MERGERS &

ACQUISITIONS
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Market for corporate control

• Acquirer (or bidder) – the buyer of the firm

• Target – the seller of the firm

• The global takeover market is highly

active, averaging more than $1 trillion per
year in transaction value.

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Twenty Largest Merger

Transactions, 1998–2015

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Merger
• Negotiated transaction between management and directors
of two firms

• Typically equal partners and friendly in nature

– Often: post merger management from both companies

• Shareholder and regulatory approval required

• Payment in the form of exchange of shares

– Target shareholders are swapping old stock for new stock in either the
acquirer or a newly created merged firm

• Term sheet
– Summary of price and method of payment
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Types of Mergers

• Horizontal merger
– Target and acquirer are in the same industry
• e.g., Daimler-Benz and Chrysler (1998)

• Vertical merger
– Target’s industry buys from or sells to acquirer’s industry
• e.g., Time Warner and Turner (1995)

• Conglomerate merger
– Target and acquirer operate in unrelated industries
• e.g., Sony acquired Columbia Pictures Entertainment (1989)

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Acquisition
• Purchase assets from a selling firm
– Payment can be in cash or stock

• Gain control of majority stake through

– Negotiated transaction with large shareholder
– Tender offer: bypass management and make offer
directly to shareholders
– Open market operation

Hostile takeover:
• Management/board of target firm does not
recommend bid to shareholders
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EMPIRICAL
REGULARITIES
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Historical Trends

• Merger Waves:
– Peaks of heavy activity followed by quiet
troughs of few transactions in the takeover
market

Fraction of U.S. Public Companies Acquired Each

Year
1926–2015

Source: Authors’ calculations based on Center for Research in Securities Prices data
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Acquisition Premium

• In most U.S. states, the law requires that when

existing shareholders of a target firm are forced
to sell their shares, they receive a fair value for
their shares.

• Research has found that acquirers pay an average

premium of 43% over the pre-merger price of the
target.

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Announcement returns
• Announcement Period Abnormal Returns for Sub-Samples,
1973-1998:
 [-1,+1] captures the period from one day before to one day after deal
announcement

(Source: Andrade, Mitchell, Stafford, 2001, table 4) 12

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Long-term performance
5 year average post-merger acquirer return relative to control
group

Stock acquisition -24.2%*

Cash acquisition 18.5%*

Mixed acquisition -9.6%

All acquisitions -6.5%

(Source: Loughran and Vijh, 2001)

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The Method of Payment

• Equity deals – signal that equity is overvalued?

• Why might management undertake value

destroying mergers? Free cash flow problem:
– Empire building
– Overconfidence

• What capital structure decisions could we make to

prevent such activities?
– Reduce excess cash (e.g., increase buybacks)

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 ECONOMICS OF M&A

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Motivations for Mergers

• Economic Motivations
– Synergies
– Monopoly Gains / Market Power
– Replace Inefficient Management
– Taxes

• Dubious Reasons
– Diversification
– Boosting EPS
– Reduce Financing Costs

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 ECONOMIC MOTIVATIONS

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Synergies

• Synergies are by far the most common

stated reason

• Synergies usually fall into two categories:

– Cost-reduction synergies
– Revenue-enhancement synergies

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Economies of Scale and Scope

• Economies of Scale
– The savings a large company can enjoy from
producing goods in high volume, that are not
available to a small company
– E.g. horizontal mergers

• Economies of Scope
– Savings large companies can realize that come from
combining the marketing and distribution of different
types of related products
– E.g. vertical mergers

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Expertise

• Firms often need expertise in particular areas to

compete more efficiently.
– Particularly with new technologies, hiring experienced
workers directly may be difficult.
– It may be more efficient to purchase the talent as an
already functioning unit by acquiring an existing firm.

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Monopoly Gains

• Merging with a major rival may enable a firm to

substantially reduce competition within the
industry and thereby increase profits.
– Most countries have antitrust laws that limit
such activity.

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Replacing Inefficient Management

• Acquirers often argue that they can run the target

organization more efficiently than existing
management could

• In the 1980s many takeovers were motivated by

a desire to replace inefficient managers
– These takeovers were “hostile”, resisted by the
management
– Often initiated by LBO funds (“raiders”)
• Increase in leverage reduces the free cash flow problems,
combined with strong pay incentives for new managers
• Sometimes lead to break-up of company, where individual pieces
are sold off

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Tax Savings from Operating Losses

• A conglomerate may have a tax advantage over a

single-product firm because losses in one division
can offset profits in another division.

