Mergers & Acquisitions

1. Preemption strategy (to prevent from competitive bids)
2. Contingency strategy (not overpaying, e.g. two-tier offer)

1. Mix of types

• Pecking order theory: from internal to external source of capital
• Cash (from previous profits) → dept → new shares

2. Maturity

• Short-term (commercial paper), intermediate-term (notes), long-term (bonds)

3. Fixed or floating yield

4. Currency

5. Exotic terms

• Plain bonds, hybris, convertible bonds...

6. Control features

⇒ See FRICTO

7. Distribution

• E.g. capital gains or dividends

Framework to evaluate financing strategies regarding:

• Flexibility
• Risk
• Income
• Control
• Timing
• Other

1. Leverage and leveraged recapitalizations

2. Exchange offers

3. Involuntary Recap (bankruptcy)

4. Financial Engineering

5. Liquidation an take-over bust-ups

6. MBO/LBO

Leveraged recaps (LR)

• Company levers itself (Buy back shares or pay out cash dividend)
• Discouraging potential acquirers (defensive tactic against hostile takeover)
• Cashing out owners
• Funding of tax liabilities (e.g. funding acquisitions)
• Pressure to improve efficiency
• Dedication of FCF (to avoid agency costs of FCF)

Dual class recaps (DCRs)

\(V_{Levered}=V_{Unlevered}+t \times D\)

with t x D = PV of DTS

Criticism:

Model does not capture default risk (costs of bankruptcy)

EV of all equity financed firm

+ PV of tax shields

+ PV of other benefits from leverage

+ PV of benefits from control change

+ PV of benefits from M&A

+ PV of benefits from changes in strategy, policy, structure...

- PV of costs of financial distress

= EV of an leveraged firm

5) \(\text{Share price}_{New}={\text{MV of firm}_{New} \over \text{Shares outstanding}_{Old}}={3'240 \over 100}=32.40\)

6) \(\text{Shares repurchased}_{New}={\text{Amount of dept}_{New} \over \text{Share price}_{New}}= {600 \over 32.40}=18.52\)

See example

Effect on equity value per share if new debt of 600 is fully distributed as dividend to shareholders?

\({2'640 \over 100}=26.40+{600 \over 100}=32.40\)

- Create second class of stock with limited voting right

- Preferential claim on CFs

• E.g.
• Class A: 100 shares, 1 vote, 50% interest, 100/110 CF claim
• Class B: 10 shares, 10 votes, 50% interest, 10/110 CF claim

- Reasons:

• Consolidate control (e.g. founding family)
• Complex operations → superior understanding
• Problem: Mgmt entrenchment (but higher dividends)

= Dept exchange

- Right or option to exchange existing obligations for different class

- E.g.

• Dept ⇔ Common stock
• Preffered stock ⇔ Common Stock
• Dept ⇔ Preffered stock

- Empirical evidence:

• Leverage to equity: Negative
• Equity to leverage: Positive

- Reasons:

• To improve on the terms and conditions of the existing bonds (due to financial distress)
• To improve liquidity position by extending the maturity
• Often distressed firms avoiding bankruptcy

- Use of calls, puts, swaps, forwards and futures to influence payoff of intended takeover

- Reason:

• Limit financial exposure of business and investors

Involuntary

• Bankruptcy
• "Worth more dead than alive"
• Creditors force firm to liqudate

Voluntary

• Shareholders receive more if firm is being sold
• Threat of bust-up acquisitions (Hostile takeover and buyer liquidates firm)

MBO

Acquisition where a company's existing managers acquire a large part or all of the company from either the parent company or from the private owners

LBO

• Acquisition by small group of investors using large portion (around 2/3) of dept finance
• Equity comes from financial sponsor (or mgmt)
• ROE upon exit (through sale or IPO)
• High leverage to increase ROE
• Tax savings (DTS)
• CF used to pay down dept and increase equity
• Improve target's financial performance

1. Strong cash flows
2. Low capex requirements
3. Leading and defensible market position
4. Growth opportunities (stable industry)
5. Efficiency enhancement opportunities
6. Proven management team
7. Strong asset base
8. (Low valuation in the stock market)

1. Tax benefits

• DTS
• Asset step-up

2. Mgmt incentives and agency cost effects

• Alignment of manager /shareholder interests
• Lower agency costs of FCF (CF committed to debt)
• Financial sponsor will monitor mgmt
• Debt causes pressure to improvements

3. Wealth transfer

• From existing bondholders to shareholders
• From current employees to new investors
• From government (taxes) to LBO premiums (But: Profitability+, Net benefit?)

