Corporate Restructuring

Mergers and Acquisitions • Merger—any combination of two or more businesses under one ownership • Acquisition (AKA: takeover)—one firm acquires the stock of another (the takeover target) • Consolidation—all the combining firms dissolve and a new one with a new name is formed

Mergers and Acquisitions • Relationships • A consolidation implies the firms combined willingly • In an acquisition one firm acquires the other, in either a friendly or hostile takeover • Stockholders • Have to be willing to give up their shares for the offered price • The majority must approve for an acquisition to be successful

Mergers and Acquisitions • Friendly Procedure • The target's management approves of the deal and cooperates with the acquiring company • Negotiation occurs until an agreement is reached • Proposal submitted to stockholders for a vote • Percentage required for approval depends on corporate charter and state law • Unfriendly Procedure • The target's management resists and may take defensive measures to stop the deal • Acquiring firm makes a tender offer to the target's shareholders • A special offer to buy the stock for a fixed price contingent upon obtaining enough shares to gain control

Why Unfriendly Mergers are Unfriendly • A target's management may resist a takeover because • The acquiring firm doesn't offer a high enough price for the firm's stock • The acquiring firm's management may lose their jobs, power or influence

Economic Classification of Business Combinations • Vertical Merger • When a firm acquires one of its suppliers or customers • Horizontal Merger • The merging firms are competitors (reduces competition) • Conglomerate Merger • The merging firms are not in the same lines of business

The Antitrust Laws • U.S. is committed to maintaining a competitive economy • Antitrust laws enacted between 1890 and 1930s prohibit certain activities that can reduce the competitive nature of the economy • Mergers have the potential to reduce competition • Antitrust laws limit the freedom of companies to merge

The Reasons Behind Mergers • Synergies • When performance as a combined entity is expected to be better than performance as separate entities • The whole is more than the sum of its parts • Usually cost saving opportunities • In practice they are hard to find and difficult to implement • Growth • Internal growth occurs when firms sell more in their current businesses • External growth occurs when a firm acquires a rival

The Reasons Behind Mergers • Diversification to Reduce Risk • A collection of diverse businesses is generally less risky than a company with only a single line of business • Variations of the different business lines tend to offset each other • Economies of Scale • A larger company can perhaps operate at a lower cost level than any of the merging organizations can individually • Guaranteed Sources and Markets • Vertical mergers can lock in a firm's sources of critical supplies or create captive markets • Acquiring Assets Cheaply • A firm can sometimes acquire assets more cheaply by buying a firm that already owns the assets then by buying the assets individually • Tax Losses • Acquiring a firm with a tax loss can shelter the acquirer's earnings

The Reasons Behind Mergers • Ego and Empire • Powerful people within an organization may be building up their empire • May mean the acquiring firm pays too high a price for the target

Holding Companies • A corporation that owns other corporations called subsidiaries • Holding company is known as the parent of the subsidiary • Advantages • Sensible when firm would like the business operations kept separate and distinct • Generally possible to keep liabilities of subsidiaries separate • Failure of one doesn't affect the parent or other subsidiaries • Possible to control a subsidiary without owning all of its stock • Sometimes an interest as small as 10% can effectively control a widely held corporation • General rule: Ownership of 25% virtually guarantees control • Thus, it's possible to effectively control an organization without spending the funds to buy the entire organization

The History of Merger Activity in the U.S. • Wave 1: The Turn of the Century, 1897-1904 • A large number of horizontal mergers transformed the U.S. into a nation of industrial giants—in many cases monopolies • Examples: U.S. Steel (formed by the combination of 785 separate companies), Standard Oil, Eastman Kodak, American Tobacco, General Electric • Wave 2: The Roaring Twenties, 1916-1929 • Began with World War I and ended with the stock market crash of 1929 • Mergers tended to be horizontal and led to oligopolies

