of available investment opportunities. Another firm in a high-growth industry may not have enough cash to realize its investment opportunities. Reflecting their different growth rates and risk levels, the firm in the mature industry may have a lower cost of capital than the one in the high-growth industry, and combining the two firms could lower their average cost of capital.
Diversification
Buying firms outside of a company's current primary lines of business is called diversification, and is typically justified in one of two ways. Diversification may create financial synergy that reduces the cost of capital, or it may allow a firm to shift its core product lines or 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 shown in Table 1.4 identifies a firm's primary diversification options.
Table 1.4. The Product–Market Matrix
| Markets | ||
| Products | Current | New |
| Current | Lower Growth/Lower Risk | Higher Growth/Higher Risk (Related Diversification) |
| New | Higher Growth/Higher Risk (Related Diversification) | Highest Growth/Highest Risk (Unrelated Diversification) |
A firm that is facing slower growth in its current markets may be able to 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 when pharmaceutical giant Johnson & Johnson announced its ultimately unsuccessful takeover attempt of Guidant Corporation in late 2004. J&J was seeking an entry point for its medical devices business in the fast-growing market for implant devices, in which it did not then participate. A firm may attempt to achieve higher growth rates by developing or 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) in 1997 or Johnson & Johnson's $16 billion acquisition of Pfizer's consumer healthcare products line in 2006 are two examples of related diversification. In each instance, the firm assumed additional risk, but less so than with unrelated diversification if it had developed new products for sale in new markets.
There is considerable evidence that investors do not benefit from unrelated diversification. 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—as much as 10 to 15%2—compared to shares of focused firms or to their value were they broken up. This discount is called the conglomerate discount or diversification discount. Investors often perceive companies that are diversified in unrelated areas as riskier because management has difficulty understanding these companies and often fails to provide full funding for the most attractive investment opportunities.3 Moreover, outside investors may have a difficult time understanding how to value the various parts of highly diversified businesses.4 Researchers differ on whether the conglomerate discount is overstated.5
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.6 Related acquisitions may even be more likely to generate higher financial returns than unrelated acquisitions.7 This should not be surprising, since related firms are more likely to be able to realize cost savings due to overlapping functions and product lines than are unrelated firms.
In contrast to the conglomerate discount often found in developed economies, diversified firms in developing countries, where access to capital markets is limited, may sell at a premium to more focused firms.8 Under these circumstances, corporate diversification may enable more efficient investment, since diversified firms may use cash generated by mature subsidiaries to fund those with higher growth potential.
Strategic Realignment
The strategic realignment theory suggests that firms use M&As to make rapid adjustments to changes in their external environments. Although change can come from many different sources, this theory considers primarily changes in the regulatory environment and technological innovation—two factors that, over the past 30 years, have been major forces in creating new opportunities for growth or threatening to make obsolete firms' primary lines of business.
Regulatory Change
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,9 because deregulation breaks down artificial barriers and stimulates competition. During the first half of the 1990s, for instance, the U.S. Department of Defense actively encouraged consolidation of the nation's major defense contractors to improve their overall operating efficiency. In some states, utilities that are required to sell power to competitors that can resell the power in the utility's own marketplace often respond with M&As to achieve greater operating efficiency.
Since the Telecommunications Reform Act of 1996, local and long-distance companies have been encouraged to compete in one another's markets, and cable companies are offering both Internet access and local telephone service. Following the Financial Services Modernization Act of 1999, commercial banks were allowed to move beyond their historical role of accepting deposits and granting loans by merging with securities firms and insurance companies. However, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (see Chapter 2) reversed this trend, particularly for large commercial banks.
Technological Change
Technological advances create new products and industries. The development of the airplane created the passenger airline, avionics, and satellite industries. The emergence of satellite delivery of cable networks to regional and local stations ignited explosive growth in the cable industry. Today, with the expansion of broadband technology, we are witnessing the convergence of voice, data, and video technologies on the Internet The emergence of digital camera technology reduced dramatically the demand for analog cameras and film and sent household names such as Kodak and Polaroid scrambling to adapt.
Hubris and the “Winner's Curse”
Acquirers may tend to overpay for targets, having been overoptimistic when evaluating synergies. Competition among bidders also is likely to result in the winner overpaying because of hubris, even if significant synergies are present.10 Studies show that CEOs who were previously successful in making acquisitions and those who appear to be overconfident, as measured by their overinvestment in their own firm's stocks, have a tendency to make value-destroying acquisitions.11
In an auction environment with bidders, the range of bids for a target company is likely to be quite wide because senior managers tend to be very competitive and sometimes self-important. Their desire not to lose can drive the purchase price of an acquisition well in excess of its actual economic value (i.e., cash-generating capability). The winner pays more than the company is worth and may ultimately 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 acquiring firm's stock to the replacement cost of its assets. Firms interested in expansion can choose to invest in new plant and equipment or obtain the assets by acquiring 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 very useful in explaining M&A activity when stock prices drop well below the book value (or historical cost) of many firms. When gasoline refiner Valero Energy Corp. acquired Premcor Inc. in 2005, the $8 billion transaction created the largest refiner in North America. It would have cost an estimated 40% more for Valero to build a new refinery with equivalent capacity.12
Mismanagement
Agency problems arise when there is a difference between the interests of current managers and the firm's shareholders. This happens when management owns a small fraction of the outstanding shares of the firm. These managers, who serve as agents of the shareholder, may be more inclined to focus on their own job security and lavish lifestyles than on maximizing shareholder value. When the shares of a company are widely held, the cost of such mismanagement is spread across a large number of shareholders, each of whom bears only a small portion. This allows for toleration of the mismanagement over long periods. Mergers often take place to correct situations where there is a separation between what managers and owners (shareholders) want. Low stock prices put pressure on managers to take actions to raise the share price or become the target of acquirers, who perceive the stock to be undervalued13 and who are usually intent on removing the underperforming management of the target firm. Agency problems also contribute to management-initiated buyouts, particularly when managers and shareholders disagree over how excess cash flow should be used.14
Managerialism
The managerialism motive for acquisitions asserts that managers make acquisitions for selfish reasons, be it to add to their prestige, to build their spheres of influence, to augment their compensation, or for self-preservation.15 But ascribing acquisition to the managerialism motive ignores the pressure that managers of larger firms are under to sustain earnings growth to support their firms' share price. As the market value of a firm increases, senior managers are compelled to make ever larger investment bets to sustain increases in shareholder value. Small acquisitions simply do not have sufficient impact on earnings growth to justify the effort required to complete them. Consequently, even though the resulting acquisitions may destroy value, the motive for making them may be more to support shareholder interests than to preserve management autonomy.
Tax Considerations
Tax benefits, such as loss carryforwards and investment tax credits, can be used to offset the taxable income of firms that combine through M&As. Acquirers of firms with accumulated losses may use them to offset future profits generated by the combined firms. Unused tax credits held by target firms may also be used to lower future tax liabilities. Additional tax shelters (i.e., tax savings) are created due to the purchase method of accounting, which requires the book value of the acquired assets to be revalued to their current market value for purposes of recording the acquisition on the books of the acquiring firm. The resulting depreciation of these generally higher asset values reduces the amount of future taxable income generated by the combined companies, as depreciation expense is deducted from revenue in calculating a firm's taxable income.
The taxable nature of the transaction often plays a more important role in determining whether a merger takes place than any tax benefits that accrue to the acquiring company. 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 resulting from the transaction until they actually sell the acquirer's stock received in exchange for their shares. If the transaction is not tax-free, the seller typically will want a higher purchase price to compensate for the tax liability resulting from the transaction.16 These issues are discussed in more detail in Chapter 12.
Market Power
The market power theory suggests that firms merge to improve their monopoly power to set product prices at levels not sustainable in a more competitive market There is very little empirical support for this theory. 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 the section of this chapter entitled “Do M&As Pay off for Society?”).
Misvaluation
In the absence of full information, investors may periodically over- or undervalue a firm. Acquirers may profit by buying undervalued targets for cash at a price below their actual value or by using equity (even if the target is overvalued), as long as the target is less overvalued than the bidding firm's stock.17 Overvalued shares enable the acquirer to purchase a target firm in a share-for-share exchange by issuing fewer shares, which reduces the probability of diluting the ownership position of current acquirer shareholders in the newly combined company. That's important because dilution represents a significant cost to the current shareholders of the acquiring firm; their shares represent claims on the firm's earnings, cash flows, assets, and liabilities.
Whenever a firm increases its shares outstanding, it reduces the proportionate ownership position of current shareholders. Overvalued shares tend to reduce this cost. Consider an acquirer who offers the target firm shareholders $10 for each share they own. If the acquirer's current share price is $10, the acquirer would have to issue one new share for each target share outstanding. If the acquirer's share price is valued at $20, only 0.5 new shares would have to be issued, and so forth. Consequently, the initial dilution of the current acquirer's shareholders' ownership position in the new firm is less the higher the acquirer's share price compared to the price offered for each share of target stock outstanding. There is evidence that the effects of misevaluation tend to be short-lived, since the initial overvaluation of an acquirer's share price is reversed in one to three years as investors' enthusiasm about potential synergies wanes.18
Merger and acquisition waves
While there is little question that the future of M&A activity will continue to evolve, reflecting new global competition and the changing regulatory climate, it will continue to be possible to draw parallels with the past. These insights should help us to understand when to make acquisitions and how to structure and finance future M&As.
Why M&A Waves Occur
M&A activity in the United States has 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 in industries react to “shocks” in their operating environments,19 such as from deregulation; the emergence of new technologies, distribution channels, or substitute products; or a sustained rise in commodity prices. The size and length of the M&A wave depends to a large part on how many industries are affected by these shocks, as well as the extent of the impact. Some shocks, such as the emergence of the Internet, are pervasive in their impact; others are more specific, such as deregulation of utilities or rapidly escalating commodity prices. In response to shocks, firms within the industry often acquire either all or parts of other firms.
The second argument is based on the misvaluation idea discussed previously 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 (measured by their price-to-earnings or market-to-book ratios compared to other firms) must increase at the same time. Managers whose stocks are believed to be overvalued move concurrently to acquire companies whose stock prices are lesser valued20 and, reflecting the influence of overvaluation, the method of payment would normally be stock.21
Evidence suggests that the “shock” argument is a stronger one, especially if it is modified to include the effects of the availability of capital in causing and sustaining merger waves. Shocks alone, without sufficient liquidity to finance the transactions, 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,22 and this was particularly important in the most recent M&A boom.
The First Wave (1897–1904): Horizontal Consolidation
M&A activity was spurred by a drive for efficiency, lax enforcement of the Sherman Anti-Trust Act, westward migration, and technological change. Mergers during this period were largely horizontal and resulted in increased concentration in primary metals, transportation, and mining. In 1901, J.P. Morgan created America's first billion-dollar corporation, U.S. Steel, which was formed by the combination of 785 separate companies, the largest of which was Carnegie Steel. Other giants formed during this era included Standard Oil, Eastman Kodak, American Tobacco, and General Electric. 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; for example, Samuel Insull built an empire of utilities with operations in 39 states. The stock market crash of 1929, along with passage of the Clayton Act that further defined monopolistic practices, brought this era to a close.
