The Editors of Encyclopaedia BritannicaSee Article HistoryMerger, corporate combination of two or more independent business corporations into a single enterprise, usually the absorption of one or more firms by a dominant one. A merger may be accomplished by one firm purchasing the other’s assets with cash or its securities or by purchasing the other’s shares or stock or by issuing its stock to the other firm’s stockholders in exchange for their shares in the acquired firm (thus acquiring the other company’s assets and liabilities).
Mergers are of several different types: horizontal, if both firms produce the same commodity or service for the same market; market-extensional, if the merged firms produce the same commodity or service for different markets; or vertical, if a firm acquires either a supplier or a customer. If the merged business is not related to that of the acquiring firm, the new corporation is called a conglomerate (q.v.).
The reasons for mergers are various. The acquiring firm may seek to eliminate a competitor; to increase its efficiency; to diversify its products, services, and markets; or to reduce its taxes. Merger activity varies with the business cycle, being higher when business is good.
https://www.britannica.com/topic/mergerMERGERS AND ACQUISITIONS
Methods by which corporations legally unify ownership of assets formerly subject to separate controls.
A merger or acquisition is a combination of two companies where one corporation is completely absorbed by another corporation. The less important company loses its identity and becomes part of the more important corporation, which retains its identity. A merger extinguishes the merged corporation, and the surviving corporation assumes all the rights, privileges, and liabilities of the merged corporation. A merger is not the same as a consolidation, in which two corporations lose their separate identities and unite to form a completely new corporation.
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Federal and state laws regulate mergers and acquisitions.
Report AdvertisementRegulation is based on the concern that mergers inevitably eliminate competition between the merging firms. This concern is most acute where the participants are direct rivals, because courts often presume that such arrangements are more prone to restrict output and to increase prices. The fear that mergers and acquisitions reduce competition has meant that the government carefully scrutinizes proposed mergers. On the other hand, since the 1980s, the federal government has become less aggressive in seeking the prevention of mergers.
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Despite concerns about a lessening of competition, U.S. law has left firms relatively free to buy or sell entire companies or specific parts of a company. Mergers and acquisitions often result in a number of social benefits. Mergers can bring better management or technical skill to bear on underused assets. They also can produce economies of scale and scope that reduce costs, improve quality, and increase output. The possibility of a takeover can discourage company managers from behaving in ways that fail to maximize profits.
Report AdvertisementA merger can enable a business owner to sell the firm to someone who is already familiar with the industry and who would be in a better position to pay the highest price. The prospect of a lucrative sale induces entrepreneurs to form new firms. Finally, many mergers pose few risks to competition.
Antitrust merger law seeks to prohibit transactions whose probable anticompetitive consequences outweigh their likely benefits. The critical time for review usually is when the merger is first proposed. This requires enforcement agencies and courts to forecast market trends and future effects. Merger cases examine past events or periods to understand each merging party’s position in its market and to predict the merger’s competitive impact.
Types of Mergers
Mergers appear in three forms, based on the competitive relationships between the merging parties. In a horizontal merger, one firm acquires another firm that produces and sells an identical or similar product in the same geographic area and thereby eliminates competition between the two firms.
Report AdvertisementIn a vertical merger, one firm acquires either a customer or a supplier. Conglomerate mergers encompass all other acquisitions, including pure conglomerate transactions where the merging parties have no evident relationship (e.g., when a shoe producer buys an appliance manufacturer), geographic extension mergers, where the buyer makes the same product as the target firm but does so in a different geographic market (e.g., when a baker in Chicago buys a bakery in Miami), and product-extension mergers, where a firm that produces one product buys a firm that makes a different product that requires the application of similar manufacturing or marketing techniques (e.g., when a producer of household detergents buys a producer of liquid bleach).
Corporate Merger Procedures
State statutes establish procedures to accomplish corporate mergers. Generally, the board of directors for each corporation must initially pass a resolution adopting a plan of merger that specifies the names of the corporations that are involved, the name of the proposed merged company, the manner of converting shares of both corporations, and any other legal provision to which the corporations agree.
Report AdvertisementEach corporation notifies all of its shareholders that a meeting will be held to approve the merger. If the proper number of shareholders approves the plan, the directors sign the papers and file them with the state. The secretary of state issues a certificate of merger to authorize the new corporation.
Some statutes permit the directors to abandon the plan at any point up to the filing of the final papers. States with the most liberal corporation laws permit a surviving corporation to absorb another company by merger without submitting the plan to its shareholders for approval unless otherwise required in its certificate of incorporation.
Statutes often provide that corporations that are formed in two different states must follow the rules in their respective states for a merger to be effective. Some corporation statutes require the surviving corporation to purchase the shares of stockholders who voted against the merger.
Horizontal, vertical, and conglomerate mergers each raise distinctive competitive concerns.
Horizontal Mergers Horizontal mergers raise three basic competitive problems.
