1. Chapter 24 Mergers, Corporate Control, and Corporate Governance
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2. Corporate Control Defined
What is Corporate Control?
Monitoring, supervision and direction of a corporation or other business organization
Changes in corporate control occur through:
Acquisitions (purchase of additional resources by a business enterprise):
1. Purchase of new assets
2. Purchase of assets from another company
3. Purchase of another business entity (merger)
Consolidation of voting power
Divestiture
Spinoff

3. Corporate Control Transactions
Statutory: Acquired firm is consolidated into acquiring firm with no further separate identity.
Subsidiary: Acquired firm maintains its own former identity.
Consolidation: Two or more firms combine into a new corporate identity.

4. LBOs, MBOs, and Dual-Class Recapitalization
Going Private Transactions
LBOs (public shares of a firm are bought and taken private through the use of debt)
MBOs (an LBO initiated by the firm’s management)
Dual-Class Recapitalization

5. Methods of Acquisition
Negotiated Mergers
Contact is initiated by the potential acquirer or by target firm.
Open Market Purchases
Buy enough shares on the open market to obtain controlling interest without engaging in a tender offer
Proxy Fights
Proxy for directors: attempt to change management through the votes of other shareholders
Proxy for proposal: attempt to gain voting control over corporate control, antitakeover amendments (shark repellents, golden parachutes, white knights, poison pills

6. Methods of Acquisition (Continued)
Tender Offers: an open and public solicitation for shares
Open Market Purchases, Tender Offers and Proxy Fights could be combined to launch a “surprise attack”
Acquirer accumulates a number of shares (‘foothold”) without having to file 13-d form with SEC

7. Divestitures and Spin-Offs
Divestiture - occurs when the assets and/or resources of a subsidiary or division are sold to another organization.
Spin-off - a parent company creates a new company with its own shares by spinning off a division or subsidiary.
Existing shareholders receive a pro rata distribution of shares in the new company.
Split-off – similar to a spin-off, in that a parent company creates a newly independent company from a subsidiary, but ownership of company transferred to only certain existing shareholders in exchange for their shares in the parent

8. Mergers by Business Concentration
Horizontal: between former intra-industry competitors
Attempt to gain efficiencies of scale/scope and benefit from increased market power
Susceptible to antitrust scrutiny
Market extension merger
Vertical: between former buyer and seller
Forward or backward integration
Creates an integrated product chain
Conglomerate: between unrelated firms
Product extension mergers vs. pure conglomerate mergers
Popular in the 60’s as the idea of portfolio diversification was applied to corporations

9. Other Concentration Classifications
Degree of overlapping business
Change in corporate focus
Herfindahl Index
demonstrates the relationship between corporate focus and shareholder wealth.
HI is computed as the sum of the squared percentages - the proportion of revenues derived from each line of business

10. Merger and Acquisition Transaction Characteristics
Method of payment used to finance a transaction
Pure stock exchange merger: issuance of new shares of common stock in exchange for the target’s common stock
Mixed offerings: a combination of cash and securities
Attitude of target management to a takeover attempt
Friendly Deals vs. Hostile Transactions
Accounting treatment used for recording a merger
With the implementation of FASB Statements 141 and 142, one standard method of accounting for mergers
Target liabilities remain unchanged, but target assets are “written up” to reflect current market values, and the equity of the target is revised upward to incorporate the purchase price paid.
The revised values are then carried over to the surviving firm’s financial statements.
Goodwill is created if the restated values of the target lead to a situation in which its assets are less than its liabilities and equity

11. Merger and Intangible Assets Accounting
Target firm has 3.2 million shares at $25 per share.
Acquirer pays a 20% premium ($30 per share) to expand in the geographic area where target firm operates.
Transaction value 3.2 million shares x $30/share = $96,000,000.
Net asset value of target company is $72,000,000.
Current Assets $22,000,000
Restated fixed assets $120,000,000 less liabilities $70,000,000
Net Asset Value $72,000,000
Acquirer pays $24,000,000 for intangible assets.
Purchase price paid $96,000,000 less Net asset value $72,000,000
Goodwill $24,000,000
Goodwill will remain on the balance sheet as long as the firm can demonstrate that is fairly valued.