The Third Wave (1965–1969): The Conglomerate Era
A rising stock market and the longest period of uninterrupted growth in U.S. history up to that time resulted in record price-to-earnings (P/E) ratios. Companies given high P/E ratios by investors learned how to grow earnings per share (EPS) through acquisition rather than through reinvestment. Companies with high P/E ratios would often acquire firms with lower P/E ratios and increase the EPS of the combined companies, which in turn boosted the share price of the combined companies—as long as the P/E applied to the stock price of the combined companies did not fall below the P/E of the acquiring company before the transaction. 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 companies declined as conglomerates bid their P/Es up. 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, a decade that saw the rise of the corporate raider, were characterized by the breakup of many major conglomerates and a proliferation of the hostile takeover and the leveraged buyout (LBO) as raider's primary acquisition strategies. A leveraged buyout or highly leveraged transaction involves the purchase of a company financed primarily by debt. While LBOs commonly involve privately owned firms, the term often is applied to a firm that buys back its stock using primarily borrowed funds to convert from a publicly owned to a privately owned company (see Chapter 13).
LBOs and takeovers of U.S. companies by foreign acquirers became more common. Conglomerates began to divest unrelated acquisitions made in the 1960s and early 1970s; in fact, of the acquisitions made outside of the acquirer's main line of business between 1970 and 1982, some 60% had been sold by 1989.23
For the first time, takeovers of U.S. companies by foreign firms exceeded in number and dollars the acquisitions by U.S. firms of companies in Europe, Canada, and the Pacific Rim (excluding Japan). Foreign purchasers were motivated by the size of the market, limited restrictions on takeovers, the sophistication of U.S. technology, and the weakness of the dollar against major foreign currencies. Foreign companies also tended to pay substantial premiums for U.S. companies, since the strength of their currencies lowered the effective cost of acquisitions. Moreover, favorable accounting practices allowed foreign buyers to write off goodwill in the year in which it occurred, unlike U.S. firms that at that time had to charge goodwill expense against earnings for many years.24
Toward the end of the 1980s, the level of merger activity tapered off in line with a slowing economy and widely publicized LBO bankruptcies. Moreover, the junk bond market dried up as a major source of financing with the demise of Drexel Burnham, the leading underwriter and “market-maker” for high-yield securities.
The Fifth Wave (1992–2000): The Age of the Strategic Mega-Merger
While M&A activity did diminish during the 1990 recession, the number of transactions and the dollar volume rebounded sharply beginning in 1992. The longest economic expansion and stock market boom in U.S. history, uninterrupted by recession, 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 the number of transactions continued to set records through the end of the 1990s before contracting sharply when the Internet bubble burst, a recession hit the United States in 2001, and global growth weakened.
The Sixth Wave (2003–2007): The Rebirth of Leverage
U.S. financial markets, especially from 2005 through 2007, were characterized by an explosion of highly leveraged buyouts and private equity investments (i.e., takeovers financed by limited partnerships) and the proliferation of complex securities collateralized by pools of debt and loan obligations of varying levels of risk. Much of the financing of these transactions, 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).
The syndication process disperses such debt among many different investors. The issuers of the debt discharge much of the responsibility for the loans to others. Under such circumstances, lenders have an incentive to increase the volume of lending to generate fee income by reducing their underwriting standards to accept riskier loans.25 Once sold to others, loan originators are likely to reduce monitoring of such loans.26 These practices, coupled with exceedingly low interest rates 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.
Declining home prices and a few highly publicized defaults in 2007 triggered concerns among lenders that the market value of their assets was actually well below the value listed on their balance sheets. Subsequent write-downs in the value of these assets reduced bank capital. Regulators require banks to maintain certain capital-to-asset ratios. To restore these ratios to a level comfortably above regulatory requirements, lenders restricted new lending. Bank lending continued to lag, despite efforts by the Federal Reserve to increase sharply the amount of liquidity in the banking system. Thus, the repackaging and sale of debt in many different forms contributed to instability in the financial markets in 2008. Limited credit availability 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 their normal operations. Compounded by rapidly escalating oil prices in 2007 and during the first half of 2008, these conditions contributed to the global economic slowdown in 2008 and 2009 and the concomitant slump in M&A transactions, particularly those that were highly leveraged.
Table 1.5 provides the historical data underlying the trends in both global and U.S. merger and acquisition activity in recent years. M&A activity worldwide reached a historical peak in 2000 in terms of both the number and the dollar value of transactions, following surging economic growth and the Internet bubble of the late 1990s. During 2000, the dollar value of transactions in the United States accounted for nearly one-half of the global total. The ensuing 2001 recession, escalating concerns about terrorism, and the subsequent decline in the world's stock markets caused both the number and the dollar value of global and U.S. transactions to decline through 2002.
Table 1.5. Trends in Announced Mergers and Acquisitionsa
Source: Compiled from information available from Thompson Reuters, Dealogic, and Bloomberg.
a All valuations include the value of debt assumed by the acquirer.
By then, though, conditions were in place for a resurgence in M&A activity, and by 2007 the dollar value and number of announced global M&A transactions outside of the United States reached new highs. However, global merger activity dropped precipitously in 2008 and again in 2009, reflecting a lack of credit, plunging equity markets, and the worldwide financial crisis.27 The drop-off in 2009 would have been greater had it not been for government-backed acquisitions accounting for 8.5% of the value of global deal volume. Global M&A activity in 2010 showed an improvement from 2009 to about $2.7 trillion, reflecting low interest rates, increasing corporate cash balances, rising equity markets, and continued growth in emerging markets.
Similarities and Differences among Merger Waves
While patterns of takeover activity and their profitability vary significantly across M&A waves, there are common elements. Mergers have tended to occur during periods of sustained high rates of economic growth, low or declining 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 (discussed in more detail later in this chapter). Table 1.6 compares the six historical U.S. merger waves. Merger waves are also present in cross-border or international M&As. Merger waves in Europe seem to follow those in the United States, with a short lag.28
Table 1.6. U.S. Historical Merger Waves
Why It Is Important to Anticipate Merger Waves
Not surprisingly, evidence shows that the stock market rewards firms that see and act on promising opportunities early and punishes those that merely imitate. Those pursuing these opportunities early on pay lower prices for target firms than do the followers. One review of 3,194 public companies that acquired other firms between 1984 and 2004 found that the deals completed during the first 15% of a consolidation wave have share prices that outperform significantly the overall stock market, as well as those deals that follow much later in the cycle, when the purchase price of target firms tends to escalate.29 Consequently, those that are late in pursuing acquisition targets are more likely to overpay.
Alternative forms of corporate restructuring
Corporate restructuring activities are often broken into two specific categories. Operational restructuring may entail 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 actions by a firm to change its total debt and equity structure, such as share repurchases or adding debt either to lower the corporation'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.
When firms combine, the resulting transaction can be known by many names: mergers, consolidations, acquisitions, or takeovers. Whether a deal is called a merger or an acquisition often depends on how management wishes to present the transaction to its own employees, its customers, and the investing public. Regardless of how such transactions are characterized, mergers are viewed mainly as friendly in that both the acquiring and target firms want the transaction to happen, while acquisitions may be friendly or hostile. These considerations are discussed in more detail following.
Mergers and Consolidations
Mergers can be described from a legal perspective and from an economic perspective. This distinction is relevant to discussions concerning deal structuring, regulatory issues, and strategic planning.
A Legal Perspective
Legal structures may take many forms, depending on the nature of a transaction. A merger is a combination of two or more firms, often comparable in size, in which all but one ceases to exist legally; the combined organization continues under the original name of the surviving firm. In a typical merger, shareholders of the target firm—after voting to approve the merger—exchange their shares for those of the acquiring firm. Those not voting in favor (minority shareholders) are required to accept the merger and exchange their shares for acquirer shares or cash. When target shareholders accept cash for their stock, they will no longer have any continuing interest in the combined firms. Such mergers often are referred to as cash-out mergers.
A statutory merger is one in which the acquiring or surviving company automatically assumes 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 target 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. Most states require a majority of the shareholders to approve a merger; some require two-thirds. Some states also allow shareholders to dissent from such transactions and to have a court appraise the value of their shares and to force the acquirer to pay a price determined by the court.
Although the terms mergers and consolidations often are used interchangeably, 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. In a merger, either the acquirer or the target survives. The combination of Daimler-Benz and Chrysler to form DaimlerChrysler is an example of a consolidation. The new corporate entity created as a result of consolidation, or the surviving entity following a merger, usually assumes ownership of the assets and liabilities of the consolidated or merged organizations.
An Economic Perspective
Business combinations may also be defined depending on whether the merging firms are in the same or different industries and on their positions in the corporate value chain.30 These definitions are particularly important for antitrust analysis.
A horizontal merger occurs between two firms within the same industry. Procter & Gamble and Gillette (2006) in household products, Oracle and PeopleSoft in business application software (2004), oil giants Exxon and Mobil (1999), SBC Communications and Ameritech (1998) in telecommunications, and NationsBank and BankAmerica (1998) in commercial banking are all examples. Conglomerate mergers are those in which the acquiring company purchases firms in largely unrelated industries, such as the mid-1980s acquisition by U.S. Steel of Marathon Oil to form USX.
Vertical mergers involve firms that participate at different stages of the production or value chain (Figure 1.1). 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.
Figure 1.1 The corporate value chain.Note: IT refers to information technology.
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 acquiring a distributor. When paper manufacturer Boise Cascade acquired Office Max, an office products distributor, in 2003, the $1.1 billion transaction represented forward integration. America Online's purchase of media and content provider Time Warner in 2000 is an example of backward integration.31 More recently, PepsiCo backward integrated through a $7.8 billion purchase of its two largest bottlers in 2010 in order to realize $400 million in annual cost efficiencies.
Acquisitions, Divestitures, Spin-Offs, Carve-Outs, and Buyouts
Generally speaking, an acquisition occurs when one company takes a controlling ownership interest in another firm, a legal subsidiary of another firm, or selected assets of another firm, such as a manufacturing facility. An acquisition 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. An equity carve-out is a transaction in which the parent firm 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.
Friendly versus hostile takeovers
The term takeover is widely used when one firm assumes control of another. In a friendly takeover of control, the target's board and management are receptive to the idea and 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,32 and reflects 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. The size of the premium can fluctuate widely from one year to the next. During the 30-year period ending in 2010, U.S. purchase price premiums averaged 43%, reaching a high of 63% in 2003 and a low of 31% in 2007.33
Analysts often attempt to identify the amount of premium paid for a controlling interest (i.e., control premium) and the amount of incremental value created that the acquirer is willing to share with the target's shareholders. An example of a pure control premium is a conglomerate willing to pay a price significantly above the prevailing market price for a target firm to gain a controlling interest, even though potential operating synergies are limited. In this instance, the acquirer often believes it will recover the value of the control premium by making better management decisions for the target firm. It is important to emphasize that what is often called a control premium in the popular press is actually a purchase or acquisition premium that includes both a premium for synergy and a premium for control.
A formal proposal to buy shares in another firm, usually for cash or securities, or both, is called a tender offer. While tender offers are used in a number of circumstances, they most often result from friendly negotiations (i.e., negotiated tender offers) between the boards of the acquirer and the target firm. 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.
An unfriendly takeover, or hostile takeover, occurs when the initial approach was unsolicited, the target was not seeking a merger, the approach was contested by the target's management, and control changed hands (i.e., usually requiring the purchase of more than half of the target's voting common stock). 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 transactions. A hostile takeover attempt may attract new bidders who might not otherwise have been interested in the target—called putting the target in play. In the ensuing auction, the final purchase price may be bid up to a point well above the initial offer price. Acquirers prefer friendly takeovers because the postmerger integration process is usually more expeditious when both parties are cooperating fully. For these reasons, most transactions tend to be friendly.
