MERGERS, ACQUISITIONS, STRATEGY

IN GLOBAL ENVIRONMENT ETC.

PROF. MURALI KRISHNAMURTHY

Mergers & Acquisitions
(and Divestitures)
Mergers and Acquisitions

• Mergers & Acquisitions

• Divestitures
• Valuation

Concept: Is a division or firm worth more

within the company, or outside it?
The Market for Corporate Control
When you buy shares, you get dividends; and
potential control rights
There is a market for corporate control—that is,
control over the extent to which a business is run in
the right way by the right people.
This market is constrained by
• Government
• Management
• Some shareholders
The Market for Corporate Control
• M&A&D situations often arise from conflicts:
• Owner vs manager ("agency problems“)
• Build vs buy ("internalization")
• Agency problems arise when owners' interests and
managers' interests diverge. Resolving agency problems
requires
• Monitoring & intervention, or
• Setting incentives, or
• Constraining, as in bond covenants
• Resolving principal-agent conflicts is costly
• Hence market price may differ from potential value of a
corporation
“Internalization”: Is an activity best done within
the company, or outside it?

Issue: why are certain economic activities conducted

within firms rather than between firms?
• As a rule, it is more costly to build than to buy—
markets make better decisions than bureaucrats
• Hence there must be some good reason, some
synergy, that makes an activity better if done within
a firm
• E.g: the production of proprietary information
• Often, these synergies are illusory
 Takeovers as a Solution to “Agency Problems”

• There is a conflict of interest between shareholders

and managers of a target company
• Individual owners do not have sufficient incentive to
monitor managers
• Corporate takeover specialists, E.g. KKR, monitor
the firm's environment and keep themselves aware
of the potential value of the firm under efficient
management
• The threat of a takeover helps to keep managers on
their toes—often precipitates restructuring.
Goal of Acquisitions and Mergers

• Increase size - easy!

• Increase market value - much harder!
Goal: Market Value Addition
Definition
It is a measure of shareholder value creation

Methodology
It is the change in the market value of invested
capital ( debt and equity) minus the change in the
book value of invested capital
 Value Changes In An Acquisition
Profit on sale 10 Taxes on sale of assets
of assets 40
30 Takeover premium

50 Gain in
Synergies and/ shareholder
or operating 50
improvements value

Value of 75
acquired
company as
a separate
entity

Value of
250
acquiring
company 175
without
acquisition

Initial value Final value of

plus gains combined company
 Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost of
transaction]
• Synergy
• Gain market power
• Discipline
• Taxes
• Financing
 Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost of transaction]
• Synergy
• Eg Martell takeover by Seagrams to match name and inventory with marketing
capabilities
• Gain market power
• Eg Atlas merger with Varity. (Less important with open borders)
• Discipline
• Eg Telmex takeover by France Telecom & Southwestern Bell (Privatization)
• Eg RJR/Nabisco takeover by KKR (Hostile LBO)
• Taxes
• Eg income smoothing, use accumulated tax losses, amortize goodwill
• Financing
• Eg Korean groups acquire firms to give them better access to within-group
financing than they might get in Korea's undeveloped capital market
Fallacies of Acquisitions
• Size (shareholders would rather have their money
back, eg Credit Lyonnais)
• Downstream/upstream integration (internal
transfer at nonmarket prices, eg Dow/Conoco,
Aramco/Texaco)
• Diversification into unrelated industries
(Kodak/Sterling Drug)
Methods of Acquiring Corporate Control
• Mergers
• Bidder typically negotiates a friendly agreement with target
management and submits this for approval to both sets of
shareholders
• Usually entails an exchange of securities
• Tender Offers
• Often hostile, often opposed, often generates competing bids
• Usually a direct cash offer to stockholders of an above-market price
• Proxy Fights
• A method of gaining control without acquisition: dissident
shareholders seek to change management by soliciting proxies from
other shareholders.
Who Gains What?
• Target firm shareholders?
• Bidding firm shareholders?
• Lawyers and bankers?
• Are there overall gains?

