Vienna MBA Mergers & Acquisitions Instructor: Adlai Fisher

About the Course Mergers, acquisitions, and restructurings offer a lens into a variety of financial management practices at a critical time in the life of a corporation Managers make decisions with guidance from Relevant financial theory Advanced quantitative methods Careful study of previous business decisions and outcomes

M&A Foundations Successful transactions require managers to have solid understanding of a variety of finance topics and tools Valuation Capital structure Financial distress Financial statement analysis Working capital management Securities markets Securities issuance Agency theory Corporate governance Executive compensation Real and financial derivatives Etc.

Course Outline 1: Introduction and M&A Overview, Valuation 4 1: Introduction and M&A Overview, Valuation Theoretical frameworks, historical and international perspective, participants DCF, multiples, due diligence, wealth effects Case: Ducati (Instructor presented) 2: Transaction Structuring Merger legal process, payment method, deal protection, accounting, tax, antitrust Case: Seagate 3: Hostile Transactions Takeover strategies and defenses, duties of directors Case: Vodafone

An Example of M&A: MSFT bids for Yahoo $44 Billion MSFT Yahoo Feb 1, 2008 62% premium 7% 47% The combination also offers an increasingly exciting set of solutions for consumers, publishers and advertisers while becoming better positioned to compete in the online services market This odd and opportunistic alliance of Microsoft has anything but the interests of Yahoo!'s stockholders in mind

Vienna MBA Mergers and Acquisitions M&A Overview: Motives and History

Overview Outline M&A objectives, creating shareholder value Three theoretical frameworks Historical and international perspective Current trends Participants Deal taxonomies

M&A and Shareholder Value Creating shareholder value is the dominant paradigm for thinking about the role of the firm Ways of increasing shareholder value Operations Finance Strategy Background reading in BM

The Corporate Objective Reconsidered Legal framework U.S.: Shareholder value is explicitly the objective Canada: CBCA expresses goal of maximizing value of the firm (not necessarily the same) Europe: broad set of explicit stakeholders Other areas: China? In practice Managers may have very different incentives than shareholders (Microsoft / Yahoo) Other stakeholders can influence decisions Employees, trade groups, government, consumers, etc. E.g., China Petroleum / Unocal Inference: Don’t take the corporate objective for granted, likely many interests at stake Background reading in BM

Creating Value An acquisition is only one among many possible tactics or strategies To create value: focus on areas of expertise or special competencies  competitive advantage An acquisition may be a well-planned way of achieving a corporate goal (strategic buyer), and/or it may be opportunistic (financial buyer ) An acquisition generally should not be considered a corporate goal in and of itself

Bidding Strategies / Winner’s Curse Common values auction: all participants get a noisy signal Si = V + ei of true value V Example: Put cash in envelope, and sealed bid auction to class. Everyone gets a noisy signal as described above. What is the equilibrium strategy? What happens if everyone bids their signal? Private values auction: Each individual has a different true value Vi and receives signal Si = Vi + ei Is the winner’s curse larger or smaller than in common values auction? How does this relate to the bidding strategies of financial and strategic buyers?

Three frameworks that help us to understand M&A #1 – Microeconomics #2 – Principal – Agent Theory #3 – Financial engineering

Three Theoretical Frameworks #1 – Microeconomics Industry structure is an equilibrium involving Technology Legal and regulatory environment Macroeconomy Dynamics Slow adjustment: internal investment / disinvestment Rapid adjustment: M&A becomes more important

M&A Frameworks #2 – Principal – Agent Theory Separation of ownership and management creates agency costs When do goals of managers and shareholders differ? Mature firm in declining industry Significant free cash flow (Jensen’s FCF Hypothesis) Underperforming firms become takeover targets LBO’s, MBO’s, and Hostile takeovers Example: T. Boone Pickens and Mesa Petroleum

M&A Frameworks #3 – Financial engineering Unlocking value by changing corporate or financial structure Tax motives (Profitable firm buys company with NOLs) Input hedging (e.g., Dupont Conoco) Risk synergies (debt capacity)

Example: Coca-Cola acquires Huiyuan Juice Corp $2.4 Billion in Cash Coca Huiyuan Sep 3, 2008 3 times Huiyuan’s price 0.2% 167% This acquisition will deliver value to our shareholders and provide a unique opportunity to strengthen our business in China. 17% 4%