The role of holding companies in mergers and acquisitions
A holding company is a legal entity having a controlling interest in one or more companies. The primary function of a holding company is to own stock in other corporations. In general, the parent firm has no wholly owned operating units. The segments owned by the holding company are separate legal entities, which in practice are controlled by the holding company. The key advantage of the holding company structure is the leverage achieved by gaining effective control of other companies' assets at a lower overall cost than if the firm were to acquire 100% of the target's outstanding 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. One firm is said to have effective control when control has been achieved by buying voting stock; it is not likely to be temporary, there are no legal restrictions on control (such as from a bankruptcy court), and there are no powerful minority shareholders.
The holding company structure can create significant management challenges. 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. Consequently, implementing holding company strategies may become very contentious. Furthermore, in highly diversified holding companies, managers also may have difficulty making optimal investment decisions because of their limited understanding of the different competitive dynamics of each business. The holding company structure also can create significant tax problems for its shareholders. Subsidiaries of holding companies pay taxes on their operating profits. The holding company then pays taxes on dividends it receives from its subsidiaries. Finally, holding company shareholders pay taxes on dividends they receive from the holding company. This is equivalent to triple taxation of the subsidiary's operating earnings.
The role of employee stock ownership plans in M&As
An employee stock ownership plan (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 contribution employee benefit pension plans that invest at least 50% of the plan's assets in the common shares of the firm sponsoring them. The plans may receive the employer's stock or cash, which is used to buy the sponsoring employer's stock. The sponsoring corporation can make tax-deductible contributions of cash, stock, or other assets to the trust. The plan's trustee holds title to the assets for the benefit of the employees. The trustee is charged with investing the trust assets productively, 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. Cash contributions made by the sponsoring firm to pay both interest and principal payments on bank loans to ESOPs are tax deductible by the firm. Dividends paid on stock contributed to ESOPs also are deductible if they are used to repay ESOP debt. The sponsoring firm could use tax credits equal to 0.5% of payroll if contributions in that amount were made to the ESOP. Finally, lenders must pay taxes on only one-half of the interest received on loans made to ESOPs owning more than 50% of the sponsoring firm's stock.
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 is one that is incorporated but has no significant assets. 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 also may be used by employees in leveraged or management buyouts 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. The mechanism is similar to owner-initiated sales to employees.
ESOPs also provide an effective antitakeover defense. A firm concerned about the potential for a hostile takeover creates an ESOP. The ESOP borrows with the aid of the sponsoring firm's guarantee and uses the loan proceeds to buy stock issued by the sponsoring firm. While the loan is outstanding, the ESOP's trustees retain voting rights on the stock. Once the loan is repaid, it is generally assumed that employees will tend to vote against bidders who they believe are jeopardizing their jobs.
Business Alliances as Alternatives to Mergers and Acquisitions
In addition to mergers and acquisitions, businesses also 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 mergers and acquisitions. See Chapter 14 for more details.
Joint ventures are cooperative business relationships formed by two or more separate parties to achieve common strategic objectives. While the JV is often an independent legal entity such as a corporation or partnership, it may take any organizational form deemed appropriate 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 falls short of creating a separate legal entity and may be an agreement to sell each firm's products to the other's customers or to codevelop a technology, product, or process. The terms of such an agreement may be legally binding or largely informal. Minority investments require little commitment of management time and may be highly liquid if the investment is in a publicly traded company. A company may choose to assist small or start-up companies in the development of products or technologies it finds useful, often receiving representation on the board in exchange for the investment. Such investments may also be opportunistic in that passive investors take a long-term position in a firm believed to have significant appreciation potential. For example, Warren Buffett's Berkshire Hathaway firm invested $5 billion in Goldman Sachs in 2008 by acquiring convertible preferred stock that pays a 10% dividend.
Licenses, which require no initial capital, provide a convenient way for companies to extend their brands to new products and new markets. They simply license their brand names to others. A company may also gain access to a proprietary technology through the licensing process. A franchise is a specialized form of 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. The success of franchising, though, has been largely limited to industries such as fast-food services and retailing, in which a successful business model can be easily replicated.
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 Mergers and Acquisitions Process
The first category of key players includes the firms and individuals that provide specialized services during mergers and acquisitions. These include investment banks, lawyers, accountants, proxy solicitors, and public relations personnel.
Investment Banks
Amid the turmoil of the 2008 credit crisis, the traditional model of the mega-independent investment bank as a highly leveraged, largely unregulated, innovative securities underwriter and M&A advisor floundered. Lehman Brothers was liquidated, and Bear Stearns and Merrill Lynch were acquired by commercial banks JPMorgan Chase and Bank of America, respectively. In an effort to attract retail deposits and to borrow from the U.S. Federal Reserve System (the “Fed”), Goldman Sachs and Morgan Stanley converted to commercial bank holding companies.
Despite these developments, traditional investment banking activities will continue to be in demand. These include providing strategic and tactical advice and acquisition opportunities; screening potential buyers and sellers; making initial contact with a seller or buyer; and providing negotiation support, valuation, and deal-structuring guidance. Along with these traditional investment banking functions, the large “universal banks” (e.g., Bank of America/Merrill Lynch) will maintain substantial broker-dealer operations, serving wholesale and retail clients in brokerage and advisory capacities to assist with the complexity and often huge financing requirements of mega-transactions.
With fees averaging more than $300,000, 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 leveraged buyout. Such letters discuss the price and terms of the deal in the context of comparable transactions and are obtained by about 80% of target firms and more than one-third of acquirers. A typical fairness opinion provides a range of “fair” prices, with the presumption that the actual deal price should fall within that range. Although such opinions are intended to inform investors, they often are developed as legal protection for members of the boards of directors against possible shareholder challenges of their decisions.34 Researchers have found that fairness opinion letters reduce significantly the risk of lawsuits associated with M&A transactions and reduce the size of the premium paid for targets if they result in acquirers performing more rigorous due diligence and deal negotiation.35
The largest investment banks are unlikely to consider any transaction valued at less than $100 million. In selecting an investment bank as a transaction advisor, the average magnitude of the abnormal returns on the announcement dates for those deals for which they serve as advisor is far more important than the investment bank's size or market share.36 In other words, results count. Smaller, more focused boutique advisors may be able to generate substantially higher returns for their clients than the mega-investment banks because of proprietary industry knowledge and relationships.
The large investment banks are more likely to be able to assist in funding large transactions because of their current relationships with institutional lenders and broker distribution networks. After registering with the Securities and Exchange Commission (SEC), such securities may be offered to the investing public as an initial public offering (IPO), at a price agreed on by the issuer and the investment banking group. Security issues may avoid the public markets and be privately placed with institutional investors, such as pension funds and insurance companies.37
Investment banks charge an advisory fee that generally varies with the size of the transaction. Often contingent on completion of the deal, the fee may run about 1 to 2% of the value of the transaction; in some cases, the fee may exceed this amount if the advisors achieve certain goals. Fairness opinion fees often amount to about one-fourth of the total advisory fee paid on a transaction,38 and typically they are paid regardless of whether the deal is consummated.
Lawyers
Lawyers play a pervasive role in most M&A transactions.39 They are intimately involved in structuring the deal, evaluating risk, negotiating many of the tax and financial terms and conditions (based on input received from accountants; see following), arranging financing, and coordinating the timing and sequence of events to complete the transaction. Specific tasks include drafting the agreement of purchase and sale and other transaction-related documentation, providing opinion of counsel letters to the lender, and defining due diligence activities.
For complicated transactions, legal teams can consist of more than a dozen attorneys, each bringing specialized expertise in a given aspect of the law such as M&As, corporate, tax, employee benefits, real estate, antitrust, securities, environmental, and intellectual property. In a hostile transaction, the team may grow to include litigation experts. In relatively small private transactions, lawyers play an active role in preacquisition planning, including estate planning for individuals or for family-owned firms, tax planning, and working with management and other company advisors to help better position a client for a sale.
Accountants
Accountants40 provide advice on financial structuring, perform financial due diligence, and help create the most appropriate tax structure of a deal. A transaction can be structured in many ways, each structure having different tax implications for the parties involved. Because there is often a conflict in the tax advantages associated with the sales agreement from the buyer's and seller's perspectives, the accountant must understand both points of view and find a mechanism whereby both parties benefit. Income tax, capital gains, sales tax, and sometimes gift and estate taxes are all at play in negotiating a merger or acquisition.
In addition to tax considerations, accountants prepare financial statements and perform audits. Many agreements require that the books and records of the acquired entity be prepared in accordance with Generally Accepted Accounting Principles (GAAP), so the accountant must be intimately familiar with those principles to ensure that they have been applied appropriately. In performing due diligence, accountants also perform the role of auditors by reviewing the target's financial statements and operations through onsite visits and interviews with managers.
The roles of the lawyer and accountant may blur, depending on the size and complexity of the transaction. Sophisticated law firms with experience in mergers and acquisitions usually have the capacity to assist with the tax analysis. Furthermore, lawyers are often required to review financial statements for compliance with prevailing securities' laws.
Proxy Solicitors
Proxy contests (discussed in detail in Chapter 3) are attempts to change the management control or policies of a company by gaining the right to cast votes on behalf of other shareholders. In contests for the control of the board of directors of a target company, it can be difficult to compile mailing lists of stockholders' addresses. The acquiring firm or dissident shareholders hire a proxy solicitor41 to obtain these addresses. The target's management may also hire proxy solicitors to design strategies for educating shareholders and communicating why they should follow the board's recommendations.
Public Relations Firms
It is vital to communicate a consistent position during a takeover attempt. Inconsistent messages reduce the credibility of the parties involved. From the viewpoint of the acquiring company in a hostile takeover attempt, the message to the shareholders must be that the plans for the company will increase shareholder value more than the plans of incumbent management. Often, the target company's management will hire a private investigator42 to develop detailed financial data on the company and do background checks on key personnel, later using that information in the public relations campaign in an effort to discredit publicly the management of the acquiring firm.
Alternative investors and lenders
Institutional investors and lenders are organizations that pool large sums of money to invest in or lend to companies, and they are an important financing source for mergers and acquisitions.
Commercial Banks
Traditionally, the model of a commercial bank is one that accepts checking, savings, and money market accounts and lends these funds to borrowers. This model has evolved into one in which banks sell many of the loans they originate to other players in the financial system for whom buying, selling, and collecting on loans is their primary business. Commercial banks also derive an increasing share of their profits from fees charged for various types of services offered to depositors and fees charged for underwriting and other investment banking services. However, the so-called Dodd-Frank legislation passed in 2010 and discussed in detail in Chapter 2 created new restrictions on these activities.
Insurance Companies
An insurance company offers to mitigate risk for its customers in exchange for an insurance premium. The main source of profit for insurance companies is the sale of insurance products, but they also make money by investing premium income that is not being paid out to customers to cover losses.
Pension Funds
Employers establish pension funds to generate income over the long term to provide pensions for employees when they retire. Typically, pension funds are managed by a financial advisory service for the company and its employees, although some larger corporations operate their pension funds in-house. Pension funds control large amounts of capital and are the largest institutional investors in many countries.
Mutual Funds
Mutual funds are pools of money professionally managed for the benefit of investors. They may focus on stocks, bonds, cash, or a combination of these asset classes. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Mutual funds can influence corporate policies by exercising the voting rights associated with their stockholdings.
Hedge and Private Equity Funds
Private equity funds and hedge funds usually are limited partnerships (for U.S. investors) or offshore investment corporations (for non-U.S. or tax-exempt investors) in which the general partner has made a substantial personal investment.43 This structure allows the general partner to achieve extensive control over the funds he or she manages. Other characteristics of partnerships that make them attractive include favorable tax benefits, a finite life, and investor liability limited to the amount of their investment. Institutional investors such as pension funds, endowments, insurance companies, and private banks, as well as high net worth individuals, typically invest in these types of funds. Once a partnership has reached its target size, the partnership closes to further investment, whether from new or from existing investors.
