The Financing for Leveraged Buyouts
There are two general categories of debt used in Leveraged Buyouts. The secured and unsecured debt are the two general categories. Both of these are often used collectively. In this article, we will talk about financing for leveraged buyouts and how these two categories play a part.
Two General Categories of Debt
Secured Debt
Secured Debt, or also known as asset-based lending, may also contain two subcategories of debt. These are the intermediate-term debt and senior debt.
These two categories may also be considered as one in some smaller buyouts. However, when it comes to larger deals, secured debt may have several layers. These layers vary according to the term of the debt and the types of assets used as security.
Unsecured Debt
We also have unsecured debt. This is also referred to as subordinated debt and junior subordinated debt. From the name itself, unsecured debt lacks the protection a secured debt has.
However, unsecured debts generally carry a higher return, this offset the additional risk for some. To the debt financing is added an equity investment.
Depending on the market condition, the percentage of the total financing that the equity component constitutes may also vary. However, it usually is between 20% to 40% range.
Sponsors or the dealmaker will usually work with providers of financing or investment banks in every leveraged buyout. It is the investment bank’s job to conduct due diligence and the proposed deal. Once they are finished doing their due diligence, the bank will decide if the deal meets the criteria, and they will present the deal to the banks they work with.
High-yield Bond
Additionally, the lead investment bank may also decide to conduct a presentation for the different prospective lenders. The presentation will show the bank’s analysis and the reasons why they think the lenders should feel secure providing capital to finance the deal.
Moreover, to develop more interest in an offering of high-yield bonds, a similar process may also be conducted. This is often done for high-yield bonds that may be part of the overall deal financing structure.
Oftentimes, these presentations are preceded by the distribution of a preliminary offering memorandum. The memorandum must be related to the bond offering. SEC approval is usually needed before the memorandum can be finalized. Otherwise, the bonds are forbidden to be offered publicly.
Banks will often provide a commitment letter first if they agree to provide debt capital to the deal. The commitment letter will put forward the stipulation of the loans.
There are also instances where banks choose to hold some of the debt in their own portfolio. Usually, this is done when the banks are still seeking commitments from different financing sources. The banks will then syndicate the rest of the debt.
Where Does Debt Capital Come From?
Most of the time, debt capital comes from two different main sources. On one hand, we have banker lenders who may choose to provide different types of loans or amortizing term loans.
These banks vary from commercial banks, finance companies, savings and loan associations, and more. On the other hand, debt commitments with longer-term usually come from institutional investors. These include insurance companies, hedge funds, pension funds, and more.
There will be times when one group can be seen providing different types of capital in different deals. Moreover, some parts of debt capital may even come from bond issuance.
A bond issuance may require the investment bank to provide a bridge loan. This is done so it can close the time gap between when all the funds are needed to close a deal and when the bonds can be sold in the market.
LBO Debt Financing
Moving on to leveraged buyouts debt financing, there are also two broad categories. One is the senior debt, and the other is the intermediate-term debt.
Loans that are secured by liens on particular assets of the company are what senior debts consist of. The collateral includes physical assets which maybe land, plants, and other equipment. This collateral provides the downside risk protection required by lenders.
Senior debt can have five or more years of terms. It also comes in various forms. Of course, it varies according to the nature of the target’s business and the type of collateral it can provide.
A senior debt may also constitute between 25% and up to 50% of the total financing of a leveraged buyout. The interest rates are usually between the 2% to 3% prime plus. Commercial banks, investments, and other institutional investors like insurance companies, finance companies, and mutual funds are the typical sources of this. The term is usually between 5 to 10 years.
Keep in mind that even though bank debt is the least costly form of debt, it also comes with maintenance covenants most of the time. These maintenance covenants often impose financial restrictions on the life of the loan.
Usually, bank debt is priced above some variable base market rate. A great example of this would be LIBOR or the prime rate. How much higher usually depends on the borrower’s creditworthiness.
Other Senior Debt Revolving Credit
Additionally, the company may also have access to a revolving credit in a leveraged buyout. The revolving credit may be secured by short-term assets. These short term assets may include but not limited to inventory and accounts receivable.
The company may also need to pay a variable rate that is pegged to some base rate. For instance, the crime rate in the prime plus a certain percentage. Additionally, revolving credit can also be repaid. It can also be reborrowed depending on the company’s agreement with the lender.
Usually, this form of credit is used to deal with seasonal credit needs. Its relevance often is contingent on the nature of the business. It is the sponsor’s choice to arrange a revolving credit line with a bank. This, in turn, may syndicate it with other banks.
Usually, the borrower is required to pay a commitment fee when it comes to these types of credit lines. This fee will give the borrower access to the credit even if it is unused.
However, if the credit is used, then the borrower is also required to pay the interest rate. Usually, the revolving credit line is secured by some specific assets. Oftentimes, it has a term of five years.
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Hubris Hypothesis of Takeovers
Roll proposed a fascinating hypothesis about takeover motives. He believed that hubris has a role in explaining takeovers. It refers to the pride of the administrators in the acquiring firm. This hypothesis states that administrators and managers want to acquire firms for their self-interest and that the pure economic advancement to the acquiring firm is not the only intent or even the dominant motive in the acquisition.
Along with other researchers, Roll used the hypothesis to understand the reason behind managers paying a lot for a firm that the market has already valued. Managers would rather lay their own valuation over one that is accurately and objectively determined by the market.
According to them the pride of the management lets them believe that their own valuation is a cut above the markets. This hypothesis implicitly shows that the efficient market can provide the best indicator of the firm’s value. But many wouldn’t believe this. Here are some pieces of evidence
Empirical Evidence of Hubris Hypothesis
Various studies over a quarter of a century show evidence of the hubris hypothesis explaining many takeovers. Early research aimed to know if the advertisements of deals caused the target’s price to increase, the acquirer’s to decrease, and a mix of the two to result in a net negative effect.
Early Research
A study by Dodd concluded that statistically significant negative returns to the acquirer after the announcement of the planned takeover. Other studies have similar results, although there are others that demonstrate the opposite. For instance, Paul Asquith failed to find a consistent pattern of declining stock prices following the announcement of a takeover.
There is more proof of positive price effects for target stockholders who experienced wealth gains after takeovers. In a study by Bradley, Desai, and Kim, tender offers led to gains for target firm stockholders.
