Mergers and Acquisitions Basics: All You Need To Know

Table of Contents

Cover Image

Front-matter

Copyright

Preface

Acknowledgments

Chapter 1. Introduction to Mergers and Acquisitions

Chapter 2. What History Tells Us about M&A Performance

Chapter 3. Developing Takeover Strategies and the Impact on Corporate Governance

Chapter 4. Common Takeover Defenses

Chapter 5. Key Players in Mergers and Acquisitions

Chapter 6. Developing the Business Plan as the Initial Phase of the Merger and Acquisition Process

Chapter 7. The Role of the Acquisition Plan, Finding a Target, and Making First Contact

Chapter 8. The Negotiation, Integration Planning, and Closing Phases

Chapter 9. Financing Transactions

Chapter 10. M&A Postmerger Integration

Glossary

References

Index

Front-matter

Mergers and Acquisitions Basics

Mergers and Acquisitions Basics

All You Need To Know

Donald DePamphilis

Academic Press is an imprint of Elsevier

Copyright © 2011 Elsevier Inc.. All rights reserved.

Copyright

Academic Press is an imprint of Elsevier

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Library of Congress Cataloging-in-Publication Data

DePamphilis, Donald M.

Mergers and acquisitions basics: all you need to know/Donald DePamphilis.

p. cm.

Includes bibliographical references.

ISBN 978-0-12-374948-2

1. Consolidation and merger of corporations—United States—Management. 2. Corporate reorganizations—United States—Management. 3. Organizational change—United States—Management. I. Title.

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Preface

Why We Need to Understand the Role of Mergers and Acquisitions in Today's World

Mergers, acquisitions, business alliances, and corporate restructuring activities are increasingly commonplace in both developed and emerging economies. Given the frequency with which such activities occur, it is critical for business people and officials at all levels of government to have a basic understanding of why and how they take place and how they can affect economic growth. A lack of understanding of the role mergers and acquisitions (M&As) play in a modern economy can mean the failure to use such transactions as an effective means of implementing a business strategy. Moreover, ignorance can lead to overregulation of what are important means of disciplining incompetent managers and transferring ownership of operating assets to those who can utilize them most efficiently.

This book seeks to bring clarity to what is a complex, sometimes frustrating, and ultimately exciting subject. It presents an integrated way to think about the myriad activities involved in mergers and acquisitions. Although various types of business alliances and aspects of corporate restructuring are addressed in brief, the primary focus is on M&As.

The Book's Unique Features

This book is unique among books of this type in several specific ways. First, it is aimed primarily at practitioners who need a quick overview of the subject without getting bogged down in minutiae. Rather than provide intensive coverage of every aspect of mergers and acquisitions, as might be found in a comprehensive textbook, or dumb down the subject matter to provide only superficial—and perhaps inaccurate or misleading explanations—the text occupies a middle ground. No significant knowledge of finance, economics, or accounting is required, although a passing acquaintance with these disciplines is helpful. While reader-friendly, the text also draws on academic studies to substantiate key observations and conclusions that are empirically based. Details of these studies are often found in chapter footnotes.

Each chapter concludes with a section called A Case in Point that illustrates the chapter material with a real-world example. These sections include thought-provoking questions that encourage you, the reader, to apply the concepts explored in the chapter.

Who Should Read This Book

This book is aimed at buyers and sellers of businesses, financial analysts, chief executive officers, chief financial officers, operating managers, investment bankers, and portfolio managers. Others who may have an interest include bank lending officers, venture capitalists, government regulators, human resource mangers, entrepreneurs, and board members. In addition, the book may be used as a companion or supplemental text for undergraduate and graduate students in courses on mergers and acquisitions, corporate restructuring, business strategy, management, governance, and entrepreneurship. Supplemented with newspaper and magazine articles, the book could serve as the primary text in an introductory course on mergers and acquisitions.

For a more rigorous and detailed discussion on mergers and acquisitions and other forms of corporate restructuring, the reader may wish to see the author's textbook on the subject, Mergers, Acquisitions, and Other Restructuring Activities. The 5th edition (2009) is published by Academic Press. The reader also may be interested in the author's Mergers and Acquisitions Basics: Negotiation and Deal Structuring, also published by Academic Press in 2010.

Acknowledgments

I would like to express my sincere appreciation for the many resources of Academic Press/Butterworth-Heinemann/Elsevier in general and for the ongoing support provided by Karen Maloney, Managing Editor, and J. Scott Bentley, Executive Editor, as well as Scott M. Cooper, who helped streamline this manuscript for its primary audience. Finally, I would like to thank Alan Cherry, Ross Bengel, Patricia Douglas, Jim Healy, Charles Higgins, Michael Lovelady, John Mellen, Jon Saxon, David Offenberg, Chris Manning, and Maria Quijada for their many constructive comments.

