Mergers & Acquisitions

Topic 1
Merger overview, arbitrage and timing
Reading: Gaughan Chapters 1, 2, 6
 Sovereign wealth fund (SWF) [主權基金]
• From Norway (largest USD882b[1990]) to Abu Dhabi Investment Authority (USD773b[1976])
• Norway SWF USD1.3t lost USD174b (-14.4%); equity -17% with tech -28%; fixed income -9.3%
in 1H2022
• Bets on scientific approach to investment
• State-owned investment fund investing in financial and real assets
• Held by a central bank
• Assets under management increased to a record USD5.78 trillion
• China Investmet Corp (USD747b)
• HKMA Investment Portfolio (USD400b[1993])
• Typically created when governments have budgetary surplus and have little or no international
debt (當政府處於財政盈餘/近乎其微的國際債務時所創立的基金)
• Stabilization SWFs to reduce volatility of government revenues, to counter boom-bust cycles’
adverse effect on government spending (減少政府盈餘的波動性, 對沖經濟下行的惡性影響)
• Savings SWFs build up savings for future generations, e.g. Government Pension Fund of Norway

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Asian activity

• High availability of capital

• USD6.6t from 2012-19, cross border deals 34% at USD2.3t
• 48% from China and HK, 9% from Japan
• Technology, real estate and finance top three industries of action

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TMT flavor

• Technology, media, telecom merging with financial institutions

• Historically high valuations help
• Firms look to stay competitive and position their business for changing consumer patterns
• Tencent (700.hk) invested in 700+ firms in the past 13 years, 63 listed and 122 valued at
USD1b+
• M&A as a means for growth, on top of organic growth
• Increasing activity by Japanese outbound flow, and in SE Asia

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Change Forces Driving Mergers
1. Technological change (科技環境轉變)
2. Efficiency of operations (企業運行的效益)
3. Globalization and freer trade (自由貿易與全球化)
4. Changes in industry organization (行業架構的改變)
5. New industries (新興市場)
6. Deregulation and regulation (法律鬆弛與新興立法)
7. Favorable economic and financial conditions (友善的經濟與金融環境)
8. Negative trends in industries and economies (行業與經濟下行)
9. Widening inequalities in income and wealth (收入財富不均的拉闊)
10. High valuation of equities (股權價值的提高)

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Issues Regarding M&A Activity

In Favor
• Critical to healthy expansion of business firms (有利於健康的企業擴長)
• Increase value and efficiency (增加企業價值和效益)
• Move resources to optimal uses (資源使用最大化)

Opposed
• No improvements subsequent to the acquisition (無實際進步)
• Redistribution of wealth from labor and other stakeholders to shareholders (財富流出)
• Speculative activity (活動過於波幅)

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Basic Forms of Takeovers:
1. Merger—a combination of 2 firms such that only one survives (A+B → A or B)
• Negotiated deals
• No acquirer or acquired
• Both parties participate in establishing the management structure* (兩者共同管理)
• Both companies are sufficiently similar in size
• Mostly involves a share swap and very little, if any, cash changes hands

2. Consolidation (A+B → C )
• Same as mergers except that an entirely new firm owning the assets of both of the first two
firms is created

3. Acquisitions (A buy B → AB)

• Acquire by purchasing minority, majority, or entire interest of another firm
• Acquisition is either on a controlling interest in the company’s stocks, or a business operation
and its assets
• The acquirer’s name is usually retained
• Control and decision making rest almost entirely with the acquirer

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Acquiring a Listed Company

• Additional regulatory requirements of listing rules, takeovers codes, and securities laws have to
be complied with (需要遵守上市條例, 收購法案以及證券法例)
• May be subject to disclosure requirements and/or shareholders’ approval (需要對外公布 +尋求
股東同意)
• May start with a tender offer directly to bypass the target firm’s management and board (需要
提供收購意向書予目標企業的管理層)

Merger or consolidation

Acquisition Acquisition of stock

Acquisition of assets

Takeovers Proxy contest

Going private

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Common Motives

• Major reasons for buying

• Business opportunities
• Defensive reasons
• Financial opportunities
• Major reasons for selling
• To raise money
• An attractive offer price
• A wish to sell off non-core activities: HSBC sold PB(Japan) ; PE (Canada) ; Retail Banking
(Chile) ; Retail brokerage (Canada) ; Credit card business (US)
• A lack of funds to invest in developing the business
• National and state authorities sell businesses to private sectors
• Privatization

