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Professor Tong Yu's slides

  1. 1. Mergers & Acquisitions 1. Values from M&A 2. The practice 1. Takeover effects 2. Anti-takeover devises 3. Other concepts 3. Valuation methods1 L8: M&A
  2. 2. 2 L8: M&A
  3. 3. Definitions  Mergers: the absorption of one firm by another  Acquisition of stocks -- tender offers  Bidder offer  Acquisition of assets – a form mal vote of shareholders of the selling firm is required. Avoid the hold-out problem  Proxy contest: designed to gain minority representation on or control of a board of directors. Typically initiated by a financial agitator.  Going-private transactions – LBOs or MBOs3 L8: M&A
  4. 4. Objectives and Considerations • To achieve cost savings through economies of scale (sharing central services such as legal, accounting, finance, and executive management) and reduction of redundant assets (real estate, corporate jets, etc.) • Before entering into a transaction, companies typically compare the costs, risks and benefits of an acquisition or merger with their organic opportunity • This buy versus build analysis is an important departure point for a company as it begins to think about a transaction. Is it better to build a brand, geographic coverage, distribution network, installed base of products or services, and relationships, or is it better to acquire them? • The inverse decision – whether to sell – is an analysis that asks whether the benefits of continuing to operate an asset is a better risk-adjusted option than monetizing the asset (for cash or stock of the acquirer)4 L8: M&As
  5. 5. Synergy from a M&A Synergy VAB (VA VB ) T CFt Synergy t t 1 (1 r ) CFt Re vt Costt Taxest Capital Re quirementt • cost synergies • revenue synergies • control premium: the percentage difference between the price an acquirer will pay to purchase control of a target company compared to the price for owning a minority share (non control) position • The purchase price premium (to the target’s current share price) in an acquisition is determined based on consideration of synergies and control premium5 L8: M&A
  6. 6. Sources of Synergy  Revenue enhance  Marketing gains  Strategic benefits  Market or monopoly power  Cost reduction  Economies of scale  Economies of vertical integration  Complementary resources  Elimination of inefficient management  Tax Gains  Net operating losses  Unused debt capacity  Surplus fund  The cost of capital6 L8: M&A
  7. 7. Principal Constituents • Shareholders: concerned about valuation, control, risk and tax issues • Employees: focus on compensation, termination risk and employee benefits • Regulators: must be persuaded that anti-trust, tax and securities laws are adhered to • Union leaders: worry about job retention and seniority issues • Credit rating agencies: focus on credit quality issues • Politicians: they get involved if constituent jobs and tax base are at risk • Equity research analysts: focus principally on growth, margins, market share and EPS • Debt holders: consider whether debt will be increased, retired, or if there is potential for changing debt values7 L8: M&A
  8. 8. Credit Ratings, Taxes and Acquisition Currency  Companies must attempt to balance the credit rating, tax and EPS impact of an M&A transaction  Paying cash as an acquisition currency often requires borrowing, creating leverage  A credit rating downgrade may occur if the transaction creates too much leverage, resulting in a higher cost of debt capital, but a potential reduction in weighted average cost of capital  If the acquisition currency is shares of the acquiring company’s stock, credit ratings will not likely be downgraded, but the acquirer’s EPS may drop, often resulting in a share price reduction  Shares used as consideration may be preferred by target company shareholders in order to delay capital gains taxes8 L8: M&A
  9. 9. Regulatory Considerations  There are local, regional, national and international anti-trust and other regulatory considerations in M&A transactions  Approvals required from regulators depend on the size of the transaction, location of the business and the industries of the participating companies  In the U.S., most public transactions require a Hart-Scott-Rodino (HSR) filing with the Federal Trade Commission and the Department of Justice  There is a 30-day waiting period after filing  If there are international operations, filing with the European Commission (EC) or with antitrust regulators in other countries may be necessary9 L8: M&A