Chapter 1. Introduction to Mergers and Acquisitions

The first decade of the new millennium heralded an era of global megamergers. Like the mergers and acquisitions (M&As) frenzy of the 1980s and 1990s, several factors fueled activity through mid-2007: readily available credit, historically low interest rates, rising equity markets, technological change, global competition, and industry consolidation. In terms of dollar volume, M&A transactions reached a record level worldwide in 2007. But extended turbulence in the global credit markets soon followed.

The first decade of the new millennium heralded an era of global megamergers. Like the mergers and acquisitions (M&As) frenzy of the 1980s and 1990s, several factors fueled activity through mid-2007: readily available credit, historically low interest rates, rising equity markets, technological change, global competition, and industry consolidation. In terms of dollar volume, M&A transactions reached a record level worldwide in 2007. But extended turbulence in the global credit markets soon followed.

The speculative housing bubble in the United States and elsewhere, largely financed by debt, burst during the second half of the year. Banks, concerned about the value of many of their own assets, became exceedingly selective and largely withdrew from financing the highly leveraged transactions that had become commonplace the previous year. The quality of assets held by banks throughout Europe and Asia also became suspect, reflecting the global nature of the credit markets. As credit dried up, a malaise spread worldwide in the market for highly leveraged M&A transactions.

By 2008, a combination of record high oil prices and a reduced availability of credit sent most of the world's economies into recession, reducing global M&A activity by more than one-third from its previous high. This global recession deepened during the first half of 2009—despite a dramatic drop in energy prices and highly stimulative monetary and fiscal policies—extending the slump in M&A activity.

In recent years, governments worldwide have intervened aggressively in global credit markets (as well as in manufacturing and other sectors of the economy) in an effort to restore business and consumer confidence, restore credit market functioning, and offset deflationary pressures. What impact have such actions had on mergers and acquisitions? It is too early to tell, but the implications may be significant.

M&As are an important means of transferring resources to where they are most needed and of removing underperforming managers. Government decisions to save some firms while allowing others to fail are likely to disrupt this process. Such decisions are often based on the notion that some firms are simply too big to fail because of their potential impact on the economy—consider AIG in the United States. Others are clearly motivated by politics. Such actions disrupt the smooth functioning of markets, which rewards good decisions and penalizes poor ones. Allowing a business to believe that it can achieve a size too big to fail may create perverse incentives. Plus, there is very little historical evidence that governments are better than markets at deciding who should fail and who should survive.

In this chapter, you will gain an understanding of the underlying dynamics of M&As in the context of an increasingly interconnected world. The chapter begins with a discussion of M&As as change agents in the context of corporate restructuring. The focus is on M&As and why they happen, with brief consideration given to alternative ways of increasing shareholder value. You will also be introduced to a variety of legal structures and strategies that are employed to restructure corporations.

Throughout this book, a firm that attempts to acquire or merge with another company is called an acquiring company, acquirer, or bidder. The target company or target is the firm being solicited by the acquiring company. Takeovers or buyouts are generic terms for a change in the controlling ownership interest of a corporation.

Words in bold italics are the ones most important for you to understand fully; they are all included in a glossary at the end of the book.

Mergers and Acquisitions as Change Agents

Businesses come and go in a continuing churn, perhaps best illustrated by the ever-changing composition of the so-called Fortune 500—the 500 largest U.S. corporations. Only 70 of the firms on the original 1955 list of 500 are on today's list, and some 2,000 firms have appeared on the list at one time or another. Most have dropped off the list either through merger, acquisition, bankruptcy, downsizing, or some other form of corporate restructuring. Consider a few examples: Chrysler, Bethlehem Steel, Scott Paper, Zenith, Rubbermaid, Warner Lambert. The popular media tends to use the term corporate restructuring to describe actions taken to expand or contract a firm's basic operations or fundamentally change its asset or financial structure. ¹

¹The broad array of activities falling under this catchall term runs the gamut from reorganizing business units to takeovers and joint ventures to divestitures and spin-offs and equity carve-outs. A detailed discussion of these alternative forms of restructuring is beyond the scope of this book. To learn more, see Mergers, Acquisitions, and other Restructuring Activities by Donald M. DePamphilis, now in its fifth edition and available through Academic Press.

Why Mergers and Acquisitions Happen

The prevalence of M&As and the importance of various factors that give rise to M&A activity varies over time. Exhibit 1-1 lists some of the more prominent theories about why M&As happen, each of which is discussed in greater detail in the following sections.

