Introduction to Mergers Acquisitions Other Restructuring Activities

Introduction to Mergers, Acquisitions, & Other Restructuring Activities

If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a life time. —Lao Tze

Success is a Personal Choice We can choose to be successful by • Setting goals, • Having high expectations of ourselves, • Never quitting, • By not making excuses, and • By accepting personal responsibility

Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities Part I: M&A Environment Part II: M&A Process Part III: M&A Valuation and Modeling Part IV: Deal Structuring and Financing Part V: Alternative Business and Restructuring Strategies Ch. 1: Motivations for M&A Ch. 4: Business and Acquisition Plans Ch. 7: Discounted Cash Flow Valuation Ch. 11: Payment and Legal Considerations Ch. 15: Business Alliances Ch. 2: Regulatory Considerations Ch. 5: Search through Closing Activities Ch. 8: Relative Valuation Methodologies Ch. 12: Accounting & Tax Considerations Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs Ch. 3: Takeover Tactics, Defenses, and Corporate Governance Ch. 6: M&A Postclosing Integration Ch. 9: Financial Modeling Techniques Ch. 13: Financing the Deal Ch. 17: Bankruptcy and Liquidation Ch. 10: Private Company Valuation Ch. 14: Valuing Highly Leveraged Transactions Ch. 18: Cross-Border Transactions

Course Learning Objectives • Define what corporate restructuring is and why it occurs • Identify commonly used valuation techniques and how they are employed • Describe how corporate restructuring creates/destroys value • Identify commonly used takeover tactics and defenses and when they are most appropriate • Develop a highly practical “planning based” approach to managing the M&A process • Identify challenges and solutions associated with each phase of the M&A process • Describe advantages and disadvantages of alternative M&A deal structures • Describe how to plan, structure, and manage JVs, partnerships, alliances, licensing arrangements, equity partnerships, franchises, and minority investments

Current Chapter Learning Objectives • Primary objective: What corporate restructuring is and why it occurs • Secondary objective: Provide students with an understanding of – M&A as a form of corporate restructuring – Alternative ways of increasing shareholder value – M&A activity in an historical context – The primary motivations for M&A activity – Key empirical findings – Primary reasons some M&As fail to meet expectations

M&As as a Form of Corporate Restructuring • Restructuring Activity – Corporate Restructuring • Balance Sheet • Assets Only – Financial Restructuring – Operational Restructuring • Potential Strategy – Redeploy Assets • Mergers, Break-Ups, & Spin-Offs • Acquisitions, divestitures, etc. – Increase leverage to lower cost of capital or as a takeover defense; share repurchases – Divestitures, widespread employee reduction, or reorganization

Alternative Ways of Increasing Shareholder Value • Solo venture (AKA “going it alone” or “organic growth”) • Partnering (Marketing/distribution alliances, JVs, licensing, franchising, and equity investments) • Mergers and acquisitions • Minority investments in other firms • Asset swaps • Financial restructuring • Operational restructuring

Discussion Questions 1. What factors do you believe are most likely to impact senior management’s selection of one strategy (e. g. , solo venture, M&A) to increase shareholder value over the alternatives? Be specific. 2. In your opinion, how might the conditions of the business (e. g. , profitability) and the economy affect the choice the strategy?

Motivations for M&A • Strategic realignment – Technological change – Deregulation • Synergy – Economies of scale/scope – Cross-selling • Diversification (Related/Unrelated) • Financial considerations – Acquirer believes target is undervalued – Booming stock market – Falling interest rates • Market power • Ego/Hubris • Tax considerations

Illustrating Economies of Scale Period 1: Firm A (Pre-merger) Period 2: Firm A (Post-merger) Assumptions: • Price = $4 per unit of output sold • Variable costs = $2. 75 per unit of output • Fixed costs = $1, 000 • Firm A is producing 1, 000 units of output per year • Firm A is producing at 50% of plant capacity Assumptions: • Firm A acquires Firm B which is producing 500, 000 units of the same product per year • Firm A closes Firm B’s plant and transfers production to Firm A’s plant • Price = $4 per unit of output sold • Variable costs = $2. 75 per unit of output • Fixed costs = $1, 000 Profit = price x quantity – variable costs – fixed costs = $4 x 1, 000 - $2. 75 x 1, 000 - $1, 000 = $250, 000 Profit = price x quantity – variable costs – fixed costs = $4 x 1, 500, 000 - $2. 75 x 1, 500, 000 - $1, 000 = $6, 000 - $4, 125, 000 - $1, 000 = $875, 000 Profit margin (%)1 = $250, 000 / $4, 000 = 6. 25% Fixed costs per unit = $1, 000/1, 000 = $1 Profit margin (%)2 = $875, 000 / $6, 000 = 14. 58% Fixed costs per unit = $1, 000/1. 500, 000 = $. 67 Key Point: Profit margin improvement is due to spreading fixed costs over more units of output. 1 Margin 2 Margin per unit sold = $4. 00 - $2. 75 - $1. 00 = $. 25 per units sold = $4. 00 - $2. 75 - $. 67 = $. 58

