20 MERGERS OHT 20 1 LEARNING OBJECTIVES Describe

20 MERGERS OHT 20. 1 LEARNING OBJECTIVES • Describe the rich array of motives for a merger • Express the advantages and disadvantages of alternative methods of financing mergers • Describe the merger process and the main regulatory constraints • Comment on the question: ‘Who benefits from mergers? ’ • Discuss some of the reasons for merger failure and some of the practices promoting success Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 2 THE MERGER DECISION Theoretically the acquisition of other companies should be evaluated using NPV. Two complicating factors: 1 The benefits from mergers are often difficult to quantify. 2 Acquiring companies often do not know what they are buying. Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 3 DEFINITIONS AND SEMANTICS Merger means the combining of two business entities under common ownership. The terms merger, acquisition and takeover will be used interchangeably. Economic and/or strategic definitions of mergers 1 Horizontal 2 Vertical 3 Conglomerate Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 4

20 MERGERS OHT 20. 5 MERGER MOTIVES (1) Synergy PVAB = PVA + PVB + gains Where: PVA = discounted cash flows of company A PVB = discounted cash flows of company B PVAB = discounted cash flows of the merged firm Synergy is often expressed in the form 2 + 2 = 5 • Value is created from a merger when the gain is greater than the transaction costs • Assume that A and B as separate entities have present values of £ 20 m and £ 10 m respectively • Transaction costs are £ 2 m • The value of the merged firms is £ 40 m • The net (after costs) gain from merger is £ 10 m £ 40 m = £ 20 m + £ 10 m + gain Who is going to receive this extra value? Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 6 20 MERGERS Exhibit 20. 3 Synergy The two firms together are worth more than the value of the firms apart. • PVAB = PVA + PVB + gains • Market power • Economies of scale • Internalisation of transactions • Entry to new markets and industries • Tax advantages • Risk diversification. • • Managerial motives Empire building Status Power Remuneration Hubris Survival: speedy growth strategy to reduce probability of being takeover target Free cash flow: management prefer to use free cash flow in acquisitions rather than return it to shareholders. Merger motives Bargain buying Target can be purchased at a price below the present value of the target’s future cash flow when in the hands of new management. • Elimination of inefficient and misguided management • Under-valued shares: strong form or semi-strong form of stock market inefficiency. Third party motives • Advisers. • At the insistence of customers or suppliers. Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS MERGER MOTIVES (2) • Market power • Economies of scale • Internalisation of transactions • Entry to new markets and industries • Tax advantages • Risk diversification Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 7

20 MERGERS MERGER MOTIVES (3) • Bargain buying • Inefficient management • Undervalued shares Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 8

20 MERGERS OHT 20. 9 MANAGERIAL MOTIVES FOR MERGERS (1) 1 More money 2 Status – feel more successful and important 3 Putting together an empire 4 Social position and stature 5 Hubris Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 10 20 MERGERS MANAGERIAL MOTIVES FOR MERGERS (2) 6 Survival Merger activity Small firms feel vulnerable to being taken over Firms become larger through takeovers Exhibit 20. 10 The self-reinforcement effect of mergers 7 Free cash flow Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS THIRD PARTY MOTIVES FOR MERGERS Advisers • Corporate financiers • Accountants and lawyers • The press Suppliers and customers Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 11

20 MERGERS FINANCING MERGERS Cash For Acquirer: Advantages: • The acquirer’s shareholders retain the same level of control over their company • Simplicity and preciseness gives a greater chance of success Disadvantage: • Cash flow strain For the target shareholders: Advantages: • Certain value • Able to spread investments Disadvantage: • May produce capital gain (tax) Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 12

OHT 20. 13 20 MERGERS SHARES AS PAYMENT Acquirer Advantages: • No immediate outflow of cash • The price–earnings ratio (PER) game can be played Disadvantages: • Dilution of existing shareholders • Greater risk of overpaying Target shareholders Advantages: • Capital gains tax can be postponed because the investment gain is not realised • They maintain an interest in the combined entity Disadvantages: • Uncertain value • Not able to spread investment without transaction costs Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 14 20 MERGERS Exhibit 20. 13 Illustration of the price to earnings ratio game – Crafty and Sloth Current earnings Number of shares Earnings per share Price to earnings ratio Share price Crafty Sloth £ 1 m 10 p 20 £ 2 £ 1 m 10 p 10 £ 1 Exhibit 20. 14 Crafty after an all-share merger with Sloth Crafty Earnings Number of shares Earnings per share Price to earnings ratio Share price £ 2 m 15 m 13. 33 p 20 267 p Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 15 THE MERGER PROCESS – THE REGULATORY BODIES The City Code on Take-overs and Mergers: • Self-regulatory by city institutions • Administered by the Takeover Panel Executive The main areas of concern are: • Shareholders being treated differently, for example large shareholders getting special deal • Insider dealing (control over this is assisted by statutory rules) • Target management action which is contrary to its shareholders’ best interests; for example, the advice to accept or reject a bid must be in the shareholders’ best interest not that of the management • Lack of adequate and timely information released to shareholders • Artificial manipulation of share prices; for example an acquirer offering shares cannot make the offer more attractive by getting friends to push up its share price • The bid process dragging on and thus distracting management from their proper tasks The Office of Fair Trading (OFT) Competition Commission European Commission in Brussels – intra-European Union mergers Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 16 20 MERGERS Exhibit 20. 17 Acquiring firm The merger process [1] Negotiation Identify target Appraise target Approach target Adviser Formulate proposals Decision to purchase target • Decide on price. • Method of payment: – cash; – shares; – other. • Timing. • Management. • Pensions. • Redundancy. • Directors. Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 Agreement Hostile bid

