Takeovers, Mergers and Acquisitions. An Introduction

Table of contents:

I. Mergers and acquisitions in general
1. Introduction
2. Basic definitions
3. Characteristics of Hostile and Friendly Takeovers
4. Leveraged Buyouts and Management Buyouts
4.1. A simplified example of an LBO
5. Objectives of mergers and acquisitions
5.1. Market share and growth
5.2. Synergies (the “2+2=5”-effect)
5.3. Undervaluations
5.4. Tax law motives
6. Merger Types and Characteristics
6.1. Horizontal Mergers
6.2. Vertical Mergers
6.3. Conglomerate Mergers

II. Corporate Raiders and Junk Bonds
1. Definitions
2. Reasons for the use of Junk Bonds
3. Junk Bonds and Merger Activity

III. Defences against takeovers
1. Introduction
2. Bid defence strategies
2.1. Pre-bid defences
2.2. Post-offer defences and the UK City (Takeover) Code
2.3. Takeover defence outside the UK

IV. The role of anti-trust regulation
1. Introduction
2. History
2.1 Antitrust Regulation in the USA
2.2. Antitrust Regulation in the European Union

REFERENCES:
Internet:

I. Mergers and acquisitions in general

1. Introduction

“European exchanges to merge”

Thursday, May 4th, 2000

This was the headline of Bruce Stanley´s article on http://www.dailysouthtown. com /southtown /dsbiz / 042bd3.htm.

2. Basic definitions

Mergers and acquisitions are a means of corporate expansion and growth. They are not the only means of corporate growth, but are an alternative to growth by internal or organic capital investment.

In a merger, the corporations come together to combine and share their resources to achieve common objectives. The shareholders, who are also the owners of the firms in question, often remain as joint owners of the combined entity. Under the agreement of our example in the introduction, the London Stock Exchange and Germany's Deutsche Boerse will each take a 50 percent stake in a new entity to be called iX, for International Exchanges.

An acquisition is a legal act, where one firm purchases the assets or shares of another, and the shareholders of the acquired firm often, but not always, end up being owners of that firm. In an acquisition, the acquired firm becomes the subsidiary of the acquirer.

A takeover is quite similar to an acquisition but also implies that the acquirer is much larger than the acquired. If the acquired firm is larger than the acquirer, the acquisition is referred to as a “reverse takeover”.

Although the above-mentioned terms “merger”, “acquisition”, “takeover” have certainly different connotations in specific contexts, we will, in general, use the terms interchangeably, if not otherwise specified.

3. Characteristics of Hostile and Friendly Takeovers

Economic analysis has always distinguished between two broad classes of takeovers.

The first is what we call “disciplinary takeovers”, with the purpose to simply correct the non-value-maximizing practices of managers of the target firm. Those practices may include excessive growth and diversification, lavish consumption of perquisites, overpayment to employees and also to suppliers, or debt avoidance to secure a “quiet life”. As disciplinary takeovers are designed to replace or change the policies of managers who do not maximize shareholder value, the actual integration of the businesses of the acquirer and the target firm is not really essential. The realization of the takeover is nothing but the most effective way to change control and with it the target´s operating business strategy.

The second class of takeovers, respectively mergers, can be loosely called “synergistic”, because the main motivating force behind those strategies is the possibility of benefits from combining the businesses of the firms in question. Such synergy gains – some economists are also referring to a so-called “2+2=5”-effect - can come from increases in market power, which always enables a firm to rise its prices relative to its costs, from offsetting the profits of one firm with the tax loss carried forward of the other, from working together in Research and Development tasks, from cheaper possibilities in marketing, production, transportation and so on.

In case of those synergistic takeovers, unlike in disciplinary takeovers, it is of course essential to integrate (combine) the two businesses for realizing the emerging gains.

It is important to note that disciplinary takeovers are often hostile whilst synergistic takeovers are often friendly.

4. Leveraged Buyouts and Management Buyouts

Before looking at examples of different takeover activities, we will consider another important form of acquisition to think about, namely “management buyouts” (MBO´s). Before that, we have to explain so-called “leveraged buyouts” (LBO´s).

