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A financial survey of mergers during the years 1968–70
OMEGA, The Int. Jl of Mgmt Sci., Vol. 1, No. 3, 1973
A Financial Survey of Mergers During the Years 1968-70 PM DALE Allied Breweries (U.K.) Ltd (Received 2 February 1973)
This paper is concerned with the financial objectives of mergers and acquisitions and the way in which considerations in the merger transaction, such as the price paid and the method of payment used, may affect such objectives subsequent to the merger. The analysis is based on a sample of 65 mergers during the years 1968-70 inclusive [2l.
INTRODUCTION THE ACQUISITION of one firm by another is probably one of the largest investments the acquiring firm will ever make. Quite apart from the original motives for the transaction, once a firm has decided that it wishes to acquire another, the situation should be treated as one of investment and a certain rate of return should be aimed for. Such a return must be in line with other investments undertaken by the firm. F r o m a review of the relevant literature certain generally accepted financial objectives come to light, as well as a number of constraints which inhibit the fulfillment of these objectives. It is the purpose of this survey to establish how far the firms involved have achieved these objectives, within the constraints, both at the time of the merger and during the subsequent period. The types of financial instruments (cash, equity, loan stock, etc.) which constituted the " p a c k a g e " offered in payment for the acquired firm are also related to the success or otherwise in achieving these objectives.
WHY MERGE? In m a n y merger situations the reasons for merging may be other than financial and some of the major ones are summarized below: 305
Dales.4 FinancialSurvey of Mergers To lengthen the product line; To gain facilities in markets not previously supplied; To enlarge a firm's capacity to supply old markets; To diversify; To gain access to further process or distributive facilities. McCarthy [4] has looked at these factors from both the buying and selling company's point of view. He suggests that the buying company may wish to diversify or add new and profitable products to its production lines faster than by means of research and development. Alternatively, it may be that the acquiring company is weak in management or technical personnel, or wants to acquire profitable operations to absorb a tax loss carry-over. From the selling firm's point of view, if the major management stockholders wish to retire and they have no understudies whom they consider capable of continuing the business profitably, they may look outside the firm for good management teams. If the business has expanded to a point where there is no need for substantial additional financing, and major stockholders are not willing to assume such a burden, a merger is a method of obtaining such financing. Alternatively, if the firm's operations have been at a depressed level for a long period, a merger is a means of survival. The prospects of technological or marketing changes adversely affecting the future operations of the company, or simply that the firm receives a very attractive offer from another firm, are also incentives to merge. In general, financial motives will only be considered by firms to which acquisition has become an integral part of the business. For the majority the purely financial gains are merely a consequence of the merger and not a reason for effecting it. A potential lender will invest in a portfolio of firms in different industries in order to minimize the probability that he will lose out on his investment, due to firms not being able to pay. This is a well-known method of "risk spreading". Lewellen [3] argues that if two firms in the portfolio merge, the risk is further reduced, since if one firm has over-capacity to pay and the other under, in the combined firm one will compensate the other. This hypothesis holds only if the cash flow distributions are independent. However, the majority of mergers which take place concern firms in the same industry, implying some dependence. Mergers are also believed to occur because of external factors and merger booms are explained in terms of these. The literature is very diverse on this matter, ranging from the traditional ideas of financial and economic indicators to the more recent views of Newbould [5] who relates merger activity to an increase in corporate uncertainty. In an endeavour to ascertain whether or not the principles outlined above, when translated into their ensuing financial consequences, are in fact adhered to, a sample of factual mergers was analysed. 306
Omega, Vol. 1, No. 3
THE SAMPLE The sample used was a selection of 65 mergers during the years 1968-70, involving selling firms operating wholly or largely in the U.K. and for which a consideration of over £10 million was paid by the acquiring company. The merger "boom" seems to have reached a peak in 1968, since which time the level of merger activity has fallen drastically. The sample consists of 38 mergers effected during 1968 and only 13 and 14 during the years 1969 and 1970 respectively. The technique of data collection used was, in the main, to analyse the daily financial press. Company reports, merger documents and Moody's investment services were also used. All types of businesses were acceptable, including several firms from non-industrial fields such as banking, insurance, finance and property, but with the exception of machine tools, newspapers and publishers, and shipbuilders and repairers. No firms came from these three categories. Since there are many definitions of the terms "acquisition" and "merger", the placing of transactions into these two categories is to a certain extent subjective. It was assumed for the purpose of this study that all business combinations may be thought of acquisitions of one firm (the victim, seller or acquired) by another (the bidder, buyer or acquirer). The acquiring firm in each case is the firm which makes the bidding, or in cases where the distinction is not at all clear, the larger in net assets of the two firms. In cases where firms A and B combine to form a new company C, again the instigator of the merger has been identified and the case is treated as if he is the acquirer. Initially the sample was categorized according to the legal form, type of competition involved, if any, and the industries concerned. The sample of 65 contained 17 mergers which were effected by means of a scheme of arrangement, 5 of which involved non-industrial firms. The majority of take-over bids were uncontested, 66 per cent compared with 12 per cent opposed by the directors of the victim