Mergers & Acquisitions (M&A)

Merger example

Firm
Firm B
A
 Merger example

Firm
Firm B
A

Firm AB
 Merger example
• “Merger of equals”
– Pooling assets together
– Shareholders of A and B give up their old stock and receive stock in new
company AB

• Acquisition or Takeover
– For example, firm A acquires firm B (firm A is the “acquirer”, firm B is the
“target”)
– Firm B shareholders receive cash (firm A pays in cash) or firm A stock (firm A
pays in stock) in return for selling their firm B stock to firm A
– Normally, firm B shareholders should receive a price higher than current
market price for selling their stock to firm A
– acquisition premium

• All these transactions require a shareholder vote to approve

 Varieties of Takeovers
Merger or consolidation

Acquisition Acquisition of stock

Takeovers Proxy contest Acquisition of assets

Going private

Takeovers can be friendly (with target management’s approval) or

they can be hostile (against the target management’s approval)

(https://www.youtube.com/watch?v=lJ2XZn9sD2k)
 Types of mergers
(from an economic standpoint)

• Horizontal mergers
– Two firms that operate and compete in the same kind of
business activity (e.g. Exxon purchasing Mobil Oil)
• Vertical mergers
– Two firms that operate in different stages of production
(e.g. an oil exploration firm purchasing an oil refinery)
• Conglomerate mergers
– Two firms engaged in completely unrelated types of
activity (e.g. RJR Nabisco)
 Merger example
• For a merger to make sense it must be that
ValueAB > ValueA + ValueB
Firm AB Firm A Firm B

• It must also be that it is faster and cheaper to

grow by M&A than it is to grow organically
 Facts about the Volume of M&A
Deals
• M&A transactions come in “waves” of activity, followed by
periods of less activity
• Generally, more deals get done when the economy is
doing well and fewer during recessions
• Merger activity generally clusters by industry (e.g. industry
merger waves)
• In the past, firms from developed markets would acquire
targets in emerging markets but recently we also observe
the opposite trend (e.g. Lenovo acquisition of IBM’s PC
assets)

• Why?
 U.S. M&A deals
2,500

2,000

1,500

1,000

500

0
80 981 982 983 984 985 986 987 988 989 990 991 992 993 994 995 996 997 998 999 000 001 002 003 004 005 006 007 008 009 010
19 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2

U.S. M&A deals

 Why do mergers happen?
• Economic disturbance theory (Gort, 1969, “An Economic
Disturbance Theory of Mergers.” Quarterly Journal of
Economics 83, 624–642)
– Shocks to industry/economy alter the optimal firm size and create
opportunities for mergers
• Technological
• De-regulation
• Globalization/European Union common market
• Market liquidity/cost of capital (easier financing)
• Mergers are efficiency-increasing responses to these shocks,
with more efficient firms buying less-efficient firms.
• Because these shocks affect all companies in the same
industry/economy, they lead to many transactions occurring
at the same time.
 Why do mergers happen?
• Acquirer overvaluation (Shleifer and Vishny, 2003, “Stock
Market Driven Acquisitions.” Journal of Financial Economics
70, 295–311)
– The stock market is not always efficient
– Some firms become temporarily overvalued
– They can use their overvalued stock in order to acquire other
companies
• Paying for the acquisition in stock
• Raising equity and paying for the acquisition in cash
• Since overvaluation may affect an entire market or industry,
it will lead to many deals occurring at the same time.
Source: Macias, Rau &
Stouraitis, “Can serial
acquirers be profiled?”
(2016)
 “Good” reasons for merger
• For a merger to make sense it must be that
ValueAB > ValueA + ValueB
Firm AB Firm A Firm B

Synergy = ValueAB – (ValueA + ValueB)

 Synergy in mergers

CFABt  (CFAt  CFBt )  CFt
Synergy V AB  (V A  VB )  t
 t
t 1 (1  r ) t 1 (1  r )