Report AdvertisementThe first is the elimination of competition between the merging firms, which, depending on their size, could be significant. The second is that the unification of the merging firms’ operations might create substantial market power and might enable the merged entity to raise prices by reducing output unilaterally. The third problem is that, by increasing concentration in the relevant market, the transaction might strengthen the ability of the market’s remaining participants to coordinate their pricing and output decisions. The fear is not that the entities will engage in secret collaboration but that the reduction in the number of industry members will enhance tacit coordination of behavior.
Vertical Mergers Vertical mergers take two basic forms: forward integration, by which a firm buys a customer, and backward integration, by which a firm acquires a supplier. Replacing market exchanges with internal transfers can offer at least two major benefits. First, the vertical merger internalizes all transactions between a manufacturer and its supplier or dealer, thus converting a potentially adversarial relationship into something more like a partnership.
Report AdvertisementSecond, internalization can give management more effective ways to monitor and improve performance.
Vertical integration by merger does not reduce the total number of economic entities operating at one level of the market, but it might change patterns of industry behavior. Whether a forward or backward integration, the newly acquired firm may decide to deal only with the acquiring firm, thereby altering competition among the acquiring firm’s suppliers, customers, or competitors. Suppliers may lose a market for their goods; retail outlets may be deprived of supplies; or competitors may find that both supplies and outlets are blocked. These possibilities raise the concern that vertical integration will foreclose competitors by limiting their access to sources of supply or to customers. Vertical mergers also may be anticompetitive because their entrenched market power may impede new businesses from entering the market.
Conglomerate Mergers Conglomerate transactions take many forms, ranging from short-term joint ventures to complete mergers.
Report AdvertisementWhether a conglomerate merger is pure, geographical, or a product-line extension, it involves firms that operate in separate markets. Therefore, a conglomerate transaction ordinarily has no direct effect on competition. There is no reduction or other change in the number of firms in either the acquiring or acquired firm’s market.
Conglomerate mergers can supply a market or “demand” for firms, thus giving entrepreneurs liquidity at an open market price and with a key inducement to form new enterprises. The threat of takeover might force existing managers to increase efficiency in competitive markets. Conglomerate mergers also provide opportunities for firms to reduce capital costs and overhead and to achieve other efficiencies.
Conglomerate mergers, however, may lessen future competition by eliminating the possibility that the acquiring firm would have entered the acquired firm’s market independently. A conglomerate merger also may convert a large firm into a dominant one with a decisive competitive advantage, or otherwise make it difficult for other companies to enter the market. This type of merger also may reduce the number of smaller firms and may increase the merged firm’s political power, thereby impairing the social and political goals of retaining independent decision-making centers, guaranteeing small business opportunities, and preserving democratic processes.
Federal Antitrust Regulation
Since the late nineteenth century, the federal government has challenged business practices and mergers that create, or may create, a monopoly in a particular market. Federal legislation has varied in effectiveness in preventing anticompetitive mergers.
Sherman Anti-Trust Act of 1890 The sherman anti-trust act (15 U.S.C.A. §§ 1 et seq.) was the first federal antitrust statute. Its application to mergers and acquisitions has varied, depending on its interpretation by the U.S. Supreme Court. In Northern Securities Co. v. United States, 193 U.S. 197, 24 S. Ct. 436, 48 L. Ed. 679 (1904), the Court ruled that all mergers between directly competing firms constituted a combination in restraint of trade and that they therefore violated Section 1 of the Sherman Act. This decision hindered the creation of new monopolies through horizontal mergers.
In Standard Oil Co. of New Jersey v. United States, 221 U.S. 1, 31 S. Ct. 502, 55 L. Ed. 619 (1911), however, the Court adopted a less stringent “rule of reason test”to evaluate mergers. This rule meant that the courts must examine whether the merger would yield monopoly control to the merged entity. In practice, this resulted in the approval of many mergers that approached, but did not achieve, monopoly power.
Clayton Anti-Trust Act of 1914 Congress passed the clayton act (15 U.S.C.A. §§ 12 et seq.) in response to the Standard Oil Co. of New Jersey decision, which it feared would undermine the Sherman Act’s ban against trade restraints and monopolization. Among the provisions of the Clayton Act was Section 7, which barred anticompetitive stock acquisitions.
The original Section 7 was a weak antimerger safeguard because it banned only purchases of stock. Businesses soon realized that they could evade this measure simply by buying the target firm’s assets. The U.S. Supreme Court, in Thatcher Manufacturing Co. v. Federal Trade Commission, 272 U.S. 554, 47 S. Ct. 175, 71 L. Ed. 405 (1926), further undermined Section 7 by allowing a firm to escape liability if it bought a controlling interest in a rival firm’s stock and used this control to transfer to itself the target’s assets before the government filed a complaint. Thus, a firm could circumvent Section 7 by quickly converting a stock acquisition into a purchase of assets.
