Answer Framework on Mergers & Acquisitions PDF

Answer framework **A** Description / terminology ------- --------------------------- **B** Critical point **C** Case study / statistics **Session 1** 1. **Motivations / reasons behind M&A** 1. **Are motives always reasonable?** 2. **Dubious reasons** A There are a number of motivators for M&A. This answer will discuss three which are commonly debated in M&A literature. **Acquirer opportunism --** this is when models are attributed to managers opportunistically exploiting the market mispricing of firms **High capital liquidity --** this occurs when firms have additional cash to spend **Valuation waves --** valuation errors and misvaluation can drive merger waves *Are motives always reasonable?* **Strategic motives --** often engage in M&A to achieve strategic goals such as market expansion, diversification, and gaining competitive advantage **Synergistic motives --** engage in M&A to achieve cost savings, revenue enhancement, and improved efficiency **Managerial motives --** engage in M&A for empire-building and personal gain **Financial motives --** engage in M&A to improve financial performance, access new capital and leverage tax benefits *Dubious reasons* **Managerial ego and empire building --** CEO's and managers can pursue deals to build larger empires and increase their influence, even when these deals do not provide significant benefits to shareholders or the company **Overestimating synergies --** While synergies are a common reason for M&A, they are often overestimated. Managers might pursue deals based on unrealistic expectations of cost savings and revenue enhancements. **Hubris and overconfidence --** Overconfident managers may believe they can turn around a struggling company or integrate businesses better than others, leading to acquisitions that are not strategically sound B **Acquirer opportunism --** Harford (2005) finds that market mistiming's do not have sufficient power to explain merger waves. **High capital liquidity --** Harford (Harford) argues that the real driver is the clustering of industry shocks in periods of high capital liquidity that drives merger waves. **Valuation waves --** Cummings et al (2023) finds periods of high market-to-book ratios often coincide with increased merger activity, especially for stock financed deals. Shleifer and Vishney (2003) find that merger waves occur when there are many overvalued bidders buying real assets (targets) with stock, which explains why merger activity and stock market levels are positively correlated. *Are motives always reasonable?* **Strategic motives --** Ngulube (2019) argues that these motives are generally considered reasonable. This is because they aim to enhance the company's long-term growth and market position. **Synergistic motives -** Ngulube (2019) argues that these motives are generally reasonable because they can create value for both the acquiring and target companies. However sometimes synergies can be overestimated, or CEO's can overestimate their ability to realise the synergies, explained more further on **Managerial motives -** Ngulube (2019) argues that these motives are oftentimes viewed to be less reasonable because they prioritise the interests of management over those of the company and its shareholders **Financial motives -** Ngulube (2019) argues that these can be reasonable if they lead to the improved financial health and stability for the company *Dubious reasons:* **Managerial ego and empire building --** Narcissism is measured by the CEO's use of first-person singular pronouns relative to his use of the first-person plural pronoun during meetings with analysts (Renneboog and Vansteenkiste, 2019). Literature states that CEO narcissism has a negative relation to merger announcement returns. Regardless of which measurement is used (CARs, BHARs or ROA), Renneboog and Vansteenkiste's analysis identifies that CEO overconfidence is consistently negatively related to deal performance. **Diversion from poor performance --** Tatsumoto (2016) find that the stock prices of acquiring companies are typically negatively evaluated immediately after the M&A announcement, suggesting the market may perceive M&A as a distraction from underlying performance issues. **Hubris and overconfidence -** CEO's exhibiting these traits often overestimate potential synergies and make poor acquisition decisions. This is known as the 'hubris hypothesis' which suggests that overconfidence of decision-makers in bidding firms tend to overpay for acquisitions (Roll, 1986), suggesting there is misalignment between the market and CEO beliefs. Under this hypothesis, CEO's believe they are acting in the best interest of shareholders. This trait is related lower acquirer announcement returns compared to deals where neither party are identified as overconfident. **Diversification --** Investors should not pay a premium for diversification since they can do it themselves C **Time Warner / AOL (2000) -** The deal valued at \$165 billion and the merger was driven by ambition to dominate the rapidly growing internet market. The deal failed to deliver expected synergies and Time Warner eventually spun off AOL in 2009 due to its underperformance. 2. **M&A waves** 3. **Reasons for the waves** 4. **What drives waves in US and UK?** A A merger wave is a period of activity in M&A when there is a significant increase in the number of mergers taking place within a short timeframe ***Wave 1 -- 1890's -- 1903*** **Beginning -** this coincided with economic expansion, industrialisation processes, introduction of new state legislations on incorporations, development of trading on NYSE and radical changes in technology. **End --** This coincided with stock market crash, economic stagnation, beginning of WW1 Companies were merging to form monopolies (one firm is dominant in the market) amid high industrial production. There were a small number of firms that controlled the majority of the market ***Wave 2 -- 1910-1929*** **Beginning --** Economic recovery after the market crash and WW1, strengthen enforcement of anti-monopoly law **End --** Stock market crash, beginning of Great Depression This was smaller than the first wave, with regulation against monopolies being enforced. Companies were now merging for oligopoly (small number of firms dominate the market). ***Wave 3 -- 1950-1973*** **Beginning --** economic recovery after WW2, tightening of anti-trust regime in 1950 **End --** Stock market crash, oil crisis, economic slowdown Companies were merging for growth and did not involve many large acquirers. The main goal was to achieve growth through diversification. ***Wave 4 -- 1981-1989*** **Beginning --** Economic recovery after recession, changes in anti-trust policy, deregulation of financial services sector, new financial instruments and markets (junk bonds), technological progress in electronics **End --** stock market crash This included hostile tender offers (company makes direct offer to shareholders of the target company to purchase their shares at premium price, bypassing target company's board of directors), bust-up takeovers (diversified underperforming firm and then sell off various parts of it), divestitures and LBOs ***Wave 5 -- 1993-2001*** **Beginning --** Economic and financial markets boom, globalisation processes, technological innovation, deregulation and privatisation **End --** stock market crash, 9/11 terrorist attach This was the mother of all waves, and took a resource-based view, i.e., the emergence of new technologies such as the Internet *Reasons* **Industry shocks --** triggered by shocks such as technological innovations or regulatory changes **Financing conditions --** crucial for merger waves, the availability of capital and favourable credit market conditions facilitate mergers **Strategic interactions --** maintaining competitive balance and responding to rivals' actions can amplify the effects of industry shocks and contribute to the clustering of mergers *Waves in US vs UK* Aspect UK US ------------------ ----------------------------------------------------------- ---------------------------------------------------------------- Economic drivers Economic stability and political calm Economic expansion and overall growth Regulatory focus Focus on compliance with EU regulations, even post-Brexit Influenced by changes in US antitrust laws and SEC regulations Market dynamics Market share and competitive positioning Overvaluation of equity and investor pressure can drive M&A Industry focus Industry-specific shocks like Brexit-related changes Rapid technological changes often play a larger role B Harford (2022) finds that merger waves are often triggered by industry shocks such as technological innovations or regulatory changes, creating opportunities for asset reallocation, leading to a cluster of merger activity. The primary driver of merger waves is the efficient reallocation of assets un response to these shocks, helping industries to adapt to changing conditions and improve overall productivity. Town (1992) approach to estimating a merger wave was to estimate a two state Markov autoregressive model and identify dates with probability of being State 1 higher than 0.5 with a two-lagged smoother). However, many followed Harford (2005) approach by finding the highest 24-month period of merger bids for each decade, randomly distribute the total number of bids over the decade into 1000 sets of 120 months, determine the highest 24-month bid concentration for each of the 1000 sets and compare the actual peak with the 1000 simulated peaks. If the peak if higher than 95% of the simulated peaks, it is considered a wave. *Reasons* **Industry shocks --** these shocks create opportunities for asset reallocation, leading to clusters of merger activity within specific industries. Mitchell and Mulherin (1996) found substantial cross-industry heterogeneity in merger activity and industry-level merger activity is tightly clustered in time, typically lasting two years or less **Financing conditions --** this allows companies to take advantage of opportunities created by industry shocks. Harford (2005) finds that if an industry shock occurs during a time of high liquidity, companies have the financial resource to pursue these opportunities, leading to a surge in M&A activity within that industry. When multiple industries experience similar conditions simultaneously, these individual industry-level waves combine to form aggregate merger waves. **Strategic interactions --** this creates a dynamic where mergers trigger more mergers. Toxvaerd (2008) finds that M&A clusters must include strategic elements in order to realistically model merger waves. He explains hat acquisitions are real options, so there is a value to waiting, but after a shock, the value of pre-emption outweighs value of waiting. Rodrigues (2014) finds that product market strategic considerations help create horizontal merger waves and that these mergers are strategic complements due to product market considerations generating a wave *Waves in US vs UK (Cho and Chung, 2022)* **Economic drivers --** US focuses more on economic expansion while the UK benefits from political stability and calm **Regulation --** US has a more dynamic regulatory environment with frequent changes in antitrust laws, whereas the UK deals with the complexities of EU regulations and post-Brexit adjustment **Market --** The US is more influenced by technological and market conditions like overvaluation, while the Uks waves are more driven by market share and competitive positioning **Industry --** The US and the UK both experience waves driven by economic conditions, regulatory changes ad industry shocks. However the specific drivers and their impacts vary due to differences in economic environments, regulatory frameworks and industry dynamics End of wave mergers perform worse in terms of long-term stock and operating performance and firms which undertake end-of-wave deals often have poor corporate governance structures 3. **Corporate restructuring, merger process and types of mergers** 5. **Hard and soft synergies** A *Corporate restructuring* Two types of acquirers: strategic (other companies, often competitors or operating in adjacent industries, such that the target company would fit nicely with their core business) and financial (institutional buyers, such as PE firms, that are looking to own but not directly operate the acquisition target for example using leverage to finance the acquisition and perform LBO) Corporate restructuring is the action to expand or contract a firm's basic operations or change its operational or financial structure *Process* 1. Business plan 2. Acquisition plan 3. Search/Screen 4. Contact 5. Information exchange 6. Initial negotiations 7. Valuation 8. Initial offer / response 9. Due diligence 10. Re-negotiate 11. Final decision 12. Integration plan 13. Deal closing 14. Integration process 15. Evaluation Participants are investment bankers, lawyers, accountants and public relations *Types of mergers* **Horizontal -** Horizontal mergers occur between companies operating in the same industry and at the same stage of production. The primary goals are to increase market share, achieve economies of scale, and reduce competition. **Vertical -** Vertical mergers occur between companies at different stages of the production process (e.g., a manufacturer and a supplier). The goal is to secure supply chains, reduce costs, and improve coordination. **Conglomerate -** Conglomerate mergers involve companies from unrelated industries. The goal is diversification, reducing overall business risk, and exploring new markets. *Hard vs soft synergies* Hard synergies are tangible, easier to achieve and primarily involve cost savings - Reduction in workforce - Economies of scale - Consolidation of facilities - Streamlining operations Soft synergies are intangible, harder to quantify and typically involve revenue enhancements - Cross-selling opportunities - Market expansion - Improved innovation - Enhanced brand value B *Corporate restructurings (Jostarndt, 2006)* Studies suggest that the market generally responds favourably to restricting announcements by distressed firms. Analysis shows a 2% increase in market value for distressed firms that successfully divest assets. This likely reflects improved operating efficjency and increased prospects for maintaining independent status, leading to lower hazards of exit. Higher operating efficiency is associated with higher survival likelihoods for firms that restructure C *Corporate restructuring --* Hewlett-Packard Company / Compaq Computer Corp. This was worth c\$25 billion. HP cut 14,500 jobs in a major restructuring move to achieve major cost savings \$1.9bn. Under new CEO, cuts are due to reorganisation to link sales and marketing efforts more closely. The restructuring reduced the number of people involved in each decision, and shortened the path from idea to customer. 4. **Post-integration audit** 6. **Impact of mergers (society, competition, product innovation, diversification)** A Post-integration audit is the stage where we determine whether the transaction delivered on its promises. Sometimes this stage is not considered important because: 1. Lack of organisational emphasis on learning 2. Each deal is unique so past experiences may seem irrelevant 3. Past learning lies in individual's experience 4. Individual's experience is not easy to be communicated A robust post-acquisition audit can contribute to effective learning and successful acquisition programmes. A good audit entails: 1. Acquisition-specific audit rather than as part of normal internal audit 2. Audit team well briefed on strategic and value creation objectives 3. Appropriate and a variety of benchmarks 4. Clead identification of reasons for success or failure *Impact of mergers* **Society** - job losses due to redundancies and changes in corporate social responsibility practices **Competition --** increased market concentration, reducing competition **Diversification --** allowing firms to enter new markets or product lines B In a survey conducted by KPMG, only less than 45% of firms carried out post-deal reviews. More evidence than not suggests that more M&A transactions fail to create the competitive advantages they are designed to. Perhaps the lack of post-acquisition learning is an explanation for this failure. *Impact of mergers* Rennebook and Vansteenkiste (2019) find that M&A deals can create value by retaining the target's valuable human capital and this is common when the targets pre-merger performance is higher **Society --** Waddock (2006) finds that stakeholder relationships and corporate governance practices can be affected by mergers, with both positive and negative outcomes. Some empirical evidence supports the expectation that M&A from the merged company will be more efficient and its employees more productive, suggesting that acquiring firms may have more innovative or progressive human-resource- or employee-related policies. Some evidence even shows progressive employee practices result in higher productivity. **Competition --** Empirical studies use the HHI index to assess the competition and some researchers suggest that while some mergers lead to efficiency gains, others may harm consumer welfare by increasing prices. Schain (2017) suggests that large efficiency savings could prevent potential future market entry and may further reduce competition in the long-run. He also offers the perspective that two firms may have relatively high market shares but the offered brands are weak substitutes which means a merger may have a low impact on the level of competition **Diversification --** Empirical evidence on the benefits of diversification through mergers is mixed. Some studies suggest that diversification can lead to improved financial performance, while others find no significant benefits or even negative effects. Investors should not pay a premium for diversification if they can do it themselves. Choi & Russell (2004) did find that related diversifications performed slightly better than unrelated diversifications. Additionally, geographically diversifying mergers tend to create more value for acquiring firms however, overall diversifying acquirers perform worse than non-diversifying acquirers. **Session 2** **2.1. Value theories** *Refer to success or failure notes* **2.2. Sources of synergies** A This posits that the combined entity from a merger can create more value than the sum of the separate firms. Synergies can come from various sources such as cost savings, increased revenue, and improved efficiency. **Cost reduction --** This is explained through economies of scale which are achieved when costs are reduced in production by increasing the scale of production. To explain how this works, production includes a fixed cost (administration, equipment etc) and so if you increase production, the average fixed cost goes down (the cost is shared among a higher amount of units). There is a limit, and this is when production volumes reach the minimum efficient scale (MES). If very large scales are achieved, antitrust regulation can actually intervene to prevent the formation of monopolies or oligopolies. Another cost synergy is the removal of redundancies, mainly in areas other than production, such as redundant personnel, office space, and accounting and audit services. **Operational efficiencies --** This can be explained through economies of scope which is dependent on various factors and capabilities. Products may have the same technological basis, geographical markets, consumer groups, managerial capabilities, diversified acquisitions. Economies of scope can increase revenue and profits. Economies of scope occurs when a firm can gain efficiencies from producing a wider variety of products, making it cheaper to produce a range of products together than to produce each one of them on its own. They apply to multi-product firms. Managerial efficiencies mean that the merger has allowed for the replacement of underperforming management with more successful managers **Revenue enhancing --** innovative activity features, new methods, originality and is often advanced. M&A synergies stemming from innovative activity could be substantial and benefits may accrue to any business where technology enables an increase in competitiveness and product differentiation. **Tax savings --** taxation savings depend on tax legislation of countries involved. This may be an increase in tax deductibles **Market power --** this is the ability to maintain prices above competitive levels for a significant period of time, leading to collusive synergies (a form of revenue enhancing) B All from Graaf and Pienaar (2012) **Cost reduction -** European regulators will only consider the cost savings from a merger if these savings lead to lower prices for consumers, are directly related to the merger, and can be clearly proven and measured. By merging in over-capacity markets, a deal can provide unique short-term cost savings that wouldn't be achievable by the firms individually. While removing redundant roles is a clear and measurable way to achieve cost savings in a merger, the broader impacts on employee morale, integration costs, and the overall success of the integration can significantly influence the outcome but are less studied **Operational efficiencies --** Mergers, especially vertical integrations, can create efficiencies by reducing transaction costs and improving supply timings. Economies of scope are achieved by better coordination and control over the production process, leading to cost savings and efficiencies. However, these benefits must be carefully managed to avoid regulatory problems. Efficiency is linked to a reduction in suboptimal decisions. However some literature finds that a merger could exacerbate some causes of inefficiency, for example by increasing organisational complexity, suggesting they may be difficult to quantify. Furthermore, improved managerial efficiency may be fully factored int the final offer price, leaving little or no synergy benefit to the acquirer **Revenue enhancing --** studies suggest that synergies are often the result of the acquisition of a specific technology or product -- not just any innovative activity. These synergies are difficult to estimate and are often considered in industries that involve a high level of technology and rapidly expanding demand. While many arguments suggest substantial synergies, there is a high degree of uncertainty and some of these relate to the removal of redundancies in R&D. Some studies even used the Black Scholes method to value these, viewing the synergy as a technology option. **Tax savings --** tax savings can increase the value of a merger, but they require careful planning and expert knowledge to achieve and measure accurately. There aren't any established practices fro valuing these as they are controversial in nature. A great example is an LBO which deducts interest payments on debt used to finance the buyout thereby reducing taxable income and lowering overall tax liability. However, some legislation can have the opposite effect such as the Tax Reform of 1986 which reduced some tax benefits associated with high-yield bonds, making hem less attractive to investors and negatively impacting LBO deals. **Market power --** In recent decades, anti-competitive legislation has curtailed certain mergers motivated by market power, however it does represent a significant synergy benefit. Both vertical and horizontal mergers may lead to increased market power by either merging with an entity closer to the end-consumer in the supply chain or in a market facing falling demand. Existing studies examine market shares and overall market concentration as well as recognising that large shares in mature markets are more likely to indicate dominance than in high-growth, tech0driven markets. One study suggests that if CEO pay and market power are positively related, then when large mergers happen and competition decreases, it may partly be because CEOs have an incentive to grow their company\'s market power, which in turn could increase their own compensation. Essentially, managerial motives, such as boosting their own pay, could be a driving force behind these large mergers. **2.3. SCP model (structure-conduct-performance)** A This is a framework which explains how the structure of a market influences behaviour of firms within that market **Short term --** industry plays a key role and determines firms conduct and performance **Long term --** competition is a dynamic process through which firms reshape an industry's structure by creating new technologies, substitute products or set new distribution channels B The model assumes that market structure directly affects firm conduct, which impacts performance. Critics argue that this relationship is not always straightforward and can be influenced by external factors like technology and regulatory change It has been used to justify antitrust policy and government interventions to promote competition however some economists believe these interventions to be counterproductive and stifle innovation Some empirical studies have used cross-sectional data to test the SCP hypothesis, finding correlations between market structure, firm conduct and performance. In the short term firms respond to industry structure and in the long term firms become more active / dynamic and can reshape the industry **2.4. Porter's model** A This model consists of 5 forces 1. Current competition (low) 2. Threat of new entrants (low resistance to new entrances) 3. Relative bargaining power of the buyers of firm's output 4. Relative bargaining power of the sellers of firm's inputs 5. Threat of substitutes (small number of substitutes) 6. BNs complementors force In order to deal with the five/six forces that threaten competitive advantage, M&A seekers need to understand what they need to change to proceed to right takeovers. B Brandenburger and Nalebuff (BN) argue that a player is a complementor if customers value your product more when they have the other player's product than when they have your product alone All of these six forces together determine the profitability of the firm within an industry and therefore, its attractiveness *How can this model affect industry competitiveness and hence a firm's attractiveness?* **Threat of new entrants --** A merger will grow a firm's size by creating economies of scale which moves the firm further to the Minimum Efficient Scale. This increases barriers to entry for new competitors as they need to match efficiency and scale of the merged entity to compete effectively **Current rivalry --** A merger with a supplier or distribution channel can reduce competition, leading to a more streamlined and efficient supply chain, giving the firm a competitive edge over others **Bargaining power of suppliers --** Merging with a rival enhances the market power of the combined entity, for example supermarkets can merge to negotiate better terms with suppliers due to increased market share and buying power **Mature industry suffering from overcapacity --** industries with overcapacity means mergers can reduce the number of competing firms, leading to increased profits for the remaining firms as competition decreases. This creates a domino effect where more firms will merge until a new equilibrium is reached. This can lead to a cluster / merger wave as companies try to adjust to new market conditions. Grundy (2006) finds however that while Porter's Five Forces model is influential in academic settings, it has less appeal among practicing managers. He suggests that applying the five forces to different segments of the business rather than treating the industry as a monolithic entity will help in understanding competitive dynamics at a more granular level as each market and industry is different and has different interdependencies. **2.5. Competitive strategies** **2.5.1. Resource-based capabilities** **2.5.2. Complementors** **2.5.3. Leveraging resource and capability** A Strategic motives for M&A comes when there is a need to acquire technologies or products to enhance competitive advantage. Acquirers will search for capabilities for innovation, product development and differentiation. We can define this in three strategies: 1. **Cost leader** is being focused on becoming the lowest-cost producer in the industry. 2. **Differentiate product** is creating unique products / services that stand out from competition 3. **Segment / niche player** is targeting a specific market segment or niche to cater to the unique needs and preferences of a particular group *RBV & leveraging resource and capabilities* Firms will compete based on their resource and capabilities. Types of resource include tangible, intangible and human. Capabilities are the essential organisational competences that allow firms to make effective use of its resource. Pelt (2010) describes a resource-based view as a competitive advantage that can be achieved by deploying valuable resources and capabilities. Merging firms can exploit each others R&C - Brand - Increase each others sales and revenues - Exploit each others distribution channels *Complementors* A complementor refers to a company or entity that provides products / services that enhance or complement the primary offerings of another company. By introducing complementors, firms can grow their revenue by increasing the demand for the main product. - This is because demand for a product rises when there is also an increased demand for a related complement product i.e., smartphones and protective cases or hotdogs and buns Often the potential benefits of complementing products are not fully realised and acquiring complementors can enhance the visibility and benefits of complementarity between two products B Eschen and Bresser (2005) wrote a paper looking at the resource-based theory to explain the success or failure of resource-driven merger and acquisition decisions. They find that while combining different assets can achieve M&A goals, if the aim is to fill resource gaps, then M&As are most beneficial when both the acquirer and target companies have valuable resources that complement each other. *RBV* Pelt (2010) says that limits to competition, resource heterogeneity, imperfect resource mobility and subsequent limits to competition, are all conditions which help a firm identify the unique resources it currently possesses and determine which new re sources could be developed to create a competitive advantage. By leveraging these unique resources, a firm can maintain a strong position in the market. One study which analysed transactions in the pharmaceutical and biotechnological industries found that mergers and acquisitions involving firms with strategically valuable resources and capabilities tend to be more successful and provides a competitive advantage. Another study found that M&A announcements often lead to abnormal stock performance, reflecting the market's perception of the value of combined resources, aligning with the RBVs emphasis on the importance of firm-specific resources in creating value. C Jay Barney introduced the VRIO (Valuable, Rare, Costly to Imitate and Organised to Capture Value) framework of which has the purpose of identifying and achieving competitive advantages. We can use Apple as an example who leverages its unique resources and capabilities to achieve a sustained competitive advantage in the tech industry. *Follow VRIO framework in answer for Apple i.e., valuable is customers highly value Apple's products, leading to strong sales* **Complementors --** the UK utility sector in 1990s -- offering discount packages for both services together can attract customers and offer more attractive deals **Leveraging R&C --** Proctor & Gamble / Clairol -- P&G leveraged its own brand management expertise to Clairol and lift sales to \$1bn, globalising the brand (especially in developing countries). Sales were increased through P&Gs distribution channels internationally and exploited technology for example trying new hair colours in store **2.6. Agency theory** A The agency problem is described by Jensen and Meckling (1976) as a conflict of interest between principals (owners or shareholders) and agents (managers) due to the separation of ownership and control within a firm. Agents may pursue their own interests which may not align with the interests of the principal, such as short-term profit maximisation, which could destroy firm value. **Minimise agency costs --** detailed contracts and close monitoring. Ideally, the cost of monitoring will equal the agency cost (optimal point). **Why should managers accept to be monitored? --** When agency costs are high, shareholders may refuse to finance company activities and so the share price decreases and the firm becomes a potential target of hostile deals. Therefore, managers are likely to accept external monitoring (audits) to reassure shareholders and maintain market value. Furthermore, monitoring can help align interests of the principal and agent. **Agency cost of debt --** creditors face challenges when lending to a firm and have less control over managers compared to shareholders, which can lead to managers taking actions that increase risk for creditors. To mitigate this, creditors use covenants which are conditions that firms must follow to protect their interests. In bankruptcy, bondholders have the first claim to the firm's assets, ensuring their interests are prioritised before shareholders. **Equity holders and det holders --** their interests may align to some extent but equity holders can use mechanisms like appointing Board of Directors to monitor and control the actions of executive managers. This helps to ensure the company's management acts in the best interest of both parties, reducing potential conflicts and agency costs. **Tobins Q --** a ratio which compares the market value of a company's assets to theor replacement cost. MV / replacement cost of asset. If the ratio is greater than 1 then the market values the company higher than the cost of replacing its assets, indicating potential growth. If it is less than 1, this implies undervaluation. B One study by Kamp et al (2015) used Tobin's Q to find that companies with higher agency costs are more likely to be targets of disciplinary takeovers, supporting the idea that agency problems can lead to M&A activity. Furthermore, Khan et al (2020), find that high-quality corporate governance and concentrated ownership can positively impact the agency-performance relationship. C **Disney / Pixar --** due to the potential conflict of interest that Disney's executives would pursue personal gains (rather than shareholder value), Disney implemented monitoring mechanisms and performance-based incentives, including specific targets for the integration of Pixar's technology and talent, tying executive compensation to the successful realisation of targets / synergies. The outcome was that this resulted in a significant increase in Disney's market value and a series of successful animated firms. A great example of how corporate governance mechanisms can mitigate agency problems and lead to successful outcomes. **Session 3** **3.1. Sources of gains of horizontal, vertical and conglomerate (2 for each)** A **Horizontal** 1. Can lead to economies of scale, reducing costs and increasing efficiency 2. By merging with competitors, firms gain greater market share and pricing power **Vertical** 1. Reduce transaction costs and improve coordination between different stages of production 2. Provides firms with greater control over supply chains and distribution channels **Conglomerate** 1. Conglomerate mergers allow firms to diversify their product offerings and reduce risk 2. Firms can achieve synergies by combining different business units and leveraging shared resources B **Horizontal** 1. Studies have shown that horizontal mergers often result in improved productive efficiency and increased pricing power 2. However, the performance of horizontal mergers can be negatively impacted by increased market concentration and reduced competition **Vertical** 1. Can lead to efficiency gains and increased market power, especially when dominant firms integrate 2. Effects of vertical mergers on competition and consumer welfare are mixed, with some studies suggesting potential anticompetitive effects **Conglomerate** 1. Studies show mixed results with some