Exhibit 1-1 Common Theories of What Causes Mergers and Acquisitions

Synergy

Synergy is the rather simplistic notion that two (or more) businesses in combination will create greater shareholder value than if they are operated separately. It may be measured as the incremental cash flow that can be realized through combination in excess of what would be realized were the firms to remain separate. There are two basic types of synergy: operating and financial.

Operating Synergy (Economies of Scale and Scope)

Operating synergy comprises both economies of scale and economies of scope, which can be important determinants of shareholder wealth creation. ² Gains in efficiency can come from either factor and from improved managerial practices.

²DeLong (2003); Houston, James, and Ryngaert (2001).

Spreading fixed costs over increasing production levels realizes economies of scale, with scale defined by such fixed costs as depreciation of equipment and amortization of capitalized software; normal maintenance spending; obligations such as interest expense, lease payments, and long-term union, customer, and vendor contracts; and taxes. These costs are fixed in that they cannot be altered in the short run. By contrast, variable costs are those that change with output levels. Consequently, for a given scale or amount of fixed expenses, the dollar value of fixed expenses per unit of output and per dollar of revenue decreases as output and sales increase.

To illustrate the potential profit improvement from economies of scale, let's consider an automobile plant that can assemble 10 cars per hour and runs around the clock—which means the plant produces 240 cars per day. The plant's fixed expenses per day are $1 million, so the average fixed cost per car produced is $4,167 (i.e., $1,000,000/240). Now imagine an improved assembly line that allows the plant to assemble 20 cars per hour, or 480 per day. The average fixed cost per car per day falls to $2,083 (i.e., $1,000,000/480). If variable costs (e.g., direct labor) per car do not increase, and the selling price per car remains the same for each car, the profit improvement per car due to the decline in average fixed costs per car per day is $2,084 (i.e., $4,167 –$2,083).

A firm with high fixed costs as a percentage of total costs will have greater earnings variability than one with a lower ratio of fixed to total costs. Let's consider two firms with annual revenues of $1 billion and operating profits of $50 million. The fixed costs at the first firm represent 100 percent of total costs, but at the second fixed costs are only half of all costs. If revenues at both firms increased by $50 million, the first firm would see income increase to $100 million, precisely because all of its costs are fixed. Income at the second firm would rise only to $75 million, because half of the $50 million increased revenue would have to go to pay for increased variable costs.

Using a specific set of skills or an asset currently employed to produce a given product or service to produce something else realizes economies of scope, which are found most often when it is cheaper to combine multiple product lines in one firm than to produce them in separate firms. Procter & Gamble, the consumer products giant, uses its highly regarded consumer marketing skills to sell a full range of personal care as well as pharmaceutical products. Honda knows how to enhance internal combustion engines, so in addition to cars, the firm develops motorcycles, lawn mowers, and snow blowers. Sequent Technology lets customers run applications on UNIX and NT operating systems on a single computer system. Citigroup uses the same computer center to process loan applications, deposits, trust services, and mutual fund accounts for its bank's customers. Each is an example of economies of scope, where a firm is applying a specific set of skills or assets to produce or sell multiple products, thus generating more revenue.

Financial Synergy (Lowering the Cost of Capital)

Financial synergy refers to the impact of mergers and acquisitions on the cost of capital of the acquiring firm or newly formed firm resulting from a merger or acquisition. The cost of capital is the minimum return required by investors and lenders to induce them to buy a firm's stock or to lend to the firm.

In theory, the cost of capital could be reduced if the merged firms have cash flows that do not move up and down in tandem (i.e., so-called co-insurance), realize financial economies of scale from lower securities issuance and transactions costs, or result in a better matching of investment opportunities with internally generated funds. Combining a firm that has excess cash flows with one whose internally generated cash flow is insufficient to fund its investment opportunities may also result in a lower cost of borrowing. A firm in a mature industry experiencing slowing growth may produce cash flows well in excess of available investment opportunities. Another firm in a high-growth industry may not have enough cash to realize its investment opportunities. Reflecting their different growth rates and risk levels, the firm in the mature industry may have a lower cost of capital than the one in the high-growth industry, and combining the two firms could lower the average cost of capital of the combined firms.

Diversification

Buying firms outside a company's current primary lines of business is called diversification, and is typically justified in one of two ways. Diversification may create financial synergy that reduces the cost of capital, or it may allow a firm to shift its core product lines or markets into ones that have higher growth prospects, even ones that are unrelated to the firm's current products or markets. The extent to which diversification is unrelated to an acquirer's current lines of business can have significant implications for how effective management is in operating the combined firms.