A LBO means that institutional investors, venture capitalists and other investors take over a dominant position in the target firm by acquisition of all the stock or assets. Buy-out specialists or investment banks usually sponsor such often very large deals. It is called leveraged because the price of a target is financed to a large extent by borrowing (typically 50 percent or more of the purchase price) and therefore a high return on equity (ROE) can be achieved. This profitability ratio is defined as: Net income (from the company´s p&l statement) divided by the owner´s equity and is a very important measure for potential investors which returns they can expect.

And if the takeover of a firm is carried out by its own top managers or its managerial employees, it will be called an MBO.

An LBO or MBO is sometimes a defensive measure against a feared or unwanted takeover by an outside investor. On the other hand, sometimes the announcement of an LBO or an MBO, especially used by public corporations when planning to go private, will consequently stimulate competing bids by outsiders.

4.1. A simplified example of an LBO^[1]

Wavell Corporation, a successful, publicly-traded manufacturer of glassware, was purchased in the 1970s by Eastern Pacific (EP), a large conglomerate company, which seemed bent on buying everything in sight during this period.

As Wavell did not fit into the EP mold, a small group of disgruntled Wavell executives began to consider the possibility of a leveraged buy-out.

Wavell´s current sales were $7,000,000 with EBIT (Earnings before Interest and Taxes) of $650,000 and net income of $400,000. Negotiations between Wavell management and EP settled on a purchase price of $2,000,000 (representing a Price/Earnings Ratio of 5). Because of the very old production equipment, there were high replacement costs of Wavell´s assets, and the firm had to take on a large amount of debt.

Banks supplied $1,200,000 of senior debt at an interest rate of 13 percent; this debt was of course secured by the finished goods inventory, and by net property, plant and equipment, and was to be amortized over a five-year period.

Moreover, an insurance company loan of $600,000 was arranged in the form of subordinated debt, also to be amortized over a five-year period. In addition, the insurance company took over an equity position worth $100,000; Wavell was expected to repurchase this equity interest after five years for an amount which would provide the insurance company with a 40 percent annual yield.

Finally, the Wavell management team put up $100,000 as their own equity position.

The following simple calculations illustrate the cash flow patterns which might be expected following the LBO. First, we have the amortization tables for the bank and insurance company loans:

Bank Loan:

Abbildung in dieser Leseprobe nicht enthalten

* The interest payment equals the nominal value at the beginning of the 5-years period, that is $1,200,000, times the 13% interest rate per anno.

Note that there are the same payments every year (annuities), namely $341,177.

Insurance Company Loan:

Abbildung in dieser Leseprobe nicht enthalten

* The intest payment in the first year equals again the nominal value of the debt, namely $600,000, times the annual interest rate, 16%.

And the year by year annuities are the total payments, $183,245.

The now following cash flow calculations are made on the basis of a number of conservative assumptions. First, no growth is assumed. A constant tax rate of 40% is given. We have a straight-line depreciation over a period of 16.67 years, that is 6 percent per year.

Pro Forma Cash Flows:

Abbildung in dieser Leseprobe nicht enthalten

(*Cash Flow before debt repayment)

(**equals the insurance company´s equity position of $100,000 plus the management team´s equity position of $100,000 as well)

If we now assume Wavell is sold at the end of year 5 for book value (another conservative assumption), we can calculate the annual compounded rate of return on equity (ROE) as follows:

ROE = (1,656,734 / 200,000) 1/5 – 1 = 53% annual compounded rate of return

Since Wavell is required to pay only 40 percent annually on the insurance company´s equity interest, a payment of $537,824 (calcuated by $100,000 times 1,405) would be sufficient to repurchase this equity. This would leave the difference of this amount to the value of the total assets ($1,656,734), or $1,118,910 for the management group, or an annual return of more than 62 percent on their initial investment ($100,000)!

After that simplified exercise of an LBO, we can summarize: The first stage of the operation consists of raising capital required for the buy-out. Also very useful is devising a management incentive system. Typically, about 10 percent of the cash is put up by the investor group, typically headed by the company´s top managers. This becomes the equity base of the new firm. Outsiders provide the remainder of the equity. Frequently, managers also get some incentives like stock-options or warrants.