Hedge funds and private equity funds are distinguished by their investment strategies, lockup periods (i.e., the length of time investors are required to commit funds), and the liquidity of their portfolios. Hedge fund investment strategies include trading a variety of financial instruments—debt, equity, options, futures, and foreign currencies—as well as higher-risk strategies such as corporate restructurings (e.g., LBOs) and credit derivatives (e.g., credit default swaps, which involve insuring the borrower against potential issuer default). Hedge fund investors typically find it easier to withdraw their money than those who invest in private equity funds because they are subject to much shorter lockup periods. Because hedge funds need to maintain liquidity to satisfy investor withdrawals, they focus on investments that can be converted to cash relatively easily, such as comparatively small investments in companies. Another way hedge funds maintain sufficient liquidity to satisfy investor withdrawals is to sell their investments after six to 18 months, with lockup periods for partners ranging from one to three years.
In contrast, private equity fund managers often make highly illiquid investments in nonpublicly listed securities of private companies. Investments often are made during the first two or three years of the fund and are maintained for five to seven years—during which time there are few new investments. Such funds invest in IPOs, LBOs, and corporate restructurings, and they attempt to control risk by becoming more actively involved in managing the firm in which they have invested. Private equity fund partnerships usually last about ten years, after which cash or shares in companies in the portfolio are distributed.
In the past, one could generalize by saying that hedge funds are traders, while private equity funds are more likely to be long-term investors. This distinction has blurred in recent years as hedge funds have taken more active roles in acquiring entire companies.44 The blurring of the differences between hedge and private equity funds reflects increased competition occurring due to the growth in the number of funds and the huge infusion of capital that occurred between 2005 and mid-2007, making it more difficult for fund managers to generate superior returns.
Like mutual funds, hedge and private equity funds receive a management fee from participating investors, averaging about 2% of the assets under management. Hedge fund managers also receive “carried interest” of 20% of any profits realized from the sale of portfolio companies before any monies are distributed to investors. Furthermore, hedge funds and private equity investors typically receive fees from their portfolio companies for completing transactions, arranging financing, performing due diligence, and monitoring business performance while the company is in the fund's portfolio.45
With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, hedge funds and private equity advisors are required to register with the SEC as investment advisers and provide information about their trades and portfolios needed to assess potential risk to the financial system (so-called systemic risk). The data will be shared with the systemic risk regulator as mandated by the Act.
Sovereign Wealth Funds
Sovereign wealth funds are government-backed or -sponsored investment funds whose primary function is to invest accumulated reserves of foreign currencies and earn a profit. Countries that had accumulated huge quantities of U.S. dollars would, through such funds, reinvest the money in U.S. Treasury securities. Recently, these funds have begun to grow and are increasingly taking equity positions in foreign firms, making high-profile investments in public companies. However, the disarray in the global capital markets in 2008 and 2009, and the resulting slide in the value of their investments, has caused many such funds to retrench by investing more in government securities than in individual firms.
Venture Capital Firms
Venture capitalists (VCs) are a significant source of funds for financing both start-ups and acquisitions, and they are sometimes willing to lend when the more traditional sources, such as banks, insurance companies, and pension funds, are unwilling because of perceived risk. Representing private equity capital, typically from institutional investors and individuals with high net worth, VC firms identify and screen opportunities, transact and close deals, monitor performance, and provide advice, adding value by providing managerial and technical expertise in addition to their capital contributions. VC firms typically provide capital to early-stage, high-potential growth companies with the expectation of generating a return through an eventual IPO or sale to a strategic investor. Investments generally are made in cash in exchange for shares in a company, and VCs usually demand a large equity position in the firm in exchange for paying a relatively low per-share price.46
Angel Investors
Angel investors are wealthy individuals who often band together in “investment clubs” or loose networks. Their objective is to generate deal flow, pool money, and share expertise. Some angel groups imitate professional investment funds, some affiliate with universities, while others engage in for-profit philanthropy.
Activist Investors and M&A Arbitrageurs
Institutional activism has become an important factor in mergers and acquisitions. Institutions often play the role of activist investors to affect the policies of companies in which they invest and especially to discipline corporate management. M&A arbitrageurs sometimes support activist investors in their efforts to change a firm's board, management, or policies.
Mutual Funds and Pension Funds
Institutional ownership of public firms increased substantially over the past few decades.47 While regulations restrict the ability of institutions to discipline corporate management, institutional investors with huge portfolios can be very effective in demanding governance changes.48 In the 1980s, pension funds, mutual funds, and insurance firms were often passive investors; however, they became more forceful in the 1990s, and there is further evidence that institutions are taking increasingly aggressive stands against management. These organizations are challenging management on hot-button issues such as antitakeover defenses, lavish severance benefits for CEOs, and employee stock option accounting. Voting against management, though, can be problematic, since some mutual funds manage retirement plans and, increasingly, provide a host of outsourcing services—from payroll to health benefits—for their business clients. Mutual funds may own stock, on behalf of individual or institutional clients, in these same firms.49
Pressure from institutional activists may account for the general decline in the number of executives serving as both board chairman and CEO of companies.50 Sometimes, CEOs choose to negotiate with activists rather than face a showdown at an annual shareholders meeting. Activists are also finding that they may avoid the expense of a full-blown proxy fight simply by threatening to vote in certain ways on supporting a chief executive officer or a management proposal. This may mean a “no” vote, although in some instances the only options are to vote in the affirmative or abstain. Abstaining is a way to indicate dissatisfaction with a CEO or a firm's policy without jeopardizing future underwriting or the M&A business for the institution.51 It should be noted, though, that institutional investor activism by mutual funds and pension funds has often failed to achieve significant benefits for shareholders.52
Hedge Funds and Private Equity Firms
In recent years, hedge funds and private equity investors have increasingly played the role of activist investors—and with much greater success than other institutional investors. Activist hedge funds are successful (or partially so) about two-thirds of the time in their efforts to change a firm's strategic, operational, or financial strategies. They seldom seek control (with ownership stakes averaging about 9%) and are most often nonconfrontational. Research shows that there is an approximate 7% abnormal financial return to shareholders around the announcement that the hedge fund is initiating some form of action.53
The relative success of hedge funds as activists can be attributed to the fact that their managers, who manage large pools of relatively unregulated capital, are highly motivated by the prospect of financial gain. Because hedge funds are not subject to the same regulations governing mutual funds and pension funds, they can hold highly concentrated positions in small numbers of firms. Moreover, hedge funds are not limited by the same conflicts of interest that afflict mutual funds and pension funds, because they have few financial ties to the management of the firms whose shares they own and, unlike mutual funds, do not have other business such as clients services at risk.
Hedge funds as activist investors tend to have the greatest impact on financial returns to shareholders when they prod management to put a company up for sale. However, their impact rapidly dissipates if the sale of the company is unsuccessful.54 Firms once targeted by activists are more likely to be acquired.
M&A Arbitrageurs
When a bid is made for a target company, the target company's stock price often trades at a small discount to the actual bid—reflecting the risk that the offer may not be accepted. Merger arbitrage refers to an investment strategy that attempts to profit from this spread. Arbitrageurs (arbs) buy the stock and make a profit on the difference between the bid price and the current stock price if the deal is consummated. Hedge fund managers often play the role of arbs.
Arbs may accumulate a substantial percentage of the stock held outside of institutions so they can be in a position to influence the outcome of the takeover attempt. For example, if other offers for the target firm appear, arbs promote their positions directly to managers and institutional investors with phone calls and through leaks to the financial press. Their intent is to sell their shares to the highest bidder. Acquirers involved in a hostile takeover attempt often encourage hedge funds to buy as much target stock as possible, with the objective of gaining control of the target later by buying the stock from the hedge funds.
Studies show that the price of a target company's stock often starts to rise in advance of the announcement of a takeover attempt, the result of arb activity (and, possibly, insider trading).55 If one firm in an industry is acquired, it is commonplace for the share prices of other firms in the same industry to increase because those firms are viewed as potential takeover targets.
Arbs also provide market liquidity—the ease with which a security can be bought or sold without affecting its current market price—during transactions. In a cash-financed merger, the merger arbitrageur seeking to buy the target firm's shares provides liquidity to the target's shareholders who want to sell on the announcement day or shortly thereafter. Arbitrageurs may actually reduce liquidity for the acquirer's stock in a stock-for-stock merger because they immediately “short” the acquirer shares (i.e., sell borrowed shares—paying interest to the share owner based on the value of the shares when borrowed—hoping to buy them back at a lower price). The downward pressure that widespread arb short-selling puts on the acquirer's share price at the time the transaction is announced makes it difficult for others to sell without incurring a loss from the premerger announcement price. Merger arbitrage short-selling may account for about one-half of the downward pressure on acquirer share prices around the announcement of a stock-financed merger.56 Merger arbitrage also has the potential to be highly profitable.57
Do M&As pay off for shareholders, bondholders, and society?
The answer to whether mergers and acquisitions pay off seems to depend on who is paid and over what period. On average, total shareholder gains around the announcement date of an acquisition or merger are significantly positive; however, most of the gain accrues to target firm shareholders. Moreover, in the three to five years after a takeover, many acquirer firms either underperform compared with their industry peers or destroy shareholder value. It is less clear whether this subpar performance and value destruction are due to the acquisition or to other factors.
Researchers use a wide variety of approaches to measure the impact of takeovers on shareholder value.58 What follows is a discussion of the results of the two most common types of analysis of pre- and postmerger returns: The “event study” that examines abnormal stock returns to the shareholders of both bidders and targets around the announcement of an offer (the “event”) and includes both successful (i.e., completed transactions) and unsuccessful takeovers; and the use of accounting measures to gauge the postmerger impact on shareholder value.
Premerger Returns to Shareholders
Positive abnormal returns represent gains for shareholders, which can be explained by such factors as improved efficiency, pricing power, or tax benefits. They are abnormal in the sense that they exceed what an investor normally expects to earn for accepting a certain level of risk. For example, if an investor can reasonably expect to earn a 10% return on a stock but actually earns 25% due to a takeover, the abnormal or excess return to the shareholder is 15%. Abnormal returns are calculated by subtracting the actual return from a benchmark indicating investors' required returns, which often are approximated by the capital asset pricing model or the return on the S&P 500 stock index. Abnormal returns are forward looking in that share prices usually represent the present value of expected future cash flows. Therefore, the large announcement returns may reflect anticipated future synergies resulting from the combination of the target and acquiring firms. Table 1.7 provides some empirical evidence of abnormal returns to bidders and targets around announcement dates.