The History of Merger Activity in the U.S. • Wave 3: The Swinging Sixties, 1965-1969 • Companies acquired firms in non-related industries (conglomerate mergers) • In many cases these mergers were driven by stock market issues rather than operating concerns • If a firm with a high P/E ratio buys a firm with a low P/E ratio and pays for the target with its own stock, the result can be an increase in combined EPS • If the stock market attaches the acquiring firm's original P/E ratio to the new firm, a higher stock price will result • An Important Development During the 1970s • Prior to 1970s hostile takeovers were unusual • However, in the 1970s hostile takeovers were viewed as acceptable

The History of Merger Activity in the U.S. • Wave 4: Bigger and Bigger, 1981 - ? • Mergers in the 1980s and onward are characterized by the following: • Size—large mergers have become more common • Hostility—the threat of hostile takeover now pervades corporate life • Raiders—corporate raiders have emerged • A financier who mounts hostile takeovers • Defenses—strategies to combat hostile takeovers have developed • Advisors—Investment bankers and lawyers have aggressively expanded their roles as advisors • Financing—the junk bond market helped spur the financing for mergers

The History of Merger Activity in the U.S. • Some Detail about Wave 4 • Merger activity slackened in the early 90s after peaking in the late 80s • The junk bond market collapsed in 1989-1990 • In the mid 1990s merger activity picked up again—many mega mergers occurred • Disturbing Implications • Mega mergers can lead to reduced competition • A great deal of power over public opinion is in the hands of a few executives

Merger Analysis and the Price Premium • What price should an acquiring company be willing to pay for a target firm? • A merger analysis attempts to determine the answer to this question • Acquiring firm projects the target's cash flows and performs a standard capital budgeting analysis to determine if the investment is expected to generate a positive NPV • Must forecast the target's cash flows • Must determine the appropriate discount rate

Merger Analysis and the Price Premium • Estimating Merger Cash Flows • Should be a straightforward exercise with two exceptions • Need to include in the analysis any adjustments for synergies that are expected to occur • Need to adjust reinvestment rate that must occur for the expected growth to occur • Unfortunately, estimating expected cash flows for a merger are quite difficult • The acquiring firm has to do the estimation, but it does not have access to the target's detailed information about future prospects or the past • In a friendly merger the target tries to bump up the price so it tends to be overly optimistic with the information shared • In an unfriendly merger the target does not share information • Tendency is for the acquirer to overestimate the value of the target

Merger Analysis and the Price Premium • The Appropriate Discount Rate • An acquisition is an equity transaction • Should be valued using a discount rate reflective of the cost of equity • Should use the target's equity rate, not the acquirer's because the risk of the project is that of the target company • The Value to the Acquirer and the Per-share Price • Once the NPV of the target is calculated, must determine the per-share value • Divide the NPV by the number of shares of stock the target has outstanding

Merger Analysis and the Price Premium • The Price Premium • The price offered to the target shareholders is generally higher than the stock's market price • Whether the merger is friendly or unfriendly • The target shareholders can always sell their stock in the market for the current price, so the acquiring firm has to offer a price that will induce the majority of stockholders to sell to them at once • The offering price exceeds the current market price by an amount know as the price premium • Major issue: determining the proper price premium--don't want it to be too high

The Price Premium • The fact that price premiums exists creates a speculative opportunity • In an investor owns stock in a company that becomes a target, the stock will experience an increase in price (generally) once the firm becomes in play • Thus, acquiring firms keep merger negotiations secret • Illegal for insiders to make short-term profits on price movements from the acquisition process • Insiders include executives and investment bankers • Some investors follow a strategy of buying stock in companies they expect to become takeover targets because they want to benefit from the price increase

Paying for the Acquisition—The Junk Bond Market • An acquiring firm pays the target firm either one or a combination of the following • Cash • Stock in the acquiring firm • Debt in the acquiring firm • Acquiring firm needs to either have cash or be able to raise it • Use the services of an investment banker • Junk bond market began in the 1980s and helped firms raise cash to finance mergers

