Understanding Industries

1. ACE387 1 Understanding Industries Mergers and Acquisitions

2. ACE387 2 Recent M&A in T&A Adidas-Salomon acquired Reebok $3.8 billion. The transaction reshapes the sports footwear and apparel industry. (The New York Times: Aug 3, 2005)

3. ACE387 3 Recent M&A in T&A Talbots to Acquire J. Jill for $517M (announced Feb. 7, 06)

4. ACE387 4 What is corporate restructuring?

5. ACE387 5 What is corporate restructuring? 1980�s: corporate restructuring identified with leveraged buyouts (LBO�s) An attempt to buy a company using borrowed money by its management or outsiders . 1990�s: corporate restructuring identified with troubled debt restructuring: workouts and reorganization Mergers and Acquisitions Booming in Technology Post 2000: back to troubled debt to improve business models In the 1980�s, corporate restructuring was usually taken to mean acquisitions, usually highly levered acquisitions, by corporate raiders financed with Michael Milliken�s Drexel Burnham Lambert�s junk bonds. Usually referred to buying long-standing diversified conglomerates and to break up the pieces and sell them off to pay off the enormous levels of debt. Often referred to defensive restructurings, MBO�s of divisions, divestitures, LCO�s undertaken to avoid the hostile acquisition by a raider. In the early 1990�s, a substantial recession, coupled by the collapse of DBL and indictments (and convictions) of several of the era�s leverage kings (Milliken, Icahn, etc.) led HLT�s into substantial trouble. Restructuring took on a different connotation: troubled debt restructuring. A cottage industry sprung up to help distressed companies with workouts, renegotiating contracts, and go through Chapter 11 reorganizations. We will take a much more general approach to restructuring. Restructuring decisions are decisions concerning the definition of the firm (what businesses the corporation will be in), ownership structure (debt vs. equity), ownership structure (equity ownership structure), control structure (power of board of directors/management/stockholders/unions/community/etc.). Course is really what is currently being called organizational architecture. Restructuring decisions are decisions involving changes (usually large changes) in the organizational architecture of the firm.In the 1980�s, corporate restructuring was usually taken to mean acquisitions, usually highly levered acquisitions, by corporate raiders financed with Michael Milliken�s Drexel Burnham Lambert�s junk bonds. Usually referred to buying long-standing diversified conglomerates and to break up the pieces and sell them off to pay off the enormous levels of debt. Often referred to defensive restructurings, MBO�s of divisions, divestitures, LCO�s undertaken to avoid the hostile acquisition by a raider. In the early 1990�s, a substantial recession, coupled by the collapse of DBL and indictments (and convictions) of several of the era�s leverage kings (Milliken, Icahn, etc.) led HLT�s into substantial trouble. Restructuring took on a different connotation: troubled debt restructuring. A cottage industry sprung up to help distressed companies with workouts, renegotiating contracts, and go through Chapter 11 reorganizations. We will take a much more general approach to restructuring. Restructuring decisions are decisions concerning the definition of the firm (what businesses the corporation will be in), ownership structure (debt vs. equity), ownership structure (equity ownership structure), control structure (power of board of directors/management/stockholders/unions/community/etc.). Course is really what is currently being called organizational architecture. Restructuring decisions are decisions involving changes (usually large changes) in the organizational architecture of the firm.

6. ACE387 6 Types of Combinations Restructuring Consolidation A + B = C Two corporations join and create a third corporation. The original two corporations dissolved.

7. ACE387 7 Types of Combinations Restructuring 2. Mergers and Acquisitions A + B = AB A + B = A One corporation may acquire and absorb another. The acquired business is dissolved. We often use the term M&A as meaning the same thing.

