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A ‘dawn raid’, i.e., a sudden entry into the stock market by the predator at a price above the previous market level, with a view to acquiring a major stake in a short space of time, in that it may lead to a further takeover offer a few days later, requires a quick reaction. There are a number of key issues to consider at the outset of a bid. First, board authorities should be obtained swiftly, and many groups set up a small sub-committee of the board to deal with urgent matters during the course of a bid, which cannot be referred in time to the full board. Its authority should, however, be closely circumscribed by the board. It is usually essential for one senior executive only to be designated for press contacts.
All bids involve considerable numbers of public statements. Very little, apart from an outline, can be agreed in advance, although vital holding statements relating to dawn raids or outright bids can be prepared. The next moves will depend on circumstances, and in particular on the identity and stated intentions of the predator.
A particular tactic during an unfriendly/undesired bid is to find a ‘white knight’, a friendly part who would act in the interests of the defender. Such a friend might already have taken a share stake. However, this could be a high risk strategy.
A ‘white knight’ might also, during the course of a bid, make a full counter-bid, as a more desirable acquirer than the initial predator, or might acquire shares which can be used in support of the board
It may be desirable to have drawn up a short list of ‘white knights’ in advance of a bid, but a boad which is confident of its ability to resist a bid may not wish to compromise its independence I involving other companies.
It is vital to ascertain, as early as possible, but preferably immediately a predator appears (eg, on same day), what its intentions are. It may be difficult to draw these out in any detail, but the aim should be to obtain its plans for the group, how it intends to manage it, fund it and develop it. It is also important to analyze the predator’s financial and commercial record, as well as its stated strategy, and the course both before and after’ acquisition of previous successful takeovers.
Many companies, in a effort to remain independent or to win time to analyze effectively a takeover bid, have implemented anti-takeover mechanisms.
Examples are:
(a) Poison pill
The most commonly used and seemingly most effective takeover defense is the so-called poison pill. Examples are:
(i) Flip-in pills involve the granting of rights to shareholders, other than the potential acquirer, to purchase shares of the target company at a deep discount. This type of plan will dilute the ownership interest of the potential acquirer.
(ii) Back-end rights are usually in the form of a cash dividend allowing shareholders other than the potential acquirer to exchange their shares for cash or senior debt securities at a price determined by the Board of Directors. The price set by the Board is usually well in excess of the market price or the price likely to be offered by a potential acquirer. Because the price that the target shareholder would receive is likely to be higher than that offered by the potential acquirer, shares will not be tendered.
(b) Pac Man
Like the video game, the Pac Man defense occurs when a target company turns around and tries to swallow its pursuer, by use of a counter-tender offer. Pac Man, while colorful in name, has seldom been used successfully.
(c) Disposal of the Crown Jewels/Scorched Earth
In a ‘disposal of the Crown Jewels’ defense, the target sells the assets which are of greatest interest to the raider. A more extreme variant of ‘Crown Jewels’ is the ‘Scorched Earth’ defense. In practical terms, this means that the target company liquidates all or substantially all of its assets. leaving nothing to the raider, thereby eliminating the raider’s motive for acquiring the target.
(d) Fat man
The other side of the ‘Crown Jewels’ and ‘Scorched Earth’ strategies is the ‘Fat man’ defense:
the target company acquires a large and/or underperforming company in order to decrease its attractiveness to the raider.
(e) Golden parachutes
One tactic that has often been mis-labelled as a takeover defense is the use of golden parachutes which are, quite simply, severance arrangements for senior officers of the firm should there be a change in the control. Although a golden parachute for one Chief Executive Officer involved in a takeover battle in the USA was reportedly US$35m, they usually are a low multiple of the most recent year’s salary.
A vital part of a defense document, which will obviously be prepared with the group’s merchant bankers, will be the section dealing with the reasons for preferring the group’s continued independence. This is a topic which, when it comes to be debated, can prove very controversial and take considerable time and effort to resolve and draft internally. Accordingly, it seems sensible to prepare this element of the defense circulars in draft form as soon as possible, having reached a reasonable consensus.