By the 1930s, Section 7 was eviscerated. Between the passage of the Clayton Act in 1914 and 1950, only 15 mergers were overturned under the antitrust laws, and ten of these dissolutions were based on the Sherman Act. In 1950, Congress responded to post–World War II concerns that a wave of corporate acquisitions was threatening to undermine U.S. society, by passing the Celler-Kefauver Antimerger Act, which amended Section 7 of the Clayton Act to close the assets loophole. Section 7 then prohibited a business from purchasing the stock or assets of another entity if “the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.”
Congress intended the amended section to reach vertical and conglomerate mergers, as well as horizontal mergers. The U.S. Supreme Court, in Brown Shoe Co. v. United States, 370 U.S. 294, 82 S. Ct. 1502, 8 L. Ed. 2d 510 (1962), interpreted the amended law as a congressional attempt to retain local control over industry and to protect small business. The Court concluded that it must look at the merger’s actual and likely effect on competition. In general, however, it relied almost entirely on market share and concentration figures in evaluating whether a merger was likely to be anticompetitive. Nevertheless, the general presumption was that mergers were suspect.
In United States v. General Dynamics, 415 U.S. 486, 94 S. Ct. 1186, 39 L. Ed. 2d 530 (1974), the Court changed direction. It rejected any antitrust analysis that focused exclusively on market-share statistics, cautioning that although statistical data can be of great significance, they are “not conclusive indicators of anticompetitive effects.” A merger must be viewed in the context of its particular industry. Therefore, the Court held that “only a further examination of the particular market—its structure, history, and probable future—can provide the appropriate setting for judging the probable anticompetitive effect of the merger.” This totality-of-thecircumstances approach has remained the standard for conducting an antitrust analysis of a proposed merger.
Federal Trade Commission Act of 1975 Section 5 of the federal trade commission Act (15 U.S.C.A. § 45), prohibits “unfair methods of competition” and gives the Federal Trade Commission (FTC) independent jurisdiction to enforce the antitrust laws. The law provides no criminal penalties, and it limits the FTC to issuing prospective decrees. The justice department and the FTC share enforcement of the Clayton Act. Congress gave this authority to the FTC because it thought that an administrative body would be more responsive to congressional goals than would the courts.
Hart-Scott-Rodino Antitrust Improvements Act of 1976 The Hart-Scott-Rodino Antitrust Improvements Act (HSR) (15 U.S.C.A. § 18a) established a mandatory premerger notification procedure for firms that are parties to certain mergers. The HSR process requires the merging parties to notify the FTC and the Department of Justice before completing certain transactions. In general, an HSR premerger filing is required when (a) one of the parties to the transaction has annual net sales (or revenues) or total assets exceeding $100 million and the other party has annual net sales (or revenues) or total assets exceeding $10 million; and (b) the acquisition price or value of the acquired assets or entity exceeds $15 million. Failure to comply with these requirements may result in the rescission of completed transactions and may be punished by a civil penalty of up to $10,000 per day.
HSR also established mandatory waiting periods during which the parties may not “close” the proposed transaction and begin joint operations. In transactions other than cash tender offers, the initial waiting period is 30 days after the merging parties have made the requisite premerger notification filings with the federal agencies. For cash tender offers, the waiting period is 15 days after the premerger filings. Before the initial waiting periods expire, the federal agency that is responsible for reviewing the transaction may request the parties to supply additional information relating to the proposed merger. These “second requests” often include extensive interrogatories (lists of questions to be answered) and broad demands for the production of documents. A request for further information may be made once, and the issuance of a second request extends the waiting period for ten days for cash tender offers and 20 days for all other transactions. These extensions of the waiting period do not begin until the merging parties are in “substantial compliance” with the government agency’s request for additional information.
If the federal government decides not to challenge a merger before the HSR waiting period expires, a federal agency is highly unlikely to sue at a late date to dissolve the transaction under Section 7 of the Clayton Act. The federal government is not legally barred from bringing such a lawsuit, but the desire of the federal agencies to increase predictability for business planners has made the HSR process the critical period for federal review. However, the decision of a federal agency not to attack a merger during the HSR waiting period does not preclude a lawsuit by a state government or a private entity. To facilitate analysis by the state attorneys general, the National Association of Attorneys General (NAAG) has issued a Voluntary Pre-Merger Disclosure Compact under which the merging parties can submit copies of their federal HSR filings and the responses to second requests with NAAG for circulation among states that have adopted the compact.
In the vast majority of antitrust challenges to mergers and acquisitions, the matters have been resolved by consent order or decree. The Department of Justice and the FTC have sought to clarify they way they analyze mergers through merger guidelines issued May 5, 1992 (4 Trade Reg. Rep. CCH ¶ 13,104). These guidelines are not “law” but enforcement-policy statements. Nevertheless, the antitrust enforcement agencies will use them to analyze proposed transactions.
The 1992 merger guidelines state that most horizontal mergers and acquisitions aid competition and that they are beneficial to consumers. The intent of issuing the guidelines is to “avoid unnecessary interference with the larger universe of mergers that are either competitively beneficial or neutral.”