Market (dawn) raid Target board informs shareholders immediately: • press; • letter. Concert party 3% 30% rule Hostile bid Acquirer posts offer document to target shareholders within 28 days of announcement. Target board informs its shareholders of its response to the offer. Care must be taken to ensure proper and reasonable profit forecasts and asset revaluations. Offer conditional on acquirer gaining 50% of voting shares. Revised offer Remains open a further 14 days from the date of posting of the revised offer. Initial offer remains open for 21 days. The merger process [2] The offer communicated to target board and its advisers. Agreement Exhibit 20. 17 Bidder does not have to take up acceptances. Less than 50% of shares acquired. 50%+ of voting shares are acquired or agreed to be acquired. If 90% of the shares not owned by the acquirer at the start of the bid are bought in the bid period then the acquirer can force remaining shares be sold to it under certain conditions. If target shareholders sell only 50– 90% of shares bid for, some will become minority shareholders in target. Target shareholders cannot withdraw their acceptances. Offer declared unconditional. No better offer is to follow. 20 MERGERS OHT 20. 17 Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 18

20 MERGERS Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 20. 19

OHT 20. 20 20 MERGERS THE IMPACT OF MERGERS • Are target firms poor performers? • Does society benefit from mergers? Benefits Costs e. g. • economies of scale; • improved management. Reduces the cost of production. e. g. increased market power leads to higher prices to consumer. Exhibit 20. 20 Societal benefits and costs of mergers Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 21 20 MERGERS DO THE SHAREHOLDERS OF ACQUIRERS GAIN FROM MERGERS? Study Country of evidence Meeks (1977) UK At least half of the mergers studied showed a considerable decline in profitability compared with industry averages. Firth (1980) UK Relative share price losses are maintained for three years post-merger. Government Green Paper (1978) (a review of Monopolies and Mergers policy) UK At least half or more of the mergers studied have proved to be unprofitable. Ravenscraft and Scherer (1987) USA Small but significant decline in profitability on average. Limmack (1991) UK Long-run under-performance by acquirers. Higson and Elliot (1993) UK Poor relative performance on average (friendly bids produce much lower returns than hostile bids). Gregory (1997) UK Share return performance is poor relative to the market for up to two years post-merger, particularly for equity-financed bids and single (as opposed to regular) bidders. Franks and Harris (1989) UK and USA Share returns are poor for acquirers on average for the first two years under one measurement technique, but better than the market as a whole when the CAPM is used as a benchmark. UK Poor return performance relative to the market for high-rated (PER) acquirers taking over low-rated targets. However some firms do well when there is a complementary fit in terms of liquidity, slack and investment opportunities. UK Cash flow improves after merger, suggesting operating performance is given a boost. Salami (1996) Sudarsanam, Holl and Thomas (1994) Manson, Stark and Thomas (1994) Comment Exhibit 20. 22 Summary of some of the evidence on merger performance from the acquiring shareholders’ perspective Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 22 THE IMPACT OF MERGERS – WHO GAINS? • Do target shareholders gain from mergers? • Do the employees gain? • Do the directors of the acquirer gain? • Do the directors of the target gain? • Do the financial institutions gain? Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

OHT 20. 23 20 MERGERS MANAGING MERGERS The three stages of mergers Preparation Analyse organisational Strategic and objective culturaland similarities planningand differences Selection of target criteria – to fit with strategy Search for potential targets Evaluate short-listed potential targets Thought and plan of action on post-merger integration Negotiation/ transaction Detailed financial analysis and evaluation of chosen target Negotiating strategy and tactics Integration Analyse organisational and cultural similarities and differences Plan the post-merger integration and implement speedily Exhibit 20. 25 The progression of a merger Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 24 PROBLEM AREAS IN MERGER MANAGEMENT • The strategic, search and screening stage • The bidding stage • Expectations of the acquiring firm’s operational managers regarding the post-merger integration stage • Aiming for the wrong type of integration Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 25 WHY DO MERGERS FAIL TO GENERATE VALUE FOR ACQUIRING SHAREHOLDERS? • The strategy is misguided • Over-optimism • Failure of integration management Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002

20 MERGERS OHT 20. 26 Arnold’s ten golden rules for alienating ‘acquired’ employees Exhibit 20. 30 1 Sack people in an apparently arbitrary fashion. 2 Insist (as crudely as possible) that your culture is superior. Attack long-held beliefs, attributes, systems, norms, etc. 3 Don’t bother to find out the strengths and weaknesses of the new employees. 4 Lie to people – some of the old favourites are: – ‘there will not be any redundancies’; – ‘this is a true merger of equals’. 5 Fail to communicate your integration strategy: – don’t say why the pain and sacrifice is necessary, just impose it; – don’t provide a sense of purpose. 6 Encourage the best employees to leave by generating as much uncertainty as possible. 7 Create stress, loss of morale and commitment, and a general sense of hopelessness by being indifferent and insensitive to employees’ needs for information. 8 Make sure you let everyone know that you are superior – after all, you won the merger battle. 9 Sack all the senior executives immediately – their knowledge and experience and the loyalty of their subordinates are cheap. 10 Insist that your senior management appear uninterested in the boring job of nuts-andbolts integration management. After all knighthoods and peerages depend upon the next high-public-profile acquisition. Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002