Finance Questions - Due April 13, 2018

Mergers and Acquisitions

The agenda for this Week:

1. Mergers and Acquisitions: A Short History

2. Comments: Mergers and Acquisitions, Characteristics and Tools

1. Mergers and Acquisitions: A Short History

In a sense, corporate mergers and acquisitions are a natural process that we observe in a market economy. Market systems, as demonstrated by the rise of capitalism and the Industrial Revolution from 1776 (the publication date of Adam Smith's The Wealth of Nations as well as the U.S. Declaration of Independence) forward, have exhibited recurring cycles of innovation, growth, maturity and creative destruction, accompanied by mergers and acquisitions. 

Typically, we see a growing intensity of innovation and invention that takes a number of years to incubate and find practical applications. These innovations spur new products, industries and the formation of new firms. First movers transform innovations into products and services. As demand grows, benefits are realized with profits and high returns on capital; many companies are many fast followers and others lags. The growth in supply to meet demand is volatile. Periods of oversupply may cause "bubbles", after which  less efficient producers go out of business. As the market for the cycle's innovations matures, supply tends to overshoot demand. There is a period of overcapacity, slower growth, and collapsing profit margins. Financial pressures usher in a period of "creative destruction" (to use Schumpeter's famous phrase), during which healthy firms acquire less efficient and poorly performing firms. The rate of innovation typically falls (patents may continue, but for improvements, not major innovations). Financial pressuers also stimulate the acquisition and merger by healthy firms as they try to create value by taking advantage of complementary assets.

For most of our history, the U.S. has had a policy of letting the capital markets determine when and how this creative destruction process occurs but providing a significant amount of legislation, government jawboning, and real and threatened anti-trust action to try to control negative externalities. How effective this hybrid free market-government oversight policy has been for society is debatable and is under constant fine tuning. The recent few years and the Dodd-Frank bill are but the latest examples of this saga.

Let's now look at mergers and acquisitions in the U.S. for the past 150 years or so, make some observations, and try to draw some conclusions.

Acquisitions and mergers tend to coincide with bull markets in equities as the losers from the last economic cycle are killed off and healthy firms look for ways to add value and leverage the positive influences of the economic cycle. The rising value of their common stock can provide the financial ammunition to achieve an acquisition.

The first large wave of U.S. mergers and acquisitions occurred after the Civil War. This period coincided with the formation of the modern corporation. Before then, industries were largely fragmented, with many small competitors. As capital was accumulated in the hands of "robber barons" and the opportunity to increase profits further by consolidating many small businesses (e.g., railroads and steel companies) became apparent.  

Technological developments after the mid-19th century provided the economies of scale that only large firms could exploit. The Bessemer Converter (1856) allowed for cheap steel production ... in quantity. The railroads, using Bessemer-process steel, linked the east and west coasts after the Golden Spike was driven at Promontory Point, Utah, in 1869, and it's much more efficient to have one railroad system than to transfer freight between systems. (Note -- the standard railroad track gauge of 4 feet, 8 inches came about for precisely this reason and wasn't needed until railroad shipments crossed territories served by several lines. A friend with a background in the railroad business suggested, incidentally, that 4 feet, 8 inches is the typical width of the pair of horses that might lead a cart.)

Oil refining is subject to great economies of scale, and pipeline systems have many features in common with railroads. John D. Rockefeller used his extensive pipeline and bulk freight network to move into refining. (Part of the issue is mathematical. For a pipeline of length L and radius R, the amount of steel needed is related to the surface area, which = 2πRL. The contained volume, however, = πR2L. Note the square of the radius in the volume equation -- it implies economies of scale.) 

Thus, we see huge companies forming at the end of the 19th century, and this period became known as the era of monopolies, typically because of horizontal mergers. The sources of value would-be monopolists wanted to capture were based on economies of scale and sheer market power because of size. As large companies were formed, they received a lot of bad press for price gouging and putting many small operations out of business. 

This aura of evil surrounding monopolies was largely responsible for the passage of the Sherman Antitrust Act of 1890. Initially thought to be a toothless piece of legislation, the law was used effectively by the (Theodore) Roosevelt Administration to take legal action to break up some of the big trusts. Perhaps the most famous was Rockefeller's Standard Oil Trust, which was broken up in 1911. Paradoxically, perhaps, Rockefeller predicted, correctly, that the combined stock market value of the newly-independent companies would soon exceed that of the old Trust. We saw a reprise of this situation after AT&T was broken up in 1984.

