Lecture Notes 1

Economic benefts of mergers

o 1. Synergies, 2. Management improvement 3. Market power 4. Tax 5. Risk reduction 6.
Managerial motives
Why Stock price of bidder decreases
o 1. Signal you are selling stock bad expectations
o 2. Signal you have issues with your own operations
o 3. Market reacting to premium you pay
Merger
o Acquirer assumes all assets and liaiblities one company survives
Requires target SH approval
Buyer SH must approve if it needs to issue more than
Short form merger no need for target shareholder approval once a bidder acquires more than 50%
o 90% in Delaware threshold
o Non-tendering shareholders: holdout problem, free riding
Timeline:
o Filing of proxy statement with SEC (10 Days)
o Review by the SEC (30-45 Days)
o Send Proxy Statemnt to shareholders and vote (20 Days)
Types of mergers
o 1. Direct merger acquiring company directly buys targets shares; two companies merge
o 2. Triangular merger acquirer forms subsidiary and transaction is done thru sub.
Tender Offer
o Offer to shareholders to sell their shares; only way for hostile offer also done with friendly
mergers
o Types: any-and-all; conditional; partial; two tier
Acquisition of assets
o Buying select assets
1. no assumption of liabilities
2. Fit assets to buying firm
3. Unfit assets for seller firm
4. SHs approval usually not required
5. Proceeds go to selling fir, not SHs
6. Tax seller pays tax on gain
Acquisition of stock
o Buying a block of shares in the target enables control
o Followed by acquiring all stocks and merger agreement
Owning 80% in vote and value tax benefits
Bear hug express interest in target by writing to management
Economic benefits
o Target firms always gain; acquirers often lose
o Economic benefits only if there is an increase in the sum of values of the acquier and the target
o 1. Synergies

2. Improve inefficient management

Agency problem separate ownership from control free rider issue; SHs cant replace
managers
Public good discipline by bidders
o 3. Market power
DoJ, FTC and state antitrust regulators
Hart-Scott-Rodino Act 1976
Pre-merger notification filed with FTC, DOJ
H <.1 low chance of challenge
.1 < H < .18 area of attention as long as change in H > .005
H > .18; Doj will sue if change in H > .01
Other issues: demand elasticity, barriers to entry, efficiency gains
o 4. Tax benefits
1. If mergers enables increase in leverage T*D is a gain to value of firm
2. Cash acquisitions are a type of investment saves tax on dividend
3. Exchange of stock in a tax free merger diversify without paying tax on gains
4. Offset profits against losses in cyclical companies if 80% held
5. NOL rate of LT gov bonds * value of acquired co each year
Tax free acquisition (statutory merger) requires 1. Acquisition for business purpose 2.
Continuity of enterprise 3. Selling company SHs receive at least 40% of payment in
stock
Tax free acquisition of stock requires 80% of targets stocks are exchanged for acquirers
voting stock; completed in 12 months
Increasing depreciable value of assets leads to corresponding tax liability for selling
company; same with intangible asset
o 5. Risk reduction
Diversification reduces risk but do they increase value?
o 6. Managerial motives
Integration in mergers difference in organizational cultures
o 1. Approach to risk 2. Innovation and adjustment to change, dynamism 3. Horizontal
cooperation and exchange of info 4. Vertical relationship 5. Performance measures and
compensation
o Due diligence: 1. Financial statemnts 2. Value of assets 3. Hidden liabilities 4. Contracts that
imply liability 5. Employees 6. Environmental matters 7. Product liabilities 6. Litigation
o Material Adverse Change
Provision in merger contracts that enables buyer to terminate the deal exclude changes
in economic conditions or law
What generates merger waves
o 1. Regulatory change 2. New technology 3. Liquidity in market (financing spreads) 4. Business
environment 5. Growth opportunities (MV/BV) 6. Taxation 7. Fashion
o