Notable Deals… Magna Int. / Opel, GM division (55% stake, Sept 2009) Kraft / Cadbury ($17 billion, Sept 2009) Microsoft intended acquisition to Yahoo ($44 billion, 2008) Murdoch’s News Corporation/Dow Jones ($5 billion, 2007) Google / YouTube ($1.65 billion in shares, 2006) Barrick / Placer ($10.4 billion, hostile then friendly cash and share tender, 2006) Sanofi / Aventis ($65 billion, 2004) Cingular / AT&T Wireless ($41 billion cash, 2004) JP Morgan / Banc One ($58 billion, 2004)

Historical Perspective Merger waves 1895-1904 1922-1929 1940-1947 1965-1969 1980’s 1993-2000 2002-2006

Historical Perspective 1895-1904 Economy Rapid economic expansion Recession begins in 1903 Technology Transcontinental railroads permit national markets Electricity Regulatory environment Permissive Supreme Court decision in 1903 begins enforcement of Sherman Act

Mergers wave around 1900 Source: Mergerstat Review 1989

Historical Perspective 1895-1904 (cont.) Mergers Mostly horizontal: characterized as “merger for monopoly” Concentrated within heavy manufacturing Forms U.S. Steel, DuPont, Standard Oil, GE, Kodak Activity peaks in 1901: result of failure of some merge

Historical Perspective 1922-29 Economy Rapid economic expansion Ends around time of crash Technology Automobiles increase consumer mobility, local distribution Radio permits product differentiation and development of national brands Regulatory environment Stricter enforcement against monopolies

Historical Perspective 1922-29 (cont.) Mergers Characterized as “merger for oligopoly” Also vertical mergers, product extension, geographic extension Concentrated in public utilities, banking, food processing, chemicals, mining, retailing IBM, General Foods, Allied Chemical

Historical Perspective 1940-1947 Rapid growth of the economy Less technological change, smaller merger wave Wartime price controls lead to vertical mergers

Historical Perspective 1960’s Conglomerate Merger Wave Economy Rapid economic expansion Recession begins in 1971 Regulatory Strict antitrust enforcement Mergers At peak in 1967-1968, only 17% of mergers are horizontal or vertical Product extension, 60% Pure conglomerate, 23% (35% of assets) Roll-ups of many small-medium firms

Historical Perspective 1960’s Conglomerate Merger Wave (cont.) Other possible factors Theory that these were defensive/diversification driven: management entrenchment Impact of management science EPS bootstrapping

Historical Perspective Example: Ling-Temco-Vought (LTV) Founder James Ling begins with $2000 investment in electronics in 1956 Acquisitions: American Microwave J & L Steel Wilson – sporting goods, meat packing, and pharmaceuticals Braniff Air – commercial airline Temco, Vought – military aircraft National Car Rental Banks, insurance companies Altec sound systems

Historical Perspective Economy Expansion begins in earnest in 1984 Recession begins in 1990 Financial innovation Junk bonds, LBO’s, MBO’s M & A Characterized as “undoing the conglomerate merger wave” Innovation in hostile takeover strategies

Historical Perspective 1980’s (cont.) Sharp decline in 1990-1992 Recession Adverse court decisions, state anti-takeover amendments Failure of junk-bond market and many leveraged transactions

Historical Perspective 1960 Source: Houlihan Lokey Howard & Zukin

Decline of mergers1970 Source: Mergerstat Review 1989

Mergers from 1980-2006 Source: Thompson Securities Financial Data (SDC)

Historical Perspective 1993-2000 Economy in rapid economic expansion Technology Telecommunications Semiconductors, Software Networking, the internet Regulatory environment Anti-trust policy changing because of convergence of previously segmented markets Technological convergence Geographic convergence: international Takeover defenses strengthened Loosening of restrictions in broadcasting, banking, insurance, utilities

Historical Perspective 1993-2000 (cont.) M&A Strategic mergers, many across previously segmented but converging businesses Most are friendly, increasing stock financing Divestitures to increase focus

Historical Perspective 2002-2006 M&As more successful this time around? Potential explanations: Deal management and governance: “Senior management today are much more attuned to shareholder opinions, and are more accountable for demonstrating shareholder value …” Better due diligence: “… companies have learned from mistakes that were made in the last two merger waves…” Financial synergies and people integration: “Cultural synergies are taken much more seriously than they were in the previous two merger waves.”