Greater changes should be produced by the hostile nature of tender offers in the stock price than friendly takeover offers. But most studies show that target stockholders gain following both friendly and hostile takeover bids.
Bidders tend to overpay, according to a study by Varaiya. The relationship between the bid premium and the combined market values of the bidder and the target was examined. The results demonstrated that the premium paid by bidders was too immense relative to the worth of the target to the acquirer.
The hubris hypothesis is not supported by the analysis of the joint impact of the uphill movement of the target’s stock and the downhill movement of the acquirer’s stock. This was done by Malatesta and the findings showed that that the long-run sequence of events culminating in the merger has no net impact on the combined shareholder. However, it could be said that Malatesta’s failure to find positive combined returns does support the theory.
Later Research of Hubris Hypothesis
The hubris hypothesis is supported by later research in a different way. Hayward and Hambrick used a sample of 106 large acquisitions. In the sample, they found that CEO hubris positively associated with the sum of premiums paid.
The company’s recent performance, the CEO self-importance, and other variables were used to measure hubris. They also took into account the independent variables, as the CEO inexperienced according to the years in the position, along with board vigilance, as measured by the number of inside directors versus outside directors.
Takeover Theory of US Firm
Other research provides support for the theory for the takeover of U.S. firms by foreign corporations. Seth and Song used shareholder wealth effect responses similar to those proposed by Roll in a sample of 100 cross-border deals from 1981 to 1990. The researchers found that hubris, along with synergy, managerialism, and other factors play a huge role in these deals. role. Managerialism is somewhat similar to hubris, in that both may involve overpaying for a target.
Managerialism is kind of similar to hubris since both entail overpaying for a target. The former, however, considers that the bidder’s management knowingly overpays so as to pursue their own gains even if it comes at the expense of their shareholders to whom they have a fiduciary obligation. In a study by Malmendier and Tate, the role that overconfidence played in the deal was examined using a sample of 394 large companies.
They measured overconfidence by the tendency of CEOs to overinvest in the stock of their own companies and their statements in the media. Results showed that doing acquisitions was 65% more likely for the overconfident group of CEOs in their sample. They also determined that these CEOs were more likely to make lower-quality, value-destroying acquisitions.
Acquisition History
In another study by Billett and Qian further studied. This using the acquisition history of 2,487 CEOs and 3,795 deals over the years 1980–2002. CEOs with a positive experience with acquisitions were more likely to pursue acquisitions. The net purchases of their company’s own stock were higher. Before the next series of deals than they were before the first deals. This result was interpreted as the CEOs being overconfident and attributing the success of the original deal to their own managerial abilities and superior insight.
CEOs Aktas, de Bodt, and Roll presented that overconfident and hubris-filled CEOs were more likely to do deals quickly and there is less time between their deals. Where the CEOs who had done more deals in the past tended to act faster and have less time between their deals. This learning effect is complementary to other studies of the same authors.
Aktas, et al.’s’ study and other research showed that the cumulative abnormal returns of serial acquirers. Therefore, it is a decline as a function of the number of acquisitions they do. For instance, some researchers, indicate hubris since the CEOs still pursue deals. In other words, it produces much lower returns to shareholders. Others, however, opine that the declining returns could just be a function of less productive opportunities available in the marketplace. Although this is justifiable, it still seems that the CEOs. Who are hubris-filled should avoid pursuing an acquisition program. When the returns fall below some certain targeted return.
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Conflicts of Interest in Management Buyouts
It is common for conflicts of interest to occur when it comes to management buyouts. Managers have the job to maximize the value of investment of stockholders and give them the highest return possible. They also have the job to present an offer to stockholders to buy the company. This is the case when the management of RJR Nabisco gave an offer to stockholders to take Nabisco private in a management buyout.
This offer was quickly supplanted by a contending offer made by KKR and other responding offers from management. Why did the management choose to advocate an offer that it knew was not in the interests of their stockholders if their actual goal is to maximize their investments? Researchers hypothesize that managers cannot serve in these dual and conflicting roles as agents for buyers and sellers.
MBOs can be more successful than LBOs because better access to information about the profitability of the company is given than an outside buying group has. When managers decide to pursue a management buyout, they can opt to secure the financing themselves. With the aid of their investment bank, or they can work with a private equity firm that offers to finance.
Earnings Management
“Earnings management” is another important issue and potential conflict before a management buyout occurs. It typically involves a meticulous process of changing financial reports. This is done to mislead shareholders about the organization’s elemental performance. Sometimes. It is also done to prompt contractual results that usually depend on reported accounting numbers.
If the managers are interested in buying a company from the shareholders, they could have an incentive. That will lower their reported profitability to pay less for the acquisition. In Perry and Williams’ analysis of 175 management buyouts between the years 1981-1988. They found evidence that discretionary accruals were manipulated. These were done in the predicted direction in the year prior to the public announcement of the MBO.
The researchers also developed a control sample where matched firms for each bought-out company were chosen. There is an association between accruals like increases in depreciation expenses or decreases in noncash working capital with a reduction in income in the MBO group. These results show a cause for concern and extra carefulness.
One proposed answer for these contentions is neutralized casting a ballot. Whereby the defenders of an arrangement don’t take part in the endorsement procedure. If the defenders or proponents are stockholders, then their votes will not be counted in the approval process. They might be allowed to participate in the voting because it goes by the law.
Important Steps to Reduce Conflict
The next step is usually the appointment of an independent financial advisor to render a fairness opinion. This helps reduce contentions in terms of interests. Regardless of whether these precautionary steps are embraced, specific practical considerations may restrict their viability. And even if the members of the board of directors who may profit from the LBO may not vote for its approval. Other members of the board with close relationships to them may consider themselves required to support the deal.
Stockholders’ lawsuits for suing directors for breach of fiduciary duty have placed limits on this tendency. The investment bankers who have put fairness opinions forward may also have much business with management. Or may have a financial interest in the deal, leaving them of questionable value.
Even if these steps are important in trying to reduce the conflicts inherent in the management buyout process. One solution that has been proposed is to have mandated auctions of corporations presented with an MBO.
