MGT6091: Issues in Finance

Session 4
Mergers & Acquisitions I:
Introduction & Theory
Dr. Abongeh Tunyi

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 Topics – Session (Lecture) 1 - 10

• Session 1: Introduction
• Session 2: Analysing portfolio returns: CAPM, FF3F, Carhart4F
• Session 3: Event Studies in Finance
• Session 4: M&A I: Introduction & Theory
• Session 5: M&A II: Impact & wealth effects
• Session 6: M&A and Bankruptcy prediction & applications
• Session 7: Social Responsible Investment and Firm value
• Session 8: Corporate governance & Firm value
• Session 9: Investment efficiency: Measures, drivers, consequences
• Session 10: Behavioural finance: Heuristics, Overconfidence, Emotions
 Learning objectives
• To overview and provide a broad background to M&As
• To explore theoretical perspectives on why M&A occurs – motives.
• To explore types of M&As, types of M&A defenses and some of the
reasons why M&As might fail.

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 Sample Questions
• Why do takeovers occur and how do they (takeovers) impact on the wealth of
bidder and target shareholders?
• Discuss whether a successful investment strategy can be built around takeover
prediction and outline the steps you will take to test this.

• To what extent do mergers and acquisitions (M&A) impact on the wealth of

shareholders?
• Discuss how and why factors such as the method of payment (cash versus stock),
the origin of the bidder (domestic versus cross-border), the relative size of the
bidder and the target, the bidder’s attitude (hostile or friendly), and the presence of
competing bids, moderate the distribution of wealth between the bidder and the
target.

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 Sample Questions
• Explain the following theories in relation to mergers and acquisitions; Inefficient
management hypothesis, Hubris theory, Monopoly theory, Empire-building
hypothesis.
• Discuss the empirical evidence on the impact of takeovers on the wealth of target
and acquirer shareholders.
• Discuss the theoretical arguments in relation to neoclassical and managerial
motives of takeovers.
• Briefly discuss the following concepts in relation to mergers and acquisitions;
Toehold, White knight, Winner’s curse, Poison pill, Crown jewels defence, Golden
parachutes
• Discuss the reasons why M&As may fail enhance shareholder value.

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Pre-lecture essential reading
• Overview – background
• Pike, R., Neale, B and Linsley, P. (2015) Corporate Finance and
Investment: Decisions and Strategies, Pearson, Chapter 20, p.593-646.
Available at the library.
• Antecedents/drivers/determinants/motivations/motives of
M&A
• Trautwein, F. (1990) Merger motives and merger prescriptions,
Strategic Management Journal, Vol. 11, p. 283-295.

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 Introduction – M&As
• A very broad area of Corporate Finance
• Interesting – Jobs (M&A advisory, Investment banks)?
• Opportunities for research
• This is only an intro with a focus on theories, determinants & impact on
shareholders.
• Need to read widely to appreciate the area.

• Firm Growth: Organic or via acquisitions

• Slow versus exponential
• What are mergers & acquisition?

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 Mergers & Acquisitions (M&A)
• An investment decision involving the acquisition of a solvent company (target) by
another (bidder).
• Bidder can acquire part (<100%) or all (100%) of the shares & voting rights of
the target.
• Terminology:
• M&A, takeovers, mergers, acquisitions, generally used interchangeably.
• Mergers & Acquisitions
• Mergers
• Combination of two into a new organisation.
• Pooling of interests.
• Generally, requires agreement of both sets of shareholders.
• Takeovers, Acquisitions
• Absorption (acquisition) of one organisation by another.
• Paid for in cash, stock, loan stock (e.g., convertible bonds) 8
Mergers & Acquisitions (M&A)- Private deals
1 – Purpose of M&A; new product
lines, access to new markets etc.
2 – Characteristics of a suitable target;
profitability, location, customer base
etc.
3 – Identify suitable targets.
4 – meet with potential targets, obtain
more info and gauge interest.
5 – Collect potential target info,
valuation, determine suitability
6 – Construct offer based on
valuation. Present offer and negotiate.
Offer accepted.
7 – Conduct detailed examination,
audit, assessment to confirm
everything is in order
8 – Finalise contract and agree on
payment method etc.
9 – Tidy up financing arrangements
10 – Close deal, work with all
stakeholders to integrate firms
What about public deals? 9
Break

