Preview Extract
10 Mergers and Acquisitions WHY MERGERS AND ACQUISITIONS? Describe Different Types Of Mergers and Acquisitions Mergers and acquisitions (often referred to as M&A) help a firm implement a strategy of diversification or vertical integration. In other words, while vertical integration and diversifications are corporate-level strategy options, M&A (along with strategic alliances and internal development) is a vehicle or mode of entry. Start with the discussion of this chapter by indicating that M&A activity is the means by which a firm can achieve its growth strategy. This is a topic that is very well covered by the business press and so you can make use of ample examples to help students understand this topic. Slide 10-2 This slide identifies the role of M&A activity in the strategic management process. Emphasize that M&A activity is a mode of entry into various businesses that a firm may want to enter as a part of the firm’s corporate level strategy. Slide 10-3 Use this slide to remind students that M&A activity should satisfy the logic of corporate level strategy. Point out that you are not claiming that managers always adhere to this logic, but that as an element of corporate level strategy, M&A activity should satisfy this logic. This slide helps set the stage for the discussion of the value creation potential of M&A activity. WHAT ARE MERGERS AND ACQUISITIONS? Slide 10-4 Use this slide to help students understand the key differences between mergers and acquisitions. Reiterate that, while the words are used interchangeably, they mean something different. Merger sounds less threatening and is often used in press releases in an effort to make the deal more attractive. Emphasize the fact that while the business press uses the terms “mergers” and “acquisitions” interchangeably, they are not the same. Acquisition is the purchase of a firm. The purchase does not have to be 100 percent ownership. It could be a majority ownership (greater than 51 percent of the acquired firm’s stock) or a controlling interest (enough stock ownership to control management and strategic decisions at the acquired firm). Acquisitions can be friendly acquisitions or unfriendly acquisitions. In a friendly acquisition, the management of the acquired firm wants the firm to be acquired. In an unfriendly acquisition (also called hostile takeovers), the management of the target firm does not want the firm to be acquired. ► Example: Berkshire Hathaway Warren Buffett, the CEO of Berkshire Hathaway, writes very readable and “folksy” letters to shareholders in his company’s annual reports. In the company’s annual report for 1995, Buffett recalled how the company acquired Helzberg’s Diamond Shops, a Kansas City, Missouri-based jewelry chain. As Buffett was walking down the street in New York’s Fifth Avenue one day, a woman hailed him by name and proceeded to tell him how she was grateful for having invested her money in Berkshire Hathaway. Upon hearing Warren Buffett’s name, another gentleman who was walking by stopped to ask Buffett if he could have a few words with him. The man was Barnett Helzberg Jr. Helzberg wanted Berkshire Hathaway to buy his family firm as he, Barnett Helzberg Jr., was tired of running it and wanted a different “parent” for the firm. The details of the deal were ironed out during that serendipitous meeting and shortly thereafter Berkshire Hathaway announced this friendly acquisition. The business press is replete with examples of unfriendly acquisitions and acquisition bids. In 2004, cable provider, Comcast, made a bid for Disney, only for Disney’s management to scuttle the attempt. Oracle engaged in an unfriendly bid for PeopleSoft for more than a year. In 2014, Men’s Wearhouse completed a contentious bid to acquire Jos. A. Bank. Typically, though not always so, acquisitions are made by larger firms in their quest to buy smaller firms. In contrast, a merger occurs when the assets of two similar-sized firms are combined. In addition, mergers are not typically unfriendly. James Kilts, the CEO of Gillette, invited A.G. Lafley, the CEO of Procter and Gamble, to merge the two companies. The merged firms may retain the name of one firm (the Gillette business was absorbed by Procter and Gamble and Gillette ceased to exist as an independent entity) or may create a new name (the merger of Newell and Rubbermaid resulted in a new firm called NewellRubbermaid). Slide 10-5 Use this slide to explain some of the mechanics of M&A activity. Students are usually quite interested in how M&A activity is actually carried out. Point out that this activity is tightly regulated by the SEC. Important Point: While a merger may start out as a transaction between equals, it may happen that in the course of time, one firm dominates the other. Thus, the management team at Newell controls the affairs of NewellRubbermaid. A.G. Lafley continues to be the CEO of Procter and Gamble that now includes Gillette. The point is that a merger may end up looking like an acquisition in terms of which firm has control. Teaching Points • Mergers and acquisitions are extremely popular as evidenced by their coverage in the business press. Stress to students that M&A activity is a much-used vehicle particularly for a strategy of diversification. • Reiterate that while the business press may use the terms “mergers” and “acquisitions” interchangeably, the two are different. • Discuss the difference between a friendly acquisition and an unfriendly one by using examples. • Remind students that M&A activity should create value for a firm according to the logic of corporate level strategy. Refer to the gains from trade concept, from strategic alliances, and to the notion of economies of scope to remind students about how this value might be created. THE VALUE OF MERGERS AND ACQUISITIONS M&A activity presents an interesting question. M&A activity is a common occurrence in the corporate