Fundamental Characteristics of Financial Industry and Natural Evolution (II) Dr. J.D. Han King’s College, University of Western Ontario.

Fundamental Characteristics of Financial Industry

and Natural Evolution (II)

Dr. J.D. Han

King’s College,

University of Western Ontario

Objectives

Learn the basic concepts

securities firms, investment banking, securities trading and brokerage, M & A, etc.

Find an answer to puzzling questions such as,

“ Why are debts, as opposed to equities, getting more important in corporate financing?”

I. Two Latest Phenomena of Corporate Financing

1) Surge in Mergers and Acquisitions

(M & A)

2) An Increased Indebtedness(D/E ratio):

Debts have become more important in corporate financing.

II. Fundamental Driving Forces for the Two Phenomena

“Principal-Agent Problem”: Old Problem

-“Information Asymmetry” leads to “Principal-Agent Problem in Equities

* separation of ownership(principals=shareholders) and management(agents=managers)*Agent often works for his own best interests at the expense of the principals’

-The more severe Moral Hazard’ problem.

An Increased Legality : New Corporate Environment of Political Correctness

makes it virtually impossible to change management

III. Solutions to these Problems

We will explain that

An increase in M & A combined with

An Increased Indebtedness

may resolve or reduce these problems

of Corporations.

How?

1. How does M & A help solve Principal-Agent Problem?

M & A leads to a change to a new and better management and thus to an enhanced EFFINCIENCY

A just credible threat will wake up the existing stale management.

* Target for M & A: How do you know whether a firm’s management is stale?

Free Cash Flow Theory

by Michael C. Jensen at Harvard Business School

In his paper entitled “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers”, American Economic Review (1986)

* * Free Cash Flows as a Litmus Test

He defines Free Cash Flows:Free Cash Flows = Cash Receipts - Cash Expenditures - Profitable (Constructive) Investment Opportunities

His Observation:FCFs are the likely object of the Management’s abuse and a good indicator of the Principal-Agent Problem- The larger the FCF of a firm, the more severe the Principal-Agent

Problem.

*** Jensen’s FCF Theory in Reverse Gear

Dictum

“ The Larger the Free Cash Flow of a Firm, the More Severe the Principal-Agent Problem, and thus the Larger the Potential Benefits from M & A and Corporate Restructuring”

Prediction

We can also identify which firm is likely to be a target of M & A.

2. How does an Increased Indebtedness enhance Corporate Efficiency?

1) Debt contracts have a better monitoring through Restrictive Covenant and thus less moral hazards.

2) Reduced Equities increase Management’s portion of Profits

- “Incentive-Compatible” - It enhances Management’s work efforts

*Numerical Example of an Increased Indebtedness enhancing Management’s Rewards

Restructuring is “Leveraged” Buyout (of Shareholders) by Management

Before RestructuringDebt-Equity Ratio = 0/1 = 0

Capital Profits

Equity 1 Shareholders’ share

$9,000 $9,000Equity 2 Manager’s share

$1,000 $1,000Total

$10,000 $10,000*assume

interest rate =10%;

rate of returns on capital =100%

After RestructuringDebt –Equity Ratio = 9

Capital ProfitsDebts Shareholders’

share

$9,000 $ 900Equity 2 Manager’s share

$1,000 $9,100Total

$10,000 $10,000*Note: Manager’s profit share has

increased by 810%.

3. Two Structural Changes as Prerequisites for a Surge of M & A

Lowering Legal Barriers-Weakening of Anti-Trust Act(USA) Competition Act(Canada)

Development of Financial Institutions, Market & Debt Instruments

- Investment Banks, Securities Houses, Junk Bonds, (Debt-Equity) Swap, etc.

*Who are the Big Players?

Securities Firms Banks’ M & A Division of Investment Banking Department For instance

- Morgan Stanley

- Goldman Sachs

- Salomon Smith Barney

- Merrill Lynch

- Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium)

**Organization of Securities Firm

M erg ers an d A q u is it ion s

B ou g h t D ea lU n d erw rit in g

M arke ted D ea l

In it ia l P u b lic O ffe rin g P riva te Issu e

In ves tm en t B an k in g secu rit ies d ea lin g an d b rockerag e

S ecu rit ies F irm

***Glossaries

Investment Banking -helps issue new securities in the primary market

- Merchant Banking Securities Trading and Brokerage

- helping trade securities in the secondary market - Dealer versus Broker- Discount Brokerage versus Full Service Brokerage

Investment Dealer-dealer is principal, not agent

- applicable for Bought Deal and Securities Dealer

4. Pros and Cons of M& A 1) Pros: Advocate for M & A

M & A enhances Efficiency of Corporate Management

Natural Part of Globalization Trend Strategy for Survival from International

Competition(evidence) Share price of Target Firm goes up by 30-50%

before and after M & A

2) Criticism of M & A

(1) Zero Sum Game for the entire economy: gains for shareholders come from someone’s loss

a) Government Loss of Tax Revenues in LBOb) Wage Concessions after M & Ac) Bond holders’ loss: Increased leverage - Increased Default Risk

- Decreased Bond Priced) Consumers’ loss: Increased monopoly power - Higher price

(2) Economic Frailty Increases(3) M & A could be costly: A High Transactions Cost

(3) A Costly M & A: “ Shark Repellants”

-Setting up costly barriers against M & A Green Mail-bribe to a raider away

Scorch Earth- make yourself unattractive

Poison Pills- sell stock under market price in case of danger

Golden Parachute- big severance package for leaving executives

IV. Canadian Context

M & A will continue to increase

M & A take on Globalization trends

Source: Crosbie & Company Inc.