4. Asymmetric information and underpricing

• Mgmt has more information than shareholders
• Believe that company will be worth more than paid

5. Other efficiency considerations

• E.g. projects do not have to be justified by board of directors
• No disclosure of information necessary

See slide

1'000 investment, 500 FCF

Scenario I:

• 750 debt, 250 equity, debt repayment (equity +500), no growth in EV, sale price 1'000, IRR=24.6%, Cash return 3x

Scenario II:

• 750 debt, 250 equity, no debt repayment, equity +500, 50% growth in EV, sale price 1'500, IRR=24.6%, Cash return 3x

Scenario III:

• 75% equity, completely debt repayment and growth in EV, sale price 1'500, IRR=14.9%, Cash return 2x

Scenario IV:

• 25% equity, constant interest payment, increase debt and growth in EV, sale price 1'500, IRR=28.3%, Cash return 3.5x

⇒ IV > I = II > III

• Increasing firm's size
• Operational improvements
• Repositioning to other segments
• + Organic growth rate and profitability

• Sale to a strategic buyer
• IPO
• Dividend recap (no exit strategy but monetization, debt+, extra dividend)

• Negotiated deal
• Mostly friendly parties
• Mutually agreeable decision to combine companies

• Direct offer to shareholders to tender (sell) their shares at a specified price
• Obtaining >50% of shares (Approval required)
• Friendly or hostile

• Conditional or unconditional
  • e.g. min. 50% interest
• Restricted or unrestricted
  • e.g. 70%, "any-or-all"
• Contested offer
• Two-tier offer or three-piece suitor: e.g.
  • Initial toehold
  • 1^st tier for cash (to obtain >50% interest)
  • 2^nd tier at a lower value (often paid in dept securities)

If buyout not completed:

• Freeze-in problem
• Possible legal actions

Solution: Minority squeeze-out

• Horizontal
• Vertical
• Conglomerate

• Same kind of business
• Benefits from economies of scale and synergies
• Government regulation due to fear of monopoly power

• Firms of different stage of production/operation
• Benefits from information- and transaction efficiency (e.g. inventory, production, prices, procurement)

• Firms in unrelated type of business
• 3 types:
  • Product extension
  • Geographic market extension
  • Pure conglomerate mergers

• Investment companies (e.g. Mutual funds)
  • Diversify PF risk
• Financial conglomerates
  • Provide funds
• Managerial conglomerates
  • Control operating decisions
• Concentric companies
  • Related business

• Statutory merger
  • Basic form
  • Requires legal procedures (e.g. percentage of vote from shareholders, board approval)
  • A+B=A, A+B=B or A+B=C
• Short-form merger
  • Streamlined legal procedures
  • No shareholder approval required
  • Typically interest >90%
• Holding company
  • Subsidiaries as seperate legal entities
  • Holding has controlling interest 25-50%

• Buying stock of takeover targets after public announcement and holding shares until deal is closed
• Bet that deal will be completed
• Bear deal risk

Existing shareholders can hold their shares until deal is closed to receive the offered price or they can sell their shares to a risk arbitrageur. His annual return would be:

\(r=(1+{Offered Price-Actual Price \over Actual Price})^{365 \over Days}-1\)

See chart

See chart

Topics:

• Historical development
• Merger waves
• Factors motivating & driving merger waves

1. Horizontal mergers 1895-1904
2. Vertical mergers 1922-1929
3. Conglomerate mergers 1965-1970
4. Deal decade 1981-1989
5. Strategic mergers 1992-2000

• Technological change (e.g. telephone, internet)
• Economies of scale
• Globalization and free trade
• Legal and regulatory changes (e.g. deregulation)
• Periods of high economic growth
• Favorable stock prices and economic conditions
• Input price volatility (e.g. oil industry)
• Finance innovations (e.g. junk bonds)

1895-1904

• Technological, infrastructure and managerial improvements (e.g. railroads, electricity)
• New products
• Economies of scale
• Availability of financiers and insurances

Cause of end: Recession 1903, anti-competitive merger ruling 1904

1922-1929

• Innovations in transportation (motor vehicle), communication (radio), merchandising (mass distribution)
• Product and market extension
• Consolidation of fragmented industries

Cause of end: Economic slowdown 1929

1965-1970

• Diversification
• Product extension
• Price earnings game
• Rise of management theroy

Cause of end: Antitrust laws, punitive tax laws, decline in stock prices