world and the dollar values involved in these transactions amount to trillions. Yet, it is not clear that M&A activity actually generates value for firms implementing these strategies. You have to make this point clear: an M&A strategy makes sense for a firm if the transaction creates value for the firm, whether it be the acquiring firm or the acquired firm. Not all M&As create value. On the other hand, loss of value can be in the billions as the example of the TimeWarner and AOL merger indicates! It is important to direct the class discussion to an examination of the value creation potential of M&A activity. Mergers and Acquisitions: The Unrelated Case Estimate The Return To The Stockholders Of Bidding and Target Firms When There Is No Strategic Relatedness Between Firms. If an acquiring firm makes a bid to buy the shares of an unrelated target firm, there would be no expectation of value creation because there would be no economies of scope to be exploited. A rational bidding firm would never pay more than the market price for a target if there were no expected economies of scope to be exploited. Therefore, there would be only normal economic returns to the bidder and the acquirer in such a case. About the only expectation of value creation would come from an internal capital market efficiency. Another possibility is that value could be created through the reversal of unrelated diversification. For example, if someone recognizes that the businesses comprising a corporation would actually be worth more if they were under different ownership (a conglomeration discount) then an acquisition of that firm followed by a break up of the businesses could create value. However, for the most part, unrelated M&A activity is unlikely to create value for the bidding firm or for the target firm. Slide 10-6 This slide shows the basic logic of unrelated M&A activity and the possible exceptions. Emphasize that there would be no expectation of value creation in the vast majority of unrelated M&A activity. Important Point: Although unrelated M&A activity will usually not create value, there are some examples in which value appears to have been created. Berkshire Hathaway is one such example. Unrelated companies are purchased and then managed with a strict philosophy and ample financial controls. This appears to be a matter of spreading a core competency (Berkshire Hathaway’s management style) across different businesses. Therefore, in a sense there can be economies of scope even in unrelated M&A activity. Be sure to point out that this is a rare exception to the rule. Mergers and Acquisitions: The Related Case Types of Strategic Relatedness Describe Different Sources Of Relatedness Between Bidding and Target Firms M&A activity usually involves bidding, and targets firms that may be strategically related in a wide variety of ways. Since strategic relatedness is an important and often difficult-to-grasp issue, it is necessary to look at what relatedness is. Three approaches to defining relatedness are: The FTC categories Michael Lubatkin’s list Jensen and Ruback’s list The Federal Trade Commission (FTC) gets involved in M&A activity because these transactions can affect the level of concentration in an industry that may have implications for competition among the players. ► Example: The Herfindahl Index The Herfindahl index is a measure of the size of firms in relationship to the industry. Thus, it measures the amount of competition among them. It uses a mathematical formula and reports results from 0 to 10,000. A score of 0 means that the industry has a large number of very small firms (highly fragmented) while a score of 10,000 implies a single monopolistic producer. The FTC uses this index (among other factors) to either approve or reject an M&A transaction. Slide 10-7 This slide presents the FTC’s typology of M&A activity. Briefly explain that there is a wide variety of M&A activity. Explain that a firm’s corporate level strategy could take the firm in a wide variety of directions. Any of these types of M&A activity could create value for a firm under the right circumstances. It is a good idea to have the students look at Table 10.1 in the text since the table defines the FTC M&A categories. A vertical merger involves a vertical integration move by the bidding company, either backwards in the industry value chain (e.g., a manufacturer buying a supplier) or forwards (e.g., a manufacturer buying a distributor). When Time Warner (a content creator) merged with AOL (a content distributor), it was a vertical (forward) merger. When a firm acquires a former competitor, it engages in a horizontal merger. Johnson & Johnson’s acquisition of Guidant is an example of a horizontal merger since both firms produce medical devices. Horizontal mergers come under FTC’s scrutiny because such mergers have immense competitive implications. The possibility of antitrust concerns (in other words, the possibility of the acquisition having an adverse impact on customers) may mean that either the acquisition will be disallowed by the FTC, or, as in the J&J-Guidant deal, the FTC may insist on J&J divesting some of Guidant’s activities after the acquisition. In a product extension merger, firms acquire complementary products through the M&A activity. An example would be Unilever’s acquisition of Ben & Jerry’s Ice Creams. The motivation to access new geographic markets drives firms toward market extension mergers. Cadbury-Schweppes’ (now Dr. Pepper Schweppes) acquisition of 7UP allowed the U.K.