firm, and 22 per cent contended by a third party. Fiftyfour per cent of the mergers were horizontal in nature, involving firms in the same industry and in direct competition with one another. A further 22 per cent involved businesses with a common factor of production. The remainder consisted of 15 per cent conglomerate mergers (11 per cent involved businesses concerned with finance or property) and 9 per cent vertical in nature. During the time in which a company is involved in merger negotiations top management resources must be devoted to bidding and an air of uncertainty lies about the future of all firms involved. Consequently the share prices will also react to uncertainty. The official end to merger negotiations occurs when the victim firm ceases to be quoted on the stock market and/or when the new company first appears on the official list. In many cases this point in time will be far removed from the time at which the offer is agreed upon by the majority of the shareholders of the victim, or the scheme approved by both firms, and 307
Dales,4 Financial Survey of Mergers yet it is this agreement which again stabilizes the share prices. Thus when defining the time span of the merger negotiations, the start of the negotiations was chosen to be that time at which the news of the first bid was made public, and the termination when it was announced that an offer had been accepted by 90 per cent of the victim's shareholders or the scheme had been approved and was awaiting court sanction. The time span of merger negotiations ranged from 4 to 50 weeks. The larger time spans were associated with mergers implemented by means of a scheme of arrangement and/or opposed by the directors of the victim firm. This is perhaps why boards are loath to oppose a bid in order to obtain better terms for their shareholders and do so in only a minority of cases. In the majority of mergers, negotiations took from 5 to 10 weeks. Competition by third parties has little influence on lengthening the time span, due to the very nature of the competition. Having once entered a bidding situation where there is more than one contender, the bidder fears that if he allows time to elapse between bids, he will ultimately fail. The firms in the sample were classified according to size (Table 1) as given by the 1968-69 Times 500. In this case, size is based on the total capital employed (total tangible assets less current liabilities and sundry provision). Banks and insurance companies were classified in terms of total funds. Throughout the analysis statistics referring to bidding firms collectively include all occasions when bidding firms appear in a merger transaction, rather than the actual number of firms involved in mergers. Since no firm included in the sample made more than two acquisitions, and in all cases with disjoint time spans, the effect of any two acquisitions may be taken as independent. TABLE I . SIZE OF FIRMS IN THE SAMPLE
Size category 1 2 3 4 5
Size £m
Bidding firms
Victimfirms
32 9 8 9 1 59
9 4 17 17 18 65
Over 100 50-100 25-50 10-25 0-10
Note that the bidding firms do not total 65 since 6 foreign-based firms whose assets were not k n o w n were a m o n g them. It is thought, however, that they would fall into the highest category.
When firms merged to form a new company with a new name (nine cases) all but one, which was a reverse take-over (i.e. the bidding firm was the smaller of the two), involved firms in the same size category. Also eight of the nine involved firms with assets valued at less than £100 million. 308
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ANALYSIS OF THE SAMPLE The analysis of the sample falls into four main parts: 1. An analysis of the payment used; 2. An analysis of the share price movement both during the merger negotiations and after the merger has been consummated; 3. An analysis of the premiums paid per share over the market price of the acquired firm; 4. A brief analysis (on a reduced sample) of the earnings performance over the three years following the merger.
1. Payment used Once the acquisition of a particular firm has been decided upon and the value of a company ascertained by such methods as discounted cash flow techniques, the acquiring firm must then decide in what form the offer is to be financed. There are numerous formats which an offer may take, but they are mainly combinations, with differing interest rates, on the following five methods: cash, equity, loan stock, convertible debentures and others (e.g. preference capital and warrants). Cash. Cash transactions are relatively rare, since in order to pay in cash a company must be large in comparison with the company it is acquiring; it should also be in a very liquid position financially, or have access to readily available credit. A cash bid will almost always carry a higher premium over the victim's share price than other forms of payment, to offset the capital gains tax to which the receiver will be liable. However, a cash deal may be desirable when the victim's earnings are currently depressed or non-existent. The same result may be achieved by an exchange of capital stock and a concurrent purchase and retirement of shares of stock from existing stockholders of the acquirer. This will preserve the "tax-free" status of the seller. The most significant advantage of using cash is its surprise value. If resistance is shown by the victim firm, a surprise cash bid may win the day and bring a long take-over battle to an abrupt halt. A cash deal also eliminates the problem of having a new group of substantial and possibly controlling stockholders and may increase the leverage for earnings on common stock. Given that a firm has the means to effect a cash bid, it must bear in mind that such a bid may affect its future debt-raising potential. There is usually a limit on the amount of debt a company may raise, and this limit is expressed as a percentage of net tangible assets. If at the time of the merger both firms have availed themselves fully of the opportunity to raise debt, then in certain cases a cash payment by the acquiring company will raise the level of debt in the combined company above the limit, thus affecting the future debt-raising potential. The condition for this to happen is that the cash bid paid exceeds the net tangible assets of the victim firm less the existing debt in the victim firm. 309
Dale A Financial Survey of Mergers Let DA be the debt in firm A DB be the debt in firm B NTA be the net tangible assets of A NTB be the net tangible assets of B then the new debt to tangible assets ratio (called t) in the combined firm will be t
debt
DA + DB
net tangibles
NTA + NTB-
cash p a i d
and the acceptable limit in terms of the old ratio is tA
=
DA/NTA.