Determinants of a firm becoming a target & effects of M&A on share

holder wealth

Likelihood of becoming a target is higher for

o 1. Smaller firms
o 2. Lower sales growth firms
o 3. Higher liquidity in low-growth firms (low liquidity in high growth)
o 4. Lower leverage (D/E ratio)
o 5. Smaller MV/BV
o 6. Prior acquisitions in the industry
Effect of M&A on stock price
o Target prices increase by 25%
o Bidder stock price decline in stock offer and flat in cash offers
o Combined change in value is positive (bidder + target)
o Tender offers; bidder and target returns are higher
o Bidders of private targets gain 2-3% - bargaining and give management liquidity
o Bidder returns are higher in early stages of merger wave
Other
o Target firms generally suck before the announcement of offer
o Acquiring firms generally good; fall when unsuccessful in offer1. Lose faith in
management 2. Gotta fix something because you wanted to buy a company
How can bidder reduce competition
o 1. Get managements agreement; talk to block holders
o 2. A high initial offer
o 3. Buy into target; legal constraints
o 4. Break-up/termination fee paid by target to bidder
Legal management says that 2nd bid wouldnt have come if they didnt take the
first bid, which required a break up fee
Deals with terminal fee have a higher target premium (4-7%)
Deals with TF have higher success rate and lower competition
Reverse break up fee makes it costly for bidder to back out (backing out shows
the company is tainted)
Incentivizing management to do value increasing acquisitons
o 1. Equity based compensation higher bidder gains, lower premiums; PE firms pay lower
premiums similar to public firms with high managerial stock ownership
o 2. CEO turnover after acquisitions if bidder return Is lower after announcement of
merger, higher likelihood that CEO is replaced
o Bidder returns lower at announcement in diversifying mergers
Effect on rivals positive
o 1. Merger chance potential targets
o 2. Revise valuation for all _____ in industry information (i.e. buffett for newspapers)
Behavioral effect 52 WK high
o Target SHs & probability of success go up if at or above 52 WK high
o Offer premium is higher if 52WH was higher relative to pre-offer price

o Market perception will penalize bidder if it sees that it is driven by 52WH

Post-merger performance
o 1. Acquirer op. margin improves from year 1 to year 3 relative to before
o 2. Post-merger performance is correlated with pre-merger; better firms are better acquirers
o 3. Acquirers stock price is negative over the 3 years in stock acquisitions, flat in cash
acquisitions
o Bidders who failed to acquire lose even more
Post-merger restructuring
o 1. Acquirers sell and close 46% total plants within 3 years
o 2. Acquirers with skills running peripheral divisions retain more plants
o 3. Smaller likelihood of selling plants in targets main division
o 4. Financially constrained buyers sell and close more divisions
o 5. Retained plants increase in productivity and margins for acquirers with high operating
margin
Worldwide Returns
o US, UK, Canada targets get paid a bigger premium
o Higher returns for rest of the world for combined bidder and target
o Bidder returns negative in US, Canada, UK; bidder returns positive elsewhere
o Target firms perform better in cash deals; same with US acquirers
Perform the same pretty much for bidders between cash and stock in ROW

Defensive Measures

Strong antitakeover measures perform worse but is it the effect of these measures or bad
performance induces adoption of measures?
Bond yields lower in firms with strong antitakeover measures
Antitakeover provisions are less likely in firms with 1. Managerial/shareholder concentration 2.
Better performance
Takeover measures
o 1. Poison piil
Flip over right to buy acquirers stock at deep discount
Flip in right to buy stock in own firm at deep discount, excluding bidder
Slow hand a pill that can be rescinded after a period of time (deferred redemption
plan)
Dead hand - only the board that adopted it can rescind it
Pill is triggered if a raider buys a specificied fraction without boards approval
Redeemable by management
Discriminates against buyer
Can be adopted with SH approval
Effect of pill adoption insignificant for SP
Pill enables negotiation for higher offer premium but lower likelihood of success of
an offer
o 2. Staggered board
Board divided into 3 groups and only one group elected at a time