-based company to enter the U.S. beverage market. A conglomerate merger is between strategically unrelated firms. In reality, the FTC considers this to be a residual (or catch-all) category, in that, a merger that does not fall within the definition of the four categories above would be classified in this category. Conglomerates were very popular in the 1950s and 1960s (parodied in Mel Brooks’ Silent Movie, where a conglomerate Engulf + Devour is the subject of much humor!). Since they generally create zero economic value, there are not very many examples of such mergers today. Professor Michael Lubatkin sought to probe deeper into the issue of relatedness in his classification of M&A activity. In his categorization (Table 10.2), firms may be related on technical economies (in marketing, production, etc. as the example of Procter and Gamble and Gillette indicates), on pecuniary economics (market power, for example, the Oracle-PeopleSoft merger), or on diversification economies (in portfolio management and risk reduction, like Berkshire Hathaway). Jensen and Ruback’s sources of strategic relatedness are listed in Table 10.3. These fall into four major categories: reducing production or distribution costs financial motivations gaining market power in product markets eliminating inefficient target management This is a good time to link this discussion to the criteria for diversification strategies discussed in Chapter 7. To reiterate: the links between the companies must build on real economies of scope, and it must be less costly for the merged firm to realize these economies of scope than for outside equity holders to realize on their own. Economic Profits in Related Acquisitions Estimate The Return To The Stockholders Of Bidding and Target Firms When There Is Strategic Relatedness Between Firms Slide 10-8 This slide briefly states the case for value creation in related M&A activity. Point out that the logic behind value creation in related M&A activity is the same as that covered previously in Chapters 6, 7, and 9. Firms are able to create value by capturing economies of scale and scope along with value chain economies. This is the notion of synergies. The economic value of a related M&A can be captured by the simple equation 2+2 = 5. In other words, in such M&A activity, the economic value of the two firms combined (i.e., 5) is greater than the economic value of the two firms separately (i.e. 2 and 2). Estimating the returns to the stockholders of the bidding firm is simply a matter of estimating the amount of the value that will be created by the M&A activity minus whatever amount the bidding firm has to pay the target firm. Of course, the amount the bidding firm has to pay for the target firm is a function of the value other firms recognize in the target firm. The winning bid price will likely rise to the point where the winning bidder will realize only normal economic profits. The returns to the stockholders of the target firm depend on the bidding process as well. If the bidding takes the price of the target firm above its current market price, then there will be an above normal return for the target firm. Notice that this has the effect of ensuring that stockholders of the target firm capture the expected value of the M&A activity if there is a bidding process. At this point in the discussion, it is best to stay focused on the logic of value creation, namely the exploitation of economies. Since these concepts have been covered earlier in the course, you probably don’t need to spend too much time on this logic. You can go into more detail about the appropriation of value later in the discussion. Teaching Points • Underscore the importance of value creation as the key motivation behind M&A. • Emphasize the need to differentiate the value creation potential of M&A activity when the bidding and target firms are unrelated and when they are related. • Anchor this discussion in the discussions from Chapters 6, 7, and 9 concerning value creation. WHAT DOES RESEARCH SAY ABOUT RETURNS TO MERGERS AND ACQUISITIONS? This section and the next section together make for an interesting discussion because as the book indicates, bidding firms, on average, do not create value through M&A activity, and yet, M&A activity continues at a vigorous pace. One effective way to cover these topics is to explain that most of the research that is done on value creation in M&A activity is based on the stock market’s reaction to the announcement of M&A activity. Then you can explain what that research shows. You can then follow with an example of one firm’s long-term results. Differences between the market reaction research and the long-term results should then be discussed. The explanations as to why we see so much M&A activity can then be explained in a broader context. M&A Research. Most M&A value creation research uses a methodology known as cumulative abnormal returns. This methodology is described in some detail in the “Strategy in Depth” box in the chapter. This methodology is actually a study of the market’s reaction to the announcement of a merger or an acquisition. As such, the ‘value’ studied in this research is the value that the market collectively expects the M&A activity to produce. The compelling thing about this research methodology is that researchers can be confident that they are examining the effects of the announcement without the confounding ‘noise’ of other events. Another compelling feature is that researchers can see who is capturing value – bidders or targets. Slide 10-9 Use this slide to briefly explain how most M&A value creation research is conducted. Emphasize that this research looks at the expected value created by the announcement of a merger or acquisition. What the M&A Research Shows. A veritable cottage industry has arisen of researchers examining the economic performance of M&A activity. The interest in studying the performance of these transactions is likely because of their popularity. The consensus of these research studies (done by both finance researchers and by researchers from the discipline of strategy) is that in M&A activity the market value of target firms increases (and their stockholders benefit) but stockholders of bidding firms earn, on average, zero economic profits. In other