The second merger wave spanned the period from, say, 1916 to 1929 and was accompanied by an increase in the Dow Jones Industrial average of 380 percent. Merger activity crashed with the stock market in 1929. This wave was characterized by the formation of oligopolies and vertical mergers, in which firms integrated backwards in their supply chains to secure sources of raw materials and forward to delivery of the product to the customer. The Sherman Act was difficult to use to prevent or undo such mergers. As earlier, investors realized value as companies became larger to take advantage of economies of scale, this time via the rising stock market. The source of this perceived value was adding the backward and forward parts of the value chain to gain greater control over ultimate profitability. General Motors was one example, but we had U.S. Steel and other companies. Ford completed its famous River Rouge complex in 1928, and it became the world's largest integrated factory immediately (because it then had its own steel mill, Rouge Steel).

The third merger wave might be considered to be the 1965 to 1969 period. This time there was only a limited rise in the stock market. Where participants in the earlier waves sought to add value by merging or acquiring horizontally or vertically, this period became known as the age of the conglomerates. Very large combinations of companies in diverse industries were formed, driven largely by very strong systems of financial management. ITT and other firms (e.g., Textron) were leaders in this movement; Harold Geneen's quarterly review of ITT subsidiaries with their managers was legendary. More recently, Jack Welch (and his predecessors) applied very similar techniques to General Electric. Dennis Kozlowski was very successful after 1990 in acquiring diversified businesses at Tyco ... until he was slapped down and imprisoned for his self-dealing actions.

Conglomerate firms sought to decrease their risk profiles (e.g., weighted average cost of capital) by bringing together a large group of unrelated businesses as a means of diversifying away the idiosyncratic risks of the individual businesses. A good idea, perhaps, in theory, but the vast majority of these mergers ended up as failures.  

Why?  

One popular argument concerns the span of control exercised by the management team. There may be too many businesses for the common knowledge base of a corporate management team to oversee effectively. A popular management principle has evolved from this period: "stick to your knitting" if you want success. The practical translation of this principle is that mergers and acquisitions within an industry have a much greater chance of being successful than unrelated ones.

The U.S. integrated oil companies fit this description very well indeed. Oil price increases in 1973 and 1979 gave companies a lot of cash at the same time as resource pessimists suggested we were running out of oil. So, "clever" oil company management teams decided that they could move profitably into other mineral ventures. Copper and related metals such as molybdenum were the commodities of choice (e.g., Exxon in Chile, Sohio -- now part of BP -- in Utah -- Bingham Canyon, and so forth). Amoco (also now part of BP) bought Cyprus Mines in 1979; Amoco Minerals, as it became known, was spun off to shareholders as soon as 1984 -- not an argument for a successful acquisition! The recessions of 1980 - 1982 had a lot to do with the collapse of metals prices, as did the end of the inflationary spiral of the 1970s.

So much for a management saying that ALL resource businesses can be managed similarly!

During the fourth merger wave,  from, say, 1981 to1989, the Dow Jones Industrial average rose by about 250%, a boom that ended in the short recession of 1990-1991. These mergers and acquisitions were characterized by "value plays." Arbitrageurs, corporate raiders and groups of investors saw great opportunities to capture value by acquiring poorly- performing firms and either liquidating them for the values of their individual assets or by restructuring them. One common method of restructuring was for a group of top managers to buy out the existing shareholders and take the firm private. High yield junk bonds and small equity stakes held by management tended to finance the buyouts. 

This technique of "leveraged buyouts" resembled a much older tradition -- companies sometimes spun off non-core businesses to their managers and financed the buyouts. Managers had every incentive to make good, because a return on assets in excess of the cost of borrowing would lead to an enhanced return on their equity. What was added in the 1980s was the use of junk bond (rated BB or worse) financing, an innovation of Michael Milken. 

By the end of the period, Milken was in jail for insider trading issues (not the use of junk bonds). Ivan Boesky also served time; Boesky was the model for Gordon Gecko in the Wall Street movies. 

The fifth merger wave began with the bull market of the 1990s in 1992 and ended with the bursting of the Internet/ IT bubble in 2000. This wave was accompanied by a more than doubling of the Dow Jones average. These mergers were driven by globalization, synergy, and cost rationalization. Many industries were affected, especially maturing ones in which cost management replaced sales growth as the major driver of profitability. 

Are most mergers considered success or failures?  

In every period, there are more failures than successes. Why? 

• Most firms overpay for acquisitions. The acquirer often pays the target and its shareholders a premium above pre-merger prices of between 30-40%. So, if the average firm makes 20% above its cost of capital on a merger (based on fair value before the bidding up), it would still destroy value by falling short of covering the premium paid. This overpayment is part of the phenomenon that is often called the "winner's curse".  