US Court on LB Conflicts
Current case law states that directors are not permitted to favor their own bid over another once the bidding has started. This prohibition was set forth by different court decisions, such as in Revlon, Inc. versus MacAndrews & Forbes Holdings, etc. In this case, the Delaware Supreme Court ruled that the directors of Revlon breached their fiduciary duty in granting a lockup option to white knight Forstmann Little & Co. The court ruled that this constituted an unfair bidding process that favored Forstmann Little & Co. over hostile bidder Pantry Pride.
In another example of Hanson Trust PLC v. SCM Corporation, the Second Circuit Court had the same position regarding the use of lockup options to favor an LBO made by Meryll Lynch instead of a hostile bid by Hanson Trust PLC. Hanson Trust had initially made a tender offer for SCM at $60 per share. In response to Merrill Lynch’s LBO offer at $70 per share, Hanson Trust upped its bid to $72.
According to the Court, SCM gave preferential treatment to Merrill Lynch by granting lockup options on two SCM divisions to Merrill Lynch. The board of directors will usually respond by creating a special committee of independent when they are faced with a management proposal to take the firm private.
Meanwhile, nonmanagement directors have the job to ensure that shareholders receive fair, if not maximal, value for their investment. The committee may then choose to have its own valuation produced, hire an independent counsel, and conduct an auction.
Post-Buyout Managerial Ownership
It should be noted that even when the management is the buyer of the business, outsiders still provide other equity. So they cannot be in full control of the post-buyout business. This is dependent on the amount of equity capital needed and how much capital the managers have and are willing to invest in the deal.
In a study by Kaplan, he used a sample of 76 management buyouts over the period of 1980–1986 and compared the median pre-buyout and post-buyout share ownership percentages of the CEOs and all management. The results of the study show that these percentages rose from 1.4% and 5.9% to 6.4% and 22.6%, respectively.
Management ownership more than tripled after the buyout. In theory, the managers are required to be better motivated considering their much higher ownership interest. This will help ensure that the company moves closer to efficiency levels that can help them maximize their profit.
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Leveraged Buyouts
In the corporate world, there are plenty of techniques you can use as a part of your merger and acquisition tactic. One of the most well-known financing techniques is a Leveraged Buyout of an LBO.
So, what exactly is a leveraged buyout? This refers to a financing technique that a variety of entities uses. Many, including corporations, individuals, investment groups, management of corporations, partnerships, and so on use LBOs as a tactic.
About Leveraged Buyouts
Leveraged Buyout is the process of using debt to purchase the stock of a corporation. Most of the time, this involves taking a public company private. The level of interest rates and the availability of debt financing are some of the few factors that affect an LBO’s popularity.
In the years between 2004 and 2007, there were plenty of low-interest rates that prevailed. These helped explain why there are a lot of large LBOs that happened in that same period.
Additionally, from 2008 to 2009, we have seen a lack when it comes to debt financing at a time when interest rates were low. These occurrences help explain the big falloff in numerous deals during those years.
When the economy recovered from 2010 to 2017, there was an increase in debt financing availability. This was mainly due to the fact that there were large amounts of liquidity that were provided by expansionary monetary policy. However, lenders were also cautious at this time. So they weren’t ready nor willing to fund all types of deals that they did before the subprime crisis happened.
Leveraged Buyout Terminologies
Usually, there is a lot of overlap when it comes to LBOs and going-private transactions. What does a going-private deal mean? This refers to a public company that goes private. There are also times where it is referred to as a public-to-private transaction or PTP.
Transactions like PTP are financed with some equity and some debt. It is also important to remember that a debt-financed buyout can be done of a non-listed, that is, not-public firm.
LBO Deal
Now, this deal can also be called an LBO when, and only when, the bulk of the financing comes from debt. These deals are also referred to as bootstrap transactions back in the 1960s and 1970s.
Additionally, there are also deals that are called institutional buyouts. Institutional buyouts are when the owner of the formerly public company is a private firm or other financial institution.
On the other hand, there are also deals that are referred to as management buyout or MBO. MBO happens when a company sells a business unit, or sometimes even the entirety of a company to a management group.
The majority of these transactions involve a public company divesting a division. In doing so, the public company sells it to the unit’s management as opposed to an outside party. These types of deals are usually referred to as unit management buyouts.
Lastly, deals may also be referred to as a leveraged buyout when managers rely heavily on borrowed capital to finance the deal. You see, this is where the significant overlap in the terms come in. There are so many gray areas between the terminologies used to describe these transactions.
Leveraged Buyouts Early Origins
So, how did leveraged buyouts came to be? Well, this terminology became popular in the 1980s. However, long before that, the concept of a debt-financed transaction where a public company goes private was already around.
Take the Ford Motor Company as a great example of an LBO. In 1919, Henry Ford and his son Edsel grew tired of having to answer to shareholders. The main reason was that the founder of the auto company and the shareholders have different opinions regarding important matters such as dividends policy.
Henry Ford’s solution was to borrow what was considered to be an astronomical sum of money at the time to take the company private. Keep in mind that this is the world’s largest automobile company. Henry and Edsel purchased the company’s shares from the shareholders for $106 million. This roughly converts to $1.76 billion dollars today.
$75 million of those $106 million was borrowed from a collection of East Coast banks including Old Colony Trust, Bond & Goodwin, and Chase Securities of New York. Additionally, Ford also wanted to be free to manufacture and sell their Model Ts ever-decreasing prices.
This means that they would have to reinvest the profits they make back to the company instead of distributing them to shareholders. The shareholders have a mixed reaction to this.
Ford Strategic Plan
Some shareholders, such as the Dodge brothers were happy to cash out their shares. They were planning on using their capital to expand their own auto company that will clash with Ford later.
There were also some investors who wanted higher profits. But of course, this means that Ford needed to sell their automobiles at higher price points. That wasn’t part of Henry Ford’s plans at the time.
He was focused on making Ford automobiles that were affordable and attainable for the average American. To do this, he needed to continually lower his prices. Hence, he decided to take his public company private.
Ford Downhill Solutions
Interestingly enough, there were also problems that befell the LBOs of the fourth merger wave (which we will discuss in the next article) that affected Ford. Years after Ford went private, the United States economy experienced a downhill which affected Ford.
During 1920-1921, the automobile company incurred a cash crunch. This worried a lot of people that the company may no longer be able to service the huge debt load it had taken on in the buyout.
However, Henry Ford responded with a smart strategy by temporarily halting production. This was followed by layoffs and measures to cut their costs.