Changes in corporate control increase the combined

market value of assets of the bidding and target
firms. The average is a 10.5% increase in total
value.
The Price: Who Gets What?
Daimler Chrysler Combined

Market value before deal $52.8 $29.4 $82.2

leaked
Value added by merger $18.0

Merged Value $100.2

Shareholders get 57.2% 42.8% 100%

Which is now worth $57.3 $42.9 $100.2

Shareholders' shares of $4.5 $13.5 $18

the gain
Premium, as % 9% 46%
 A Case Study: Kodak - Sterling Drugs
• Eastman Kodak’s Great Victory
Earnings and Revenues at Sterling
Drugs
Sterling Drug under Eastman Kodak: Where is the synergy?

5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1988 1989 1990 1991 1992

Revenue Operating Earnings

 Kodak Says Drug Unit Is Not for
Sale (NYTimes, 8/93)
• Eastman Kodak officials say they have no plans to
sell Kodak’s Sterling Winthrop drug unit.
• Louis Mattis, Chairman of Sterling Winthrop,
dismissed the rumors as “massive speculation,
which flies in the face of the stated intent of Kodak
that it is committed to be in the health business.”
Sanofi to Get Part of Kodak Drug
Unit (6/94)
• Taking a long stride on its way out of the drug business,
Eastman Kodak said yesterday that the Sanofi Group, a
French pharmaceutical company, had agreed to buy the
prescription drug business of Sterling Winthrop, a Kodak
subsidiary, for $1.68 billion.
• Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50
on the New York Stock Exchange.
• Samuel D. Isaly an analyst , said the announcement was “very good
for Sanofi and very good for Kodak.”
• “When the divestitures are complete, Kodak will be entirely
focused on imaging,” said George M. C. Fisher, the company's
chairman and chief executive.
 Smithkline to Buy Kodak’s Drug
Business for $2.9 Billion
• Smithkline Beecham agreed to buy Eastman
Kodak’s Sterling Winthrop Inc. for $2.9 billion.
• For Kodak, the sale almost completes a
restructuring intended to refocus the company on
its photography business.
• Kodak’s stock price rose $1.25 to $50.625, the
highest price since December.
Reasons Why Many Acquisitions Fail To Generate Value

Overestimating
synergies

Over Poor
optimistic Value
market post-merger
Destruction integration
assessments

Deal price not based on

cash flow value
Using Industry Structure Analysis
SUBSTITUTES
Questions:
 Do substitutes exist?
 What is their price/
performance?
Potential Action:
 Fund venture capital and
joint venture to obtain
key skills
 Acquire position in new
segment
SUPPLIERS CUSTOMERS
Questions: Questions:
 Is supplier industry  Is the customer base
concentrating? concentrating?
 Is supplier value/cost  Is value added to
added to end product high, COMPETITIVE customer end product
changing? high,changing?
ADVANTAGE
Potential Actions: Potential Actions:
 Backward - integrate  Create differentiated
product
 Forward - integrate

BARRIERS TO ENTRY
Questions:
 Do barriers to entry exist?
 How large are the barriers?
 Are they sustainable?
Potential Actions:
 Acquire to achieve scale in
final product or critical
component
 Lock up supply of critical
industry input
 Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost of
transaction]
• Synergy
• Gain market power
• Discipline Example:
• Taxes Ciba-Geigy/
• Financing
Sandoz
 Most Value is Created on the Asset Side (Operational
Restructuring)
• Discounted Cash Flow (DCF) analysis for project
evaluation
• Value-Based Management for performance
evaluation

Wärtsilä NSD
(from Wärtsilä Diesel & New Sulzer Diesel

?
 Wärtsilä NSD: Consolidating
Production and Distribution
Wärtsilä NSD now has the
world’s most extensive portfolio
of heavy duty engines. Its 4-
stroke engines are mainly
Wärtsilä design, while the 2-
stroke engines are based on
Sulzer design. The engine range
consists of lean burn gas engines,
dual fuel engines and gas diesels.
Market share is strong and
production is being consolidated
or out-sourced, particularly for
low-speed engine technologies.
Wärtsilä NSD: Gains Market
Power
 Sometimes, Too Late is Too Little
30 Peruvian Banks: Market Share by Deposits, %

