MERGERS AND ACQUISITIONS



Mergers And Acquisitions 241
Photo by: Valeriy Lebedev

A merger takes place when two companies decide to combine into a single entity. An acquisition involves one company essentially taking over another company. While the motivations may differ, the essential feature of both mergers and acquisitions involves one firm emerging where once there existed two firms. Another term frequently employed within discussions on this topic is takeover. Essentially, the difference rests in the attitude of the incumbent management of firms that are targeted. A so-called friendly takeover is often a euphemism for a merger. A hostile takeover refers to unwanted advances by outsiders. Thus, the reaction of management to the overtures from another firm tends to be the main influence on whether the resulting activities are labeled friendly or hostile.

MOTIVATIONS FOR MERGERS
AND ACQUISITIONS

There are a number of possible motivations that may result in a merger or acquisition. One of the most oft cited reasons is to achieve economies of scale. Economies of scale may be defined as a lowering of the average cost to produce one unit due to an increase in the total amount of production. The idea is that the larger firm resulting from the merger can produce more cheaply than the previously separate firms. Efficiency is the key to achieving economies of scale, through the sharing of resources and technology and the elimination of needless duplication and waste. Economies of scale sounds good as a rationale for merger, but there are many examples to show that combining separate entities into a single, more efficient operation is not easy to accomplish in practice.

A similar idea is economies of vertical integration. This involves acquiring firms through which the parent firm currently conducts normal business operations, such as suppliers and distributors. By combining different elements involved in the production and delivery of the product to the market, acquiring firms gain control over raw materials and distribution out-lets. This may result in centralized decisions and better communications and coordination among the various business units. It may also result in competitive advantages over rival firms that must negotiate with and rely on outside firms for inputs and sales of the product.

A related idea to economies of vertical integration is a merger or acquisition to achieve greater market presence or market share. The combined, larger entity may have competitive advantages such as the ability to buy bulk quantities at discounts, the ability to store and inventory needed production inputs, and the ability to achieve mass distribution through sheer negotiating power. Greater market share also may result in advantageous pricing, since larger firms are able to compete effectively through volume sales with thinner profit margins. This type of merger or acquisition often results in the combining of complementary resources, such as a firm that is very good at distribution and marketing merging with a very efficient producer. The shared talents of the combined firm may mean competitive advantages versus other, smaller competition.

The ideas above refer to reasons for mergers or acquisitions among firms in similar industries. There are several additional motivations for firms that may not necessarily be in similar lines of business. One of the often-cited motivations for acquisitions involves excess cash balances. Suppose a firm is in a mature industry, and has little opportunities for future investment beyond the existing business lines. If profitable, the firm may acquire large cash balances as managers seek to find outlets for new investment opportunities. One obvious outlet to acquire other firms. The ostensible reason for using excess cash to acquire firms in different product markets is diversification of business risk. Management may claim that by acquiring firms in unrelated businesses the total risk associated with the firm's operations declines. However, it is not always clear for whom the primary benefits of such activities accrue. A shareholder in a publicly traded firm who wishes to diversify business risk can always do so by investing in other companies shares. The investor does not have to rely on incumbent management to achieve the diversification goal. On the other hand, a less risky business strategy is likely to result in less uncertainty in future business performance, and stability makes management look good. The agency problem resulting from incongruent incentives on the part of management and shareholders is always an issue in public corporations. But, regardless of the motivation, excess cash is a primary motivation for corporate acquisition activity.

To reverse the perspective, an excess of cash is also one of the main reasons why firms become the targets of takeover attempts. Large cash balances make for attractive potential assets; indeed, it is often implied that a firm which very large amount of cash is not being efficiently managed. Obviously, that conclusion is situation specific, but what is clear is that cash is attractive, and the greater the amount of cash the greater the potential to attract attention. Thus, the presence of excess cash balances in either acquiring or target firms is often a primary motivating influence in subsequent merger or takeover activity.

Another feature that makes firms attractive as potential merger partners is the presence of unused tax shields. The corporate tax code allows for loss carry-forwards; if a firm loses money in one year, the loss can be carried forward to offset earned income in subsequent years. A firm that continues to lose money, however, has no use for the loss carry-forwards. However, if the firm is acquired by another firm that is profitable, the tax shields from the acquired may be used to shelter income generated by the acquiring firm. Thus the presence of unused tax shields may enhance the attractiveness of a firm as a potential acquisition target.

A similar idea is the notion that the combined firm from a merger will have lower absolute financing costs. Suppose two firms, X and Y, have each issued bonds as a normal part of the financing activities. If the two firms combine, the cash flows from the activities of X can be used to service the debt of Y, and vice versa. Therefore, with less default risk the cost of new debt financing for the combined firm should be lower. It may be argued that there is no net gain to the combined firm; since shareholders have to guarantee debt service on the combined debt, the savings on the cost of debt financing may be offset by the increased return demanded by equity holders. Nevertheless, lower financing costs are often cited as rationale for merger activity.