words, there is economic profit created, but all of it is appropriated by the target firm. This is true regardless of whether the firms were involved in a related or an unrelated M&A! Slide 10-10 This slide presents the well-established pattern of results of M&A value creation research. Point out that the value created flows to shareholders of target firms because of the bidding process. Sometimes bidding firms will start with a bid much higher than the market value of the target in order to prevent a bidding war. Expected versus Operational Value. It is instructive to take a look at what happens over a longer period of time for a firm engaged in M&A activity. As you begin this discussion, be sure to point out that there are always confounding effects that may be influencing the performance of a firm. To the extent that other things besides the focal M&A activity are influencing firm performance this is not a fair comparison to cumulative abnormal returns research. However, the following example serves to make the point. ► Example: Wells Fargo Acquires First Security Bank In 1999, Zions Bank, a regional bank headquartered in Utah, announced its proposed acquisition of First Security Bank of Utah for $5.9 billion. After several months, shareholders of Zions decided that the acquisition was grossly overvalued and they pressured Zions’ management to terminate the acquisition. Wells Fargo, based in California, quickly stepped in and announced that it would acquire First Security for just over $3 billion (April, 2000). Wells Fargo proposed to buy First Security using Wells Fargo stock. The valuation was set at $43.69 for Wells Fargo stock and $15.50 for each share of First Security stock. Wells Fargo agreed to trade 0.355 shares of Wells Fargo stock for each share of First Security stock. As predicted by M&A value creation research, when the deal was announced, Wells Fargo stock dropped on the first day $0.25 to $39.50. First Security’s shares rose $1.19 to $13.38. (These numbers do not correspond to the valuation prices because stock prices were not the same as the valuation placed on the deal several weeks earlier). In effect the market was saying, “We think this is a good deal for First Security shareholders but not for Wells Fargo shareholders.” In fact, the market was predicting that Wells Fargo would actually see a decrease in value over time because of this deal. The movement in stock prices reflected the market’s expectation. The deal was completed by October of 2000. A look at Wells Fargo’s stock prices and market capitalization tells a very different story. At the end of 1999, before the deal was announced, the stock price stood at $40.44 and the market capitalization was at $65.7 billion. A year later, after the acquisition, the stock price stood at $56.69 and the market capitalization was at $95.2 billion. To be fair, the stock market was rising rapidly during that time. But, in just a few months the market had rewarded Wells Fargo handsomely for the acquisition. The stock price had risen by more than the per share acquisition price of $15.50 and the market cap had risen by much more than the $3+ billion total price of the acquisition. Over the next four years, Wells Fargo continued to acquire other financial concerns. None was as large as the First Security deal, but Wells Fargo was clearly following a corporate level strategy of acquisition. The internet bubble burst in 2001 and stock prices fell. But over time, an M&A strategy has seemed to work well for Wells Fargo. Stock prices and market capitalization changed from year to year as follows:
Year Year-end Stock Price Market Capitalization
2001 $43.60 $74.0 billion
2002 $46.87 $82.0 billion
2003 $58.89 $100.0 billion
2004 $62.15 $105.0 billion
These numbers indicate that Wells Fargo is good at M&A activity. The company appears to be able to buy other banks and financial concerns and create operational value. Another interesting aspect of this example is that First Security was probably worth more to Wells Fargo than it was to Zions Bank. If Zions Bank had purchased First Security bank, regulators would have forced Zions to close many branches in cities and small towns throughout Utah and neighboring states where First Security and Zions were both doing business. Wells Fargo did not face the same constraint because it was not currently doing business in most of those same cities and small towns. Thus, it would seem that the stock market may not always be accurate in its assessment of M&A activity. Slide 10-11 Use this slide to present the Wells Fargo example. Remind students that this long-term analysis of a single firm is focusing on a different question than the cumulative abnormal return studies of M&A activity. However, this example tells a very different story over time. Why Are There So Many Mergers and Acquisitions? At this point, students are likely to be puzzled and curious. Why is there such a disconnect between the popularity of M&A activity and the evidence from so much research on the economic performance of such transactions? If owners of target firms are the only ones benefiting, what motivates firms to bid for target firms? The Wells Fargo example suggests that bidding firms may benefit in the long run, but in the short run there seems to be little incentive for bidding firms. This provides a good segue to look at possible motivations for M&As. Table 10.4 should be used as the reference point for this discussion. Describe Five Reasons Why Bidding Firms Might Still Engage In Acquisitions, Even If On Average They Do Not Create Value For A Bidding Firm’s Stockholders The first motivation to engage in an M&A may be to ensure survival. If all the major competitors are becoming bigger through these transactions, then a firm may engage in an acquisition to ensure competitive parity. This is a defensive reason as the book example of consolidation in the banking