25

BBV ACQUISITION
20

15
SANTANDER
10
ACQUISITION

0
Banco de la

Santander
Continental

Interbanc

Del Sur
Credito

Latino
Wiese

Lima

Mundo
Nacion

Nuevo
Corporate Restructuring
• Divestiture—a reverse acquisition—is evidence
that "bigger is not necessarily better"
• Going private—the reverse of an IPO (initial public
offering)—contradicts the view that publicly held
corporations are the most efficient vehicles to
organize investment.
 Divestitures
Divestiture: the sale of a segment of a company to a third
party
• Spin-offs—a pro-rata distribution by a company of all its
shares in a subsidiary to all its own shareholders
• Equity carve-outs—some of a subsidiary' shares are offered
for sale to the general public
• Split-offs—some, but not all, parent-company shareholders
receive the subsidiary's shares in return for which they
must relinquish their shares in the parent company
• Split-ups—all of the parent company's subsidiaries are
spun off and the parent company ceases to exist.
Divestitures Add Value
• Shareholders of the selling firm seem to gain,
depending on the fraction sold:
• Total value created by divestititures between 1981
and 1986 = $27.6 billion.

% of firm sold Announcement effect

0-10% 0
10-50% +2.5%
50%+ +8%
Going Private
A public corporation is transformed into a privately held
firm
• The entire equity in the corporation is purchased by
management, or managment plus a small group of
investors
• These account for about 20% of public takeover activity in
recent years in the United States.
• Can be done in several ways:
• "Squeeze-out"—controlling shareholders of the firm buy up the
stockholding of the minority public shareholders
• Management Buy-Out—management buys out a division or
subsidiary, or even the entire company, from the public
shareholders
• Leveraged Buy-Out (LBO)
 Leveraged Buy-Outs
LBO is a transaction in which an investor group acquires a
company by taking on an extraordinary amount of debt, with
plans to repay the debt with funds generated from the
company or with revenue earned by selling off the newly
acquired company's assets
• Leveraged buy-out seeks to force realization of the firm’
potential value by taking control (also done by proxy fights)
• Leveraging-up the purchase of the company is a "temporary"
structure pending realization of the value
• Leveraging method of financing the purchase permits
"democracy" in purchase of ownership and control--you
don't have to be a billionaire to do it; management can buy
their company.
LBOs, Agency Costs
and Free Cash Flow

• "Free cash flow" is cash-cow type earnings in excess

of amounts required to fund all positive-NPV
projects
• Payout of free cash flow, to stockholders, reduces
the amount of resources under managment's
discretion. Forces management to go out into the
markets and justify raising funds
• Thus debt has a disciplining role. “Safe” managers
choose less debt.
Example
• AT&T sells AT&T Capital (equipment leasing
division) for $2.2 billion
• The division goes private
• Financed by:
• Bank debt
• Asset securitization
• $900 million equity (85% GRS UK, 10% Babcock &
Brown, 5% management)
• Another major step in AT&T’s restructuring
The LBO of EMAS
• EMAS is in the retailing and hire-purchasing business in
Malaysia

• An LBO was done in 1998 by financial investors

• The management of the business have been retained by

EMAS to continue to operate the businesses

• EMAS’s assets include a strong local brand-name, and high-

yielding accounts receivables with a low default rate
The Buyout
• EMAS was incorporated to buy existing assets, liabilities
and business at 10.5 times prospective PER i.e. equivalent
to 2 times book value, subject to a minimum of $52m and a
maximum of $63m

• The leveraged buyout was financed primarily by bank

borrowings ($10.25m equity and $42m senior debt). The
loan was made by the Malaysian Bumi Bank at Libor + 2%.

• The vendors have an option to subscribe up to 20% of

EMAS’s issued shares prior to IPO at an 8% discount from
IPO price
After the LBO
• EMAS’s existing business is profitable. However, additional
funds are required to finance its expansion plan and the
penetration into new business

• EMAS intends to reduce its senior debt to more acceptable

levels with proceeds from IPO targeted for launch before end-
2000

• Meanwhile, where can EMAS get additional funding?

• And how will the lender get paid back?

