M&A: Strategy

Paolo Volpin

www.cass.city.ac.uk
Plan of Attack
•  Acquisition as an Investment Decision

•  Merger Checklist: Sources of

•  Value Creation
•  Value Transfers
•  Underpayment
•  Bad Deals

•  Evidence

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Acquirer’s Perspective
•  Making an acquisition is no different from any other corporate
decision:
•  The goal is to increase shareholder wealth
•  This should be the ultimate motive: Can we purchase a company
(or a division of a company) that is worth more to us than it costs?
•  Key to doing M&A right is to produce a correct valuation of the
target firm and making sure that the frenzy of completing the deal
does not lead to overpayment!

•  Differences with regular valuation (like an analyst valuation) is

that you have control:
•  You can change the way it is run
•  There may be synergies with existing businesses
•  You can finance it differently
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 Good Deal (for Acquirer): ΔV > ΔO + ΔP + C

•  ΔV : Total value created in the deal [Synergies]

•  ΔO : Transfer to parties other than both firms’ shareholders

(creditors, employees, government, …)

•  ΔP : Premium paid over the target’s equity value

•  C : Cost of organizing the deal

•  Proof: see next slide

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Proof:
•  Consider Firm A’s acquisition of Firm B for a price P
•  Let E denote the value of a firm’s equity (EA is the value of the
equity of A as a standalone; EB is the value of the equity of B as
a standalone; and EA+B is the value of the equity of A and B
together)
•  Firm A’s shareholders gain if the following condition holds:

EA+B – P – C > EA (1)

•  By definition, the premium ΔP = P – EB

•  Therefore, the condition (1) becomes:

EA+B – EA – EB > ΔP + C (2)

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Proof (cont.)
•  Total firm value is by definition the equity value plus that of all
other stakes in the firm (i.e., debt, taxes, employees’ rents,
etc.):
V=E+O

•  Therefore, condition (2) becomes:

(VA+B – OA+B) – (VA – OA) – (VB – OB) > ΔP + C

•  Rearrange the terms and you’re done:

[VA+B – (VA + VB )] > [OA+B – (OA + OB)] + ΔP + C

or ΔV > ΔO + ΔP + C

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Merger Strategy: Checklist

Value Creation (ΔV >0) Underpaying (ΔP <0)

•  Operating synergies •  Target undervalued
•  Financial synergies •  Merger over-valued
•  Disciplinary takeovers + Pay with stocks

Value Transfers (ΔO < 0) “Bad Acquisitions”

•  Tax savings •  Mistakes
•  Cut employee benefits •  Governance problems
•  Expropriate existing creditors

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Operating Synergies (#1 Driver of M&A)
•  Merge to increase market power:
•  Horizontal (i.e., within same market): Increase market share.
•  Vertical (i.e., within markets that are vertically integrated):
Market foreclosure
•  However, these mergers:
•  May be challenged by antitrust authorities
•  More difficult with global competition

•  Merge to make better use of complementary resources, e.g.,

distribution networks, geographical presence, managerial
expertise, etc: Economies of scale è Higher margins

•  Industry consolidation: Some industries have excess capacity

(i.e., at full capacity they would produce more than the market
demands) è Merge to avoid a costly war of attrition
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Financial Synergies
•  After the merger, external financing becomes cheaper: Why?
•  Economies of scale in financing (i.e., fixed costs of hiring bankers)
•  Smaller firm accesses financial markets via larger one (which
would be impossible to reach as a standalone)
•  Some cross-border deals: companies from countries with less
developed capital markets may benefit from being acquired by
companies from countries with more developed capital markets
•  After the merger, there is a better use of internal funds:
•  Internal Capital Market (ICM) redeploys funds across firms to best
investments (“Winner-picking”)
•  Cash Cows (i.e. firms that generates lots of cash) merge with
Finance Junkies (i.e., firms with lots of investment opportunities),
i.e., balancing cash generators and cash users (Boston
Consulting Group model) è Ultimately, this reduces reliance on
costly external financing
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Financial Synergies: Caveats
Remark 1:
•  Why might merger reduce the cost of capital?
•  One channel: Debt co-insurance, i.e., diversification (even
within industry) reduces the likelihood of financial distress è
together companies are less risky than as standalone
•  Note, however, that part of the benefits go to existing creditors
(who end up lending to less risky firm)!
Remark 2:
•  Better use of internal funds relies on well-functioning ICM
•  Otherwise, ICM might destroy rather than create value
•  Most evidence suggests that ICM is dysfunctional, especially in
conglomerates (diversified firms): ICM does not pick winners
but hand on to losers! Why? Politics within the conglomerate
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Governance Problems
•  Self-serving management:
•  “The Quiet Life” : Management may avoid necessary but painful
decisions (e.g., cost-cutting, layoffs, divestitures, shrinking, etc.)
•  Entrenchment: Management may take moves to secure their
position at the expense of shareholders
•  Empire building: Management’s tendency to increase firm size
(e.g., egomania, power is tied to size, growth is “fun” to manage)