8. ACE387 8 Types of Combinations Restructuring 3. Holding (parent) and Subsidiary Corporations ? A may own all or almost all of the stock of B. A is parent corporation or holding company. B is subsidiary. Advantages: Ability to control without owning all its stocks, Less risks Disadvantages: Double taxes of earnings, Easily dissolved by regulations

9. ACE387 9 Mergers & Acquisitions as an Economic Phenomenon Trillion dollar business Rapid increase volume Multinational dimension A way how to expand rapidly

10. ACE387 10 Mergers and Acquisitions in T&A $4.4 billion worth in 2003 $6.9 billion worth in 2004 excluding $11 billion Kmart/Sears Highlights (2004): Gucci bought by Pinault Printemps Redoute SA's: $3.5B VF Corp. closed its takeover bid for Vans Inc.: $396M Jones Apparel bought Maxwell Shoe: $345M Polo Ralph Lauren reclaimed the RL Childrenswear license from S. Schwab Co.: $250M. Reebok International bought Hockey Co. Holdings: $196M Source: From WWD, 12/7/04

11. ACE387 11 Mergers A + B = AB Companies A and B become one company (A+B) via an agreement which is Negotiated with between the firms� boards Subsequently voted on by shareholders Company B receives some number of company A shares, plus also (perhaps) some cash. Combining forms through some mutual negotiations usually friendly.

12. ACE387 12 Acquisitions A + B = A One company (or individual) A buys a controlling stake of another company B. Management/board approval not required No shareholder meeting/vote required Accomplished by Tender Offer

13. ACE387 13 Types of Mergers Horizontal Merger Vertical Merger Conglomerate Mergers Concentric Mergers

14. ACE387 14 Types of Mergers Horizontal Merger Combination of two or more firms operating in the same stage of production. - Diamler-Benz and Chrysler - Apparel firm and apparel firm Motives for horizontal mergers Economies of Scale Eliminate competition (Gain market share)

15. ACE387 15 Types of Mergers Vertical Merger Combination of two firms that operate in different stages of production. - Textiles firm merges raw materials firm Motives for vertical mergers i.e. Efficiency of market transaction Motorola: �We bought a firm because we wanted access to their engineers. We did not want the products the firm was making.�

16. ACE387 16 Types of Mergers Conglomerate Mergers Merger of firms in unrelated lines of business that are neither competitors nor potential or actual customers or suppliers of each other. Buying and selling ability to manage Example: General Electric buying NBC television Rational Portfolio management Risk diversification Academicians have long argued that conglomerate mergers which produce no synergy are not economically efficient because overhead costs are incurred in managing the combined enterprise, thus lowering earnings and (2) rele�vant risk is not reduced, because the combined firm's beta is a weighted average of the betas of the merged firms. In other words Investors could, individually, get whatever benefits of diversification there are by buying the stocks of the two firms, without incurring unnecessary overhead. The recent rash of corporate divestitures attests to the merits of this position. The only logical rationale for nonsynergistic conglomerate mergers is that debt capacity may be increased by lowering the risk of bankruptcy. This would increase the value of the merged company because of the debt tax effect: TD, and D, could now be larger than the sum of the D's of the separate com�panies. In general, it is safe to conclude that one should be wary of nonsynergistic mergers. Academicians have long argued that conglomerate mergers which produce no synergy are not economically efficient because overhead costs are incurred in managing the combined enterprise, thus lowering earnings and (2) rele�vant risk is not reduced, because the combined firm's beta is a weighted average of the betas of the merged firms. In other words Investors could, individually, get whatever benefits of diversification there are by buying the stocks of the two firms, without incurring unnecessary overhead. The recent rash of corporate divestitures attests to the merits of this position. The only logical rationale for nonsynergistic conglomerate mergers is that debt capacity may be increased by lowering the risk of bankruptcy. This would increase the value of the merged company because of the debt tax effect: TD, and D, could now be larger than the sum of the D's of the separate com�panies. In general, it is safe to conclude that one should be wary of nonsynergistic mergers.

17. ACE387 17 Types of Mergers 4. Concentric Mergers Merger of two firms that are so related that there is a carryover of specific management functions (research, manufacturing, finance, marketing, etc.) Example: Citigroup (principally a bank) buying Salomon Smith Barney (an investment banker/stock brokerage operation)

18. ACE387 18 Why M&A? To gain market power To enhance efficiency Economies of Scale Economies of Vertical Integration Combining Resources To further goals of self-interested managers

19. ACE387 19 Why M&A? 1. To gain market power Conglomerates can yield power in several ways that are anticompetitive. Differentiation of product to balance good and bad years in a specific industry Vertical Merger � Textiles and Raw Materials Horizontal Merger � Apparel and Apparel

20. ACE387 20 2. To Enhance Efficiency Economies of Scale A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.

21. ACE387 21 2. To Enhance Efficiency Economic of Scale Size of a plant ? ? average costs of production ? Inputs ?, outputs ? ? ? Productivity ? Unit costs ? Productivity (P) = Output (O) Input (I)

