Mergers and Acquisitions

MSc. Management
Lecture 1: M&A Overview and
corporate governance I

Dr. Juliana Malagon

 Contact details

Dr Juliana Malagon (Module Leader, Lecturer and Seminar

Tutor)

MHL 151
Consultation Hours: Wednesdays in term time 08:30 to
10:30, by email appointment:
Email: juliana.malagon@durham.ac.uk
 Course Information
Book:
Donald M. DePamphilis, (2014). Mergers,
Acquisitions and Other Restructuring Activities,
7th Edition, AP.

Papers are going to be referenced and used

for some of the seminars.
These are mandatory reading!
 Outline of first 3-4 lectures
What is corporate restructuring and why it occurs. (Course Text: Ch. 1)
M&A as a form of corporate restructuring
Alternative ways of increasing shareholder value
M&A activity in an historical context
The primary motivations for M&A activity
Key empirical findings
Primary reasons some M&As fail to meet expectations
The corporate governance aspects of the corporate takeover market. (Ch. 3)
Protection of stakeholders and attack and defence!
The US, UK and EU Regulatory Environment. (Ch. 2)
Who are the regulators and why is regulation needed.
Notification and disclosure.
Sarbanes-Oxley and Dodd-Frank.
 Assessment

Summative:
Written assignment in the May/June Examination
Period

Formative
Initial draft of the summative assignment at the end
of the teaching term through duo, marked and
returned
Feedback from seminars
 Exam Structure
One written assignment (100%):
Essay type that reviews topics covered in the
course
The course document has a set of example
questions for you to look at
There is no specific right answer, but you will
have a number of questions you need to answer
in your essay so that you have some guidelines
 Contact and Learning Time
Main contact time
Nine lectures 90 minutes each.
Four seminars 45 minutes each.
One Revision Lecture after Easter

Expected Learning Time

Reading: two chapters per teaching week from the
text book, plus some additional reading from
research papers (particularly in week nine).
Seminar preparation
Lecture 1
M&A OVERVIEW
 Readings

DePamphilis, (2014).
Chapter 1
Chapter 3
 Objectives
Understand why are M&A important
Differencing between:
Takeover
Acquisition
Merger
Consolidation
Corporate restructuring
Understanding the role of corporate governance in
the M&A context
Section I
THE CORPORATE ENVIRONMENT
 The context of corporations

Potential
Conflict
manager

designs
Elect
shareholders
BOD

separation

Ownership Control

Firm
 Corporations objectives

Employment
provider

Survival
Avoid
financial
Increase distress

shareholders
Avoid
wealth
bankruptcy
Increase
market
share
Outperform
competitors
 Corporate Restructuring
What is corporate restructuring?
Corporate restructuring reflects strategies which primarily
impact the firms balance sheet.

Financial restructuring often focuses on balance sheet

liabilities but can also include share repurchases

Operational restructuring refers primarily to plant closings,

right-sizing, and subsequent layoffs

We will focus will be on corporate restructuring through

mergers and acquisitions.
Section II
INTRODUCTION TO M&A
 M&As as a Form of
Corporate Restructuring
Restructuring Activity Potential Strategy
Corporate Restructuring Redeploy Assets
Balance Sheet Mergers, Break-Ups, &
Spin-Offs
Assets Only Acquisitions, divestitures,
etc.
Financial Restructuring Increase leverage to lower
cost of capital or as a takeover
defense; share repurchases
Operational Restructuring Divestitures, widespread
employee reduction, or
reorganization
 Jargon
Corporate restructuring activities:
A merger a combination of two firms, usually of roughly
equal size.
An acquisition/takeover typically the purchase of a smaller
firm by a larger firm company
A divestiture the sale of a business unit or asset.
A consolidation
The merger of two or more business units or asset (internal to the
firm).
The merger of firms within an industry (between firms).
 Why are M&A important?
To provide an exit route for shareholders

Enable more efficient managers to acquire the resources used

by less efficient managers

Provide a mechanism whereby shareholders can `discipline'

directors: there is (in theory) always the threat of a takeover
hanging over the heads of directors