Value effect unknown SB enables target firms to receive higher premium IF

offer is made; but lowers likelihood of even receiving an offer
o 3. Supermajority
o 4. Fair price (supermajority necessary if not all shares are acquired at the same price stops
two tier offers)
o 5. Change state of incorporation
o 6. Leveraged recap make yourself less attractive by levering up
o 7. Restructuring: MBO
o 8. Restructuring: divestiuture
o 9. Restructuring: Dual class re-cap
o 10. White knight
o Recent trend less adoption of antitakeover measures; declassify board and shorten poison
pills
o 11. Ordinary business contracts - in event of acquisition, i.e. company must refund 2-5x
costs
o Delaware state laws
Buyer of 15% of target stock cannot complete merger for 3 years unless:
1. Board approves before the buyer crosses 15% threshold
2. Buyer buys at least 85% of stock in the same transaction in which it crosses 15%
3. Transaction is approved by 2/3 of shares excluding buyers shares
In general there are two major types of state laws 1. Control share acquisition 2.
Freeze out business combination
Studies show adoption of state takeover laws induces inefficiency of firms
Smith Goran Case (1985 for Trans Union)
o Established role of the board, duty of care and loyalty procedure the board must take
Moran v Household (1985)
o Uphold shareholder rights plan poison pill
o Business judgment rule boards decision was informed, decision was careful and no
evidence of bad faith
Unocal Standard
o 1. Is there a perceived threat to corporate policy and effectiveness
o 2. Is the response reasonable in relation to the threat
Revlon
o You can say no, but once you say yes; you have to take the highest offer
o Revlon duty directors have a responsibility to maximize reward to SHs

Method of Payment

Cash offers more likely in 1. Tender offers 2. Hostile offers 3. LBO/PE offers
Bidder stock price falls in stock offers; flat or slight rises in cash offers
In cash offers, both bidder and target do better
Recently, more favorable bidder stock price reaction to announcements
Floating stock offers is better than fixed stock offers for bidders
CVR contingent value rights offer a limited price guarantee over some period after the deal is done

o Signal effect that bidders are willing to provide a guarantee stock isnt a dog
o Demand of bidders that are vague, from other countries, etc.
o Bidder and target both gain with stock + CVR offer vs just stock
o Just a long put at price and short put to cancel it out
Collar guarantee some value to target SHs within some limits if the bidders price changes by the time
of payment, may also limit the payment if bidders price rises
o Value collar fixed value in a range of bidders price and fixed rations outside (by far most
popular)
Stock price discounted back to day one, call option for the top part, short put at
the bottom
o Fixed exchange ratio fixed maximum and min values of offer, with a fixed exchange ratio
within this range
o Rate of success in collar deals is higher than in cash or stock (friendlier deals)
o Bidders price reaction is more favorable in stock offers with collar
Contingent earnout price depends on target meeting post-merger performance targets
o May create moral hazard cheat the incentives
o Bidders gain over 2% on average acquisitions using earnouts
o Mainly for know-how, knowledge based companies tech, bio tech, foreign companies

Effect of mergers on value of debt

If merger reduces risk, it increases value of risky debt

Assume no synergies, value from shareholders moved to bondholders
Synergies may lead to stockholder and bondholder gains
Variance = var^2 * .5 + var^2 +.5
If merger lowers risk, debt price goes up
If merger increases risk, debt value goes down
o Only when synergies > wealth transfer will both be better off
If merger lowers risk, value flows from higher quality bonds to lower quality bonds
if merger increases bond risk, theres a wealth transfer from
o bondholders to shareholders
o safer bonds to risky bonds
o long term bonds to short term bonds
shareholders will always prefer to redeem them than go bankrupt
Target BHs gain on average during announcement period
o Gain is greater for below investment grade bonds (+4%)
o Investment grade bonds lose a little
o Gain is greater when targets bond rating is below acquirers
o The merger reduces asset risk
o The targets bond maturity is shorter than acquirers
Acquiers BH lose significantly
o Combined bond returns = 0; combined stock returns = 4.3%
o BH of acquirers dont like cash acquisitions cash is safe asset
o Prefer stock offers indifferent

Event risk covenants protect bondholders wealth

o Bonds with event risk covenants have lower YTM and higher prices
o Put on bonds is conditioned on the takeover being hostile poison put
o Issuing bonds with puts would:
Positive effect on existing risky bond prices addition layer of protection for BHs
Negative effect on stock prices makes acquisition more difficult