industry indicates. The concept of free cash flow was introduced in Chapter 7. Profits left for a firm after investing in all current positive net present value opportunities is the firm’s free cash flow. As indicated earlier, these can amount to millions or even billions of dollars. For example, Apple is reported to have a free cash flow of around $150 billion in 2014! Dominant firms in mature businesses often find themselves in such situations. For firms with free cash flow, the obvious decision should be to give it back to stockholders in the form of dividend payments or stock buybacks. Either the firm may choose not to do this or stockholders (because of high marginal tax rates) may prefer the firm invest the money on its own. In such situations, firms may engage in M&A activity because such transactions may at least create competitive parity. In other words, this motivation is akin to saying that there are worse things we could do with the extra money and we are choosing the lesser of all evils. Managers may be motivated to engage in M&As even when such transactions do not benefit the principals – the agency problem. These motivations may stem from reducing the risk of the firm going bankrupt (and them losing their jobs) or from increasing their compensation because they are now managing a bigger organization – in other words, empire building. It is important to underscore at this point in the discussion that agency issues come to the forefront every time a firm announces an M&A! The dictionary defines hubris as “overbearing pride or presumption; arrogance.” In the context of M&A activity, this means that managers may engage in an M&A even when evidence is clear on the fact that there is zero economic value for bidding firms. The argument made by managers here is that they can do better in managing the target firm (and thereby producing more profits) than can the current managers of the target firm. Going against the conventional wisdom may be because of overconfidence in their own abilities. Slides 10-12 and 10-13 These two slides cover the first four reasons offered in the book as to why managers may engage in M&A activity. Each of these four reasons has a somewhat negative connotation in that each suggests that managers lack a truly value creating strategy that will benefit shareholders. At the end of Slide 10-13, ask students if they think the four reasons you have just mentioned satisfy the logic of corporate level strategy. The final motivation for M&A activity is the fact that while M&A activity, on average, creates zero economic profits for bidding firms, they don’t always do so. The notion of average means some M&A activity creates negative economic value while others create positive economic value. The fact that some firms create positive economic value in M&A activity may spur some firms to pursue such transactions. Slide 10-14 Refer to the Wells Fargo example and point out that managers at Wells Fargo apparently saw something in the acquisition that the market didn’t see. Of the five reasons offered in the book, this one seems to be the one that makes the most strategic sense from the point of view of shareholders. Teaching Points • Point out that while M&A activity is popular, the research evidence clearly indicates that only the target firm gains and not the bidding firm. Be sure to offer the important caveat that this research is market reaction research. • Use the Wells Fargo example to indicate that firms may go on to do very well with an M&A strategy even if the market does not immediately reward the firm for its strategy. • Emphasize that firms have a variety of motivations to do M&As. • Underscore the fact that many of the motivations for M&A activity are not necessarily positive from the point of view of shareholders. • Refer back to the discussion of implementation in Chapter 8 to remind students that the need for control stems, at least in part, from motivations to engage in M&A activity that may be at odds with shareholder interests. MERGERS AND ACQUISITIONS AND SUSTAINED COMPETITIVE ADVANTAGE Describe Three Ways That Bidding Firms Might Be Able To Generate High Returns For Their Equity Holders Through Implementing Mergers Or Acquisitions Slide 10-15 Use this slide to provide a broad overview of how a firm’s M&A strategy can create sustained competitive advantage. This sets the stage for a more specific discussion that follows. Make the point that generating value with M&A activity is like so much of what has been discussed in the course – some managers are better at it than others. Point out that value can be created by ‘doing the deal’ and/or by operating the combined firm. In the last part of the previous section, one of the motives mentioned for M&A activity was that, while on average M&A activity does not yield economic profits to bidding firms, the implication was that some bidding firms gain from these transactions. This provides a good segue to this section. The discussion in this section is on imperfectly competitive markets. The market for corporate control (also known as the takeover market) is the market that is created when multiple firms actively seek to acquire one or several firms. Only when the market for corporate control is imperfectly competitive would it be possible for bidding firms to earn above normal returns from M&A activity. The question is: when is the market for corporate control imperfect? Three situations result in an imperfect market for corporate control: when valuable, rare, and private economies of scope exist when valuable, rare, and costly-to-imitate economies of scope exist when unexpected valuable economies of scope between bidding and target firms exist By relating the following discussion to the concepts developed in Chapter 3 (the VRIO Framework), you ensure that these concepts are not only understood but students also see their relationship to earlier concepts.