Thus the new debt will exceed the limit if t > tA
or
if
cash p a i d > N T B -- D B .
Equity. A merger may be financed by a simple exchange of equity, so that the selling company become stockholders in the combined firm and no tax is payable on the transaction. The difficulty arises in establishing a suitable exchange ratio, by deciding on the relative value of each company and expressing it in terms of the acquiring company's shares. If a company feels that its shares are under-valued on the market, it will be loath to use equity as payment. The relationship between the market price per share and earnings per share of the two companies is also relevant in determining whether the surviving firm will suffer a reduction (:dilution) in earnings and a reduction in return on capital as a conseuqence of the merger. It is generally accepted that earnings per share is one of the most dominant factors in determining the market price and that a dilution of earnings is to be avoided where possible. Unlike cash payment, equity exchange will have no effect on the acquiring firm's future debt-raising potential. Since no net tangible assets have left A's possession, the debt to net tangibles ratio will remain unchanged. Using the terms defined above, if DA/NTA
= DB[NTB
= limit
then it is a simple matter to show that the new ratio is equal to DA + DB/NTA
+ NTB = DA/NTA
:
limit.
Loan stock. As long as the interest rate is equivalent to the return on ordinary capital, stockholders may be persuaded to accept loan stock partly or wholly in place of cash or equity. The interest rate required to make the offer attractive will also depend on the risk involved. If the stock being offered is some way down in the scale of priorities for payment, the risk will be greater and a higher return expected. Current trends of other stock yields must also be taken into consideration. The effects of increasing the debt in a company upon the future earnings and share price are complex and somewhat conflicting. Bierman [1] shows that 310
Omega, VoL 1, No. 3 the addition of debt, if issued at an interest rate equal to the return currently being earned on the common stock investment, will not affect the expected return of the common stock but will increase the variance of the earnings per share. This is relevant to the merger situation when a firm issues debt in return for the assets of the acquired firm. Since stability of earnings is thought to be a significant determinant of share price (i.e. the more stable the earnings, the greater the confidence in the stock and the higher the market price) the addition of debt would have an adverse effect. Conversely, payment by loan stock is beneficial from the tax point of view, since interest is deductible for tax purposes. Convertible debentures. The shareholders of the selling firm will often insist upon part of the offer at least being in the form of equity of the combined firm. In cases where, for various reasons, the acquiring firm prefers not to issue new equity at the time of the merger, convertible debentures may be used. The advantage to the seller is that the capital is protected to a much higher degree than on equity security. The stockholder has a virtually guaranteed income plus the advantage of exercising his option to convert into equity at a fixed price if the company prospers. On the other hand, the buyer will gain some leverage on earnings and if the selling firm's earnings are currently depressed, a steady conversion after the merger will offset the dilution of earnings which would otherwise have occurred. Care must be taken by the acquiring company to ensure that the issue of convertibles does not increase the gearing of the company to an unacceptable level. If the company prospers, a large conversion at one time will significantly increase the equity base, dilute earnings, and consequently tend to keep the market price depressed. If the company does not satisfy expectations and the market price is kept low, the unwillingness to convert on the part of the stockholders will cause an "overhang", which will in turn constrain the company in its ability to obtain new finance. Others. There are distinctions between voting and non-voting equities, and mention should be made of debentures convertible to voting and non-voting stock. Non-voting shares are little used since they are unattractive to the shareholders of the selling company, but have obvious advantages to the acquiring firm when it decides on an exchange of equity but wishes to retain control of the combined firm. Finally, preference capital, debentures convertible to preference capital, and warrants may also be used. Again, a warrant to purchase common stock at a given price is not usually acceptable as a form of payment, especially if there has to be a significant price appreciation before the warrant is worth exercising. There is a market for warrants, implying that they do have some implicit worth, but they are usually only included in an offer as an extra bonus. However, warrants to pay in cash at a later date are a good way of spreading the capital gains tax over a period of time. 311
Dale--A Financial Survey of Mergers Combinations. Many bids are composed of two or more of the above financial instruments and in this case, the management concerned must be careful not to nullify their objectives. In an equity exchange it is generally agreed that up to 25 per cent of the shares received may be disposed of without nullifying the "pooling of interests" criteria (i.e. when all the ownership interests in the constituent corporations survive in the combined enterprise). If the part payment is in cash, care must be taken to ensure that the "tax-free" status of the reorganization is preserved. If the preference shares in the acquiring company are valued highly relative to the stock of the seller, the acquirer may wish to offer preference shares together with ordinary stock. The seller then emerges with less voting power, but is induced to accept by virtue of a safer investment and higher dividend yield. Equity exchange is by far the most popular form of payment--81 per cent of all bids used equity to some extent. Cash is used in only 17 per cent of the bids and in nine of the eleven cases accounted for the total offer. Loan stock and convertible debentures are mainly used in part payment, to back up the equity or cash, though in one instance each the bid was financed entirely by loan stock or convertible debentures. All the cash paying firms in the sample came