Table 1.7. Empirical Evidence on Abnormal Returns to Bidders and Targets around Announcement Datesa
| Total Gains from Takeoversb | Target Shareholders | Bidder Shareholders |
1 Takeovers increase on average the combined market value of the merged firms, with target shareholders earning large positive returns and bidding firm shareholders on average showing little or no abnormal return. 2 Largest gains are realized at the beginning of a takeover wave. 3 Takeovers with the largest losses come during the second half of a takeover wave |
1 For the two-week period around the announcement date, returns range from 14% to 44%. 2 Average returns vary by time period: 3 Average returns vary by type of bid: 4 Returns are higher for all-cash bids than for all-equity offers. 5 Target share prices often react as much as six weeks prior to an announcement, reflecting speculation or insider trading |
1 For the two-week period around the announcement date, average returns are close to zero when the target is a public firm; some studies show small positive gains and others small losses. 2 Returns can be 1.5% to .6% when the target is a private firm (or a subsidiary of a public firm) due to improved performance from increased monitoring by the acquiring firm, the frequent absence of multiple bidders, and the liquidity discount resulting from difficulty in valuing such firms. 3 In the U.S., all-equity financed takeovers of public firms frequently exhibit negative abnormal returns and underperform all-cash bids. 4 In Europe, all-equity financed M&As are frequently associated with positive returns (often exceeding all-cash bids), reflecting the greater concentration of ownership and the tendency of holders of large blocks of stock to more closely monitor management. |
Source: Adapted from Martynova and Renneboog (2008).
a Results are based on 65 studies of successful nonfinancial (friendly and hostile) M&As in the U.S., U.K., and Continental Europe. Studies include horizontal, vertical, and conglomerate mergers, as well as tender offers. The studies also include related and unrelated takeovers: all-stock, all-cash, and mixed forms of payment involving both public and private firms.
b Includes the sum of returns to target and acquirer shareholders.
High Returns for Target Shareholders in Successful and Unsuccessful Bids
While averaging 30% between 1962 and 2001, abnormal returns for tender offers have risen steadily over time,59 reflecting the frequent bidder strategy of offering a substantial premium to preempt other potential bidders and the potential for revising the initial offer because of competing bids. Other contributing factors include the increasing sophistication of takeover defenses, as well as federal and state laws requiring bidders to notify target shareholders of their intentions before completing the transaction. Moreover, the abnormal gains tend to be higher for shareholders of target firms, whose financial performance is expected to deteriorate over the long term.60 This may suggest that the bidding firms see the highest potential for gain among those target firms whose management is viewed as incompetent. Returns from hostile tender offers typically exceed those from friendly mergers, which are characterized by less contentious negotiated settlements between the boards and management of the bidder and the target firm. Moreover, friendly takeovers often do not receive competing bids.
Unsuccessful takeovers may also result in significant announcement date returns for target company shareholders, but much of the gain dissipates if another bidder does not appear. The immediate gain in target share prices disappears within a year if the takeover attempt fails.61 To realize abnormal returns, target firm shareholders must sell their shares shortly after the announcement of a failed takeover attempt.
Returns to Acquirer Shareholders May Not Be So Disappointing
In the aggregate, abnormal returns are modest to slightly negative for successful takeovers, whether through tender offers or mergers. Bidder returns generally have declined slightly over time as the premiums paid for targets have increased. Even if the abnormal returns are zero or slightly negative, these returns are consistent with returns in competitive markets in which financial returns are proportional to the risk assumed by the average competitor in the industry. For unsuccessful takeovers, bidder shareholders have experienced negative returns in the 5 to 8% range,62 perhaps reflecting investors' reassessment of the acquirer's business plan more than concerns about the acquisition.63
Bidders with low leverage show a tendency to pay high purchase premiums.64 Not surprisingly, such bidders are in a position to pay higher prices than are more leveraged bidders. However, this tendency may also result in such bidders overpaying for target firms.
Focusing on aggregate returns to acquirer shareholders can be highly misleading. The results can be distorted by a relatively few large transactions.65 Whether abnormal returns to acquirers are positive or negative varies with the characteristics of the acquirer, the target, and the deal (discussed in more detail following). Furthermore, while event studies treat acquisitions as a single event, gains from a specific acquisition often depend on subsequent acquisitions undertaken to implement a firm's business strategy,66 and because of potential synergies among the acquired firms, the success or failure of these acquisitions should be evaluated in the context of the entire strategy and not as standalone transactions. Finally, there is evidence that the initial stock market reaction to the announcement of an acquisition often is biased or incomplete.67
Postmerger Returns to Shareholders
The objective of examining postmerger accounting or other performance measures such as cash flow and operating profit, usually during the three- to five-year period following closing, is to assess how performance changed. The evidence, however, is conflicting about the long-term impact of M&A activity. Where some studies find a better than average chance that M&As create shareholder value, others find that as many as 50 to 80% have underperformed their industry peers or failed to earn their cost of capital.68 What may seem like a hubris-driven inability of CEOs and boards to learn from the past (since the number and size of transactions continue to increase over time) looks more like the result of methodological issues and the failure to distinguish among alternative situations in which M&As occur, leading to an understatement of potential returns to acquirers.69
Acquirer Returns Vary by Characteristics of Acquirer, Target, and Deal
There is strong evidence that abnormal returns to acquirer shareholders are largely situational, varying according to the size of the acquirer, the type and size of the target (i.e., publicly traded or private), and the form of payment (i.e., cash or stock) (Table 1.8).
Table 1.8. Acquirer Returns Differ by Characteristics of the Acquirer, Target, and Deal
| Characteristic | Empirical Support |
| TYPE OF TARGET | |
| Acquirer returns are often positive when the targets are privately owned (or are subsidiaries of public companies) and slightly negative when the targets are publicly traded (i.e., so-called “listing effect”) regardless of the country. | Faccio et al. (2006)
Draper and Paudyal (2006) Moeller et al. (2005) Fuller et al. (2002) |
| Form of Payment | |
• Acquirer returns on equity-financed acquisitions of public firms often less than cash-financed deals in the United States. • Acquirer returns on equity-financed acquisitions of public or private firms frequently more than all-cash-financed deals in European Union countries. • Acquirer returns on equity-financed acquisitions of private firms often exceed significantly cash deals, particularly when the target is difficult to value. |
Schleifer and Vishny (2003)
Megginson et al. (2003)
Heron and Lie (2002)
Linn and Switzer (2001)
Martynova and Renneboog (2008a) Chang (1998) Officer et al. (2009) |
| Acquirer/Target Size | |
| Moeller et al. (2004)
Moeller et al. (2005)
Gorton et al. (2009)
a
Hackbarth et al. (2008) Frick and Torres (2002) Gell et al. (2008) |
a Size is measured not in absolute but in relative terms compared to other firms within an industry.
Smaller Acquirers Tend to Realize Higher Returns
The size of the acquirer and the financial returns realized on mergers and acquisitions are inversely related, with relatively smaller acquirers, on average, realizing larger abnormal returns than larger acquirers. Why does this happen? It seems to be a function of management overconfidence and the empire-building tendencies of large firms. For the 20-year period ending in 2001, researchers found that large firms destroyed shareholder wealth, while small firms created wealth.70
Returns Are Often Positive for Private or Subsidiary Targets
U.S. acquirers of private firms or subsidiaries of publicly traded firms often realize positive excess returns of 1.5 to 2.6%.71 Acquirers are inclined to pay less for nonpublicly traded companies due to the difficulty of buying private firms or subsidiaries of public companies. In both cases, shares are not publicly traded, and access to information is limited. Moreover, there may be fewer bidders for nonpublicly traded companies. Consequently, these targets may be acquired at a discount from their actual economic value (i.e., cash-generation potential). As a consequence of this discount, bidder shareholders are able to realize a larger share of the anticipated synergies resulting from combining the acquirer and target firms.
Relatively Small Deals May Generate Higher Returns
Average target size appears to play an important role in determining financial returns to acquirer shareholders.72 High-tech firms often acquire small, but related, target firms to fill gaps in their product offerings. Consequently, the contribution of these acquisitions should not be viewed individually but in terms of their impact on the implementation of the acquirer's overall business strategy. Larger deals tend to be more risky for acquirers73 and, as a percentage of the acquiring firms' equity, experience consistently lower postmerger performance, possibly reflecting the challenges of integrating large target firms and realizing projected synergies on a timely basis.
Under certain circumstances, though, larger deals may offer significant positive abnormal rates of returns. For instance, acquirer's returns from buying product lines and subsidiaries of other companies tend to be higher when the size of the asset is large relative to the buyer and small relative to the seller.74 The implication is that parent firms interested in funding new opportunities are more likely to divest relatively small businesses that are not germane to their core business strategy at relatively low prices to raise capital quickly. Buyers are able to acquire sizeable businesses at favorable prices, increasing the likelihood that they will be able to earn their cost of capital.
Cash Deals Often Exceed Equity-Financed Deals
Managers tend to issue stock when they believe it is overvalued. Over time, investors learn to treat such decisions as signals that the stock is overvalued and sell their shares when the new equity issue is announced, causing the firm's share price to decline. There is considerable evidence that bidding firms that use cash to purchase the target firm exhibit better long-term performance than do those using stock, since investors anticipate that stock-financed mergers underperform precisely because investors treat stock financing as a signal that shares are overvalued.75 However, equity financed transactions in the European Union often display higher acquirer returns due to the existence of large block shareholders, whose active monitoring tends to improve the acquired firm's performance. Such shareholders are less common in the United States.
Using stock to acquire a firm often results in announcement period gains to bidder shareholders that dissipate within three to five years, even when the acquisition was successful.76 These findings imply that shareholders, selling around the announcement dates, may realize the largest gains from either tender offers or mergers.
Some argue that equity overvaluation occurs when a firm's management cannot expect to make investments that will sustain the current share price except by chance.77 Management will be enticed to pursue larger, more risky investments (such as unrelated acquisitions) in a vain attempt to support the overvalued share price. These actions destroy shareholder value, since the firm is unable to earn its cost of capital, and the longer-term performance of the combined firms suffers because the stock price declines to its industry average performance.
Abnormal returns to acquirers are negatively related to equity offers but not to cash offers. However, there appears to be no difference in abnormal returns for cash offers for public firms, equity offers for public firms, and equity offers for private firms when such firms exhibit similar business-specific risk (e.g., institutional ownership, growth rates, leverage, etc.).78
While still underperforming cash deals, successful acquirers that use stock as the form of payment significantly outperform unsuccessful attempts by a wide margin.79 It seems that the successful stock-financed acquirers' relatively better performance results from their ability to use their overvalued stock to buy the target firm's assets fairly inexpensively.80
Acquirer Experience May Not Improve Performance
Experience is a necessary but not sufficient condition for successful acquisitions. It contributes to improved financial returns, it appears, only if it is applied to targets in the same or similar industries or in the same or similar geographic or cultural regions.81 Abnormal returns to serial acquirers (i.e., firms that make numerous and frequent acquisitions) have tended to decline from one transaction to the next.82 This is typically attributed to the CEO of the serial acquirer becoming overconfident with each successive acquisition. The CEO then tends to overestimate the value of synergies and the ease with which they can be realized. Now subject to hubris, the CEO tends to overpay for acquisitions.83
Bidder Returns Are Good Predictors of Completed Transactions
There is evidence that the magnitude of abnormal returns to acquirers around the announcement date is a good predictor either of whether the initial offer price will be renegotiated or that the deal will be cancelled.84 The acquirer's management will react to a significant negative decline in their stock immediately following a merger announcement as investors display their displeasure with the deal. Cancellation is much less likely if an agreement of purchase and sale was signed before the announcement, since reneging on a signed agreement can result in expensive litigation.
Bondholder Payoffs
Mergers and acquisitions have relatively little impact on abnormal returns either to the acquirer or to the target bondholders, except in special situations. The limited impact on bondholder wealth is due to the relationship between leverage and operating performance.85 How M&As affect bondholder wealth reflects, in part, the extent to which an increase in leverage that raises the potential for default is offset by the discipline that increasing leverage imposes on management to improve operating performance.86 Other things being equal, increasing leverage will lower current bondholder wealth, while improving operating performance will improve bondholder wealth.