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Terminology
• The buyer:
• Bidder, acquirer, acquiror, offeror
• The seller:
• Target, offeree
• Bid, offer
• Method of payment
• Cash, Shares, Loan stock (e.g., convertible bonds), Mix
• Contingent payment, Earnout
• Bid premium
• Due diligence
• Delist
• Integrate 11
 Terminology and characteristics

• Dates:
• Announcement date
• Completion date
• Bid resistance (hostile, tender offers) vs Friendly
• Why resist?
• Completed bids vs Failed bids
• Competing bids ( & revised bids) versus single bidder
• Friendly vs Hostile bids
• Cross-border vs domestic bids
• Focus versus diversifying bids
• Toeholds
• Why toehold?
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 Process for Targets & Bidders (guided by local regulations)

• Process – Bidder • Process – Target

• Search Regulators • Set prebid defenses
• Engage consultants, investment banks • In anticipation
• Valuation • Some are illegal in UK
• Bid, offer Competition
• Consider bid/deal
• Improved offer and Markets • Allow due diligence (or not)
Authority
• Hostile approach CMA • Resist versus accept
• Due diligence • Seek improved offer
• Pay- delist • Litigate
• Integrate • Seek protections
• Sell-offs Takeover • Agree terms
• Restructure Panel • Allow due diligence
• Lay-offs City code of • Accept payment
Takeovers &
Mergers • Delist (if 100% acquisition)
• Continue operations (if <100%)
• Accept earnouts
Break

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 Theories on M&A motives – Trautwein 1990

• Why do M&As occur? Motivations

• Neoclassical theory
• Efficiency hypothesis (synergies)
• Management inefficiency hypothesis
• Firm undervaluation hypothesis
• Monopoly theory
• Managerial theory
• Hubris hypothesis
• Empire building hypothesis

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 Theories on why M&A occurs – Trautwein 1990

• Neoclassical theory: Managers engage in M&A to maximise

shareholder wealth. But how?
• Efficiency hypothesis (synergies)
▪ Financial – Lower cost of capital (Size, Collateral, Internal capital market)
▪ Operational – Duplication, economies of Scale & Scope
▪ Managerial – Management skill & knowledge, control
• Management inefficiency hypothesis
▪ Managers seek to replace inefficient management teams through M&As.
▪ Poor performance leads to M&A.

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Theories on why M&A occurs – Trautwein 1990

• Neoclassical theory: Managers engage in M&A to

maximise shareholder wealth. But how?
• Firm undervaluation hypothesis
▪ Managers seek to acquire undervalued assets through
M&As.
▪ Restore value through better management
• Monopoly theory
▪ Managers seek to increase market power through M&A.
▪ Hence, better competitive position & profitability

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 Theories on M&A motives – Trautwein 1990
• Managerial theory: Managers are self-serving through M&As. M&As destroy
shareholder value.
• Hubris hypothesis
▪ Hubris – Excessive overconfidence or arrogance which leads someone to
believe in their “supernatural” ability.
▪ Managerial pride, hubris, overconfidence leads to M&As.
▪ Managers believe they can revive or extract value from ailing companies
▪ They overpay for their targets and lose from M&As.
• Empire building hypothesis
▪ Managers seek to increase assets under their control through M&A.
▪ This leads to managerial pride (social status).
▪ This may also allow them to demand high compensation (pay) and
managerial perquisites.
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Other arguments for M&As: Neoclassical
• Economies of scale benefits
• Reduce marginal costs, improve competitive position
• Synergy creation:
• Cross-selling
• Cost reduction
• Access to new markets
• Fill gaps in product line
• Strategic realignment:
• Technological change
• Deregulation
• Response to industry restructuring/Competitiveness
• To restore growth
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 Other arguments for M&As: Neoclassical
• To acquire market power, improve competitive position
• Diversification (Related/Unrelated):
• Reduce dependence on current activities
• Reduce risk
• Financial considerations
• Target is undervalued
• Booming stock market
• Falling interest rates
• To obtain stock market listing
• Tax considerations

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Other arguments for M&As: Managerial

• Managerial pay & benefits

• Pay and benefits are tied to firm size (as well as performance)
• Managerial status: Ego/Hubris
• Managers of larger firms associated with higher social status; bigger more
luxurious offices, private jets.
• Overconfidence leads managers to systematically over-value targets
• Excess free cash flow & agency problems
• Managers with excess free cash flow (and no positive NPV projects) use this to
acquire firms – instead of returning funds to shareholders.
• Returning excess free cash flow to shareholders may signal lack of investible
projects (i.e., poor management)

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Break

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Types of M&A & value creation

• Horizontal integration
• EG – Tesco acquires Sainsbury
• Benefits
• Market power
• Economies of scale/scope
• Synergies
• Vertical integration
• EG – Tesco acquires ABC Milk Farms
• Control of supply chain
• Manage Costs
• Conglomerate integration
• EG – Tesco acquires Toyota
• Diversification benefits
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Regulation of takeovers
• The Competition & Markets Authority (CMA)
• Previously, The Competition Commission
• Ensure that takeovers (M&As) do not unfairly impact on consumers.
• Guard against firms having too much market power through M&As.
• Prevent the creation of monopolies.