Historical Perspective: Summary All of the U.S. merger waves are Associated with economic expansion, and end with recessions Greatly affected by the regulatory environment 1895-1904: Merger for monopoly 1922-1929: Merger for oligopoly 1960’s: Conglomerate 1993-2000: interstate banking, global industrial consolidation Greatly affected by technology 1895-1904: Transcontinental railroads permit concentration of heavy manufacturing industries 1922-1929: Radio permits product differentiation and development of national brands 1993-2000: telecommunications, semiconductors, the internet Financial innovation also plays a role LBO’s, junk bonds, and the merger wave of the 1980’s: Undoing the conglomerate merger wave

International Perspective

International Perspective 1999 Data: Dramatic growth in European, cross-border, and Far Eastern M&A volume North America: $1.5 trillion Europe: $1.1 trillion Asia: $232 billion South America: $21 billion Cross border North America – Europe: $350 billion North America – Asia: $54 billion Europe – South America: $36 billion Europe – Asia: $31 billion North America – South America: $18 billion

European Merger Wage Source: Thompson Securities Financial Data (SDC)

Australia Merger Wage Source: Thompson Securities Financial Data (SDC)

China Merger Wage Source: Thompson Securities Financial Data (SDC)

Japan Merger Wage Source: Thompson Securities Financial Data (SDC)

Key Elements of a Successful Deal The shocking truth: most acquisitions hurt shareholder value! Search for synergies Added hurdle of takeover premium We can generally think of a deal as being composed of four stages: Strategy Valuation Mechanics Implementation & integration

The Principal Participants Buyer / seller Board of Directors Managers Shareholders Employees Advisors Bankers Lawyers Accountants Consultants

The Principal Participants (cont.) Regulators Antitrust Industry regulators Securities regulators Others Risk arbitrageurs Short term financiers All of these parties have separate interests… Inference: Need for leadership and orchestration

Deal Taxonomies By economic motivation Synergies in either costs or revenues Market power Wealth transfers from / to shareholders, debtholders, employees, the government M&A as a solution to agency problems M&A as a manifestation of agency problems – empire building The winner’s curse and overpayment

Types of Deals Takeover Acquisition Merger The transfer of control from one ownership group to another. Acquisition The purchase of one firm or set of assets by another Merger The combination of two firms into a new legal entity A new company is created Both sets of shareholders have to approve the transaction.

Types of Transactions How the Deal is Financed Cash Transaction The receipt of cash for shares by shareholders in the target company. Share Transaction The offer by an acquiring company of shares or a combination of cash and shares to the target company’s shareholders.

Financial Data Source M&A: Thomson ONE Banker / SDC Platinum (http://toby.library.ubc.ca/resources/infopage.cfm?id=1423 ) Financial statement and stock price: Yahoo Finance (http://finance.yahoo.com/ ) Google Finance (http://finance.google.com/finance ) Corporate News Factiva (http://toby.library.ubc.ca/resources/infopage.cfm?id=970 )

Vienna MBA Mergers & Acquisitions Valuation: DCF Methods

Outline DCF valuation techniques Weighted Average Cost of Capital (WACC) Adjusted Present Value (APV) Capital Cash Flows (CCF) Flow to Equity (FTE)

Weighted Average Cost of Capital UCF: Unlevered cash flow WACC: After-tax weighted average cost of capital

Adjusted Present Value (APV) NPVF: NPV of financing side effects rB: required return on debt NPVU: NPV of unlevered firm r0: required return on unlevered firm The NPVF formula above includes only interest tax shields Ideally, we would also like to capture other financing side effects (but this is often difficult) cost of financial distress, financing subsidies, issuing cost Similar caveat applies to WACC

Capital Cash Flow Method (CCF) You will sometimes hear a valuation method called capital cash flows discussed (e.g., Yell) This is just an APV method, where instead of using rB to discount the tax shield benefits of debt, use r0 to discount tax shield benefits of debt.