• where incremental cash flows are

CFt Rev t  Costs t  Taxes t  Capital Requiremen ts t

 Sources of Synergy
• Increases in revenue
– marketing gains (e.g. cross-selling products)
– market power (but anti-trust authorities are watching…)
– network externalities
• Lower costs
– elimination of duplicate activities/excess capacity
– elimination of transactions costs
– economies of scale
– economies of scope
– economies of learning
– elimination of inefficient management
• Lower taxes
– use of losses in one firm to reduce tax
– increase debt capacity
• Lower financing costs
– cost of issuing securities lower for large issues compared to small issues
 Marketing gains
• Exploit merging companies existing resources
and capabilities to augment sales of each
other’s products
• Distribution channels established by each firm
may be used to sell the other firm’s products
• For example, a bank acquiring an insurance
company and selling insurance products
through its branches
 Market power
• A horizontal merger of two firms selling in the
same market increases market share of the
combined entity
• May increase market power to dictate prices or
non-price terms
• Anti-trust authorities scrutinize such mergers
– Often merging firms are asked to sell some
activities as a condition to merger
 Network externalities
• A network externality exists whenever the value
of a product to an individual customer depends
on the number of other users
• The product’s value does not depend on its
attributes per se but on the gateway it provides
to the network
– For example, e-mail is more valuable to me if many
other people have it – it is less valuable if few
people have it
• Example: An internet service provider acquiring
a web browser
 Elimination of duplicate activities
or excess capacity
• More likely in horizontal mergers
• More likely in mature industries, characterized by
– Low overall growth in demand
– Excess capacity
– Small number of large competitors
– Price pressure
– Pressure to reduce costs
 Elimination of transactions costs
• More likely in vertical mergers
• The cost of writing contracts may be high due to
– Uncertainty and inability to anticipate all eventualities
– Asymmetric information between contracting parties
– Opportunistic behavior
– Disagreement on how to measure performance
– Asset specificity (investment in production facilities
that satisfy the needs of only one buyer and have no
economic value for other buyers)
 Economies of scale
• Average cost of production goes down as the
quantity of produced output increases
 Economies of scope
• When the costs of joint production of two or
more goods by a multi-product firm are lower
than the combined costs of separate production
of these goods
• For example,
– R&D activities create spillovers to other products
– a supermarket chain selling gasoline on the
premises
 Economies of learning
• When managers and workers become more
experienced and effective in using the available
resources of the firm – thus reducing average
costs
• More likely in horizontal mergers
– For example a study of Airbus Industrie found that
at the initial production level of e.g. 20 aircraft, the
production of each aircraft required 60 hours.
When output rose to 200 aircraft, the production
of each aircraft required only 20 hours per aircraft!
 “Bad” reasons for mergers
• (1) Diversification (conglomerate mergers)
– Acquiring targets which operate in unrelated
activities

