MODULE 1

MERGERS
Scheme of discussion…
 Introduction to Corporate Restructuring
 Rationale behind Mergers and acquisitions (M&A)
and corporate restructuring
 What is merger?
 Types of mergers
 Motives behind mergers
 Theories of mergers
 Efficiency theories
 Other theories
 Introduction to Corporate
Restructuring
 Corporate restructuring implies activities
related to expansion/contraction of a firm’s
operations or changes in its assets
or financial or ownership structure.

 The "Corporate restructuring" is an umbrella

term that includes mergers and
consolidations, divestitures and liquidations
and various types of battles for corporate
control.
Introduction to Corporate
Restructuring continued….
 The essence of corporate
restructuring lies in achieving
the long run goal of
wealth maximization.
 It helps us to know, if restructuring
generates value gains for shareholders (both
those who own the firm before the
restructuring and those who own the firm
after the restructuring), how these value
gains have be created and achieved or
failed.
 Rationale behind Mergers and
acquisitions (M&A) and corporate
restructuring
 Mergers and acquisitions (M&A) and corporate
restructuring are a big part of the corporate finance
world. One plus one makes three: this equation is the
special alchemy of a merger or an acquisition.

 Thekey principle behind buying a company is to create

shareholder value over and above that of the sum of
the two companies. Two companies together are more
valuable than two separate companies.
 Rationale behind Mergers and
acquisitions (M&A) and corporate
restructuring continued….
 Thisrationale is particularly alluring to companies when times
are tough. Strong companies will act to buy other companies
to create a more competitive, cost-efficient company.
 The
companies will come together hoping to gain a greater
market share or to achieve greater efficiency. Because of
these potential benefits, target companies will often agree to
be purchased when they know they cannot survive alone.
What is Merger?

A Merger involves a combination of

two firms such that only one firm
survives.

 Mergers tend top occur when one

firm is significantly larger than the
other and the survivor is usually
the larger of the two.
Types of Mergers

 Horizontal Mergers
 Vertical Mergers
 Conglomerate Mergers
Horizontal mergers
 A Horizontal mergers involves two firms
operating and competing in the same
kind of business activity.
Motives:
i. Elimination or reduction in competition
ii. Putting an end to price-cutting
iii. Economies of scale in production
iv. R&D, marketing and management
 Vertical Mergers
 Vertical mergers occur between firms in
different stages of production
operations
 Upstream & Downstream Mergers
Motives :
i. Lower buying cost of materials
ii. Lower distribution costs
iii. Assured supplies and market
iv. Increasing or creating barriers to
entry for potential competitors
Conglomerate mergers
 Conglomerate mergers involves firms
engaged in unrelated types of business
activity.
 Product extension mergers
 Market extension mergers
 Pure Conglomerate mergers
Motive:
Diversification of risk.
 Motives behind mergers
 Economies of scale
i. Production activity
ii. R&D/ technological activities
iii. Marketing and distribution activities
iv. Transport, storage ,inventories
 Synergy
 Fast growth
 Tax benefits
 Diversification
Theories of mergers
1. Efficiency theories
2. Information and signaling
3. Agency problems and managerialism
4. Free cash flow hypothesis
5. Market power
6. Taxes
7. Redistribution
Efficiency Theories
 These theories hold that mergers and
other forms of asset redeployment
have potential for social benefits.
 Theygenerally involve improving the
performance of incumbent
management or achieving a form of
synergy.
Efficiency Theories

1. Differential managerial efficiency

2. Insufficient management
3. Operating synergy
4. Pure diversification
5. Strategic realignment to changing
environments
6. undervaluation
Differential managerial
efficiency
 Ifthe management of firm A is more efficient
than the management of firm B and if after firm
A acquires firm b, the efficiency of firm b is
brought up to the level of efficiency of firm A,
efficiency is increased by merger
 Differential efficiency would be most likely to be
a factor in mergers between firms in related
industries where the need for improvement could
be more easily identified.
Insufficient management

 Maysimply represent management that is

inept in an absolute sense. Almost anyone
could do better
 Thetheory suggests that target
management is so incapable that virtually
any management could do better, and
thus could be an explanation for mergers
between firms in unrelated industries.
Operating synergy
 The theory is based on operating
synergy assumes that economies of
scale do exist in the industry and that
prior to the merger, the firms are
operating at levels of activity that fall
short of achieving the potentials for
economies of scale.
 It includes the concept of
complementarities of capabilities
Operating synergy
continued…
 For
e.g.: one firm might be strong in
R&D but weak in marketing while
another has a strong marketing
department without the R&D
capability. Merging the two firms
would result in operating synergy.
Pure diversification
 Thefirm may simply lack internal
growth opportunities for lack of
requisite resources or due potential
excess capacity in the industry.