from the largest size category and, with the exception of two, they merged with firms from the smallest two categories (Table 1 above). Of the two exceptions, one was a partial bid to increase the acquirer's holdings to 50 per cent, and in the second case only 16.6 per cent of the value of the bid was paid in cash. It may be concluded that cash bids are made by large companies when acquiring companies considerably smaller than themselves. In such cases the strain on the liquidity of the acquiring firm will be small. It must also be noted that four of the five non-quoted foreign concerns made 100 per cent cash bids. Since the problems associated with evaluating exchange rates become greater when considering stocks of different countries, and also it will be difficult to persuade a shareholder to accept foreign stocks, cash is obviously a good method of payment when buying or selling abroad. In two of the four cash bids contested by third parties the acquiring firm made one successful cash bid after a series of equity/loan stock/convertible bids from other firms. This illustrates the benefits of the surprise element of cash payments. The other two bids followed a series of cash bids. The remaining three considerations (share price variations, premiums and earnings per share) were analysed both generally, taking account of competition and size factors, and from the point of view of the method of payment used. 2. Share price variations The price four weeks before news of the first bid was assumed to give a fair representation of how the market valued the shares at the time of the bid, 312
Omega, Vol. 1, No. 3 taking into account all factors relevant to share price valuation except the effect of the merger itself. Consequently the point in time four weeks before the first bid was used as a "reference" point from which certain merger effects could be established. The prices were adjusted to allow for scrip issues but since the effects of a dividend pay-out are not so easily quantifiable, the exdividend prices were left unaltered. Firstly, changes in the share prices of the bidding firm and victim firm over the period of merger negotiations were analysed. Then a follow-up study of the six-month period after the merger was made. The final prices in uncontested mergers were on average 21.4 per cent higher than the reference price; the mean increases for contested bids were much higher: 60"5 per cent in the case of those contested by directors and 63.9 per cent where third parties were involved. The variance about the mean was high in all cases and highest where there was competition from a third party. When looking at the changes in the bidding firms' share prices, in general no large increases or decreases occurred. The average increase for the whole sample was 0.8 per cent, or categorizing as before, a mean decrease of 0.9 per cent for third party involvement, a mean increase of 6.6 per cent when contested by directors and a mean increase of 0.3 per cent for uncontested bids. The variance for the changes for uncontested bids was very much smaller than that for contested bids, indicating much less variability of the observations underlying the mean. One conclusion from the study is that the share price of the victim firm engaged in merger negotiations is likely to increase appreciably over the negotiating period, while the price of the bidding firm is not greatly affected. As with any purchase, the effect on the purchaser is likely to depend on the relative size of the purchase. A large firm acquiring a firm of comparatively much smaller size will absorb the acquisition without too many external effects. However, if the two firms are near equal size, the acquirer is nearly doubling in magnitude and the effect will be significant. Effects will also occur when the bidding firm is the smaller of the two. It is possible that similar differences in effect will occur amongst the victim firms. Consequently, the changes in price over the merger span were categorized into three main divisions, namely firms in the "same size" category, "reverse take-overs" and "others" (i.e, where the acquiring firm is in a higher size category than the acquired firm). The mean change in "same size" mergers was a decrease of 0.9 per cent and for "reverse take-overs" a decrease of 10.4 per cent, whilst that for the "others" was an increase of 1"4 per cent. For the victim firms the most noticeable difference was that between "same size" mergers (a mean increase of 17.4 per cent) and "others" (a mean increase of 39.7 per cent). The mean increase for "reverse take-overs", rather than exhibiting the same trend as in the bidders, lay between the "same size" and "others" categories at 31.6 per cent. 313
Dale A Financial Survey of Mergers Thus it may be concluded that the victim firm in a "same size" merger will not experience such great increases in its share price over the period of merger negotiations compared with other firms. From the bidder's point of view, however, a "reverse take-over" is most likely to depress the share price. Thirdly, the changes in share price were summarized according to method of payment. The highest mean percentage change amongst the victim firm is achieved by mergers financed with cash. This is reasonable since cash bids usually carry a higher premium over the victim's share price and this premium will cause the price to rise until the shareholder is indifferent between selling his shares on the market and exchanging the shares for cash from the bidding firm. As will be seen later, the mean premium on cash bids was 63.9 per cent based on the reference prices, compared with a mean increase in price during the merger of 61"2 per cent. The remaining single instrument bids induced price rises of decreasing magnitude in the order equity, loan stock and convertibles, all significantly lower than that corresponding to cash bids. Generally, the only outstanding difference in the increase in price is achieved by the cash bids and this is attributed to the higher premium paid. From the bidding firm's point of view, loan stock seems to have the most beneficial effect on the share price, followed by equity and cash. Hence it is apparent that the shareholders approve of the single instrument bids in the decreasing order of cash, equity and loan stock, and the shareholders of the bidder show approval in the opposite order. Thus 26 of the 65 firms studied used a combination of instruments to obtain a balance between gaining the approval of their own shareholders