indicating positive synergies and diversification benefits, while others suggest limited value creation 2. The success of conglomerate mergers depends on the ability to effectively manage and integrate diverse business units C **Horizontal --** BT / EE -- BT bought all EE shares, Vodafone called for Competition Authorities tp block but they allowed it to go through. After deal complete, still 4 main players; Vodafone, BT-EE, O2 and Three. Market reaction saw BT shares rise and Vodafones (competitor) fall. **Vertical --** Alibaba vertical integration allows for greater efficiency and coordination across different stages of the e-commerce process. Apple also controls both the hardware and software production, as well as distribution through its retail stores. **Conglomerate -** Amazon acquired Whole Foods Market, allowing Amazon to cross-promote Whole Foods' products on its online platform, increasing sales and expanding the reach of Whole Foods' offerings to a larger customer base. It created a seamless shopping experience, significantly bolstered Amazon's entry into the grocery business and improved services like Amazon Fresh and Prime Now. **3.2. Network externality** A The value of a product to an individual customer depends on the number of other users of the product, for example the internet or email Value creation is achieved through economies of learning that can improve the size of the network Acquisitions of a target with network externality potential ca be a source of potential revenue growth B In a study which examines horizontal mergers in markets with network externalities, it found that this merger could reduce competition in the industry because it increases the network sizes for the companies involved and makes their products more unique compared to those of competitors. As a result, this merger might benefit all companies, improve consumer satisfaction and enhance overall social welfare while making it a win-win situation for everyone involved. C Use Allfunds as an example and how acquiring a platform like Allfunds, or the acquisitions Allfunds has made, enhances the network effect. **3.3. Collusion and efficient hypothesis in driving gains** A **Collusion hypothesis --** Firms in concentrated industries collude, either explicitly or tacitly, to limit competition and keep prices high, leading to higher profits **Efficient hypothesis** -- Firms in concentrated industries are more efficient, meaning they have lower costs and can offer better products or services, leading to higher profits B **Collusion --** Levenstein (2015), finds that cartels engage in various behaviours to increase profits such as setting minimum prices or coordinating price increases. Effective antitrust policies are crucial in breaking up such cartels. Research also shows that industries with fewer firms are more likely to engage in collective lobbying efforts, which can be a form of tactic collusion. **Efficiency -** Studies are mixed with some supporting the hypothesis. Efficiency gains, such as cost savings and improved operational performance are significant factors contributing to successful M&A outcomes C **Collusion --** Cartels can increase prices by an average of 20-30% above competitive levels Firms in highly concentrated industries have profit margins that are 10-15% higher than those in less concentrated industries **Efficiency --** Firms in concentrated industries can achieve cost savings of up to 20% due to economies of scale and that larger firms are 10-15% more productive than smaller firms in the same industry. **3.4. Adverse selection and moral hazard through contracts** A **Benefits of contracts** - Incentive for supplier to deliver quality products / services - Avoid under-investment - Enhances relationship and understanding of the supplier and buyer **Costs of contracts** - Complete contracts which specifically and accurately detail the process of monitoring, performance measures, enforcement mechanisms etc are unrealistic - Incomplete contracts cause uncertainty and inability about future circumstances - Asymmetric information between two parties **Asymmetric information, adverse selection and moral hazard** Adverse selection occurs when one party has superior information and takes advantage of it Moral hazard occurs when there is an inability to measure performance and identify the factors that cause failure in performance Information may be exploited opportunistically by the party which has superior information B Sung (2005) finds that optimal controls are constant over time, leading to contracts that are straightforward and predictable in the final outcome. He finds that how sensitive the contracts are to changes (like profits going up or down) depends on the costs of managing the company and how the company makes things. It's like saying the tougher it is to manage or produce, the more the contract needs to be adjusted to account for this. Furthermore Sung (2023) finds that when there's a mix of tricky hiring (adverse selection) and the risk of employees not working hard enough unless monitored (moral hazard), workers with average talent get less bonus pay. This is because it\'s harder to measure and reward their actual performance. He also finds agents are more motivated to take on riskier projects under the combined presence of adverse selection and moral hazard. This might be because they believe taking risks could lead to higher rewards or because the system encourages them to go for riskier options to stand out. **3.5. Diversification and innovation trade-off in conglomerate deals** A Diversification is measured in terms of the number of industries in which a firm is operating and SIC codes are a typical way of classifying diversified firms (first two digits of bidder's SIC code are different from first two digits of the target's SIC code) *Why do firms diversify?* **Economic perspective --** increased market power and operating efficient internal capital market **Strategic perspective --** Enhance competitive advantage by exploiting R&C (increased risks in conglomerates because lower degree of familiarity between products) **Finance perspective --** Spread out risk and stabilise earnings by combining businesses under one roof. While it is more expensive to form conglomerates, it provides a more stable income stream and reduces bankruptcy risk **Managerial perspective --** Managerial compensation can be related to firm size (empire building hypothesis) and also to develop their own skills within the firm **The trade-off** - In a diversified firm, resources might be spread too thin, reducing the ability to invest heavily in innovative projects - The complexity of managing multiple business units can divert attention away from innovation efforts - Different business units might have varying cultures and priorities, making it challenging to maintain a consistent focus on innocation B Servaes (1991) find that international differences in corporate governance affect the impact of diversification on shareholder wealth Rajan, Servaes and Zingales (2000) find that diversified firms tend to allocate funds inefficiently, often directing resources towards the most inefficient dividions with the extent of misallocations positively related to the diversity of investment opportunities across divisions. **The trade-off** One study found that firms with moderate levels of diversification had the highest firm value, while those with very high or very low levels of diversification had lower firm values. This suggests there is an optimal level of diversification that maximises firm value, beyond which the costs of managing a diversified portfolio outweigh the benefits Another study found that diversified firms often trade at a discount compared to focused firms, with the discount estimated to be around 10-15% on average **Session 4** **4.1. Event study** A A statistical method used to assess the impact of a specific event on the value of a firm, typically measured through stock price. If markets are informationally efficient, they can capture all future benefits, and costs, of a merger (or any type of investment) and factor them into stock prices at the time of the M&A announcement, the effective announcement date or the withdrawn date. 1. **Defining the event window -** the days around the M&A announcement, for example -10, +10 days relative to the announcement date 2. **Selecting the estimation window -** precedes the event window and is used to estimate the normal stock return. It might be, for example, from -120 to -11 days relative to the announcement date 3. **Calculating expected returns -** using the data from the estimation window, we estimate the expected return using a model like the Market Model 4. **Measuring abnormal returns -** the difference between the actual returns and expected returns. This represents the impact of the M&A announcement on the stock price 5. **Testing statistical significance --** the abnormal returns are aggregated over the event window to compute cumulative abnormal returns (CARs). Statistical tests (such as t-tests) are used to determine whether these CARs are significantly different from zero, indicating whether the M&A event had a meaningful impact on the stock price B **CARs -** Renneboog and Vansteenkiste (2019) -- the sum of abnormal returns over a long event window starting at, prior to, or after the event. Doesn't allow for compounding. **BHARS -** Renneboog and Vansteenkiste (2019) -- (buy-and-hold abnormal returns) differs from CARs because it aggregates the abnormal returns geometrically rather than arithmetically over the vent perios and allows for compounding which CARs does not **Dealing with cross-correlated abnormal returns and overstated t-tests -** Since majority of M&A activity occurs in clusters and by industry (i.e., not random), this can lead to the above problem. To solve this, you can use calendar time-based approaches such as CTARs (calendar time abnormal returns) or CTPRs (calendar time portfolio regression returns), which aggregate benchmark firms matching portfolios, whose variance corrects for cross-sectional correlation in a firm's abnormal returns. C *Compounding example - If you have abnormal returns of +2% on Day 1 and +3% on Day 2, the CARs method would simply sum these to get a total of +5%. However, if returns were compounded, the calculation would be different, as the +2% return on Day 1 would generate additional returns on Day 2.* *In the context of mergers and acquisitions (M&A), **abnormal returns** refer to the difference between the actual returns on a company\'s stock and the expected returns during the period surrounding an M&A announcement.