The guidelines prescribe five questions for identifying hazards in proposed horizontal mergers: Does the merger cause a significant increase in concentration and produce a concentrated market? Does the merger appear likely to cause adverse competitive effects? Would entry sufficient to frustrate anticompetitive conduct be timely and likely to occur? Will the merger generate efficiencies that the parties could not reasonably achieve through other means? Is either party likely to fail, and will its assets leave the market if the merger does not occur?
The guidelines essentially ask which products or firms are now available to buyers, and where could buyers turn for supplies if relative prices increased by five percent (the measure for assessing a merger-generated price increase). The guidelines redraw market boundaries to cover more products and a greater area, which tends to yield lower concentration increases than U.S. Supreme Court merger decisions of the 1960s.
Mergers in the Telecommunications Industry
Beginning in 1980, with President Ronald Reagan’s administration, the federal government has adjusted its policies to allow more horizontal mergers and acquisitions. The states have responded by invoking their antitrust laws to scrutinize these types of transactions. Nevertheless, mergers and acquisitions have increased throughout the U.S. economy, and this has been especially true in the telecommunications industry.
Beginning in the mid 1980s and extending to the mid 1990s, each of the three major television networks, ABC, CBS, and NBC, was purchased by another corporation. In 1985, Capital Cities purchased ABC for $3.5 billion. The same year, General Electric (G.E.) purchased RCA, and in 1985, G.E. purchased NBC. Westinghouse purchased CBS in 1994 for $5.4 billion, and the Walt Disney Co. purchased Capital Cities/ABC for $19 billion in 1995. Other mergers also had a major impact on the industry. In 1989, Time, Inc. merged with Warner Corporation to form the largest media conglomerate in the world, and in 1993, Viacom, Inc. purchased Paramount Corporation in an $8.2 billion deal.
These mergers were major news at the time, and they still have an impact on the industry. Congress deregulated much of the industry with the passage of the Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (codified in scattered sections of 47 U.S.C.A.). It was the most significant legislative change in the industry since the passage of the Communications Act of 1934, 48 Stat. 1064. The act called for more open competition among companies within the industry, designed for the purpose of improving services to consumers. The result of the legislation was a wide number of mergers among smaller and larger companies within the industry.
Almost immediately after the passage of the Telecommunications Act, four of the seven Bell telephone regional holding companies announced proposed mergers. More mergers occurred among Bell companies and other local carriers. At least 13 significant mergers in the industry occurred in 1996 alone. Time Warner merged with Turner Broadcasting in 1996 in a $6.7 billion deal, creating the largest media corporation in the world. Worldcom, Inc. purchased MFS Communications for $12.4 billion to become the first local and long-distance telephone company since 1984. Westinghouse/CBS purchased Infinity Broadcasting for $4.9 billion, allowing Westinghouse/CBS to become the dominant power in the radio market.
These mergers continued throughout the 1990s and beyond. For instance, Time Warner merged with America Online, Inc. in 2000 in a $166 billion deal to form the largest convergence of internet access and content in the world. Although some companies and consumer groups complained that the formation of these conglomerate companies could stifle competition and control prices, these mergers have become commonplace.
The Future of Mergers and Acquisitions
Although a number of factors influence mergers and acquisitions, the market is the primary force that drives them. The late 1990s saw an unprecedented influx in mergers. In 1999, companies filed a record 4,700 Hart-Scott-Rodino filings, about three times the number received in 1995. The total dollar value of the mergers announced in 1998—$11 trillion—was ten times the amount since 1992. The rash of mergers in the telecommunications industry accounted for many of these mergers, but companies in other industries were involved as well.
Another factor in the rise in mergers during the late 1990s was a booming economy, which grew at unprecedented levels. As the country faced recession in the following decade, many companies were forced to downsize, and the number of major mergers decreased accordingly. Improvements in the economy, as well as potential legislative changes, could very well spark another wave of mergers.
Ginsburg, Martin D. and Jack S. Levin. 1989. Mergers, Acquisitions and Leveraged Buyouts. Chicago: Commerce Clearing House.
Marks, Mitchell Lee. 2003. Charging Back up the Hill: Workplace Recovery after Mergers, Acquisitions, and Down-sizings. San Francisco: Jossey-Bass.
Antitrust Law; Bonds “Michael R. Milken: Genius, Villain, or Scapegoat?” (Sidebar); Golden Parachute; Junk Bond; Restraint of Trade; Scorched-Earth Plan; Unfair Competition.
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Mergers And Acquisitions
Encyclopedia of Management COPYRIGHT 2009 Gale
Mergers and Acquisitions
A merger takes place when two companies decide to combine into a single entity. When the merger is forced through buyouts or financial leverage, it is referred to as an acquisition (also called a takeover ). While the motivations may differ, the essential feature of both mergers and acquisitions involves one firm emerging where once there existed two firms.