and those of the firm they wished to acquire. However, such combination bids produced actual decreases in the share price, suggesting that the share price analysis should be followed up and extended for some time after the merger has been effected. The share price of the combined firm was taken at monthly intervals for six months after the merger had taken place, and analysed according to competition, size and method of payment as before. The results showed that the mean change over the six-month period was a decrease of 4.9 per cent based on a sample of 57. The sample size was reduced for this analysis since some mergers were too recent to allow a six-month follow-up study. Mergers involving competition from a third party showed the most significant increase in price, perhaps because the effects of inflated offers on the part of the bidding firm were beginning to tell. When classified according to size, the significant result was a 14"2 per cent mean increase where reverse take-overs had been effected. This compares with a decrease of 4.2 per cent and 6.7 per cent in the "same size" and "others" categories respectively. All single instrument methods showed further mean decreases with exception of loan stock with a 1.3 per cent increase. Again, four of the five combination methods showed decreases. In terms of the net change over the whole time period studied, a total of 314
Omega, VoL 1, No. 3 27 increases compared with 30 decreases implies that no conclusions can be drawn as to whether mergers in general are useful tools for increasing a firm's share price. However, there are indications that as the proportion of the offer expressed in equity increases so the likelihood of the share price depreciating becomes greater. Cash payment will have a similar effect, whilst loan stock exhibits a reverse trend.
3. Premiums The analysis of the total price paid was carried out in terms of the premiums paid per share. When a firm A makes an offer for firm B, the shareholders of B are induced to accept because the offer, when translated into its cash equivalent, is worth more than the current market price of these shares. This difference in the value of the price paid on the market price is known as the share premium. In this analysis the premium was expressed as a percentage of the market price. The premium, then, is some measure of the gain to a victim shareholder if he accepts an offer. Consequently the higher the premium the more likely is the bidder to gain acceptance, and in a competitive situation share premiums may be considered major elements of persuasion. The share premiums exchange of equity was evaluated both using the reference price and the price on the Friday after the bid was announced, called the "at bid price". (An analysis using daily prices showed that significant errors would not be introduced if prices were taken on a weekly basis. The closing price on a Friday was chosen for convenience.) The nominal price of the loan stock was used and the convertibles were valued as if they could be converted into equity immediately. These definitions of the cash equivalent of the financial instruments used do not in all cases assign the true value. The real worth of the loan stock will depend on its rate of interest, priority rating and proximity to redemption. A convertible debenture again should be valued according to its interest rate before conversion, together with the expectation of future trends in the price of the stock to which it is convertible. For these reasons a bid may be accepted at a low premium because the premium understates the true value of the bid. Premiums are important in merger analysis because if a firm is forced to pay an unduly high premium in order to gain acceptance, the total price paid may be so high that an unreasonable growth in earnings, as a result of the merger, is required if the merger is to be justified on a return on capital basis. The average premium for the sample was 38.4 per cent, the mergers involving competition producing much higher mean premiums (64.4 per cent) than the mean premium of the uncontested bids (21.2 per cent). When based on the "at bid price" all types produced similar means at a much lower level of 6"2 per cent. This is an indication of how the share price adjusts towards a level at which the shareholder is indifferent to accepting the offer of selling his shares on the market. 315
Dale A Financial Survey of Mergers The mean premium for cash was 63.9 per cent compared with 34.6 per cent for equity, 34.5 per cent for combinations of equity and loan stock and 37.2 per cent for equity combined with convertibles. Since the variances are again large, the only significant difference is between the premium on cash bids and the premiums on each of the other three. As the spread of premiums based on the "at bid prices" is very small, little information can be gained by classification according to the method of payment used. The premiums were calculated for each bid in a competitive situation. The average premiums for the first bids where there was opposition from the directors was 43.1 per cent compared with 55"8 per cent for the final bids. This substantiates the hypothesis that if directors oppose a bid, there is a good chance of obtaining better terms for the shareholders. With one exception the largest increase in percentage premium from the initial to the final bid occurred in mergers where a single financial instrument was offered throughout. In the three cases where a combination of equity and loan stock was offered initially, the greatest increase in premium based on reference prices was achieved over four consecutive bids. By continually opposing the bid the directors obtained for their shareholders a 36.5 per cent increase in premium and a final offer wholly in equity. It must be noted, however, that only by continuous buying of shares on the market over a period of a year and accumulating over 50 per cent of the voting equity, did the bidding firm finally persuade the shareholders of the victim firm to accept. Hence the motive for opposition was survival and not to increase the premium, the increase being merely a consequence of the opposition. The consequence, however, is significant and should be noted by all firms who are the object of a take-over bid. Where a third party was involved, the premiums based on reference prices again increased substantially as the bidding progressed. Bids finalized with cash offers all showed an increase in premium of over 40 per cent.