Historical Canadian Mergers & Acquisition Announcements

Valu

e in

$ B

illion

sAn

nou

ncem

en

ts

1,400

1,200

1,000

800

600

400

200

0

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

$210

$180

$150

$120

$90

$60

$30

0

Announcements

M & A at Canadian Cross-Border

# of Value # of Value # of ValueCanadians Acquiring: Transactions $millions Transactions $millions Transactions $millions

Foreign Companies 56 2,997 309 54,176 303 25,362

Canadian Companiesfrom Foreigners 13 3,503 46 7,081 41 4,491

Total Canadian Buyers 69 6,500 355 61,257 344 29,853

Foreigners Acquiring:

Canadian Companies 50 20,159 152 18,977 142 11,638

Foreign Companies from Canadians 13 990 60 14,068 52 15,709

Total Foreign Buyers 63 21,149 212 33,045 194 27,347

YTD March 31, 1999 FY1998 FY1997

M & A Resulting in Efficiency: CanadianCases

Average Median Average Median Average Median

Purchase Price ($mil) $240.6 $29.4 $217.1 $34.1 $126.6 $28.0

Market Premium 38% 33% 33% 28% 33% 26%

Price Mulitples:

Revenue 4.1 1.9 3.3 2 3.3 2

Net Book Value 3.8 2.1 2.8 2.3 3.7 2.3

Net Income 22.4 17.9 31.1 22.2 29.3 24.2

YTD March 31, 1999 FY1998 FY1997

Classic Study Case of M & A– The Company’s objective is to build value for its

investors through the acquisition of underperforming businesses( with a large amount of Free Cash Flow) financed largely with debts borrowed from third party lenders.

Performances. - Acquired Celestica for C$750mm in October, 1996 which

now has a market value of C$4.6 billion.

- Onex announces a bid for Air Canada and Canadian Airlines during a time when the industry is struggling.

3. Case Studies Case Study I) Excellent Execution - Onex Corporation

Case Study - Excellent Execution - Onex Corporation

Stock Price Performance September 29, 1994 - September 30, 1999

5.00

10.00

15.00

20.00

25.00

30.00

09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999

Onex Corp Sub Vtg

Oct 1/96: Onex acquires

Celestica for C$750mm

Nov 13/96: ProSource

completes IPO of US$48mm

Oct 1/98: Onex

announces

SoftBank acquisition

May 29/98: Onex sold

ProSource Inc. to

AmeriServe Food

Distribution for

C$123mm

Jan 29/99: Onex announces

LCS Industries acquisition

Mar 11/99: Onex announces

that it will sell 23%

of its stake in Sky

Chefs to LSG

Mar 25/99: Onex announces

C$1.5bn Telecom Fund

with Telefonica

May 11/99: Onex purchases

American Buildings

Aug 24/99: Onex

announces bid

for Air Canada

and Canadian Airlines

Case Study 2) - Disastrous Execution - Extendicare

Stock Price Performance September 29, 1994 - September 30, 1999

3.00

6.00

9.00

12.00

15.00

18.00

21.00

24.00

09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999

Extendicare Inc Cda Sub Vtg Shs

Nov 26/97: Extendicare acquired

all outstanding shares

of Arbor Health Care Co.

for US$419mm

Sept 17/98: Extendicare sells

its U.S. pharmaceutical

operations to Omnicare

Inc. for US$265mm

Nov 24/98: Extendicare intends

to buy back up to 3mm

of company's subordinate

voting shares

Feb 2/99: Extendicare's

stock dropped from TSE 100

Case Study 3 - High Yield Debt - Rogers Communications

Stock Price Performance September 29, 1994 - September 30, 1999

5.00

15.00

25.00

35.00

09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999

Rogers Communications Inc Cl B

Nov 11/95: Rogers Cablesystems

announces two new high yield

debt issues of US$150mm and US$125mm

Jan 16/96: Issues US$100mm

high yield debt

Jan 25/96: Issues

C$75mm high yield debt

July 17/97: Two new high yield

debt issues of US$330mm

and C$165mm announced

May 21/98: Rogers sells local

telephone services to

Metronet for C$1bn

July 12/99: Microsoft makes C$600mm

investment in Rogers; Aug 16/99: Completes

sale of 33% interest of Rogers Cantel to

AT&T Corp and BT PLC for C$1.4bn

Sep 9/99: Rogers repurchases

C$1.3bn in debt