Essentially, the difference rests in the attitude of the incumbent management of firms that are targeted. A so-called friendly takeover is often a euphemism for a merger. A hostile takeover refers to unwanted advances by outsiders. Thus, the reaction of management to the overtures from another firm tends to be the main influence on whether the resulting activities are labeled friendly or hostile.
Many kinds of mergers increase the emerging company’s Herfindahl-Hirschman Index (HHI), the concentration rating of their industry.
Report AdvertisementIf the merger raises the HHI by 100 points or more (especially in industries rated 1800 or higher), the Justice Department may take steps to prevent the merger. This is done primarily to discourage monopolistic practices, as the combining firms often lessen competition. Although the HHI Index is used primarily by the United States, it has applications internationally in providing checks and balances for merger activity. For instance, in 2007 Ireland adopted the HHI Index as a guide in restraining monopolistic mergers in its private health insurance industry.
MOTIVATIONS FOR MERGERS AND ACQUISITIONS
There are a number of possible motivations that may result in a merger or acquisition. One of the most oft-cited reasons is to achieve economies of scale. Economies of scale may be defined as a lowering of the average cost to produce one unit due to an increase in the total amount of production. The idea is that the larger firm resulting from the merger can produce more cheaply than the previously separate firms.
Report AdvertisementEfficiency is the key to achieving economies of scale, through the sharing of resources and technology and the elimination of needless duplication and waste. Economies of scale sounds good as a
Rationale for merger, but there are many examples to show that combining separate entities into a single, more efficient operation is not easy to accomplish in practice.
A similar motivation is economies of scope, often found when the merger involves vertical integration. This involves acquiring firms through which the parent firm currently conducts normal business operations, such as suppliers and distributors.
By combining different elements involved in the production and delivery of the product to the market, acquiring firms gain control over raw materials and distribution outlets. This may result in centralized decisions and better communications and coordination among the various business units. It may also result in competitive advantages over rival firms that must negotiate with and rely on outside firms for inputs and sales of the product.
Horizontal integration is a merger or acquisition to achieve greater market presence or market share.
Report AdvertisementThe combined, larger entity may have competitive advantages such as the ability to buy bulk quantities at discounts, store and inventory needed production inputs, and achieve mass distribution through sheer negotiating power. Greater market share also may result in advantageous pricing, since larger firms are able to compete effectively through volume sales with thinner profit margins. This type of merger or acquisition often results in the combining of complementary resources, such as a firm that is very good at distribution and marketing merging with a very efficient producer. The shared talents of the combined firm may mean competitive advantages versus other, smaller competition.
The ideas above refer to reasons for mergers or acquisitions among firms in similar industries. When two unrelated firms join without an industrial relationship, it is referred to as a conglomerate merger. Since conglomerate mergers do not involve noticeable vertical or horizontal integration, they are more rare than other types of mergers.
Conglomerate mergers were especially popular in the 1960s wave of merger activity, when companies believed that combining certain departments—such as accounting or human resources—would streamline even unrelated businesses.
Report AdvertisementYet conglomerate mergers developed a history of being unsuccessful, and their use has faded. There are very few restrictions against conglomerate mergers today, since the combination of unrelated companies does not radically interfere in many industries. However, in Europe, legislation passed in 2007 which restricted even conglomerate mergers if (upon examination) they threatened to create monopolies.
There are several additional motivations for firms that may not necessarily be in similar lines of business. One of the often-cited motivations for acquisitions involves excess cash balances. Suppose a firm is in a mature industry, and has little opportunities for future investment beyond the existing business lines. If profitable, the firm may acquire large cash balances as managers seek to find outlets for new investment opportunities. One obvious outlet is to acquire other firms. The ostensible reason for using excess cash to acquire firms in different product markets is diversification of business risk.
Management may claim that by acquiring firms in unrelated businesses the total risk associated with the firm’s operations declines.
Report AdvertisementHowever, it is not always clear for whom the primary benefits of such activities accrue. A shareholder in a publicly traded firm who wishes to diversify business risk can always do so by investing in other companies’ shares. The investor does not have to rely on incumbent management to achieve the diversification goal. On the other hand, a less risky business strategy is likely to result in less uncertainty in future business performance, and stability makes management look good. The agency problem resulting from incongruent incentives on the part of management and shareholders is always an issue in public corporations. However, regardless of the motivation, excess cash is a primary motivation for corporate acquisition activity.
To reverse the perspective, an excess of cash is also one of the main reasons why firms become the targets of takeover attempts. Large cash balances make for attractive potential assets; indeed, it is often implied that a firm with a very large amount of cash is not being efficiently managed.
Report AdvertisementWhile that conclusion is situation specific, it is clear that cash is attractive, and the greater the amount of cash the greater the potential to attract attention. Thus, the presence of excess cash balances in either acquiring or target firms is often a primary motivating influence in subsequent merger or takeover activity.
