Chapter 4

Distribution in global M&A activity

America 45% Europe 32% Asia 18% Japan 3% Africa 2%

Third wave (1960s) - conglomerate mergers

- conglomerate (when acquirer & target operate in unrelated industries) or diversifying combinations - booming economy - equity financing due to boom in stock market prices

Irrational managers & irrational markets

- economics has little to say about this world - swarm behaviour and market mania

Drivers, Industry & Turning point wave 2

- Boom in stock market prices - Heightened regulation against horizontal mergers - technology innovation -public utilities, banking, chemicals, mining, food processing, metal - Stock market crash of 1929

The economic turbulences

- Deregulation: loosening of regulatory requirements - Trade liberalisation: lifting of barriers to foreign trade - Geopolitical change: fall of iron curtain was a trigger - Demographic change - Technological change - Innovation in financial markets - Globalisation - Changes in consumer demand - Changes in capital market conditions

Drivers, Industry & Turning points Wave 3

- Favorable economic and stock market condition - heightened regulation against horizontal merger - some concentration on oil industry - recession starting in 1971 - Antitrust enforcement against the rise of conglomerates

Wave 6: 2003-2007

- Lots of cross border mergers - cash is the main coinage - many hostile deals - many LBO deals - many industries are involved - many european deals

Overvaluation of stocks & Asymmetry of information

- M&A waves occur in line with increases in stock prices. - Overvaluation increases the amount of stock-for-stock deals (stock swap) in order to make the expected negative returns less negative - managers know more about firm than outsiders - assumes buyer's managers are rational but markets irrational

Drivers, Industry & Turning Point Wave 4

- Rising stock prices and falling interest rates - growing capital market innovation - deregulations - broad based & all sectors - many hostile deals - Recession in 1990

Drivers, Industry & Turning Point Wave 5

- Rising stock prices and falling interest rates - industry specific shocks - almost all sectors - clustering in banking, media, telecom - many strategic buyers and more friendly deals - Burst of the internet bubble in march 2000

Agency Costs

- The fourth wave differed from others in 2 ways: relatively high volumes of hostile takeovers & leveraged buyouts. - This was a response of investors to the mounting agency costs (= inefficiencies arising from conflicts of interests between agent (manager) and principals (shareholders) - merger might remove these costs & make firm more efficient - assumes buyer's managers & markets are rational

Driver & Industry & Turning point wave 1

- favourable economic and stock market conditions - rapid technological innovation - variety of manufacturing firms - stock market crash and banking panic - regulation against horizontal M&A

Second wave (1916-1929) - vertical mergers

- firms integrate backward into supply and forward into distribution of their core business - merger of oligopoly - 12000 manufacturing, mining, public utility firms disappeared - innovations: rail transportation, motor vehicle, radios, entertainment

Creative destruction as the driver of M&A - by Schumpeter

- focuses on the entrepreneur & what he does - business cycles occur because entrepreneurs swarm or cluster around opportunities (silicon valley) - at the centre are leaders who get things done - profit creation opportunities arise from new products and processes - M&A is a process of creative destruction - M&A waves depend on economic turbulences

Fifth wave (1992-2000) - cross border & stock based mergers

- following a recession M&A activity increased as a response to overcapacity due to deregulation - low interest & rising stock prices - more venture capitalists - flourishing banking, finance, communication & broadcasting sector - Oligopoly market structure - large megamergers, fewer hostile deals & more strategic mergers - more equity based transactions

wave 6: Drivers & turning points

- high stock prices, low interest rates - more relaxed antitrust rules - innovation - credit derivatives - Credit crunch in 2007 - Economic decline in 2008

Fourth wave (1980s) - LBOs and hostile takeovers

- large deals, more hostile takeovers, more leverage, more going private transactions (falling interest and rising stock prices) - total $ paid rose sharply - increasing size & prominence of targets - innovation in acquisition techniques by investment bankers - more aggressive use of debt

Wave 1 characteristics

- limited impact of the Sherman Antitrust Act - easy financing - stock market crash in 1904 = easy finance ends here - as a result standard oil broke into 30 companies

Irrational managers & rational markets

- manages do stupid things for which the market punishes them (hubris) - hubristic behaviour is possible in a world with poor governance systems

