SM PPT 10

Chapter 14
Mergers and Acquisitions
Copyright 2008 Pearson Prentice Hall. All rights reserved.
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Mergers andAcquisitions Mergers & Acquisitions
Mergers and Acquisitions

Diversification strategy, either through strategic alliances or corporate diversification, can be an important source of competitive advantage. What about the performance implications of the process through which firms become diversified? Mergers and acquisitions are an important strategic option open to firms pursuing diversification strategies and have been used by numerous firms worldwide. These strategies create above-normal economic profits for the firms that pursue them.
Copyright 2008 Pearson Prentice Hall.Management & Competitive Advantage Strategic All rights reserved.
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Mergers & Acquisitions Defined

Mergers
two firms are combined on a relatively co-equal basis
Acquisitions
one firm buys another firm
the words are often used interchangeably even though they mean something very different merger sounds more amicable, less threatening
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Mergers
parent stocks are usually retired and new stock issued name may be one of the parents or a combination one of the parents usually emerges as the dominant management
Acquisitions
can be a controlling share, a majority, or all of the target firms stock can be friendly or hostile usually done through a tender offer
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Logic of Corporate Level Strategy Applies

Corporate level strategy should create value:
1) such that the value of the corporate whole increases
2) such that businesses forming the corporate whole are worth more than they would be under independent ownership
3) that equity holders cannot create through portfolio investing

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Economic value of Merger and Acquisition strategies Like with the other strategies, the economic value of mergers and acquisitions depends on the market context within which they are implemented. To the extent that a merger or acquisition enables a firm to exploit competitive opportunities and neutralize threats, that merger and acquisition will enable a firm to reduce its costs or increase its revenues, and that strategy will be economically valuable.
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Do Mergers and Acquisitions Create Value?

The Logic
Unrelated M&A Activity there would be no expectation of value creation due to the lack of synergies between businesses there might be value creation due to efficiencies from an internal capital market there might be value creation due to the exploitation of a conglomerate discount a corporate raider who buys and restructures firms
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Merger and Acquisition relatedness Acquisition of strategically related targets will generate only normal economic profits for both the bidding and the target firms this is very consistent with the discussion of economic consequences of unrelated diversification. It is argued that there is no economic justification for a corporate diversification strategy that does not build on some type of economy of scope across the businesses within which a firm operates, and thus that unrelated diversification is not an economically viable corporate strategy.
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FTC categories of mergers and acquisitions

There is a wide variety of ways that bidding and target firms can be strategically related. Because mergers and acquisitions can have the effect of increasing or decreasing the level of concentration in an industry, the Federal Trade Commission (FTC) is charged with responsibility of evaluating the competitive implications of proposed mergers and acquisitions. FTC will disallow any acquisitions involving firms with headquarters in the US that could have the potential of generating monopoly (or oligopoly) profits in an industry. FTC has developed a typology of mergers and acquisitions, each of which can be thought of as the different way in which a bidding and a target firm can be related in a merger or acquisition.
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Main types of mergers and acquisitions

The particularly important are: Vertical merger vertical integration, either backward (purchasing critical suppliers of raw materials) or forward (acquiring customers and distribution networks); Horizontal merger acquiring a former competitor the major concern for FTC as these strategies have the most direct and obvious anticompetitive implications in an industry. Product extension merger firms acquire complementary products. Market extension merger primary objective is to gain access to a new geographic market. Conglomerate merger if there is no other types of links between the firms, FTC defines the activity as conglomerate merger. Conglomerate mergers are relatively uncommon, as it has been known that mergers and acquisitions between strategically unrelated firms will not generate above-normal profits for either bidders or targets. Because firms can be strategically related in multiple ways, a particular merger or acquisition can be often categorized in two or more of the FTC categories.
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Types of M&A Activity FTC Categories Vertical Related Horizontal suppliers or customers competitors
Product Extension complementary products Market Extension complementary markets Unrelated Conglomerate everything else
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The Logic
Related M&A Activity value creation would be expected due to synergies between divisions economies of scale economies of scope transferring competencies sharing infrastructure, etc.
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Other types of mergers and acquisitions