Chapter 1

Statutory merger target becomes a subsidiary of the parent

Forward triangular merger subsidiary of acquirer is merged with target and acquirers subsidiary is
the surviving entity
Reverse triangular merger transaction between acquirers subsidiary and target and the target is
surviving entity
o Triangular mergers are advantageous because it allows the acquirer to gain control of target
without directly assuming its liabilities
Horizontal merger - Two competitors merge increase market power; could be anticompetitive
Vertical merger - Combination of companies with a buyer-seller relationship
Conglomerate merger when companies are not competitors and dont have buyer-seller
relationship

Reasons for mergers

Expansion, synergies, financial factors, taxes

Merger consideration

Pricing period number of shares is determined by dividing the value offered by the bidders average
stock price during a prespecified period
Holdback provision - $$ held in escrow as payment that could be returned to the buyer

J&J Case

Used material adverse change clause after buying Guidant for $25.4
o Recalls of heart devices
Agreed to 21.5B, but backfired after Boston Scientific came in and bought Guidant for $27B

Legal Framework Chapter 3

Friendly, cash financed bidder files proxy statement with SEC and deal has to be approved at a
shareholder meeting
Friendly, stock financed same as above, but securities used to purchase have to be registered
Hostile deal cash tender
o Bidder initiates tender offer by disseminating tender offer to target shareholders
Hostile deal stock tender
o Bidder must submit a registration statement prior to submitting tender offer to shareholders
o SEC may have comments on registration statement
8K must be filed within 15 calendar days after certain events
o Information includes description of assets, nature of consideration, financial statements of
businesses
o Acquisition or disposition exceeds 10% of total book assets means you file 8K
S-4
o Disclosure form for when a public company issues new stock to acquire a target

If a company issues more than 20% of shares to acquire target, it must get shareholder
approval
Williams Act
o 1. Regulated tender offers 2. Provide procedures and disclosure requirements for
acquisitions 3. Provide shareholders with time to make informed decisions regarding tender
offers 4. Increase confidence in securities markets
o Also made it that you must file after going past 5% ownership of target common stock
within 10 days 13D
o Tender offer must file schedule TO
o Tender offer must be kept open for 20 days
Tender offers that are oversubscribed are pro rated
o Two tiered offers one price for first 51% and another for the rest not technically illegal
but not in spirit of the Act
o

AntiTrust Laws

Hart-Scott-Rodino Act FTC and Justice Department given the opportunity to review proposed
M&A in advance
o Prevent transactions that would be judged to be anticompetitive
Size requirements for filing
o Between 53 million and 212 million transaction size test is met if one party has net revenue
of at least 100 mill and the other part has assets or sales of at least 10 mill
o Transactions over $200 must be reported
Important to merge early, mergers later on have bad numbers in terms of objectionable
concentrations of the industry
Justice Department Merger Guidelines
o Concentrated if 4 largest companies own 75% - 1968 rules
o Herfindahl Hirschman sum of the squares of the market shares of each firm in the
industry
Less than 1000 unconcentrated
1000 -1,800 modestly concentrated; if a merger increases the HH index by less
than 100 points its unlikely to be a problem
Over 1,800 highly concentrated; if a merger raises index by less than 50 pts,
should be fine
o Market is the smallest group of products or geographic area where a monopoly could raise
prices by a certain amount such as 5%
o Other considerations: efficiency gains, whether either party would fail or exit the market but
for the merger, companies losing market share?
European competition policy
o Not dependent on the courts like in the U.S.
o Focuses more on post-merger market share wherein the US more focus on market power
and expected post-merger price effects
o US is less focused on conglomerates and vertical acquisitions

