Mergers & Acquisitions

Session 8

Professor Dimas Fazio

National University of Singapore Business School

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 M&As: An Overview

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 Mergers and Acquisitions

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 Mergers and Acquisitions

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 M&As Generally:

Transactions can
Are very Large sums of transform local &
complex deals money involved. international
economies, inter-
country relations.

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 M&As Generally:

Transactions can
transform local &
Are very complex Large sums of international
deals money involved. economies, inter-
country relations.

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 M&As Generally:

Transactions can
transform local &
Are very complex Large sums of international
deals money involved. economies, inter-
country relations.

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 M&As Generally:

Transactions can
transform local &
Are very complex Large sums of international
deals money involved. economies, inter-
country relations.

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 M&As Generally:

Transactions can
transform local &
Are very complex Large sums of international
deals money involved. economies, inter-
country relations.

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 Takeovers

• Takeover: any situation where there is a change in control of the firm.

• Takeovers can take place via acquisition (and much less commonly, via proxy contests)

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 Mergers

• Mergers: The combination of two or more corporations in which one corporation survives and the other
corporation ceases to exist.
• The surviving corporation retains the name, identity, assets, and liabilities of the firm that ceases to exist.

• Consolidation: Two firms terminate their legal existence and become part of a new firm.

• Under both cases, target firms are completely absorbed.

• Mergers are negotiated among senior managers of the combining firms. Post merger management often
includes managers from both firms

• Mergers and consolidations must be approved by the Board of Directors and a vote of the stockholders of
each firm.

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 Acquisition of Stock
• Under a complete acquisition, one firms buys another firm’s voting stock

• Effectively acquires control of all the assets

• Also assumes all the liabilities of the target

• May or may not start as a private offer to target management.

• Tender offers: the stock is purchased through a public offer, made directly by the acquiring firm to the
shareholders of the target. Thus, no need for shareholder vote

• Hostile takeover: target firm’s management opposes the bid.

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 Acquisition of Assets

• One firm acquires another firm by buying all or selected assets of the target

• Assumes all, a portion, or none of the liabilities of the target

• Requires voting approval by the target company’s shareholders when involves a

substantial sale of assets

• The legal process of transferring assets can be costly

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 Motives for M&As

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 WHY?

• Like any other investments, firms will merge if NPV > 0

• Say two firms with value $2 decide to merge

• Value of the combined firm?

• What is the NPV of the investment?

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 What is the NPV of acquiring a firm worth
$200 by paying its fair value?

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 Why merge?

Firm A Firm B Firm A + B

+ =

2 + 2 = 6?
Firm A Firm B Synergies Firm A + B

+ + =

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 What are the motives behind M&As?
• Synergies: 𝑉𝐴𝐵 − 𝑉𝐴 + 𝑉𝐵 = ?

• Operational Synergies
• Economies of scale
• Economies of vertical integration
• Complementary resources
• Revenue enhancements

• Financial Synergies

• Reduction in Agency Costs

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 Synergies

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 Examples of Synergies

8 February 1988 | The Dallas Morning News

SEAGRAM: MARTELL DEAL TO GET BETTER WITH AGE

….Seagram Co…. $850 million winning bid for Martell

….over time…. Seagram's worldwide liquor and wine business will definitely be enhanced by the
Martell acquisition.
Seagram plans to use its international marketing resources to boost Martell's image

Seagram also hopes to help its other brands by making use of Martell's strong distribution network in
the Far East, the fastest growing liquor market in the world.

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 Examples of Synergies

23 August 2005 | Straits Times

ComfortDelGro expands into Australia

Joined forces with an Australian company to purchase Westbus, one of Australia's largest private bus firms
Hold a 51% stake.
‘.. marks.. entry into the Australian transport sector, widening .. global footprint …’

10 July 2008 | Business Times

ComfortDelGro unit to acquire Custom Coaches

ComfortDelGro’s Australian subsidiary, ConfortDelgro Cabcharge (CDC) will acquire bus builder Custom Coaches to
get a 35% share of the Australian bus building market.​

The acquisition will act as a base when CDC’s new manufacturing plant … opens in early 2009.​
‘…. help .. get a foothold until the building plant goes into operation’

… Comfortdelgro, the world’s 2nd largest land transport company, …has operations in 7 countries (Singapore,
China, UK, Ireland, Australia, Vietnam, Malaysia)​
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 What are the potential synergies when
two airlines merge?