Another feature that makes firms attractive as potential merger partners is the presence of unused tax shields. The corporate tax code allows for loss carry-forwards; if a firm loses money in one year, the loss can be carried forward to offset earned income in subsequent years. A firm that continues to lose money, however, has no use for the loss carry-forwards. However, if the firm is acquired by another firm that is profitable, the tax shields from the acquired firm may be used to shelter income generated by the acquiring firm. Thus the presence of unused tax shields may enhance the attractiveness of a firm as a potential acquisition target.
A similar idea is the notion that the combined firm from a merger will have lower absolute financing costs.
Report AdvertisementFor example, two firms, X and Y, have each issued bonds as a normal part of the financing activities. If the two firms combine, the cash flows from the activities of X can be used to service the debt of Y, and vice versa. Therefore,
With less default risk the cost of new debt financing for the combined firm should be lower. It may be argued that there is no net gain to the combined firm; since shareholders have to guarantee debt service on the combined debt, the savings on the cost of debt financing may be offset by the increased return demanded by equity holders. Nevertheless, lower financing costs are often cited as rationale for merger activity.
During the U.S. merger wave in the 1960s, many firms attempted to acquire other companies to artificially boost their earnings per share. Consider two firms, A and B. Firm A has earnings of $1,000, 100 shares outstanding, and thus $10 earnings per share. With a price-earnings ratio of 20, its shares are worth $200. Firm B also has earnings of $1,000, 100 shares outstanding, but due to poorer growth opportunities its shares trade at 10 times earnings, or $100. If A acquires B, it will only take one-half share of A for each share of B purchased, so the combined firm will have 150 total shares outstanding. Combined earnings will be $2,000, so the new earnings per share of the combined firm are $13.33 per share. It appears that the merger has enhanced earnings per share, when in fact the result is due to inconsistency in the rate of increase of earnings and shares outstanding. Such manipulations were common in the 1960s, but investors have learned to be more wary of mergers instigated mainly to manipulate per share earnings. It is questionable whether such activity will continue to fool a majority of investors. The use of this ploy has faded since the 1980s.
Finally, there is the ever-present hubris hypothesis concerning corporate takeover activity. The main idea is that the target firm is being run inefficiently, and the management of the acquiring firm is likely to do a better job of utilizing the target’s assets and strategic business opportunities. In addition, there is additional prestige in managing a larger firm, which may include additional perquisites such as club memberships or access to amenities such as corporate jets or travel to distant business locales. These factors cannot be ignored in detailing the set of factors motivating merger and acquisition activity.
TYPES OF TAKEOVER DEFENSES
As the previous section suggests, some merger activity is unsolicited and not desired on the part of the target firm. Often, the management of the target firm will be replaced or let go as the acquiring firm’s management steps in to make their own mark and implement their plans for the new, combined entity. In reaction to hostile takeover attempts, a number of defense mechanisms have been devised and used to try and thwart unwanted advances.
To any offer for the firm’s shares, several actions may be taken which make it difficult or unattractive to subsequently pursue a takeover attempt. One such action is the creation of a staggered board of directors. If an outside firm can gain a controlling interest on the board of directors of the target, it will be able to influence the decisions of the board. Control of the board often results in de facto control of the company. To avoid an outside firm attempting to put forward an entire slate of their own people for election to the target firm’s board, some firms have staggered the terms of the directors. The result is that only a portion of the seats is open annually, preventing an immediate takeover attempt. If a rival does get one of its own elected, they will be in a minority and the target firm’s management has the time to decide how to proceed and react to the takeover threat.
Another HYPERLINK “https://www.encyclopedia.com/medicine/psychology/psychology-and-psychiatry/defense-mechanism” defense mechanism is to have the board pass an amendment requiring a certain number of shares needed to vote to approve any merger proposal. This is referred to as a supermajority, since the requirement is usually set much higher than a simple majority vote total. A supermajority amendment puts in place a high hurdle for potential acquirers to clear if they wish to pursue the acquisition. This is sometimes referred to as a fair price amendment.
Finally, another preemptive strike on the part of existing management is a poison pill provision. A poison pill gives existing shareholders rights that may be used to purchase outstanding shares of the firms stock in the event of a takeover attempt. The purchase price using the poison pill is a significant discount from fair market value, giving shareholders strong incentives to gobble up outstanding shares, and thus preventing an outside firm from purchasing enough stock on the open market to obtain a controlling interest in the target. Such strategies as staggering director terms, fair price amendments, and poison pills are sometimes referred to as “shark repellents.”
Once a takeover attempt has been identified as underway, incumbent management can initiate measures designed to thwart the acquirer. One such measure is a dual-class recapitalization; whereby a new class of equity securities is issued which contains superior voting rights to previously outstanding shares. The superior voting rights allow the target firm’s management to effectively have voting control, even without a majority of actual shares in hand. With voting control, they can effectively decline unsolicited attempts by outsiders to acquire the firm.