FTC categories still do not capture the full complexity of the links that might exist between bidding and target firms. Some other possible sources of strategic relatedness includes technical economies (in marketing, production etc.), pecuniary economies (market power), and diversification economies (in portfolio management and risk reduction); potential reductions in production or distribution costs (from economies of scale, vertical integration, reduction in agency costs, etc.), realization of financial opportunities (gaining access to underutilized tax shields, avoiding bankruptcy costs), creation of market power and ability to eliminate inefficient management in the target firm.
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The Empirical Evidence
Research is based on stock market reaction to the announcement of M&A activity this reflects the markets assessment of the expected value of the merger or acquisition these studies look at what happens to the price of both the acquirers stock and the targets stock thus, we can see who is capturing any expected value that may be created
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Economic profits in related acquisitions

The existence of strategic relatedness between bidding and target firms is not a sufficient condition for the equity holders of bidding firms to earn above-normal economic profits from their acquisition strategies. If the economic potential of acquiring a particular target firm is widely known, if several potential bidding firms can all obtain this value by acquiring target, and semi-strong capital market efficiency holds, the equity holders of bidding firms will, at best, earn only normal economic profits from implementing an acquisition strategy. In this setting, a strategically related merger or acquisition will create economic value, but this value will be distributed in the form of above-normal economic profits to the equity holders of acquired target firms.
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Economic profits in related acquisitions

The fact that a particular target is not the object of multiple bids, does not necessarily imply that a bidding firm will be able to earn above-normal economic performance from its acquisition of a target. In anticipation of other potential bidders, a bidding firm may make an initial bid equal to the full value of a target and thus will be able to acquire target but will earn only normal economic profits from doing so. Also, different bidding forms may have different types of strategic relatedness with target firms and these performance implications of mergers and acquisitions will still be unchanged. All that is required is that the different bidding firms value targets at the same level. When this is the case, bidding firms will earn normal economic profits and targets will earn above-normal profits.
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The Empirical Evidence
M&A Activity creates value, on average, as follows: Acquiring Firms no value created Target Firms value increases by about 25%
related M&A activity creates more value than unrelated M&A activity
M&A activity creates value, but target firms capture it

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Expected versus Operational Value
April 2000: Wells Fargo offers to acquire First Security Bank for about $3 billion Expected
The Deal: Stock values were: Wells Fargo: $43.69 First Security: $15.50 .355 shares of WF for each share of FS stock Wells Fargo: down $0.25 to $39.50 First Security: up $1.19 to $13.38 Stock Price 12/1999 $40.44 12/2000 $56.69 12/2001 $43.60 12/2002 $46.87 12/2003 $58.89 12/2004 $62.15
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Operational
Market Cap. $65.7 B $95.2 B $74.0 B $82.0 B $100.0 B $105.0 B

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Why there are so many mergers and acquisitions