  10. 10. Strategic Buyers vs Financial Buyers  Private equity firms (also called LBO firms, buyout firms or financial sponsors) are considered financial buyers because they usually do not bring synergies to an acquisition  Strategic buyers are generally competitors of a target company and will benefit from synergies when they acquire or merge with the target  As a result, in auctions conducted by investment banks for target companies, strategic buyers are usually able to pay a higher price than the price offered by financial buyers10 L8: M&A
  11. 11. Fairness Opinion • Investment bankers are usually asked to render a fairness opinion to the respective boards of companies involved in an M&A transaction • The opinion is made publicly available and it states, among other things, that the transaction is ―fair from a financial point of view‖ • A fairness opinion is not an evaluation of the business rationale for the transaction, a legal opinion or a recommendation to the board to approve the transaction • The fairness opinion includes a summary of the valuation analysis conducted by the investment bank to show the basis on which the opinion is offered • Companies must decide whether it makes sense for the same investment bank that provides the fairness opinion to also act as the M&A advisor (since advisory fees are only paid if the transactions is deemed to be fair)11 L8: M&A
  12. 12. M&A Hostile Defense Strategies  Shareholder rights plan (poison pill)  White Knight bidder  Management Buyout (MBO)  Stagger board  Delay annual shareholder’s meeting  Trigger acceleration of debt repayment  Litigation12 L8: M&A
  13. 13. Shareholder Rights Plan  The key feature of a shareholder rights plan involves implementation of a ―poison pill‖, which gives non-hostile shareholders a right to purchase additional shares in the company at a substantial discount (usually 50%)  The result of the exercise of this right is that hostile shareholder ownership percentage declines as ―friendly‖ shareholder ownership increases  This dilution of hostile ownership economically compels the hostile party to give up, negotiate a higher price, or launch a proxy contest to gain control of the target company’s board and then rescind the poison pill  A shareholder rights plan usually does not require a shareholder vote and often has a 10-year maturity13 L8: M&A
  14. 14. White Knight Bidder  The first type, the white knight, refers to the friendly acquirer of a target firm in a hostile takeover attempt by another firm. The intention of the acquisition is to circumvent the takeover of the object of interest by a third, unfriendly entity, which is perceived to be less favorable. The knight might defeat the undesirable entity by offering a higher and more enticing bid, or strike a favorable deal with the management of the object of acquisition.  The second type refers to the acquirer of a struggling firm that may not necessarily be under threat by a hostile firm. The financial standing of the struggling firm could prevent any other entity being interested in an acquisition. The firm may already have huge debts to pay to its creditors, or worse, may already be bankrupt. In such a case, the knight, under huge risk, acquires the firm that is in crisis. After acquisition, the knight then rebuilds the firm, or integrates it into itself.14 L8: M&A
  15. 15. Stagger Board  Only a fraction (often one third) of the members of the board of directors is elected each time instead of en masse (where all directors have one-year terms). Each group of directors falls within a specified "class‖, hence the use of the term "classified" board.  In publicly held companies, staggered boards have the effect of making hostile takeover attempts more difficult. When a board is staggered, hostile bidders must win more than one proxy fight at successive shareholder meetings in order to exercise control of the target firm. Particularly in combination with a poison pill, a staggered board that cannot be dismantled or evaded is one of the most potent takeover defenses available to U.S. companies.  Institutional shareholders are increasingly calling for an end to staggered boards of directors—also called "declassifying" the boards. The Wall Street Journal reported in January 2007 that 2006 marked a key switch in the trend toward declassification or annual votes on all directors: more than half (55%) of the S&P 500 companies have declassified boards, compared with 47% in 200515 L8: M&A