Flow to Equity (FTE)

Summary of the Methods All the three DCF methods are equivalent in theory In practice, some method may be easier, depending on the situation WACC and FTE assume constant debt/equity ratio. For time-varying debt/equity ratio, discount rates change each period. APV uses r0, which does not depend on capital structure. If debt/equity ratio is constant, then use WACC or FTE If the dollar value of debt over time is known, then use APV

Estimating rs The primary method of estimating the required return on equity is to use the CAPM. We will focus on this. Other models can also be used, e.g., Fama-French, conditional CAPM (time-varying loadings/risk-premia)

Using the CAPM Beta: Google finance, typically calculated from 1-5 year market model regressions on monthly, weekly, or sometimes daily data Risk-free rate: Intermediate or long-term government bond rate, usually chosen to match duration of cash flows Google finance The market risk premium: Estimated from medium (10-20 year) to long-run (80 year) averages of excess market returns Elaborations: conditioning variables, international data, structural breaks In practice, typically use values between 3.5% and 7%

Cautions when using the CAPM to get rs Remember that any beta estimate from Google or your own regression reflects the historical risk of the company’s equity Equity risk can be changed by altering the financial structure of the company, or the asset mix Thus, if leverage is changing, or the assets are changing, need to think carefully about how to use historical beta Example 1: You have a historical equity beta estimate, and plan to use the same assets going forward, but with a different capital structure. Delever to get asset beta, relever for new equity beta Example 2: You are changing the asset mix of the company, or the way assets are used Find pure play comparables, delever to get asset betas, relever for your own capital structure

The All-equity cost of capital Method 1: Use Modigliani-Miller Proposition II, with taxes Can use solver to obtain r0 or some algebra gives:

MM Proposition II, no taxes rs=r0+B/S(r0-rB) r0 rWACC rB

MM Proposition II, with taxes rs=r0+(B/S)(r0-rB)(1-T) r0 rWACC rB

The All-equity cost of capital Method 2: Use the levering and delevering formulas for betas, and the CAPM Note: you will often see the beta levering/unlevering formula written without (1-T) anywhere. This reflects an assumption that the riskiness of debt tax shields is equal to the risk of the unlevered assets.

Example Johnson and Johnson operate in several lines of business: Pharmaceuticals, consumer products, and medical devices. To estimate the all-equity cost of capital for the medical devices division, we need a comparable, i.e., a pure play in medical devices (we should really have several). Data for Boston Scientific: Equity beta = 0.98 Debt = $1.3b Equity = $9.1b Tax rate (T)= 20%

Example (cont.) Compute Boston Scientific’s asset beta (assuming D = 0): Let this be our estimate of the unlevered asset beta for the medical devices business. Use CAPM to calculate the all-equity cost of capital for that business (assuming 6% risk-free rate, 8% market risk premium): r0 = 6% + 0.88 *8% = 13.04%

Which WACC should we use, the acquirer or the target? Generally, we use the target WACC. We should adjust the discount rate based on the riskiness of their investment. The riskiness of an acquisition depends upon the characteristics of the target, hence, we use target WACC. The first exception: the target will be restructured If the acquirer plans to change the operations of the target and this would have a foreseeable effect on the riskiness of the target cash flows, then we would want to consider this. The second exception: the target is private No market data available for WACC. Use the WACC of a publicly traded company that is most similar to the target. Use the acquirer WACC as a proxy

Whose capital structure to use, the acquirer or the target? Generally, we use the target capital structure. Optimal capital structure is determined by the riskiness of the underlying assets It is not typically affected by a change of control. Again, one exception: the target will be restructured Acquirer projects major changes that will predictably affect the riskiness of the target cash flows. Another exception: risk synergies Two firm’s risk cancels each other. This is a minor issue

Market values or book values to weight debt/equity? The weightings should be based on market values of both debt and equity. Because market and book value tend not to be very different for debt, the book value of debt is often used in practice.

