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Chapter 6

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Theories of Mergers and Tender Offers

2001 Prentice Hall

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Basic Concepts
Economies of scale average costs
decline over a broad range of output
Different from spreading fixed costs
over a larger number of units
Mergers allow a reorganization of
production processes so that plant scale
may be increased to obtain economies
of scale
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Economies of scope
Organization capital
Organization reputation
Human capital resources
Generic managerial capabilities
Industry-specific managerial capabilities
Nonmanagerial human capital

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Free-Rider Problem
Problem of diffused, small shareholders
Small shareholders may not expend
resources monitoring management
performance in a diffusely held corporation
Shareholders simply free-ride on monitoring
efforts of other shareholders and share in
any resulting performance improvements of
the firm

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 Free-rider problem in mergers

Small shareholders will not tender at any
offer price below the higher expected price
that should result from the merger
Individual decision to accept or reject
tender offer does not affect success of the
offer
If offer succeeds, they fully share in the
improvement brought by takeover

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 Possible solutions to free-rider problem

Allow bidder to dilute value of nontendered
shares of the target firm after takeover
Two-tier offer
Make some shareholders pivotal in the
outcome of the bid (Bagnoli and Lipman,
1988)
Tender offer from a large shareholder or an
outsider who had secretly accumulated a
large fraction of the equity
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Models of the Takeover

Process

Economic competition vs. market power

Auction types Dutch, English
Forms of games
Types of equilibria pooling, separating,
sequential
Types of bids one, multiple
Bidding theory preemptive; successive
bids
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Framework
Total gains for both target and acquirer
Positive
Efficiency improvement
Synergy
Increased market power

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 Zero
Hubris
Winner's curse
Acquiring firm overpays

Negative
Agency problems
Mistakes or bad fit

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 Gains to target all empirical studies

show gains are positive
Gains to acquirer
Positive efficiency, synergy, or market
power
Negative overpaying, hubris, agency
problems, or mistakes

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Sources of Value Increases

from M&As
Efficiency increases
Unequal managerial capabilities
Better growth opportunities
Critical mass
Better utilization of fixed investments

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 Operating synergy
Economies of scale
Economies of scope
Vertical integration economies
Managerial economies

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 Diversification motives
Demand for diversification by
managers/employees because they make
firm-specific investments
Diversification for preservation of
organization capital
Diversification for preservation of
reputational capital

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 Diversification and financial synergy

Diversification can increase corporate debt
capacity, decrease present value of future tax
liabilities
Diversification can decrease cash flow
variability following merger of firms with
imperfectly correlated cash flow streams

2001 Prentice Hall

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 Diversification discount
Studies find that the average diversified firm has
been worth less than a portfolio of comparable
single-segment firms
Reasons
External capital markets allocate resources more
efficiently than internal capital markets
Rivalry between segments may result in subsidies to
underperforming divisions within a firm
Managers of multiple activities are not well informed
about each segment
Securities analysts may be less likely to follow multiple
segment firms
Performance of managers of segments cannot be
adequately evaluated without external market measures
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 Financial synergies
Complementarities between merging firms in
matching the availability of investment
opportunities and internal cash flows
Lower cost of internal financing
redeployment of capital from acquiring to
acquired firm's industry
Increase in debt capacity which provides for
greater tax savings
Economies of scale in flotation of new issues
and lower transaction costs of financing
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 Circumstances favoring merger over

internal growth
Lack of opportunities for internal growth
Lack of managerial capabilities and other
resources
Potential excess capacity in industry

Timing may be important mergers can

achieve growth and development of new
areas more quickly
Other firms may be competing for
investments in traditional product lines
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 Strategic realignments
Acquire new management skills
Less time to acquire requisite capabilities
for new growth opportunities or to meet
new competitive threats

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 The q-ratio
Ratio of the market value of the firm's
securities to the replacement costs of its
assets
High q-ratio reflects superior management
Depressed stock prices or high replacement costs
of assets cause low q-ratios

