Mergers and Acquisitions

Mergers

• Mergers and acquisitions represent major investment decisions undertaken by financial managers.
• Successful mergers can greatly improve a company, while unsuccessful ones can harm or hinder its progress for many years.
• In 2020, North American companies participated in over 17,000 deals worth over $2 trillion.
• During intense merger activity, management dedicates time to finding firms to acquire or guarding against being acquired.
• Note: Several mergers were subject to regulatory approval or potential rival bids.

Types of Merger

• Mergers are classified as horizontal, vertical, or conglomerate.
• Horizontal mergers occur between firms in the same line of business.
• Vertical mergers involve companies at different production stages.
• The acquiring company expands towards raw materials or the ultimate consumer.
• Example: CVS Health's $69 billion acquisition of Aetna in 2018.
• Conglomerate mergers involve companies in unrelated businesses.

Sensible Motives for Mergers

• A merger's value is determined by whether the merged firm is worth more than the sum of its parts.
• Synergies develop when the merged firm's value surpasses the sum of its individual parts.
• Strategic alliances supported by long-term contracts can achieve similar synergies without merging.

Economies of Scale and Scope

• Economies of scale are sought after in many mergers.
• Economies of scale occur when production costs decrease as production volume increases.
• Fixed costs can be spread across a larger production volume to achieve economies of scale.
• BB&T and SunTrust merged, anticipating annual cost savings of $1.6 billion by 2022.
• Achieving economies of scope is the goal of other mergers.
• Economies of scope arise from broadening a firm's range of products.
• Procter & Gamble's 2018 acquisition of Merck KGaA's consumer health business aimed to create marketing efficiencies.

Economies of Vertical Integration

• Vertical mergers seek control over the production process by expanding to raw materials or the consumer.
• A way to achieve this goal is through merging with a supplier or a customer.
• Contracts can manage supplier and customer relationships by specifying volume, quality, and price, but have drawbacks.
• Combining operations within a vertically integrated firm grants control over asset usage.

Complementary Resources

• Large firms may acquire small firms to gain access to missing elements essential for their achievements.
• Small firms may possess unique products but lack the necessary engineering and sales organizations.
• Merging with a firm that already has the desired talent may be quicker and cheaper than creating it from scratch.
• Pharmaceutical firms have increasingly acquired biotech firms to replace the diminishing patent protection

Changes in Corporate Control

• Some firms hold excess cash and do not distribute it to stockholders, these firms become targets for takeover.
• Acquirers aim to secure control of companies' cash flow to prevent wasteful spending on negative-NPV.
• Firms with unexplored avenues for cost reduction, sales growth, and earnings are ideal acquisition targets.
• "Better management" can involve implementing painful cuts or restructuring operations.
• Acquisitions often happen before a shift in the management of the target company.

Industry Consolidation

• Significant efficiency gains can be achieved in industries characterized by too many firms and too much capacity.
• A wave of mergers and acquisitions can be triggered by these conditions.
• Mergers can result in capacity and employment reductions, freeing up capital for reinvestment.

Logic Does Not Guarantee Success

• Merger success depends on management's ability to handle integrating different production processes, accounting methods, and corporate cultures.
• The primary value of most businesses lies in their human assets, including managers, employees, scientist and engineers.

Dubious Motives for Mergers

Diversification

• The lack of correlation between two businesses is expected to result in risk diversification through a merger.
• Diversification is more accessible and cost-effective for individual stockholders rather than corporations.

Increasing Earnings per Share: The Bootstrap Game

• A company's earnings per share increase with the acquisition of another company with a lower P/E ratio.
• This leads to several years of increasing earning per share, even when no economic gains are apparent.

Lower Borrowing Costs

• Merged firms can often borrow at cheaper rates than separate entities.
• Economies of scale are inherent in the creation of new issues which lead to genuine savings.
• The blended company can often borrow at lower interest rates than what either firm could separately.

Management Motives

• Management's decision to merge may stem from hubris or personal objectives rather than economic logic.
• Overconfident managers may believe they can manage a target company better than its current management, but end up damaging its value.
• Firm size is strongly correlated with CEO pay, which reinforces management motivation.