* **4.2. Factor models** A Used in M&A to evaluate the impact of various factors on the value of a firm or the success of a merger or acquisition **Linear factor models --** linear regression to estimate the relationship between the dependent and independent variable i.e., firm value and financial ratios **Macroeconomic factor models --** incorporate macroeconomic variables such as GDP growth, interest rates or inflation **Fundamental factor models --** use fundamental financial metrics like earnings, book value, and cash flow **4.3. Capturing short and long run performance** A **Short-term performance** - Event studies - Market reaction - Operational metrics -- change in revenue, profit margins and market share shortly after M&A - Integration milestones -- assessing completion of key integration milestones like merging IT systems, aligning corporate culture and consolidating operations **Long-term performance** - Financial performance - Strategic goals - Cost synergies - Innovation and growth -- development of new products and services, patent filings and R&D expenditures - Cultural integration -- employee morale, retention and productivity - Price stickiness -- was there a delayed stock market reaction? - Windows are usually 1-5 years after completion date - Analyst coverage B Many studies find that acquiring firms tend to underperform compared to non-acquiring firms in the long-run. Agrawal et al (1992) found that acquirer shareholders suffer substantial losses of about 10% over a 5-year post-merger period. Barber and Lyon (1996) find there is a reduced reliability of long-term results **4.4. Factors which determine success and failure (Renneboog and Vansteenkiste paper)** *Separate study on this paper* *\ * **Session 5** **5.1. Acquisition process** A Strategic analysis helps evaluate the choice of M&As in achieving strategic goals by selecting an appropriate target firm **SSSFNAI** 1. Strategic objective 2. Search and screening 3. Strategic evaluation 4. Financial evaluation 5. Negotiation 6. Agreement 7. Integration **Organisational perspective --** communication issues can occur, egos, managerial hubris, internal power plays. Each group focuses on its speciality and senior management takes decision. External advisors can be involved and push for deal to be completed. **Managerial perspective -** There is pressure on managers to not fail and good prospects if it is successful. Managers often like high-profile corporate events. It is not unknown for two high-profile CEOs to get together over dinner and agree a merger, then leave it for vice-presidents to rationalize it in terms of value creation (managerial overconfidence). **Psychological perspective --** managers maximise shareholder value by taking risks and returns into consideration. However, remember agency problem where conflicts of interest can arise. \^ this section should relate to hubris, overconfidence, overoptimism Halo effect if you are successful in one task, you believe you will be successful in another task **5.2. Public vs private acquisitions** B **Public target firms** - Jensen and Ruback (1983) find that there are small positive gains for the overall sample but also highly negative in subperiods - Bradley et al (1988) find negative abnormal returns and only positive during unregulated period **Private target firms** - Hansen and Lott (1996) find that acquisitions of private target firms generate higher abnormal returns than those of public firms. They discuss auction theory which is when private firm have the difficulty of choosing the best offer - Chang (1998) find positive abnormal returns for private acquisitions and even more positive when stock is offered as a method of payment **Overall** - Capron and Shen (2007) find acquirers tend to favour private targets in familiar industries and public targets to enter new business domains. Acquisitions of private targets elicit more positive stock market reactions compared to public targets and acquirers of private firms perform better than if they had acquired public firms, and vice versa **Integration** - Fan and Goyal (2006) find that vertical mergers result in significantly higher combined announcement returns relative to diversifying deals, supporting the theory that firms with a higher degree of relatedness can enjoy a smoother integration process as they have a better sense of familiarity about the industry and business operations - Technology relatedness, human capital relatedness and product market relatedness all increase long-run operating performance and sales **5.3. Managerial hypothesis vs liquidity hypothesis** B Draper and Paudyal (2006) summarise the different hypotheses **Managerial --** suggests that managers may use corporate resources to entrench themselves and pursue personal benefits rather than maximizing shareholder value. so they are more likely to acquire public firms, pay a high premium and destroy value. \- Acquisitions for private firms are smaller and less well-known. The synergy is more likely to be the motivation to create value as smaller firms can more easily be integrated by the firm **Liquidity -** suggests that firms with excess cash may engage in acquisitions to utilise this cash, as holding large amounts of cash can be inefficient, even if the acquisitions do not necessarily create value for shareholders. Farinha (2003) finds evidence to support the managerial hypothesis, showing that firms with higher dividend payouts tend to have more entrenched managers. The results suggest that higher dividend payouts can reduce agency costs by limiting the free cash flow available to managers, thereby potentially increasing firm value. **5.4. Psychology perspectives (Rationality, agency theory, hubris, overconfidence, self-attribution bias, celebrity bias, halo effect, imitation)** *The success and failure of M&A separate analysis* **5.5. The role of compensation (link to corporate governance)** A **Compensation contracts:** - Cash salary, cash bonus, stock, stock options - Benchmarks, vesting periods, risk-incentives **Relation to M&A** - CEOs are paid bonuses to complete M&A - Acquisitions increase firm value which can increase compensation **Target board** - They may be concerned about their job after the deal (i.e., they may be fired). By offering monetary or non-monetary compensation in the new entity, this can offer an incentive to complete the deal Agency theory suggests that management compensation contracts should reduce opportunism by linking their interests with that of shareholders. One way to achieve this is to link management compensation to equity-based compensation, however this should include stock-options that vest over a long period of time as those that vest over a short period can incentivise decisions that create short-term profit maximisation which destroys long-term performance. Excessively high levels of CEO compensation can blur managerial corporate investment judgement and may constitute an agency problem or be indicative of weak governance in general. An alternative to equity-based compensation is debt-based compensation structures such as pension benefits or deferred compensation packages. B Studies show a positive correlation between acquisition and increase in compensation CEOs may even be motivated to entertain value-destroying deals if there is a personal gain to be had such as prestige, reputation and media attention. Some studies actually suggest that even non-confident CEOs can be persuaded to engage in such value-destroying activity Datta et al (2001) finds that firms in the US which have a higher level of equity-based compensation is associated with short- and long-run returns and that firms with low-equity based compensation underperform matched control firms by 23%. This is because their executives are less incentivised to increase firm value. Some studies argue that performance-based pay may not discourage managers to undertake value-destroying deals if part of the performance criteria includes pursuing acquisitions and there is some evidence that shows CEO compensation increases after a deal regardless of the outcome. Phan (2014) confirms that higher inside debt holdings by CEOs result in less risky M&A deals evidenced by higher bond returns at the M&A announcement and better long-run operatig performance. **5.6. Selecting targets** **5.6.1. Markup pricing for targets** **5.6.2. Due diligence and the role of the DD process** A *Selecting targets* **Strategic fit --** does it align with company objectives such as entering new markets or acquiring new technologies **Financial health --** what is the target's financial performance (revenue, EBITDA, profitability) **Market position --** market share, competitive position and growth potential **Cultural fit --** corporate culture to ensure smooth integration with minimal disruptions **Regulatory and legal issues --** evaluate potential regulatory hurdles and legal risks associated with the acquisition **Management team --** quality and experience of the target's management team can influence the success of the integration process **Target firm characteristics** - Capable management which are willing to bet personal wealth on success - String market position within the industry - A liquid balance sheet with undervalued assets **Typical target industries for PE firms** - Basic, non-regulated industry with stable earnings, predictable cash flows and low financing requirements - High tech industry is less appropriate as there is more risk associated, no track record, fewer assets and high P/E ratios *Markup pricing* **Substitution hypothesis --** valuation of target depends on the information each party possesses. As long as they think they possess more information than the market, both parties will ignore stock price movements that occur prior to and during negotiation in setting the final deal price. In this case, the final agreed upon price will be lower because they are substituting their inside knowledge for the market's valuation **Mark-up pricing hypothesis --** if both parties are uncertain about the targets rue value, they may consider that the target share price movements in the pre-bid period may reflect valuable private information held by other market participants (like traders). Due to this, both parties revise their estimates of the target's value and as a result the final price (or premium) that the bidder is willing to pay increases. *Due diligence* A critical process that involves thorough examination and analysis of target company's business to confirm assumptions and uncover any hidden issues or liabilities early on. It induces: - Informed decision making - Transparency and trust (vital for the integration / post-transaction phase) - Assessment of organisational cultures Each business unit will typically conduct due diligence for their area. They will have access to a VDR where the diligence will be securely coordinated. **Commercial --** products, customer journeys, competitive position **Operational --** production technology, systems **Financial --** historical information, management systems **Tax --** Current and potential tax liabilities, availability of tax losses **Organisational / cultural --** Mission, values, management style **HR --** Compensation, incentives, pensions, human resources to target, morale, labour contracts, TUPE **Legal --** contractual agreements, liabilities (product and environmental) B Victanis (2019) finds that processes which involve proactive and systemic searches improve the chances of finding suitable targets **Markup hypothesis --** W. Schwert (1996) finds that the pre-bid stock price increases (run-up) contributes to the final deal price (mark-up). The pre-merger stock price increase is not linked to the further increase in the target\'s share price after the announcement. This means the run-up and the post-announcement mark-up are independent of each other. The pre-bid stock price increases (run-up) contribute to the final deal price (mark-up). **Due diligence --** empirical findings suggest that comprehensive due diligence can significantly impact the success of M&A deal by identifying potential risks and ensuring that the acquiring company makes an informed decision. It also helps in aligning strategic goals and maximising synergies between both parties **Session 6 & 7** **6.1. Intrinsic value** A The time value of money suggests that a pound today is worth more than one pound in one year (PV of future expectations) NPV = -initial investment + future cash flows The intrinsic value on the other hand is not always equal to market value - It refers to the inherent worth of an asset, independent of its market price - A fundamental analysis concept used to determine the rue value of an asset (or in this case a deal) based on underlying characteristics - It is unobservable, not easy to calculate and there are different ways to estimate Essentially value is created. Buyers POV is intrinsic value \> payment and Sellers POV is intrinsic value \< payment Value of combined firm is value of bidder + value of target -- payment Three key elements to measuring intrinsic value 1. Fundamentals 2. DCF 3. Comparable **Additional notes** *Enterprise value =* value of debt + value of equity or equity value + total debt -- cash and cash equivalents *Equity value =* enterprise value -- net debt *Value of equity =* value of residual claim on firm's assets (value of firm's common stock) B Research suggests that market prices often deviate from intrinsic value due to factors like investor sentiment, market speculation and information asymmetry **6.2. Asset base valuations and liquidation counterparts** A **Accounting book value** - Determines