Valuable, Rare, and Private Economies of Scope Slide 10-16 Explain that Firm A can earn a $2,000 above normal return because the economy between Firm A and Firm C exists only between these two firms. Firm C is worth only $10,000 to every other firm in the market except Firm A. Firm A doesn’t have to pay the full value of $12,000 because no one else would rationally bid above $10,000 for Firm C. Private economies, by their nature, cannot be imitated. When a target is worth more to one bidder than it is to other bidders and this information is not known to the other firms (bidders and targets), an imperfect market for corporate control exists. In such a setting, even when the bidder pays the prevailing price for the target, it stands to gain. When would this happen? The special additional value accruing to the bidding firm (and to it alone) may be from economies of scope stemming from unusual resources and capabilities possessed by the bidding firm. In other words, such capabilities are not just valuable but they are also rare – in short, they are private economies of scope not available to other bidders. However, the value of a private economy depends on that economy remaining private. If other bidders or the target become aware of the economy, the above normal value of the economy may quickly dissipate. It may be the case that if other bidders knew of the economy they could easily imitate the economy, in which case it would make sense for them to raise the bidding price accordingly. Valuable, Rare, and Costly-to-Imitate Economies of Scope In the previous case, the successful bidding firm had a rare capability that allowed it to create additional economic value in combination with the target firm because that economy remained private. The market was held to be imperfect because one bidding firm knew something other bidding firms did not know (causal ambiguity). It may also be possible that an economy exists between two firms that is costly-to-imitate. For example, a firm may have a location advantage that other firms could not imitate without incurring excessive costs. Much of the grain that is grown in the Northwest is shipped down the Columbia River to Portland, Oregon for export to Pacific Rim countries. Several barge companies provide the shipping down the river. A grain export company (Firm A) that owns a grain loading facility on the water in Portland would have an economy with a barge company (Firm C) that would not exist for an export firm without its own grain loading facility. If the export company with its own grain loading facilities decides to acquire a barge company, other potential bidders (Firm B) will be at a distinct disadvantage. Suppose the barge company (Firm C) has a market value of $1.5 million and that, because of the economy of the grain loading facility, the barge company is worth $2.0 million to the grain export company possessing these facilities (Firm A). Other bidders (Firm B) for the barge company would not be willing to bid above $1.5 million. Thus, Firm A, the grain export company with the loading facilities, would be able to buy Firm C, the barge company, for $1.5 million and realize an above normal return of $0.5 million. This benefit would accrue to the grain export company (Firm A) regardless of whether this information is public or private. Slide 10-17 Use the above example to explain that if an economy is costly-to-imitate, it can generate an above normal return for the bidding firm even if other firms know about the economy. Unexpected Valuable Economies of Scope Between Bidding and Target Firms In the previous two scenarios, the successful bidding firm approached the M&A knowing that it had either a private economy or a costly-to-imitate economy that allowed it to create value in combination with the target firm. While this is possible, in reality the M&A process is typically complex involving numerous unknown and complicated relationships between firms. In such cases, serendipity may place a key role. Since such unexpected events occur after the transaction is complete, the price may not reflect such benefits – yielding a windfall to the successful bidder. The example of WPP’s acquisition of J. Walter Thompson in the advertising industry cited in the textbook is a good one to use to bring home this point. Needless to say, managers cannot anticipate and prepare for such benefits – they just happen after the transaction is completed. Slide 10-18 Use this slide to help explain to students how unexpected economies of scope can create value in an M&A. Although being lucky doesn’t sound very strategic, sometimes things happen that are just plain lucky. However, a firm’s luck in any given area seems to improve as the firm gains competencies in that area. Implications for Bidding Firm Managers The above discussion points out that the market for corporate control may be imperfect in certain conditions. It makes sense, then, for managers of bidding firms to look for such conditions and use them to their firm’s advantage. You should move the discussion to more practical matters by stating that the focus now shifts to this important question: what are the implications of imperfect markets for corporate control for bidding firm managers? In other words, how can they take advantage of such conditions? Table 10.5 in the text succinctly identifies the rules for bidding firm managers. It is important to take students through each of these rules. In so doing, you should talk about “due diligence” – the process by which bidding firms learn more about the target. This is an important but often poorly performed activity in practice. It is important for the managers of bidding firms to search for rare economies of scope. A good understanding of their own resources and capabilities is the starting point. Managers should then look for synergies between their firm’s resources and capabilities and those of the target firm. Such an investigation is likely to rule out obvious benefits such as reductions in corporate overhead by combining two firms because they are available to all bidding firms. The second rule for bidding firm managers is to keep information about the bidding process and about the sources of economies of scope as private as possible. While this may be possible when the target firm is privately owned, SEC disclosure requirements may preclude a bidding firm from keeping things private. On the other hand, a firm does not have to reveal complete details about the economies of scope possibilities between the two firms. It is also important to keep proprietary information away from targets, lest the targets pass on this information