MERGERS AND ACQUISITIONS: THEORY MEETS PRACTICE. Sergey Barabanov and Mufaddal Baxamusa University of St Thomas

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1 MERGERS AND ACQUISITIONS: THEORY MEETS PRACTICE Sergey Barabanov and Mufaddal Baxamusa University of St Thomas

2 Fundamentals 4-step process Agenda Mini Case Valuation

3 Fundamentals

4 Mergers occur in waves Waves caused by liquidity in capital markets Not by overvaluations

5 Do M&As create value? It depends

6 Some industry experts believe 80 % of mergers fail - most companies undergoing mergers typically erode shareholder wealth; create years of chaos, fear and turmoil for employees; and end up taking missteps that leave them perfectly positioned to lose the battle against their competition. Lamb and Grubb (2000)

7 Creation Acquirer s wealth Medium and small firms. Warning: As an acquirer be careful!!! Large firms and repeat acquirers Destruction

8 Target s wealth Generally beneficial Combined (Acquirer + target) wealth Generally beneficial

9 Why do M&A occur? % of Total Acquisitions Unrelated Horizontal Vertical 25.62

10 Vertical acquisitions Business reasons Academic verdict Supply chains Does not facilitate shipment of goods Only 0.4% of goods are transferred vertically in firms

11 Horizontal acquisitions Academic infatuation Business pushback Market power and pricing IBM: market power would only come if we were buying everyone

12 Horizontal acquisitions Business reasons Academic support Technology Complementary products Technology and product similarity independently lead to better acquisitions However, simultaneous presence of technology and product complementarity leads to poorer outcomes

13 Unrelated acquisitions Business reasons Academic support Strategic reasons Internal cash flows Talent Diversification Product bundling

14 The 4 step process

15 Step 1: Make a plan Compare your objectives to academic reasons Make sure to go beyond generalities like strategic fit and growth. Acquirers Make sure your reasons are for increasing the owners wealth Not for resume building, hubris, or personal glory Subject your plan to a healthy dose of skepticism

16 Potential sources of synergy Increased productivity of capital and labor in target Decrease investments, wages, employment in target Output is unchanged Product switching

17 Step 2: Search and screening process List firms that: cite your patents. or, spend heavily on R&D but do not yet have patents. or, are in the similar product space. or, your directors know about. Screen out firms with bad quality accounting data Do quick valuation

18 Quick valuation First find Free cash Flows Use comps, only if data is not available Find NPV Remember to use real option valuations

19 Should we hire an M&A banker? Experienced advise Help in selecting target Is an execution house i.e. follows instructions and no value added Increases acquirer returns by 1.26% Little dispersion if bank does more than 10 M&As in a year

20 What should we look for in a banker? Ivy league education Multiple industry experience Number of deals Better deal performance Shorter time to completion Higher completion rates

21 Step 3: Due diligence, negotiation and deal structure

22 Premiums High for growth firms Lower: If CEO is planning to stay, or has good severance package.

23 Each female director on the acquirers board:

24 Fairness opinions: Do they matter? Acquirer opinions have + valuation errors Target opinions have valuation errors Top tier advisors are more accurate Protects in litigations As necessary to valuation analysis as the appendix to human digestive system, Elson (1992)

25 Litigation generally by target shareholders Single bidder, friendly acquisitions Low premiums, however after the litigation the premium rises Lower completion rate

26 Material-Adverse-Clauses are important Material-Adverse-Events 69% of terminations 80% of renegotiations Fewer Material-Adverse-Events Higher premiums Larger arbitrage spreads

27 Termination fees Lesser than 5% Increases completion Does not remove competing bids Greater than 5% Lower premiums Poorer target corporate governance

28 Step 4: Post-merger impact on firm Quality converges across products Prices fall relative to industry Prices do not fall if entering new industry Effects are stronger in mature, slow growth industries

29 3 Years from acquisition 27% of target s plants are sold 19% of target s plants will be closed Remaining target s plants show increased productivity

30 An afterthought: trading strategy Buy target stocks with high probability of deal completing Sell target stocks with high probability of failure 1% abnormal monthly return

31 Valuation Valid Reasons If company A wants to buy company B, then NPV of purchase must be > 0. NPV = Gain Cost > 0 Gain = PV AB (PV A + PV B) = Value of Synergy i.e. PV of combined company AB must be greater than PV of each separate Dubious Reasons Diversification Ambitions (e.g., Agency Problem)

32 Positive NPV Cash Acquisition Example (company A buys company B) Cost = cash PV B; thus, NPV = gain cost NPV = [ PV AB (PV A + PV B)] [(COST PV B)] Example: Given: PV A = $100, PV B = 50. B is bought for $65. Suppose there are $35 in synergies, i.e., PV AB = $185. Solution: Gain =PV AB (PV A + PV B) =Cost savings = $35 Cost = cash PV B = = 15 Therefore, NPV = gain-cost = = 20

33 Real Options!!! NPV Real Options Value Call options: Product switching, growth Put option: Sell the plants, close the plants, layoffs.

34 Valuation: Sources of Cash Flows Increased Revenues Gains from better marketing efforts Strategic benefits leader in new markets Decreased costs Economies of scale, scope Elimination of inefficiencies Taxes Transfer of net operating losses Unused debt capacity Reduced investment needs Use of excess capacity

35 Valuation is not that straight-forward Status-Quo Valuation Estimate FCFF, FCFE, Growth Rates, Terminal Value, Cost of Capital, Debt Ratios All are varying over time Value of control = Value of firm optimally managed Value of firm with current management

36 Value of Corporate Control Mini Case Study Value of Digital Equipment to Compaq was more than twice its status-quo valuation in 1997/98 acquisition (Damodaran) Value of firm (optimally managed)= $4, million Value of firm (status quo) = $2, million Value of control = $2, million

37 Typical Merger Valuation Biases Selection Bias for Comparable Firms / Multiples Mismatching Cash Flows and Discount Rates Use the target s cost of equity (not bidding firm s) Use the cost of equity to discount FCFE (not the cost of capital) Do not transfer acquirer s low cost of debt or debt capacity to the target s firm valuation Subjective Adjustments any valuation you want it to be!

38 Additional Valuation Considerations Excess reserves for restructuring Shift earnings from the present to the future and create an illusion of financial turnaround Debit restructuring reserve (liability on the Balance Sheet) and credit earnings Unintended transfer of wealth from stockholders to bondholders If the cash flows of new firm are less volatile the debt of the new firm will be less risky and its value will be higher and equity value will be smaller

39 CASH VS COMMON STOCK Sharing Gains If cash is used, then target firm s shareholders will not participate in the potential gains of the merger. If it is not successful, the shareholders of the acquiring company will be worse off. Is your stock overvalued? Exchange Ratio (fair/max/min) Control No dilution with cash acquisitions.

40 So You make a Monday morning announcement! What to disclose? Aggregate vs. detailed financial projections Large complex valuations Stocks may be over- or under-valued Competitors may gain information Criticized for not meeting the sub-target Additional focus on non-financial targets to track merger progress (e.g., headcount, market share, etc.)

41 Thank You! Mufaddal Baxamusa, Ph.D. Associate Professor Department of Finance Opus College of Business University of St. Thomas Sergey S. Barabanov, Ph.D. Associate Professor Department of Finance Opus College of Business University of St. Thomas