Mergers

John Wiley & Sons

Chapter One

The field of mergers and acquisitions (M&As) has greatly expanded over the past quarter of a century. While M&As used to be somewhat more of a U.S. business phenomena, this changed significantly in the 1990s, and now M&As are more commonly used by corporations throughout the world to expand and pursue other corporate goals. This was very much the case in the latest merger wave of the 1990s and early 2000s, where the numbers of deals in Europe were comparable to those in the United States. In addition, other markets, such as the Asian economies, also saw much M&A activity as well as other forms of corporate restructuring. Restructuring, sell-offs, and acquisitions become more common in Asia, where countries such as Japan and South Korea began the slow process of deregulating their economies in an effort to deal with economic declines experienced during that period.

In this book we will analyze how mergers and acquisitions can be used to further a corporation's goals. However, we will focus mainly on how M&As can be misused and why this occurs so often. We will see that flawed mergers and failed acquisitions are quite common and are not restricted to one time period. We will see that while we have had three merger booms in the United States over the past four decades, every decade featured many prominent merger failures. One characteristic of thesefailures is their similarity. It might seem reasonable that if several corporations had made certain prominent merger errors, then the rest of the corporate world would learn from such mistakes and not repeat them. This seems not to be the case. It is ironic, but we seem to be making some of the same merger mistakes-decade after decade. In this book we will discuss these errors and try to trace their source.

Before we begin such discussions, it is useful to establish a background in the field. For this reason we will have an initial discussion of the field of M&As that starts off with basic terminology and then goes on to provide an overview. We will start this review by highlighting some of the main laws that govern M&As in the United States. It is beyond the bounds of this book to provide a full review of the major laws in Europe and Asia. Fortunately, many of these are covered elsewhere.

Following our review of the regulatory framework of M&As, we will discuss some of the basic economics of M&As as well as provide an overview of the basic reasons why companies merge or acquire other companies. We will generally introduce these reasons in this chapter, but we will devote Chapter 2 to this issue.

In this initial chapter on M&As, we will also review leveraged transactions and buyouts. The role of debt financing, and the junk bond market in particular, and the private equity business will be covered along with the trends in leveraged deals. We will see that these were more popular in some time periods than in others. In the most recent merger wave, for example, we saw fewer of the larger leveraged buyouts than what we saw in the 1980s when M&As were booming to unprecedented levels.

Finally, we will review the trends in number of dollar value of M&As. We will do this from a historical perspective that focuses on the different merger waves we have had in the United States, but also elsewhere-where relevant. As part of this review, we will point out the differences between the merger waves. Each is distinct and reflects the changing economy in the United States.

BACKGROUND AND TERMINOLOGY

A merger is a combination of two corporations in which only one corporation survives. The merged corporation typically ceases to exist. The acquirer gets the assets of the target but it must also assume its liabilities. Sometimes we have a combination of two companies that are of similar sizes and where both of the companies cease to exist following the deal and an entirely new company is created. This occurred in 1986 when UNISYS was formed through the combination of Burroughs and Sperry. However, in most cases, we have one surviving corporate entity and the other, a company we often refer to as the target, ceases to officially exist. This raises an important issue on the compilation of M&A statistics. Companies that compile data on merger statistics, such as those that are published in Mergerstat Review, usually treat the smaller company in a merger as the target and the larger one as the buyer even when they may report the deal as a merger between two companies.

Readers of literature of M&A will quickly notice that some terms are used differently in different contexts. This is actually not unique to M&As but generally applies to the use of the English language. Mergers and acquisitions are no different, although perhaps it is true to a greater extent in this field. One example is the term takeover. When one company acquires another, we could refer to this as a takeover. However, more often than not, when the term takeover is used, it refers to a hostile situation. This is where one company is attempting to acquire another against the will of the target company's management and board. This often is done through the use of a tender offer. We will discuss hostile takeovers and tender offers a little later in this chapter. Before doing that, let's continue with our general discussion of the terminology in the field of M&As.