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Example

• Consider two firms, Ying Corporation and Yang Corporation. Both

corporations will either make $50 million or lose $20 million every
year with equal probability.
• The only difference is that the firms’ profits are perfectly
negatively correlated. That is, any year Yang Corporation earns
$50 million, Ying Corporation loses $20 million, and vice versa.
• Assume that the corporate tax rate is 34%.

1. What are the total expected after tax profits of both firms when
they are two separate firms?
2. What are the expected after-tax profits if the two firms are
combined into one corporation called Ying-Yang Corporation, but
are run as two independent divisions? (Assume it is not possible
to carry back or carry forward any losses.)

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Solution

• In the profitable state, Ying Corporation must pay corporate

taxes, so after-tax profits are $50 × (1 - 0.34) = $33
million. No taxes are owed when the firm reports losses, so
the after-tax profits in the unprofitable state are -$20
million.
• Thus, the expected after-tax profits of Ying Corporation are
33(0.5) + (-20)(0.5) = $6.5 million.

• Because Yang Corporation has identical expected profits, its

expected profits are also $6.5 million.

• Thus, the total expected profit of both companies operated

separately is $13 million.

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Solution – cont.

• If the firms are combined, their total profits in any year

would always be $50 million - $20 million = $30 million, so
the after-tax profit will always be $30 × (1- tax rate).
• The merged corporation, Ying-Yang Corporation, would have
after-tax profits of $30 × (1-0.34) = $19.8 million.

• Thus, Ying-Yang Corporation has significantly higher

after-tax profits than the total stand-alone after-tax
profits of Ying Corporation and Yang Corporation.

• This is because the losses on one division reduce the taxes

on the other division’s profits.

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 DUBIOUS REASONS

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Diversification

• Risk Reduction
– Large firms bear less unsystematic risk, so mergers are
often justified on the basis that the combined firm is less
risky.
– But this argument ignores the fact that investors can
achieve the benefits of diversification themselves by
purchasing shares in the two separate firms.
– Diversification may reduce idiosyncratic risk, but so
what?
• If diversification creates value, it must follow from
a failure of an MM assumption:
– e.g. cost of distress, taxes, undiversified shareholders
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Boosting EPS

• It is possible to combine two companies with the result that

the earnings per share of the merged company exceed the
pre-merger earnings per share of either company, even
when the merger itself creates no economic value.

• When company acquires a company with lower P/E, then

EPS increases
– Accretive deals increase EPS
– Dilutive deals reduce EPS

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Boosting EPS, cont.

• Some practitioners assign great value to accretion
in mergers

• Most academics and other practitioners think it is

a misguided concern
– In MM world, value additivity holds, and total value
shouldn’t change just because EPS changes

• However, if investors blindly slap P/E multiple on

combined firm, price may increase

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Managerial Motives to Merge

• Conflicts of interest
– Managers may prefer to run a larger company due to
additional pay and prestige.
– This is known as “Empire building.”

• Overconfidence
– Overconfident CEOs pursue mergers that have low
chance of creating value because they believe their
ability to manage is great enough to succeed.

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Friendly vs. Hostile Takeovers

• Friendly Takeover
– When a target’s board of directors supports a merger,
negotiates with potential acquirers, and agrees on a price
that is ultimately put to a shareholder vote

• Hostile Takeover
– In some cases, the target management resists takeover
bid
– The acquirer must go around the target board and
appeal directly to the target shareholders.
– The acquirer in a hostile takeover is sometimes called a
“corporate raider”

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Anti-Takeover Defenses

• Corporations can erect “takeover defenses” to

make hostile takeovers and proxy fights more
difficult for the acquirer or raider
• Examples:
 poison pills – prevent unauthorized shareholders from
purchasing more than X% of shares outstanding
(typically 20%)
 staggered boards – only 1/3 of board is elected every
year, implying that a raider can take over the board only
within two years
 golden parachutes – increase costs of deals

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Anti-Takeover Defenses, cont.

• Pros:
– Can lead to a higher takeover price for the
current shareholders, deter frivolous takeovers

• Cons:
– Shields underperforming managers, can lead to
missed opportunities for shareholders to get
takeover gain

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Disappearing Anti-Takeover
Defenses

Source: Factset
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Anti-Takeover Defenses – Financial

Restructuring
• A company changes its capital structure to
make itself less attractive as a target.
– Pay a dividend or repurchase stock
– Increase leverage
– Make random acquisitions to burn cash

• Remember Interco case?

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