Summary Three DCF methods If debt-equity ratio is stable over time, use WACC or FTE If not, use APV (for LBO, use APV)

Appendix: Valuation Example

Singer Company Valuation Example Calculate value using WACC APV FTE

Singer Company WACC Valuation

Singer Company APV Valuation

Singer Company FTE Valuation

Vienna MBA Mergers & Acquisitions Valuation II: Multiples Valuation

Multiples Valuation: Introduction Basic idea: use prices of a peer group to build up an estimate of value for the firm you are analyzing (law-of-one-price) Outline of typical steps: Choose a relevant peer group (e.g., firms in an industry) Propose a quantity (e.g., EBITDA) that you believe correlates to value (e.g., EV) among firms in the peer group Calculate the corresponding ratio (e.g., λi=EVi/EBITDAi) for all observations i in the peer group Designate the average multiple: Apply this multiple to the firm you are analyzing to estimate its value:

Multiples Valuation: Theory You are already familiar with the theory behind some important multiples E.g., the price-dividend (P/D) ratio: For a firm i with constant growth of dividends: Gordon Growth Formula Hence: Thus, the P/D ratio is driven by equity risk (rs) and the growth rate (gD)

P/D Ratio Example For different values of rs and gD: Higher risk (rs) reduces the P/D ratio Higher growth (gD) increases the P/D ratio

The P/E Multiple Note That Following the Gordon Growth formula again: Again shows: The higher the expected growth rate, g, the higher the P/E The higher the required rate of return, r, the lower the P/E Changing the payout ratio has two effects: Direct effect in numerator, and indirect effect on g in denominator, which effect dominates depends on the investment opportunities of firm Good investment opportunities: High plowback (reducing payout) should maximize P/E Poor investment opportunities: High payout should maximize P/E

Intuition for P/E The ratio tells you how many times projected annual earnings (per share) the share is currently trading If you buy a company that is trading 10 times projected earnings, it may take 10 years of those earnings to recover your investment. If you buy a company trading 100 times projected earnings, it may take 100 years of those earnings to simply recover your investment (excluding time value on your investment).

The S&P/TSX Composite P/E Earnings volatility creates wide variations in P/Es associated with the business cycle.

P/E Ratios in the Forest Industry P/E is uninformative when company has negative (or small) earnings

Other Ratios Motivated by Theory The enterprise value (EV or V) to free cash flow (FCF=UCF) ratio Hence: EV/FCF is driven by firm risk (rWACC) and the growth rate (gFCF)

Other Ratios Motivated by Theory The enterprise value (EV) to capital cash flow (CCF) ratio Hence: EV/CCF is driven by unlevered firm risk (r0) and the growth rate (gCCF)

Varieties of Multiples: Numerator and Denominator In the numerator: Enterprise value, denoted V or EV Equity value, either per share (P) or total market cap (S) In the denominator: Dividends (for P or S) Aggregate Dividends plus coupon payments (for EV) FCF=UCF (for EV) CCF (for EV) LCF (per share for P, aggregate for S) EBIT (for EV) EBITDA (for EV) Sales/Revenues (for EV) # of customers, web site hits, # of employees, R&D spending, … (EV) Book value (of assets for EV, of equity for S, of equity per share for P) …

Choosing the Numerator (P or EV) From theory we know that equity multiples (P) will be determined roughly by Equity risk rS=r0+(B/S)(r0-rB)(1-T) Growth rate of equity cash flows Enterprise value multiples (EV) are determined roughly by: Firm risk (r0 or rWACC) Growth rate of FCF, CCF Includes business risk (r0) and financial risk (determined by B/S) Much less sensitive to capital structure: r0 invariant; rWACC has only tax impacts Using EV in the numerator has an important advantage: EV ratios are not as sensitive to capital structure and corresponding variations in equity risk

Choosing the Denominator With EV in the numerator, theory encourages us to look at FCF or CCF Many other variants that focus on income flows to all claimants EV/EBIT, EV/EBITDA, EV/(Net Income + interest), etc. Accounting adjustments can be motivated if they help to smooth noise in cash flows, providing more accuracy Other attempts to smooth noise include taking an average of cash flows, EBIT, or EBITDA over multiple quarters / years

EV/Sales (or P/S) Usually driven by industry that is not currently profitable (e.g., internet companies in late 90’s) Advantages Sales are less sensitive to accounting decisions and are never negative Not as volatile as earnings Provides information about corporate decisions such as pricing Disadvantage Does not include information about expenses and profit margins which are key determinants of corporate performance Other multiples based on profit potential (sometimes distant): customers, geographic coverage, web site hits, etc.