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Regulation of takeovers
• The Panel on Takeovers & Mergers
• Administers the City Code on takeovers & Mergers (The Takeover Code,
The Code)
• Members – The City, Confederation of British Industry (CBI), the Stock
Exchange, ICAEW
• Statutory but no legal authority
• Objective – ‘to ensure fair treatment for all shareholders in takeover
bids’
• Provides guidance on the takeover process.

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 On takeover defence tactics
• Firms (managers) do not generally like to be takeover targets.
• Why?
• Managers of takeover targets generally lose their jobs.
• Takeover may signal poor management – which may adversely impact future
career prospects.
• It is common for (target) managers to defend against impending
takeovers.
• Common defense strategies
• Revalue assets
• Denigrate profit and share price record of bidder
• Promise dividend increase
• Publish improved profit forecasts
• White Knight – friendly bidder
• Lobby Competition & Market’s Authority
• Share Repurchases 26
 On takeover defence tactics
Illegal in the UK per the Takeover Code?
• Pacman Defense
▪ Launching a bid for the bidder
• Golden Parachutes (Silver Parachutes, Tin Parachutes)
▪ Protection for incumbent managers
▪ Severance pay, stock options, bonuses
• Launching a bid for another company
• Poison pills
▪ Warrant/option attached to existing shares. Flip-in poison pill allows existing shareholders with
ownership below a designated level to buy new shares at a discounted rate.
• Kamikaze Defense – (Japanese army special suicide attack unit)
• Crown Jewels Defense
• Sale or spin-off of most attractive assets
• Scotched Earth Defense
• Destroy value parts; e.g., fire skilled workers, halt maintenance of assets
• Fat Man defense
• Bloat/load up new assets, acquisitions, debt which make the company to complex, large, unwieldly for acquisition.

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Why bidders fail
• Information asymmetry
• All facts about target unknown to bidder pre-merger
• …Even after due diligence
• Target only sells if bidder pays > value of target
• Managerial hubris
• Manager’s systematically overestimate benefits of takeovers
• Bidders pay too much for targets
• Since targets (M&As) are relatively larger than other investments
– bidders go into a lot of debt, which they may struggle to service.
• Acquisitions and post M&A integration issues, consumes a lot of
managerial time and capacity.
Why bidders fail
• Empire building through M&A
• Post merger integration issues
• Integration is time consuming, expensive, creates uncertainty, discontinuity
• Key stakeholders (customers, suppliers) may choose to leave
• Synergies overestimated & unrealised
• Synergies through employee reduction: Morale issues?
• Culture clash
• Financial advisers & investment bankers
• Bidders rely on advisers who have a stake in promoting M&As.
• Advisers: High costs, High fees!
Break

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Assessing the impact of M&A on shareholders
• Financial characteristics approach
• Pre and post-merger performance (ROA, AAR) analysis.
• Problems:
• Difficult to associate change in performance to M&A
• Long run or short run performance?
• Capital markets approach – Event studies
• Efficient market hypothesis
• Announcement gains (abnormal returns)
Impact of M&As: Franks and Harris, 1989