12. Shareholder Wealth Effects and Transaction Characteristics
Target returns – stockholders almost always experience substantial wealth gains
Acquirer returns – less conclusive than those for target shareholders
Combined returns
Mode of payment
Cash transactions
Stock transactions
Tax hypothesis: target shareholders must be awarded a capital gains tax premium in cash offers, which is not required in a stock offer.
Preemptive bidding hypothesis: acquirers wishing to ward off other potential bidders for a target offer a substantial initial takeover premium in the form of cash.

13. Returns to Other Security Holders
Bonds
Convertible
Nonconvertible
Preferred stock

14. International Mergers and Acquisitions
One company’s acquisition of the assets of another is observed worldwide.
Countries differ not only with respect to how frequently takeover attempts are launched, but also
how often these are friendly versus hostile bids
how often these are cross-border deals (involving a bidder and a target firm in different countries)
the average control premium offered
the likelihood that payment will be made strictly in cash.

15. Geographic Distribution of Worldwide Announced Mergers and Acquisitions, 2004 v. 2003

16. Industrial Distribution of Worldwide Announced Mergers and Acquisitions, Value in $ Millions, 2004 v. 2003

17. Value Maximizing Strategies
Geographic (internal and international) expansion in markets with little competition may increase shareholders’ wealth.
External expansion provides an easier approach to international expansion.
Joint ventures and strategic alliances give alternative access to foreign markets. Profits are shared.
Synergy, market power, and strategic mergers
Operational, managerial and financial merger-related synergies

18. Operational Synergies
Economies of scale: Merger may reduce or eliminate overlapping resources
1995 merger between Chemical Bank and Chase Manhattan Bank resulted in elimination of 12,000 positions.
Economies of scope: involve some activities that are possible only for a certain company size.
The launch of a national advertising campaign
Economies of scale/scope most likely to be realized in horizontal mergers.
Resource complementarities: Merging firms have operational expertise in different areas.
One company has expertise in R&D, the other in marketing.
Successful in both horizontal and vertical mergers

19. Managerial Synergies and Financial Synergies
Managerial synergies are effective when management teams with different strengths are combined.
For example, expertise in revenue growth and identifying customer trends paired with expertise in cost control and logistics
Financial synergies occur when a merger results in less volatile cash flows, lower default risk, and a lower cost of capital.

20. Managerial Synergies and Financial Synergies
Market power is a benefit often pursued in horizontal mergers.
Number of competitors in industry declines
If the merger creates a dominant firm, as in the Office Depot-Staples merger’s attempt to create market power and set prices
Other strategic reasons for mergers:
Product quality in vertical mergers
Defensive consolidation in a mature or declining industry: consolidation in the defense industry

21. Cash Flow Generation and Financial Mergers
Acquirer sees target undervalued.
Many junk bond-financed deals of the 1980s had one of the following two outcomes:
“Busting up” the target for greater value than acquisition price
Restructuring the target to increase corporate focus. Sell non-core businesses to pay acquisition cost
Tax-considerations for the merger:
Tax loss carry-forward of the target company used to offset future taxes; resulting in increased cash flow.
1986 change in tax code limits the use of tax loss carry-forward.
Merging may yield lower borrowing costs for the merged company.
Cash flows of the two businesses are less risky when combined, leading to lower probability of bankruptcy and lower default risk premium

22. Non-Value-Maximizing Motives
Agency problems: Management’s (disguised) personal interests are often driver of mergers and acquisitions.
Managerialism theory of mergers: Managerial compensation often tied to corporation size
Free cash flow theory of mergers: Managers invest in projects with negative NPV to build corporate empires.
Hubris hypothesis of corporate takeovers: Management of acquirer may overestimate capabilities and overpay for target company in belief they can run it more efficiently.
Agency cost of overvalued equity

23. Non-Value-Maximizing Motives
Diversification
Coinsurance of debt: the debt of each combining firm is now insured with cash flows from two businesses
Internal capital markets: created when the high cash flows (cash cow) businesses of a conglomerate generate enough cash flow to fund the “rising star” businesses