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Types of Mergers:

Horizontal Mergers : Two companies are in the same industries

Vertical Mergers:
- Two firms are in different stages of a given industry
- To secure a source of supply for key materials or services; or to secure a distribution
outlet or a major customer for the company’s products; or to improve profitability by
expanding into the high-margin activities of supplier or customers
Concentric Mergers:
- Two firms are related through basic technologies, production processes or markets,
aiming for expansion
Conglomerate Mergers:
- Two firms are in unrelated industries
- Product extension; Geographic market extension; Pure conglomerate

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Players and Benefits
M&As can be categorized into 2 groups:
• Industrial/strategic acquisitions
• The industry buyer is driven primarily by commercial considerations
• The benefits come from various kinds of synergies
• Financial acquisitions
• The buyer is driven primarily by financial reasons
• Financial investors benefit from companies undervalued or with growth potential

Investment Bankers

• Select and value the appropriate targets on behalf of the buyer

• Advise on strategies
• Arrange external financing
• Overall coordination
• Assist the preparation of a selling document on behalf of the seller

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Lawyers

• Perform legal due diligence

• Provide legal structure advisory
• Prepare legal documentation
• Obtain government approvals, if necessary

Accountants

• Perform financial and operational due diligence

• Perform financial projection and business evaluation
• Provide accounting and tax advisory services
• Identify appropriate representations, warranties and indemnification

Other Advisors

• Surveyors
• Environmental and technical experts
• Human resources experts
• Market/commercial consultants

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The Takeover Process

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Negotiation Process
• Necessary steps in a typical process
• Make initial approach
• Set up negotiation team
• Sign confidentiality letter
• Receive information memorandum from target
• Make indicative bid
• Identify areas for investigation in due diligence
• Carry out due diligence
• Make a firm offer
• Letter of Intent / MOU
• Disclosure of merger negotiations

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Offer Process (1)

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Offer Process (2)
• Special Committees of the BoDs
• To evaluate the merger proposal
• Legal counsel to guide it on legal issues
• Directors could be personally liable if the court thought that the decision-making process was
inadequate
• Fairness Opinions
• To retain an outside valuation firm to evaluate the transaction’s terms and price
• The evaluator should state what was investigated and verified and what was not
• Shareholder Approval
• They adopt a resolution approving the deal
• The deal is taken to the shareholders for approval. The exact percentage necessary for
approval depends on the articles of incorporation
• Official Approval
• The merger plan may have to be submitted to the relevant government official for further
approval

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 Minority Shareholders
• Holdout Problem (-)
• When the majority of shareholders approves the deal, minority shareholders are required to tender
their shares—said to be frozen out of their positions
• This is designed to prevent a holdout problem. That is, a minority attempts to hold up the
completion unless getting compensation over and above the acquisition stock price

• Appraisal Rights (+)

• Minority may go to court to pursue their shareholder appraisal rights
• If there is a lawsuit, the court may appoint an appraiser to determine the fair value

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Assumption of the Seller’s Liabilities
• Successor Liability
• The change in stock ownership does not free the new owners of the stock from the seller’s
liabilities (股權交易並不代表新買家可以免除於賣家的債務)
• The acquirer can avoid seller’s liabilities by buying only the assets rather than the stocks of the
target (可以單純購買其資產而非其股權)
• Substantial Asset Acquisition
• If a buyer purchases a substantial portion of the target's assets, the court may rule
• that the buyer is responsible for the seller’s liabilities― the trust funds doctrine
• that the transaction is a de facto merger

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Warranties and Indemnities

• the bidder might demand certain warranties and indemnities from the seller
• A warranty is a form of guarantee in which an undertaking is given by the vendor to the
purchaser. In the event that a breach of warranty occurs, and the promise has been broken,
the purchaser has to demonstrate that a breach has occurred that qualifies the purchaser
for damages/ compensation (可以尋找賣家賠償)
• An indemnity reinforces a warranty, and removes the responsibilities on the purchaser to
prove that a breach has occurred