The section can take the form of a review of the past few years, comparing strategy and objectives against achievement; and then projecting the continuing strategy forward. The arguments would then be based on the requirement for independence to achieve projected strategic objectives.
In particular, the document would examine closely the predator’s intentions, as previously determined, against the group’s projected strategy and objectives; and of course it would discuss its ability, real desire and likelihood of carrying them out.
Such an examination would be the crucial basis for a successful defense. It should be appreciated that the less a predator has been prepared to say, the more ammunition he might provide for a victim’s defense against his predatory bid.
At an appropriate time during the course of the bid, but not necessarily in the first defense document, a forecast, duly corroborated by an independent firm of chartered accountants, would normally be presented, for at least the current year’s trading. This has already been discussed above.
Any board recognizes that there is a point at which an offer becomes irresistible, although it would normally be appropriate to offer strong and logical resistance right up to this point. This is based primarily on price, but with important considerations being the interests of employees and customers.
Of course, directors recommending acceptance of a bid clearly have a duty to make sure that the price is the best available in the circumstances, and that independence is still not a better course, bearing in mind longer term considerations. A board can legitimately believe that shareholders may be financially better off by retaining their shares for a further period, instead of accepting a takeover offer, however attractive.
Many acquisitions do not bring the benefits anticipated at the time that the acquisition was planned. Prospective acquirers should ask themselves the following questions:
All too often a management’s attention turns after an acquisition to planning the next acquisition rather than ensuring that the newly acquired company settles in to its new group comfortably.
However lessons can be learned by carrying out a post-audit of the acquisition some years after the date of the takeover to examine its progress and compare this with the plan. There are three reasons for undertaking these analyses:
(a) To discourage managers from spending money on doubtful projects, because they may be called to account at a later date.
(b) It may be possible over a period of years to discern a trend of reliability in the estimates of various managers.
(c) A similar project may be undertaken in the future, and then the recently completed project will provide a useful basis for estimation.
The management writer Drucker has suggested five golden rules for the process of post-acquisition integration.
Rule 1 Both acquirer and acquiree should share a ‘common core of unity’ including shared technology and markets, not just financial links.
Rule 2 The acquirer should ask ‘What can we offer them?’ as well as ‘What’s in it for us?’
Rule 3 The acquirer should treat the products, customers etc, of the acquired company with respect, not disparagingly
Rule 4 The acquirer should provide top management with relevant skills for the acquired company within a year
Rule 5 Cross-company promotions of staff should happen within one year
When the acquisition is done for common stock, a “ratio of exchange,” which denotes the relative weighting of the two companies with regard to certain key variables, results.
A financial acquisition occurs when a buyout firm is motivated to purchase the company (usually to sell assets, cut costs, and manage the remainder more efficiently), but keeps it as a stand-alone entity.
Mergers that take place between two firms in the same line of business are known as horizontal mergers. Recent examples include bank mergers, such as Chemical Bank’s merger with Chase and NationsBank’s purchase of BankAmerica. Other headline-grabbing horizontal mergers include those between oil giants Exxon and Mobil, and between British Petroleum (BP) and Amoco.
A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer. An example is Walt Disney’s acquisition of the ABC television network. Disney planned to use the ABC network to show The Lion King and other recent movies to huge audiences.
A conglomerate merger involves companies in unrelated lines of businesses. The majority of mergers in the 1960s and 1970s were conglomerate. They became less popular in the 1980s. In fact, much of the action since the 1980s has come from breaking up the conglomerates that had been formed 10 to 20 years earlier.