•  Free-cash flow problems:

•  Cash Cows (firms generating lots of cash and with little good
investment opportunities) may pile up cash in the bank account or
in unprofitable investment activity (excessive diversification)
•  No pressure to cut organizational slack (as the cash buffer
protects managers)
•  Forcing payout of cash would help
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Disciplinary Takeovers
•  Target with “bad” management:
•  Management doesn’t get it
•  Management is self-serving
•  Dysfunctional organization (e.g., inefficient ICM, poor
divisional incentives, Cash Cows)

•  Following (hostile) takeover:

•  Remove management (usually)
•  Restructure the target (e.g., divest past acquisitions)

Note: Takeover threat in itself could provide discipline

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Transfer from Government:
Tax Savings
•  Tax Deductions:
•  One firm (generally acquirer) can use the other’s unused tax
deductions, e.g, depreciation, tax shields, Tax Loss Carry
Forwards, etc.
•  Tax avoidance may be challenged by tax authorities
•  Debt Tax Shield:
•  Merger can result in higher leverage è Greater tax shield
•  But you should ask: Do you need a merger for (all of) that?
Could the debt be increased without a merger?
•  Tax arbitrage in cross-border mergers:
•  Allocate earnings to minimize overall taxation

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Transfer from Employees:
Breaching (Implicit) Contracts
•  Employees may be earning above-market wages and benefits
due to past (implicit) agreements

•  Breach of (implicit) agreements: Layoffs, wage renegotiations,

pension fund reversions, etc.

•  Note: Is this opportunism or recognition of changed conditions?

Why a takeover is needed to change these contracts? Wouldn’t
this also occur without takeover? Why takeover makes the
difference?

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Transfer from Existing Creditors:
Risk Shifting
•  Many mergers result in increased leverage (esp. if paid in cash)

•  Other things equal, increasing leverage makes existing debt

riskier and existing creditors worse-off (i.e., ΔO <0)

•  However:
•  Do you need a merger to increase leverage?
•  Also, recall that debt co-insurance can benefit existing creditors (i.e.,
ΔO >0)
•  Whether existing creditors are better (or worse) off really depends
on whether the mergers increases the liquidity that can used to pay
back debt (or not)
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Undervalued Target
•  If the target is undervalued by the stock market pre-merger,
•  it is an opportunity for bargains through takeover
•  Really, a transfer from target shareholders

•  Is under-valuation really a problem?

•  Target management often say so
•  They sometimes are willing to take very costly actions to block
takeovers (e.g., poison pills, law-suits, etc.) [see Week 2]
•  However, target shareholders typically receive takeover premiums of
20-50%!!!
•  Is the firm still undervalued after this takeover premium?

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Overvalued Merger
•  Merged firm may be overvalued post-merger because:
•  Buyer is over-valued pre-merger and/or
•  Synergies are overvalued

è  Acquirer should pay target shareholders with shares in

the merged company

•  Some evidence:
•  More M&A activity when stock market is (excessively?) high
•  Long-run stock-price performance of mergers: 3-year post
merger, the abnormal buy-and-hold return is about -1.5%:
•  if payment involves stock, about -4%;
•  otherwise, more like +4%
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Takeovers as Mistakes
•  Valuation mistakes è Overpay

•  “Winner’s Curse”: Highest bidder is also the most likely to have

overestimated the target’s value è Overpay

•  Hubris: The acquirer’s management overestimates its own

ability to run the target è Overpay

•  Remarks:
•  Sometimes hard to tell the mistaken from the governance problems
•  Even good acquisitions can turn sour at the integration stage

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Takeovers as Governance Problems
•  Some mergers may be self-serving decisions by management
and detrimental to shareholders

•  Empire building is faster via acquisitions

•  Managers in declining industries may want to protect their jobs

by acquiring firms in other industries è Maybe creating a
dysfunctional organization in the process.

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Evidence
•  Event study:
•  Abnormal return for acquirers is negative or close to zero!
•  Typical finding: –0.5% on average

•  The announcement-day returns are lowest for acquiring firms …

•  … in which management has smaller stakes
•  … that have under-performed their industries
•  … that have accumulated more free-cash flows
•  … that buy outside (vs. inside) core business
•  … that “buy growth”

•  “Bad bidders become good targets”

•  Following hostile takeover, some of the target’s previous

acquisitions are often divested
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