One rather dubious motivation for merger activity is to artificially boost earnings per share. Consider two firms, A and B. Firm A has earnings of $1,000, 100 shares outstanding, and thus $10 earnings per share. With a price-earnings ratio of 20, its shares are worth $200. Firm B also has earnings of $1,000, 100 shares outstanding, but due to poorer growth opportunities its shares trade at 10 times earnings, or $100. If A acquires B, it will only take one-half share of A for each share of B purchased, so the combined firm will have 150 total shares outstanding. Combined earnings will be $2,000, so the new earnings per share of the combined firm are $13.33 per share. It appears that the merger has enhanced earnings per share, when in fact the result is due to inconsistency in the rate of increase of earnings and shares outstanding. Such manipulations were common in the 1960s, but investors have learned to be more wary of mergers instigated mainly to manipulate per share earnings. It is questionable whether such activity will continue to fool a majority of investors.

Finally, there is the ever-present hubris hypothesis concerning corporate takeover activity. The main idea is that the target firm is being run inefficiently, and the management of acquiring firm should certainly be able to do a better job of utilizing the target's assets and strategic business opportunities. In addition, there is additional prestige in managing a larger firm, which may include additional perquisites such as club memberships or access to amenities such as corporate jets or travel to distant business locales. These factors cannot be ignored in detailing the set of factors motivating merger and acquisition activity.

TYPES OF TAKEOVER DEFENSES

As the previous section suggests, some merger activity is unsolicited and not desired on the part of the target firm. Often, the management of the target firm will be replaced or let go as the acquiring firm's management steps in to make their own mark and implement their plans for the new, combined entity. In reaction to hostile takeover attempts, a number of defense mechanisms have been devised and used to try and thwart unwanted advances.

To any offer for the firm's shares, several actions may be taken which make it difficult or unattractive to subsequently pursue a takeover attempt. One such action is the creation of a staggered board of directors. If an outside firm can gain a controlling interest on the board of directors of the target, it will be able to influence the decisions of the board. Control of the board often results in de facto control of the company. To avoid an outside firm attempting to put forward an entire slate of their own people for election to the target firm's board, some firms have staggered the terms of the directors. The result is that only a portion of the seats is open annually, preventing an immediate takeover attempt. If a rival does get one of its own elected, they will be in a minority and the target firm's management has the time to decide how to proceed and react to the takeover threat.

Another defense mechanism is to have the board pass an amendment requiring a certain number of shares needed to vote to approve any merger proposal. This is referred to as a supermajority, since the requirement is usually set much higher than a simple majority vote total. A supermajority amendment puts in place a high hurdle for potential acquirers to clear if they wish to pursue the acquisition.

A third defensive mechanism is a fair price amendment. Such an amendment restricts the firm from merging with any shareholders holding more than some set percentage of the outstanding shares, unless some formula-determined price per share is paid. The formula price is typically prohibitively high, so that a takeover can take place only in the effect of a huge premium payment for outstanding shares. If the formula price is met, managers with shares and stockholders receive a significant premium over fair market value to compensate them for the acquisition.

Finally, another preemptive strike on the part of existing management is a poison pill provision. A poison pill gives existing shareholders rights that may be used to purchase outstanding shares of the firms stock in the event of a takeover attempt. The purchase price using the poison pill is a significant discount from fair market value, giving shareholders strong incentives to gobble up outstanding shares, and thus preventing an outside firm from purchasing enough stock on the open market to obtain a controlling interest in the target.

Once a takeover attempt has been identified as underway, incumbent management can initiate measures designed to thwart the acquirer. One such measure is a dual-class recapitalization; whereby a new class of equity securities is issued which contains superior voting rights to previously outstanding shares. The superior voting rights allow the target firm's management to effectively have voting control, even without a majority of actual shares in hand. With voting control, they can effectively decline unsolicited attempts by outsiders to acquire the firm.

Another reaction to undesired advances is an asset restructuring. Here, the target firm initiates the sale or disposal of the assets that are of primary interest to the acquiring firm. By selling desirable assets, the firm becomes less attractive to outside bidders, often resulting in an end to the acquisition activity. On the other side of the balance sheet, the firm can solicit help from a third party, friendly firm. Such a firm is commonly referred to as a "white knight," the implication being that the knight comes to the rescue of the targeted firm. A white knight may be issued a new set of equity securities such as preferred stock with voting rights, or may instead agree to purchase a set number of existing common shares at a premium price. The white knight is, of course, supportive of incumbent management; so by purchasing a controlling interest in the firm unwanted takeovers are effectively avoided.