Another reaction to undesired advances is an asset restructuring. Here, the target firm initiates the sale or disposal of the assets that are of primary interest to the acquiring firm, usually called the “crown jewel.” The divestiture of the crown jewel results in an end to the acquisition activity. On the other side of the balance sheet, the firm can solicit help from a third party, friendly firm. Such a firm is commonly referred to as a “white knight,” the implication being that the knight comes to
The rescue of the targeted firm, or “maiden.” A white knight may be issued a new set of equity securities such as preferred stock with voting rights, or may instead agree to purchase a set number of existing common shares at a premium price. This is called the lockup defense. The white knight is supportive of incumbent management; by purchasing a controlling interest in the firm unwanted takeovers are effectively avoided.
There are other drastic measures that targeted firms can take. Professor Michael Baye, in his 2008 book Managerial Economics and Business Strategy, names several other options. One is the golden parachutestrategy, in which leading managers retaliate against the takeover by creating contracts for themselves with provisions for significant severance pay or compensation in case they lose their jobs through an acquisition. If the takeover is successful, the golden parachute will grant top managers enormous gains upon their release from the new firm.
The targeted firm may also use the strategy called greenmail, in which it buys back the shares the hostile firm owns. If this practice is successful, the raider will sell its stock in the firm, usually at a very inflated price, to gain a significant profit. This leaves the targeted firm safe with its own shares, if also in debt.
Lastly, a maiden firm may use the going private defense as a last resort. They find a buyer (less agreeable than a white knight) to buy the public stock in the firm and delist it as a public firm. Stock trading is then no longer possible, and the firm, though privately owned, is safe from the raider.
Baye also lists several practices used by a hostile firm upon attempting a takeover. These include stripping, which is the practice of selling off the assets of the targeted company to create extra cash when the takeover is complete, and the less aggressive standstill agreement, which is a last-minute contract in which the hostile company ceases the acquisition process and ends the takeover, keeping only its current holdings in the company.
One of the most prominent takeover activities associated with liability restructuring involves the issuance of junk bonds. “Junk” is used to describe debt with high default risk, and thus junk bonds carry very high coupon yields to compensate investors for the high risk involved. During the 1980s, the investment-banking firm Drexel Burnham Lambert (led by Michael Milken) pioneered the development of the junk-bond market as a vehicle for financing corporate takeover activity. Acquisition groups, which often included the incumbent management group, issued junk bonds backed by the firm’s assets to raise the capital needed to acquire a controlling interest in the firm’s equity shares. In effect, the firm’s balance sheet was restructured with debt replacing equity financing. In several instances, once the acquisition was successfully completed the acquiring management subsequently sold off portions of the firm’s assets or business divisions at large premiums, using the proceeds to retire some or all of the junk bonds. The takeover of RJR Nabisco by the firm Kohlberg Kravis Roberts ; Co. in the late 1980s was one of the most celebrated takeovers involving the use of junk-bond financing.
VALUING A POTENTIAL MERGER
There are several alternative methods that may be used to value a firm targeted for merger or acquisition. One method involves discounted cash flow analysis. First, the present value of the equity of the target firm must be established. Next, the present value of the expected synergies from the merger, in the form of cost savings or increased after-tax earnings, should be evaluated. Finally, summing the present value of the existing equity with the present value of the future synergies results in a present valuation of the target firm.
Another method involves valuation as an expected earnings multiple. First, the expected earnings in the first year of operations for the combined or merged firm should be estimated. Next, an appropriate price-earnings multiple must be determined. This figure will likely come from industry standards or from competitors in similar business lines. Now, the PE ratio can be multiplied by the expected combined earnings per share to estimate an expected price per share of the merged firm’s common stock. Multiplying the expected share price by the number of shares outstanding gives a valuation of the expected firm value. Actual acquisition price can then be negotiated based on this expected firm valuation.
Another technique that is sometimes employed is valuation in relation to book value, which is the difference between the net assets and the outstanding liabilities of the firm. A related idea is valuation as a function of liquidation, or breakup, value. Breakup value can be defined as the difference between the market value of the firm’s assets and the cost to retire all outstanding liabilities. The difference between book value and liquidation value is that the book value of assets, taken from the firm’s balance sheet, are carried at historical cost. Liquidation value involves the current, or market, value of the firm’s assets.
Some valuations, particularly for individual business units or divisions, are based on replacement cost. This is the estimated cost of duplicating or purchasing the assets of the division at current market prices. Some premium is usually applied to account for the value of having existing and established business in place.