q provides a ratio describing value added by the firm EV/Assets The other main type of denominator is based on assets E.g., the ratio EV/(Book Value of Assets) is closely related to a theoretically motivated measure called Tobin’s Q q provides a ratio describing value added by the firm When Market/Book uses equity in the numerator and denominator, it is the inverse of the B/M ratio in the Fama-French 3-factor model

Choosing the Peer Group The first, and perhaps most important, step in multiples valuation is choosing a peer group Most commonly, peer group chosen by industry and country / geography of primary business location 4 digit SIC codes, NAIC codes, Fama-French industry definitions, Yahoo or Google stock screener industry definitions, etc. Choose firms that are legitimately in a similar line of business, that one would expect to have similar profit profiles and risk characteristics If EV in numerator, not essential that peers have similar capital structures; for equity multiples, capital structure is an important control.

Two Primary Variants Trading Multiples: Common general purpose technique Calculate multiples for peers based on the current trading values of equity and, where available, debt (otherwise can use book for debt) Typically require that peers are publically traded so that market value of equity can be obtained Discounts sometimes applied for illiquidity if the firm being valued is not publically traded. Does not include a control premium Transaction Multiples: Used in M&A settings Based on relatively recent transactions involving purchases or acquisitions of peer group firms Peer group transactions may be public or private Generally harder to find good peer comparisons, and sometimes the transactions are older than we would like Includes a control premium

Strengths and Weaknesses of Multiples Valuation Simple, easy to use, easy to understand Incorporates current information on how the market values peer firms Weaknesses Multiples are based on relative valuation and are only accurate if the market values other firms correctly By contrast, DCF methods use absolute valuation, and do not rely on the market’s valuations of peer firms Paradox: if all investors use only relative valuation, then nothing ties down the price level and the market becomes inefficient Use of relative valuation methods is often cited as an important contributor to speculative bubbles (internet bubble, housing bubble, etc.)

Choosing a Multiple to Use For any industry/situation, there are often a number of potential multiples one could use EV/EBITDA, EV/FCF, EV/sales, EV/Assets, etc. To compare accuracy of different multiples within peer group, interpret multiples valuation as a restricted (zero intercept) regression:

Combining Information in Different Multiples Suppose we have several multiples that seem to work well One ad hoc way to combine information is to calculate implied values from each multiple, and average A more systematic way to approach the problem is to run a multiple regression, e.g. Obtain estimates of regression coefficients using peers, and apply these coefficients to the corresponding variables for firm being analyzed: Need to check the correlation of your regressors in first regression and collinearity diagnostics if two or more are very closely related.

Which to Use, DCF or Multiples? Often, both are valuable Intuitively, DCF more accurate for projects with easy to forecast cash flows (e.g., infrastructure projects), and where the purchase will be buy and hold Multiples may tend to be more often used when cash flows are difficult to predict, and the asset will be sold at current market valuations (e.g., IPO)

Appendix

Example Consider the following target firm Sales $10 M EBITDA $ 3.3 M Net Income $ 1 M # of shares $0.5 M Debt $5 M Equity Market Value of Equity $15 M Ratio T1 T1 5-Yr. Avg. Ind. Avg. P/E 15 X 14.5 16.5 Value/EBIT 8 X 5.5 7.5 Value/EBITDA 6.06 4.8 6 P/Sales 1.5X 1.35 1.6 P/Book 3 X 3 3.2

Example Using the industry average as the justifiable multiples P/E P/E * Net Income 16.5 *1M= 16.5 M V/EBIT V/EBIT * EBIT – Debt 7.5*2.5 – 5 = 13.75 M V/EBITDA V/EBITDA *EBITDA–Debt 6*3.3－5=14.8 M P/Sales P/Sales * Sales 1.6*10=16 M P/Book P/B*Book Value 3.2*5=16 M Using the 5 Yr. average as the justifiable multiples P/E P/E * Net Income 14.5 *1M= 14.5 M V/EBIT V/EBIT * EBIT – Debt 6.5*2.5 – 5 = 11.25 M V/EBITDA V/EBITDA *EBITDA–Debt 4.8*3.3－5=10.8 M P/Sales P/Sales * Sales 1.35*10=13.5 M P/Book P/B*Book Value 3*5=15 M

Multiples Using Number of Employees This sample used for all plots in this file is all Compustat firms in 2007. Each dot represents a firm. The regression line is restricted to have an intercept of zero.