Paying for the Acquisition—The Junk Bond Market • Junk bonds are low quality bonds that pay high yields • Firms that issue them are risky • Prior to 1980s it was not possible for small, risky companies to borrow via bonds • However, investment bankers started pooling risky bonds into funds • A recession in the late 1980s caused the junk bond market to collapse • Pioneered by Michael Milken of Drexel Burnham Lambert

Merger Analysis and the Price Premium • The Capital Structure Argument to Justify High Premiums • If a company uses debt to raise cash to buy out a target's stockholders • Usually results in a more leveraged firm • If the increased leverage results in a higher firm value the use of debt may be justified • The Effect of Paying Too Much • An acquiring firm that pays too much for a target transfers value from its shareholders to the target shareholders • If the money was raised by borrowing, the combined firm may perform poorly or face future failure • Must pay interest payment on debt obligations

Defensive Tactics • Represent different strategies management of a target firm can take to prevent firm from being acquired • Tactics After a Takeover is Under Way • Challenge the price—management attempts to convince stockholders that the price offered is too low • Claim an antitrust violation—hope the Justice Department will intervene and prevent the merger • Issue debt and repurchase shares—tends to drive up the current price of the stock, making the price offered by the acquirer less attractive as well as increasing the firm's leverage

Defensive Tactics • Tactics After a Takeover is Under Way (continued) • Seek a white knight—find an alternative acquirer with a better reputation for its treatment of acquired firms • Greenmail—buy back stock from a targeted group of stockholders (a group expected to acquire a controlling interest in the firm) at a price greater than the current price

Defensive Tactics • Tactics in Anticipation of a Takeover • Staggered Election of Directors—if elections are staggered it will take time for a controlling interest to take control of the board • Approval by a supermajority—mergers need to be approved by stockholder vote—requiring approval by a supermajority makes taking control of the company more difficult • Poison pills—legal devices making it prohibitively expensive for outsiders to take control of the company without approval of the management

Types of Poison Pills • Golden parachutes—exorbitant severance packages for a target's management • Accelerated debt—requires the principal amounts be paid immediately if the firm is taken over • Share rights plans (SRPs)—current shareholders are given rights that enable them to buy shares in the merged company at a reduced price after a takeover

Leveraged Buyouts (LBO) • A publicly held company's stock is bought by a group of investors either through a negotiated deal or a tender offer • Company is no longer publicly traded but is now a private or closely held firm • Majority of the money for the stock purchase is raised by borrowing with loans secured by the firm's assets • Tend to be very risky due to high debt burden • However company attempts to pay down the debt load quickly • Specialized LBO companies help put together LBOs • Example: Kohlberg, Kravis & Roberts helped with the LBO of RJR Nabisco

Proxy Fights • When corporations elect boards of directors management usually solicits stockholders for their proxies • Generally no opposition occurs and stockholders willingly grant their proxies • However, proxy fights occur when opposing groups solicit shareholders' proxies for the election of directors • The winner of the proxy fight owns the controlling interest on the board

Divestitures • A company decides to get rid of a particular business operation • Reasons for divestitures • Cash—a firm needs cash so it sells an operation to generate cash • Firm may do this after an LBO to raise cash to reduce the debt burden • Strategic fit—a division may not fit into the firm's long-term plans • Poor performance

Divestitures • Methods of Divesting Companies • Sale for cash and securities • Spin-off—the operation is divested as a separate corporation and shareholders in the original company are given shares of the new firm • Liquidation—the divested business is closed down and its assets sold

Failure and Insolvency • Economic failure—a firm is unable to provide adequate return to its stockholders • Commercial failure—a business cannot pay its debts (insolvent) • Technically insolvent—can't meet short-term obligations • Legally insolvent—a firm's liabilities exceed its assets • A business can be an economic failure but not be a commercial failure