the value of a company's assets (as recorded on balance sheet) minus any liabilities - It includes items such as common stock, preferred stock, retained earnings, and additional paid-in capital - It is a conservative method, underestimating market value because it doesn't account for future growth or intangible assets - Based on GAAP (generally accepted accounting principles) - Based on historical cost of assets i.e., backward-looking **Liquidation value** - Conservative, often used on worst-case scenarios - Liquidation value represents the total amount that could be obtained if the firm's assets were liquidated today - Usually smaller than book value because book value assumes the firm will operate indefinitely and maintain its asset values over time - It doesn't account for potential future opportunities or intangible assets such as brand value or goodwill - Useful for firms in distress as it provides a realistic estimate of what could be recovered by selling off assets **Replacement cost value** - This represents the cost of replacing the assets of a firm today - It is useful in high inflation environments - It reflets current conditions (not past) - However it is not always clear what is to replace, the cost is subjective and it is difficult to replace intangible assets - Tobins Q is related because this is Market Value / Replacement cost **Market value** - If markets are efficient, the market value should reflect what is known about the firm and all future opportunities - It is useful for listed firms but not private firms - The price offered to a target firm is rarely below the current trading share price of the target firm - MV = MV(debt) -- MV(equity) - MV (debt) = PV of debt cash flows - MY(equity) = price \* no of shares B **Kevin Kaiser, Professor at Wharton Business School, podcast discussion:** He argues that a good valuation looks at the amount of happiness, which has a form of discounted cash flows going forward relative to the opportunity cost of capital, which is the effort you need to make to get those cash flows **6.3. Discounted cash flow method** A The DCF determines the firm's value by computing the present value of cash flows over the lifetime of the firm. This is done in two parts: 1. The forecasted period (extrapolation) -- precise forecasts must be developed (often up to 5-10 years). The projection period should match the length of time that the company is expected to maintain its competitive advantage. 2. The terminal value (TV) -- estimated in the last year of the forecasted period and capitalises the present value of all CFs beyond that point **Terminal value and firm value** 1. TV is calculated with CFs which are projected with the assumption that there will be no exceptional growth after a certain forecast period. Essentially the company is expected to grow at a stable rate indefinitely, and the return on investment equals the required return 2. Once CFs are developed, the WACC is used to discount the CFs and determine their PV 3. The sum of PV of CFs and TV provide an estimate of firm value TV = FCF\*(1+g) / (r -- g) G = growth rate of FCF R = Discount rate **Growth rate** *G can be calculated in 2 ways:* 1. ROE and DPO (Dividend Payout Ratio) -- g = ROE \* (1-DPO) 2. Real growth rate The growth rate cannot be higher than the cost of capital **Discount rate** This should reflect the weighted average of investors' opportunity cost (WACC) con comparable investments It matched the business risk, expected inflation, and currency of the cash flows to be discounted WACC = W~D~ K~D~ (1-t) + W~e~ K~e~ K~d~ = yield to maturity K~e~ = cost of equity (calculated via CAPM model - K~e\ =~ R~f~ + B(R~m~ = R~f~) W~D~ W~e~ = target % of debt and equity (using mv of debt and equity) T = marginal tax rate **Firm vs equity** Can value either the firm, or the equity alone, depending on what CFs we use **Firm =** Cash flows (enterprise) which are CFs to all capital providers (debt and equity) and WACC can be used as the discount factor **Equity =** Residual CFs (equity) which is CFs only to shareholders (EAIBIT) and use expected rate of return as discount factor **Free Cash Flows** Represent the cash generated by the company's operations after accounting for capital expenditures (CapEx). The DCF model values a company by estimating the PV of its future free cash flows - FCF = Net Operating Profits after Taxes (NOPAT) + Depreciation + Noncash charges -- capital investment -- investment in working capital (WC) - The tax deductibility of interest payments is accounted for in WACC so these financing affects are excluded from the free cash flow **Value creation** This happens when RONA (Return on Net Assets) \> WACC - Essentially the company is generating more returns from its assets than what is costs to finance those assets **Increasing earnings power --** improving the profit margin (NOPAT/sales) means the company is making more profit for every dollar of sales **Improving asset efficiency --** increasing the efficiency of asset use (Sales/Net Assets) means the company is generating more sales from its assets Essentially, value creation occurs when the company improves its profit margins and uses its assets more efficiently than the cost of financing those assets (WACC). **Advantages (why is it the most common method?)** - Not tied to historical or accounting data - A forward-looking method - Cash flows and not profit, therefore reflecting non-cash and investment inflows and outflows - Time value of money **Disadvantages** - Many complexities - Likely errors based on forecasts and potentially subjective **Modigliani and Miller proposition** MM consists of 2 propositions M1 = capital structure irrelevance - Without taxes, the MV of a company is independent of its capital structure so regard;ess of whether the company is financed by debt or equity, the value is the same - With taxes, debt financing adds value to the company due to tax shields on interest payments so the value of the company increases with the amount of debt M2 = cost of equity and financial leverage - Without taxes, the cost of equity increases with the company's leverage because debt increases financial risk and equity investors demand higher returns to compensate for increased risk - With taxes, the relationship still holds but the tax advantage of debt makes the overall cost of capital lower than in the no-tax scenario According to the MM proposal, in perfect markets without taxes, the value obtained through DCF should be the same regardless of the company's capital structure. This is because the firm's value is determined by its ability to generate cash flows, not by how it is financed. **How can DCF be adapted in various settings** **Startups and high-growth companies --** often have unpredictable cash flows and high growth rates. We can use multiple scenarios to project different growth paths and apply a higher discount rate for increased risk **Cyclical industries --** cash flows fluctuate with economic cycles so use historical data to forecast cyclical patterns and apply discount rate that reflects the industry's volatility **Leveraged buyout --** involve a significant amount of debt financing, affecting cash flow availability for debt repayment. Incorporate debt schedules and project cash flows to include interest and principal repayments. Also use a higher discount rate to reflect leveraged risk. B One study discusses the application of sensitivity analysis in company valuation and finds that the most influential variable in DCF valuation is the WACC, followed by future free cash flow and the growth rate in future free cash flow Another study finds that the DCF method is very vulnerable to changes in underlying assumptions with only marginal changes to the perpetual growth rate leading to huge variances in the terminal value. It should be used in combination with comparable or precedent transaction (M&A values) analysis to give a range of appropriate values for the company. **Reflecting synergies** Valuation models such as DCF or precedent transaction can be adjusted to capture estimated synergies. One study found however that buyers are often unwilling to pay more than 50% for the discounted value of the synergies due to uncertainty. NPV is typically used to value synergies because if it is positive, it indicates that the deal Is expected to add value. Sensitivity analysis is also used to help assess the robustness of the analysis under different scenarios. Loukianova et al (2017) proposes a model for assessing cumulative synergies using the real options approach which integrates various types of synergies and uses simulation modelling to evaluate their cumulative effect. **6.5. The role of multiples in M&A transactions** A Multiples are financial metrics used to value a company by comparing it to similar companies that have been recently acquired or merged. For example the EV multiple is used to compare the total value of a company with another financial metric. **EV / EBITDA multiple --** used to compare companies with different capital structures **EV / Sales multiple** -- compares the company's total value to its sales revenue **P/E --** compares the company's market value to its earnings **P/B --** compares the company's total value to its sales revenue **Forward multiples** are based on the following twelve months **Trailing multiples** are based on past twelve months **Risks** 1. Multiples are only used appropriately when comparing two assets that are similar in nature 2. Multiples are easy to use when they are stable across similar assets 3. Multiples may vary over time **How are they estimated?** - From the price of other companies with characteristics comparable to the company being valued - Peer companies are usually companies in the same industry - Comparable companies need to have similar expected growth and risk - Usually firms in the same industry **P/E multiple** This expresses the relationship between a company's stock relative to its earnings i.e., share price / earnings per share A high PE ratio suggests investors expect higher earnings growth in the future relative to firms with lower PE ratios Investors generally employ actual and expected PE ratios to compare current share price to earnings of most recent reporting with current share price to expected earnings Adjustments can be made to targets reported profit to bring it in line with the acquirer's policies. For example, extraordinary items, non-recurring items and owner's compensation **6.6. Valuing CB deals (exchange rate risk, inflation, political and regulation risk)** A Cross border M&A is targeting a firm in another country. Valuation can be challenging and many of the assumptions of domestic valuation are affected. The tools and concepts are the same, but you have to consider factors such as inflation, currency exchange rate, taxes law, culture etc **Inflation --** employ local countries inflation rates and use same inflation assumptions throughout the valuation process **Foreign currency exchange rates --** factors like PPP (purchasing power parity) and IRP (interest rate parity) helps assess these impacts. **PPP** suggests over the long term, exchange rates should adjust so that identical goods cost the same in different countries when priced in a common currency. This ensures that valuations reflect true purchasing power, ensuring that you aren\'t overpaying or underestimating the value of the target company\'s assets and operations in different currencies. **IRP** indicates that the difference in interest rates between two countries will be equal to the differential between the forward exchange rate and the spot exchange rate. Aids in forecasting future exchange rates based on current interest rate differentials, which is crucial for accurately valuing future cash flows from the target company. Also helps mitigate exchange rate risk. These considerations help to ensure that the deal's valuation remains accurate and fair and also address cross-border **heterogeneities** **Tax rates --** corporate tax rates affect forecasted cash flows and the discount rate Should choose a tax rate appropriate to the country in which the cash flows are generated **Accounting principles** -- difference in accounting principals are important but not meaningful and cash flows are cash flows in all countries. However, the process of deriving cash flows may differ and require familiarity in foreign accounting principals **Political risk --** degree of gov intervention in the market can affect the value of corporate assets **Other alternative models** **APV --** this separates the value of the project without debt from the created value by financing decisions, allowing for a more flexible adjustment for cross-border factors **Multifactor models --** consider multiple risk factors, such as currency risk and inflation risk **Real options approach --** valued the flexibility of making future investment decisions in response to changing conditions**\ ** **Session 8** **8.1. LBOs** A This is the purchase of a company by a small investor group using a high percentage of debt financing. An LBO is executed mainly by the firm's managers. Investors are outside financial group, managers or executives of company. It can result in a significant increase of equity share ownership by managers and turnaround in performance is usually associated with formation of an LBO. Typically, the financial buyer purchases the company using a high level of debt financing and then replaces top management. The new management the improves operations and the financial buyer makes a public offering of the improved firm. Usually the public firm will become private. In some cases the public firm may stay listed on stock exchange but this is less common. *Typical target industries* - Basic, non-regulated industry with stable earnings, predictable cash flows and low financing requirements - High tech industry is less appropriate as there is more risk associated, no track record, fewer assets and high P/E ratios - Half of LBOs occur in 5 industries; retail, textiles, food, apparel and soft drinks (Lehn, Poulsen, 1988) *Target firm characteristics* - Capable management which are willing to bet personal wealth on success - String market position within the industry - A liquid balance sheet with undervalued assets **Stage 1 -- planning and fundraising** Financing may look like 10% cash from investor group, 50-60% bank loans, and the rest from senior and junior subordinated debt. Management incentives include stock price-based incentives for example options **Stage 2 -- firm taken private** Stock-purchase (buy outstanding shares), or asset-purchase (buy assets and firm new privately help corporation) is conducted. New owners usually sell of parts of acquired firm to reduce debt. **Stage 3 -- attempt to increase cash flows** Cut operating costs and spending, and when possible, delay expenditures. They will try new marketing to increase revenues. **Stage 4 -- reverse LBOs increase liquidity** Investor group may take improved company public again through public equity offering (secondary initial public offering -- SIPO). **The role of private equity** A leveraged buyout is the acquisition of a public or private company with a significant amount of borrowed funds (debt). A private equity firm (or group of private equity firms) acquires a company using debt instruments as the majority of the purchase price. After the purchase of the company, the debt / equity ratio is generally greater than 1.0x (debt generally constitutes 50-80% of the purchase price). During the ownership of the company, the company's cash flow is used to service and pay down the outstanding debt The overall return realised by the investors in an LBO is determined by the exit cash flow of the company (EBIT or EBITDA), the exit multiple (of EBIT or EBITDA), and the amount of debt that has been paid off over the time horizon of the investment Companies of all sizes and industries can be targets of leveraged B Philippot (2024) - Agency theory have not been successful for both the purchased firms and the investors and benefits of LBOs aligning interests have been overestimated. Agency theory leads to a reductionist approach which can overlook the ethical and moral dimensions of business decisions, leading to actions that prioritise financial gains over broader ethical considerations - Recent results show that there have been disappointing returns to investors since mid-2000s - The study also identifies a series of ethical problems such as undervaluation and moral hazard. A **Example LBOs** **Energy future holdings (TXU)** led by KKR, TPG Capital and Goldman Sachs. Ended in bankruptcy. **Heinz --** acquired by Berkshire Hathaway and 3G Capital for \$28 billion. The deal included \$12 billion in debt (42% of purchase price). Investment bank helped navigate high interest rates and significant amount of debt. Warren Buffet was involved in the deal which added prestige and scrutiny. Typically, he criticises high leverage deals but he \[partnered with 3G capital in this case and this created stability and appealing profitability prospects in investors eyes. **8.2. LBO Valuation** A *First, consider valuing tax shield* Free cash flow is independent from leverage (amount borrowed) and is often referred to as un-levered free cash flow. Therefore the value derived from the interest tax shield (interest on debt is tax deductible) has still to be incorporated in the enterprise valuation. There are three approaches, each of which differ: WACC, APV and CCF WACC -- this values the tax shield by adjusting the cost of capital APV -- this valued the tax shield separately from the un-levered free cash flow CCF -- this valued the tax shield by incorporating it in the cash flow Discounting all future cash flows using a constant WACC assumes that the company manages its capital structure to a fixed debt to value ratio (D/V). Therefore the company's WACC is the right discount rate only if the company's debt ratio (D/V) is expected to remain reasonably close to constant. However, if the company is expected to significantly change its capital structure (i.e., constant level of debt, LBO, recapitalisation), then the WACC would have to be continuously adjusted, making the approach more difficult to apply. This is why it may be an unsuitable method for LBOs. The key issue is that the leverage ratio changes over time. Using the basic discounted cash flow method (DCF), we must recalculate WACC to reflect leverage changes. This is why CCF or APV are better choices because they better reflect changing leverage. **Capital cash flows (CCF)** FCF is the same as in the DCF method Interest tax shield = actual tax rate \* interest expense FCF + tax shield is referred to as capital cash flow [CCFs are discounted as the expected asset return rate] **Adjusted present value (APV)** FCF is the same as in the DCF method Interest tax shield = actual tax rate \* interest expense [FCF discounted at cost of equity of an unlevered firm] *APV = Unlevered NPV + Present Value of Tax Shield* **APV vs CCF** Both methods are equivalent if TS is discounted at the expected asset return rate, however CCFs assume that interest tax shields are subject to the same uncertainties as cash flows from assets. APV, on the other hand, treats the tax shields separately, which allows for potentially different discount rates for the firm\'s base value and the financing effects. **Using CCF** Using this approach, capital cash flows are discounted at the return on assets (ROA = net income / total assets). This implicitly assumes that interest tax shields are as risky as the firm's overall assets and are discounted at the return on assets. This is true when debt is a fixed proportion of the value. The CCF approach directly accounts for the company's entire cash flows, including the tax shields generated by interest payments. This gives a comprehensive view of the cash flows available to both debt and equity holders, which is crucial in an LBO scenario where debt plays a significant role. Instead of separately discounting the tax shield and operating cash flows as done in APV, the CCF approach discounts the combined cash flows at the weighted average cost of capital (WACC). This simplifies the valuation process and aligns the discount rate with the overall risk profile of the business. By combining operating cash flows with tax shields, it provides a realistic assessment of the firm's value under the leveraged structure, avoiding the need for separate calculations and assumptions about the discount rate for tax shields. Under this assumption, the capital cash flow approach will generate the same results as the WACC approach. If the forecasted debt levels imply a change in the debt-to-value ratio, the CCF retains its simplicity since the discount rate, the return on assets, is independent of the capital structure and can be used for every forecast period. Therefore this approach is easier to apply in transactions which involve change in capital structure such as an LBO or a restructuring. **Step 1 -- Purchase price assumption** Making assumptions on the purchase price, debt interest rate, etc **Step 2 -- create sources and uses** "Sources" lists how the transaction will be financed and "uses" lists the capital uses **Step 3 - Financial projections** Project out the three financial statements (usually 5 years) and determine how much debt is paid down each year **Step 4 -- balance sheet adjustments** Adjust the balance sheet for he new debt and equity **Step 5 -- Exit** Calculate the exit value based on EV/EBITDA multiple on year 5 EBITDA and then subtract net debt to get the company's exit equity value **Step 6 -- Calculate internal rate of return on initial investment** Using XIRR excel formula, enter the date of purchase and the equity amount invested in one column and the date of exit and equity value in second column with respective dates. B Perek (2012) found that, while both DCF and CCF are theoretically similar, they can generate different results in practice and therefore the choice of method significantly impacts valuation outcomes Here are some further findings: - Multiple bid auctions had premiums higher than 50% - High premium levels appear to compensate shareholders for added risk in LBO - More insider trading tends to happen before an MBO rather than LBO because insiders i.e., the management team, have access to non-public information that they may use to their advantage - Of 136 highly leveraged transactions from 1980-9, 31 had defaulted by 1996 and 8 others distressed (Kaplan, 1998) **8.3. Junk bonds and the role of debt** A Junk bonds are high-yield bonds rates below investment grade (below BBB, Baa3) They are used as a way to finance innovation by allowing high risk firms to obtain public financing. **Size of junk bond market:** Firms began issuing below investment grade bonds (almost 20% of new bonds by 1985) In 1986, Drexel Burnham Lambert had 45% share meaning they underwrote nearly half of all junk bonds issued during that time. They were a dominant player in the junk bond market at the time The tax reform act of 1986 is often cited as legislation which caused temporary setbacks because it significantly altered the tax code, reducing tax benefits associated with high-yield bonds. This led to a decrease in the demand for junk bonds because it increased the cost of capital for companies issuing junk bonds. In 1993, the junk bond market achieved record highs which coincided with economic recovery seen in early 1990s. The FED also maintained relatively low interest rates during this period, making borrowing cheaper and encouraging companies to issue junk bonds to finance their operations. **Linking LBOs and the role of debt** LBOs are typically financed with a significant amount of borrowed money -- junk bonds, which are high-yield, high-risk debt instruments, provide a substantial portion of this financing In an LBO, the debt is often structured in different layers including senior debt (lower interest rates, higher priority in repayment) and subordinated debt (higher interest rates, lower priority in repayment). Junk bonds usually fall into the subordinated debt category. B **Michael Milken** He was a main player in Drexel junk bonds (getting companies with lower credit ratings access to capital). He is a key