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 Other Motives For M&As

• Diversification (Reduction of Idiosyncratic Risk)

• Same argument as the one applied to a large portfolio

• Concentration and anti-competitive measures

• Managerial motives to merge

• Conflicts of Interest / Empire Building
• Overconfidence

• 2 + 2 = 3???

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 Valuing the Target

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 Valuing the Target

• For now, we will calculate the maximum offer price that the Acquirer would be willing to
offer

• Later, we will discuss how the synergies are split between Acquirer and Target

• To determine the maximum target offer price we can either:

• Find the target’s value to the acquirer as a whole (Target Value + Synergies)
• Separately value the additional synergies that will be obtained by acquiring the target. This value will then be
added to our value of the target without synergies

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 Valuing the Target

• To value the target as a whole to the acquiring firm, the target’s total cash flows AFTER
acquisition must be estimated. Thus, both the target’s existing abilities and its impact on the
Acquirer’s cash flows must be estimated.

𝐶1 𝐶2 𝐶3 𝐶𝑛 + 𝑇𝑉𝑛
𝑉𝑎𝑙𝑢𝑒 = + 2
+ 3
+ ⋯+
1+𝑟 1+𝑟 1+𝑟 1+𝑟 𝑛

• We then need to calculate the value of

• Target Equity Share = Total Target Value - Debt
• Target price per share = Target Equity Value / Shares Outstanding

• Thus, it is necessary to estimate the target’s new expected cash flows and applicable discount rate,
assuming acquisition

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 Establishing a Floor Value

• Since we have two parties, we first need to determine whether there will be synergies in the
first place.

• Calculating the target on a stand-alone basis (without the benefits of acquisition) should
establish a floor for negotiating purposes.

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 Valuing the Target – Some considerations

• Discount Rate estimates: WACC must match the business risk, financial risk, expected inflation
and currency of the cash flows to be discounted
• What is the business risk of the cash flows as the merger/acquisition proceeds?
• Are the acquirer and target in the same industry?
• Will the target’s business risk somehow change?
• Will the target’s financing change?

• Terminal Value estimates: it may be useful to compare different methods

• Market multiples:
• Try to use the most relevant market multiple
• Exclude outlier comparables
• Dividend growth model

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 Valuing the Synergies Separately

• If the acquirer and target values are known and/or accepted as is, then the merged firm can be
valued by focusing on valuing the synergies

• We then focus on specifically identifying the synergistic cash flows and the associated risk with
realized those synergies.

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 Example: Valuing the Synergies Separately
• First, assume that the Target’s Value as is equals $71 per share.

• What is the Target's Additional Value as an Acquisition? To determine the value of the target to
the acquirer, we need to add the PV of the synergies

• Synergy Cash Flow Estimates ($ in Millions):

• Assume 𝑟 = 14.57%, the PV of the Synergies is $2.661M. The target has 90.5M shares
outstanding, thus the synergies are $29.40 per share

• So the maximum offer price is $71 + $29.4 = $100.4 per share

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 M&A Premiums

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 Premium in Takeovers

• Definition of Premium: Difference between the price effectively paid for the takeover
and the fair value

• What is the size of premiums in takeovers?

• Why would a bidder want to pay a premium for the acquisition?

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 Premium in Takeovers

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 Hostile vs Friendly Takeovers

Bid Premia for Targets

US UK
Hostile 40% 28%
Friendly 33% 18%
Sources: Franks and Mayer, 1996 (UK), Kini, Kracaw and Mian, 2004 (US)

Why hostile takeovers have a higher premium than friendly takeovers?