However, bondholders, in certain circumstances, may benefit from M&As. For example, bondholders of target firms whose debt is below investment grade tend to experience positive abnormal returns if the acquirer has a higher credit rating. In addition, when loan covenant agreements for firms that are subject to takeovers include poison puts that allow bondholders to sell their bonds back to the company at a predetermined price, bondholders experience positive abnormal returns when a change of control takes place.87
Payoffs for Society
While mergers and acquisitions have continued to increase in number and average size, since 1970, M&A activity has not increased industry concentration in terms of the share of output or value produced by the largest firms in an industry.88 Further, most empirical studies show that M&A activity results in improved operating efficiencies and lower product prices than would have been the case without the merger. Gains in aggregate shareholder value are attributed more to the improved operating efficiency of the combined firms than to increased market or pricing power.89 In fact, corporate transactions seem to result in an overall improvement in efficiency by transferring assets from those who are not using them effectively to those who can.90
Why some M&As fail to meet expectations
The notion that most M&As fail in some substantive manner is not supported by the evidence. In fact, the failure of an M&A to meet expectations depends to a great extent on how you define failure. The failure rate is low if failure is defined as the eventual sale or liquidation of the business, but it is higher if failure is defined as the inability to meet or exceed financial objectives. Managers are often very satisfied with their acquisitions if they are able achieve strategic objectives, so the failure rate is also low if failure is defined as not achieving strategic, nonfinancial objectives.91
No single factor seems likely to be the cause of M&As failing to meet expectations. There are, however, three explanations that are most commonly used to explain failure: overpaying (often due to overestimating synergies), the slow pace of postmerger integration, and a flawed strategy.92 Overpaying for a target firm increases the hurdles an acquirer must overcome to earn its cost of capital, since there is little or no margin of error in achieving anticipated synergies on a timely basis.93
Consequently, the postmerger share price for such firms should underperform broader industry averages as future growth slows to more normal levels. By substantially overpaying for an acquisition, acquirers are condemned to having to improve profitability dramatically to earn the financial returns required by investors on a higher net asset base (including the fair market value of the target's net assets). Failure to achieve integration in a timely manner often results in customer attrition, loss of key employees, and the failure to realize anticipated synergies (see Chapter 6). Finally, under any circumstances, success will be elusive if the strategy justifying the acquisition is severely flawed.
Long-term performance
There is little compelling evidence that growth strategies undertaken as an alternative to M&As fare any better. Such alternatives include solo ventures, in which firms reinvest excess cash flows, and business alliances, including joint ventures, licensing, franchising, and minority investments. Failure rates among alternative strategies tend to be remarkably similar to those documented for M&As.94
Some things to remember
M&As represent only one of several ways of executing business plans. There are alternatives, from the various forms of business alliances to a solo venture. Which method is chosen depends on management's desire for control, willingness to accept risk, and the range of opportunities present at a particular moment in time.
Although M&As clearly pay off for target company shareholders around announcement dates, shareholder wealth creation in the three to five years following closing is problematic. Abnormal returns to acquirers of private (unlisted) firms or subsidiaries of public firms frequently show larger returns than M&As involving publicly listed firms. U.S. acquirers using cash rather than equity often show larger returns compared to those using equity, although these results are reversed for European acquirers. Also, abnormal returns tend to be larger when acquirers are relatively small and the target is relatively large compared to the acquirer but represents a small portion of the selling firm. Finally, acquirer returns tend to be larger when the transaction occurs early in a merger wave.
The most common reasons for a merger to fail to satisfy expectations are the overestimation of synergies and subsequent overpayment, the slow pace of postmerger integration, and the lack of a coherent business strategy. Empirical studies also suggest that M&As tend to pay off for society due to the improved operating efficiency of the combined firms. The success rate for M&As is very similar to alternative growth strategies that may be undertaken.
Discussion Questions
1.1 Discuss why mergers and acquisitions occur.
1.2 What are the advantages and disadvantages of holding companies in making M&As?
1.3 How might a leveraged ESOP be used as an alternative to a divestiture, to take a company private, or as a defense against an unwanted takeover?
1.4 What is the role of the investment banker in the M&A process?
1.5 Describe how arbitrage typically takes place in a takeover of a publicly traded company.
1.6 Why is potential synergy often overestimated by acquirers in evaluating a target company?
1.7 What are the major differences between the merger waves of the 1980s and 1990s?
1.8 In your judgment, what are the motivations for two M&As currently in the news?
1.9 What are the arguments for and against corporate diversification through acquisition? Which do you support and why?
1.10 What are the primary differences between operating and financial synergy? Give examples to illustrate your statements.
1.11 At a time when natural gas and oil prices were at record levels, oil and natural gas producer Andarko Petroleum announced the acquisition of two competitors, Kerr-McGee Corp. and Western Gas Resources, for $16.4 billion and $4.7 billion in cash, respectively. These purchase prices represented a substantial 40% premium for Kerr-McGee and a 49% premium for Western Gas. The acquired assets strongly complement Andarko's existing operations, providing the scale and focus necessary to cut overlapping expenses and concentrate resources in adjacent properties. What do you believe were the primary forces driving Andarko's acquisition? How will greater scale and focus help Andarko cut costs? Be specific. What are the key assumptions implicit in your answer to the first question?
1.12 Mattel, a major U.S. toy manufacturer, virtually gave away The Learning Company (TLC), a maker of software for toys, to rid itself of a disastrous acquisition that actually had cost the firm hundreds of millions of dollars. Mattel, which had paid $3.5 billion for TLC, sold the unit to an affiliate of Gores Technology Group for rights to a share of future profits. Was this related or unrelated diversification for Mattel? Explain your answer. How might your answer to the first question have influenced the outcome?
1.13 AOL acquired Time Warner in a deal valued at $160 billion. Time Warner is the world's largest media and entertainment company, whose major business segments include cable networks, magazine publishing, book publishing, direct marketing, recorded music and music publishing, and film and TV production and broadcasting. AOL viewed itself as the world leader in providing interactive services, Web brands, Internet technologies, and electronic commerce services. Would you classify this business combination as a vertical, horizontal, or conglomerate transaction? Explain your answer.
1.14 Pfizer, a leading pharmaceutical company, acquired drug maker Pharmacia for $60 billion. The purchase price represented a 34% premium to Pharmacia's preannouncement price. Pfizer was betting that size is what mattered in the new millennium. As the market leader, Pfizer was finding it increasingly difficult to sustain the double-digit earnings growth demanded by investors. Such growth meant the firm needed to grow revenue by $3 billion to $5 billion annually while maintaining or improving profit margins. This became more difficult due to the skyrocketing costs of developing and commercializing new drugs. Expiring patents on a number of so-called blockbuster drugs intensified pressure to bring new drugs to market. In your judgment, what were Pfizer's primary motivations for acquiring Pharmacia? Categorize these in terms of the primary motivations for mergers and acquisitions discussed in this chapter.
1.15 Dow Chemical, a leading chemical manufacturer, acquired Rohm and Haas Company for $15.3 billion. While Dow has competed profitably in the plastics business for years, this business has proven to have thin margins and to be highly cyclical. By acquiring Rohm and Haas, Dow would be able to offer less cyclical and higher-margin products such as paints, coatings, and electronic materials. Would you consider this related or unrelated diversification? Explain your answer. Would you consider this a cost-effective way for the Dow shareholders to achieve better diversification of their investment portfolios?
Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.
Chapter business cases
Case Study 1.1
Xerox Buys ACS to Satisfy Shifting Customer Requirements
In anticipation of a shift from hardware and software spending to technical services by its corporate customers, IBM announced an aggressive move away from its traditional hardware business and into services in the mid-1990s. Having sold its commodity personal computer business to Chinese manufacturer Lenovo in mid-2005, IBM became widely recognized as a largely “hardware neutral” systems integration, technical services, and outsourcing company.
Because information technology (IT) services have tended to be less cyclical than hardware and software sales, the move into services by IBM enabled the firm to tap a steady stream of revenue at a time when customers were keeping computers and peripheral equipment longer to save money. The 2008–2009 recession exacerbated this trend as corporations spent a smaller percentage of their IT budgets on hardware and software.
These developments were not lost on other IT companies. Hewlett-Packard (HP) bought tech services company EDS in 2008 for $13.9 billion. On September 21, 2009, Dell announced its intention to purchase another information technology services company, Perot Systems, for $3.9 billion. One week later, Xerox, traditionally an office equipment manufacturer, announced a cash and stock bid for Affiliated Computer Systems (ACS) totaling $6.4 billion.
Each firm was moving to position itself as a total solution provider for its customers, achieving differentiation from its competitors by offering a broader range of both hardware and business services. While each firm focused on a somewhat different set of markets, all three shared an increasing focus on the government and healthcare segments. However, by retaining a large proprietary hardware business, each firm faced challenges in convincing customers that they could provide objectively enterprise-wide solutions that reflected the best option for their customers.
Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into services achieved limited success due largely to poor management execution. While some progress in shifting away from the firm's dependence on printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate transitioning from a product-driven company to one whose revenues were more dependent on the delivery of business services.
With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing and claims processing for governments and private companies. With about one-fourth of ACS's revenue derived from the healthcare and government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets that should benefit from the 2009 government stimulus spending and 2010 healthcare legislation. More than two-thirds of ACS's revenue comes from the operation of client back office operations such as accounting, human resources, claims management, and other business management outsourcing services, with the rest coming from providing technology consulting services. ACS would also triple Xerox's service revenues to $10 billion.
Xerox hopes to increases its overall revenue by bundling its document management services with ACS's client back office operations. Only 20% of the two firms' customers overlap. This allows for significant cross-selling of each firm's products and services to the other firm's customers. Xerox is also betting that it can apply its globally recognized brand and worldwide sales presence to expand ACS internationally.
A perceived lack of synergies between the two firms, Xerox's rising debt levels, and the firm's struggling printer business fueled concerns about the long-term viability of the merger, sending Xerox's share price tumbling by almost 10% on the news of the transaction. With about $1 billion in cash at closing in early 2010, Xerox needed to borrow about $3 billion. Standard & Poor's downgraded Xerox's credit rating to triple-B-minus, one notch above junk.
Integration is Xerox's major challenge. The two firms' revenue mixes are very different, as are their customer bases, with government customers often requiring substantially greater effort to close sales than Xerox's traditional commercial customers. Xerox intends to operate ACS as a standalone business, which will postpone the integration of its operations consisting of 54,000 employees with ACS's 74,000. If Xerox intends to realize significant incremental revenues by selling ACS services to current Xerox customers, some degree of integration of the sales and marketing organizations would seem to be necessary.
It is hardly a foregone conclusion that customers will buy Affiliated Computer Systems services simply because ACS sales representatives gain access to current Xerox customers. Presumably, additional incentives are needed, such as some packaging of Xerox hardware with ACS's IT services. However, this may require significant price discounting at a time when printer and copier profit margins already are under substantial pressure.
Customers are likely to continue, at least in the near term, to view Xerox, Dell, and HP more as product than as service companies. The sale of services will require significant spending to rebrand these companies so that they will be increasingly viewed as service vendors. The continued dependence of all three firms on the sale of hardware may retard their ability to sell packages of hardware and IT services to customers. With hardware prices under continued pressure, customers may be more inclined to continue to buy hardware and IT services from separate vendors to pit one vendor against another. Moreover, with all three firms targeting the healthcare and government markets, pressure on profit margins could increase for all three firms. The success of IBM's services strategy could suggest that pure information technology service companies are likely to perform better in the long run than those that continue to have a significant presence in both production and sale of hardware as well as IT services.