MERGER PROCESS

Most M&As are friendly deals in which two companies negotiate the terms of the deal. Depending on the size of the deal, this usually involves communications between senior management of the two companies, in which they try to work out the pricing and other terms of the deal. For public companies, once the terms of the deal have been agreed upon, they are presented to shareholders of the target company for their approval. Larger deals may sometimes require the approval of the shareholders of both companies. Once shareholders approve the deal, the process moves forward to a closing. Public companies have to do public filings for major corporate events, and the sale of the company is obviously one such event that warrants such a filing by the target.

In hostile deals, the takeover process is different. A different set of communications takes place between the target and bidder. Instead of direct contact, we have an odd communications process that involves attorneys and the courts. Bidders try to make appeals directly to shareholders as they seek to have them accept their own terms, often against the recommendations of management. Target companies may go to great lengths to avoid the takeover. Sometimes this process can go on for months, such as in the 2004 Oracle and People-Soft takeover battle.

ECONOMIC CLASSIFICATIONS OF MERGERS AND ACQUISITIONS

Economic theory classifies mergers into three broad categories:

1. Horizontal

2. Vertical

3. Conglomerate

Horizontal mergers are combinations between two competitors. When Pfizer acquired Warner Lambert in 2000, the combination of these two pharmaceutical companies was a horizontal deal. The deal is an excellent example of the great value that can be derived from acquisitions, as Pfizer was able to acquire Lipitor as part of the package of products it gained when it acquired Warner Lambert. Lipitor, the leading anticholesterol drug, would become the top-selling drug in the world, with annual revenues in excess of $11 billion by 2004. This helped Pfizer maintain its position as the number-one pharmaceutical company in the world. This transaction was actually part of a series of horizontal combinations in which we saw the pharmaceutical industry consolidate. Such consolidations often occur when an industry is deregulated, although this was not the case for pharmaceuticals as it was for the banking industry. In banking this consolidation process has been going on for the past two decades. Regulatory strictures may prevent a combination that would otherwise occur among companies in an industry. Once deregulation happens, however, the artificial separations among companies may cease to exist, and the industry adjusts through a widespread combination of firms as they seek to move to a size and level of business activity that they believe is more efficient.

Increased horizontal mergers can affect the level of competition in an industry. Economic theory has shown us that competition normally benefits consumers. Competition usually results in lower prices and a greater output being put on the market relative to less competitive situations. As a result of this benefit to consumer welfare, most nations have laws that help prevent the domination of an industry by a few competitors. Such laws are referred to as antitrust laws in the United States. Outside the United States they are more clearly referred to as competition policy. Sometimes they may make exceptions to this policy if the regulators believe that special circumstances dictate it. We will discuss the laws that regulate the level of competition in an industry later in this chapter.

Sometimes industries consolidate in a series of horizontal transactions. An example has been the spate of horizontal M&As that has occurred in both the oil and pharmaceutical industries. Both industries have consolidated for somewhat different reasons. The mergers between oil companies, such as the merger between Exxon and Mobil in 1998, have provided some clear benefits in the form of economies of scale, which is a motive for M&As that we will discuss later in this chapter. The demonstration of such benefits, or even the suspicion that competitors who have pursued mergers are enjoying them, can set off a mini-wave of M&As in an industry. This was the case in the late 1990s and early 2000s as companies such as Conoco and Phillips, Texaco and Chevron merged following the Exxon-Mobil deal, which followed on the heels of the Amoco-BP merger and occurred at roughly the same time as the PetroFina-Total merger.

Vertical mergers are deals between companies that have a buyer and seller relationship with each other. In a vertical transaction, a company might acquire a supplier or another company closer in the distribution chain to consumers. The oil industry, for example, features many large vertically integrated companies, which explore for and extract oil but also refine and distribute fuel directly to consumers.