Possible motivations to engage in mergers and acquisitions are: Ensuring survival even if mergers and acquisitions, on average, generate only normal economic profits for bidding firms, it may still be necessary for bidding firms to engage in these activities, to ensure their survival. If all of a bidding firms competitors have been able to improve their efficiency and effectiveness through a particular type of acquisition, then failing to make such an acquisition may put a firm at a competitive disadvantage. Here, the purpose of a merger or acquisition is to gain competitive parity and normal economic profits. Free cash flows the amount of cash a firm has to invest after all positive NPV investments in a firms ongoing business have been funded. In some situations (e.g. when stockholders face high marginal tax rates and may prefer not to take dividends) a firm may retain this free cash flow and invest it either in strategies that have a belownormal expected profit or in strategies that have normal expected economic profits. In this context, merger and acquisition strategies are a viable option, for bidding firms, on average, can expect to generate normal economic profits from them.
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Agency problems mergers and acquisitions benefit managers directly, independent of any value they may or may not create for a bidding firm stockholders, in at least two ways managers may use mergers and acquisitions to help diversify their human capital investments in their firms. As it is known, managers have difficulty diversifying their human capital investments when a firm operates in narrow range of businesses. By acquiring firms with cash flows not perfectly correlated with the cash flows of firms current businesses, managers can reduce the probability of bankruptcy for their firm and thus partially diversify their human capital investments in their firm. To the extent that this diversification leads managers to make firm-specific human capital investments and to the extent that these investments can be a source of economic profits, this kind of diversification can indirectly benefit equity holders. Second, managers can use mergers and acquisitions to quickly increase firm size, measured either in sales or assets. Managers who increase firm size, may also increase their compensation. The size of a bidding firm can grow through merger or acquisition, as can the value of management compensation, even though, on average, acquisitions do not generate wealth for the owners of the bidding firm.
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Managerial hubris unrealistic belief y the managers of bidding firms, that they can manage the assets of a target firm more efficiently than can the target firms current management. This notion can lead bidding firms to engage in acquisition strategies even though there may not be positive economic profits from doing so. The existence of managerial hubris suggests that the economic value of bidding firms will fall once they announce the merger or acquisition strategy. The potential for above-normal profits the final reason why managers might continue to pursue merger and acquisition strategies is the potential that these strategies offer for generating above-normal economic profits for at least some of the bidding firms.
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Why is M&A Activity So Prevalent?

If managers know that acquiring firms do not capture any value from M&As, why do they continue to merge and acquire?
Survival avoid competitive disadvantage avoid scale disadvantages
Free Cash Flow
cash generating, normal return investment
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Agency Problems managers benefit from increases in size managers benefit from diversification
Managerial Hubris
managers believe they can beat the odds
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some M&A activity does generate above normal profits (expected and operational over the long run) Above Normal Profits proposed M&A activity may satisfy the logic of corporate level strategy managers may see economies that the market cant see
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Competitive Advantage
Can an M&A strategy generate sustained competitive advantage? Yes, if managers abilities meet VRIO criteria
1 2 3 Managers may be good at recognizing & exploiting potentially value-creating economies with other firms Managers may be good at doing deals Managers may be good at both
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Mergers and acquisitions and sustained competitive advantage

Valuable, rare and private economies of scope between bidding and target firms Only when the market for corporate control is imperfectly competitive might it be possible for bidding firms to earn above-normal economic profits from implementing merger and acquisition strategies. An imperfectly competitive market for corporate control can exist when a target is worth more to one bidder than to others and when no other firms, including bidders and targets, are aware of this additional value. Once the target is acquired, however, the performance of the special bidder that acquires a target firm, will be greater than generally expected, and this level of performance will generate above-normal economic profits for the equity holders of the bidding firm.
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Recognizing and Exploiting Economies of Scope
Private Economies Firm A Firm C Firm B Bidders Target Firm Cs recognized value is $10,000 Firm A sees value of $12,000 in Firm C Firm A can earn a profit of $2,000 only if the economy remains private
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Valuable, rare and costly to imitate economies of scope between bidding and target firms
If other bidders cannot imitate one bidders valuable and rare economies with targets, then competition in this market for corporate control will be imperfect, and the equity holders of this special bidding firm will earn economic profits. In this case the existence of valuable and rare economies does not need to be private (although it can also be the case), because other bidding firms cannot imitate them. Typically, bidding firms will be unable to imitate one bidders valuable and rare economies of scope with targets when the strategic relatedness between them stems from some rare and costly to imitate resources and capabilities controlled by the special bidding firm.
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Costly-to-Imitate Economies Firm A Firm C Firm B Bidders Target if the economy between A & C is costly to imitate, it doesnt matter if other firms know Firm A can still earn a $2,000 profit
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Unexpected valuable economies of scope between bidding and target firms
The discussion of above-normal profits to bidding firms implementing merger and acquisition strategies had adopted, for convenience, the strong assumption that the present value of strategic relatedness between bidders and targets is known with certainty by individual bidders. Most modern acquisitions and mergers are massively complex, involving numerous unknown and complicated relationships between firms. In these settings, unexpected events after an acquisition has been completed may make an acquisition or merger more valuable than bidders and targets anticipated it would be.
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Unexpected Economies Firm A Firm C Firm B Bidders Target
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Firm C has a market value of $10,000 Firm A buys Firm C for $10,000 Firm C turns out to be worth $12,000
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Implications for bidding firm managers