Merger Strategy Chapter 4

Two reasons cited for M&A

o Faster growth and synergies
o Operating synergy is the most economically sound basis
Companies experience greater success with horizontal mergers which result in an increase in
market share
Diversification acquisitions do not have an impressive track record
Other motives hubris, pride of management, improved management, tax benefits
Expansion outside ones industry is called diversification
Merger within industry
o Internal growth may be too slow
o To facilitate growth when a company wants to expand to another geographic region
o Need to critically examine if merger growth will generate good returns for shareholders
Is risk-adjusted return from the deal greater than the next best use of capital
Studies for acquisitions of targets in countries which they did not have operations previously
o Positive
o Negative (not significant) when acquirers already had operations there
o Another study
Positive returns of non-U.S. companies buying U.S. companies
Negative returns from U.S. acquiers of non-U.S.
o Another study
U.S. bidders realized lower returns than acquisitions of U.S. targets
o Overall spotty record of many U.S. acquirers of non-U.S. companies entering new markets
has unique risks
Synergy
o NAV = Value of AB (Value of A + Value of B) Premium Paid for B Expenses of the
acquisition process
o Two types of synergy operating synergy and financial synergy
Operating synergy revenue enhancements and cost reductions
May be derived from horizontal or vertical mergers
o Financial synergy cost of capital may be lowered by combining one or companies
o Failed synergies Allegis & United; Sears; Citicorp
Revenue enhancing operating synergy
o Cross-marketing each merger partners products
o Usually difficult to achieve, quantify, and build into models
Cost reducing synergies
o May result from economics of scale decreases in per-unit costs that result from an increase
in the size or scale of a companys operations
o Just because mergers are associated with operating economies, does not mean mergers are
the best method of achieving those economies

Economies of scope utilize one set of inputs to provide a broader range of products in
products and services
i.e. financial institutions can afford to offer a broader range of services that small
banks cant
clear synergies for banks, but still targets overperform and bidders underperform or
negligible difference
European bank mergers perform better
Financial synergy
o Matter of dispute among academics
o Acquisition may reduce risk if firms cash flows are not perfectly correlated
Reduce risk of bankruptcy
Debtholders have a less risky company and benefit at the expense of stockholders
Target company bonds which are less than investment grade earned positive period
returns
Acquiring company bonds earned negative period returns
Cost of capital reduces; better access to markets and lower costs of raising capital
less risky
Diversification growing outside a companys current industry category
o Mostly bad acquisitons; GE exception
GE south to buy companies that were 1 or 2 in market share
o May seek to enter industries that are more profitable current industry is mature
Probably bad strategy in the long run as long run returns stabilize and go down as
more firms enter
o Coinsurance benefit questionable if shareholders cant just diversify on their own at a
lower cost; probably a benefit for management
o Diversification has attracted criticism but some evidence that market responds favorably to
such announcements of acquisition programs
3rd merger wave before tax reform in 1969 favorable response of the market to
announcement of acquisitions program (diversification program)
But years following underperformed so market may have been overly optimistic in
its assessment of the success of these programs
Study shows conglomerate gains for both buy and seller firms between 1957 and
1975
Generally shown that diversification lowers firms values, however not 100%
accepted by finance academics
May not control for bad companies wanting to buy companies to drive
performance confounding variable
Related versus Unrelated Diversification
o Diversification does not mean conglomeration; it is possible to diversify into fields that are
related to buyers business
o Track record of related acquisitons is significantly better than that of unrelated acquisitons
Other Economic motives beyond scale and diversificaition
o Horizontal integration increase in market share and power that results from acquisitions of
rivals
o

Market power or monopoly power ability to set price above competitive levels
o Vertical integration buyer-seller relationship
o Roll-up acquistiions
Serial acquirers generally underperform
Vertical integration
o Buying supplier or consumer
Just-in-time delivery advantages or steady supply
Lowers transaction costs no supply disruption
Specialized inputs
Hubris Hypothesis of Takeovers
o Managers think their valuation of a firm is better than the markets (efficient) and are wrong
o Hubris leads to overpaying - Winners curse
o Bad bidders become good targets
o Executive compensation theory managers acquire to bump executive compensation
Better deals lead to higher compensation; bad deals dont.
More recent evidence deals lead to higher compensation
Improved Management
o Takeovers motivated by Belief that management can better manage targets resources
o Not much evidence and research hard to know which firms are buying for management
issues
Improved R&D
o Accelerate R&D with companies that are good at it; Cut R&D for pharma; use marketing
team to cost cut
Improved Distribution
Tax Motives

Chapter 6 Takeover Tactics