Not only that, but Ford also had other alternatives at his disposal. He exercised his rights in his agreements with Ford dealers and sent them the mounting inventory of cars, even though they didn’t necessarily have a need for them.
In return, this required the dealers to pay for the cars and dealers from all over the United States headed out for financing. At the end of the day, this gave Ford Motor Company the cash infusion it needed to resume production.
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Management Entrenchment Hypothesis versus Stockholder Interests Hypothesis
Over the past years, antitakeover measures have changed and reached new levels of hostility. And it was accompanied by different innovations as well. These measures can be divided into two, preventative and active measures. To reduce the possibility of a financially successful hostile takeover, there are preventative measures put in place.
On the other hand, there are also what’s referred to as active measures. These active measures are employed only after a hostile bid has already been attempted.
There are two different types of preventative antitakeover measures. This includes poison pills. This type of preventative antitakeover measure refers to the securities issued by a potential target. This is done so the firm would look like a less valuable venture in the eye of a hostile bidder and corporate charter amendments.
Management Entrenchment Hypothesis
The management entrenchment hypothesis proposes that non-participating stockholders have less wealth. When management takes actions to deter attempts to take control of the corporation. This concept states that corporate managers aim for the maintenance of their positions by using active and preventative corporate defenses. This theory also asserts that stockholder wealth declines due to a firm’s stock reevaluation by the market
Stockholder Interests Hypothesis
Meanwhile, the shareholder interest hypothesis is also referred to as the convergence of interest hypothesis. It states that stockholder wealth rises when management takes actions to prevent changes in control. It is considered a cost-saving when the management needs not devote resources to preventing takeover attempts. This also shows that antitakeover defenses can be utilized for making the most out of shareholder value through the bidding process. Management can assert that it will not withdraw the defenses until it gets an offer that is in the shareholder’s interests.
Effects on Wealth of Interest Hypothesis
The wealth effects on shareholders of the different antitakeover defenses. Both preventative and active, are analyzed in the lenses of the two competing hypotheses. If the installation of given antitakeover defense results in a decline in shareholder wealth, then it lends support to the management entrenchment hypothesis. But if shareholder wealth increases after the defense have been implemented, the shareholder interests hypothesis gains credence.
Support Research Interest Hypothesis
In a study by Mork, Shleifer, and Vishny, the validity of the two opposite hypotheses were examined separately from a consideration of antitakeover defenses. They took into account the entrenchment of managers as well as other important factors like management’s tenure with the company. personality, and their status as a founder.
Other factors like the presence of a large outside shareholder or an active group of outside directors were also considered. It also examined the relationship between Tobin’s q, the market value of all a company’s securities divided by the replacement costs of all assets. As a dependent variable, and the shareholdings of the board of directors in a sample of 371 of the Fortune 500 firms in 1980. Results show that Tobin’s q rises as ownership stakes rise. While a positive relationship was not uniform in that it applied to ownership percentages between 0% and 5%. Same to those above 25%, a negative relationship applied for those from 5% to 25%.
This positive correlation except for those between 5% and 25% supports the shareholder interest hypothesis. Because the higher the ownership percentage, the higher the entrenchment. This, then, whose association with higher values of securities except for the intermediate range of 5% to 25%. The researchers did not provide enough evidence of the shareholder interest hypothesis. But recent support by Straska and Waller shows how companies with low bargaining power can improve their position and shareholders’ potential gains through antitakeover.
The Right to Resist in the US vs Other Countries
Much leeway in resisting hostile bids provided by US laws to the boards of directors of US companies. Under the law, boards can resist as part of what they consider as their fiduciary responsibilities. However, there is a different situation in other countries. Other areas like Great Britain, the Eurozone, and Canada have laws that are more shareholder rights-oriented. And also boards are more limited in the defensive measures they are able to take. The laws here are more in favor of offers being made to shareholders directly and letting them decide. Meanwhile, in the United States, the laws let directors exercise their right to dictate what is best for shareholders. When boards are too close to entrenched managers, this can work against shareholders’ interests.
Takeover Defenses Life Cycle effects
The estimation of takeover protections frequently changes over the life of a firm. In the initial post-IPO years, takeover protections can solidify the bond between the company and significant partners. For instance, Johnson, Kang, and Yi report that 65% of IPO firms report at least one enormous customer.
In a study of over 2000 companies from 1997-2011 by researchers Johnson, Karpoff, and Yi. It was found that on average, firms had 2.42 defenses in place at the time of the IPO. However, this average increase at 0.67 defenses during the next 10 years that followed. The results also show that 90% of the companies in their sample never removed any of these defenses over this time. This means that such defenses are “sticky”. They also noted in their study that early in the companies’ public lives. The takeover defenses implemented were related to firm value increases. Meanwhile, the opposite was the case in a public company’s life later on. This may imply that such defenses might outlive their value as public companies age.
Preventative Anti Takeover Measures
These kinds of antitakeover measures are very typical in America. In fact, most of the fortune 500 companies have considered. And developed a plan of defense in case the company becomes a target of a hostile bid. It can be used as an action of the potential target. This means having a defensive strategy developed and a defense team selected, such as an outside law firm. Investment bankers, proxy solicitors, and a public relations firm. This group ideally meets and outlines strategies they will implement in case of an unwanted bid. This strategy should be revisited based on changes in the M&A arena as well as other changes, such as industry M&A trends.
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Do Managerial Agendas Drive M&A
Managers of firms have their personal interests, and these may be different from the other company. For managers and CEOs, this may be for the purpose of extending their stay in their position. They may also have a managerial agenda of continuing to receive what in the United States are bountiful compensations and perks. This compensation in the form of money is on top of the income they receive from being the “Big Cheese”.
In a study by Morck, Shleifer, and Vishny, 326 acquisitions over the period 1975-1987 were analyzed. The researchers found that bad deals were due to the aims of these managers doing the deals. Three types of acquisitions were found to cause lower and usually bad announcement period returns. These were diversifying M&As, acquiring a rapidly growing target, and acquiring a company when the managers have a poor performance track record before the deals. The results regarding diversification are also proof that this strategy is debatable. But their result about growing targets may reflect the fact that it is hard to “buy growth,” and when you do, you might have no choice but to overpay.
