1 Finance 7311 Market for Corporate Control

2 Terminology Target – Potential takeover candidate Acquirer (Bidder) – Firm doing the ‘taking over’ Merger – Friendly combination of two firms Tender Offer (Hostile Takeover) – Opposed by target management

3 Terminology, cont. Leveraged Buyout – Takeover in a highly leveraged transaction – Advantages Concentrates ownership in fewer hands Takes cash out of management hands Tax advantage of debt – Disadvantages Effect of economic downturn

4 Terminology, cont. Management Buyout – Same as LBO, except existing management is major shareholder Proxy Contest – Voting by S/H on major corporate transactions Restructuring – Significant change in allocation of corporate resources – Current management stays on

5 Defensive Tactics Methods used by management to avoid being taken over Poison Pill White Knight Greenmail Just Say No Supermajority Voting Courts: OK if only one ‘bidder’

6 Selecting and Valuing a Target Business Plan or Objective – Vertical Integration – Excess Capacity Product ==> Distribution Distribution ==> Product –(Time Warner; Paramount, previously) –(AOL, Time Warner) – Strategic: Enter a new market for example – Diversification (Later)

7 Valuation PVt = PV of target (stand alone) PVa = PV of acquiring firm (stand alone) PVc = PV of combined firm TP = tender price

8 Synergy ==> Value Created PVc - (PVa - PVt) = Total Synergy NPV of acquisition to acquiring firm: PVc - (Pva + PVt) - (TP - PVt) = total synergy - synergy to target

9 Synergy Sources of Synergy? – Economies of Scale in Production Distribution Management/Administration – Strategic – Management: better allocation of resources

10 Calculation of Synergy Estimate ‘combined’ cash flows and subtract sum of the parts Estimate the change in cash flows Must identify the source of value

11 Acquisition What is reflected in Target’s current price? – Value ‘as is’ – Value with expected changes (current mgmt) – Value ‘in play’ How much of a ‘change in control’ premium is already reflected in price?

12 Acquisition Acquirer must offer a Premium to induce S/H to tender Must bid less than total value; (Neg NPV) Do other Bidders exist? Is source of value generic or specific? – Provision of ‘information’ to market – If value highest to you, you can win

13 Acquisition, cont. Strategy:Bid high enough to deter potential bidders, but low enough to retain value Avoid Winner’s Curse Target: – Defensive Tactics

14 Motives or Reasons Corporate Raiding – Raider buying company for less than value – Premiums average 30% Creation of Monopoly Power – Hard to test; others should benefit Wealth Transfer from other parties – Not much evidence Taxes: May support economics

15 Motives, cont. Market Inefficiency – Firm is Undervalued by Market – Information to market Unsuccessful takeovers – Target value goes back to preoffer price – No perm. Reevaluation of firm – Value created in combination

16 Diversification Reduce Risk - may obtain better terms and/or better relationships from: – Employees – Suppliers – Customers – Analagous to ‘too much debt’ before Management - much human risk and human capital tied up in firm; S/H?

17 Diversification Evidence Comment & Jarrell (‘95 JFE) – Firm performance is increasing in firm focus Lang & Stulz (‘94 JPE) – Firms diversify when growth opportunities within industry exhausted – Such diversification does not benefit S/H

18 Diversification Evidence Berger & Ofek (‘95 JFE) – Compare stand-alone value of diversified firm segments to specialized firms – Diversified firm worth 13% - 15% less than sum of stand alone components Day (‘95 JFE) – Examines motives for risk reduction

19 Day, cont. Firms pursue equity variance reducing activities: – Higher levels of personal wealth in firm – More years invested w/ firm – The poorer previous performance – CEO specialists invest in similar specialties

20 Performance Changes Dennis & Denis (‘95 JFE) – Turnover Forced Normal – Forced: Operating Income/Assets decreases in 3 years prior & increases following – Normal: Little difference prior; small improvement afterward

21 Dennis & Dennis, cont. Forced resignations are rare – 68% preceded by active monitoring by large s/h, b/h or potential acquirers – 56% are the target of some form of control activity Boards not so effective in isolation Modern Trend: Outside Directors