Enable the buyer company to achieve rapid growth:

improving market position
achieving economies of scale
enabling opportunities to be exploited which otherwise could not be
taken.
 Motivations for M&A
Strategic realignment
Technological change
Synergy
Economies of scale/scope
Cross-selling
Diversification (Related/Unrelated)
Financial considerations
Acquirer believes target is undervalued
Falling interest rates
Market power
Ego/Hubris
Tax considerations
 Causes and Significance
of M&A Waves
Factors contributing to increasing M&A activity:
Shocks (e.g., technological change, deregulation, and escalating
commodity prices)
Ample liquidity and low cost of capital
Overvaluation of acquirer share prices relative to target share prices
Improving business confidence
Why it is important to anticipate M&A waves?
Financial markets reward firms pursuing promising (often undervalued)
opportunities early on and penalize those that follow later in the cycle.
Acquisitions made early in the wave often earn substantially higher
financial returns than those made later in the cycle.
 Economies of Scale
Period 1: Firm A (Pre-merger) Period 2: Firm A (Post-merger)

Assumptions: Assumptions:
Price = $4 per unit of output sold Firm A acquires Firm B which is producing 500,000
Variable costs = $2.75 per unit of output units of the same product per year
Fixed costs = $1,000,000 Firm A closes Firm Bs plant and transfers production
Firm A is producing 1,000,000 units of output per year to Firm As plant
Firm A is producing at 50% of plant capacity Price = $4 per unit of output sold
Variable costs = $2.75 per unit of output
Fixed costs = $1,000,000

Profit = price x quantity variable costs Profit = price x quantity variable costs
fixed costs fixed costs
= $4 x 1,000,000 - $2.75 x 1,000,000 = $4 x 1,500,000 - $2.75 x 1,500,000
- $1,000,000 - $1,000,000
= $250,000 = $6,000,000 - $4,125,000 - $1,000,000
= $875,000
1
Profit margin (%) = $250,000/$4,000,000 = 6.25% Profit margin (%)2 = $875,000/$6,000,000 = 14.58%
Fixed costs per unit = $1,000,000/1,000,000 = $1 Fixed costs per unit = $1,000,000/1.500,000 = $.67
Key Point: Profit margin improvement is due to spreading fixed costs over more units of output. Profit margin
improvement from economies of scale higher in industries with higher fixed costs.
 Economies of Scope
Pre-Merger: Post-Merger:

Firm As data processing center Firm As and Firm Bs data

processing centers are combined
supports 5 manufacturing
into a single operation to support
facilities all 8 manufacturing facilities
Firm Bs data processing center By combining the centers, Firm A
supports 3 manufacturing is able to achieve the following
facilities annual pre-tax savings:
Direct labor costs = $840,000.
Telecommunication expenses
= $275,000
Key Point: Cost savings due to expanding Leased space expenses =
the scope of a single center to support all 8 $675,000
manufacturing facilities of the combined General & administrative
firms. expenses = $230,000
 Empirical Findings
Abnormal (or excess) financial returns are those earned by acquirer and target
shareholders above or below what would have been earned without a takeover.
Around transaction announcement date, abnormal returns:1
For target shareholders averaged 25.1% during the 2000s as compared to 18.5% during the 1990s
For acquirer shareholders generally positive averaging about 1-1.5%
However, zero to slightly negative for acquirer shareholders for deals involving large public firms and those
using stock to pay for the deal
Positive abnormal returns to acquirer shareholders often are situational and include the
following:
Target is a private firm or a subsidiary of another firm
The acquirer is relatively small (large firm management may be more prone to hubris)
The target is small relative to the acquirer
Cash rather than equity is used to finance the transaction
Transaction occurs early in the M&A cycle
No evidence that alternative strategies (e.g., solo ventures, alliances) to M&As are likely to
be more successful
See J. Netter, M. Stegemoller, and M. Wintoki, 2011 Implications of Data Screens on Merger and Acquisition Analysis: A Large Sample Study of
Mergers and Acquisitions, Review of Financial Studies 24 2316-2357 and J. Ellis, S. B. Moeller, F.P. Schlingemann, and R.M. Stulz, 2011
Globalization, Governance, and the Returns to Cross-Border Acquisitions, NBER Working Paper No. 16676.
 When M&As dont work
Primary Reasons Some M&As Fail to Meet Expectations