One of the most prominent takeover activities associated with liability restructuring involves the issuance of junk bonds. "Junk" is used to describe debt with high default risk, and thus junk bonds carry very high coupon yields to compensate investors for the high risk involved. During the 1980s, the investment-banking firm Drexel Burnham Lambert led by Michael Milken pioneered the development of the junk-bond market as a vehicle for financing corporate takeover activity. Acquisition groups, which often included the incumbent management group, issued junk bonds backed by the firm's assets to raise the capital needed to acquire a controlling interest in the firm's equity shares. In effect, the firm's balance sheet was restructured with debt replacing equity financing. In several instances, once the acquisition was successfully completed the acquiring management subsequently sold off portions of the firm's assets or business divisions at large premiums, using the proceeds to retire some or all of the junk bonds. The takeover of RJR Nabisco by the firm Kohlberg Kravis Roberts & Co. in the late 1980s was one of the most celebrated takeovers involving the use of junk-bond financing.

VALUING A POTENTIAL MERGER

There are several alternative methods that may be used to value a firm targeted for merger or acquisition. One method involves discounted cash flow analysis. First, the present value of the equity of the target firm must be established. Next, the present value of the expected synergies from the merger, in the form of cost savings or increased after-tax earnings, should be evaluated. Finally, summing the present value of the existing equity with the present value of the future synergies results in a present valuation of the target firm.

Another method involves valuation as an expected earnings multiple. First, the expected earnings in the first year of operations for the combined or merged firm should be estimated. Next, an appropriate price-earnings multiple must be determined. This figure will likely come from industry standards or from competitors in similar business lines. Now, the PE ratio can be multiplied by the expected combined earnings per share to estimate an expected price per share of the merged firm's common stock. Multiplying the expected share price by the number of shares outstanding gives a valuation of the expected firm value. Actual acquisition price can then be negotiated based on this expected firm valuation.

Another technique that is sometimes employed is valuation in relation to book value, which is the difference between the net assets and the outstanding liabilities of the firm. A related idea is valuation as a function of liquidation, or breakup, value. Breakup value can be defined as the difference between the market value of the firm's assets and the cost to retire all outstanding liabilities. The difference between book value and liquidation value is that the book value of assets, taken from the firm's balance sheet, are carried at historical cost. Liquidation value involves the current, or market, value of the firm's assets

Some valuations, particularly for individual business units or divisions, are based on replacement cost. This is the estimated cost of duplicating or purchasing the assets of the division at current market prices. Obviously, some premium is usually applied to account for the value of having existing and established business in place.

Finally, in the instances where firms that have publicly traded common stock are targeted, the market value of the stock is used as a starting point in acquisition negotiations. Earlier, a number of takeover defense activities were outlined that incumbent management may employ to restrict or reject unsolicited takeover bids. These types of defenses are not always in the best interests of existing shareholders. If the firm's existing managers take seriously the corporate goal of maximizing shareholder wealth, then a bidding war for the firm's stock often results in huge premiums for existing shareholders. It is not always clear that the shareholders interests are primary, since many of the takeover defenses prevent the use of the market value of the firm's common stock as a starting point for takeover negotiations. It is difficult to imagine the shareholder who is not happy about being offered a premium of 20 percent or more over the current market value of the outstanding shares.

CURRENT TRENDS IN MERGERS
AND ACQUISITIONS

Mergers and Acquisitions were at an all-time high from the late 1990s to 2000. They have slowed down since then—a direct result of the economic slowdown. The reason is simple, companies did not have the cash to buy other companies. In 2005, however, we are seeing a robust economy and corporate profits, which means that businesses have cash. This cash is being used to buy companies—mergers and acquisitions. The end of 2004 saw several deals: Sprint is combining with Nextel, K-Mart Holding Corp is buying Sears, Roebuck & Co., Johnson & Johnson is planning to buy Guidant. These big corporation deals are spurring on an environment triggering more acquisitions. The telecom industry, the banking industry, and the software industry are potential areas for big mergers.

SEE ALSO: Financial Ratios

Howard Finch

Revised by Judith M. Nixon

FURTHER READING:

Brealey, R.A., and S.C. Myers. Principles of Corporate Finance. 7th ed. Boston, MA: McGraw-Hill/Irwin, 2003.

Bruner, R.F. Applied Mergers and Acquisitions. Hoboken, NJ: J. Wiley, 2004.

Coy, P., et al. "Shake, Rattle, and Merge." Business Week, 10 January 2005, 32.

Harrington, D.R. Corporate Financial Analysis in a Global Environment. 7th ed. Mason, Ohio: Thomson/South-Western, 2004.



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