With these distinctions in mind, we are about to consider
motives for mergers, that is, reasons why two firms may be worth more together
than apart. We proceed with some trepidation. The motives, though they often
lead the way to real benefits, are sometimes just mirages that tempt unwary or
overconfident managers into takeover disasters. This was the case for AT&T,
which spent $7.5 billion to buy NCR. The aim was to shore up AT&T’s
computer business and to “link people, organizations and their information into
a seamless, global computer network.” It didn’t work. Even more embarrassing
(on a smaller scale) was the acquisition of Apex One, a sporting apparel
company, by Converse Inc. The purchase was made on
Many mergers that seem to make economic sense fail because managers cannot handle the complex task of integrating two firms with different production processes, accounting methods, and corporate cultures. This was one of the problems in the AT&T–NCR merger. It also bedeviled Novell’s acquisition of WordPerfect. That merger at first seemed a perfect fit between Novell’s strengths in networks for personal computers and WordPerfect’s applications software. But WordPerfect’s post acquisition sales were horrible, partly because of competition from other word processing systems but also because of a series of battles over turf and strategy:
WordPerfect executives came to view Novell executives as rude invaders of the corporate equivalent of Camelot. They repeatedly fought with. . . Novell’s staff over everything from expenses and management assignments to Christmas bonuses. [This led to] a strategic mistake: dismantling a WordPerfect sales team... needed to push a long-awaited set of office software products.[3]
The value of most businesses depends on human assets–managers, skilled workers, scientists, and engineers. If these people are not happy in their new roles in the acquiring firm, the best of them will leave. One Portuguese bank (BCP) learned this lesson the hard way when it bought an investment management firm against the wishes of the firm’s employees. The entire workforce immediately quit and set up a rival investment management firm with a similar name. Beware of paying too much for assets that go down in the elevator and out to the parking lot at the close of each business day. They may drive into the sunset and never return.
Just as most of us believe that we would be happier if only we were a little richer, so every manager seems to believe that his or her firm would be more competitive if only it were just a little bigger. Achieving economies of scale is the natural goal of horizontal mergers. But such economies have been claimed in conglomerate mergers, too. The architects of these mergers have pointed to the economies that come from sharing central services such as office management and accounting, financial control, executive development, and top-level management.
The most prominent recent examples of mergers in pursuit of economies of scale come from the banking industry. The United States entered the 1990s with far too many banks, largely as a result of outdated regulations on interstate banking. As these regulations eroded and communications and technology improved, hundreds of small banks were bought out and merged into regional or “supra-regional” firms. When Chase and Chemical, two of the largest money-center banks, merged, they forecasted that the merger would reduce costs by not 16 percent a year, or $1.5 billion. The savings would come from consolidating , operations and eliminating redundant costs.
Optimistic financial managers can see potential economies of scale in almost hat any industry. But it is easier to buy another business than to integrate it with yours
afterward. Some companies that have gotten together in pursuit of scale economies still function as a collection of separate and sometimes competing operations with different production facilities, research efforts, and marketing forces.
Vertical mergers seek economies in vertical integration. Some companies try to gain control over the production process by expanding back toward the output of the raw material and forward to the ultimate consumer. One way to achieve this is to merge with a supplier or a customer.
Vertical integration facilitates coordination and administration. Think of an airline that does not own any planes. If it schedules a flight from Boston to San Francisco, it sells tickets and then plane for that flight from a separate company. This strategy might work on a small scale, but it would be an administrative nightmare for a major carrier, which would have to coordinate hundreds of rental agreements daily. In view of these difficulties, it is not surprising that all major airlines have integrated backward, away from the consumer, by buying and flying airplanes rather than patronizing rent-a-plane companies.
Do not assume that more vertical integration is better than less. Carried to extremes, it is absurdly inefficient, as in the case of LOT, the Polish state which in the late 1980s found itself raising pigs to make sure that its had fresh meat on their tables. (Of course, in a centrally managed economy it may be necessary to raise your own cattle or pigs, since you can’t be sure you’ll be able to buy meat.)
Nowadays the tide of vertical integration seems to be flowing out. C are finding it more efficient to outsource the provision of many services and various types of production.
Here’s another argument for mergers: Suppose that your firm is in a mature industry. It is generating a substantial amount of cash, but it has. few profitable in vestment opportunities. Ideally such a firm should distribute the surplus cash to shareholders by increasing its dividend payment or repurchasing stock. Unfortunately, energetic managers are often reluctant to adopt a policy of shrinking their firm in this way. If the firm is not willing to purchase its own shares, it can instead purchase another company’s shares. Firms with a surplus of cash and a shortage of good investment opportunities often turn to mergers financed by cash as a way of redeploying their capital.