Discussion Questions
1. Discuss the advantages and disadvantages of Xerox's intention to operate ACS as a standalone business. As an investment banker supporting Xerox, would you have argued in support of integrating ACS immediately, at a later date, or of keeping the two businesses separate indefinitely? Explain your answer.
2. How are Xerox and ACS similar, and how are they different? In what way will their similarities and differences help or hurt the long-term success of the merger?
3. Based on your answers to questions 1 and 2, do you believe that investors reacted correctly or incorrectly to the announcement of the transaction?
Answers to these questions are found in the Online Instructor's Manual available to instructors using this book.
Case Study 1.2
Assessing Procter & Gamble's Acquisition of Gillette
The potential seemed almost limitless, as the Procter & Gamble (P&G) company announced that it had completed its purchase of Gillette Company (Gillette) in late 2005. P&G's chairman and CEO, A.G. Lafley, predicted that the acquisition of Gillette would add one percentage point to the firm's annual revenue growth rate, while Gillette's chairman and CEO, Jim Kilts, opined that the successful integration of the two best companies in consumer products would be studied in business schools for years to come.
Five years after closing, things have not turned out as expected. While cost savings targets were achieved, operating margins faltered due to lagging sales. Gillette's businesses, such as its pricey razors, have been buffeted by the 2008–2009 recession and have been a drag on P&G's top line rather than a boost. Moreover, most of Gillette's top managers have left. P&G's stock price at the end of 2010 stood about 12% above its level on the acquisition announcement date, less than one-fourth the appreciation of the share prices of such competitors as Unilever and Colgate-Palmolive during the same period.
On January 28, 2005, P&G enthusiastically announced that it had reached an agreement to buy Gillette in a share-for-share exchange valued at $55.6 billion. This represented an 18% premium over Gillette's preannouncement share price. P&G also announced a stock buyback of $18 billion to $22 billion, funded largely by issuing new debt. The combined companies would retain the P&G name and have annual 2005 revenue of more than $60 billion. Half of the new firm's product portfolio would consist of personal care, healthcare, and beauty products, with the remainder consisting of razors and blades and batteries. The deal was expected to dilute P&G's 2006 earnings by about 15 cents per share. To gain regulatory approval, the two firms would have to divest overlapping operations, such as deodorants and oral care.
P&G had long been viewed as a premier marketing and product innovator. Consequently, P&G assumed that its R&D and marketing skills in developing and promoting women's personal care products could be used to enhance and promote Gillette's women's razors. Gillette was best known for its ability to sell an inexpensive product (e.g., razors) and hook customers into a lifetime of refills (e.g., razor blades). Although Gillette was the number 1 and number 2 supplier in the lucrative toothbrush and men's deodorant markets, respectively, it has been much less successful in improving the profitability of its Duracell battery brand. Despite its number 1 market share position, Duracell had been beset by intense price competition from Energizer and Rayovac which generally sell for less.
Suppliers such as P&G and Gillette had been under considerable pressure from the continuing consolidation in the retail industry due to the ongoing growth of Wal-Mart and industry mergers at that time, such as Sears and Kmart. About 17% of P&G's $51 billion in 2005 revenues and 13% of Gillette's $9 billion annual revenue came from sales to Wal-Mart. Moreover, the sales of both Gillette and P&G to Wal-Mart had grown much faster than sales to other retailers. The new company, P&G believed, would have more negotiating leverage with retailers for shelf space and in determining selling prices, as well as with its own suppliers, such as advertisers and media companies. The broad geographic presence of P&G was expected to facilitate the marketing of such products as razors and batteries in huge developing markets, such as China and India. Cumulative cost cutting was expected to reach $16 billion, including layoffs of about 4% of the new company's workforce of 140,000. Such cost reductions were to be realized by integrating Gillette's deodorant products into P&G's structure as quickly as possible. Other Gillette product lines, such as the razor and battery businesses, were to remain intact.
P&G's corporate culture was often described as conservative, with a “promote-from-within” philosophy. While Gillette's CEO was to become vice chairman of the new company, the role of other senior Gillette managers was less clear in view of the perception that P&G is laden with highly talented top management. To obtain regulatory approval, Gillette agreed to divest its Rembrandt toothpaste and its Right Guard deodorant businesses, while P&G agreed to divest its Crest toothbrush business.
The Gillette acquisition illustrates the difficulty in evaluating the success or failure of mergers and acquisitions for acquiring company shareholders. Assessing the true impact of the Gillette acquisition remains elusive, even after five years. Though the acquisition represented a substantial expansion of P&G's product offering and geographic presence, the ability to isolate the specific impact of a single event (i.e., an acquisition) becomes clouded by the introduction of other major and often uncontrollable events (e.g., the 2008–2009 recession) and their lingering effects. While revenue and margin improvement have been below expectations, Gillette has bolstered P&G's competitive position in the fast-growing Brazilian and Indian markets, thereby boosting the firm's longer-term growth potential, and has strengthened its operations in Europe and the United States. Thus, in this ever-changing world, it will become increasingly difficult with each passing year to identify the portion of revenue growth and margin improvement attributable to the Gillette acquisition and that due to other factors.
Discussion Questions
1. Is this deal a merger or a consolidation from a legal standpoint? Explain your answer.
2. Is this a horizontal or vertical merger? What is the significance of this distinction from a regulatory perspective? Explain your answer.
3. What are the motives for the deal? Discuss the logic underlying each motive you identify.
4. Immediately following the announcement, P&G's share price dropped by 2% and Gillette's share price rose by 13%. Explain why this may have happened.
5. P&G announced that it would be buying back $18 billion to $22 billion of its stock over the 18 months following the closing of the transaction. Much of the cash required to repurchase these shares required significant new borrowing by the new company. Explain what P&G is trying to achieve in buying back its own stock. Explain how the incremental borrowing may help or hurt P&G in the long run.
Answers to these questions are found in the Online Instructor's Manual available to instructors using this book.
1 Houston, James, and Ryngaert, 2001; DeLong, 2003
2 Berger and Ofek, 1995; Lins and Servaes, 1999
3 Morck, Shleifer, and Vishny, 1990
5 Some researchers argue that diversifying firms are often poor performers before they become conglomerates (Campa and Simi, 2002; Hyland, 2001), while others conclude that the conglomerate discount is a result of how the sample studied is constructed (Villalonga, 2004; Graham, Lemmon, and Wolf, 2002). Several suggest that the conglomerate discount is reduced when firms either divest or spin off businesses in an effort to achieve greater focus on the core business portfolio (Shin and Stulz, 1998; Dittmar and Shivdasani, 2003.
6 Harding and Rovit, 2004; Megginson et al., 2003
8 Fauver, Houston, and Narrango, 2003
9 Mitchell and Mulherin, 1996; Mulherin and Boone, 2000
11 Billet and Qian, 2008; Malmendier and Tate, 2008
14 Mehran and Peristiani, 2006
15 Masulis, Wang, and Xie, 2007
16 Ayers, Lefanowicz, and Robinson, 2003
17 Dong et al., 2006; Ang and Cheng, 2006
19 Martynova and Renneboog, 2008a; Brealey and Myers, 2003; Mitchell and Mulherin, 1996
20 Rhodes-Kropf and Viswanathan, 2004; Shleifer and Vishny, 2003
21 Numerous studies confirm that long-term fluctuations in market valuations and the number of takeovers are positively correlated. See Dong et al., 2006, and Ang and Cheng, 2006. However, whether high valuations contribute to greater takeover activity or whether increased M&A activity boosts market valuations is less clear.
24 Goodwill represents the excess of the purchase price paid by the acquirer for the net assets acquired (i.e., assets purchased revalued to their current market values less acquired liabilities). Prior to December 15, 2001, the value of goodwill on the acquirer's balance sheet had to be written off (i.e., amortized) over as long as 40 years. This is no longer required, but it must be checked for impairment in the wake of any significant event that may reduce the value of the goodwill to less than what is shown on the acquirer's balance sheet. Whenever this occurs, the value of the goodwill must be revised downward to reflect these events, with the amount of the downward revision charged against the firm's current earnings.
26 Under the Dodd-Frank legislation of 2010, mortgage loan originators are required to retain ownership in at least 5% of loans that are securitized and sold by the originator.
27 According to Dealogic, 1,307 previously announced deals valued at $911 billion were cancelled in 2008, underscoring the malaise affecting the global M&A market. Deals sponsored by private equity firms and hedge funds hit a five-year low worldwide, falling 71% in 2008 from the prior year to $88 billion.
28 Brakman, Garretsen, and Van Marrewijk, 2005
29 McNamara et al. (2008) define a merger consolidation wave as a cycle in which the peak year had a greater than 100% increase from the first year of the wave, followed by a decline in acquisition activity of greater than 50% from the peak year. For some of the 12 industries studied, consolidation waves were as long as six years. There is also evidence that acquisitions early in the M&A cycle produce financial returns over 50% and, on average, create 14.5% more value for acquirer shareholders. See Gell et al., 2008.
31 According to Gugler et al. (2003), horizontal, conglomerate, and vertical mergers accounted for 42%, 54%, and 4% of the 45,000 transactions analyzed between 1981 and 1998, respectively.
32 U.S. merger premiums averaged about 38% between 1973 and 1998 (Andrade, Mitchell, and Stafford, 2001). Rossi and Volpin (2004) document an average premium of 44% during the 1990s for U.S. mergers. The authors also find premiums in 49 countries ranging from 10% for Brazil and Switzerland to 120% for Israel and Indonesia. The wide range of estimates may reflect the value attached to the special privileges associated with control in various countries.
33 Mergerstat Review, 2010
34 Problems associated with fairness opinions include the potential conflicts of interest with investment banks that generate large fees. In many cases, the investment bank that brings the deal to a potential acquirer is the same one that writes the fairness opinion. Moreover, these letters are often out of date by the time shareholders vote on the deal, they do not address whether the firm could have gotten a better deal, and the overly broad range of values given in such letters reduces their relevance. Courts agree that because the opinions are written for boards of directors, investment bankers have no obligation to the shareholders (Henry, 2003).
37 Unlike public offerings, private placements do not have to be registered with the SEC if the securities are purchased for investment rather than for resale.
39 Leading M&A law firms in terms of their share of the dollar value of transactions include, at the time of this writing, Wachtell Lipton Rosen & Katz; Simpson Thatcher & Bartlett; Skadden Arps Slate Meagher & Flom; Sullivan & Cromwell; and Davis Polk & Wardwell.
40 As of this writing, the accounting industry is dominated by the group of firms called the “big four”: Ernst & Young, PricewaterhouseCoopers, KPMG, and Deloitte & Touche. Large regional firms (e.g., Grant Thornton and BDO Seidman) likely have some national and possibly some international clients, but they are largely tied to specific regional accounts. Local accounting firms operate in a number of cities and tend to focus on small businesses and individuals.
41 Georgeson & Company and D. F. King & Company are two major proxy solicitor firms.
42 There are many private investigators, but Kroll Associates is by far the largest such firm that frequently investigates target management.
43 For an exhaustive discussion of hedge fund investing, see Stefanini (2006).
44 For example, the hedge fund Highfields Capital Management, which owned 7% of Circuit City, made a bid to buy the entire company in 2005. That same year, hedge fund manager Edward Lampert, after buying a large stake in Kmart, engineered an $11 billion takeover of Sears. The Blackstone Group (a private equity firm) and Lio Capital (a hedge fund) banded together to purchase the European beverage division of Cadbury Schweppes in early 2006. Blackstone also acted like a hedge fund that same year with its purchase of a 4.5% stake in Deutsche Telekom. According to Dealogic, hedge funds accounted for at least 50 leveraged buyouts in 2006.