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 How much to pay: Splitting the Synergies
Example
• Pre-merger
• The acquirer has 50 million shares outstanding, each currently selling at $100 per share ($5 billion market value)
• The target has 40 million shares outstanding, each currently selling for $70 per share ($2.8 billion market value)

• Post-merger
• The net present value of the synergies is $1.7 billion

• Assume payment in cash (for now)

• Offer price $100 per share

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 How much to pay: Splitting the Synergies
Example
Synergy
expected by
Expected acquirer? 30%
$12.5 / sh
Total
100% Synergies Synergy
Value
"Captured"
$42.5 / sh Target 70%
by Target?
Offer
Price $30 / sh
40 Million Target
Shares Outstanding
Target - on $100 * $30/share
its own, per target premium = $1.2
Price/Share share in Billion Total
cash or Premium
$70 / sh stock
HOW we pay affects
HOW MUCH we pay 38
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 How to calculate the bid premium?

• Bid premium = Amount paid – Target’s Pre-Bid Market Capitalization

• Assume market value of target is $10 one day before bid announcement and the value of the
bid is $12. Then the bid premium is $2.

• Correct?

• Assume the target value was $8 one month before bid announcement. Is the bid premium $4?

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 How to calculate the bid premium?

• The answer to these questions depend on whether information on the bid was leaked
before announcement.

• If there is no leakage, then take the price just before announcement

• However, assume there is a leakage about one month prior to the announcement.
Prices will increase from $8 to $10 because of “run-up”, i.e. anticipation of the merger.

• If that is the case, then one should take the “unaffected price”, i.e., $8 to calculate the
premium

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 Target’s Stock Price Around M&A
Announcement

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## NUS Confidential ## Source: Keown, Pinkerton (1981) using US data from 1975-1978
 Stock Prices Around M&A Announcement
Target Acquirer

Source: Asquith (1983) using US data from 1962 to 1976

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 How to calculate the bid premium?

• Note: in this scenario, we are assuming that the stock market indices have not changed over the
previous period. If the stock market increased over the previous month, one needs to adjust the
model using the CAPM (or other similar asset pricing models)

• Usual practice: assume a high possibility of leakage 1 month (or also 3 months) before the
announcement.
• Could check using information on trade volume, as well.

• All in all, the premium paid can be divided into two parts:

𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑅𝑢𝑛 − 𝑢𝑝 + 𝑀𝑎𝑟𝑘 − 𝑢𝑝

where ‘Markup’ is increase in stock price from 1 day before announcement to 1 day after
announcement

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 What causes runups?

• Insider trading
• Meurlbroek (1992) shows that pre-bid runups are correlated with insider trading using a
sample of cases where the SEC has successfully prosecuted insiders. She estimates that
almost half the runup is attributable to days when insiders traded.
• Acharya, Johnson (2007) find that in case of private equity buyouts, the pre-bid runup is
higher when the number of financing participants is higher. They find that more “insiders”
may be leading to more insider trading.

• Jarrell & Poulsen (1989) find several sources of legitimate information for
runup: announcement of 13D filing when investors announce stake of 5%+.
They also find that bid premiums are higher when runups are large.

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 Evidence of Bill Schwert (JFE, 1996): used in
expert testimony in a court case
• Examined a sample of 1,814 successful & unsuccessful mergers in 1975-1991

• Used a market model for 253 trading days ending 6 months before first public announcement (to
estimate alpha and beta).

• Runups for whole sample was 13-14%.

• When SEC found insider trading the runup was 18.3%.

• Runups fell after successful prosecutions of insider trading.

• Bid premium: 14.3% (run up) + 15.8% (mark up) =30.1%

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 Toehold

• Should a bidder buy shares in the target prior to the announcement, often called a
‘toehold’?

• Seems obvious if the price is below the bid value

• But suppose share buying increases share price prior to bid announcement (higher ‘run
up’), how will this affect the premium?
• Bidder may end up paying more

• Target may argue that runup is not part of the bid premium but reflects its own
performance.
• This will again increase the price that the bidder needs to pay

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 Bid premium in mergers

• Market model

𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝑒𝑖

where

• 𝑅𝑖 : returns on security i
• 𝛼𝑖 : past out performance against market index
• 𝑅𝑚 : returns on the market index
• 𝛽𝑖 : beta of security i

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 Bid premium in mergers
• Step 1: Estimate alpha and beta using a ‘clean period’ outside window of bid announcement period
(say 4 months).

• If bid announcement window is 4 months, estimate alpha and beta, 36 months prior to
announcement window.