Some firms have excess cash and do not pay it out to stockholders or redeploy it by wise acquisitions. Such firms often find themselves targeted for takeover by other firms that propose to redeploy the cash for them. During the oil price slump of the early 1980s, many cash-rich oil companies found them selves threatened by takeover. This was not because their cash was a unique as set. The acquirers wanted to capture the companies’ cash flow to make sure it was not frittered away on negative-NPV oil exploration projects.
Cash is not the only asset that can be wasted by poor management. There are al ways firms with unexploited opportunities to cut costs and increase sales and earnings. Such firms are natural candidates for acquisition by other firms with better management. In some instances “better management” may simply mean the de termination to force painful cuts or realign the company’s operations. Notice that the motive for such acquisitions has nothing to do with benefits from combining t firms. Acquisition is simply the mechanism by which a new management team replaces the old one.
A merger is not the only way to improve management, but sometimes it is the only simple and practical way. Managers are naturally reluctant to fire or demote themselves, and stockholders of large public firms do not usually have much direct influence on how the firm is run or who runs it.
If this motive for merger is important, one would expect to observe that acquisitions often precede a change in the management of the target firm. This seems to be the case. For example, Martin and McConnell found that the chief executive is four times more likely to be replaced in the year after a takeover than during earlier years. The firms they studied had generally been poor performers; in the four years before acquisition their stock prices had lagged behind those of other firms in the same industry by 15 percent. Apparently many of these firms fell on bad times and were rescued, or reformed, by merger.
Of course, it is easy to criticize another firm’s management but not so easy to improve it. Some of the self-appointed scourges of poor management turn out to be less competent than those they replace. Here is how Warren Buffet, the chairman of Berkshire Hathaway summarizes the matter:
Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toad’s body by a kiss from the beautiful princess. Consequently, they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price they’d pay if they made direct purchases on their own? In other words
investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. We’ve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.
The benefits that we have described so far all make economic sense. Other arguments sometimes given for mergers are dubious. Here are a few of the dubious ones.
We have suggested that the managers of a cash-rich company may prefer to see i use that cash for acquisitions rather than distribute it as extra dividends. That is why we often see cash-rich firms in stagnant industries merging their way into fresh woods and pastures new.
What about diversification as an end in itself? It is obvious that diversification
reduces risk. Isn’t that a gain from merging?
The trouble with this argument is that diversification is easier and cheaper for the stockholder than for the corporation. No one has shown that investors pay premium for diversified firms; in fact, discounts are common. For example, Kaiser Industries was dissolved as a holding company because its diversification apparently subtracted from its value. Kaiser Industries’ main assets were shares of Kaiser E Steel, Kaiser Aluminum, and Kaiser Cement. These were independent companies and the stock of each was publicly traded. Thus you could value Kaiser Industry by looking at the stock prices of Kaiser Steel, Kaiser Aluminum, and Kaiser Cement. But Kaiser Industries’ stock was selling at a price reflecting a significant discount from the value of its investment in these companies. The discount vanishes when Kaiser Industries revealed its plan to sell its holdings and distribute the proceeds to its stockholders.
Why the discount existed in the first place is a puzzle. But the example at le shows that diversification does not increase value. The appendix to this chapter provides a simple proof that corporate diversification does not affect value in perfect markets as long as investors’ diversification opportunities are unrestricted
Some companies begin their merger analyses with a forecast of the target firm’s future cash flows. Any revenue increases or cost reductions attributable to the merger are included in the forecasts, which are then discounted back to the present and compared with the purchase price:
Estimated net gain = DCF valuation of target including merger benefits - cash required for acquisition
This is a dangerous procedure. Even the brightest and best-trained analyst can make large errors in valuing a business. The estimated net gain may come up positive not because the merger makes sense but simply because the analyst’s cash- flow forecasts are too optimistic. On the other hand, a good merger may not be pursued if the analyst fails to recognize the target’s potential as a stand-alone business. Our procedure starts with the target’s stand-alone market value (PVB) and concentrates on the changes in cash flow that would result from the merger. Ask you r self why the two firms should be worth more together than apart.