Their results with regards to bad managerial track records are also intuitive. Managerial performance may worsen if you are bad at running a business. And then you add to it and increase the managerial demands. Managers may be good at managing a specific type of focused business. Allowing them to perform in fields that they aren’t knowledgeable of may cause a tragedy. On the other hand, senior management at companies that have always been diverse since the start. Like GE is in the business of managing very diverse industries. These abilities in management are their skill set.
Vivendi and Messier’s Hubris
One relevant example in this topic is Vivendi and Messier’s Hubris. There was a case study about a stodgy French water utility before it was named Vivendi Universal. The CEO of the French water utility aimed to be a high-flying leader of an international media company. But he sacrificed shareholders’ interests to do so. The shareholders picked up the tab and he walked away with too much of their money when they failed. The combination of water and entertainment assets were so poor that they lost 23 billion euros in 2002, and 13.6 billion in 2001.
According to reports, Messier, the CEO was not satisfied with his position. He didn’t want to be the CEO of a water utility company. Instead, he engaged in major acquisitions of entertainment companies so he can become an entertainment CEO.
In the year 2000, Messier bought Seagram Universal. This resulted in him giving the major shareholders 8.9% of the Vivendi company or 88.9 million in shares.
This signaled Vivendi’s invasion in the media industry by acquiring a company which was a combo of liquor and soft drinks. Messier bought Seagram Universal as this company was formed by the acquisition engineered by young Edgar Bronfman when he took an authority position at Seagram. To finance its ventures into the entertainment industry, Edgar Bronfman used the assets and cash flow of the Seagram family business. This arrangement experienced its own rough period as the film business ended up being not as energizing to Seagram’s investors as it was to the youthful Mr. Bronfman.
Vivendi Universal Entertainment
Messier also bought Canal Plus and Barry Diller’s USA Networks which failed. This arrangement united the Universal Studios Group with the diversion resources of the USA Networks to shape what they called Vivendi Universal Entertainment. He paid 12.5 billion euros for Canal Plus despite the limitations, debts, and the company not being profitable. He even purchased a portion of Cegestal, a French telephone organization. Likewise, the organization bought Houghton Mifflin, a book distributor, for $2.2 billion, which included $500 million underwater. Vivendi also owned an equipment division that held U.S. Filter Corporation.
Messier moved to New York in 2001 and was filled with hubris. He concedes that this is a normal trait of a CEO. He said that a strong ego is more becoming, although each has his own wearing. Vivendi began to rack up the losses and shareholders and creditors called for an end of the acquisition binge and the ouster of its CEO. The company started the slow process of disassembling the media. And utility that Messier built under a new management team of Chairman Jean-Rene Fourtou and CEO Bernard Levy. The new management went back to being profitable and stable.
Winner’s Curse Hypothesis of Takeovers
Winner’s Curse was first coined by three engineers at Atlantic Richfield who discussed auctions for oil drilling rights and the bidding challenges for assets whose true value is difficult to estimate. Those who succeed in the bid can be cursed by putting forward a winning bid that exceeds the value of the assets. Thaler has shown how the winner’s curse works in different situations, even in mergers and acquisitions.
The curse of takeovers is most likely won by bidders because they are more likely to pay more and outbid contenders who are more accurate in value. This is a natural outcome of any biding competition. One of the more public forums where this usually happens is the free-agent markets of sports like baseball and basketball. In a study by Varaiya, he used 800 acquisitions from 1974 to 1983 and found that on average gains by as much as 67%. Overpayment is considered the difference between the winning bid premium. It demonstrates the existence of the winner’s curse, which then supports the hubris hypothesis.
The Bad Bidders, The Good Targets
In a study of 1, 158 companies, Mitchell and Lehn analyzed their control transactions. From 1980 to 1988 found that companies that make acquisitions show that takeovers are both a blessing and a curse. Those that reduce market value may be bad deals. Assuming the market accurately assess them, and this is the challenge. However, the deals market may take care of the problem through another takeover of a “bad bidder.” When the negative market impact of bad deals is considered. Then it is clear that good acquisitions should have a positive effect on share values. While bad deals should cause the stock price of the acquirers to decline behind the market.
It is a good thing that there is evidence where the corporate governance process may resolve the poor performance of the bad acquirer CEOs. This is proven by a study of 390 firms over the period 1990-1998 by Lehn and Zhao. The researchers found that there is an inverse relationship between the returns of acquiring firms and the possibility that the CEOs would be fired.
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Diversification
Diversification refers to a process where a company grows outside its current category. Diversification assumed a significant job in the acquisitions and mergers. That occurred in the third merger wave, also known as the conglomerate era. In the 1960s, huge numbers of firms that developed into conglomerates. Were dismantled through different spin-offs and divestitures in the 70s and 80s. This procedure of de-conglomeration raises genuine questions with regards to the estimation of enhancement dependent on expansion.
Some companies gained significantly, while others didn’t. For instance, General Electric (GE) has not been just an electronics-oriented company despite the name. Through acquisitions and divestitures, the firm has gotten an expanded aggregate. With activities in protection, financial administrations, TV channels, plastics, clinical gear, and many more. Their profit rose significantly during the 80s and 90s when the firm was gaining and stripping multiple organizations. The market reacted well to these diversified acquisitions by following the rising pattern of earnings.
Diversification and the Acquisition of Leading Industry Positions
One of the many reasons why GE has been successful in diversifying is because of the types of companies it has acquired. General Electric looked to get leading positions. In which the different industries in which it claimed businesses. Leading is usually deciphered as the first or second position as indicated by market shares.
GE and other acquiring firms believe that leading positions like number one or two give a more dominant position. Offering more advantages over the smaller competitors. These advantages can show themselves in various manners. Such as a more extensive consumer awareness in the marketplace as leading positions in distribution. Corporations in secondary positions like number four or five, may here and there be at such an impediment. That it is hard for them to produce positive returns. Candidates for divestiture include companies within the overall company framework. That does not hold a leading position and those that don’t have reasonable prospects of cost-effectively acquiring such a position. The discharged resources obtained from such a divestiture would then be able to be reinvested in different companies. That is to exploit the advantages of their prevailing position or used to obtain leading companies in other ventures.