About 50 to 60 percent of the required cash is raised by borrowing in secured bank loans. The rest is obtained by issuing subordinated debt in a private placement (with pension funds, insurance companies and so on) or public offering as “high-yield” notes or bonds, also called “junk bonds”.

In the second stage, the organizing sponsor group buys all the outstanding shares or all the assets of the company. In that case, the sponsor group forms a new, privately -held corporation. In order to repay part of the debt, the new owners sell off some part of the firm and may begin slashing inventory.

In the third stage, the management strives to increase profits and cash flows by cutting down operating costs and changing marketing strategies. This can be done by reorganizing production facilities, improving inventory control and accounts receivables management, it can change product quality, product mix, customer service, pricing, or extract better conditions from the suppliers. Or the mangagers may even lay off employees and cut spending on research and development.

In the last stage, the investor group may take the company public again if the company emerges stronger and the goals of the group are achieved. This reverse LBO is effected through public equity offering, referred to as secondary initial public offering (SIPO). The main purpose of this “back-to-public”-movement is to create liquidity for existing stockholders.

5. Objectives of mergers and acquisitions

5.1. Market share and growth

The immediate objective of an acquisition is of course growth and expansion of the acquirer´s assets, sales and market share. However, this represents only an intermediate objective.

A more fundamental objective may be the enhancement of shareholder´s wealth through acquisitions aimed at accessing or creating competitive advantage for the acquirer in the long run. In modern finance theory, shareholder wealth maximisation is the main criterion for investment and financing decisions made by managers. In this context, we are also referring to the “neoclassical view” of the firm.

In reality, shareholder wealth maximisation is often in sharp opposition to the self-interest pursuit of managers making those decisions. According to the managerial utility theory, acquisitions may be driven by managerial ego or desire for power, empire building or other benefits emerging for managers from those actions. In economic theory, this problem is often called the “principal-agent problem”, where the shareholders are acting as the principals and therefore the owners of the assets and the equity capital, whereas the managers represent the agents who should make their decisions in favour of the principals. But since the modern economy is characterised by large corporations with widespread diffusion of ownership, which is always divorced from management, the shareholders typically sustain a loss, which is also called the agency cost.

It must be remembered that the conflict between the two perspectives may permeate all decisions made by managers and not just acquisitions.

5.2. Synergies (the “2+2=5”-effect)

“The combined resources of two companies, if properly integrated, can create a stronger operation than stand-alone firms”.^[2]

First of all, in case of horizontal integration synergies are quite normal if the merging firms dispose of considerable capacity reserves before the merger, and can therefore profit from fixed cost and average cost degression. Moreover, if the market dominating firm buys a competitor, he will be able to offer his procucts at prices that would not be possible under higher competition.

In case of vertical integration, synergy effects can be realized by better communication relations to the suppliers or customers.

Conglomerate integration favours above all financial synergy effects (because of diversification and consequently lower risk of bankruptcy.

As mentioned, synergies can have more or less strong effects on the firms operational activities if the companies in question do not operate at its capacity ceilings before the merger transaction. Only in this case economies of scale can be achieved.

5.2.1. Negative Synergies (the “2+2=3”-effect)

For sake of completeness, we can also think of negative synergies. Those can happen if the companies´ organizations and cultures are inconsistent. “In most mergers, at least one and possibly more of the factors can be negative”.^[3] One example of a negative synergy can be that a brand-name articles manufacturing company acquires a discounter. So, both companies can maybe lose market shares: the brand-name producer if customers are faced with lower quality products, and the discounter if aiming at the wrong target group with a high-price policy.

5.3. Undervaluations

From the acquirer´s view it can be more favourable to buy an existing firm as to found a new company from the very beginning. The new owner will maybe not only find large capacity reserves but also undervaluated assets, which should raise his profits at all.

From many macroeconomic point of views, there can be a valuation practice of a whole business branch that does not point out the true value of the cumulative assets of the whole branch and be therefore pupolar victims of potential company raiders.

[...]

^[1] see Weston (1990), p. 398ff

^[2] see Jauch, Glueck, Business Policy and strategic management, New York, 1988, p. 234, quoted after Reicheneder (1992), p. 50.

^[3] see Jauch, Glueck, Business policy and strategic management, New York, 1988,p. 234, quoted after: Reicheneder (1992), p. 54.