4. Earnings per share It is a common belief that an exchange of equity should not be made between two firms where the bidding firm has the lower price to earnings (P/E) ratio, because a dilution of the acquiring company's earnings will result. However, as Newbould [5] shows, if the rate of growth of the seller is higher than that of the buyer (and this will be the case if the market's expectations for future growth are correct), then an initial dilution will become an earnings accretion in subsequent years. Conversely, if the required earnings accretion in the first year is achieved because the acquired firm has the lower P/E ratio and again the market expectations for growth are correct, dilution will occur in the future. The only case in which this will not be so is if the synergistic effects produce higher earnings than the sum of the expected earnings. An empirical investigation of earnings, i.e. the total amount available for distribution to the ordinary shareholders after tax, interest and other deductions, 316
Omega, VoL 1, No. 3 was carried out on a reduced sample of 25 mergers during 1968. The price to earnings ratios were calculated on the earnings per share of each firm at the time of the last publishing of accounts before the merger took place and the market price per share four weeks before news of the first bid was published. The earnings per share three years after the merger compared with that of the bidding firm just before the merger are summarized in Table 2. PEB and PEV refer to the P/E ratio of the bidding firm and victim firm respectively. TABLE 2.
Relative
EFFECT OF RELATIVE
PIE RATIOS ON
RESULTS
Subsequent PIE ratio Number decreasing
PIE ratios
Number increasing
PEB > PEV PEB < PEV P E B "~ P E V
3
7
10
6 3
3 3
9 6
12
13
25
Total
This would seem to question the belief that a firm should not acquire one with a higher PIE ratio. However, three years is a short time span and perhaps more important is the movement of earnings over the period. Where the bidding firm had the highest PIE ratio, six firms at the end of the three years were showing a tendency for the yearly earnings to increase. In two of these cases, however, an unexpected initial dilution occurred. One of the offers carried an above average premium, which may mean that the acquiring firm had paid a sufficiently high price to cause such dilution. Alternatively, the fact that both offers included loan stock, thus increasing the interest payments to be made, may have been responsible for the dilution in earnings for the ordinary shareholder. Three other firms showed initial earnings accretion, followed by a fall in earnings to a level just below that before the merger. Two of these carried exceptionally high premiums based on the reference price of over 80 per cent and it is not surprising that the growth required to maintain a growth in earnings could not be achieved. Where the bidding firm has the smaller P/E ratio, two firms which made acquisitions solely by equity exchange performed in a similar manner to Newbould's example (i.e. an initial earnings dilution followed by accretion). A further four, however, followed the opposite trend. One was a bid solely in cash and though a high premium of 76.2 per cent based on reference prices was paid an increase in earnings in the first year was achieved. Similarly, though perhaps more surprising, the all equity bid carded a premium of 89"4 per cent and yet there was still considerable earnings accretion in the first year. The other two bids in this category both included loan stock and the consequent 317
D
Dale A FinancialSurvey of Mergers increase in gearing will cause the earnings movement. Where the PIE ratios are very similar or the earnings oscillate, few conclusions can be drawn. Thus while the sample is small, it suggests that PIE ratios are not the sole determinant of future earnings, though in an exchange of equity they may be relevant.
S U M M A R Y OF RESULTS General results Since confidence in the firm, and consequently the ability to raise more capital when necessary, is reflected in the share price, this was the first area of investigation. During the period of merger negotiations the share price of the victim firm was found to increase considerably, the major part of the increase occurring on news of the first bid. Competition, either by directors or by a third party, increased the price even more. Differences were also found where the relative sizes of the firms involved differed: mergers involving firms of equivalent size showed a considerably lower increase in the victim firm's share price than mergers in which the bidding firm was substantially larger than the victim firm. The fluctuations in the bidding firm's share price were remarkably small, with a slight overall tendency for the shares to fall in price. The most substantial decrease occurred when the bidding firm was effecting a reverse take-over, i.e. acquiring a firm larger than itself. On average, during the six months following the merger, the share price of the combined firm decreased further, with mergers involving competition from third parties displaying the most significant falls. In general, significant increases occurred only where reverse take-overs had been effected. When comparing the share price six months after the merger with that of the bidding firm's reference price (four weeks before news of the first bid) 27 firms showed increases compared with 30 decreases. Thus no conclusions could be drawn as to whether mergers in general are useful tools for increasing a firm's share price, but six months is too short a time for the full benefits of the merger to be realized. A second factor important in determining the success or otherwise of a merger is earnings performance. It was found that an exchange of equity may produce initial earnings dilution if the bidding firm has the lower PIE ratio. However, if the growth rate of the victim firm is good and synergy can be created, the earnings are likely to increase subsequently. Conversely, where the bidding firm has the higher PIE ratio, an initial earnings accretion is likely to be followed by earnings dilution. Twelve of the reduced sample of 25 (Table 2) achieved an increase in earnings by the third year after the merger (compared with the bidding firm's earnings in the year before the merger) and thirteen 318
Omega, Vol. 1, No. 3 showed decreases. Similarly, at the end of the time period studied, twelve firms showed a tendency for earnings accretion, eight for earnings dilution and five showed no trend. Again, no general conclusions could be drawn as to whether a merger will increase earnings or dilute them. Both the share price and earnings performance will be affected according to whether the bidding firm pays a bargain price or an exceptionally high price. It was found that substantial premiums over the market price (based on reference prices) were paid in the majority of bids, and where a bid found opposition, the final premium tended to be even higher. When based on the share prices immediately after the final bid, the premiums were reduced to an average of 6.2 per cent because of a tendency for the share price to adjust towards the value of the bid.