• The bid announcement window is roughly the period beginning with the bid rumors to bid
announcement day, e.g., 4 months.

• Step 2: Using estimates of alpha and beta from step 1, calculate abnormal returns for merger
window say for 4 months prior to announcement.

• 𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 (−3 𝑡𝑜 0) = 𝑅𝑖 − 𝛼𝑖 − 𝛽𝑖 𝑅𝑚

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 Bid premium in mergers

• An unexpectedly bad (or good) earnings announcement around the time of the merger might
contaminate the data and make measurement of the bid premium more difficult
• Market timing is also important in merger and acquisition. GKN was doing badly and new CEO just
appointed when the bid by Melrose was launched

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 Payment Options

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 Payment Options
• There are two main ways to pay a merger

• Cash: bidder pays cash

• Stock:
• give stock of bidder company to shareholders of target company in exchange for their stock in the target firm
• Target shareholders become shareholders of the bidder firm
• Exchange Ratio: How many shares of the bidder should you give for each share of the target. How to calculate it?

• 26% of all mergers are cash-financed, 37% are all stock deals. The rest are a mix (Betton, Eckbo,
Thorburn, 2008)

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 Payment Options

• In case of stock-swap merger, the acquiring shareholders would benefit if the price of the shares of the merged
firm is higher than the price of the shares of the standalone acquiring firm

• Let A be the value of the acquiring firm, T of the target firm, S the value of synergies, 𝑁𝐴 the number of shares of
the acquiring firm, x the number of new shares to pay for the target.

• Then the acquirer's share price will increase if:

𝐴+𝑇+𝑆 𝐴
> = 𝑃𝐴
𝑁𝐴 + 𝑥 𝑁𝐴

𝑇
• Another way to see this 𝑥𝑃𝐴 < 𝑇 + 𝑆, and since 𝑃𝑇 = , then:
𝑁𝑇

𝑥 𝑃𝑇 𝑆
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = < 1+
𝑁𝑇 𝑃𝐴 𝑇

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 Splitting the Synergies

• Pre-merger:
• The acquirer is an all-equity firm with 1 M shares currently selling for $15 per share. Its equity value is
comprised of its own project, the PV of which is $10M. The firm has $5M in cash as well
• The target is an all-equity firm with 0.5M shares valued at $8 per share. It has one project valued at $4M.

• Post-Merger:
• The NPV of synergies is $1 M

• Let us look at four scenarios

• A: Cash Payment, Acquirer Gains Full Synergies
• B: Cash Payment, Target Gains Full Synergies
• C: Stock Payment, Acquirer Gains Full Synergies
• D: Stock Payment, Target Gains Full Synergies

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 Splitting the Synergies

• A: Cash Payment, Acquirer Gains Full Synergies

Acquirer pays the target $8 per share. The value of the acquiring firm will be $16 M ($
15M as before + $ 1M of synergies)

• B: Cash Payment, Target Gains Full Synergies

Acquirer pays the target $10 per share. The value of the acquiring firm will be $15 M
(same as before)

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 Splitting the Synergies
C: Stock Payment, Acquirer Gains Full Synergies

Step 1: What is the value of the combined firm?

𝐴 + 𝑇 + 𝑆 = $15 + $4 + $1 = $20

Step 2: How much of the combined firm will be owned by the target shareholders?
• Since zero synergies are given to target shareholders, the price paid for their shares is
the market price pre-merger.
• Target shareholders will get 4/20 = 20% of the combined firm
• Acquirer shareholders will hold 80% of the combined firm

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 Splitting the Synergies

Step 3: Calculate the implied price per share of acquirer’s stock post-merger
• (80%*$20M)/(1M) = $16 per share

Step 4: Calculate how many shares need to be issued to pay the target shareholders
• $4M/$16 = 250,000 shares

Step 5: Calculate the exchange ratio (shares of acquirer given to target per share of the
target): 250,000/500,000 = 50%

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 Splitting the Synergies

D: Stock Payment, Target Gains Full Synergies

Step 1: What is the value of the combined firm?