Estimating Merger Gains and Costs

• Analyzing a possible purchase of firm T involves assessing the potential economic gain.
• The economic gain exists if the two firms are worth more together (PVAT) than apart (PVA + PVT). Therefore: Gain = PVAT – (PVA + PVT) = ΔPVAT
• Acquiring firms must pay shareholders of target firm more than the firm is worth. That acquisition premium is the cost of merger.
• The net present value (NPV) to firm A is determined by comparing the gain and cost of the merger: NPV = (ΔPVAT – Cost) > 0

Estimating NPV When the Merger Is Financed by Cash

• Calculating merger is simplest when target is paid for with cash.
• The cost of acquisition equals amount of the cash payment minus the stand-alone value. Therefore: Cost = Cash – PVT
• The combined value of A and T is $275 million, with A shareholders getting $10 million, and T's capturing $15 million.
• Total value creation remains $25 million.

Estimating NPV When the Merger Is Financed by Stock

• Payment in stock affects cost depending on the value of shares in the new company received by selling company's shareholders.
• Assuming x represents the fraction of equity in the merged firm given to the target, the cost is. Therefore: Cost = xPVAT – PVT.

Asymmetric Information

• A primary distinction between cash and stock financing involves asymmetric information, meaning management access to information is unavailable to outsiders.
• Optimistic managers favor cash, not stock, to finance takeovers when shares are over valued.
• Pessimistic managers who regard their company shares as overvalued are far more likely to favor stock financing.

More on Estimating Costs - What If the Target’s Stock Price Anticipates the Merger?

• The buyer bears the premium paid above stand-alone value in a merger transaction.
• The target may overstate its standalone value if people expect A to acquire T.

Right and Wrong Ways to Estimate the Benefits of Mergers

Right way

• Start with the target’s stand-alone market value (PVB) and focus on cashflow changes after merger
• Then ask, why should two firms be worth more together than apart?

The Mechanics of a Merger

Mergers, Antitrust Law, and Popular Opposition

• Mergers can be hindered by federal antitrust laws.
• The most important statute is the Clayton Act of 1914, which disallows acquisitions that could substantially reduce competition or create a monopoly.
• The Hart-Scott-Rodino Antitrust Act of 1976 requires agencies to be informed of stock acquisitions greater than $75 million.
• Companies operating globally deal with antitrust laws from other nations.

The Form of Acquisition

• The first thing to be considered by company A is that the purchase of T will not be challenged on antitrust laws.
• One step (or statutory) merger occurs when company A assumes all of T's assets and liabilities and must have 50% approval of T's shareholders.
• A takeover (or two-step) offer involves buying T's stock for cash, shares, or other securities.

Merger Accounting

• Newly issued rules from the Financial Accounting Standards Board (FASB), required buyer to use purchase method of merger accounting.
• Goodwill = purchase price less the fair market value of identifiable net assets.

Some Tax Considerations

• An acquisition may be taxable or tax-free and dependent on the form of payment.
• Payment in cash characterizes a taxable acquisition - selling stockholders are treated as having sold their shares.
• Largely in the form of shares an acquisition becomes tax-free -shareholders viewed as exchanging old shares for similar new ones.
• The tax status of an acquisition affects the taxes that are paid by the merged firm afterward.

Takeovers and the Market for Corporate Control

• The mechanisms by which firms are matched up with owners, and management teams describe the market for corporate control.
• Three ways to change the management of a firm include:
• A successful proxy contest
• A takeover of one company by another
• A leveraged buyout of the firm by a private group of investors.
• If the takeover offer is in cash, it is called a tender offer, and if it is partly in stock, it is an exchange offer.
• Often, they convince shareholders to agree to shark-repellent changes to the corporate charter, as well.

Merger Waves and Merger Profitability

• Merger activity occurs in waves, often associated with booming stock markets. Motives include the need to consolidate.
• Mergers tend to concentrate in small industries and can deregulation this. Changes in technology or demand patterns that may prompt such patterns.
• Target shareholders gain abnormal returns from the merger, while those on the bidding side gain proportionately less.
• Merger profitability varies, because there’s a wide range of possible issues.