The significance of the method of payment used When classified according to the method of payment used, a strong correlation was found between share premiums and increases in the share price of the victim firm. As anticipated, cash bids received the highest premiums (based on reference prices) and consequently the highest price rises, inducing a fall in the share price of the combined firm of 6.6 per cent during the six months after the merger. Equity bids carded substantially lesser premiums but induced a similar decline in price after the merger. From the bidding firm's point of view, payment in loan stock had the most beneficial effect. The loan stock bid produced an increase in price during merger negotiations and a further increase subsequently. When combined with equity, the decline in price after the merger was not as marked as with other forms of payment. Similarly, convertibles seemed to produce a greater decline in share price during the merger compared with equity and a slower decline subsequently. Combination bids were unfavourable during bidding but showed lesser declines in price afterwards. Dilution of earnings may result from equity bids which increase the share base, or from loan stock which involve high interest payments. Convertibles spread the increase in share base over a number of years and usually carry lower interest rates, while cash payment in theory should not affect future earnings, provided the merger is followed by an appropriate rate of growth.
CONCLUSIONS Over half the sample had not achieved an increase in share price six months after the merger, and over half the smaller sample had not increased their earnings three years after the merger. It can be concluded that only in a minority of cases are these objectives (considered to be two of the most important) fulfilled. 319
Dale--A Financial Survey o f Mergers
High premiums were paid for the firms which were acquired and the analysis of method of payment shows that some methods are preferable to others. Payment by loan stock and, to a lesser extent, convertibles have advantages to the bidding firm, whereas equity and cash have value in persuading the victim firm to accept, the latter applying especially where competition is involved. Thus in many cases it could be said that the bidding firm was too anxious to gain acceptance and could have achieved better results by paying less through a different "package".
REFERENCES I. BIERMANH Jr, (1970) Financial Policy Decisions. Macmillan, London. 2. DALI~PM (1971) A Financial Survey of Mergers During the Years 1968-70. MSc. Thesis, Imperial College of Science and Technology, London. 3. LF.WEI.LENWG (1971) A pure financial rationale for the conglomerate merger. J. Fin. 26 (2), 521-538. 4. McC^RTnV GD (1963) Acquisitions and Mergers. The Ronald Press, New York. 5. NEWnOULDGD (1970) Management and Merger Activity. Guthstead, Liverpool.
320
A Financial Survey of Mergers During the Years 1968-70 PM DALE Allied Breweries (U.K.) Ltd (Received 2 February 1973)
This paper is concerned with the financial objectives of mergers and acquisitions and the way in which considerations in the merger transaction, such as the price paid and the method of payment used, may affect such objectives subsequent to the merger. The analysis is based on a sample of 65 mergers during the years 1968-70 inclusive [2l.
INTRODUCTION THE ACQUISITION of one firm by another is probably one of the largest investments the acquiring firm will ever make. Quite apart from the original motives for the transaction, once a firm has decided that it wishes to acquire another, the situation should be treated as one of investment and a certain rate of return should be aimed for. Such a return must be in line with other investments undertaken by the firm. F r o m a review of the relevant literature certain generally accepted financial objectives come to light, as well as a number of constraints which inhibit the fulfillment of these objectives. It is the purpose of this survey to establish how far the firms involved have achieved these objectives, within the constraints, both at the time of the merger and during the subsequent period. The types of financial instruments (cash, equity, loan stock, etc.) which constituted the " p a c k a g e " offered in payment for the acquired firm are also related to the success or otherwise in achieving these objectives.