Dynamic Market
Considering that markets are dynamic, a business can be in an attractive industry and be a leader. In which a decade only to see the industry contract in response to changes in the market. Therefore, diversified companies should always examine their constituent units. And know if a business that used to be leading can still generate a return that’s consistent with the parent company’s goals. This evaluation process was experienced by GE in recent years. And shed many units, like consumer finance and media businesses. But in 2015, it acquired the energy business of Alstom SA in a return to the industrial orientation of the GE of the old.
Diversification to Enter More Gainful Industries
Management sometimes chooses to diversify. And expand because of their desire to enter more profitable markets than the acquiring firm’s current industry. The parent company’s industry may have reached maturity or that the competitive pressures within that industry preclude the possibility of raising prices to a level where extranormal profits may be enjoyed.
Profitable industries may not stay in the same profitable state in the future. Competitive pressures serve to achieve a development toward a drawn-out equalization of rates of return over industries. This obviously doesn’t imply that the paces of return in all industries at any second in time are equivalent. The competition that moves industries to have equivalent returns are balanced by restricting powers, for example, industrial development, that causes industries to have to change paces of return. Those with returns that are above average without imposing barriers to entry will have declining returns until they reach the cross-industry average.
In the long run, as implied by economic theory, those industries that are difficult to enter are the only ones that will have above-average returns. This means that diversifying to enter more profitable industries will not be successful after some time. The growing firm will be unable to enter those businesses that show better than expected returns due to obstructions that forestall entry and might have the option to enter just the industries with low barriers. When entering low-barrier industries, the growing company might be required to compete against other entrants who were attracted by the temporarily above-average returns and low barriers. The increased number of competitors will drive down returns and cause the expansion strategy to fail.
Benefits of Conglomerates
Various studies are skeptical of the risk-reduction benefits of conglomerates, although there is evidence that shows the wealth effects of conglomerates positively. For instance, Elger and Clark show that the returns stockholders get in conglomerate purchases are far better compared to those in non-conglomerate acquisitions. They examined 337 mergers from 1957 to 1975 and found that conglomerates offered superior gains compared to non-conglomerates. It also showed gains not just for the buyer, but for the seller firms as well. These significant gains are cataloged by stockholders of the firms who are selling, and the conservative gains are for buying company stockholders.
This was similar to a later study by Wansley, Lane, and Yang, who examined 52 non-conglomerates and 151 conglomerates. This research found that returns to shareholders were bigger in horizontal and vertical acquisitions than in chain acquisitions.
Diversification Discounts
In a study by Henri Servaes in the 1960s, a comparison between Tobin’s qs of diversified and those that were not diversified showed no evidence that diversification may increase corporate values. However, he found that Tobin’s qs for diversified firms were significantly lower than those for multi-segment companies. Other research has discovered that the diversification discount was not confined to the conglomerate era. A study by Berger and Ofek used a huge sample of firms over the 1986–1991 sample period and found that diversification came about in lost firms that averaged between 13% and 15%.35. This investigation assessed the imputed value of a diversified firm’s segments as though they were separate firms. The results show that the loss of firm worth was not influenced by the firm but was less at the point when diversification happened in the related industries.
The loss of firm value was buttressed by the fact that the diversified segments showed lower profitability than single-line businesses. They also showed that the diversified firms invested too much in the diversified segments than single-line businesses, meaning overinvestment may be a reason for the loss of value related to diversification.
Other Sources Influence Diversification
Lang and Stulz tracked value-reducing effects of diversification through a sample of over 1000 companies. They concluded that greater corporate diversification in the 1980s was inversely related to Tobin’s q of these firms. This supports Berger and Ofek’s study, showing that diversification often lowers the value of firms.
On the other hand, Villalonga believes that the diversification discount is just an artifact of the data used by these researchers. According to him, the data used by these researchers were artificially restricted by the Financial Accounting Standards Board definition of segments, as well as requirements that only segments that makeup 10% or more of a company’s business are required to be reported.
Using a source that is not influenced by the issue, Villalonga finds a diversification premium than a discount. This entangled issue can be complicated. It is also difficult to draw expansive speculations about diversification that apply universally.
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Financial Synergy
The next topic in our Merger Strategy chapter is all about Financial Synergy. The financial synergy is all about the impact of a business merger or acquisition on the costs of capital to the acquiring firm or the combined partners.
The costs of the capital may be decreased significantly depending on the level to which financial synergy exists in a corporate merger. Now, you may ask yourself if the benefits of a specific financial synergy are reasonable. This is a matter of discussion among corporate finance theorists.
The Effect in Terms of Debt Coinsurance
As previously mentioned, the merger of the two firms may reduce risk. But this is only if both firms’ cash flow streams are not perfectly tied in. The suppliers of capital may view or consider the firm less risky if the acquisition or merger lowers the volatility of the cash flows.
Presumably, the risk of a firm getting bankrupt will significantly decrease. This is because of the fact that there will be fewer chances of wild ups and downs on the merged firm’s cash flow. This was explained in detail by Higgins and Schall. They called this effect in terms of debt coinsurance.
For instance, the risk of getting bankrupt that’s associated with the merging of the two firms will be significantly reduced if this result has no general agreement, too. Now, there is a chance that one of the firms could experience certain conditions or circumstances that will force them into bankruptcy. It can be a little bit tricky to know ahead of time which one of the two firms will experience bankruptcy.
That also means that creditors may suffer a loss should one of the firms fail. However, let’s say that both firms were merged ahead of certain financial problems. There is a chance that the excess cash flow of the solvent firm can cushion the decline in the other firm’s cash flow.
Now, in order to prevent the combined or merged firm from falling into bankruptcy. The offsetting earnings of the firm that is in good condition should be sufficient. This will also be helpful when it comes to preventing the creditors to suffer losses.
Debt-Coinsurance Effect
Like with most things in life, there is also a downside to this debt-coinsurance effect. The downside is that the benefits accrue to debtholders at the expense of the equity holders. Remember, these debtholders gain by holding debt in a much less risky firm.
In their observation, Higgins and Schall noted that these gains come at the expense of stockholders. These stockholders are the ones who lose in the acquisition. According to Higgins and Schall, the total returns or the RT that can be provided by the merged firm are constant. Now, if the bondholders (RB) are provided with more of these returns, then the returns must come at the expense of stockholders or (RS). Check the formula below:
RT = RS + RB
Moreover, Higgins and Schall maintain that the debt-coinsurance effect does not make room for any new value. However, it does redistribute the gains amongst the providers of capital to the firm. This result has no generic understanding, too.