to other bidders to raise the bid price. To prevent the target firm from holding out for a higher price, the true value of this transaction to the bidding firm should be kept private. This advice comes with a caveat, though. For an M&A to be successful and create value, the two firms must be integrated to exploit the economies. Keeping things hidden from the target firm may make it difficult for the bidding firm to successfully integrate the two firms. The key is to strike the right balance between disclosing information for competitive advantage and facilitating integration of the two companies. Economists have a term “winner’s curse” – to refer to the situation when the winner scores a Pyrrhic victory (a victory that comes at a cost so high that the victory loses its value). An example: suppose a number of publishing houses bid for the rights to publish a potential bestselling book. The competitive bidding process raises the bid price and the winner gets the bid at an enormous price. This high price takes away all the possible profits from the book. In the M&A context, managers of bidding firms should not get into a bidding war so that the price of the target reduces the profit to the bidder. Note that firms possessing rare and costly-to-imitate economies do not face such bidding wars because competing bidders will not rationally bid above the market value of the target. A rule of thumb for managers of bidding firms is to close the deal quickly. When the process is quickly done, there is less possibility for information leakage and dissipation of value. Many firms often make “pre-emptive” bids. Such bids are at a significant premium over the target firm’s prevailing market price and the target firm is likely to accept such a “sweetheart” deal. The key, though, is not to hurry the due diligence process. M&A decisions must be carefully made and firms should take their time in the preparatory work. However, once the target is identified, the firm should move quickly to consummate the deal. A “thinly traded market” is one where only a small number of buyers and sellers exist, and where information about opportunities in this market is not widely known. The industry is likely to be fragmented or it may be out of the radar screen of stock analysts. For bidding firms, target firms in thinly traded markets are attractive because they can capitalize on information asymmetries. A highly public M&A (such as the Oracle-PeopleSoft transaction which, at times, seemed to take on a soap operatic tone) leads to a competitive market where bidding firms are not likely to gain. However, in thinly traded markets, there may be greater opportunities because of a lack of publicity. ► Example: Quest Diagnostics Quest Diagnostics started its corporate life by being a division of Corning, Inc. The division made over 70 acquisitions of small, locally-owned medical laboratories to become the leading player in the industry. It was spun off as a separate company in 1996 and continued the strategy of acquiring small local players. Most of these small targets were traded in thinly traded markets, allowing Quest to buy them at attractive prices. Today, Quest is the largest player in the $35 billion medical testing market with $7.1 billion in 2013 revenues and over 2,200 centers. Kocourek, Chung & McKenna. “Strategic Rollups: Overhauling the multi-merger machine,” Strategy + Business, Second Quarter 2000, and Quest Diagnostics Investor Relations site www.questdiagnostics.com. Slide 10-19 Use this slide to take students through each one of the implications for bidding firm managers. Point out that each one of these implications is tied to the ability to earn above normal returns. Failure to recognize these implications could be the difference between above normal returns, normal returns, or even below normal returns. Implications for Target Firm Managers So far the discussion has focused on what managers of bidding firms can do to maximize the value creating potential of M&A activity for their firms. It is important to reiterate that target firms are not passive onlookers in this whole process. They can take proactive steps to maximize the value to their stockholders. They can do this in a variety of ways and typically, these moves mirror those of the bidding firms, except in the opposite way. Bidding firm managers were implored to keep information away from target firms for fear of dissipation of value. The argument is that target firms are likely to hold out for more if they know the true value of their firm to the bidder. Managers of target firms can increase the value of the transaction to their stockholders if they seek additional information from bidding firms. They should keep themselves informed of their value to bidding firms. Creating a competitive market for the transaction helps the target get greater value for their firm. Inviting more firms to bid for them helps create this competitive market. Finally, delaying the transaction helps the target firm. Just as the bidding firm is motivated to quicken the process so that information leakage is at a minimum, target firms stand to benefit when the process is delayed. However, target firms should not stop the acquisition as this would result in their equity holders not getting the value. Important Point: Target firms have a number of ways to delay or prevent an M&A. These are discussed in detail in the “Research Made Relevant” box. This is often an interesting topic to discuss in class because it has a lot of “cloak-and-dagger” type of symbolism attached. Besides, students are likely to be intrigued by terms such as “greenmail,” “poison pills,” and the “Pac Man defense.” This is also a good time to discuss the ethical implications of such practices. Slide 10-20 Use this slide to show what managers of target firms can do to extract greater value for their firms in M&A activity. Remind students that managers of target firms can benefit from M&A activity at the “doing the deal” point. Teaching Points • Stress that while, on average, bidding firms do not gain from M&A activity, some firms do. • Emphasize the logic behind the above normal returns that are available to firms that are able to exploit economies that are rare and costly to imitate, either because they are private or the economies themselves are costly to imitate. • Help students recognize that managers of bidding firms can influence the value of M&A activity at both the “doing the deal” stage and during the operational stage. • Help students recognize that target firms are not passive onlookers in the M&A process; rather they can take active steps to increase their