Finally, in the instances where firms that have publicly traded common stock are targeted, the market value of the stock is used as a starting point in acquisition
Negotiations. Earlier, a number of takeover defense activities were outlined that incumbent management may employ to restrict or reject unsolicited takeover bids. These types of defenses are not always in the best interests of existing shareholders. If the firm’s existing managers take seriously the corporate goal of maximizing shareholder wealth, then a bidding war for the firm’s stock often results in huge premiums for existing shareholders. It is not always clear that the shareholders interests are primary, since many of the takeover defenses prevent the use of the market value of the firm’s common stock as a starting point for takeover negotiations. It is difficult to imagine the shareholder who is not happy about being offered a premium of 20 percent or more over the current market value of the outstanding shares.
https://www.encyclopedia.com/social-sciences-and-law/economics-business-and-labor/money-banking-and-investment/acquisitions-and-mergersHow corporate mergers and acquisitions impact small investors
, ET Bureau|
Jul 17, 2017, 06.30 AM IST
The mergers and acquisitions (M&A) activity has picked up recently with deals such as IDFC Bank and Shriram Capital, ABC Bearings and Timken India, HPCL and ONGC, in the offing.The government is also planning for more SBI-like mergers. Investors cannot afford to ignore M&A activity. So, here’s a primer.Why companies go for M;A”The objective is usually one or more of the following: To consolidate market share, forward or backward integration, ..
“The objective is usually one or more of the following: To consolidate market share, forward or backward integration, acquiring geographical presence, intangible assets or a customer-base,” says Prashant Mehra, Partner, Grant Thornton India.Generally, the entities getting merged reinforce each other’s strengths. “The logic of synergy is two plus two is more than four,” says V.K. Vijayakumar, Chief Investment Strategist, Geojit Financial Services. To illustrate, consider the IDFC Bank-Shriram Capital merger proposal.IDFC Bank has a good presence in Karnataka, Maharashtra, and Madhya Pradesh with 75 branches, while Shriram Transport Finance (STF), a commercial vehicle financing player, has a national presence with around 1,000 branches. “The merger will allow IDFC to leverage the huge branch network of STF. The cost of funds for the merged entity will also be lower, thanks to lower cost of CASA (current and savings account) deposits of IDFC,” says Vijayakumar.A wealth creation opportunity
What happens to your stock holdingsThis depends on the swap or the share exchange ratio of an M&A. Swap ratio is the ratio in which the acquiring company offers its own shares in exchange for the target company’s shares. For instance, the recent merger of Kotak Mahindra Bank and ING Vysya Bank had a swap ratio of 725:1000. ING Vysya shareholders received 725 shares of Kotak for every 1,000 shares of ING Vysya.
Your stock holdings generally benefit if the merger or acquisition turns out to be successful. Kotak-ING Vysya merger and HDFC Bank’s acquisition of Centurion Bank of Punjab have created wealth for investors of both the acquiring and the target companies. However, in some cases, such as Ranbaxy-Sun Pharma merger, investors may lose out.
impact on stock pricesMergers and acquisitions usually lead to an increase in the share price of the merged entity in the long run. “This is because the merged entity will benefit from the synergy,” says Arpit Jain, Assistant Vice President, Arihant Capital Markets. The stock prices could fall too, due to inappropriate valuations, say experts. “If the target company’s valuations are high, then the shareholders of the acquiring company may be at the losing end due to the dilu .. dilution of their holdings.If the valuations are low, then the merger may erode the target company’s shareholders’ value,” says Jimeet Modi, CEO, Samco Securities. Keep in mind the valuations of the two companies before making an investment decision. Sometimes, companies announce open offers where you get an opportunity to exit your investment at a premium price usually. “This is a good opportunity, especially for a company whose stocks may not be trading actively,” says Dipankar Bandyopadhyay, Partner, Verus Advocates.What to look in for a new entityThe track record of the management, the potential of the sector, existing competition, entry barriers for new players, innovative business model, scalability and the acquiring company’s financial track record are among the things that investors should closely monitor. You should closely watch the company for signs of loss in shareholders’ value—likely if the intended objectives of the merger are not being met.You should also assess the increase in the market share of the merged entity. Generally, too ambitious deals, especially those financed through debt, can be quite disastrous, say experts. Suzlon’s acquisition of German company REpower is a case in point.
Few options for small investorsM;A related decisions are taken by the management, and small retail investors do not have much of a say in it. “At best, small shareholders can vote against any resolutions altering the company’s capital structure and specific M&A opportunities. But they usually do not have enough votes to influence the decisions,” says Sanjeev Krishan, Partner and Leader, Deals, PwC India. Small investors are often tied with the ‘drag along’ provision which forces them to go along with the majority view.If the majority shareholders sell the target company at a low price—maybe to a related entity— it may impact the minority shareholders adversely. Under such circumstances, small investors may move the court. But still, arriving at a fair price is very complex. “An apparently unfair price at the time of the merger may prove to be ‘more than fair’ later when the merger produces results. Tata Motors acquisition of JLR is an example,” sa .. ys Vijayakumar.No adverse tax implicationsMergers and acquisitions don’t give rise to any tax liability for the existing shareholders of either of the target company or the acquiring company. “For calculating the capital gains, the holding period is calculated from the date of original purchase of shares,” says Modi.
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