For instance, Lewellen has concluded that stockholders gain from these types of mergers or firms’ combinations. However, there is a lot of other research that fails to indicate that the debt-related motives are relevant for the conglomerate acquisitions as opposed to the non-conglomerate acquisitions.
Research Studies
There are also a lot of studies that have proven the existence of a coinsurance effect on bank mergers. In their research, Penas and Unal examined 66 bank mergers. This research looked into the effects of these deals on 282 bonds.
In their research, Penas and Unal found positive bond returns for both targets that are approximately at 4.3%, and for acquiring banks at 1.2%. Some would argue that this is because larger banks may be too big to fail. And that plays a large role in this because regulators would not want to allow a larger bank to fail outright. These regulators would step in to offer their assistance instinctively.
In another research, Billet, King, and Mauer looked into the wealth effects for both the target and acquirer returns. They looked at these wealth effects in the 1980s and 1990s. This particular research concluded that the target company bonds that were below investment grade right before the deal. It received substantially positive returns on the duration of the announcement.
The Debt Equity Ratio
On the other hand, they discovered that the purchase of company bonds received negative returns from the announcement time. More importantly, Billet, King, and Mauer have found that these announcement period returns were far greater in the decade of the 1990s as opposed to the 1980s. These results provide further more proof and support for the coinsurance effect.
Higgins and Schall also showed that the losses of the stockholders may be offset through the means of issuing a new debt after the merger. In return, the stockholders may gain through the tax savings on the payments of debt interest. This result was greatly demonstrated by Galai and Masulis.
The debt-equity ratio of the post-merger firm will also be increased because of the additional firm. It was increased to a level that stockholders must have found good, or at least acceptable, before the merger.
The firm also becomes a higher risk-higher return investment because of the higher debt-equity ratio. As previously mentioned, there will come a point when a company may experience economies of scale through acquisitions.
Production Cost
Usually, these economies are thought to come from production cost decreases. These are attained by operating at a higher capacity level. Similarly, these can also be attained through a reduced sales force or a shared distribution system. These acquisitions may result in the possibility of financial economies scale in the form of lower flotation and transaction costs.
A larger company also has certain advantages that can possibly lessen the firm’s cost of capital in financial markets. This means larger companies enjoy the advantage of better access to financial markets. Another advantage is that they tend to experience lower costs of raising capital. Because it is considered less risky than a smaller firm. This means that the costs of borrowing by issuing bonds are significantly less because a larger firm would be able to issue bonds offering a lower interest rate than a smaller company.
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Operating Synergy
Synergy is often used in the physical sciences. If two substances or influences combine to create a much greater impact together. What we refer to as synergy is the reaction to that merger. The effect of the merger must be greater than the sum of both factors or substances operating independently.
In business, synergy is simply the 1 + 1 = 3 effect. It is where the whole is greater than the sum of its part, so when two or more people or organizations combine their efforts.
As a result, firms are able to incur the expenses of the acquisition process. At the same time, the firms will also be able to provide a premium for the target shareholder’s shares.
Operating Synergy
Now let’s dive deeper into what operating synergy means. Think of it this way, there are two firms that are looking to merge together. If both firms are able to achieve greater value and performance while they merge. They also increase their operating income. This also means higher growth for both firms instead of what they achieve when both firms are apart. That is what operating synergy is. This comes from gains that increase revenues or lower costs, although the former is more challenging to attain. However, as it is with most things in life, gains like these are easier in paper than in real life.
Revenue-Enhancing Operating Synergy
As mentioned, this type of synergy can be a lot more challenging to attain. For instance, in one study, McKinsey revealed that approximately seventy percent of mergers fail to reach or attain their goal or expected revenue synergies.
This can come from sources like pricing power, a combination of strengths, and growth from faster-growth markets. When two companies combine, this may result in greater pricing power. Or purchasing power if both are in the same business. Its possibility of being achieved is dependent on the degree of competition in the industry and relevant geographic markets, as well as the size of the merger partners. This may be attained in terms of pricing power if the combination leads to a more oligopolistic market structure.
Oligopoly
What is an oligopoly? It is a state of limited competition. This means that a market may be big or small, but it is only shared by a limited number of producers, suppliers, and sellers.
The combination of functional strengths is another source of revenue enhancement. This can be possible if, for example, one company has strong production abilities while the other has great marketing and distribution. One merger partner could contribute something that the other lacks.
Another potential source of revenue enhancement is higher-growth new markets. In mature markets, corporate growth slowed in Japan and Europes. Large companies needed to invest greater amounts to increase market share or sometimes to merely maintain what they have. But they can also move into rapidly growing markets as a faster way to realize meaningful growth.
Aside from M&A-related increase in revenue being difficult to achieve, M&A-related losses in revenues may also be difficult to avoid. Larger companies are usually avoided by customers of the target. But when the bidder pays a premium for the target, the profitability of its total revenues was likely used to compute the total price. The deal can be a loser if revenues are lost, that’s why an examination of why simplistic projections of deal gains must be carefully done.
Cost-Reducing Operating Synergy
Cost-reducing synergies, according to merger planners, tend to be the main source of operating synergies as revenue enhancement is more difficult to achieve. Economies of scale, or the decreases in per-unit costs, are the cause of cost reductions. When the operation of a certain company or business increases in either size or scale, the result is what we call economies of scale.
Firms that operate at a high per-unit cost for low levels of output are typically manufacturing firms, especially capital-intensive ones. Their fixed costs of running their manufacturing factories are spread out over lower scales of output.
Take note that spreading overhead is the term for when the per-unit costs decline as their output levels rise. An increase in the specialization of labor and management is also another source of these gains, as well as the more efficient use of capital equipment. However, it may not be probable to use capital equipment at such low output levels. As firms experience higher costs and other issues related to the coordination of a large-scale operation, diseconomies of scale may arise. The extent to which these exist is controversial for economists.
For instance, there are those who argue indications of firms that have displayed continued periods of growth while still paying stockholders sufficient return on equity. On the contrary, some economists believe that these companies would be able to give stockholders a greater rate of return if they were smaller, more competent companies.