figure in the development of the high-yield bond market (junk bonds). He worked at Drexel Burnham Lambert which was a company that helped companies with lower credit ratings gain access to capital that they might otherwise not have been able to obtain. Saul (1993) argues that Michael Milken acted wrongly by engaging in securities parking, violating the Williams Act. Securities parking involves temporarily transferring securities to another party to avoid regulatory requirements or to manipulate the market. The Williams Act is a federal law that was enacted in 1968 to protect investors from hostile takeovers. Milken's actions were seen as a way to bypass these regulations. Milken essentially guaranteed against high yield investment losses while markets absorbed new issues and he monopolised the high yield market, making it hard for other firms to compete. Some saw this as an unfair advantage and a way to absorb new issues into the market. Fischel (1995) offers an alternate view which was that Milken was simply a tough competitor and actions against him were part of a broader hysteria against "excesses of the 1980s", a time when financial markets were undergoing significant changes and there was a backlash against perceived corporate greed and financial manipulation. Hurduzeu (2015) conclude that junk bonds are a crucial source of financing for LBOs to ensure companies raise significant capital despite having below IG ratings. They also find that junk bonds allow LBO firms to transfer some of the financial risk to investors, as these bonds are senior only to equity. Furthermore Hurduzeu (2015) found that junk bonds enable larger and more frequent LBO transactions howeve the high leverage associated with them increases the risk of financial distress and defaults. **8.4. Debt financing mix** A **Senior debt** -- lower interest rates, higher priority in repayment **Subordinated debt** -- higher interest rates, lower priority in repayment **Mezzainine debt** -- a type of business loan than combines aspects of debt and equity financing. Higher risk form of debt than traditional loans but offers higher returns. **8.5. Direct and indirect risks of LBOs (financial, operational, market and economic risks)** A **Financial risks** - High debt levels and susceptibility to interest rate fluctuations - Substantial debt is used for acquisition financing. If the company fails to meet performance expectations, this debt burden can become unsustainable **Operational risks** - Integration challenges and potential disruptions to business operations - Integrating new and existing team members, as well as business processes - Expected operational efficiencies may also not materialise **Market and economic risks** - Economic downturns and industry-specific shocks - Unexpected shocks, such as those experienced by the airline industry post 9/11, or the real estate market following 2008 financial crisis, can severely impact LBO performance - Staying informed about market trends and economic forecasts can mitigate some risks. **Financial constraints** Direct costs: legal expenses, accounting costs, administrative costs - The percentage of these costs relative to the firm's value varies depending on the size of the firm. Represents 2-5% of firm value for large firms, 20-25% of firm value of medium sized firms Indirect costs: loss of custom / suppliers, management time / effort (loss in productivity), employee retention, agency costs and loss of asset value - Agency costs arise when there is a conflict of interest between managers and shareholders. In financially troubled firms, managers might prioritise their own interests over those of shareholders, leading to suboptimal decision making **Over-gearing** A company takes on too much debt relative to its equity, leading to an excessively high debt-to-equity ratio. If the company performs well, the high leverage can significantly lead to substantial losses but if the company underperforms, the high debt levels can lead to major losses or even bankruptcy **8.6. The role of financial advisors** A - Valuation and due diligence - Deal structuring - Financing - Regulatory compliance - Risk management - Post-acquisition strategy B *(Ritter & Welch, 2002), At the last / reversal stage:* Investment bankers don\'t want to price the IPO too high and run the risk of the stock performing poorly in the secondary market, which would be a bit of a reputation blemish - or worse, have the issue fail to entirely sell out and be stuck with unsold shares in their inventory. However, they don\'t want to price it too low and cost their client working capital they could otherwise have raised for them at a higher price. **8.7. Mitigating strategies** A **Financial risk management** Shrewd debt structuring and hedging can help mitigate financial risks associated with LBOs - Properly structuring debt by balancing debt levels with cash flow projections and revenue forecasts. Hedging against interest rate fluctuations can provide stability. Fixed-rate debt instruments or interest rate swaps can help safeguard against the impact of variable interest rates. **Operational risk management** Keeping tabs on operational risks is all about strategic management planning Detailed integration plans and clear communication channels. - The more business risks that you consider as threats early on (problems with suppliers, HR issues etc), the better prepared you will be to minimise the costs these will incur Foster a culture of adaptability and resilience within the organisation **Market and economic risk mitigation** Diversification strategies and scenario planning Business continuity plans Diversify investments across different industries and performing frequent scenario planning **8.8. Exit options** A **Sale** In a sale, another buyer acquires the entire company from the private equity firm. So, the private equity firm sells all of its ownership in the company to that buyer. This is oftentimes the most preferred exit strategy. SBO could be similar to a sale. **IPO/SIPO** Alternatively, the private equity firm can choose to take the company public and exit via an IPO. It'll still hold some equity ownership after the IPO, but since the company is now publicly traded, the PE firm can slowly sell down its shares in the stock market **Dividend recapitalisation** In a dividend recap, the company takes on more debt and uses the proceeds from the debt to pay dividends to the PE firms **\ ** **Session 9** **9.1. CB acquisitions** A A cross border acquisition is the purchase of a company or assets located in another country **Increasing trend / factors** 1992 -- creation of a single market in the EU enhanced the free movement of goods, services, capital, and people, making cross-border transactions easier and more attractive 1999 -- the introduction of the Euro simplified financial transactions across Eurozone countries, reducing exchange rate risk and facilitating cross-border trade and investments The inclusion of additional countries (particularly from Western Europe such as Poland and Hungary), expanded the market and created new opportunities **Globalisation** surged, converging consumer needs and preferences **Global competition** also heightened, pushing companies to expand operations internationally **Tech advancements** drove massive investments in R&D and enabled firms to operate more efficiently on a global scale. Also facilitated collaboration / communication across borders **Privatisation of state-owned enterprises**, such as power and gas, has opened up new markets for foreign investors More countries adopted a more welcoming stance towards foreign ownership, **reducing barriers** to cross-border investments **The European Directive on cross-border mergers** aims to harmonise rules for cross-border conversions, mergers, and divisions of limited liability companies within the European Economic Area (EEA). 1. The directive reduced legal fragmentation and uncertainty that previously existed 2. It allows companies to move their registered office across borders within the EEA more easily 3. It safeguards creditor and minority shareholder protection, ensuring that their rights are protected during cross-border reorganisations 4. It introduces simplified procedures for less complex mergers, making it easier for companies to undergo cross-border reorganisations **Foreign direct investments** This refers to investments made by a company / individual in one country into business interests located in another country One model to explain FDIs is Dunnings (2000) eclectic model. It consists of three stages / questions 1. Ownership decision: does the firm possess certain competitive advantages that can be exploited to create value through FDIs? - Asset exploiting -- deploy existing competitive advantages, such as tech or reputation, to enter foreign markets. The aim is to transfer the firm's home country competitive advantage to the host country. These firms leverage their competitive business advantages - Asset augmenting -- strengthen their resource and capabilities with those of the host country firms to gain a competitive advantage. These firms seek valuable resource 2. Location decision: is location in foreign country superior to that of home country? - Trade-off: pull (advantages of host country) and push (disadvantages in home country) - Pull factors -- size, demand of product, availability of complementary assets, scale economies - Push factors -- market maturity, intense competition, poor infrastructure, gov regulation, political and economic uncertainty 3. Internalisation decision: should the foreign production be carried out under the ownership and organisational control of the firm or through alternative modes - Make or buy decision: - Make -- produce internally, keeping control over processes and products - Buy -- outsource production / partner with other entities - Trade-offs: - Internalisation -- greater control and protect technology and maintain quality standards - External relationships -- local expertise, reduce costs and share risks **OLI framework (ownership -- location -- internalisation)** **O --** the firms unique assets or capabilities that give it a competitive edge over local firms in the host country **L --** specific attributes of the host country that make it an attractive destination **I --** benefits of maintaining control over foreign operations rather than licensing or outsourcing B **Cross-border M&A** - In 1986 to 2000, CB M&A had a share of 26%. By 2016 this grew to over 50% - R&V (2019) find that while CB M&A can create opportunities by enabling knowledge transfers and exposing the new firm to new practices and techniques, it can also increase social conflicts and induce post-merger coordination difficulties which curb the realisation of synergies - Datta and Puia (1995) find that cultural differences lead to a lack of knowledge about the foreign market and induces the bidder to overpay for the target - Conn et al (2005) finds that while CB deals earn less negative returns than domestic deals in the short run, returns become considerably more negative relative to domestic deals in the long-run stock returns based on BHARs or CTARs. - Long-run stock returns improve when the deal involved high-tech or R&D intensive acquirers, because they can benefit from learning opportunities and knowledge transfers - Additionally, some studies find that CB M&A can create additional synergies with spillovers in governance standards which can benefit both bidder and target shareholders and bondholders, particularly when the bidder's standards are stricter than the target's as this facilitates the bidder to shift the target's focus to shareholder value creation rather than private managerial benefits - From a political perspective, when legal systems are weak and corruption levels are high, politically connected bidders outperform unconnected peers by 20%. On the other hand, when corruption levels are low and there is a firm legal structure in place, connected bidders receive 15% lower long-run abnormal returns compared to unconnected bidders **FDI -- OLI Relationship

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