Overpayment due to over-estimating synergy

Slow pace of integration
Poor strategy
 Home reading and reflection: Xerox

In 2010, Xerox, traditionally a slow growing, cyclical office equipment manufacturer, acquired Affiliated Computer Systems
(ACS) for $6.4 billion. With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing and claims
processing for governments and private companies. With about one-fourth of ACS revenue derived from the healthcare and
government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets which
should benefit from the 2009 government stimulus spending and 2010 healthcare legislation. There is little customer overlap
between the two firms. Service firms tend to offer more stable and higher margin revenue streams than product companies.
Previous Xerox efforts to move beyond selling printers, copiers and supplies and into services achieved limited success
due largely to poor management execution. While some progress in shifting away from the firms dependence on mature
printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate transitioning
from a product driven company to one whose revenues were more dependent on the delivery of business services.
More than two-thirds of ACS revenue comes from the operation of client back office operations such as accounting,
human resources, claims management, and other outsourcing services, with the rest coming from providing technology
consulting services. ACS would also triple Xeroxs service revenues to $10 billion. Xerox chose to run ACS as a separate
standalone business.
Discussion Questions:
1.What alternatives to buying ACS do you think Xerox could have considered?
2.Why do you think they chose a merger strategy? (Consider the advantages and disadvantages of alternative strategies.)
3.Speculate as to Xeroxs primary motivations for acquiring ACS?
4.How might the decision to manage ACS as a separate business affect realizing the full value of the transaction? What
other factors could impact the ability to realize synergy?
 Alternative Ways of
Increasing Shareholder Value
Solo venture (AKA going it alone or organic growth)
More control, but possibly greater risk and reward.
Partnering (Marketing/distribution alliances, JVs, licensing, franchising, and
equity investments) Requires sharing!
Minority investments in other firms
Can be very limiting, subject to ex-post bargaining.
Financial restructuring Adjusting capital structure.
Operational restructuring Balance sheet composition, often by merging units,
divestitures and spin-offs.
Section III
M&A WAVES AND CORPORATE
GOVERNANCE
 Merger Waves
Horizontal Consolidation (1897-1904)
Horizontal consolidation refers to combinations of competitors. Vertical refers to combinations up and
down the supply chain. For instance, mergers of suppliers, manufacturers and distributors.
Increasing Concentration (1916-1929)
Increasing concentration refers to the proliferation of monopolies and oligopolies.
The Conglomerate Era (1965-1969)
highly diversified firms whose investments are usually unrelated.
The Retrenchment Era (1981-1989)
characterized by the breaking up of firms to correct for past strategic mistakes such as the formation of
conglomerates during the 1960s and early 1970s.
Age of Strategic Megamerger (1992-2000)
huge mergers often intended to strategically realign a firm or to achieve industry consolidation to
exploit economies of scale and scope.
Age of Cross Border and Horizontal Megamergers (2003-2007)
mergers and horizontal megamergers are those involving firms merging with foreign firms often to
consolidate global industries.
Post crisis merger wave? Oil price merger wave? (2015?)
 Agency problems
in the corporation
Board of Directors
misbehaviour

Manager director manager

=director Lack of
of BOD expertise

What firm
represents
for
Overcommitment
shareholders

and for
the director
 Agency problems
in the corporation
Moral hazard if BOD aligns with manager

Principal: Agent: Board of

Agent: Manager
Shareholders directors

Moral hazard if shareholders do not:

Actively monitor manager
Coordinate to monitor
 Corporate Governance
in the context of M&A
Corporate governance is supposed to be there to protect
stakeholders in the firm
There are external and internal factors affecting corporate
governance
Common takeover tactics employed in the market for
corporate control and when and why they are used
Common takeover defences employed by target firms
and when and why they are used
The concept of control
 Alternative Models of
Corporate Control
Market model applies when: Control model applies when:
Capital markets are liquid Capital markets are illiquid
Equity ownership is widely Ownership is heavily
dispersed concentrated
Board members are largely Board members are largely
independent insiders
Ownership & control are Ownership & control
separate overlap
Financial disclosure is high Financial disclosure limited
Shareholder focus more on Shareholder focus more on
short-term gains long-term gains
Prevalent In U.S. and U.K. Prevalent in Europe, Asia, &
Latin America
 Factors Affecting Corporate Governance:
Market Model Perspective
External to Firm

Legislation:
UK CMA
US Dodd-Frank Act (2010)
EU European Comm.