22. ACE387 22 Economic of scale in M&A Labor specialization Managerial specialization Efficient use of capital Efficient use of excess capacity in productive resources Better by-product utilization Labor specialization more workers means jobs can be divided and can divide skilled and unskilled work, Productivity ? Managerial specialization managerial experts will be able to spend all their time on the function that they specialize in Efficient use of capital larger firms can use most efficient technology for production Efficient use of excess capacity in productive resources expansion provides a way of more profitably using resources that have been underused Better by-product utilization large firms has better position to utilize by-products of productionLabor specialization more workers means jobs can be divided and can divide skilled and unskilled work, Productivity ? Managerial specialization managerial experts will be able to spend all their time on the function that they specialize in Efficient use of capital larger firms can use most efficient technology for production Efficient use of excess capacity in productive resources expansion provides a way of more profitably using resources that have been underused Better by-product utilization large firms has better position to utilize by-products of production

23. ACE387 23 ProblemsDiseconomies of Scale in M&A Size can begin to get inefficient. Too many managers--in the depth and width of management hierarchy entails problems of communication, bureaucracy, conflicting decisions. etc.

24. ACE387 24 2. To Enhance Efficiency Economies of Vertical Integration Control over suppliers �may� reduce costs. Over integration can cause the opposite effect.

25. ACE387 25 2. To Enhance Efficiency Combining Complementary Resources Merging may results in each firm filling in the �missing pieces� of their firm with pieces from the other firm.

26. ACE387 26 Why M&A?3. To further goals of self-interested managers Agency Theory Corporate managers are agents who work in interests of owners of corporation: the stockholders. Their own personal interests are prioritized above stockholders, who are invisible, not actively involved in day-to-day corporate activities. Managers hold little equity in the firm and therefore deploy corporate assets to benefit themselves rather than benefit shareholders. Goals mixed or confused. Empire Building Some M&A occurs b/c the pure joy of empire building Transaction Theory (Williamson)

27. ACE387 27 Evaluating Mergers AB = A + B Is there an overall economic gain to the merger? Do the terms of the merger make the company and its shareholders better off?

28. ACE387 28 Synergy: WHAT IS IT? Two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. the situation where two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. Synergy generally results from economies of scale or scope. the situation where two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. Synergy generally results from economies of scale or scope.

29. ACE387 29 Synergy: WHAT IS IT? Popular definition: 1 + 1 = 3 ? There is really �something out there� which enables the merged entity to create shareholders value 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. the situation where two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. Synergy generally results from economies of scale or scope. the situation where two firms merge and the merged firm has higher cash flows than the sum of the cash flows from the two merger partners. Synergy generally results from economies of scale or scope.

30. ACE387 30 FRIENDLY MERGER The management of one firm (the acquirer) agrees to buy another firm (the target). The action is initiated by the acquiring firm. The managements of both firms get together and work out terms to be beneficial to both sets of shareholders. Then they issue statements to their stockholders recommending that they agree to the merger.

31. ACE387 31 HOSTILE MERGER The acquirer make a direct appeal to the target firm's shareholders in form of a Tender Offer. Target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stock, bonds, or some combination of the three. If 51 percent or more of the target firm's shareholders tender their shares, then the merger will be completed.

32. ACE387 32 Illustration of a Tender Offer

33. ACE387 33 Tender Offers It is not possible to surprise another company with its acquisition because the SEC requires extensive disclosure. The tender offer is usually communicated through financial newspapers and direct mailings if shareholder lists can be obtained in a timely manner. A two-tier offer may be made with the first tier receiving more favorable terms. This reduces the free-rider problem.

34. ACE387 34 Two-Tier Tender Offer Increases the likelihood of success in gaining control of the target firm. Benefits those who tender �early.�

35. ACE387 35 Defensive Tactics to M&A The company being bid for may use a number of defensive tactics including: (1) persuasion by management that the offer is not in their best interests, (2) taking legal actions, (3) increasing the cash dividend or declaring a stock split to gain shareholder support, and (4) as a last resort, looking for a �friendly� company (i.e., white knight) to purchase them.