Bankruptcy—Concept and Objectives • Bankruptcy is a legal proceeding designed to keep a single creditor from seizing a firm's assets for itself and preventing other creditors from a claim • Bankruptcy court protects a firm from its creditors and determines whether the firm should remain running or shut down • If a firm is insolvent due to business gone bad • Best to shut the company down before it loses any more money • Salvage assets to pay off debt • If a firm is insolvent due to too much debt but is in a survivable situation • Firm may be able to make good on its debt if given enough time

Bankruptcy—Concept and Objectives • An insolvent company in a situation that is perceived as recoverable will reorganize • Debt will be restructured and a plan developed to pay creditors as fairly as possible • An insolvent company in a situation deemed unrecoverable will liquidate • Assets will be sold under the court's supervision • Proceeds used to pay creditors according to priority • Bankruptcy proceedings are designed to save as much pain and loss as possible when a firm fails

Bankruptcy Procedures—Reorganization, Restructuring, Liquidation • A bankruptcy petition can be initiated by either the insolvent company (voluntary) or its creditors (involuntary) • A group as small as three unsecured creditors owed as little as $5,000 can place a firm in involuntary bankruptcy • A firm in bankruptcy is usually allowed to continue operations • However, to guard against unethical acts, a trustee may be appointed to oversee operations

Reorganization • A reorganization is a plan under which an insolvent firm continues to operate while attempting to pay off its debts • Management and stockholders support a reorganization over liquidation • If liquidation occurs management has no job and stockholders usually receive nothing • Once a bankruptcy petition is filed, management has 120 days to file a reorganization plan • Reorganization plans are judged based on fairness and feasibility • Fairness—claims are satisfied based on priorities • Feasibility—the likelihood that the plan will actually occur • A reorganization plan must be approved by the bankruptcy court as well as the firm's creditors and stockholders

Debt Restructuring • Insolvent firms are those that cannot meet their debt obligations • Generally a reduction in payments is needed • Debt restructuring involves concessions that lower an insolvent firm's payments so it can continue operating • Debt restructuring can be accomplished in two ways: • Extension—creditors agree to extend the time the firm has to repay its debts • Deferrals of interest and principal are common • Composition—creditors agree to settle for less than the full amount owed • Creditors have an incentive to compromise because if the firm fails they are unlikely to receive as much as they would otherwise

Debt Restructuring • Debt-to-equity conversions are a common method of restructuring debt • Creditors give up their debt claims in return for stock in the company • Reduces debt burden on firm • Eases cash flow problems • If the firm survives the equity may be worth more in the long run than the debt given up

Liquidation • Liquidation involves closing a troubled firm and selling its assets • A trustee attempts to recover any unauthorized transfers out of the firm • When bankruptcy is anticipated assets are frequently removed • Illegal because these assets should be used to satisfy creditors' claims • Trustee then supervises the sale of the assets and pools the funds so that creditors' claims can be satisfied • The trustee then distributes the funds

Liquidation • Claimants include • Vendors who sold to the firm on credit • Employees who are owed wages • Customers who put down deposits for merchandise • Government which may be owed taxes • Lawyers and the court itself • Stockholders receive what is left over (if anything)

Distribution Priorities • Distribution follows an order of priority set forth by the bankruptcy code • The priority code states that some claimants are ahead of others in the order of payoff • Priority code payoffs • Secured debt—debt that is guaranteed by a specific asset • These creditors are paid when the specified assets are sold—remaining funds are placed into the pool of funds to pay remaining claimants

Distribution Priorities • Priority code payoffs • Administrative expenses of the bankruptcy proceedings • Certain business expenses incurred after the bankruptcy petition is filed • Unpaid wages—up to $2,000 per employee • Certain unpaid contributions to employee benefit plans • Certain customer deposits—up to $900 per person • Unpaid taxes • Unsecured creditors • Preferred stockholders • Common stockholders

Corporate Restructuring