Undervaluation theory
Acquiring firm (A) seeks to add capacity; implies
(A) has marginal q-ratio > 1
More efficient for (A) to acquire other firms in
industry that have q-ratios < 1 than building a new
facility
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 Information
New information generated during tender offer
process causes target firm share to be permanently
revalued upward even if offer is unsuccessful
Two information hypotheses
Sitting on a gold mine" tender offer disseminates
information that target shares are undervalued
Kick in the pants" tender offer forces target firm
management to implement more efficient business
strategies

Synergy explanation upward revaluation in

unsuccessful offer merely reflects likelihood that
other bidders may surface with specialized
resources to apply to target
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 Signaling
Information an outside event not initiated
by the firm conveys information
Signaling particular actions by the firm
may convey other significant forms of
information, e.g., that management does not
tender at the premium price in a share
repurchase signals that the company's
shares are undervalued

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Winner's Curse and Hubris

Winner's Curse: The winning bid in a
bidding contest for an object of uncertain
value will typically pay in excess of its
true value
One cause of the winner's curse
phenomenon in M&As is hubris, defined
as overweening pride and excessive
optimism
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Agency Problems
Agency problems arise when managers
own only fraction of the ownership
shares of the firm
Managers may work less (shirk) and/or
overconsume perks
Individual shareholders have little incentive
to monitor managers
Dealing with agency problems give rise to
monitoring and controlling costs
2001 Prentice Hall

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 Solutions to agency problem

Organizational mechanisms
Compensation arrangements tied to
performance
Market mechanisms
Market for managers
External monitoring through stock market
Takeovers external control device of last
resort

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 Managerialism
Mergers are a manifestation of agency
problems
Managers are motivated to increase the size
of their firms because their compensation is
a function of firm size, sales, or total assets
Theory may not be valid if managers'
compensation is based on profitability or
value increases

2001 Prentice Hall

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Free Cash Flow Hypothesis

(FCFH)
Jensen (1986, 1988)
Free cash flows (FCF) are cash flows in
excess of the amount needed to fund all
positive net present value projects

2001 Prentice Hall

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 Payout of free cash flow to reduce

agency costs
Reduces amount of resources under
control of managers
Prevents managers from investing in
negative NPV projects
Outside financing is subject to monitoring
by capital markets

2001 Prentice Hall

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 Bonding mechanism
Forces managers to pay out future cash
flows by debt creation without retention of
the proceeds of the issue
Discipline to be efficient to meet debt
obligations
Prevents unsound investments

2001 Prentice Hall

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 Theory prediction
Positive stock price reaction to unexpected
increases in payouts
Increased tightness of constraints requiring
the payout of future FCF will result in positive
stock price reaction
Predictions do not apply for
Firms that had more profitable projects than cash
flows to fund them
Growth firms

If agency costs cannot be resolved

perfectly, takeovers can help reduce them
2001 Prentice Hall

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 LBOs
Bonding effects of high debt ratios
undertaken by LBOs cause increase in
share price
Successful LBOs also involve a turnaround,
an improvement in the firm's performance
Strong incentives provided by large
ownership stakes of managers

2001 Prentice Hall

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Redistribution
Gains to target shareholders represent
redistribution from other stakeholders
Tax gains redistribution from the government or
public at large
Market position mergers may increase market
power and redistribution from consumers
Redistribution from bondholders account for only a
small percentage of gains to shareholders
Redistribution from labor Is it forced recontracting
or is it recognition of changed industry conditions?
Pension fund reversions not a major source of
takeover gains
2001 Prentice Hall

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Patterns of Restructuring in
the Chemical Industry
Change forces
Technological change
Globalization of markets
Favorable financial and economic
environments

2001 Prentice Hall

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 Characteristics of the chemical industry

U.S. chemical industry accounts for 2% of
U.S. GDP
Diverse and complex
Many distinctive segments; some overlap
with oil and other energy industries,
pharmaceutical and life science products
Two major types of firms
"All-around" companies operate in many areas
"Focused" firms operate in downstream
specialized segments
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 Commoditization of products
"Keystone" industry building blocks at
every level of production in major industries
Economic trends
Chemical shipments not keeping up with growth
in economy
Increase in service industries relative to major
users of chemicals has caused a decline in
growth of chemical shipments

Easy entry

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 M&As in the chemical industry