• The complexity of the integration of company operations (especially IT systems) is often underestimated. Nations Bank (based in Charlotte, NC), for example, bought Bank of America (based in San Francisco) in 1998 and assumed the Bank of America name. The IT systems of the two banks have never been -- and will not be -- combined, even though the systems integration related to B of A's later acquisition of Fleet Financial was accomplished without incident. (Personal note: when I moved from California to Virginia in 2001, I had to close my old account and open a new one because of the failure to merge IT systems.)

• Even more important is the difficulty (and sometimes impossibility) of merging corporate cultures. AOL/Time-Warner failed in large part for this reason, as well as overpaying.

The issue of overpayment is actually a bit more complicated than spending too much. In any acquisition, the acquired company, for whatever reason) e.g., product or market complementarities), is worth more to the acquirer than to prior shareholders. The bargaining issue is how much of the premium is paid to prior shareholders and how much is retained by the acquirer.

2. Comments: Mergers and Acquisitions, Characteristics and Tools

The returns from mergers and acquisitions activity extend over many years. Many other characteristics also apply equally to capital budgeting and M&A decisions:

• Consequences of decisions affect the firm for long periods; once made, decisions can reduce the firm's flexibility.

• Effective planning to assure proper timing of acquisitions is essential.

• The size of the outlay may require financing to be arranged in advance.

• The size of outlay required may mean the decision can "make or break" the firm

M&A deals usually, but not always, require more expenditures than internal capital budgeting projects. In M&As, a whole organization is being acquired, and the people and activities in the acquired firm may face some major (often unpleasant) surprises. 

Changing forces in today’s economy have reflected the importance of continuing technological advances (including computers, software, servers, information systems, and the Internet) in many industries. With these improvements reducing the costs of communication and transportation, markets have become increasingly international. The heightened competition resulting from the emerging global economy has produced new industries and deregulation in older ones. These economic forces have had a large impact on industry structure, providing an impetus for M&A activity. For firms to remain competitive, they must adapt to the industry changes.

The basic economic rationale for mergers is that they can increase the value of the combined firm beyond what the individual values of the firms were before a merger.  The synergy value of a net present value investment is calculated as the difference between the value of the combined firm and its component parts, pre-merger
If firms of unequal managerial or operating capabilities combine, value can be increased by improving the efficiency of the relatively less efficient party through restructuring of operations (managerial responsibilities) and application of best demonstrated practices. Synergies can also be achieved.

The q-ratio (a measure that is due to the late Yale economist James Tobin) is defined as the ratio of the market value of the firm’s securities to the replacement costs of its assets, and can otherwise be thought of as a measure of managerial efficiency. If a firm seeks to add capacity, its implied marginal q-ratio is greater than 1. If other firms in the industry have q-ratios less than 1, it would be more efficient for the firm to add capacity by purchasing those other firms than investing directly on its own. 

Joint ventures create a new entity by combining the resources of two firms, allowing for many objectives to be achieved without as much risk as a merger. Since each firm limits its capital costs (to its share of the venture) the risks of entering a new industry are reduced. What is more, the integration challenges of merging two companies do not come into play when creating a joint venture because it is generally limited in scope and duration. Joint ventures also have an advantage in an international setting, where local partners might help navigate local regulatory situations. 
A JV can be useful in determining the value of a divested segment.  Since there may be uncertainty about the value of the segment before the sale, a JV can serve as an interim step whereby the acquirer buys only a part of the divested segment. Once the potentials of the segment are understood better, the acquirer and the seller can arrive at a mutually agreeable price for the transaction.   

Alliances are typically more informal than joint ventures and do not require the creation of new entities or even formal written contracts. In some aspects this flexibility can be an advantage because it provides the partners with the ability to adapt to changing environments. However, the absence of a formal contract requires mutual trust among partners, which can be a challenge when relationships change rapidly with the emergence of attractive possibilities and in the event of lawsuit. Alliances are also attractive because they give firms access to new markets and technologies with relatively little investment compared with joint ventures and acquisitions.

The M&A activities of a firm are dynamic processes that occur continually over long periods. Successful companies, such as GE and IBM, engage in multiple M&As throughout the course of a year, but each maintains a different emphasis on the types of M&As used (IBM for example puts more emphasis on alliances than on mergers and acquisitions relative to GE). These activities allow a firm to extend capabilities into new markets or improve capabilities in existing ones. Divestitures are also included in the M&A process and are often used to help a company sharpen its focus in certain markets.