Multiples Valuation Using Sales

Multiples Valuation Using EBIT

Multiples Valuation Using EBITDA

Multiples Valuation Using Book Value of Assets

Cross-Industry Comparison of R2 from Regressions of EV on other variables # of Employees Sales EBIT EBITDA Assets Manufacturing 0.42 0.67 0.70 0.72 Mining 0.16 0.87 0.88 0.86 0.79 Retail 0.90 0.92 0.97 0.94 Info. Tech. 0.54 0.61 0.48 0.35 0.58 Finance and Insurance 0.82 0.84 0.66 0.68 0.73 This table reports R2 from univariate regressions of enterprise value (EV) on each of the variables listed in the column headings. The initial sample is all Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in that industry.

Cross-Industry Comparison: Regression Coefficient # of Employees Sales EBIT EBITDA Assets Manufacturing 545.7 1.05 7.53 5.95 1.13 Mining 559 2.44 6.99 5.35 1.10 Retail 106 0.57 10.20 7.90 1.26 Info. Tech. 663.3 2.11 10.25 5.22 0.85 Finance and Insurance 899 1.34 2.86 2.81 0.09 This table reports the regression coefficients from univariate regressions of enterprise value (EV) on each of the variables listed in the column headings. The initial sample is all Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in that industry.

Vienna MBA Mergers & Acquisitions M&A Wealth Effects

Overview Large literature in finance studying the wealth and performance effects of M&A activity E.g., Event Studies Findings: Basic Wealth Effects in M&A The Market Timing Hypothesis and Stock Market Driven Acquisitions Extras

Three approaches to measure M&A profitability Event studies (most used in finance) Accounting studies 3. Surveys of executives ( seldom used in finance)

Procedures of event study Identify the event of interest. (e.g., M&A, CEO turnover) Define the event period? (e.g., -1 days and +1 day) Compute the real stock return Measure “normal” return using asset pricing model (CAPM, APT, Fama-French, etc) Abnormal return= real return – “normal” return Sum up abnormal return to get cumulative abnormal returns

Example of an event study Merrill Lynch $50 Billion in Stock Bank of America Sep. 15, 2008 Date Rm (S&P500) R (BA) AR(BA)= R(BA)-Rm R (ML) AR( ML)= R(ML)-Rm 16-Sep 1.75% 11.30% 9.55% 30.01% 28.26% 15-Sep -4.71% -21.31% -16.60% 0.06% 4.77% 12-Sep 0.21% 2.06% 1.84% -12.25% -12.46% Firm Accumulative abnormal returns (CAR3) MV Equity Dollar Gain/Loss BM -7.95% $ 155 Billion －$12.3 Billion ML 17.8% $ 37 billion +$6.6 Billion

Assumptions for event studies Event Study Methodology (CIS9280) 10/19/2004 Assumptions for event studies Event is unanticipated Abnormal returns are result of reaction No confounding effects Eliminate other events Markets are efficient (recall 3 forms of EMH hypothsis) Weak ( all past price and trading information) Semi-strong (all publicly known and available information) Strong (both public and private information) @2004 Lily Chen, Alina Dulipovici and Sweta Sneha

Event studies Strengths: A relatively direct measure of value to shareholders A forward-looking measure Weaknesses: Requires strong assumptions Vulnerable to confounding events…

Findings: Wealth effects for Bidders Approximately zero returns to successful bidders Possibly higher return to bidders in tender offers (+4%) than in mergers (+0%) Slightly positive in 60s (+5%) and 70s (+2%), and slightly negative in 80s (-1%) Very negative during late 90s and early 2000s

Wealth effects: Targets Target shareholders gain Tender offer vs. merger Aggregate 30% abnormal return to targets in tender offers 20% abnormal return to “targets” in mergers

Predictive Ability of CAR If negative bidder returns on announcement Future divestiture is more likely The acquirer is more likely to become a target itself Positive event returns produce the opposite