24. History of Merger Waves
Five merger waves in the U.S. history
Merger waves positively related to high economic growth.
Concentrated in industries undergoing changes
Regulatory regime determines types of mergers in each wave.
Usually ends with large declines in stock market values
First wave ( ): period of “merging for monopoly”.
Horizontal mergers possible due to lax regulatory environment
Ended with the stock market crash of 1904
Second wave ( ): period of “merging for oligopoly”
Antitrust laws from early 1900 made monopoly hard to achieve.
Just like first wave, intent to create national brands
Ended with the 1929 crash

25. History of Merger Waves (Continued)
Third wave ( ): conglomerate merger wave
Celler-Kefauver Act of 1950 could be used against horizontal and vertical mergers.
Result of portfolio theory applied to corporations: conglomerate empires were formed: ITT, Litton, Tenneco
Stock market decline of 1969
Fourth wave ( ): spurred by the lax regulatory environment of the time
Junk bond financing played a major role during this wave: LBOs and MBOs commonplace.
Hostile “bust-ups” of conglomerates from previous wave
Antitakeover measures adopted to prevent hostile takeover attempts.
Ended with the fall of Drexel, Burnham, Lambert

26. Fifth Merger Wave
Fifth wave (1993 – 2001): characterized by friendly, stock-financed mergers
Relatively lax regulatory environment: still open to horizontal mergers
Consolidation in non-manufacturing service sector: healthcare, banking, telecom, high tech
Explained by industry shock theory: Deregulation influenced banking mergers and managed care affected health care industry.
Merger activity: unprecedented transaction value for both US and non-US mergers
In 2000, aggregate merger value hit $3.4 trillion: $1.8 trillion in US and $1.6 trillion outside US.
Declined in 2001 to $1.7 trillion and only $1.2 trillion in 2002

27. Major US Antitrust Legislation
Legislation (Year)
Purpose of Legislation
Sherman Antitrust Act
(1890)
Prohibited actions in restraint of trade, attempts to monopolize an industry
Violators subject to triple damage
Vaguely worded and difficult to implement
Clayton Act
(1914)
Prohibited price discriminations, tying arrangements, concurrent service on competitor’s board of directors
Prohibited the acquisition of a competitor’s stock in order to lessen competition
Federal Trade Commission Act
Created FTC to enforce the Clayton Act
Granted cease and desist powers to the FTC, but not criminal prosecution powers
Celler-Kefauver Act
(1950)
Eliminated the “stock acquisition” loophole in the Clayton Act
Severely restricts approval for horizontal mergers
Hart-Scott-Rodino Act
(1976)
FTC and DOJ can rule on the permissibility of a merger prior to consummation.

28. Determination of Anti-competitiveness
Since 1982, both DOJ and FTC have used Herfindahl-Hirschman Index (HHI) to determine market concentration
HHI = sum of squared market shares of all participants in a certain market (industry)
Elasticity tests (“5 percent rule”) is an alternative measure used to determine if merged firm has the power to control prices.
1000
1800
HHI Level
Not Concentrated
Moderately Concentrated
Highly Concentrated

29. The Williams Act (1968) Ownership disclosure requirements
Section 13-d must be filed within 10 days of acquiring 5% of shares of publicly traded companies.
Raises the issue of “parking” shares
Tender offer regulations
Shareholders of target company have the opportunity to evaluate the terms of the merger.
Section 14-d-1 for acquirer and section 14-d-9 by target company (recommendation of management for shareholders regarding the tender offer)
Minimum tender offer period of 20 days
All shares tendered must be accepted for tender.

30. Other Legal Issues Sarbanes-Oxley Act of 2002
primarily targeted accounting practices, it also mandated significant changes in how, and how much, information companies must report to investors.
Laws Affecting Corporate Insiders
SEC rule 10-b-5 outlaws material misrepresentation of information for sale or purchase of securities.
Rule 14-e-3 addresses trading on inside information in tender offers.
The Insider Trading Sanctions Act, 1984 awards triple damages.
Section 16 of Securities and Exchange Act
Requires insiders to report any transaction in shares of their affiliated corporations.

31. Other Legal Issues State Antitrust Laws
Include anti-takeover and anti-bust up provisions
Fair price provisions disallow two-tiered tender offers. All shareholders receive the same price for their shares, regardless of when they are tendered.
Cash-out statutes forbid partial tender offers.
Provisions usually used in conjunction with each other

32. Corporate Governance Law and finance
Efficient capital markets promote rapid economic growth
Privatization’s impact on stock and bond market development