  16. 16. Sell Side Transactions and Methods Alternative Sell-Side Processes Divestiture Description # of Advantages Disadvantages Circumstances Strategy Buyers Preemptive • Screen and identify most 1 • Efforts focused on one • Unlikely to maximize • Have very clear sense of likely buyer buyer value most logical buyer • Maximum confidentiality • Tied to result of one • High risk of damage from • Speed of execution negotiation business disruptions • Minimum business • Have strong negotiating disruption position Targeted • High-level approach to 2 to 5 • Speed of execution • Requires substantial • Have limited group of Solicitation selected potential buyers • Confidentiality maintained top-level management logical buyers • Customized executive • Limited business time commitment • Have key objectives of summary-type presentation disruption • Risks missing confidentiality and • No pre-established • Sense of competition interested buyers limiting any business guidelines or formal process enabled • May not maximize disruption • No public disclosure value Controlled • Limited range of logical 6 to 20 • Reasonably accurate test • Lack of confidentiality • Seek good balance Auction potential buyers contacted of market price • May “turn off” logical between confidentiality • Requires formal guidelines • High degree of control buyers and value on sale process over process • Potential for disruption • No public disclosure • Creates strong sense of due to rumors competition Public • Public disclosure made N/A • Most likely to obtain • May limit subsequent • Believe business is Auction • Preliminary materials highest offer options if process fails unlikely to be damaged by distributed to wide range of • Finds “hidden” buyers • Highest risk of business public process potential buyers disruption • Have difficulty identifying potential buyers16 L8: M&A
  17. 17. Break-up Fee  A break-up fee is paid if a transaction is not completed because a target company walks away from the transaction after a merger agreement or stock purchase agreement is signed  This fee is designed to discourage other companies from making bids for the target company since they would, in effect, end up paying the breakup fee if successful in their bid  A reverse breakup fee is paid if the acquiring company walks away from a transaction after signing the agreement  These fees are usually set at 2-4% of the target company’s equity value, but this is the subject of negotiation17 L8: M&A
  18. 18. Corporate Restructurings • Carve-out: the sale through an IPO of a portion of the shares of a subsidiary to new public market shareholders in exchange for cash • Spin-off: parent gives up control over a subsidiary by distributing subsidiary shares to parent company shareholders on a pro-rata basis • Split-off: parent company delivers shares of a subsidiary to only those parent shareholders who are willing to exchange their parent company shares for the shares of the subsidiary18 L8: M&A
  19. 19. Risk Arbitrage • In a stock-for-stock acquisition, some traders will buy the target company’s stock and simultaneously short the acquiring company’s stock, creating a ―risk arb‖ position • The purchase is motivated by the fact that after announcement of a pending acquisition, the target company’s share price typically trades at a lower price in the market compared to the price reflected by the Exchange Ratio that will apply at the time of closing • Traders who expect that the closing will eventually occur can make trading profits by buying the target company’s stock and then receiving the acquiring company’s stock at closing, creating value in excess of their purchase cost • To hedge against a potential drop in value of the acquiring company’s stock, the trader sells short the same number of shares to be received at closing in the acquiring company’s stock based on the Exchange Ratio • Risk arb trading puts downward pressure on the acquiring company’s stock and upward pressure on the selling company’s stock19 L8: M&A
  20. 20. Risk Arbitrage (cont.) Median Arbitrage Spread 35 30 Arbitrage Spread (%) 25 20 Failed Deals 15 10 Successful Deals 5 0 125 115 105 95 85 75 65 55 45 35 25 15 5 Number of Trading Days Until Resolution This chart plots the median arbitrage spread versus time until deal resolution. The arbitrage spread is defined to be the offer price minus the target price divided by the target price. For failed deals, the deal resolution date is defined as the date of the merger termination announcement. For successful deals, the resolution date is the consummation date. Source: Mitchell, Mark L. and Todd C. Pulvino. “Characteristics of Risk and Return in Risk Arbitrage.” Journal of Finance 56: 2135-2176.20 L8: M&A
  21. 21. Risk Arbitrage (cont.) Expected Return for Cash Merger Expected Return = [C*G-L(100%-C)]/Y*P Where: • C is the expected chance of success (%) • G is the expected gain in the event of a success (usually takeover price – current price) • L is the expected loss in the event of a failure (current price – original price) • Y is the expected holding time in years (usually the time until the acquisition takes place) • P is the current price of the security Example: Company A makes a tender offer at $25 a share for Company B, currently trading at $15. The deal is expected to close in 3 months. The stock of Company B immediately increases to $24 • C = 96% • G = $1.00 • L = $9.00 ($24-$15) Exp. Return = [0.96*$1 - $9*(1 – 0.96)]/(0.25*$24) = 10% • Y = 25% (3/12 months) • P = $2421 L8: M&A