Issues of indemnity
• Seller’s financial position
• Nature and scope of warranties and indemnities
• Disclosure letter
• Restrictions on when and how a claim can be made
• Minimum level of claim and a ceiling on amount receivable
• How to establish breach and make a claim
• Size of damages
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 Business Combinations
• Holding Companies
• The acquiring firm may choose to purchase only a portion of the target’s stock and act as a
holding company
• Joint Ventures
• Companies enter into an agreement to provide certain resources
• They would be shared among the venture partners
• Strategic Alliances/Partnership
• A flexible means of working together for varying periods of time to accomplish a specific goal
• This form has special benefits to growing firms

Leveraged Buyout / Management Buyout

• Acquisitions heavily financed by debt
• The acquired company becomes private as all its public equity is purchased
• If the acquirer is the management of the acquired company, it is referred as MBO
• Most LBOs are buyouts of small/medium-sized firms or divisions of large ones.
• KKR acquired RJR Nabisco for USD25.1b
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 Corporate Restructuring
• It usually refers to asset sell-offs
• Possible forms:
• Divestitures
• Spin-offs
• Possible reasons:
• Poor performance of the unit
• Financial emergency
• A change in the strategic orientation of the company

• Other forms of restructuring

• Corporate downsizing—cost and work force restructuring
• Financial restructuring
• Going private

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Merger arbitrage
• Arbitrage: zero-investment purchase of a security financed by sale of an identical security
at higher price
• Risk-free profit
• MA: risky due to occasional deal failure
• Specialize in bearing deal-failure risk

• Purchase target’s stock after merger announcement

• Typically trades at a small discount relative to consideration offered
• Reflects time value of money
• Possibility that merger might fail -> target stock often plummets

Deal spread
• Arbitrageur translates discount into annualized return rate
• Estimate deal failure probability
• Decide if spread compensates for time value of money and deal termination possibility
• If spread sufficiently large, buy target shares

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Opposite side of trade
• Investors receive a substantial windfall due to large value appreciation
• Face a choice
• Sell target stock
• Hang on to stock in order to obtain remaining premium
• Arbitrageurs sell insurance against deal failure to investors
• Compensate for bearing this transaction risk

Merger failure
• Agreements fall apart
• Aggregate market conditions
• Typically idiosyncratic (不尋常的)
• Government approval (reaction to the deal)
• Voting decision

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 U.S. Merger Movements

1922-1929 1981-1989
Second Merger Deal
Movement Decade

1900 1920 1940 1960 1980 2000

1895-1904 1960s 1992-2000

First Merger Conglomerate Strategic
Movement Movement Mergers

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Common Characteristics of Merger Movements
• Various environmental factors may contribute to merger movements
• Periods of high economic growth
• Favorable stock prices and financial conditions
• Technological change
• Input price volatility
• Legal and regulatory changes
• Financing innovations

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1895-1904: First Merger Movement
• Motivating factors
• Changes in economic infrastructure and production technologies
• Transcontinental railroads resulted in national market
• Innovations
• Economies of scale
• Availability of financiers and underwriters
• “Merging for monopoly”

• Success of mergers due to “astute business leadership” (Livermore, 1935)

• Technological and managerial improvements
• Development of new products
• Promotion of quality brand names
• Commercial exploitation of research

• Reasons for failed mergers (Dewing, 1953)

• Failure to modernize plant and equipment (無法令設備/設施現代化)
• Lack of flexibility due to large size (規模過大, 缺乏彈性)
• Inadequate supply of talent to manage large groups of plants (管理上人力資訊短缺)

• Causes of the end of the movement

• In 1901, merger activity began downturn as some combinations failed to realize gains (併購無法帶來有效收益)
• In 1903, economy went into recession (經濟進入衰退周期)
• In 1904, Supreme Court ruled against Northern Securities, establishing that mergers can be attacked by Section One of the
Sherman Act (併購受到Section one of the Sherman Act 管制)

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1922-1929: Second Merger Movement

• Motivating factors
• Product-extension
• Market-extension
• Vertical mergers
• Consolidation of fragmented industries
• “Merging for oligopoly”

• Critical innovations
• Transportation
• Communications
• Merchandising
• Vertical integration due to advantages from technological economies or from
reliability of input supply

