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Many mergers are arranged amicably, but in other cases one firm will make a hos-
tile takeover bid for the other. We describe the principal techniques of modern merger
warfare, and since the threat of hostile takeovers has stimulated corporate restructurings
and leveraged buyouts (LBOs), we describe them too, and attempt to explain why these
deals have generated rewards for investors. We close with a look at who gains and loses
from mergers and we discuss whether mergers are beneficial on balance.
After studying this material you should be able to
Describe ways that companies change their ownership or management.
Explain why it may make sense for companies to merge.
Estimate the gains and costs of mergers to the acquiring firm.
Describe takeover defenses.
Summarize the evidence on whether mergers increase efficiency and on how the gains
from mergers are distributed between shareholders of the acquired and acquiring firms.
Explain some of the motivations for leveraged and management buyouts of the firm.

TABLE 22.1
Payment, Billions
Some important recent
Year Buying Company Selling Company of Dollars
mergers
1999 MCI WorldCom Sprint 115
1999 Viacom CBS 35
1999 AT&T MediaOne Group 54
1999 Travelers Group Citicorp 83
1999 Exxon Mobil Corp. 80
1999 TotalFina (France) Elf Aquitaine (France) 55
1999 Olivetti (Italy) Telecom Italia (Italy) 58
1999 Vodafone (UK) Air Touch Communications 61
1998 British Petroleum (UK) Amoco Corp. 48
1998 Daimler-Benz (Germany) Chrysler 38
1998 Zeneca (UK) Astra (Sweden) 35
1998 Nationsbank Corp. BankAmerica Corp. 62
1998 WorldCom Inc. MCI Communications 42
1998 Norwest Corp. Wells Fargo & Co. 34

568
Mergers, Acquisitions, and Corporate Control 569



The Market for Corporate Control
The shareholders are the owners of the firm. But most shareholders do not feel like the
boss, and with good reason. Try buying a share of General Motors stock and marching
into the boardroom for a chat with your employee, the chief executive officer.
The ownership and management of large corporations are almost always separated.
Shareholders do not directly appoint or supervise the firm™s managers. They elect the
board of directors, who act as their agents in choosing and monitoring the managers of
the firm. Shareholders have a direct say in very few matters. Control of the firm is in
the hands of the managers, subject to the general oversight of the board of directors.
The separation of ownership and management or control creates potential agency
costs. Agency costs occur when managers or directors take actions adverse to share-
holders™ interests.
The temptation to take such actions may be ever-present, but there are many forces
and constraints working to keep managers™ and shareholders™ interests in line. As we
pointed out earlier, managers™ paychecks in large corporations are almost always tied to
the profitability of the firm and the performance of its shares. Boards of directors take
their responsibilities seriously”they may face lawsuits if they don™t”and therefore are
reluctant to rubber-stamp obviously bad financial decisions.
But what ensures that the board has engaged the most talented managers? What hap-
pens if managers are inadequate? What if the board of directors is derelict in monitor-
ing the performance of managers? Or what if the firm™s managers are fine, but re-
sources of the firm could be used more efficiently by merging with another firm? Can
we count on managers to pursue arrangements that would put them out of jobs?
These are all questions about the market for corporate control, the mechanisms by
which firms are matched up with management teams and owners who can make the
most of the firm™s resources. You should not take a firm™s current ownership and man-
agement for granted. If it is possible for the value of the firm to be enhanced by chang-
ing management or by reorganizing under new owners, there will be incentives for
someone to make a change.

There are four ways to change the management of a firm. These are (1) a
successful proxy contest in which a group of stockholders votes in a new
group of directors, who then pick a new management team; (2) the purchase
of one firm by another in a merger or acquisition; (3) a leveraged buyout of
the firm by a private group of investors; and (4) a divestiture, in which a firm
either sells part of its operations to another company or spins it off as an
independent firm.

We will review briefly each of these methods.