The task facing managers in firms contemplating merger and acquisition strategies, is to choose the ones that are most likely to generate above-normal returns for their equity holders. Search for rare economies of scope Managers in bidding firms need to consider not only the value of a target firm when combined with their own company, but also that value when combined with other potential bidders. The difference defines the size of the potential economic profits from an acquisition. Keep information away from other bidders One way to avoid multiple bidders for one target is to keep information about bidding process, and about underlying sources of economies of scope between a bidder and a target as private as possible. If one firm knows the information about the value of the economies of scope between itself and a target and if this bidder is able to close the deal before the full value of a target is known, then this bidding firm may earn above-normal economic profits from this acquisition. This is difficult and sometimes illegal, most likely possible with privately held firms.
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Implications for bidding firm managers Keep information away from targets
If a target knows what it is actually worth, it is very likely to hold out for highest bid. In fact, it may contact other potential bidding firms and tell them of the opportunity, when some bidder has created with the lower bid than a target is actually worth. This is also difficult and sometimes illegal, and limiting the amount of information that flows to the target firm may have other consequences as well. Complete sharing of information, insights and perspectives before an acquisition increases the probability that economies of scope will actually be realized once the acquisition is completed.
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Avoid winning bidding wars
To ensure the competitive bidding, target firms can actively encourage other bidding firms to enter into the bidding process. Bidding firms should generally avoid winning a bidding war pay a price at least equal to the full value of the target. Many times, given the emotions of intense bidding contest, the winning bid may actually be larger than the true value of the target. Completing this type of acquisition will certainly reduce the economic performance of the bidding firm. The only time it might make sense to win a bidding war is when the winning firm possesses a rare and private or rare and costly to imitate economy of scope with a target that is more valuable than the strategic relatedness that exists between any other bidders and that target.
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Implications for bidding firm managers Close the deal quickly

Another rule of thumb to obtain superior performance from implementing merger and acquisition strategy. It takes time for other bidders to become aware of the economic value associated with acquiring a target, it takes time for a target to recruit other bidders, information leakage becomes more of a problem over time, etc. Once a target has been located and valued, bidding firms have a strong incentive to reduce the period of time between the first bid and the completion of the deal. The longer this period of negotiation, the less likely is the bidding firm to earn economic profits from the acquisition.
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Complete acquisition in thinly traded markets In general, a thinly traded market is where there are only a small number of buyers and sellers, where information about opportunities in the market is not widely known, and where interests besides purely maximizing the value of a firm can be important. In thinly trade markets only one (or a few) firms are implementing acquisition strategies. These unique firms may be the only ones to understand the full value of the acquisition opportunities in this market. In general, thinly traded acquisition and merger markets are highly fragmented, competition occurs at local level, as one local small firm competes with other local small firms for a common group of geographically defined customers. Most of these firms are privately held, many are sole proprietorship. Consolidation is possible through merger and acquisition strategy, and as long as the number of firms implementing this consolidation strategy is small, then the market for corporate control is probably less than perfectly competitive, and opportunities for above-normal economic profits may be possible.
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Doing the Deal
Search for Rare Economies Seek Thinly Traded Markets Close the Deal Quickly Bidding Firms Perspective Limit Information to Other Bidders
Limit Information to the Target
Avoid Bidding Wars