• Economic slowdown beginning in 1929 ended the merger wave

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1960s: Conglomerate Mergers

• Decline in relative importance of horizontal and vertical mergers. At 1967-8 peak:

• Horizontal & vertical mergers declined to 17%
• Product extension mergers increased to 60%
• Market extension mergers were negligible
• Conglomerates increased steadily to about 23% of all mergers
• Typical acquiring firm
• Acquired firm characteristics
• Defensive diversification to avoid: (出現分散避險式保守型投資)
• Sales/Profit instability 避免利潤不穩
• Poor growth prospects 避免較差增長前景
• Adverse competitive shifts 避免過激的市場競爭
• Technological obsolescence 科技過時
• Examples:
• Aerospace industry
• Industrial machinery + autoparts
• Railway equipment, textiles, tobacco, movie distribution

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1960s: Conglomerate Mergers

• Other motives for mergers

• Some mergers reflected personality of chief executive resulting in noncore acquisitions
• Some conglomerates were formed to imitate earlier conglomerates that appeared to have
achieved high growth and high valuations (早期的異位擴張形成高估值高增長)
• Differential price/earnings (P/E) game (分散性的P/E)
• No sound conceptual basis — source of sell-offs in later years
• Rise of management theory
• End of conglomerate merger wave
• Antitrust laws (反壟斷法)
• Congress began to move against conglomerate firms in 1968
• Suits filed by the Department of Justice
• Punitive tax laws (懲罰性稅法)
• Tax Reform Act of 1969 limited use of convertible debt to finance acquisitions
• EPS calculated on fully diluted basis
• Declining stock prices

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 Characteristics of first 3 waves
• Relatively few mergers had market monopolization as their goal
• Economic prosperity and rapidly rising stock market
• Simply ordinary business transaction among entrepreneurs seeking to exit
• Massive changes in the economy’s infrastructure

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1981-1989: The Deal Decade
• Motivating forces
• Surge in the economy and stock market
• Impact of international competition on mature industries
• Unwinding diversified firms
• New industries as a result of new technologies and managerial innovations
• Rise of wide range of defensive measures as a result of increased hostile takeovers
• Financial innovations
• High yield bonds provided financing for aggressive acquisitions by raiders
• Emergence of leveraged buyout, MBO, private equity firms
• Financial buyers arranged going private transactions
• "Bust-up acquisitions"
• Buyers sought firms whose parts as separate entities were worth more than the whole
• Segments were divested
• Proceeds of sales were used to reduce the debt incurred to finance the transaction

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1981-1989: The Deal Decade
• End of fourth merger wave
• Government actions
• Highly publicized insider trading cases
• Passage of the Financial Institution Reform, Recovery, and Enforcement Act (FIRREA)
in 1989
• Indictment of Michael Milken and bankruptcy of Drexel Burnham
• Development of powerful takeover defenses
• Economic recession associated with Gulf War

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Mitchell and Mulherin (1996)
• Takeovers tend to cluster in time
• 50% of takeovers in a given industry cluster within two years
• Several industries did not exhibit time clustering

5th wave (1992-2000): Strategic Mergers

• Technological innovations
• Globalization
• Technological developments in transportation and communications
• Europe and other regions moving toward common markets
• Economic Environment
• Rising stock prices and P/E ratios
• Low interest rate levels
• New supranational trading blocs lowered barriers to trade and capital mobility
• Mature industries undergoing substantial restructuring
• Consolidation of fragmented industries by financial buyers and strategic buyers
• Moving towards core business started in 1980s to improve shareholder value

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5th wave (1992-2000): Strategic Mergers
Deregulation of numerous industries caused reorganization
• Method of payment
• Wide use of stock for stock transactions
• Less reliance on highly leveraged transactions
• Share repurchases
• Stock options
• Megamergers of the 1990s
• Top ten deals of the nineties totaled about $700 billion
• Size of M&As in relation to level of economic activity
• In the eighties, M&As represented less than 4% of GDP
• For period 1993-2000, M&As represented about 9% of GDP
• In 1999, M&As represented 15% of GDP

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 Mergers Since 2000
• Steep decline in dollar value and number of M&A transactions
• Weak economic recovery
• Corporate fraud and dismal record of active acquirers
• Outlook for M&A activity
• M&As represent industry/firm adjustments to change forces – opportunities in some
sectors
• Financial buyers still find opportunities for turning around depressed situations
• Full recovery of M&A activity requires growing economy and rising stock market

6th wave: 2003-7

• Private equity acquirers
• Benevolent economic environment with enormous liquidity + low interest
• Hedge funds emerged as important players
• Shareholder activists: attacks on corporate managements
• 7th wave: 2014-2021 peaking?