Income Statement
Forecast
1997 1998 1999 2000
$'m $'m $'m $'m

Turnover 139.8 117.8 119.4 165.2

Net operating profit 8.4 8.8 5.2 10.5

Management and legal fees 0.0 0.0 (0.2) (0.5)
Net operating profit
before interest & tax 8.4 8.8 5.0 10.0
Interest expense 0.0 0.0 (0.7) (2.1)
Net profit before tax 8.4 8.8 4.3 7.9
Tax (Assume 26%) (2.2) (2.3) (1.1) (2.1)
Net profit after tax 6.2 6.5 3.2 5.8
Balance Sheet
As at 31 Dec 1999
$'m

Fixed Assets 1.2

Goodwill 25.6
Current Assets 54.4

Total Assets 81.2

Current Liabilities 28.5

Bank Loan 41.2

Total Liabilities 69.7

Share capital 10.3

Retained Earnings 1.2

81.2

Net Tangible Assets (14.1)

What's It Worth?
Valuation Methods
• Book value approach
• Market value approach
• Ratios (like P/E ratio)
• Break-up value
• Cash flow value -- present value of future cash
flows
How Much Should We Pay?
Applying the discounted cash flow approach, we
need to know:
1. The incremental cash flows to be generated
from the acquisition, adjusted for debt servicing
and taxes
2. The rate at which to discount the cash flows
(required rate of return)
3. The deadweight costs of making the
acquisition (investment banks' fees, etc)
How Should We Pay?
• Payment in cash
• (What happens to acquirer's stock price?)
• Payment with debt
• (When you buy something by mail order, it's best to pay
with a credit card)
• Payment with equity shares
• (Figure out how many shares acquirer needs to offer)
Framework for Assessing Restructuring
Opportunities
Current
Market
Current market Value Maximum
overpricing or restructuring
underpricng 1 opportunity

Company’s Total
DCF value 2 5 restructured
value

Restructuring Financial
Framework structure
Operating improvements
improvements (Eg Increase D/E)

3 4
Potential
Potential value with
value with internal
internal Disposal/ + external
improvements Acquisition improvements
opportunities
 Using The Restructuring Framework
($ Millions of Value)
$1,000
Current
$ 25 Market $ 635
Current Price Maximum
perceptions 1 restructuring
Gap: “Premium” opportunity

$ 1,635
Company Optimal
$ 975 2 5 restructured
value as is value

Strategic Restructuring Financial

$ 300 and operating Framework engineering $ 10
opportunities opportunities

Eg Increase D/E
3 4
Potential
Potential value with
value with internal
internal Disposal/ and external
improvements Acquisition improvements
opportunities
$ 1,275 $ 1,625
$ 350
 M&A Advisory Services:
1. Role of the Seller's Advisor
• Develop list of buyers
• Analyze how different buyers would evaluate company
• Determine value of the company and advise seller on probable
selling price range
• Prepare descriptive materials showing strong points
• Contact buyers
• Control information process
• Control bidding process
• Advise on the structure of the transaction to give value to both
sides
• Ensure all nonfinancial terms are settled early
• Smooth postagreement documentation
 M&A Advisory Services:
2. Role of Buyer's Advisor
• Thoroughly review target & subs
• Advise on probable price range
• Advise on target's receptiveness
• Evaluate target's options and anticipate actions
• Devise tactics
• Consider rival buyers
• Recommend financial structure and plan financing
• Advise on initial approach and follow-up
• Function as liason
• Advise on the changing tactical situation
• Arrange the purchase of shares through a tender offer
• Help arrange long term financing and asset sales
M&A & D Opportunities
Target Companies
• Need value chain integration – eg dependent on supplier – vertical integration
• Benefit from greater efficiency – avoid cutthroat competition, achieve production
or distribution efficiencies
• Company has weak financials – flat earnings, overleveraged
• Has several businesses that have no synergies – some growth, some flat
• Company has businesses with incompatible cultures – or two different companies
with compatible cultures
• Company is in sector with overcapacity – too much bread (!) – benefit from
consolidation
• Company wants to buy competitor who could end up in a rival’s hands
• Company wants to do an IPO but is not suitable – eg not in a “new economy”
business, or the size is insufficient
• Companies in the same line of business, but with P/E differentials
• Conglomerate discount – company is undervalued in the market and would be
worth more if some businesses were hived off
• Owner wants to retire
Strategic Alliances:
An Alternative to Acquisition