Mergers & Acquisitions
There are several examples of mergers and acquisitions motivated by the pursuit of scale economies in the cruise industry. One great example of this would be the 1989 acquisition of Sitmar Cruises by Princess Cruises, and the 1994 merger. It is between Radisson Diamond Cruises and Seven Seas Cruises. This acquisition allowed them to offer a wider range for their product line. It allowed them to produce more ships, beds, itineraries while reducing the costs.
There are many pieces of evidence that show the success of M&As in achieving operating economies. In a study done by Lichtenberg and Siegel, they noted the progress in the capability of plants. That had been through adjustment in ownership.
Additionally, they noted that the plants that had the worst performance were the ones most likely to undergo a change in ownership.
Another study by Shahrur analyzed the returns around 563 announced horizontal mergers and tender offers between 1987-1999. He found that there are conclusive combined bidder/target returns. And interpreted that these findings mean that the market saw these deals as to imply that the market saw the deals as better options. Despite these studies, one should not assume that mergers are always the best way to attain such economies.
Economy Scope
Lastly, the economies of scope are the ability of a certain firm to use a set of inputs to provide ample options when it comes to products and services. This concept is closely related to economies of scale. The baking industry is one great example of scope economies. One factor that affected the consolidation within the industry that occurred on the fifth merger wave is the pursuit of these economies.
A meaningful reduction in costs can also be a result of the combination of two companies that yield enhanced purchasing power. One example can be seen in InBev’s acquisition of Anheuser Busch and Mittal’s consolidation of steel producers.
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Is Growth or Increased Return the More Appropriate Goal?
Without a doubt, the achievement of growth is a company’s management and board’s major goal. However, it must be guaranteed by managers that growth is also what would generate good returns for shareholders. Sometimes, management should keep their company at a stable size while generating good returns, but choose to go with aggressive growth instead. Boards should always determine whether the growth is worth the cost by examining the expected profitability of the revenue derived from growth.
The Hewlett-Packard Case
For instance, Hewlett-Packard made a questionable $19 billion mega-acquisition of Compaq in 2002. And managed many business segments in which it was a leader in only one. In 2009, the company had revenues over $114 billion. If it had the goal of, say, 10% per year. Then it needs to make about $11 billion in new revenues annually. That said, it still needs to create another large company’s worth of revenues every year to meet the growth goals. Take note that Compaq itself used to acquire Tandem Computers in 1997 and Digital Equipment in 1998. And the case happened post-Fiorina era. Growth can be a huge difficulty when much of its business comes from highly competitive personal computer markets. With its weak margins coupled with steady product price deflation.
After the departure of Fiorina, many failed acquisitions continued to occur in the company, and with Mark Hurd at the helm, HP acquired EDS. The corporation tried hard to catch AT&T for the position of “world leader” in M&A failures. This was followed by an $8 billion write-down, and HP acquired Autonomy in 2011 for $10 billion, with Leo Apotheker as CEO. Later on, an acquisition-related charge was done for $8.8 billion. In 2013, however, HP acquired data storage giant EMC. HP started growing and the market got fed up, deciding it had enough. Later on, it got divided into two, the PC and printer business called HP, Inc., and the services and data unit called HP Enterprise. While the former remained competitive, the latter had been experiencing declines in revenues. Although the enterprise believes it has more potential for growth.
Cross-Border Takeovers
As the word indicates, cross-border activities include interactions between two separate countries, we may, therefore, assume that cross-border mergers and acquisitions. Those transactions in which the target business and the acquirer business originate from different countries of origin. Cross-border acquisitions are a tremendous boost to the regional market for companies with already popular products. They have been a great way to achieve more profits and revenues, even more, convenient than pursuing further growth within their own nation. This is because pursuing growth within the country may potentially diminish their returns. While cross-border acquisitions let them enter a new market. This kind of deal lets acquirers use the country-specific know-how of the target, as the indigenous laborers and distribution network. Many factors encouraging cross-border deals include financial market globalization and market conditions. Also consider the foreign competition, technology shares and the aim of profitably rising.
The main concern here is if the risk-adjusted return from the acquisition is bigger than what can be achieved. With the next best use of the capital that is invested. It’s the same question in every other acquisition.
The European Common Market helped reduce cross-country barriers, giving rise to a spate of cross-border deals in the continent. Asian markets, however, continue to be resistant to foreign acquirers. But it is said that cross-border deals in this region. And it will be less than what it will be in the future if and when the artificial market restrictions be more relaxed. There are actually signs that this is changing.
Challenges with Cross-Border Acquisitions
Despite the potential of cross-border acquisitions, it poses some challenges that domestic deals lack. First, a business model doesn’t always work in two different countries. For example, Target failed to expand in Canada. They thought that Canadian tourists in the US liked to shop at Target and it was a sign to expand into the country. But in 2015, target only closed its 133 Canadian stores two years after the expansion strategy. Another challenge is linguistic barriers. This may pose a challenge not only in the initial negotiations but in the post-deal integration. Physical distance is also an obvious challenge that they may face as this will surely require more managerial demands.
Comparative Study
Just like with any type of acquisition, it is important to consider the reaction of the market to international M&As and compare them to domestic deals. In a study by Doukas and Travlos, they found that unlike many domestic acquisitions. Acquirers enjoyed positive returns when they acquired targets in countries in which they did not previously have operations. Returns are usually negative when the acquirers already had operations in these foreign countries. Investors may be less sanguine about the gains that may be realized through an increased presence in the same region when the company is already in the market.
In another comparative study by Cakiki, Hessel, and Tandon. It is found that non-U.S. acquirers generated statistically significant returns of just under 2% over a 10-day window. Whereas the U.S. acquirers realized the negative returns that we often generally see from acquisitions.
On the other hand, Markides and Oyon used a sample of 236 deals, compared US acquisitions of European ones and US acquisitions of Canadian targets. Results showed found positive announcement effects for acquisitions of continental European targets but not for acquisitions of British or Canadian target firms. The same negative shareholder wealth effects for acquisitions of Candian firms were also discovered in a study by Eckbo and Thorburn. Where they used 390 sample deals that involve Candian companies over the period of 1962-1983.
In these studies, it can be concluded that non-US targets by US companies can be riskier than deals involving all-US targets. This issue is underscored by a large sample study by Moeller and Schlingemann who analyzed 4430 deals from 1985-1992. And, later on, found that US bidders who pursued cross-border deals acquired lower returns than acquisitions where bidders choose US targets.
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