Market Manias

- mass behaviour that produces market bubbles and crashes is a variant on the behavioural theme. - M&A world leads to deal frenzy - assumes buyer's managers & markets are irrational

Derivatives

- most interesting are standardised derivatives contracts on corporate securities - of greatest interest will be the implied volatility embedded in the pricing of these derivatives. - are said to trade no risk

Rational managers & irrational markets

- possibility of bubbles - managers can and will act rationally - explains why the form of payment in M&A varies (overvaluations) - overvaluation express irrationality of markets - with information asymmetry managers can respond rationally

Rational managers & rational markets

- share prices fairly reflect intrinsic value - managers take effective actions to maximise share prices. - managers pursue competitive advantage - with external shocks managers respond rational - firms conduct M&A to exploit profitable opportunities

Industry shocks (changes in demand, technology, movements in capital markets, changes in barriers within industries)

- surprising changes in demand could trigger firms acquisitions additional capacity through M&A. - economic disturbance trigger M&A wave when it is cheaper to buy than to make. - Positive shocks increase uncertainty of firms asset values & value of merger option -> rise in M&A - assumes buyer's managers & markets are rational

Competitive positioning and rent seeking behaviour

- the creation of monopolies and oligopolies (1st & 2nd wave) permits producers to extract excessive returns form consumers = rent seeking - antitrust regulations but a constraint on the creation of monopolies - assumes buyer's managers & markets are rational

Hubris (Selbstüberschätzung)

- the urge to merge is driven by pride and hubris although the risks of negative returns following mergers is well known. - Managerial psychology plays a major role - Say nothing about M&A waves - markets are rational but managers are irrational

Macroeconomic conditions

-unemployment rate - if low= upward pressure on wages - Fiscal policy: government spending or tax raising - Monetary policy: expansionary or contractionary - inflation rate: high rates destabilise competition & increase uncertainty - Interest rates: directly affect valuations - exchange rates: volatility destabilises competition - trade balance: imbalance can affect available capital - consumer optimism: correlated with demand - GDP: driver of corporate investment decision

5 periods of heightened merger activity

First wave (1897-1904) - horizontal merger Second wave (1916-1929) - vertical mergers Third wave (1960s) - conglomerate mergers Fourth wave (1980s) - LBOs and hostile takeovers Fifth wave (1992-2000) - cross border & stock based mergers Sixth wave (2003-2007) - PE (private equity) & LBOs

Drivers of M&A activity

Hubris - managerial psychology (selbstüberschätzung) Market Manias - mass behaviour Overvaluation of stocks & asymmetry of information Agency Costs Competitive positioning Industry shocks - changes in demand

Equity multiples

Pricing multiples are a commonly used tool of analysis in the global financial markets and give a convenient indication of the price of an asset relative to some benchmark

Bebt yields and their associated risk premiums

debt yields are excellent indicators of risk - the premium is measured as the difference between the yield of corporate debt, and the yield on a contemporaneous government debt instrument (bond) - premium increases as risk increases

Common characteristics of the waves:

falling interest rates rising stock market expanding economy but differ sharply in industry focus, type of transaction

First wave - horizontal mergers (1897-1904)

firms want built market power in response to overcapacity induced by rapid technological innovation. Mainly mining & manufacturing - merger for monopoly - megamerger between federal Steel and Carnegie Steel - 3000 companies disappeared - exploit economies of scale (decrease in cost of production)

peaks of M&A waves

in 2000 & 2007

Betas

is a measure of the historical volatility of a firms share price relative to the entire stock market. More precisely it measure the degree of systematic risk

economic turbulences approach

lisetenting to markets = top down approach listenting to firms = bottom up approach start with hard data = inside out approach start with ideas = outside in approach Page 90!!

2 ways to consider deal activity

numer of transactions (equal weight to all deals-> measure of breadth) in terms of their aggregate dollar value (measure of depth or materiality)

Credit ratings

publicly traded debt issues are ordinarily rated for creditworthiness = risk of default in servicing the issue

Listening to consumers

through analysis of purchasing behaviour - price elasticity of demand (% change in units sold for every % change in price - Rates of growth - Sensitivity of demand & availability of complements & substitutes - Demand segmentation