An example of a vertical transaction occurred in 1993 with the $6.6 billion merger between drug manufacturer Merck and Medco Containment Services-a company involved in the distribution of drugs. As with horizontal transactions, certain deals can set off a series of other copycat deals as competitors seek to respond to a perceived advantage that one company may have gotten by enhancing its distribution system. We already discussed this concept in the context of the oil industry. In the case of pharmaceuticals, Merck incorrectly thought it would acquire distribution-related advantages through its acquisition of Medco. Following the deal, competitors sought to do their own similar deals. In 1994 Eli Lilly bought PCS Health Systems for $4.1 billion, while Roche Holdings acquired Syntex Corp. for $5.3 billion. Merck was not good at foreseeing the ramifications of such vertical acquisitions in this industry and neither were the copycat competitors. They incorrectly believed that they would be able to enhance their distribution of drugs while gaining an advantage over competitors who might have reduced access to such distribution. The market and regulators did not accept such arrangements, so the deals were failures. The companies simply could not predict how their consumers and regulators in their own industry would react to such combinations.

Conglomerate deals are combinations of companies that do not have a business relationship with each other. That is, they do not have a buyer-seller relationship and they are not competitors. Conglomerates were popular in the 1960s, when antitrust enforcement prevented companies from easily engaging in horizontal or even vertical transactions. They still wanted to use M&As to facilitate their growth, and their own alternative was to buy companies with whom they did not have any business relationship. We will discuss this phenomena more when we review merger history. Also, we will discuss diversifying deals in general in Chapter 2 on merger strategies. We will find that while some types of diversifying mergers promote shareholder wealth, many do not. We will also see that even those companies that have demonstrated a special prowess for doing successful diversifying deals also do big flops as well. General Electric (GE) is a well-known diversified company or conglomerate, but even it failed when it acquired Kidder Peabody. Acquiring a brokerage firm proved to be too big a stretch for this diversified corporation that was used to marketing very different products. The assets of brokerage firms are really their brokers, human beings who walk in and out of the company every day. This is different from capital-intensive businesses, which utilize equipment that tends to stay in the same place you put it. With a brokerage firm, if you do not give the "asset" a sufficient bonus, it takes off to one of your competitors at the end of the year. If you are not used to dealing with such human assets, this may not be the acquisition for you. It wasn't for GE.

REGULATORY FRAMEWORK OF MERGERS AND ACQUISITIONS

In the United States, three sets of laws regulate M&As: securities, antitrust, and state corporation laws. The developments of these laws have been an ongoing process as the business of M&As has evolved over time. In this section we will cover the highlights of some of the major laws.

Securities Laws

In the United States, public companies-those that have sold shares to the public-are regulated by both federal and state securities laws. Although these laws regulate issuers of stock in many ways that are less relevant to M&As, they do contain specific sections that relate to such deals. Companies that engage in control transactions, of which an M&A would be considered such a transaction, have to make certain filings with the national governmental entity that regulates securities markets in the United States-the Securities and Exchange Commission (SEC). Securities laws require that with the occurrence of a significant event, including an M&A above a certain size, companies must file a Form 8K. This filing contains basic information on the transaction. In addition to this filing, when an entity is pursuing a tender offer, it must make certain filings with the SEC pursuant to the Williams Act. This law is primarily directed at the activities of companies that are seeking to pursue hostile deals.

The two most important laws in the history of U.S. securities regulation are the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act required the registration of securities that were going to be offered to the public. This was passed in the wake of the stock market crash of 1929, when so many companies went bankrupt and their investors lost considerable sums. At this time investors had little access to relevant financial information on the companies that offered shares. The law was designed, in part, to provide greater disclosure, which small investors could use to assess the prospects for their investments in these public companies. The lawmakers' reasoning at that time was that individual investors would be better protected if companies were required to disclose such information with which the investors could make more informed decisions.

The Securities Act of 1934 added to the provisions of the 1933 Act but also established the federal enforcement agency that was charged with enforcing federal securities law-the Securities and Exchange Commission (SEC). Many of the securities and merger-related laws that have been enacted are amendments to the Securities Exchange Act. One major amendment to this law was the Williams Act, which regulated tender offers.

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Excerpted from Mergers by Patrick A. Gaughan Excerpted by permission.
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