• Classic event study on M&A in the UK

• Examines effects of takeovers on shareholder wealth,
• i.e., How the wealth of shareholders (targets & acquirers) of firms involved
in M&A is affected by the event.
• Sample:
• 1,898 UK targets and 1,058 UK bidders between Jan 1955 and June 1985.
• Collect price data from LSPD, data for M&A announcement date
taken from EXTEL
• Similar data can be collected from Thomson DataStream & Thomson One.
• Available at the university.
Franks and Harris, 1989: UK evidence
• Uses monthly (not daily returns)
• Event study parameters
• Event window (months) -4 to +1
• Estimation period: 60 months beginning at t=-71
• Expected return computed using OLS Market model, Market-
adjusted returns model and CAPM
• OLS Market Model (MM):
• ER = alpha + beta (Market return)
• Market Adjusted Returns (MAR):
• ER = market return,.
• Similar to MM but sets alpha to zero and beta to 1.
• CAPM: ER = RF+ Beta (Rm-RF)
Franks and Harris, 1989: UK evidence
• Results reported: AAR and CAAR
• AR= Actual return – Expected returns.
• AAR = Average of AR for each day across all sampled companies.
• CAAR = Sum of AAR over the event window.
• Average Abnormal Returns (AAR):
• AAR for all targets in month 0: 23.3% (significant and large)
• AAR for all bidders in month 0: 1.0% (significant but small)
• Cumulative Average Abnormal Returns (CAAR):
• CAAR for all targets between -4 and +1: 29.7% (significant and large)
• CAAR for all bidders between -4 and +1: 7.9% (significant)

• Conclusion: Targets gain, bidders earn modest gains.

Returns to targets: Danbolt, Siganos & Tunyi (2016)
Bid Characteristics Matter
• Franks and Harris (1989) further explore whether M&A
characteristics shape AR to targets and bidders:
• Relative size of the bidder
• Tender offers versus mergers
• Single bids versus Multiple bids
• Pre-merger interests – Toeholds
• Other related studies have used a similar methodology (sub-
sample analysis) to further explore:
• Successful versus failed bids – bid completion
• Cash offers versus stock offers – form of payment
• Foreign versus domestic bids – origin of the bidder
• Focus versus diversifying bids
Appendices
• Recent high profile UK M&As reported on BBC.
• The classic cases of Kraft’s (USA) acquisition of
Cadbury (UK).

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Break

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 Some takeovers and mergers: BBC News

• Travel booking site Expedia has snapped up rival Orbitz Worldwide

in a $1.34bn cash deal.
• BT has made a £12.5bn acquisition of EE, the UK's largest mobile
group.
• Under Armour is paying more than $500M to acquire two fitness
tracking apps - MyFitnessPal and Endomondo
• Staples to buy Office Depot for $6.3bn.
• AG Barr, the maker of Irn-Bru and Rubicon fizzy drinks, is spending
£21m on Funkin, a company that makes natural fruit ingredients for
cocktails.

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 Some takeovers and mergers: BBC News

• Aviva's £5.6bn takeover of Friends Life creates UK's largest

insurer.
• O2 purchase by Three confirmed for £10.25bn as mobile
operator consolidation continues.
• Comcast & Time Warner Cable merged in a deal value of
$69.8 billion.
• Facebook & WhatsApp merged in a deal worth $19 billion:
Aer Lingus is the target of a €1.4bn bid from International
Airlines Group, parent of British Airways and Iberia.
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UK takeovers by foreign firms
• O2: UK mobile phone company O2 was sold to Spain's Telefonica for £18bnin
2005.
• Retailer Alliance Boots was bought by private equity firm KKR in 2007
for £11.1bn.
• BAA: Airport owner BAA was sold to Spanish firm Ferrovial for more than
£10bn in 2006.
• Powergen: German energy group E.on completed a £9.6bn takeover of Powergen
in 2002.
• ICI: Dutch chemical group Akzo Nobel NV sealed an £8bn takeover of ICI in
2008.

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 UK takeovers by foreign firms
• Thames Water: Thames Water was acquired by the German utility company
RWE in 2001 for £4.8bn. Four years later, RWE announced that it would sell
Thames Water to Kemble Water Limited - a consortium led by an investment
fund run by the Australian Macquarie Bank- for £8bn.
• Corus: Steelmaker Corus accepted a £4.3bn takeover offer from Indian rival
Tata Steel in 2006.
• P&O: Port and shipping group P&O's £3.9bn takeover by rival Dubai Ports
World was approved by a High Court judge in 2006.
• Jaguar: Ford sold its luxury UK-based car brands Jaguar and Land Rover to
Indian company Tata for $2.3bn (£1.15bn) in 2008 .
• Pilkington: Japan's Nippon Sheet Glass UK glass manufacturer Pilkington
agreed to buy the remaining 80pc of Pilkington it does not already own
for £1.8bn ($3.14bn) in 2006.
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 Kraft Food’s Takeover of
Cadbury – A Case study

Read through the case and reflect on how the transaction impacts on the
stakeholders (customers, shareholders, managers, suppliers, employees) of
the two firms.