Illustrating Economies of Scope Pre-Merger: Post-Merger: • • • Firm A’s data processing center supports 5 manufacturing facilities Firm B’s data processing center supports 3 manufacturing facilities • Firm A’s and Firm B’s data processing centers are combined into a single operation to support all 8 manufacturing facilities By combining the centers, Firm A is able to achieve the following annual pre-tax savings: – Direct labor costs = $840, 000. – Telecommunication expenses = $275, 000 – Leased space expenses = $675, 000 – General & administrative expenses = $230, 000 Key Point: Cost savings due to expanding the scope of a single center to support all 8 manufacturing facilities of the combined firms.

Empirical Findings • Abnormal (or excess) financial returns are those earned by acquirer and target shareholders above or below what would have been earned without a takeover. • Around transaction announcement date, abnormal returns: 1 – For target shareholders averaged 25. 1% during the 2000 s as compared to 18. 5% during the 1990 s – For acquirer shareholders generally positive averaging about 1 -1. 5% – However, zero to slightly negative for acquirer shareholders for deals involving large public firms and those using stock to pay for the deal 1 • Positive abnormal returns to acquirer shareholders often are situational and include the following: – Target is a private firm or a subsidiary of another firm – The acquirer is relatively small (large firm management may be more prone to hubris) – The target is small relative to the acquirer – Cash rather than equity is used to finance the transaction – Transaction occurs early in the M&A cycle • No evidence that alternative strategies (e. g. , solo ventures, alliances) to M&As are likely to be more successful 1 These conclusions are based on recent studies using large samples over lengthy time periods involving U. S. , foreign, and cross-border deals (including public and private firms). See J. Netter, M. Stegemoller, and M. Wintoki, 2011 Implications of Data Screens on Merger and Acquisition Analysis: A Large Sample Study of Mergers and Acquisitions, Review of Financial Studies 24 2316 -2357 and J. Ellis, S. B. Moeller, F. P. Schlingemann, and R. M. Stulz, 2011 Globalization, Governance, and the Returns to Cross-Border Acquisitions, NBER Working Paper No. 16676.

Primary Reasons Some M&As Fail to Meet Expectations • Overpayment due to over-estimating synergy • Slow pace of integration • Poor strategy

Discussion Questions 1. Discuss whether you believe current conditions in the U. S. and global markets are conducive to high levels of M&A activity? Be specific. 2. Of the factors potentially contributing to current conditions, which do you consider most important and why? 3. Speculate about what you believe will happen to the number of M&As over the next several years in the U. S. ? Globally? Defend your arguments.

Application: Xerox Buys ACS In 2010, Xerox, a slower growing, cyclical an office equipment manufacturer, acquired Affiliated Computer Systems (ACS) for $6. 4 billion. With annual sales of about $6. 5 billion, ACS handles paper-based tasks such as billing and claims processing for governments and private companies. With about one-fourth of ACS’ revenue derived from the healthcare and government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets which should benefit from the 2009 government stimulus spending and 2010 healthcare legislation. There is little customer overlap between the two firms. The sale of services tends to be more stable and offers higher margins than product companies. Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into services achieved limited success due largely to poor management execution. While some progress in shifting away from the firm’s dependence on printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate transitioning from a product driven company to one whose revenues were more dependent on the delivery of business services. More than two-thirds of ACS’ revenue comes from the operation of client back office operations such as accounting, human resources, claims management, and other outsourcing services, with the rest coming from providing technology consulting services. ACS would also triple Xerox’s service revenues to $10 billion. Xerox chose to run ACS as a separate standalone business. Discussion Questions: 1. What alternatives to buying ACS do you think Xerox could have considered? 2. Why do you think they chose a merger strategy? (Hint: Consider the advantages and disadvantages of alternative implementation strategies. ) 3. Speculate as to Xerox’s primary motivations for acquiring ACS? 4. How might the decision to manage ACS as a separate business affect realizing the full value of the transaction? What other factors could limit the realization of synergy?