The same advice holds when you are contemplating the sale of part of your business. There is no point in saying to yourself, This is an unprofitable business and should be sold. Unless the buyer can run the business better than you can, the price you receive will reflect the poor prospects.
In this section, I will briefly discuss the major types of divestitures, in which corporations sell divisions or other operating units. Types of Divestitures
There are four types of divestitures: (1) sale of an operating unit to another firm, (2) setting up the business to be divested as a separate corporation and then “spinning it off’ to the divesting firm’s stockholders, (3) following the steps for a spin-off but selling only some of the shares, and (4) outright liquidation of assets.
Sale to another firm generally involves the sale of an entire division or unit, usually for cash but sometimes for stock of the acquiring firm. In a spin-off, the firm’s existing stockholders are given new stock representing separate ownership rights in the division that was divested. The division establishes its own board of directors and officers, and it becomes a separate company. The stockholders end up owning shares of two firms instead of one, but no cash has been transferred. In a carve-out, a minority interest in a corporate subsidiary is sold to new shareholders, so the parent gains new equity financing yet retains control. Finally, in a liquidation the assets of a division are sold off piecemeal, rather than as an operating entity..
1. ‘Pepsi recently spun off its fast-food business, which included Pizza Hut, Taco Bell, and Kentucky Fried Chicken. The spun-off businesses now operate under the name Tricon Global Restaurants. Pepsi originally acquired the chains because it wanted to increase the distribution channels for its soft drinks, Over time, how ever, Pepsi began to realize that the soft-drink and restaurant businesses were quite different, and synergies between them were less than anticipated. The spin off is part of Pepsi’s attempt to once again focus on its core business. However, Pepsi tried to maintain these distribution channels by signing long-term contracts that ensure that Pepsi products will be sold exclusively in each of the three spun- off chains.
2. United Airlines sold its Hilton International Hotels subsidiary to Ladbroke Group PLC of Britain for $1.1 billion, and also sold its Hertz rental car unit and its Weston hotel group. The sales culminated a disastrous strategic move by United to build a full-service travel empire. The failed strategy resulted in the firing of Richard J. Ferris, the company’s chairman. The move into nonairline travel-related businesses had been viewed by many analysts as a mistake, because there were few synergies to be gained. Further, analysts feared that United’s managers, preoccupied by running hotels and rental car companies, would not maintain the company’s focus in the highly competitive airline industry. The funds raised by the divestitures were paid out to United’s shareholders as a special dividend.
A pure conglomerate merger is one that has no effect on the operations or profitability of either firm. If corporate diversification is in stockholders’ interests a conglomerate merger would give a clear demonstration of its benefits. But if present values add up, the conglomerate merger would not make stockholders better or worse off.
In this section I will examine more carefully my assertion that present value add. It turns out that values do add as long as capital markets are perfect and investors’ diversification opportunities are unrestricted.
Let us call the merging firms A and B. Value additivity implies
PVAB = PVA + PVB
where
PVAB = market value of combined firms just after merger;
PVA, PVB = separate market values of A and B just before merger.
For example, we might have
PVA = $100 million ($200 per share x 500,000 shares outstanding)
and
PVB = $200 million ($200 per share X 1,000,000 shares outstanding)
Suppose A and B are merged into a new firm, AB, with one share in AB exchanged for each share of A or B Thus there are 1,500,000 AB shares issued If value additivity holds, then PVAB must equal the sum of the separate values of A and B just before the merger, that is, $300 million That would imply a price of $200 per share of AB stock
But note that the AB shares represent a portfolio of the assets of A and B Before the merger investors could have bought one share of A and two of B for $600. Afterward they can obtain a claim on exactly the same real assets by buying three shares of AB.