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Case study: Kraft Food’s takeover of Cadbury

• On 7 September 2009 Kraft Foods made a £10.2 billion (US$16.2

billion) indicative takeover bid for Cadbury. The offer was rejected,
with Cadbury stating that it undervalued the company. Kraft
launched a formal, hostile bid for Cadbury valuing the firm at
£9.8 billion on 9 November 2009.
• Kraft sought Cadbury because of its strong growth in emerging
markets, like India and Latin America. Kraft, famed for its Oreo
cookies and Philadelphia cream cheese, derives over half its sales
from the mature North American market.

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 Case study: Kraft Food’s takeover of Cadbury
• On 19 January 2010, it was announced that Cadbury and Kraft Foods
had reached a deal and that Kraft would purchase Cadbury for £8.40
per share, valuing Cadbury at £11.5bn (US$18.9bn). Kraft, which issued
a statement stating that the deal will create a "global confectionery
leader", had to borrow £7 billion (US$11.5bn) in order to finance the
takeover.
• The cash-and-stock agreement, which dealmakers said was struck after
all-night negotiations at the London headquarters of investment bank
Lazard, values each Cadbury share at 840 pence. Shareholders are also
set to get a 10p special dividend, bringing it to a total of 850p.
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Case study: Kraft Food’s takeover of Cadbury

• The final offer marked a 14 percent increase over Kraft’s

initial bid of 745p and about 11 percent above the value of the
offer on Friday. The price tag is 50 percent above where
Cadbury’s stock was trading the day before Kraft’s initial bid
was disclosed in early September.
• Cadbury shares hit a record high of 838 pence in early
trading and closed up 3.6 percent at 836.5p. Kraft was down
1.1 percent, to $29.25.
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 Case study: Kraft Food’s takeover of Cadbury

• The Hershey Company, based in Pennsylvania, manufactures and

distributes Cadbury-branded chocolate (but not its other confectionery) in
the United States and has been reported to share Cadbury's
"ethos". Hershey had expressed an interest in buying Cadbury because it
would broaden its access to faster-growing international markets. But on
22 January 2010, Hershey announced that it would not counter Kraft's
final offer.
• The acquisition of Cadbury faced widespread disapproval from the British
public, as well as, groups and organisations including trade union Unite.
Unite estimated that a takeover by Kraft could put 30,000 jobs "at
risk", and UK shareholders protested over the mergers and acquisitions
advisory fees charged by banks.
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Case study: Kraft Food’s takeover of Cadbury

• Cadbury's M&A advisers were UBS, Goldman Sachs and Morgan Stanley.
Controversially, RBS, a bank 84% owned by the United Kingdom
Government, funded the Kraft takeover.
• On 2 February 2010, Kraft secured over 71% of Cadbury's shares thus
finalising the deal. Kraft had needed to reach 75% of the shares in order to
be able to delist Cadbury from the stock market and fully integrate it as
part of Kraft. This was achieved on 5 February 2010, and the company
announced that Cadbury shares would be de-listed on 8 March 2010.
• On 3 February 2010, the Chairman Roger Carr, chief executive Todd
Stitzer and chief financial officer Andrew Bonfield all announced their
resignations. Stitzer had worked at the company for 27 years.
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 Case study: Kraft Food’s takeover of Cadbury

• On 9 February 2010, Kraft announced that they were planning to close

the Somerdale Factory, Keynsham, with the loss of 400 jobs. The
management explained that existing plans to move production to
Poland were too advanced to be realistically reversed, though
assurances had been given regarding sustaining the plant.
• Staff at Keynsham criticised this move, suggesting that they felt
betrayed and as if they have been "sacked twice“. On 22 April 2010,
Phil Rumbol, the man behind the famous Gorilla advertisement,
announced his plans to leave the Cadbury company in July following
Kraft's takeover.

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Case study: Kraft Food’s takeover of Cadbury

• In June 2010 the Polish division, Cadbury-Wedel, was sold

to Lotte of Korea. The European Commission made the sale a
condition of the Kraft takeover. As part of the deal Kraft will keep
the Cadbury, Hall's and other brands along with two plants
in Skarbimierz. Lotte will take over the plant in Warsaw along with
the E Wedel brand.
• On 4 August 2011, Kraft Foods announced they would be splitting
into two companies beginning on 1 October 2012. The confectionery
business of Kraft became Mondelēz International, of which Cadbury
is a subsidiary.

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Reflection: What the transaction means for
stakeholders of (i) Kraft (ii) Cadbury.

• Customers
• Shareholders
• Managers
• Suppliers
• Employees

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