METHOD 1: PROXY CONTESTS
Shareholders elect the board of directors to keep watch on management and replace un-
satisfactory managers. If the board is lax, shareholders are free to elect a different
board. In theory this ensures that the corporation is run in the best interests of share-
holders.
In practice things are not so clear-cut. Ownership in large corporations is widely dis-
persed. Usually even the largest single shareholder holds only a small fraction of the
570 SECTION SIX


shares. Most shareholders have little notion who is on the board or what the members
stand for. Management, on the other hand, deals directly with the board and has a per-
sonal relationship with its members. In many corporations, management sits on the
committee that nominates candidates for the board. It is not surprising that some boards
seem less than aggressive in forcing managers to run a lean, efficient operation and to
act primarily in the interests of shareholders.
When a group of investors believes that the board and its management team should
be replaced, they can launch a proxy contest. A proxy is the right to vote another share-
PROXY CONTEST
holder™s shares. In a proxy contest, the dissident shareholders attempt to obtain enough
Takeover attempt in which
proxies to elect their own slate to the board of directors. Once the new board is in con-
outsiders compete with
trol, management can be replaced. A proxy fight is therefore a direct contest for control
management for
of the corporation.
shareholders™ votes. Also
But most proxy contests fail. Dissidents who engage in such fights must use their
called proxy fight.
own money, while management can use the corporation™s funds and lines of communi-
cation with shareholders to defend itself. Such fights can cost millions of dollars.1
Institutional shareholders such as large pension funds have become more aggressive
in pressing for managerial accountability. These funds have been able to gain conces-
sions from firms without initiating proxy contests. For example, firms have agreed to
split the jobs of chief executive officer and chairman of the board of directors. This en-
sures that an outsider is responsible for keeping watch over the company. Also, more
firms now bar corporate insiders from serving on the committee that nominates candi-
dates to the board. Perhaps as a result of shareholder pressure, boards also seem to be
getting more aggressive. For example, outside directors were widely credited for has-
tening the recent replacement of top management at Coke and British Airwaves.


METHOD 2: MERGERS AND ACQUISITIONS
Proxy contests are rare, and successful ones are rarer still. Poorly performing managers
face a greater risk from acquisition. If the management of one firm observes another
firm underperforming, it can try to acquire the business and replace the poor managers
with its own team. In practice, corporate takeovers are the arenas where contests for cor-
porate control are usually fought.
There are three ways for one firm to acquire another. One possibility is to merge the
two companies into one, in which case the acquiring company assumes all the assets
and all the liabilities of the other. Such a merger must have the approval of at least 50
Combination of
MERGER
percent of the stockholders of each firm.2 The acquired firm ceases to exist, and its for-
two firms into one, with the
mer shareholders receive cash and/or securities in the acquiring firm. In many mergers
acquirer assuming assets
there is a clear acquiring company, whose management then runs the enlarged firm.
and liabilities of the target
However, a merger is often a combination of two equals with both managements hav-
firm.
ing a major say in the running of the new company. For example, the $330 billion pro-
posed merger between Time Warner and AOL is a merger of equals.
A second alternative is for the acquiring firm to buy the target firm™s stock in ex-
change for cash, shares, or other securities. The acquired firm may continue to exist as
a separate entity, but it is now owned by the acquirer. The approval and cooperation of
the target firm™s managers are generally sought, but even if they resist, the acquirer can

1 J. H. Mulherin and A. B. Poulsen provide an analysis of proxy fights in “Proxy Contests and Corporate
Change: Implications for Shareholder Wealth,” Journal of Financial Economics 47 (1998), pp. 279“313.
2 Corporate charters and state laws sometimes specify a higher percentage.
Mergers, Acquisitions, and Corporate Control 571