  22. 22. Shareholder Activism Shareholder Activism • Some corporations are vulnerable to hostile initiatives by activist shareholders • Hedge funds can be vocal investors who demand change in the corporate governance landscape in a number of ways: o Publicly criticizing/challenging Boards and managements o Nominating Board candidates and pursuing their agenda through proxy contests o Supporting other activists • Hedge funds’ activist strategy has been successful by taking advantage of: o Like-minded hedge funds’ herd mentality o Ability to overcome reputation for short-term focus o Ability to skillfully use a deep arsenal of securities and financial instruments o Familiarity with M&A and legal regulations and rights o Readiness to go to battle and devote significant resources to full-blown public relations battles Source: Morgan Stanley22 L8: M&A
  23. 23. Shareholder Activism (cont.) Comparison of All Hedge Fund Returns vs. Activist Hedge Fund Returns, 2005 – 2008 Annualized total return, % 26.3% 17.8% 9.3% 5.0% 2.7% 4.2% All hedge funds (HFRX Global Hedge Fund Index) -23.3% Activist hedge funds (HFRX Activist Index) -30.8% 2005 2006 2007 2008 Source: Hedge Fund Research, Inc.23 L8: M&A
  24. 24. Valuation Methods Summary of Valuation Methods Publicly Traded Comparable Comparable Discounted Cash Flow Leveraged Buyout Companies Analysis Transactions Analysis Analysis Analysis Other Description • “Public Market • “Private Market • “Intrinsic” value of • Value to a financial buyer • Sum-of-the-parts analysis Valuation” Valuation” business • Value based on debt • Liquidation analysis • Value based on market • Value based on multiples • Present value of repayment and return on • Break-up or net asset trading multiples of paid for comparable projected free cash flows equity investment value analysis comparable companies companies in sale • Incorporates both short • Historical trading • Applied using historical transactions and long-term expected performance and projected multiples • Includes control premium performance • Discounted future share • Does not include a • Risk in cash flows and price control premium capital structure • Dividend discount model captured in discount rate Comments • Similarity of companies • Limited number of truly • The preferred valuation • Usually represents a floor • May be more situational (size, growth prospects, comparable transactions technique when credible bid because of lack of and not as relevant as a product mix) • Dated information due to cash flows can be synergies and high cost broad-based valuation • Placement within peer changes in market projected and confident of capital and high technique group • Data missing or hard to in WACC determination required return (IRR) • Near-term EPS impact • Underlying market / find (earnings often • Sensitive to terminal • Requires various may not reflect true sector trading unavailable on subsidiary value assumptions assumptions on capital value fluctuations transactions) structure • Market may view firm’s • May not be a viable outlook differently option due to size or type • Valuing synergies, tax of business benefits problematic24 L8: M&A
  25. 25. Valuation Summary M&A Valuation Summary (Football Field) Bid Range Comparable Companies Comparable Transactions DCF DCF + Synergies LBO Break-Up Current Price 30-Day Moving Avg. 52-Week High/Low $34 $36 $38 $40 $42 $44 $46 $48 $50 $5225 L8: M&A
  26. 26. Comparable Companies Analysis  A comparable companies valuation analysis compares similar publicly trading companies using multiples  Comparable companies are in the same industry and have similar growth, profitability, size, capital structure and margin characteristics  The key multiples used for comparison are:  Enterprise multiples: EV/Revenue; EV/EBITDA and EV/EBIT  Equity multiples: EPS; Market Value/Book Value; PE/Growth Rate (PEG ratio)  This analysis values a non-controlling ownership in comparable companies and does not include any synergy26 considerations L8: M&A
  27. 27. Using Multiples in Valuation  Multiples based analysis incorporates key accounting concepts and financial information in the process of valuing of companies  Comparable Companies analysis and Comparable Transactions analysis are the two principal multiples based valuation methodologies  Enterprise Value (EV) = a company’s total economic value, which is shared by holders of equity, debt, preferred stock and minority interest  To determine EV, calculate market value of equity, debt, preferred stock and minority interest and then deduct cash and cash equivalents  Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is important to determine since it and EBIT are often used in multiples calculations: EV/EBITDA and EV/EBIT  Earnings Per Share (EPS) and Price Earnings (PE) are also important multiples used in valuing companies27 L8: M&A