• "A strategic alliance is a collaborative agreement between

two or more companies, which contribute resources to a
common endeavor of potentially important competitive
consequences, while maintaining their individuality."
• Example with internal emphasis: Sunkyong with GTE,
Vodaphone & Hutchinson Whampoa for cellular system
• Example with external emphasis: Santander with Royal
Bank of Scotland for European market in financial services
• Driving forces:
• Complementary resources - gain strategic resources
• Similar capabilities - gain economies or market power
 A List Of Alliance Options
Alliances

Acquisition     
Merger    
Core Business JV     
Sales JV    
Production JV    
Development JV    
Product Swap    
Production License     
Technology License  
Development License   
product markets

Increase capacity
Leapfrog product
Share upstream

Share develop-

Penetrate new
Develop new

geographic
ment costs

Fill product
technology

economies
utilization

line gaps

markets
of scale
Exploit
risks
 Forms of Strategic Alliance
• Many linkages are options for future development
of relationships
POTENTIAL ACQUISITION MERGER
WITH FULL
FOR CONTROL
INTEGRATION

JOINT
VENTURE

JOINT
PROJECTS SPECIFIC
DISTRIBUTION
INFORMAL OR SUPPLY
ALLIANCE AGREEMENT
IRREVERSIBILITY OF COMMITMENT
 Questions to Ask Before the Alliance

• Identify value creation logic to both firms. Are the logics similar? Are they
compatible?
• What is the potential value of the alliance to each firm (versus the cost of not
having the alliance?)
• What are the specific financial and competitive risks to each partner?
• What is the value of complementary assets? Of common assets contributed?
• Evaluate the investment each partner would make.
• Evaluate other resource commitments.
• What are the scope and boundaries of the alliance?
• What commitments are made in the alliance?
• What are the criteria for success? Are they shared?
• What revenues and returns are projected? What risks?
• What are the critical limiting factors?
• Is there an action plan to reduce the limiting factors?
Mergers and Acquisitions: Summary