External to Firm Internal to Firm External to Firm

Board of Directors
Regulators: Management Market for Corporate
SEC Internal Controls Control:
Justice Department Incentive Systems Proxy Contests
FTC Corporate Culture & Hostile Takeovers
Values
Takeover Defenses
Bond Covenants
External to Firm

Institutional Activism:
Pension Funds (Calpers)
Mutual Funds
Hedge Funds
 Internal Factors: Board of Directors
and Management

Board responsibilities include:

Review management proposals/advise CEO
Hire, fire, and set CEO compensation
Oversee management, corporate strategy, and financial
reports to shareholders
Good governance practices include:
Separation of CEO and Chairman of the Board
Boards dominated by independent members
Independent members serving on the audit and
compensation committees
 Internal Factors: Controls &
Incentive Systems
Dodd-Frank Act (2010):
Gives shareholders of public firms nonbinding right to vote on executive
compensation packages.
Public firms must have mechanism for recovering compensation 3-yrs prior to
earnings restatement.
Consolidates regulatory agencies (establishes systemic risk council).
Comprehensive regulation of financial markets, including increased transparency.
Consumer protection reforms including a new consumer protection agency.
Provides authority to allow for orderly winding down of bankrupt firms.
Alternative mechanisms are contractual:
Link stock option exercise prices to firms stock price performance relative to the
overall market.
Key managers should own a significant portion of the firms outstanding shares.
 Internal Factors:
Corporate Culture & Values
Corporate culture refers to a common set of values, traditions, and beliefs that
influence management and employee behaviour within a firm.
The desired culture for the new organization can be promoted through
Clear and consistent communication to all employees of what is appropriate and
what is not
Senior management consistently displaying the desired behavioural norms.
Reward systems that foster desired behaviours while penalizing undesirable
conduct
Trust in a new organization is undermined when there is ambiguity about the
new organizations culture/identity.

This was the predominant paradigm in US corporate policy pre-crisis, but the
absence of oversight appears to be one aspect of the systematic governance
failures observed after 2008.
 Summary

In this lecture you have been given a crash course in the language
and process of M&A.
M&A is a form of corporate restructuring.
Corporate governance is important!

Following lectures:
The market for control
Regulation and its impact on M&A
Payment methods
Target valuations
Readings: Trautewein (1990, Strategic Management Journal)
Section IV
APPENDIX
 Jargon
The words to describe mergers and acquisitions are often
used loosely and they are used differently between
Britain and the US
In Britain:
Takeover: The process whereby one company buys (from
the shareholders) ownership of another company. This
transfers the rights attached to the ownership of the
shares, to the acquiring company
Acquisition: The process whereby one company buys
ownership of another company or (sometimes) of its
assets
 Jargon
Merger: A `merger-of-equals', where shareholders of two
companies agree to merge into a single company under as
single umbrella. In the UK, this is normally understood to
mean a merger where no (or very little) money changes
hands; there is no `takeover premium and all shareholders
of the two companies before the merger, remain
shareholders of the new, merged entity
Consolidation: The process of incorporation of two entities
into one.
Corporate Restructuring: A catch-all word describing any
restructuring of a company to achieve (hopefully) better
returns for the shareholders
 Jargon

Joint Venture: An entity, usually a separate company,

owned jointly by two or more other companies, enabling
both to participate (without competing with one another)
in a new business opportunity
Conglomerate: A `holding company' which owns, or part-
owns, companies in many different industries, often with
nothing in common except their common ownership
Leveraged buy-out: A purchase of a company or part of a
company, financed by an exceptionally large proportion of
debt
 Jargon
Going Private: purchase of a company or part of a
company by managers (`Management Buyout' (MBO), by a
third party (a `third party' buying with the participation of
managers is called a `Bimbo'), or by private equity
Private Equity: An unlisted company or partnership which
exists for the specific purpose of buying other companies,
normally with a view to increasing liquidity and
profitability and then to selling them again
Reverse Takeover: Acquisition of a publicly-listed company
by a private company (often the cheapest way for the
private company to obtain a listing) or of a larger company
by a smaller company
 Jargon
Holding Company: Company formed for the purpose of
holding shares in, or owning, other companies. A holding
company may also wish to keep subsidiaries as separate
legal entities, so that in the case of a failure of one
subsidiary, the holding company cannot be liable for the
debts of the subsidiary
Listing: `Listing' means membership of a stock exchange.
For example, a company might be `AIM-listed'. This means
that the company is a member of (on the list of members
of) the Alternative Investment Market. In the UK, a
company described as `listed' with no other qualification,
means that they are a member of the London Stock
Exchange.