Exhibit 1-2 is a product–market matrix that identifies a firm's primary diversification options. A firm facing slower growth in its current markets may be able to accelerate growth through related diversification by selling its current products in new markets that are somewhat unfamiliar and, therefore, more risky. Such was the case when pharmaceutical giant Johnson & Johnson announced its ultimately unsuccessful takeover attempt of Guidant Corporation in late 2004. J&J was seeking an entry point for its medical devices business in the fast-growing market for implantable devices, in which it did not then participate. A firm may attempt to achieve higher growth rates by developing or acquiring new products with which it is relatively unfamiliar and then selling them in familiar and less risky current markets. Retailer JCPenney's acquisition of the Eckerd Drugstore chain or J&J's $16 billion acquisition of Pfizer's consumer healthcare products line in 2006 are two examples of related diversification. In each instance, the firm assumed additional risk, but less so than unrelated diversification if it had developed new products for sale in new markets. There is considerable evidence that investors do not benefit from unrelated diversification.

Exhibit 1-2 Product–Market Matrix

Firms that operate in a number of largely unrelated industries, such as General Electric, are called conglomerates. The share prices of conglomerates often trade at a discount—as much as 10 to 15 percent³—compared to shares of focused firms or to their value were they broken up. This discount is called the conglomerate discount or diversification discount. Investors often perceive companies diversified in unrelated areas (i.e., those in different standard industrial classifications) as riskier because management has difficulty understanding these companies and often fails to provide full funding for the most attractive investment opportunities. ⁴ Moreover, outside investors may have a difficult time understanding how to value the various parts of highly diversified businesses. ⁵ Researchers differ on whether the conglomerate discount is overstated. ⁶

³Berger and Ofek (1995); Lins and Servaes (1999).

⁴Morck, Shleifer, and Vishny (1988).

⁵Best and Hodges (2004).

⁶Some argue that diversifying firms are often poor performers before they become conglomerates (Campa and Simi, 2002; Hyland, 2001), whereas others conclude that the conglomerate discount is a result of how the sample studied is constructed (Graham, Lemmon, and Wolf, 2002; Villalonga, 2004). Several suggest that the conglomerate discount is reduced when firms either divest or spin off businesses in an effort to achieve greater focus on the core business portfolio (Dittmar and Shivdasani, 2003; Shin and Stulz, 1998). Still others find evidence that the most successful mergers are those that focus on deals that promote the acquirer's core business (Harding and Rovit, 2004; Megginson et al., 2003). Related acquisitions may even be more likely to experience higher financial returns than unrelated acquisitions (Singh and Montgomery, 2008). This should not be surprising in that related firms are more likely to be able to realize cost savings due to overlapping functions and product lines than are unrelated firms. There is even an argument that diversified firms in developing countries, where access to capital markets is limited, may sell at a premium to more focused firms (Fauver, Houston, and Narrango, 2003). Under these circumstances, corporate diversification may enable more efficient investment because diversified firms may use cash generated by mature subsidiaries to fund those with higher growth potential.

Still, although the evidence suggests that firms pursuing a more focused corporate strategy are likely to perform best, there are always exceptions.

Strategic Realignment

The strategic realignment theory suggests that firms use M&As to make rapid adjustments to changes in their external environments. Although change can come from many different sources, this theory considers only changes in the regulatory environment and technological innovation—two factors that, over the past 20 years, have been major forces in creating new opportunities for growth, and threatening, or making obsolete, firms' primary lines of business.

Regulatory Change

Those industries that have been subject to significant deregulation in recent years—financial services, health care, utilities, media, telecommunications, defense—have been at the center of M&A activity⁷ because deregulation breaks down artificial barriers and stimulates competition. During the first half of the 1990s, for instance, the U.S. Department of Defense actively encouraged consolidation of the nation's major defense contractors to improve their overall operating efficiency.

⁷Mitchell and Mulherin (1996); Mulherin and Boone (2000).

Utilities now required in some states to sell power to competitors that can resell the power in the utility's own marketplace respond with M&As to achieve greater operating efficiency. Commercial banks that have moved beyond their historical role of accepting deposits and granting loans are merging with securities firms and insurance companies thanks to the Financial Services Modernization Act of 1999, which repealed legislation dating back to the Great Depression. The Citicorp–Travelers merger a year earlier anticipated this change, and it is probable that their representatives were lobbying for the new legislation. The final chapter has yet to be written: this trend toward huge financial services companies may yet be stymied by new regulation passed in 2010 in response to excessive risk taking.

