Sesi 4

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1

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Theories of Mergers and Tender Offers


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


• Economies of scope

• Organization capital

• Organization reputation

• Human capital resources– Generic managerial capabilities– Industry-specific managerial capabilities

– Nonmanagerial human capital


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


• 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


• 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


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


Framework

• Total gains for both target and acquirer– Positive

• Efficiency improvement• Synergy

• Increased market power


– Zero• Hubris

• Winner's curse• Acquiring firm overpays

– Negative• Agency problems

• Mistakes or bad fit


• 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


Sources of Value Increases from M&As

• Efficiency increases – Unequal managerial capabilities– Better growth opportunities– Critical mass– Better utilization of fixed investments


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


• 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


– 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


– 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


• 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


• 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


• Strategic realignments– Acquire new management skills – Less time to acquire requisite capabilities

for new growth opportunities or to meet new competitive threats


• 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


• 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


• 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


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


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


• 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


• 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


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


• 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


• 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


• 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


• 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


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


Patterns of Restructuring in the Chemical Industry

• Change forces– Technological change– Globalization of markets– Favorable financial and economic

environments


• 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


– 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


• 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


– 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


• 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


– 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


– Include changes in financial policies and effectiveness

• Considerable use of highly leveraged restructuring such as leveraged buyouts (LBOs) and management buyouts (MBOs)

• Share repurchases


• 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


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


• 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

t (time)C1 C2 T2T1 t0m0

“clean” period

event window

“event”


– Predicted (or normal) return, , 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

jtR

jjt RR =ˆ


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

– Estimates for α and β are obtained from a regression using returns during clean period

– 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

– Approximate market model where α = 0 and β = 1 for all firms

mtjjt RR βα ˆˆˆ +=

jtmtjjjt RR εβα ++=

mtjt RR =ˆ


• Measures– Residual

• Actual return minus predicted return

• 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

• Averaging across large number of firms mitigates noisy component of returns

jtjtjt RRr ˆ−=

N

r

AR jjt

t

∑=


– Cumulative average residuals (CAR)• Cumulate average residual returns for

successive days over event period

• Represents average total effect of event across all firms over event period

∑=

=2

1

T

TttARCAR


• Absolute gains and losses– Absolute dollar gain or loss at time t due to

abnormal return during event period

0MKTVALCARW tt ×=∆

CARt = cumulative average residual returns (%) to date t for firm

MKTVAL0 = market value of firm at date m0 previous to event window interval


• 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

• Alternative hypothesis

H0: CAR = 0 (event does not affect returns)

H1: CAR ≠ 0 (event does affect returns)


– Test statistic is ratio of value of cumulative average residuals, CAR, to its estimated sample standard deviation

– 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

)CAR(S

CARt-stat =

Sesi 4

Education

corporate governance

e weston

mergers small shareholders

positive gains

shareholders pivotal

corporation shareholders

target firm

rejecttender offer