Theories of Mergers & Tender Offers By AV Vedpuriswar June 2008 GENERALLY ACCESSIBLE Theories of Mergers & Tender Offers By AV Vedpuriswar June 2008

Theories of Mergers & Tender Offers Efficiency theories Information & signaling Agency problems Free cash flow hypothesis Market power Taxes Redistribution

Efficiency Theories The differential efficiency theory says that more efficient firms will acquire less efficient firms and realize gains by improving their efficiency. Differential efficiency is likely to be a factor in mergers between firms in related industries. The inefficient management theory suggests that target management is so inept that virtually any management could do better. This could be an explanation for mergers between firms in unrelated industries. The operating synergy theory postulates economies of scale/scope and complementarity of capabilities.

Efficiency Theories The financial synergy theory emphasises complementarities in the availability of investment opportunities and internal cash flows. Is diversification justified? Shareholders can diversify more easily. But managers and other employees are at greater risk if the single industry in which their firm operates should fail. Firms may diversify to encourage firm specific human capital investments which make their employees more valuable and productive. The organization and reputation capital of the firm is more likely to be preserved by transfer to another line of business in the event there is a decline in the prospects for the earlier business.

Efficiency Theories (Contd) The theory of strategic alignment to changing environments says that mergers take place in response to environmental changes. External acquisitions of needed capabilities allow firms to adapt more quickly and with less risk than developing capabilities internally. The undervaluation theory states that mergers occur when the market value of the target firm stock for some reason does not reflect its true or potential value or its value in the hands of alternative management. Firms may be able to acquire assets for expansion more cheaply by buying the stocks of existing firms than by buying or building assets when the target’s stock price is below the replacement cost of its assets.

Information/Signaling Theory The tender offer sends a signal to the market that the target company’s shares are undervalued. The offer may signal information to the target management which motivates them to become more efficient. The target management’s response to the offer and the means of payment may also have signaling value.

Agency Theory Agency problems may result from a conflict of interest between managers and shareholders and between shareholders and debt holders . Takeovers are viewed as the last resort to discipline self serving managers.

Managerialism Takeovers are a manifestation of the agency problem, not its solution. Self serving managers embark on mergers to expand their empire and improve their own career prospects.

Hubris Theory Acquiring firms commit errors of optimism (winner’s curse) in bidding for targets. Consider Anil Ambani’s bid for MTN.

Free Cash Flow Hypothesis Takeovers take place because of the conflicts between managers and shareholders over the payout of free cash flows. Free cash flows should be paid out to shareholders thereby reducing the power of management and subjecting managers to the scrutiny of the public markets more frequently. Debt-for-stock exchange offers are viewed as a means of bonding the manager’s promise to pay out future cash flows to stakeholders.

Market Power Market gains are the results of increased concentration leading to collusion and monopoly effects. But anti trust authorities are on the prowl. So these kinds of gains are becoming increasingly difficult.

Tax Effects Carry over of net operating losses, tax credits and the substitution of capital gains for ordinary income are among the tax motivations for mergers. Looming inheritance taxes may also motivate the sale of privately held firms with aging owners.

Redistribution Theory Gains from a merger may come at the expense of other stakeholders in the firm. Expropriated stakeholders may include bond holders, government and organized labour.