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 Timing of Merger Activity
• Empirical evidence does support merger waves
• Generalizations on major merger movements
• Each movement reflected some underlying economic and/or technological changes
• Some common financial factors associated with high levels of merger activity
• Rising stock prices
• Low interest rates
• Narrow risk premium

Industry Clustering in M&As

• 1920s : 5 of 25 industries represented 2/3 merger activities
• 1980s : over 2/3 companies in telecommunication, petroleum producing & aircraft has been
acquired ; 50% mergers appear within 2 years
• 1990s : Half of 1300 sample firms are acquired ; mostly focus on banking & telecom. ;
divestitures occur commonly due to deregulation

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Strategic implications
• Not all shocks are exogenous
• Relation of shocks and takeovers is not linear
• Through mergers to escape current industry structure
• Industry boundaries are blurred in the case like internet and media
• Some industries undergo turbulent restructuring
• Copy-cat moves going on

• Deregulation, mergers, and performance

• Data indicates deregulation has led to greater capacity utilization, lower firm costs and
reduced consumer prices
• Deregulation is usually followed by increased merger activity
• Deregulation results in significant internal corporate reorganization
• Study of 1990s bank mergers showed to increase combined wealth of bidder and target
shareholders by 3.5%

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Merger waves
• Cause of industry wave: regulatory and economic shocks accompanied by capital liquidity
• Cause of aggregate wave: multiple simultaneous industry waves clustering because of
macro liquidity factor
• Cash partial-firm acquisitions: ↑ during waves and are made by stock bidders

• Pre-wave returns and P/B ratios are high

• Dispersion in pre-wave returns is normal
• Post-wave returns are normal
• Measures of tight credit is low
• Post-merger operating performance is similar/better in waves

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International Perspectives
• M&A activity in other developed countries of the world has usually paralleled the U.S.
• Similar levels of merger activity
• Similar industry clustering
• Underlying factors
• Internationalization of markets
• Globalization of competition
• Privatization achieves similar results to deregulation
• Antimerger laws and regulations are generally loosening internationally

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In Class Exercise
• On August 23, 2023, Firm A agreed to a takeover offer by Firm B to acquire each outstanding
share of Firm A’s stock in exchange for $8 in cash plus 0.675 of a share of Firm B. At the close of
trading on the merger agreement date, Firm A’s share was $17.72 and Firm B’s share price was
$14.56. The merger was expected to be completed by September 14, 2023. At the time, the 3-
month Treasury Bill rate was 1.75% p.a. Professional arbitrage fund managers were receiving
short selling stock proceeds interest rebates (100% of margin deposit) at 1.5% p.a. Yet they had
to pay stock commission costs of 3 cents per share. What is the expected annualized percentage
return should the merger arbitrage fund manager undertake this investment?

• Concept :
B is going to takeover A
1. $8 exchange in cash + 0.675 of a share in firm B ( 0.675*14.56 = 9.828) = 8 + 9.828 = 17.828
2. Consider the takeover = $17.828 and the original price of A = $17.72
3. Arbitrage is built by long the share of A ($17.72) and short sell takeover ($17.828) to earn the
difference of $0.108
4. Consider commission expense = 0.03*1 (long original stock A) + 0.03*0.675 (Short takeover) =
0.05025
5. Consider Interest Rebate by short sell = 0.675*14.56*1.75%*22/365 (time count) =0.0089
6. Base of M&A transaction = 17.828 – 0.108 – 0.05025 + 0.0089 = 17.76135
7. Yield = 0.0666 (Net from diff. + interest + commission) / 17.76135 = 0.3752%
8. Annualized yield = (1+0.3752%)^(365/22) – 1 = 6.4098%
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