Chemical and related industries occupy
one of the top ranking areas in M&A
activity
Include a wide range of adjustments and
adaptations to changing technologies,
changing markets, and changing
competitive thrusts

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 Roles of M&As
Strengthen existing product line by adding
capabilities or extending geographic markets
Add new product line
Foreign acquisitions to obtain new capabilities
or needed presence in local markets
Obtain key scientists for development of
particular R&D programs
Reduce costs by eliminating duplicate activities
and shrinking capacity to improve sales to
capacity relationships
Divest activities not performing well
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 Harvest successful operations in advance of

competitor programs to expand capacity and
output
Round out product lines
Strengthen distribution systems
Move firm into new growth areas
Attain critical mass required for effective
utilization of large investment outlays
Create broader technology platforms
Achieve vertical integration
Revise and refresh strategic vision

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 Disadvantages of M&As
Buyer may not have full information of acquired
assets
Implementation may be difficult
Considerable executive talent and time commitments
Different organization cultures

Wide use of joint ventures and strategic

alliances
Combine different expertise and capabilities of
different companies
Reduce size of investments and risks

2001 Prentice Hall

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 Include changes in financial policies and

effectiveness
Considerable use of highly leveraged
restructuring such as leveraged buyouts
(LBOs) and management buyouts (MBOs)
Share repurchases

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 Concentration trends
US chemical industry
HHI in 1980 was 178, declined to 148 in 1990 and to
102 in 1998
HHI is far below critical 1,000 specified in anti-trust
guidelines
HHI has declined while M&A activity has increased

Intense competition
New entrants
Reduced firm size inequalities
New firms as a result of divestitures

World chemical industry

Significantly below critical 1,000 level
HHI declining for the same reasons as in US market
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Measurement of Abnormal
Returns
Residual analysis tests whether
returns to common stock of individual
firms or groups of firms is greater or
less than that predicted by general
market relationships between return and
risk

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event window

C1

C2

m0

T1

t0

T2

t (time)

clean period
event

Calculation of residuals
Event period
Identify event and its announcement day, t0
Define event period from day T1 to T2 usually
centered on announcement date

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 Predicted (or normal) return, R jt , for each

day t and for each firm j
Represents return that would be expected
absent of event
Estimated using "clean" period (C1 to C2) that
does not include event period

Three methods
Mean adjusted return
Predicted return is mean of daily returns for firm j
during clean period

R jt R j

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 Market model
Predicted return for firm j in day t in event period

R jt j Rmt
Estimates for and are obtained from a regression
using returns during clean period

R jt j j Rmt jt
Takes explicit account of both risk associated with
market and mean returns

Market adjusted return

Predicted return is return on market index for that day

R jt Rmt
Approximate market model where = 0 and = 1 for
all firms
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 Measures
Residual
Actual return minus predicted return

rjt R jt R jt
Represents abnormal return part of return that
was unexpected as a result of event

Average residual returns

Average across N firms for each event day t
ARt

jt

Averaging across large number of firms mitigates

noisy component of returns
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 Cumulative average residuals (CAR)

Cumulate average residual returns for
successive days over event period
T2

CAR ARt
t T1

Represents average total effect of event across

all firms over event period

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 Absolute gains and losses

Absolute dollar gain or loss at time t due to
abnormal return during event period
Wt CARt MKTVAL 0
CARt = cumulative average residual returns (%)
to date t for firm
MKTVAL0 = market value of firm at date m0 previous
to event window interval

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 Statistical significance of event returns

Test whether estimated cumulative average
residuals, CAR, is significantly different from
zero with a specified level of confidence
Null hypothesis presumed true unless statistical
tests establish the contrary
H0: CAR = 0 (event does not affect returns)

Alternative hypothesis
H1: CAR 0 (event does affect returns)

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 Test statistic is ratio of value of cumulative

average residuals, CAR, to its estimated
sample standard deviation
CAR
t-stat
S ( CAR )

If absolute value of t-stat ratio is greater than

specified critical value, reject null hypothesis
with some degree of confidence
|t-stat | > 1.96, CAR is significantly different from
zero at 5% level
|t-stat | > 2.58, CAR is significantly different from
zero at 1% level
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