When there are multiple bidders for a firm with an uncertain value, competition drives up the winning bid to a price in excess of what one might expect from bilateral negotiation between the eventual buyer and the seller. This effect, which was suggested earlier, is often called  the "Winner’s Curse". 

Empirical studies show that the more uncertain the outcome in bidding (e.g., for offshore leases to drill for oil in contrast to, say, building a new filling station) the wider will be the range of bids, as one might expect intuitively. Thus, one might expect the winning bid to be higher, the wider the distribution of bids. Over optimism may also be present and can result from many factors. Roll emphasizes the influence of the hubris of excessive confidence in one’s judgments under uncertainty. Hubris also implies that bidders do not learn from experience and continue to make overoptimistic bids. Sometimes, a CEO can want to establish his or her legacy with a mega-venture.

The Shleifer and Vishny theory of mergers is based on overvaluation of bidders and undervaluation of targets. Firms have an incentive to overvalue their equities and make acquisitions with stock and grow, and undervalued firms then become targets. Cash acquisitions, on the other hand, are more likely when the acquirers are undervalued and the acquisitions are more hostile. Shleifer and Vishny apply this theory to the merger waves of the last 40 years. In the 1960s, for example, the conglomerate merger waves were defined by acquisitions of undervalued firms by overvalued ones with stock. The tax laws favored this approach (and continue to do so), because, while selling one's stock created a taxable event to owners of acquired firms (with much higher top rates than today), being acquired for stock was (and remains) a tax-free exchange of "like-kind" assets. 

The break-up takeovers of the 1980s were also due to the undervaluation of targets, but tended to be hostile and made with cash. This wave ended, in Shleifer and Vishny’s opinion, because of rising stock market prices, which eliminated the undervaluation. Lastly, the takeover wave of the 1990s can also be explained by rising stock market valuations ,according to Shleifer and Vishny.

Agency problems occur because the managers (agents) of a firm and the shareholders (owners) of the firm have different goals. Managers may be tempted to overconsume perquisites (club memberships, private jets, ornate offices), or to shirk or underperform in other ways because owners of the corporation will bear most of the costs. Managers may also look at their incentive compensation schemes and contractual severance benefits and "bet the company" on a risky acquisition on the basis that "heads they win, tails they break even". This behavior may well have been behind the financial crisis of 2008.

With widely diffused ownership, individual shareholders do not have sufficient incentives to monitor the managers. To overcome this problem, corporations have at least formal control mechanisms put in place, whereby a board of directors (elected by shareholders) has the power to ratify decisions and monitor management. Also, the compensation that managers receive can be tied to the performance of the company, providing an incentive for managers to increase the value of the company. If all else fails, takeovers provide an external control device, acting as a threat to managers if a company shows weakness because of inefficiencies or agency problems.

Future synergies are difficult to estimate. Direct and potential competition from other bidders may result in a winner’s curse and the payment of excess premiums. 

The post-merger integration of cultures and organizations can represent a major challenge to the success of a merger. Because mergers are often driven by top management, individual parts of the business might not be contacted for their input. It is important that after the merger an integration task force communicates fully and continuously to complete the integration process within a very few months. 

The CEO should always be directly involved with all but the smallest acquisitions because the strategy and scope of the enterprise are substantially affected by acquisitions. These are the central responsibilities of top executives.

Are mergers/acquisitions completely rational decisions from the perspective of adding shareholder value? Research coming from cognitive psychology and behavioral finance indicates that an overconfidence bias may account for the large proportion of mergers and acquisitions that fail to add value to the acquirer. Tversky and Kahneman surveyed the managers of a large sample of cash rich firms (those most likely to undertake a future merger/acquisition transaction) some time ago. 

Their survey asked the managers to estimate the percentage of mergers that add value to the acquirer. The average estimate of respondents was 37% (consistent with research). Later in the survey, the same managers were asked to estimate the probability that their next merger would add value to their firm. The average response was 67%. In other words, the average manager is estimating that he or she is better than average by 30 percentage points! This situation resembles the fictional Lake Wobegon of Garrison Keillor, in which all students were "above average".

There's another view of acquisitions that describes some behavior in the high-tech sector. Cisco, for example, does almost no basic research. Rather, it scouts for emerging high tech companies whose ideas might be of value to Cisco and whose founders (and financial backers) might want to cash out. Cisco then develops the products, some of which succeed, and some of which do not succeed. Microsoft acts in this way as well, though not to the same extent.

3. Capsim Report II: Due by 11:59 PM, the last day of the week.

4. Discussion Issues: Please participate in this week's discussions.