Remembering the Past “Those who do not remember the past are condemned to relive it. ” Alexis De Tocqueville

Merger Waves 1 (Boom Periods) • Horizontal Consolidation (18971904) • Increasing Concentration (19161929) • The Conglomerate Era (19651969) • The Retrenchment Era (19811989) • Age of Strategic Megamerger (1992 -2000) • Age of Cross Border and Horizontal Megamergers (20032007) 1 Periods characterized by robust increases in the number and value of transactions.

Causes and Significance of M&A Waves • Factors contributing to increasing M&A activity: – Shocks (e. g. , technological change, deregulation, and escalating commodity prices) – Ample liquidity and low cost of capital – Overvaluation of acquirer share prices relative to target share prices – Improving business confidence • Why it is important to anticipate M&A waves: – Financial markets reward firms pursuing promising (often undervalued) opportunities early on and penalize those that follow later in the cycle. – Acquisitions made early in the wave often earn substantially higher financial returns than those made later in the cycle.

Horizontal Consolidation (1897 -1904) • Spurred by – Drive for efficiency, – Lax enforcement of antitrust laws – Westward migration, and – Technological change • Resulted in concentration in metals, transportation, and mining industry • M&A boom ended by 1904 stock market crash and fraudulent financing

Increasing Concentration (1916 -1929) • Spurred by – Entry of U. S. into WWI – Post-war boom • Boom ended with – 1929 stock market crash – Passage of Clayton Act which more clearly defined monopolistic practices

The Conglomerate Era (1965 -1969) • Conglomerates buy earnings streams to boost their share price – Overvalued firms acquired undervalued high growth firms – Number of high-growth undervalued firms declined as conglomerates bid up their prices – Higher purchase price for target firms and increasing leverage of conglomerates brought era to a close

The Retrenchment Era (1981 -1989) • Strategic U. S. buyers and foreign multinationals dominated first half of decade • Second half dominated by financial buyers – Buyouts often financed by junk bonds – Drexel Burnham provided market liquidity • Era ended with bankruptcy of several large LBOs and demise of Drexel Burnham (Michael Milken)

Age of Strategic Megamerger (1992 -2000) • Dollar volume of transactions reached record in each year between 1995 and 20001 • Purchase prices reached record levels due to – Soaring stock market – Consolidation in many industries – Technological innovation – Benign antitrust policies • Period ended with the collapse in global stock markets and worldwide recession 1 The cumulative dollar value of M&As during this period in the U. S. was $6. 5 trillion, With $3. 5 trillion taking place in the last two years.

Age of Cross Border and Horizontal Megamergers (2003 – 2007) • Average merger larger than in 1980 s and 1990 s, mostly horizontal, and cross border • Concentrated in banking, telecommunications, utilities, healthcare, and commodities (e. g. , oil, gas, and metals) • Spurred by – Continued globalization to achieve economies of scale and scope; – Ongoing deregulation; – Low interest rates; – Increasing equity prices, and – Expectations of continued high commodity prices • Period ended with global credit market meltdown and 2008 -2009 recession

Debt Financed 2003 -2007 M&A Boom Low Interest Rates & Declining Risk Aversion Drive Increasing --Sub-Prime Mortgage Lending --LBO Financing & Other Highly Leveraged Transactions Investment Banks: Repackage & Underwrite --Mortgage Backed --High Yield Bonds Banks & Hedge Funds Create: --Collateralized Debt Obligations (CDOs) --Collateralized Loan Obligations CLOs) Investment Banks Lend to Hedge Funds Foreign Investors Buy Highest Rated Debt Hedge Funds Buy Lower Rated debt

Similarities and Differences Among Merger Waves • Similarities – Occurred during periods of sustained high economic growth – Low or declining interest rates – Rising stock market • Differences – Emergence of new technology (e. g. , railroads, Internet) – Industry focus – Type of transaction (e. g. , horizontal, vertical, conglomerate, strategic, or financial)

Discussion Questions 1. What can senior management learn by studying historical merger waves? 2. What can government policy makers learn by studying historical merger waves? 3. What can investors learn by studying historical merger waves?

Things to Remember • Motivations for acquisitions: – Strategic realignment – Synergy – Diversification – Financial considerations – Hubris • Common reasons M&As fail to meet expectations – Overpayment due to overestimating synergy – Slow pace of integration – Poor strategy • M&As typically reward target shareholders far more than bidder shareholders • Success rate of M&A not significantly different from alternative ways of increasing shareholder value