 Purediversification as a theory of
mergers differs from share holders
portfolio diversification.
Pure diversification
continued…
 Therefore, firms may diversify to encourage firm-
specific human capital investments which make their
employees more valuable and productive
 and to increase the probability that the organization
and reputation of the firm will be preserved by
transfer to another line of business owned by the
firm in the event its initial business declines.
Strategic realignment to
changing environments
 Itsays 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
 Rationale is that by mergers the firm
acquires management skills for needed
augmentation of its present capabilities.
Undervaluation
 It states that mergers occur when the market
value of target firm stock for some reason does
not reflect its true or potential value in the hands
of an alternative management.
 One possibility of undervaluation may be that
management is not operating the company up to
its potential.
Undervaluation continued…

A second possibility is that the

acquirers have inside information.
 Itis not much different from the
inefficient management or differential
efficiency theory. it cannot stand
alone and requires an efficiency
rationale.
 Information and signaling

 This theory attempts to explain why target shares

seem to be permanently revalued upward even if
the offer turns out to be unsuccessful.
 The merger offer disseminated information that the
target shares are undervalued and the offer
prompts the market to revalue those shares.
 Information and signaling
continued
 Noparticular action by the target firm or any others is
necessary to cause the revaluation.
 This
is called “sitting on a gold mine” explanation (Bradley,
Desai and Kim, 1983)
 Theother hypothesis is that the offer inspires target firm
management to implement a more efficient business
strategy on its own.
 Nooutside input other that the merger offer itself is
required for the upward revaluation.
 This is called “kick in the pants” explanation.
 Agency problems

 Agency problems arise basically

because contracts between managers
(decision or control agents) and owners
(risk bearers) cannot be enforced.
 May result from conflict of
interest between managers
and shareholders or between
shareholders and debt holders
Agency problems
continued…
 An agency problem arises when managers own
only a fraction of the ownership shares of the firm.
This may cause managers to work less vigorously
than otherwise and consume more perquisites
 In large corporations with widely dispersed
ownership, there is not sufficient resources to
monitor the behavior of managers.
 Takeovers as a solution to agency problems (Fama
& Jensen, 1983)
 Managerialism (Mueller 1969)
Free cash flow hypothesis

 Jensen’s Free cash flow hypothesis says

that takeovers takes place because of the
conflicts between managers and
shareholders over the payout of free cash
flows.
 Hedefines free cash flow as cash flow in
excess of the amounts required to fund all
the projects that have positive NPVs.
Free cash flow hypothesis
continued…
 Hestates that such free cash flow
must be paid out to shareholders if
the firm is to be efficient and to
maximize share price
 Thepayout of free cash flow reduces
the amount of resources under the
control of managers and reduces
their power resulting in agency costs.
Market power

 Market power advocates claim that merger

gains are the result of increased
concentration leading to collusion and
monopoly effects.
 The theory posts that mergers take place
to increase their market share, means
increasing the size of the firm relative to
other firms in an industry.
Market power continued..

 Anobjection is often raised against

permitting a firm to increase its market
share by merger is that the result will be
“undue concentration” in the industry.
 On contrary, some economists hold that
increased concentration is generally the
result of active and intense competition.
Tax effects
 Tax implications may be important to
mergers , although they do not play a
major role. Carry over of net operating
losses and tax credits, substitution of
capital gains for ordinary incomes are
among the tax motivation for mergers
 Carryover of net operating losses and tax
credits: a firm with accumulated tax losses
and tax credits can give positive earnings
of another firm with which it is joined
Tax effects continued…

2 conditions to be met:
 Majority of the target corporation
should be acquired in exchange for the
stock of the acquiring firm.
 Secondly, the acquisition should have
legitimate motives/ business purposes
 net operating losses: can be carried
back 3 years and forward 15 years
Tax effects continued…
 Substitution of capital gains for ordinary income: a
mature firm with few internal investment
opportunities can acquire a growth firm in order to
substitute capital gains taxes for ordinary income
taxes.
 The acquiring firm provides the necessary funds
which otherwise would have to be paid out as
dividends taxable as ordinary incomes.
Redistribution hypothesis

 Value increases in mergers by

redistribution among the
stakeholders of the firm. Possible
shifts are from debt holders to stock
holders and from labor to
stockholders.
Next discussion…
 A presentation on Hubris hypothesis (agency
problems)
 A presentation on Framework for analysis of mergers-
1. Organization learning and organization capital
2. Investment opportunities
 Herfindahl index (H – index)
 Redistribution benefit calculation
 Operating , financial and managerial synergy of
mergers
 Value creation
 Merrill Lynch
Herfindahl index
 The Herfindahl index, also known as Herfindahl-
Hirschman Index or HHI, is a measure of the size of
firms in relation to the industry and an indicator of the
amount of competition among them.
 It is an economic concept widely applied in competition
law, antitrust and also technology management
 The theory behind the use of the H-index is that if one
or more firms have relatively high market shares, there
is of even greater concern than the share of the largest
four firms
 E.g.1:

In one market four firms each hold

15% market share and the remaining
40% is held by 40 firms, each with 1%
market share. Its HHI would be:
2 2
H = 4(15) + 40(1) = 940
 E.g.2:

In another market 1 firm has 57%

market share and the remaining 43%
is held by 43 firms, each with 1%
market share. What would be the H-
index?
 For e.g.:
Two cases in which the six largest firms
produce 90 % of the output:
Case 1: All six firms produce 15% each, and
Case 2: One firm produces 80 % while the
five others produce 2 % each.
Assuming that the remaining 10% of output
is divided among 10 equally sized
producers.
A HHI index below 0.01 (or 100) indicates a
highly competitive index.
A HHI index below 0.1 (or 1,000) indicates
an unconcentrated index.
A HHI index between 0.1 to 0.18 (or 1,000
to 1,800) indicates moderate
concentration.
A HHI index above 0.18 (above 1,800)
indicates high concentration
Synergy WHAT IS IT?

 Popular definition: 1 + 1 = 3
 Roundabout definition: If am I willing to
pay 6 for the business market-valued at 5
there has to be the Synergy justifying that
 More technical definition: Synergy is
ability of merged company to generate
higher shareholders wealth than the
standalone entities
Drivers of Synergy
INITIAL FACTORS INTERNAL FACTORS
Method of
Operations
Payment
Strategic System
Relatedness Integration
Control and
Culture
Contested Acquisition SYNERGY
vs. Premium Strategy
Uncontested
Relative
Size
Managerial
Risk Taking

Time
The Synergy Matrix

Managerial Synergy Financial Synergy

• Improve management or • Redeploy capital
replace inefficient one • Increase RoI

Company-specific Risk VALUE Operating Synergy

• Cost-of-capital reduction • Scale Economies
CREATION • Improve margins

Market Valuation
• Release “value”
Operating synergy

 Economies of scale
 Economies of scope

 Vertical integration economies

 Managerial economies
Financial synergies
 Complementarities between merging firms in
matching the availability of investment
opportunities and internal cash flows
 Lower cost of internal financing — redeployment of
capital from acquiring to acquired firm's industry
 Increasein debt capacity which provides for
greater tax savings
 Economies of scale in flotation of new issues and
lower transaction costs of financing
Managerial synergy
 Ifa firm has an efficient management team
whose capacity is in excess of its current
managerial input demand, the firm may be
able to utilize the extra managerial resources
by acquiring a firm that is inefficiently
managed due to shortages of such resources.
 Managerial Synergy hypothesis can be
formulated more vigorously and may be called
as differential efficiency theory
 Transaction Support
Ensuring Value Creation at all stages
Transactio Closing
Consideratio Transactio Managemen Funding
n Business Warranties Arrangement
n n Structure t Structure
Scope s

Strategic Transaction Elements

Business
Need

Target
Search
P
r
Target o
Cultivation c
e
Business
s
Evaluation s

Financial
Evaluation

Preliminary
Offer
 Transaction Support
Ensuring Value Creation at all stages
Transactio Closing
Consideratio Transactio Managemen Funding
n Business Warranties Arrangement
n n Structure t Structure
Scope s

Transaction Elements

Negotiations

MoU
P
r
Due o
Diligence c
e
Risk
s
Assessment s

Definitive
Agreement

Implement
 Transaction Support
Ensuring Value Creation at all stages
Transactio Closing
Consideratio Transactio Managemen Funding
n Business Warranties Arrangement
n n Structure t Structure
Scope s

Strategic Transaction Elements

Business
Need

Target
Search
P
Presenting
r the Story
Target o right
Cultivation c
e
Business
s
Evaluation s
What is the Regulatory Mitigating
fair EV; compliance LBO vs contingent
Financial “Walk- check / Equity risks
Evaluation Away” solutions

Preliminary
Offer
Circumstances favoring merger
over internal growth
 Lack of opportunities for internal growth
 Lack of managerial capabilities and
other resources
 Potential excess capacity in industry
 Timing may be important — mergers can
achieve growth and development of new
areas more quickly
 Other firms may be competing for
investments in traditional product lines
Roles of M&As
Strengthen existing product line by adding
capabilities or extending geographic markets
Add new product line

Foreign acquisitions to obtain new capabilities

or needed presence in local markets

Obtain key scientists for development of

particular R&D programs

Roles of M&As continued…
Reduce costs by eliminating duplicate
activities and shrinking capacity to
improve sales to capacity relationships
Divest activities not performing well
Harvestsuccessful operations in
advance of competitor programs to
expand capacity and output
Round out product lines
Roles of M&As
continued…
Strengthen distribution systems
Move firm into new growth areas
Attain critical mass required for effective
utilization of large investment outlays
Create broader technology platforms
Achieve vertical integration
Revise and refresh strategic vision
Disadvantages of M&As
 Buyer may not have full information of
acquired assets
 Implementation may be difficult
• Considerable executive talent and
time commitments
• Different organization cultures
 Wide use of joint ventures and strategic
alliances
 Combine different expertise and
capabilities of different companies
 Reduce size of investments and risks