𝐴 + 𝑇 + 𝑆 = $15 + $4 + $1 = $20

Step 2: How much of the combined firm will be owned by the target shareholders?
• Since full synergies are given to target shareholders, the price paid for their shares is the market
price pre-merger plus the synergies.
• Target shareholders will get 5/20 = 25% of the combined firm
• Acquirer shareholders will hold 75% of the combined firm

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 Splitting the Synergies

Step 3: Calculate the implied price per share of acquirer’s stock post-merger
• (75%*$20M)/($1M) = $15 per share

Step 4: Calculate how many shares need to be issued to pay the target shareholders
• $5M/$15 = 333,333 shares

Step 5: Calculate the exchange ratio (shares of acquirer given to target per share of the
target): 333,333/500,000 = 66.6%

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 Exercise
Calculate the target offer price and the exchange ratio (when applicable) for the following
scenario:

• Pre-merger:
• The acquirer is an all-equity firm with 1 M shares currently selling for $15 per share. Its equity value is comprised of its on
project, the PV of which is $10M. The firm has $5M in cash as well
• The target is an all equity firm with 0.5M shares valued at $8 per share. It has one project valued at $4M.

• Post-Merger:
• The NPV of synergies is $5 M

• Let us look at four scenarios

• A: Cash Payment, Acquirer Gains Full Synergies
• B: Cash Payment, Target Gains Full Synergies
• C: Stock Payment, Acquirer Gains Full Synergies
• D: Stock Payment, Target Gains Full Synergies

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 Payment Options: the United-Continental Case

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 The problem in a nutshell

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 One way to think about the problem

• If Continental stockholders receive a fraction y of the combined firm, the

premium United is paying to Continental is

𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑦 ⋅ 𝐴 + 𝑇 + 𝑆 − 𝑇

• Rumors in April 6th. Assume April 30th is the date of announcement of the bid.

• What are the synergies in this case? Do you need to make any more
assumptions?

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 One way to think about the problem

• Say United is willing to give a premium equal to half the merger gains.

• What is y, the fraction of the merged firm owned by Continental shareholders?

• Assume the market index did not change over this period. Otherwise, you have
to take into account for the change.

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 Economic Gains: Stock Acquisition

• If the premium United is paying is equal to half the merger gains ($554m) then the premium is $277m.
Continental stockholders should then receive a fraction y of the combined firm, where

𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑦 ∗ 𝐴 + 𝑇 + 𝑆 − 𝑇
$277 = 𝑦 ⋅ $6898 − $2939
277 + 2939
𝑦= = 46.6%
6898

• So Continental stockholders should receive a total of x new United shares where

𝑥 𝑥
= = 46.6% ⇒ 𝑥 = 152.63𝑚 𝑠ℎ𝑎𝑟𝑒𝑠
𝑥 + 𝑁𝐴 𝑥 + 174.9𝑚

𝑥
• Exchange ratio?
𝑁𝑇

152.63
• For each Continental share they should receive = 1.09 United shares
139.6

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 What determines exchange ratio

All equity exchange offers require the publication of the exchange ratio. It is influenced by:

Value of How they are Number of

synergies shared between bidder’s shares
bidder and target pre-bid

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 What actually happened

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 Exercise 2

A company X has just announced a bid for a target Y. The table below gives the prices of the
respective shares just after the announcement of the bid, September 1, and two months
earlier July 1, when rumors of the bid first began.
Assume the rise in share prices reflects expected value of the synergies. The intention of the
merging parties is to share the synergies roughly equally between the merging parties, ie.
the bid premium to the target is 50 percent of the synergies. The merger is an all equity
exchange transaction.

Calculate the fraction of the merged company that will be owned by Y. Also, calculate the
exchange ratio (the # of shares offered to Y for each of its shares)

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 Exercise 2

Solution
In this case, bid premium is $20 (half of the synergies)
To calculate the fraction of the merged company that will be owned by Y, we need to solve
the formula
$20𝑚 = 𝑦 ⋅ 335𝑚 – 75𝑚

20+75
y= = 28.35%
335
Thus, the number of shares that Y should receive from the new company X should be
𝑥
= 28.35%
𝑥 + 110𝑚
0.2835 𝑥 + 31.19 = 𝑥
𝑥 = 43.54𝑚
Thus, for each share of Y, they should receive
43.54𝑚
= 0.86 (the exchange ratio)
50𝑚

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 Takeover Defenses

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 Takeover Defenses

• If bids are above market value on average, why would management oppose an
acquisition offer?