45 Kaplan and Schoar (2005) found little evidence that private equity funds on average outperform the overall stock market once their fees are taken into account. In contrast, hedge funds have tended to outperform the overall market by one to two percentage points, even after fees are considered, although the difference varies with the time period selected (The Deal, 2006). Moreover, hedge fund returns appeared to be less risky than the overall market, as measured by the standard deviation of their returns. These data may be problematic, since hedge fund financial returns are self-reported and not subject to public audit. Furthermore, such returns could be upward biased due to the failure to report poorly performing funds. Metrick and Yasuda (2007) found that for a sample of 238 LBO funds from 1992 to 2006, the average private equity fund collected about $10.35 in management fees for every $100 under management compared with $5.41 for every $100 under management that came from carried interest. Consequently, about two-thirds of fund income comes from fees.
46 General partners of venture capital firms receive a 2 to 3% fee and 15 to 25% of any capital gains from initial public offerings and mergers. The remaining 75 to 85% of capital gains, plus a return of principal, goes back to investors in the VC fund (Bygrave and Timmons, 1992). Only 2 to 4% of the firms contacting VC firms actually receive funding (Vachon, 1993).
47 The percent of equity held by institutions was 49.1% in 2001, compared to 31% in 1970 (Federal Reserve Bulletin, December 2003, p. 33).
48 The Investment Company Act of 1940 restricts the ability of institutions to discipline corporate management. For example, mutual funds, to achieve diversification, are limited in the amount they can invest in any one firm's outstanding stock. State regulations often restrict the share of a life insurance or property casualty company's assets that can be invested in stock to as little as 2%.
49 A study of the 24 largest mutual funds in the United States indicated that in 2004 American Funds, T. Rowe Price, and Vanguard voted against management and for key shareholder proposals 70%, 61%, and 51% of the time, respectively—sharply higher than in 2003. However, industry leader Fidelity voted against management only 33% of the time (Farzad, October 16, 2006; Davis and Kim, 2007).
50 Goyal and Park, 2002. The number of executives serving in both positions in their companies declined from about 91% during the 1980s to 58% during the 1990s (Kini, Kracaw, and Mian, 2004).
51 In an unprecedented expression of no confidence in early 2003, 43% of the votes cast were opposed to Michael Eisner continuing as chairman and CEO of Disney. Even though Eisner won a majority of the votes, the Disney board voted to strip him of his role as chairman. Later that year, Eisner announced that he would retire when his contract expired in 2006.
52 Karpoff, 2001; Romano, 2001; Gillan and Starks, 2007
53 Brav et al. (2006) argue that activist hedge funds occupy a middle ground between internal monitoring by large shareholders and external monitoring by corporate raiders. Clifford (2007) and Klein and Zur (2009) also found that hedge fund activism can generate significant abnormal financial returns to shareholders.
54 Greenwood and Schor (2007) found that under such circumstances, there is little change in the firm's share price during the 18 months following the sale of the company, even if the firm follows the activist's recommendations and buys back shares or adds new directors.
55 Ascioglu, McInish, and Wood, 2002
56 Mitchell, Pulvino, and Stafford, 2004
57 A number of studies find that such arbitrage generates financial returns ranging from 4.5% to more than 100% in excess of what would be considered normal in a highly competitive market (Jindra and Walkling, 1999; Mitchell and Pulvino, 2001).
58 In an analysis of 88 empirical studies between 1970 and 2006, Zola and Meier (2008) identify 12 different approaches to measuring the impact of takeovers on shareholder value. Of these studies, 41% use the event study method to analyze premerger returns, and 28% utilize long-term accounting measures to analyze postmerger returns.
61 Akhigbe, Borde, and Whyte, 2000; Bradley, Desai, and Kim, 1988; Sullivan, Jensen, and Hudson, 1994
62 Bradley, Desai, and Kim, 1988
64 Morellec and Zhdanov, 2008; Uysal, 2006
65 Moeller et al., 2005. Acquirer returns around transaction dates were in the aggregate positive during the 1990s (around 1.5%), particularly during the 1990–1997 period. However, losses incurred by a relatively few mega-transactions between 1998 and 2001 offset much of the gains during the earlier period.
66 Barkema and Schijven, 2008. For example, in an effort to become the nation's largest consumer lender, Bank of America spent more than $100 billion to acquire credit card company MBNA in 2005, mortgage lender Countrywide in 2007, and the investment firm Merrill Lynch in 2008.
67 Harrison et al., 2005. Event studies assume that markets are highly efficient, and that share prices reflect all of the public and private information available with respect to the transaction. In practice, much of the information provided by the seller to the buyer is confidential and therefore largely unavailable to the public. Furthermore, the investing public often is unaware of the target's specific business plan at the time of the announcement, making a comparison of whether to continue to hold or to sell the target's stock difficult. Zola and Meier (2008) note that short-term event studies results do not correlate with any of the other measures of M&A performance because the “blip” in the financial returns of the buyer and seller on or about the announcement date often reflects the “collective bet” by investors on the probable success or failure of the merger. Such bets are often wrong, providing evidence contrary to the often presumed efficiency of the financial markets.
68 In a review of 26 studies of postmerger performance during the three to five years after the merger, Martynova and Renneboog (2008a) found that 14 showed a decline in operating returns, 7 provided positive (but statistically insignificant) changes in profitability, and 5 showed a positive and statistically significant increase in profitability. The diversity of conclusions about postmerger returns may be the result of sample and time selections, methodology employed in the studies, or factors unrelated to the merger, such as a slowing economy (Barber and Lyon, 1997; Fama, 1998; Lyon, Barber, and Tsai, 1999). Using a sample of 1,300 transactions from 1993 to 2002, Dutta and Jog (2009) did not find evidence of any systematic long-term deterioration in acquirer financial performance and attribute findings of such deterioration to the choice of benchmarks, differing methodologies, and statistical techniques.
69 Presumably, the longer the postmerger period analyzed, the greater the likelihood that other factors, wholly unrelated to the merger, will affect financial returns. Moreover, these longer-term studies are not able to compare how well the acquirer would have done without the acquisition.
70 Moeller et al., 2004. Small firms are defined as the smallest 25% of firms listed on the New York Stock Exchange each year during that 20-year period. Forty-six percent of a sample of 12,023 transactions involved acquisitions of private firms, 32% involved acquisitions of subsidiaries, and the remaining 22% involved acquisitions of public firms. Regardless of how they were financed (i.e., stock or cash) or whether they were public or private targets, acquisitions made by smaller firms had announcement returns 1.55% higher than a comparable acquisition made by a larger firm.
71 Moeller et al., 2005; Fuller et al., 2002; Ang and Kohers, 2001. Similar results were found in an exhaustive study of U.K. acquirers (Draper and Paudyal, 2006) making bids for private firms or subsidiaries of public firms, where the positive abnormal returns were attributed to the relative illiquidity of such businesses.
72 For the 10-year period ending in 2000, high-tech companies, averaging 39% annual total return to shareholders, acquired targets with an average size of less than $400 million, about 1% of the market value of the acquiring firms (Frick and Torres, 2002).
73 Hackbarth and Morellec, 2008
75 Schleifer and Vishny, 2003; Megginson et al., 2003; Heron and Lie, 2002; Linn and Switzer, 2001
76 Deogun and Lipin, 2000; Black et al., 2000; Agrawal and Jaffe, 1999; Rau and Vermaelen, 1998
79 Savor and Lu, 2009. Over the first year, the mean abnormal financial return for acquirers using stock is a negative 7%, reaching a negative cumulative 13% at the end of three years. However, acquirers using stock who fail in their takeover attempts do even worse, experiencing negative returns of 21% and 32% after one year and three years, respectively, following their aborted takeover attempts.
80 Studies of European firms indicate that postmerger returns to bidders using stock often are higher than those using cash. These results may reflect the greater concentration of ownership in European firms than in the United States and the tendency of large shareholders to more closely monitor the actions of management (Martynova and Renneboog, 2008).
81 This is the conclusion from Barkema and Schijven (2008), an extensive survey of the literature on how firms learn from past acquisitions.
82 Fuller et al., 2002; Billett and Qian, 2005; Conn et al., 2005; Ismail, 2005
83 These findings are in sharp contrast with the findings that acquirers have great potential to learn from their mistakes, suggesting that serial acquirers are more likely to earn returns in excess of their cost of capital (Harding and Rovit, 2004). Atkas et al. (2007) propose an alternative explanation for the role of hubris in the decline in abnormal acquirer returns for serial acquirers. If acquirers are learning from prior acquisitions, they should improve their selection of, and ability to integrate, target firms. Therefore, the risk of each successive acquisition should decline. If risk associated with the successive acquisitions declines faster than the abnormal return, risk-adjusted acquirer returns can rise. If so, CEOs of highly acquisitive firms should be willing to bid more aggressively for targets as the perceived risk associated with such targets declines. As such, abnormal returns are simply declining in line with the level of perceived risk for experienced acquirers.
84 Luo (2005), based on a sample of 1,576 transactions between 1995 and 2001.
85 Renneboog and Szilagyi, 2007
86 The empirical evidence is ambiguous. A study by Billett, King, and Mauer (2004) shows slightly negative abnormal returns to acquirer bondholders regardless of the acquirer's bond rating; the researchers used a sample of 831 U.S. transactions between 1979 and 1998. However, they also find that target firm holders of below-investment-grade bonds earn average excess returns of 4.3% or higher around the merger announcement date, when the target firm's credit rating is less than the acquirer's and when the merger is expected to decrease the target's risk or leverage. Maquierira, Megginson, and Nail (1998) show positive excess returns to acquirer bondholders of 1.9%, and .5% for target bondholders, but only for nonconglomerate transactions; their sample includes 253 U.S. transactions from 1963 to 1996. Another study, using a sample of 225 European transactions between 1995 and 2004, finds small positive returns to acquirer bondholders of .56% around the announcement date of the transaction (Renneboog and Szilagyi, 2006).
87 Billet, Jiang, and Lee, 2010
89 Shahrur, 2005; Ghosh, 2004; Song and Walking, 2000; Akhigbe, Borde, and Whyte, 2000
90 See Maksimovic and Phillips (2001), an exhaustive study of 10,079 transactions between 1974 and 1992.
92 Articles indicating the importance of overpaying and/or overestimating synergy as a cause of M&As failing to meet expectations include Cao (2008), Harper and Schneider (2004), Christofferson, McNish, and Sias (2004), Henry (2002), Bekier, Bogardus, and Oldham (2001), Chapman et al. (1998), Agrawal, Jaffee, and Mandelker (1999), Rau and Vermaelen (1998), Sirower (1997), Mercer Management Consulting (1998), Hillyer and Smolowitz (1996), and Bradley, Desai, and Kim (1988). Articles referencing the slow pace of integration include Adolph (2006), Carey and Ogden (2004), Coopers & Lybrand (1996), and Mitchell (1998). Articles discussing the role of poor strategy include Mercer Management Consulting (1998) and Bogler (1996).
93 In an exhaustive study of 22 different papers examining long-run postmerger returns, Agrawal and Jaffe (1999) separated financial performance following mergers and hostile tender offers. Reviewing a number of arguments purporting to explain postmerger performance, they deemed most convincing the argument that acquirers tend to overpay for so-called high-growth glamour companies based on their past performance.
94 AC Nielsen (2002) estimates the failure rate for new product introductions at well over 70%. Failure rates for alliances of all types exceed 60% (Ellis, 1996; Klein, 2004).