The telecommunications industry offers a striking illustration. Historically, local and long-distance phone companies were not allowed to compete against each other, and cable companies were essentially monopolies. Since the Telecommunications Act of 1996, local and long-distance companies are actively encouraged to compete in each other's markets, and cable companies are offering both Internet access and local telephone service. When a federal appeals court in 2002 struck down a Federal Communications Commission regulation prohibiting a company from owning a cable television system and a broadcast TV station in the same city, and threw out the rule that barred a company from owning TV stations that reach more than 35 percent of U.S. households, it encouraged new combinations among the largest media companies or purchases of smaller broadcasters.

Technological Change

Technological advances create new products and industries. The development of the airplane created the passenger airline, avionics, and satellite industries. The emergence of satellite delivery of cable networks to regional and local stations ignited explosive growth in the cable industry. Today, with the expansion of broadband technology, we are witnessing the convergence of voice, data, and video technologies on the Internet. The emergence of digital camera technology has reduced dramatically the demand for analog cameras and film and sent household names such as Kodak and Polaroid scrambling to adapt. The growth of satellite radio is increasing its share of the radio advertising market at the expense of traditional radio stations.

Smaller, more nimble players exhibit speed and creativity many larger, more bureaucratic firms cannot achieve. With engineering talent often in short supply and product life cycles shortening, these larger firms may not have the luxury of time or the resources to innovate. So, they may look to M&As as a fast and sometimes less expensive way to acquire new technologies and proprietary know-how to fill gaps in their current product portfolios or to enter entirely new businesses. Acquiring technologies can also be a defensive weapon to keep important new technologies out of the hands of competitors. In 2006, eBay acquired Skype Technologies, the Internet phone provider, for $3.1 billion in cash, stock, and performance payments, hoping that the move would boost trading on its online auction site and limit competitors' access to the new technology. By September 2009, eBay had to admit that it had been unable to realize the benefits of owning Skype and was selling the business to a private investor group for $2.75 billion.

Hubris and the Winner's Curse

Managers sometimes believe that their own valuation of a target firm is superior to the market's valuation. Thus, the acquiring company tends to overpay for the target, having been overoptimistic when evaluating synergies. Competition among bidders also is likely to result in the winner overpaying because of hubris, even if significant synergies are present. ⁸ In an auction environment with bidders, the range of bids for a target company is likely to be quite wide, because senior managers tend to be very competitive and sometimes self-important. Their desire not to lose can drive the purchase price of an acquisition well in excess of its actual economic value (i.e., cash-generating capability). The winner pays more than the company is worth and may ultimately feel remorse at having done so—hence what has come to be called the winner's curse.

⁸Roll (1986).

Buying Undervalued Assets (The Q-Ratio)

The q-ratio is the ratio of the market value of the acquiring firm's stock to the replacement cost of its assets. Firms interested in expansion can choose to invest in new plants and equipment or obtain the assets by acquiring a company with a market value less than what it would cost to replace the assets (i.e., q-ratio < 1). This theory was very useful in explaining M&A activity during the 1970s, when high inflation and interest rates depressed stock prices well below the book value of many firms. High inflation also caused the replacement cost of assets to be much higher than the book value of assets. Book value refers to the value of assets listed on a firm's balance sheet and generally reflects the historical cost of acquiring such assets rather than their current cost.

When gasoline refiner Valero Energy Corp. acquired Premcor Inc. in 2005, the $8 billion transaction created the largest refiner in North America. It would have cost an estimated 40 percent more for Valero to build a new refinery with equivalent capacity. ⁹

⁹Zellner (2005).

Mismanagement (Agency Problems)

Agency problems arise when there is a difference between the interests of incumbent managers (i.e., those currently managing the firm) and the firm's shareholders. This happens when management owns a small fraction of the outstanding shares of the firm. These managers, who serve as agents of the shareholder, may be more inclined to focus on their own job security and lavish lifestyles than on maximizing shareholder value. When the shares of a company are widely held, the cost of such mismanagement is spread across a large number of shareholders, each of whom bears only a small portion. This allows for toleration of the mismanagement over long periods. Mergers often take place to correct situations in which there is a separation between what managers and owners (shareholders) want. Low stock prices put pressure on managers to take actions to raise the share price or become the target of acquirers, who perceive the stock to be undervalued¹⁰ and who are usually intent on removing the underperforming management of the target firm.

¹⁰Fama and Jensen (1983).

Agency problems also contribute to management-initiated buyouts, particularly when managers and shareholders disagree over how excess cash flow should be used. ¹¹ Managers may have access