value. ORGANIZING TO IMPLEMENT A MERGER OR ACQUISITION Describe The Major Challenges That Firms Integrating Acquisitions Are Likely To Face This can be called the “morning after” discussion. Once the euphoria of completing an M&A deal is over, the real task of implementing the transaction begins. Very often, implementation can leverage the synergies that motivated the M&A in the first place or it can thwart the exploitation of any synergies. The bidding firm must organize the target firm so that it can be folded into the organization seamlessly. Chapter 8 talked about the M-form structure, control systems, and compensation practices as the three important levers to organizing a diversification strategy. Since M&A activity is often the vehicle through which a firm diversifies, these same issues surface here once again. A fairly brief discussion of these issues will suffice if you remind students that the discussion from Chapter 8 applies. Important Point: Acquiring firms have latitude as to how much the target should be integrated into the existing firm. The target firm could be left to operate fairly autonomously or it could be integrated completely and lose all former identity. Slide 10-21 Explain that firms that merge or acquire face the issues discussed in Chapter 8. The issues of structure, control, and compensation discussed there apply here. Furthermore, the responses are very similar. Be sure to point out that acquiring firms can decide to completely integrate the target firm or they can decide to let the target firm operate autonomously. There are specific issues associated with implementing an M&A though. These issues center on one thing: the bidding firm and the target firm have led a separate existence up till this point. They have had separate histories, separate management philosophies, and separate strategies. The challenge is to integrate these very disparate entities. Tangible or codifiable differences like: different production systems different technologies different human resource policies, etc. can usually be integrated with consistent effort. However, the more difficult integration issue is typically the different cultures of the two firms. These different cultures are marked by intangible elements – such as risk propensity, communication style, etc. They are usually much more difficult to integrate than the tangible elements. The problem is likely to be compounded when the acquisition is “unfriendly” and there is a distinct “victor vanquished” mentality. As a case in point, when Quaker Oats acquired Snapple, a number of cultural problems arose. Quaker Oats was a large company and was quite formal in the way it operated. In contrast, Snapple was a small company that thrived on its “folksy” image. Quaker Oats found it very difficult to integrate the two cultures, leading to the eventual failure of this transaction. Some acquirers regard implementation problems as an additional cost of the transaction. The cost of integration is sometimes factored in to the bid price of the acquisition to the extent that the acquiring firm is aware of the cost. Slide 10-22 Point out that cultural integration is a function of the level to which the acquiring firm decides to integrate the target firm. Emphasize that acquiring firms may face some surprises when it comes to cultural integration. Firms that are very good at handling integration may realize a competitive advantage from that capability per se. Cooper Industries has followed a strategy of acquisition for decades. It has become very good at integrating targets. It refers to its integration process as Cooperization. Teaching Points • Point out to students that post-merger integration is often the less “glamorous” aspect of the process and therefore often is done poorly. This may lead to the failure of the whole transaction. • Emphasize that managers have discretion in deciding to what extent a target will be integrated into the existing business. • Point out, with examples, the possible effect of cultural differences that may make post-merger integration difficult. SUMMARY OF ISSUES IN MERGERS AND ACQUISITIONS Students must understand that M&A activity is a commonplace occurrence in the business world. On a regular basis, they read about these transactions and some may have worked in an organization that was involved in M&A activity. One of the most important things for students to understand is that M&A activity is part of a firm’s corporate level strategy. As such, M&A activity should generate value for the firm that stems from economies that shareholders could not get by simply diversifying their individual portfolios. The popularity of M&A activity runs contrary to the research on the value created by these transactions. The essence of the research findings is that stockholders of target firms gain while those of bidding firms do not. However, the popularity of M&A activity is not so perplexing when the long-term results of the strategy are considered. Remind students that the outstanding long-term results of Wells Fargo were the result of Wells Fargo pursuing an M&A strategy with attention to detail and spreading its core competencies to its targets. Another key takeaway from this chapter should be the importance of post-merger integration. The long-term success of an M&A strategy depends heavily on a firm’s ability to recognize the challenges of integration and respond with the appropriate structure, controls, and compensation policies. Although M&A activity is popular, perhaps even glamorous in the business world, at the end of the day the ability of an M&A strategy to generate competitive advantage and above normal returns comes down to the basic logic of the VRIO model. If the economies being exploited are valuable, rare, costly-to-imitate, and the firm is organized to exploit the economies, then competitive advantage is likely. An M&A strategy can create significant long-term value for a firm. In fact, some firms with aggressive growth goals must rely on M&A activity to achieve that growth. Such firms cannot afford to fail at M&A activity. Slide 10-23 Remind students that M&A activity is a mode of entry into vertical integration and/or diversification as part of a firm’s corporate level strategy. Emphasize that a good M&A strategy will satisfy the logic of corporate level strategy. Point out that M&A activity results in a market reaction that typically creates value that only target firm shareholders capture. On the other hand, a sound M&A strategy can create operational value over time if managers follow the logic laid out in this chapter. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