– Example:
• CK Hutchison Holdings Limited (Stock Exchange of HK
Code: 00001)
 Diversification
• CK Hutchison Holdings Limited
– Hutchison Port Holdings Limited (Hutchison Ports)
– A.S. Watson Group (health and beauty retailer)
– CK Infrastructure Holdings Limited (energy infrastructure, transportation infrastructure,
water infrastructure, waste management, energy-from-waste)
– Husky Energy Inc.
– Hutchison Telecommunications Hong Kong Holdings Limited, Hutchison Asia
Telecommunications, 3 Group Europe
– Hutchison Whampoa (China) Limited (aircraft management, maintenance, engineering and
cabin cleaning services, household and industrial detergent products, consumer goods,
logistics services and the operation of a rice farm and rice trading)
– Hutchison China MediTech Limited (biopharmaceutical company)
– CK Life Sciences Intl., (Holdings) Inc. (nutraceuticals, pharmaceuticals and agriculture-
related products)
– TOM Group Limited (media and technology company)
– Hutchison Water (water technologies)
– Marionnaud (European perfume and cosmetics retailer)
 Diversification
• What are the benefits to diversification?
– Internal capital markets
• Cash may be distributed from subsidiaries that generate
it (but have no investment opportunities) to subsidiaries
that have investment opportunities (but lack the cash to
invest)
– Debt capacity may be increased if the firm is
diversified (due to reduction in risk)
– Employees and managers who cannot diversify
their human capital may become too risk averse
 Diversification
– In emerging markets:
• In smaller markets talent may not be as widely available
to be able to support many narrowly focused firms.
• Obtaining financing (especially venture capital
financing) may be difficult for stand-alone firms that are
not part of larger industrial groups.
• Connections may be important for securing contracts,
financing etc.
 Diversification
• Diversification may also have costs:
– Investors can diversify on their own
– Running unrelated divisions may be too complex
– Numerous studies in developed markets have shown
that diversified firms underperform and trade at lower
valuations compared to focused firms
• In other words, investors pay less to buy the stock of a
diversified firm compared to a portfolio of similar stand-
alone focused firms.
– Conglomerates became targets of hostile bids during
the 1980s and many were broken up
• Acquiring under-valued businesses, restructuring them and
re-selling them at a higher price became a strategy for many
corporate raiders.
 Diversification
• Diversification may also have costs:
– But, viewed from a managerial perspective,
managers prefer to run larger companies
• Executive compensation often related to firm size
• Prestige and publicity associated with running larger
companies
 “Bad” reasons for mergers
• (2) EPS game
– Popular in the 1960s but still going on
– Applies to stock-financed acquisitions
– Assume target is acquired at current market value
(no premium) and acquirer compensates the
target’s shareholders by issuing acquirer shares
– Acquirer and target earnings assumed unchanged
by the acquisition
667
 “Bad” reasons for mergers
• Acquirer can increase EPS mechanically by
acquiring low P/E companies
– Notice that no value has been created by the
acquisition
• Target and acquirer earnings haven’t changed
• No premium has been paid
• No synergies
 “Bad” reasons for mergers
• If market practitioners naively believe that after
the acquisition
Pnew = EPSnew x (P/E)old
– Essentially applying mechanically the acquirer’s old
P/E ratio on the target’s earnings
– Acquirer stock price P may increase as well
 “Bad” reasons for mergers
• (3) Related party transactions/Connected
transactions
Minority shareholders Mr Aris: Majority
of firm A shareholder of firm A

49% 51% 100%

Firm A Firm B
Publicly listed Not publicly listed
company company
 “Bad” reasons for mergers
• (3) Related party transactions/Connected
transactions
Minority shareholders Mr Aris: Majority
of firm A shareholder of firm A

49% 51% 100%

Firm A Firm A acquires Firm B

Publicly listed firm B from Mr
Aris for $100
Not publicly listed
company mil in cash company
 “Bad” reasons for mergers
• (3) Related party transactions/Connected
transactions
Minority shareholders Mr Aris: Majority
of firm A shareholder of firm A

49% 51% 100%

Firm A Firm A acquires Firm B

Publicly listed firm B from Mr
Aris for $100
Not publicly listed
company mil in cash company

Is firm B really worth $100 mil or is firm A overpaying for firm B, to the personal benefit of Mr Aris?
 Stock price reaction following the announcement of related
party (connected party) transactions in Hong Kong 1998-2000

All connected
2%
0%
-2%
CARs

-4%
-6%
-8%
-10%
-12%
-14%
-16%
-12
-10-8 -6 -4 -2 0 2 4 6 8 1012
Month

Source: Cheung, Rau & Stouraitis, 2006, “Tunneling, propping and

expropriation: Evidence from connected party transactions in Hong Kong”,
Journal of Financial Economics 82, 343-386
 When firm A acquires
assets from a related party,
the stock price goes down
 When firm A acquires
assets from an unrelated
third party, the stock price
does not go down
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