36. ACE387 36 Antitakeover Amendments Stagger the terms of the board of directors Change the state of incorporation Supermajority merger approval provision Fair merger price provision Leveraged recapitalization

37. ACE387 37 Takeover Defenses Poison Pill ? Measure taken by a target firm to avoid acquisition Example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.

38. ACE387 38 Ownership Restructuring The debt is secured by the assets of the enterprise involved. A management buyout is an LBO in which the pre-buyout management ends up with a substantial equity position.

39. ACE387 39 Leveraged Buyout (LBO) Acquisition using borrowed money on assumption that acquired firm is worth more than it is actually worth Purchase without any real investment made by buyers and a huge acquired debt Idea is that the debt will ultimately be paid with funds generate by acquired company�s operations on the sale of its assets. Acquisition of a business in which buyers use mostly borrowed money to finance the purchase price of acquired firm. The debt is incorporated into the structure of the business after change in ownership. Assumption is that acquired firm is worth more than what is paid for it. Based on undervalued assets.. Essence of deal is that it involves purchase without any real investment by the buyers. Idea is that debt will ultimately be paid with funds generated by acquired company's operations or the sale of its assets. Acquisition of a business in which buyers use mostly borrowed money to finance the purchase price of acquired firm. The debt is incorporated into the structure of the business after change in ownership. Assumption is that acquired firm is worth more than what is paid for it. Based on undervalued assets.. Essence of deal is that it involves purchase without any real investment by the buyers. Idea is that debt will ultimately be paid with funds generated by acquired company's operations or the sale of its assets.

40. ACE387 40 Leveraged Buy-Outs Unique Features of LBOs

41. ACE387 41 Leveraged Buy-Outs Junk bond market Leverage and taxes Other stakeholders Leverage and incentives Free cash flow

42. ACE387 42 Common Characteristics For Desirable LBO Candidates The company has gone through a program of heavy capital expenditures (i.e., modern plant). There are subsidiary assets that can be sold without adversely impacting the core business, and the proceeds can be used to service the debt burden. Stable and predictable cash flows. A proven and established market position. Less cyclical product sales. Experienced and quality management.

43. ACE387 43 Realities of M&A Consider Warren Buffet�s view: �Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders� We've observed many kisses but very few miracles.� http://www.wallstraits.com/buffett/buffett_quote26.html

44. ACE387 44 M&A FailureLessons from history

45. ACE387 45 M&A failure The majority of the studies report that there has been a significant proportion of M&A failures over last five decades since the waves of mergers started. Actual success rate varies could be approximately 50% However, studies are very alarming: 1) Millman and Grey show that ��83% of mergers produce no benefit whatsoever to shareholders� 2) Sirower finds 60-70% of acquisitions failing to produce positive returns.

46. ACE387 46 Why do so many M&A fail? Too much money paid; acquired firm not worth as much as acquiring firm thought A boom market may crash; often assumptions made that things won't change--or not soon. Acting too quickly Conflicting corporate culture Taking on something too big Unrealistic expectation of possible synergies Counting on key managers to stay (52% of top management typically leaves within 3 years after an acquisition) Firm acquired by leveraged buyout

47. ACE387 47 Empirical Evidence on Mergers Target firms in a takeover receive an average premium of 30%. Evidence on buying firms is mixed. It is not clear that acquiring firm shareholders gain. Some mergers do have synergistic benefits.

48. ACE387 48 Mergers & Acquisitions Hard to keep up with acquisitions and divestitures, who owns whom. The most important factor leading to successful mergers is the existence of good synergies Without synergistic gains the acquirer cannot afford to pay much of a premium for the target. The higher the premium, the more likely the merger is completed. Compatibility of the two corporate cultures Willingness of one CEO to give up power. Remains to be seen whether the current wave of acquisition activity, which now seems to be friendly rather than hostile takeovers, will result in greater economies of scale or greater "managerial entrenchment." (the latter refers to self-interest managers who direct a firm's diversification in a way to increase the demand for their own services or particular skills.)Remains to be seen whether the current wave of acquisition activity, which now seems to be friendly rather than hostile takeovers, will result in greater economies of scale or greater "managerial entrenchment." (the latter refers to self-interest managers who direct a firm's diversification in a way to increase the demand for their own services or particular skills.)

49. ACE387 49 Next class

50. ACE387 50 OK, Now You can all go home!