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Doing the Deal
Seek Information from Bidders
Target Firms Perspective
Invite Other Bidders to Join in Bidding Contest
Delay, But Do Not Stop the Acquisition

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Implications for target firm managers

Target firm managers can counter the efforts of bidding firms to maximize the probability of earning economic profits from their merger and acquisition strategies, to ensure that the owners of target firms appropriate whatever value is created by a merger or acquisition.
Seek information from the bidders

It is well known that bidding firms must fully inform themselves about the resources and capabilities of potential acquisition targets to ensure that they price those targets appropriately. However, what is not as well known is that target firms must also inform themselves about the resources and capabilities of current and potential bidders in this way they can become fully aware of the value that they hold for bidders, and they are more likely to extract this full value in the acquisition process.
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Implications for target firm managers Invite other bidders to join the bidding competition
Once a target is fully aware of the nature and value of economies of scope that exist between it and current bidding firms, it can exploit this information by seeking other firms that may have the same relationship with it and then informing these firms of a potential acquisition opportunity. Thus the target firm increases the competitiveness of the market for corporate control and the probability that the value by an acquisition will be fully captured by the target firm.
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Delay but do not stop the acquisition To increase the probability of receiving more than one bid, target firms have a strong incentive to delay an acquisition to create more competitive market for corporate control, not to stop the acquisition. Some of these actions have the effect of reducing the wealth of target firm equity holders and some increase this wealth, others have no impact on it. Responses that reduce the wealth of target firms equity holders Anti-takeover actions include: Greenmail a maneuver in which target firms management purchases any of the target firms stock owned by a bidder, for a price greater than current market value of that stock. Greenmail effectively ends a bidding firms effort to acquire a particular target, in a way that can greatly reduce the wealth of a target firms equity holders. Not only they do not appropriate any economic value that could have been created if the acquisition had been completed, but also they have to bear the cost of the premium price that management pays to buy its stock back from the bidding firm.
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Standstill agreements are often negotiated in conjunction with greenmail a contract between a target and a bidding firm wherein the bidding firm agrees not to attempt to take over the target in some period of time, thus reducing the number of bidders that might have become involved in future acquisition efforts. Standstill agreements reduce the economic value of the target firm, therefore, the equity holders lose the value they could have appropriated if the acquisition had been completed and some of the future value. Poison pills variety of actions that target firm managers can take to make the acquisition of the target prohibitively expensive. E.g. a target firm issues rights to its current stockholders indicating that if the firm is acquired in an unfriendly takeover, it will distribute a special cash dividend to stockholders. This cash dividend increases the cost of acquiring the target and discourage otherwise interested bidding firms from attempting to acquire the target. Another poison pill tactic substitutes the distribution of additional shares of firms stock, at very low prices, for the special cash dividend, increasing the cost of acquisition.
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Tender offers Direct offers to stockholders of a target firm by a bidding firm - if a bidding firm and a target firm are strategically related, the value that can be created in an acquisition can be substantial, and most of this value will be appropriated by the stockholders of the target firm. Responses that do not affect the wealth of target firms equity holders Delay responses include: Shark repellents relatively minor corporate governance changes supposed to make it more difficult to acquire a target firm e.g. supermajority voting rules (more than 50% of target firms board of directors must approve a takeover). Pac Mac defense targets acquire the bidding firms. Crown jewel sale sometimes a bidding firm is interested in just a few of the businesses currently owned by a target firm crown jewels. To prevent an acquisition, a target firm can sell off these crown jewels, either directly to the bidding firm, or set up a separate company to own them. In this way, the bidder is likely to be less interested in acquiring the target. Lawsuits against bidding firms, least effective delay strategies.
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Responses that increase the wealth of target firms equity holders Delay actions include: Search for white knight another bidding firm that agrees to acquire a particular target in the place of original bidding firm may be another firm possesses more valuable economies of scope with a target firm, or this firm may have a longer-term view in managing a target firms assets than other bidding firms. As the number of bidders increases the competition, the likelihood that the equity holders of the target firm appropriate all the value created by an acquisition also increases. Auction among bidding firms organized by a target. Golden parachutes compensation arrangements between a firm and its senior management team that promises these individuals a substantial cash payment if their firm is acquired and they lose their jobs in the process. These cash payments appear to be very large, but are actually quite small compared to the total value that can be created if a merger or acquisition is completed. In this sense, golden parachutes are a small price to pay to give a potential target firms managers incentives not to stand in the way of completing a takeover of their firm, reducing the agency problems by aligning the interests of firms managers and its equity holders.
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Implementation Issues
Structure, Control, and Compensation
M&A activity requires responses to these issues: m-form structure is typically used management controls & compensation policies are similar to those used in diversification strategies Managers must decide on the level of integration: target firm may remain somewhat autonomous target firm may be completely integrated
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Organizing to implement a merger or acquisition