The market is suspicious of both Failed Transactions Both bidder and target have negative CAR after unsuccessful tender offer Market’s initial reaction predict outcomes Targets of failed tender offers who are acquired within the next 60 days had the most positive initial announcement effects (50% compared to 23% for others) For unsuccessful bidders If the target is acquired by another buyer in first 180 days, negative returns for initial bidder (CAR 0 to 180) are –8% If the target is not acquired by another firm, the CAR (0 to 180) for the initial bidder is zero. The market is suspicious of both Market reacts most positively initially for targets who are most attractive in general Suggests that the market believes there is a problem with the buyer when deal fails and target is acquired by different firm

Financing Higher abnormal returns for targets in cash offers than stock offers information effect (bidders use cash when they are more confident) Also possibly tax effect (higher premium may be needed since cash transactions taxed immediately, stock not)

Timing Average time between announcement and completion of acquisition is 66 days Twice as long for completion when securities are involved as opposed to an all cash transaction

Multiple bidders When multiple bidders arise For a single bidder Target CAR +26% on day 1, +45% to day 80 For a single bidder Target CAR +26% on day 1, +26% to day 80 Initial acquirer loses 2.4% when a second bid is announced

Predictors of Hostile vs. Friendly Structure Insider ownership Tends to be low in targets that get hostile bids High in targets that get friendly bids Previous performance of target Below average in hostile deals Above average in friendly deals

Surveys of managers Bruner (2002) conducted his own survey. According to the respondents: 37% of deals create value for the buyer 21% of deals achieve their strategic goals

An important caveat Impossible to empirically test if stakeholders would have been better off if no M&A activity; hence, full tests of value of M&A activity are impossible.

So, does M&A pay? Summary of findings Target firms: significant positive returns Acquirer firms: no value creation (NPV=0), on average. IF Cash offer: zero or slightly positive returns IF stock offer: negative returns Note: acquirer is typically larger in size. Therefore % effect of acquisition is smaller for acquirer, all else being equal Combined Target and Acquirer: value is created, NPV > 0

II. Market Timing and Stock Mergers Discussion based on Moeller, Schlingemann, and Stulz, Journal of Finance (2005)…

Dollar Gain/Loss ($M) in M&A 1980-1997 Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

Dollar Gain/Loss ($M) in M&A 1998-2001 Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

Dollar Gain/Loss ($M) in M&A 1980-2001 Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

What drove such massive losses, purely agency costs? Puzzle What drove such massive losses, purely agency costs? Market timing hypothesis: an explanation for how: bidder increases its fundamental value via mergers but bidder still has negative stock return

Market timing: issuing overvalued equity, buy back undervalued equity $5 $6 $4 Good performance Bad performance If manager has private information, in which situation should she issue equity? What is the stock market reaction? Negative stock reaction when firms issue equity Positive stock reaction when firms repurchase equity

Stock market driven acquisition Current MV= 100 shares × $10/share=$1000 Fundamental MV = 100 × $1/share=$100 Manager issues equity of $200 to undertake acquisitions Information asymmetry No Learning Issuing Price 10 Shares Issued 200/10 =20 Price (Short term) Price (Long term) (100+200)/120=2.5 Full Learning 1 200/1=200 (100+200)/300=1 Partial Learning 5 200/5=40 (100+200)/140=2.1 During merger, negative bidder return Without merger, more negative bidder return

Stock market driven acquisition Overvalued bidders use equity to acquire real assets from target Stock price of bidders go down during the merger But the merger still serves the interests of bidder shareholders, because the bidder’s stock return would be more negative without the merger. Most evident in the later 1990s (Internet bubble).

III. Extras …

CARs for Successful and Unsuccessful Bidders Full sample: 1,815 deals. 1,401 successfully (dotted line), and 414 Unsuccessful (dashed line). Period 1971-1991. Source: Schwert, Journal of Financial Economics, (1996), Markup Pricing in M&A

A Refinement of Bidder Returns Bidder CAR(-1,1) for deals in 1980 – 2005 Large and small are the upper and lower quartile of market cap at -42. Source: Eckbo, Betton, and Thorburn, Handbook of Empirical Corporate Finance (2008)

Some Links Does M&A Pay? (NY Times) New Merger Wave? CNN NY Times