• Why would a firm want to engage in defensive targets?

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 Poison Pill
• Goal: increase the cost of hostile takeovers

• Examples:
• Diluting the hostile acquirer existing position
• Option to buy new shares at half price if you are not the
hostile acquirer
• Special voting rights
• Hostile acquirers are left out

• Company constitution (at time of IPO) restricts one share

one vote if bid is hostil

• Poison pills do not make it impossible for

takeovers to happen, but they surely increase
the cost of takeovers

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 Poison Pill

• Papa John’s stock price around 23-Jul-2018: ~ -10%

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Price (USD)

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Days Relative to Poison Pill

• Why did the market react this way?

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 Golden Parachutes

• Large severance pay for top manager

• Examples:
• Activision Blizzard CEO Bobby Kotick: $250 million
golden parachute

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 Other Defenses

• Staggered Boards
• Only a fraction of the board is elected each year
• Makes it difficult to elect a new board quickly

• White Knights: seeking alternative friendly bidder

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 Managerial Resistance
• Management of the target activates press releases and mailings to shareholders.

• The resistance may be in pursuit of target management’s own interest.

• Only 34% of target CEOs are retained as officers of the merged firm (Hartzell, Ofek and Yermack, 2000)

• Use golden parachutes (compensation to target management) to align interests.

• However, resistance may benefit shareholders if it results in a higher offer from the bidding firm or another
bidder.

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 The rise & fall of Yahoo

https://www.youtube.com/watch?time_continue=1&v=Ec_IHQWyTXY&feature=emb_title
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 Example where managerial resistance hurt
shareholders
• The rise and fall of Yahoo https://www.youtube.com/watch?v=Ec_IHQWyTXY

• Feb 1 2008, Microsoft (CEO Steve Ballmer) made an unsolicited acquisition offer for Yahoo at $44.6 billion or $31
per share
• 62% premium over Yahoo’s stock price of $19.18

• Feb 11, Yahoo rejected Microsoft’s offer as being too low. Asked for $35-$37
• Yahoo began looking for a white knight.

• Feb 22, two pension companies sued Yahoo and its BOD for breaching their duty to shareholders by opposing
Microsoft’s takeover bid.

• Early March, Google CEO Eric Schmidt said he was concerned that a Microsoft-Yahoo merger might hurt the
internet by compromising its openness.

• May 2, Yahoo’s stock closed at $28.67.

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 Example where managerial resistance hurt
shareholders
• May 3, Microsoft withdrew its bid. Yahoo stock price plunged to $23.02
• May 15, Carl Icahn (a well known corporate raider) started a proxy contest to attempt a boardroom coup to oust
Yahoo's management at its August annual meeting.
• June 12, Yang issued statement that talks with Microsoft had ended
• Announced a search advertising alliance with Google. Many executives and senior management announced plans to leave Yahoo. Lost
confidence in Yahoo’s strategies.

• July 7, Microsoft declared that it might consider another bid if Yahoo’s 9 directors were ousted at the August annual
meeting
• Able to better negotiate with a new board

• July 21, Yahoo appointed Carl Icahn and 2 of his allies onto an expanded board.
• Aug 1, all directors were re-elected.
• Nov 20, Yahoo’s stock dropped to a 52 week low of $8.94.
• Nov 30, Microsoft offered to buy Yahoo for $20 billion (1st offer at $44.6b).
• Jan 13 2009, Carol Bartz replaced Jerry Yang as CEO. Stock price at $12.10
…
• Acquired by Verizon in 2017 for $4.5 billion.

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 Conclusion

• Mergers and Acquisitions are complex deals and involve large sums

• Why merge? Ultimately, merge if NPV > 0

• But beware of managerial incentives… and managerial resistance

• Usually done to protect private interests at the expense of shareholder value
• Acquirer: risk of overpaying for the target
• Target: risk of rejecting a good deal for shareholders

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 Thanks!
Does anyone have any questions?

dimasfazio@nus.edu.sg
BIZ 1 - #07-62

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