Suppose that the opening price of AB shares just after the merger is $200 so that PVAB = PVA + PVB Our problem is to determine if this is an equilibrium price, that is, whether we can rule out excess demand or supply at this price.
For there to be excess demand, there must be some investors who are willing to increase their holdings of A and B as a consequence of the merger. Who could they be? The only thing new created by the merger is diversification, but those investors who want to hold assets of A and B will have purchased A’s and B’s stock before the merger. The diversification is redundant and consequently won’t attract new investment demand
Is there a possibility of excess supply? The answer is yes. For example, there will be some shareholders in A who did not invest in B. After the merger they cannot invest solely in A, but only in a fixed combination of A and B. Their AB shares will be less attractive to them than the pure A shares, so they will sell part of or all their AB stock In fact the only AB shareholders who will not wish to sell are those who happened to hold A and B in exactly a 1:2 ratio in their premerger portfolios!
Since there is no possibility of excess demand but a definite possibility of excess supply, we seem to have
PVAB ≤ PVA + PVB
That is, corporate diversification can’t help, but it may hurt investors by restricting the types of portfolios they can hold. This is not the whole story, however, since in vestment demand for AB shares might be attracted from other sources if PVAB drops below
PVA + PVB
Suppose that you are the financial manager of firm A and you want to analyze the possible purchase of firm B. The first thing to think about is whether there is an economic gain from the merger.
There is an economic gain only if the two firms are worth more together than apart. For example, if you think that the combined firm would be worth PVAB and that the separate firms are worth PVA and PVB, then
Gain = PVAB – (PVA + PVB) = ∆PVAB
If this gain is positive, there is an economic justification for merger. But you also have to think about the cost of acquiring firm B. Take the easy case in which payment is made in cash. Then the cost of acquiring B is equal to the cash payment minus B’s value as a separate entity. Thus
Cost = cash paid - PVB
The net present value to A of a merger with B is measured by the difference between the gain and the cost. Therefore, you should go ahead with the merger if its net present value, defined as
NPV = gain - cost
= ∆PVAB - (cash – PVB)
is positive.
I like to write the merger criterion in this way because it focuses attention on two distinct questions. When you estimate the benefit, you concentrate on whether there are any gains to be made from the merger. When you estimate cost, you are concerned with the division of these gains between the two companies.
An example may help make this clear. Firm A has a value of $200 million, and B has a value of $50 million. Merging the two would allow cost savings with a present value of $25 million. This is the gain from the merger. Thus,
PVA = $200
PVB = $50
Gain = ∆PVAB = +$25
PVAB = $275 million
Suppose that B is bought for cash, say, for $65 million. The cost of the merger is’
Cost = cash paid - PVB
= 65 - 50 = $15 million
Note that the stockholders of firm B–the people on the other side of the transaction are ahead by $15 million. Their gain is your cost. They have captured $15 million of the $25 million merger gain. Thus when we write down the NPV of the merger from A’s viewpoint, we are really calculating that part of the gain which A’s stockholders stock holders get to keep. The NPV to A’s stockholders equals the overall gain from the merger less that part of the gain captured by B’s stockholders: -
NPV = 25 - 15 = +$10 million
Just as a check, let’s confirm that A’s stockholders really come out $10 million ahead. They start with a firm worth PVA = $200 million. They end up with a firm worth $275 million and then have to pay out $65 million to B’s stockholders.’ Thus their net gain is
NPV = wealth with merger - wealth without merger
= (PVAB – cash) - PVA
= ($275 - $65) - $200 = +$10 million
Suppose investors do not anticipate the merger between A and B. The announcement will cause the value of B’s stock to rise from $50 million to $65 million, a 30 percent increase. If investors share management’s assessment of the merger gains, the market value of A’s stock will increase by $10 million, only a 5 percent increase.
It makes sense to keep an eye on what investors think the gains from merging are. If A’s stock price falls when the deal is announced, then investors are sending the message that the merger benefits are doubtful or that A is paying too much for them.
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