Mergers and Acquisitions

Discuss why mergers and acquisitions occur

Answer:  The primary motivations for M&As include an attempt to realize synergy by combining the acquiring and target firms, diversification, market power, strategic realignment, hubris, buying what are believed to be undervalued assets, so-called agency problems, managerialism, and tax considerations.  Synergy is the notion that combining two firms results in a valuation of the combined firms that exceeds the sum of the two firms valued on a standalone basis.  Synergy represents the incremental cash flows only achievable by combining the acquirer and target firms. Synergy is often realized by achieving economies of scale, the spreading of fixed costs over increasing levels of production, or economies of scope, the utilization of a specific set of skills or an asset currently employed to produce a specific product to produce related products.  Financial synergy represents another source of increased value that may be realized by lowering the combined firm’s cost of capital if the new firm experiences lower overall transaction costs in raising capital and a better matching of investment opportunities with internally generated funds.  Diversification may be either related or unrelated.  Both forms represent an effort by the acquirer to shift assets away from a lower growth, less profitable focus to a higher growth, potentially more profitable area.   Strategic realignment represents a radical departure from a firm’s primary business to another area of focus often because of changes in regulations or technology, which makes obsolete the firm’s primary business.

Hubris is often the motivation for M&As even if the market correctly values a firm, since the acquiring firm’s management may believe that there is value in the target firm that investors do not see.  Firms may also be motivated to buy another firm if the firm’s market value is less than what it would cost to replace such assets.  Agency problems arise when there is a difference between the interest of incumbent managers and the firm’s shareholders.  By acquiring the firm, value is created when managers whose interests are more aligned with shareholders replace current management; and, as such, these new managers are more inclined to make value enhancing investments rather than those intended to entrench management or contribute to their overall compensation. Firms may acquire another firm to achieve greater market share in an effort to be able to gain more control over pricing.  Managerialism is a situation in which a firm’s managers acquire other firms simply to increase the acquiring firm’s size and their own compensation.  Finally, an acquirer with substantial taxable income may wish to acquire a target firm with significant loss carryforwards and investment tax credits in order to shelter more of their taxable income.

1.2          What is the role of the investment banker in the M&A process?

Answer:  Investment bankers serve as advisors to firms developing business strategies. They also recommend M&As and other types of restructuring activities intended to build shareholder value, screen potential buyers and sellers, make initial contact with a seller or buyer, and provide negotiating support, valuation, and deal structuring.  Investment bankers may also assist in arranging M&A financing.

1.3          In your opinion, what are the motivations for two mergers or acquisitions in the news?

Answer:  In 2002, Hewlett Packard announced its interest in acquiring Compaq Computer, a major competitor.  The justification was to achieve cost savings by eliminating duplicate overhead and by closing under-utilized manufacturing facilities and to move the two firms increasingly into selling such services as maintenance and consulting.  Northrop Grumman announced its desire to purchase TRW in 2003, primarily for its strong position in satellites and surveillance technologies.  The HP acquisition represents an effort to realize operating synergy by combining two highly related firms.  In contrast, the Northrop attempt to takeover TRW is driven more by a desire to diversify into a related market that is expected to exhibit high growth due to the “war of terrorism.”

1.4          What are the arguments for and against corporate diversification through acquisition? Which do you support and why?

Answer:  In discussing diversification, it is important to distinguish between unrelated and related diversification.  Firms often justify unrelated diversification if they believe their current core business is maturing or is too “cyclical.” By shifting their focus to higher growth areas, management argues they can improve shareholder value.  Moreover, by moving into an industry whose cash flows are uncorrelated with those in the core business, it is argued that the firm’s earnings growth will become more predictable and hence less risky, thereby boosting the share price. Related diversification reflects an effort to sell the firm’s current products into new markets or to sell new products into current markets.  Such efforts are often less risky, because the firm is either familiar with how to produce the current products being sold into the new markets or is familiar enough with the needs of the customers in its current markets to know which new products they are likely to want.  Empirical studies show that unrelated diversification tends to destroy shareholder value.  Moreover, an investor is always able to more cheaply diversify their own portfolio by buying a minimum of 12-15 stocks in distinctly different industries than by buying the stock of a highly diversified firm. In 2002, a number of highly diversified companies such as Tyco were severely punished by investors because of the complexity of their business portfolios and the inability of investors to see the value added by the holding company structure.

1.5          What are the primary differences between operating and financial synergy? Give examples to illustrate your statements.

Answer:  Operating synergy includes economies of scale and scope.  Economies of scale may be realized when two firms with manufacturing facilities operating well below their capacity merge.  If such facilities are combined, the average operating rate is increased and fixed expense per unit of output is reduced.  Significant savings may be realized if two firms merge and combine their data centers such that all operations in the future are supported by one rather than two or more such centers.  Financial synergy may be realized in a holding company if the holding company can more cheaply raise capital for its subsidiaries than they could do on their own.

1.6 At a time when natural gas and oil prices were at record levels, oil and natural gas producer, Andarko

Petroleum, announced on June 23, 2006 the acquisition of two competitors, Kerr-McGee Corp. and Western Gas Resources, for $16.4 billion and $4.7 billion in cash, respectively.  These purchase prices represent a substantial 40 percent premium for Kerr-McGee and a 49 percent premium for Western Gas. The acquired assets strongly complement Andarko’s existing operations, providing the scale and focus necessary to cut overlapping expenses and to concentrate resources in adjacent properties. What do you believe were the primary forces driving Andarko’s acquisition?  How will greater scale and focus help Andarko to reduce its costs? Be specific. What are the key assumptions implicit in your argument?

Answer: Given the escalation in oil prices and the increasing difficulty in finding new reserves, Andarko concluded that it would be cheaper to buy reserves rather than to explore and develop new reserves. Recovering the substantial premium it paid assumed that oil prices would remain high. Declining oil prices would make it difficult for the firm to recover the premium without very aggressive cost cutting.  The firm also expects to achieve significant cost savings from combining overhead functions such as human resources and finance. Increasing operational scale will enable the firm to obtain savings from bulk purchases of supplies and services. Moreover, the adjacency of the properties will enable better utilization of production equipment and distribution pipelines. Achieving these savings assumes that the simultaneous integration of two companies can be handled smoothly without disruption to the firm’s existing operations. Furthermore, the ability to recover the large premiums paid assumes that energy prices will continue to escalate into the foreseeable future.