To realize the full value of any strategic relatedness between a bidding and a target firm, the merged organizations must be properly organized at least some coordination must exist. Active management of linkages between the merged firms is required. Given that most merger and acquisition strategies are used to create corporate diversification strategies, the same organizational approaches (M-form structure and management compensation policies) apply. Special problems reflect operational, functional, strategic, cultural differences between merged firms. These firms may also have different computer telephone systems, technology differences, human resources practices. Integrating the firms may require resolution of numerous differences. Although organizing to implement mergers and acquisitions can be a source of significant cost, it can also be a source of value and opportunity.
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Implementation Issues
Cultural Differences
high levels of integration require greater cultural blending cultural blending may be a matter of: combining elements of both cultures essentially replacing one culture with the other integration may be very costly, often unanticipated the ability to integrate efficiently may be a source of competitive advantage
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International Issues
Cultural Issues
Individualism
Social Orientation Power Orientation Uncertainty Orientation Goal Orientation Time Orientation
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Collectivism
Respect
Tolerance
Acceptance
Avoidance
Aggressive
Passive
Long-term
Short-term
(Hofstede, 1980)
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Summary
M&A activity is a mode of entry for vertical integration and diversification strategies A firms M&A strategy should satisfy the logic of corporate level strategy M&A activity can create economic value at announcement, but target firms usually capture that value M&A activity can create value over the long term for the acquiring firm
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Chapter 14

Mergers and Acquisitions

Copyright 2008 Pearson Prentice Hall. All rights reserved.

Mergers andAcquisitions Mergers & Acquisitions

Mergers and Acquisitions

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Mergers andAcquisitions Mergers & Acquisitions

Mergers & Acquisitions Defined

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Mergers andAcquisitions Mergers & Acquisitions

Mergers & Acquisitions Defined

Mergers andAcquisitions Mergers & Acquisitions

Logic of Corporate Level Strategy Applies

3) that equity holders cannot create through portfolio investing

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Mergers andAcquisitions Mergers & Acquisitions

Do Mergers and Acquisitions Create Value?

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FTC categories of mergers and acquisitions

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Main types of mergers and acquisitions

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Mergers & Acquisitions Defined

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Do Mergers and Acquisitions Create Value?

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Other types of mergers and acquisitions

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Do Mergers and Acquisitions Create Value?

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Economic profits in related acquisitions

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Economic profits in related acquisitions

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Do Mergers and Acquisitions Create Value?

M&A activity creates value, but target firms capture it

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Do Mergers and Acquisitions Create Value?

Market Cap. $65.7 B $95.2 B $74.0 B $82.0 B $100.0 B $105.0 B

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Why there are so many mergers and acquisitions

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Why there are so many mergers and acquisitions

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Why there are so many mergers and acquisitions

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