  28. 28. Comparable Transactions Analysis  A comparable transaction analysis compares historical M&A transaction values for companies in the same industry that have similar growth, profitability, size, capital structure and margin characteristics  This valuation assumes that the acquirer obtains control (usually 51%- 100% ownership of the target), so a control premium and synergies are included in the purchase price  The principal multiples used in this analysis are similar to the multiples used in a comparable companies analysis  To determine value/share for enterprise multiples based valuation methodologies, use the following formula:  Value/share=[EV-debt-preferred stock-minority interest+cash] divided by total (fully diluted) shares outstanding28 L8: M&A
  29. 29. Discounted Cash Flow (DCF) Analysis  This analysis determines the intrinsic value of a company. DCF analysis determines EV for a company by calculating the present value of a) projected unlevered (not including financing costs) future cash flows and b) projected terminal value  Present value is typically calculated by using a discount rate equal to the weighted average cost of capital (WACC)  levered beta  The quality of this analysis depends on the accuracy of cash flow projections and the assumptions used in determining WACC and terminal value29 L8: M&A
  30. 30. Levered beta and WACC If debt beta is 0, then This is WACC. rs is determined by equity beta.30 L8: M&A
  31. 31. Example (1)  Consider a firm whose debt has a market value of $40 million and whose stock has a market value of $60 million. The firm pays a 15-percent rate of interest on its new debt and has an asset beta of 1.41. The corporate tax rate is 34%. Assume that the SML holds, that the risk premium on the market is 9.5 percent, and that the current Treasury bill rate is 11 percent. Answer the following questions:  What is debt beta?  What is equity beta?  What is WACC?31 L8: M&A
  32. 32. Example (2)  Assume a company has been growing at a rate of 10% for 5 years and then drops to 3% per year and remains constant indefinitely. Its total cash flow in the past year was $5 million and required rate of return is the WACC we got from Example (1). What is the total value of the stock?32 L8: M&A
  33. 33. Leveraged Buyout (LBO) Analysis  This valuation analysis is used only if the company being valued has characteristics that make it an interesting target for a Buyout fund  These characteristics include: strong and predictable cash flow, clean balance sheet with room for leverage, limited need for future capital expenditures, quality assets that can be used as collateral for loans, cost cutting opportunities and a viable exit strategy in 3-7 years  Buyout funds target an IRR (compound annual return) of more than 20% and determine the highest price they can pay such that this return is achieved as of the assumed exit date  Buyout funds will not be competitive bidders if the maximum price they can bid that achieves their minimum IRR return target is substantially less than the price that strategic buyers will bid33 L8: M&A
  34. 34. Comparing LBO and DCF Analysis LBO Analysis and DCF Analysis DCF Analysis LBO Analysis • Projected Cash Flow • Projected Cash Flow Inputs • Terminal Value • Terminal Value (Sale Price) • Discount Rate • Present Value (Purchase Price) Creates Creates Enterprise Value IRR Outputs (Present Value) (Discount Rate) Source: Castillo, Jerilyn and Peter McAniff. The Practitioner’s Guide to Investment Banking, Mergers & Acquisitions, Corporate Finance. Circinus Business Press, 2007.34 L8: M&A
  35. 35. Other Potential Valuation Analysis  Sum of the parts analysis (break-up analysis) is a useful additional valuation tool when a company has many different businesses that, when analyzed separately and then added together, are worth more than the value of the company as a whole  In this analysis, EV for each separate business is calculated based on comparable transaction multiples (multiplying EBITDA for each business by the relevant comparable company multiple) to determine the total EV for the target company when the EVs for each business are added together  Other valuation methodologies may be appropriate for certain industries, including an analysis of acquisition premiums in comparable transactions35 L8: M&A