• Mergers & Acquisitions

• Divestitures
• Valuation

Concept: Is a business worth more within

our company, or outside it?
Strategy in the Global
Environment
The Global Environment
• Managers need to consider:
– How globalization is impacting the environment in
which their company competes
– What strategies they should adopt to exploit
opportunities
– How to counter competitive threats
The Global Environment
• Industry boundaries do not stop at national
borders
• The shift to global markets has intensified
competitive rivalry in industries
• Global markets created enormous opportunities
Increasing
Profitability Through Globalization
• The success of many multinational companies is
based not just on the goods and services they sell,
but upon the distinctive competencies that
underlie their production and marketing
• Globalization increases profits by:
– Expanding the market
– Realizing economies of scale
– Realizing location economies
– Leveraging the skills of global subsidiaries
Competitive Pressures
• Two main pressures:
• Pressure for cost reduction
• Pressure to be locally responsive
• These pressures place conflicting demands on a
company
Cost Reductions
• Cost reductions are common in:
– Industries where price is the main competitive
weapon
– Industries with universal need products
– Universal Need: When consumer preference is similar
or identical in different nations
• Companies may achieve cost reduction by basing
production in a low-cost location or by offering a
standardized product.
Local Responsiveness Pressures
• These arise from differences in:
– Consumer taste and preferences
– Infrastructure or traditional practices
– Distribution channels
– Host government demands
• The more that customer preferences vary, the
more local responsiveness is required
Choosing a Strategy
Basic four strategies:
• Global Standardization Strategy
• Localization Strategy
• Transnational Strategy
• International Strategy
Global Standardization Strategy
• Focuses on increasing profitability by pursuing a
low-cost strategy on a global scale
• Works best if there is:
– Strong pressure for cost reduction
– Low pressure for local responsiveness
Localization Strategy
• Customizes goods or services to provide a good
match to tastes and preferences in different
national markets
• Works best if there is:
– Low cost pressure
– Varied taste and preferences by nation
Transnational Strategy
• Attempts to achieve low-cost, differentiated
products across markets and to foster a flow of
skills between different subsidiaries
• Works best if there is simultaneous :
– High cost pressures
– High local responsiveness pressures
International Strategy
• Centralizes product development, but
manufactures and markets globally
• Works best if there is:
– Low cost pressure
– Low pressure for local responsiveness
– A universal need product
– No significant competitors
Choices of Entry Mode
• Exporting
– Many companies begin global expansion through
exporting production
– Exporting allows companies to bypass the cost of
establishing manufacturing facilities
– Exporting may be consistent with scale economies and
location economies
Choices of Entry Mode (cont’d)
• Licensing
– A licensee in a foreign country can purchase the rights
to produce a product in their country
– The cost of development is low, as well as the risk
involved
Choices of Entry Mode (cont’d)
• Franchising
• A specialized form of licensing where the franchiser
sells intangible property (usually a brand or
trademark).
• The franchisee agrees to follow the strict rules and
business plans of the company
Choices of Entry Mode (cont’d)
• Joint Venture
– Separate corporations come together to form a new
corporate entity
– Two or more companies have an ownership stake, but
combine resources for mutual benefit
– Sharing knowledge can be dangerous for the
companies involved
Choices of Entry Mode (cont’d)
• Wholly Owned Subsidiaries
– A parent company owns 100% of a smaller self-
contained business unit
– This can be a very costly approach, since the parent
company is responsible for all of the financing
 Creating Value through Corporate
Strategy
The development of a corporate strategy should
amount to more than the aggregation of business unit
strategies. The best corporate strategies, force a multi-
business company to make clear choices about its
portfolio and the allocation of its resources.
Yet the results of a recent McKinsey survey show that
just one executive out of five says his or her
corporation fully addresses strategy in this way.
What’s more, more than a quarter of executives at
multi-business companies say their corporations lack a
consistent process for developing strategy.
 Creating Value through Corporate
Strategy
In both the boom of the mid-2000s and the financial crisis that
followed, many companies did not (or could not) make critical
portfolio choices and trade-offs. This may be why so few—just
19 percent of all respondents to this survey—say their
companies have a distinct process for developing corporate
strategy.
Nearly a quarter, however, think their companies should engage
in corporate strategy development on an ongoing basis (as
opposed to episodically), compared with only 8 percent who
say they currently do so.
The small group of respondents at the effective-developer
companies is ahead of the pack: 19 percent say their
companies currently review corporate strategy on an ongoing
basis.
 Creating Value through Corporate
Strategy
A similar pattern emerges with regard to the amount of time a
company’s senior-executive team actually spends—and ideally
should spend—on developing corporate strategy in a typical
year.
No more than one in seven respondents say their companies’
senior leaders currently spend more than 15 percent of their
time on this activity, but nearly three times as many describe
that as the ideal time commitment.
Among respondents at effective developers, a quarter say
senior leaders currently spend more than 15 percent of their
time on corporate strategy development.
 Creating Value through Corporate
Strategy
What goes into strategy
Financial projections are important for allocating capital to
businesses in the existing portfolio. But the importance of trend
analysis grows when it comes to adding corporate value by creatively
reallocating resources and by changing its composition through
mergers, acquisitions, and divestments.
Yet executives rank financials as their companies’ most important
input when developing corporate strategy—23 percent of all
respondents rank it first, followed by the performance of the overall
portfolio, which 21 percent of all respondents rank first. Interestingly,
executives at effective developers rank financial projections lower
and macrolevel trends significantly higher. Furthermore, when asked
what triggers a review of corporate strategy, more respondents say
the trigger is their internal planning cycle rather than any external
event, regardless of whether they work at effective companies or
not.
 Creating Value through Corporate
Strategy
Looking ahead
Many corporations have emerged from the hunker-down
mentality of the financial crisis with strong balance sheets and
profits. Robust corporate strategy development will be
essential to charting a future path to successful growth and
returns.
Companies would do well to design an ongoing corporate
strategy-development process that explicitly tackles key
corporate-level issues, such as resource reallocation, and that
drives on major economic trends and other external factors.
Managers should forge much stronger links between corporate
strategy and other key management processes, such as talent
management and allocation of capital expenditures, to ensure
that their strategies translate into meaningful action.