attempt to purchase a majority of the outstanding shares. By offering to buy shares
directly from shareholders, the acquiring firm can bypass the target firm™s management
altogether. The offer to purchase stock is called a tender offer. If the tender offer is
TENDER OFFER
successful, the buyer obtains control and can, if it chooses, toss out incumbent man-
Takeover attempt in which
agement.
outsiders directly offer to buy
The third approach is to buy the target firm™s assets. In this case ownership of the
the stock of the firm™s
assets needs to be transferred, and payment is made to the selling firm rather than di-
shareholders.
rectly to its stockholders. Usually, the target firm sells only some of its assets, but oc-
casionally it sells all of them. In this case, the selling firm continues to exist as an in-
dependent entity, but it becomes an empty shell”a corporation engaged in no business
activity.
The terminology of mergers and acquisitions (M&A) can be confusing. These
phrases are used loosely to refer to any kind of corporate combination or takeover. But
strictly speaking, merger means the combination of all the assets and liabilities of two
Takeover
ACQUISITION
firms. The purchase of the stock or assets of another firm is an acquisition.
of a firm by purchase of that
firm™s common stock or
assets.
METHOD 3: LEVERAGED BUYOUTS
Sometimes a group of investors takes over a firm by means of a leveraged buyout, or
LEVERAGED BUYOUT
LBO. The LBO group takes the firm private and its shares no longer trade in the secu-
(LBO) Acquisition of the
rities markets. Usually a considerable proportion of LBO financing is borrowed, hence
firm by a private group using
the term leveraged buyout.
substantial borrowed funds.
If the investor group is led by the management of the firm, the takeover is called a
management buyout, or MBO. In this case, the firm™s managers actually buy the firm
MANAGEMENT BUYOUT
from the shareholders and continue to run it. They become owner-managers. We will
(MBO) Acquisition of the
discuss LBOs and MBOs later.
firm by its own management
in a leveraged buyout.
METHOD 4: DIVESTITURES AND SPIN-OFFS
Firms not only acquire businesses; they also sell them. Divestitures are part of the mar-
ket for corporate control. In recent years the number of divestitures has been about half
the number of mergers.
Instead of selling a business to another firm, companies may spin off the business by
separating it from the parent firm and distributing stock in the newly independent com-
pany to the shareholders of the parent company. For example, in 1996, AT&T was split
into four separate firms: AT&T continued to operate telecommunication services, Lu-
cent took responsibility for telecommunication equipment manufacturing, NCR took on
the computer business, and AT&T Capital, which handled leasing, was spun off and
sold to another firm. Instead of holding shares in one megafirm, AT&T™s shareholders
were given shares in Lucent and NCR as well as AT&T. Investors clearly welcomed this
move: when the announcement of the split was made in 1995, AT&T™s shares jumped
11 percent.
Probably the most frequent motive for spin-offs is improved efficiency. Companies
sometimes refer to a business as being a “poor fit.” By spinning off a poor fit, the man-
agement of the parent company can concentrate on its main activity. If each business
must stand on its own feet, there is no risk that funds will be siphoned off from one in
order to support unprofitable investments in the other. Moreover, if the two parts of the
business are independent, it is easy to see the value of each and to reward managers ac-
cordingly.
572 SECTION SIX



Sensible Motives for Mergers
We now look more closely at mergers and acquisitions and consider when they do and
do not make sense. Mergers are often categorized as horizontal, vertical, or conglom-
erate. A horizontal merger is one that takes place between two firms in the same line of
business; the merged firms are former competitors. Most of the mergers around the turn
of the twentieth century were of this type. Recent examples of horizontal mergers have
occurred in banking, such as the merger between Deutsche Bank and Bankers Trust,
and in oil, such as the merger between Exxon and Mobil.
A horizontal merger can be blocked if it would be anticompetitive or create too much
market power. The Mobil and Exxon merger was challenged, but it was finally con-
summated after the two companies agreed to sell a number of service stations to other
retailers.
During the 1920s, vertical mergers were predominant. A vertical merger is one in
which the buyer expands backward toward the source of raw material or forward in the
direction of the ultimate consumer. Thus a soft drink manufacturer might buy a sugar
producer (expanding backward) or a fast-food chain as an outlet for its product (ex-
panding forward). Pepsi owns BurgerKing, for example.
A conglomerate merger involves companies in unrelated lines of business. For ex-
ample, before it went belly up in 1999, the Korean conglomerate, Daewoo, had nearly
400 different subsidiaries and 150,000 employees. It built ships in Korea, manufactured
microwaves in France, TVs in Mexico, cars in Poland, fertilizers in Vietnam, and man-
aged hotels in China and a bank in Hungary. No U.S. company is as diversified as Dae-
woo, but in the 1960s and 1970s it was common in the United States for unrelated busi-
nesses to merge. However, the number of conglomerate mergers declined in the 1980s.
In fact much of the action in the 1980s came from breaking up the conglomerates that
had been formed 10 to 20 years earlier.


Are the following hypothetical mergers horizontal, vertical, or conglomerate?
Self-Test 1
a. IBM acquires Apple Computer.
b. Apple Computer acquires Stop & Shop (a supermarket chain).
c. Stop & Shop acquires Campbell Soup.
d. Campbell Soup acquires IBM.


We have already seen that one motive for a merger is to replace the existing man-
agement team. If this motive is important, one would expect that poorly performing
firms would tend to be targets for acquisition; this seems to be the case.3 However,
firms also acquire other firms for reasons that have nothing to do with inadequate man-
agement. Many mergers and acquisitions are motivated by possible gains in efficiency
from combining operations. These mergers create synergies. By this we mean that the
two firms are worth more together than apart.


3 For example, Palepu found that investors in firms that were subsequently acquired earned relatively low rates
of return for several years before the merger. See K. Palepu, “Predicting Takeover Targets: A Methodological
and Empirical Analysis,” Journal of Accounting and Economics 8 (March 1986), pp. 3“36.
Mergers, Acquisitions, and Corporate Control 573

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