Corporate Restructuring

Chapter 17

© 2003 South-Western/Thomson Learning

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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