WHY MERGE? In m a n y merger situations the reasons for merging may be other than financial and some of the major ones are summarized below: 305
Dales.4 FinancialSurvey of Mergers To lengthen the product line; To gain facilities in markets not previously supplied; To enlarge a firm's capacity to supply old markets; To diversify; To gain access to further process or distributive facilities. McCarthy [4] has looked at these factors from both the buying and selling company's point of view. He suggests that the buying company may wish to diversify or add new and profitable products to its production lines faster than by means of research and development. Alternatively, it may be that the acquiring company is weak in management or technical personnel, or wants to acquire profitable operations to absorb a tax loss carry-over. From the selling firm's point of view, if the major management stockholders wish to retire and they have no understudies whom they consider capable of continuing the business profitably, they may look outside the firm for good management teams. If the business has expanded to a point where there is no need for substantial additional financing, and major stockholders are not willing to assume such a burden, a merger is a method of obtaining such financing. Alternatively, if the firm's operations have been at a depressed level for a long period, a merger is a means of survival. The prospects of technological or marketing changes adversely affecting the future operations of the company, or simply that the firm receives a very attractive offer from another firm, are also incentives to merge. In general, financial motives will only be considered by firms to which acquisition has become an integral part of the business. For the majority the purely financial gains are merely a consequence of the merger and not a reason for effecting it. A potential lender will invest in a portfolio of firms in different industries in order to minimize the probability that he will lose out on his investment, due to firms not being able to pay. This is a well-known method of "risk spreading". Lewellen [3] argues that if two firms in the portfolio merge, the risk is further reduced, since if one firm has over-capacity to pay and the other under, in the combined firm one will compensate the other. This hypothesis holds only if the cash flow distributions are independent. However, the majority of mergers which take place concern firms in the same industry, implying some dependence. Mergers are also believed to occur because of external factors and merger booms are explained in terms of these. The literature is very diverse on this matter, ranging from the traditional ideas of financial and economic indicators to the more recent views of Newbould [5] who relates merger activity to an increase in corporate uncertainty. In an endeavour to ascertain whether or not the principles outlined above, when translated into their ensuing financial consequences, are in fact adhered to, a sample of factual mergers was analysed. 306
Omega, Vol. 1, No. 3
THE SAMPLE The sample used was a selection of 65 mergers during the years 1968-70, involving selling firms operating wholly or largely in the U.K. and for which a consideration of over £10 million was paid by the acquiring company. The merger "boom" seems to have reached a peak in 1968, since which time the level of merger activity has fallen drastically. The sample consists of 38 mergers effected during 1968 and only 13 and 14 during the years 1969 and 1970 respectively. The technique of data collection used was, in the main, to analyse the daily financial press. Company reports, merger documents and Moody's investment services were also used. All types of businesses were acceptable, including several firms from non-industrial fields such as banking, insurance, finance and property, but with the exception of machine tools, newspapers and publishers, and shipbuilders and repairers. No firms came from these three categories. Since there are many definitions of the terms "acquisition" and "merger", the placing of transactions into these two categories is to a certain extent subjective. It was assumed for the purpose of this study that all business combinations may be thought of acquisitions of one firm (the victim, seller or acquired) by another (the bidder, buyer or acquirer). The acquiring firm in each case is the firm which makes the bidding, or in cases where the distinction is not at all clear, the larger in net assets of the two firms. In cases where firms A and B combine to form a new company C, again the instigator of the merger has been identified and the case is treated as if he is the acquirer. Initially the sample was categorized according to the legal form, type of competition involved, if any, and the industries concerned. The sample of 65 contained 17 mergers which were effected by means of a scheme of arrangement, 5 of which involved non-industrial firms. The majority of take-over bids were uncontested, 66 per cent compared with 12 per cent opposed by the directors of the victim firm, and 22 per cent contended by a third party. Fiftyfour per cent of the mergers were horizontal in nature, involving firms in the same industry and in direct competition with one another. A further 22 per cent involved businesses with a common factor of production. The remainder consisted of 15 per cent conglomerate mergers (11 per cent involved businesses concerned with finance or property) and 9 per cent vertical in nature. During the time in which a company is involved in merger negotiations top management resources must be devoted to bidding and an air of uncertainty lies about the future of all firms involved. Consequently the share prices will also react to uncertainty. The official end to merger negotiations occurs when the victim firm ceases to be quoted on the stock market and/or when the new company first appears on the official list. In many cases this point in time will be far removed from the time at which the offer is agreed upon by the majority of the shareholders of the victim, or the scheme approved by both firms, and 307
Dales,4 Financial Survey of Mergers yet it is this agreement which again stabilizes the share prices. Thus when defining the time span of the merger negotiations, the start of the negotiations was chosen to be that time at which the news of the first bid was made public, and the termination when it was announced that an offer had been accepted by 90 per cent of the victim's shareholders or the scheme had been approved and was awaiting court sanction. The time span of merger negotiations ranged from 4 to 50 weeks. The larger time spans were associated with mergers implemented by means of a scheme of arrangement and/or opposed by the directors of the victim firm. This is perhaps why boards are loath to oppose a bid in order to obtain better terms for their shareholders and do so in only a minority of cases. In the majority of mergers, negotiations took from 5 to 10 weeks. Competition by third parties has little influence on lengthening the time span, due to the very nature of the competition. Having once entered a bidding situation where there is more than one contender, the bidder fears that if he allows time to elapse between bids, he will ultimately fail. The firms in the sample were classified according to size (Table 1) as given by the 1968-69 Times 500. In this case, size is based on the total capital employed (total tangible assets less current liabilities and sundry provision). Banks and insurance companies were classified in terms of total funds. Throughout the analysis statistics referring to bidding firms collectively include all occasions when bidding firms appear in a merger transaction, rather than the actual number of firms involved in mergers. Since no firm included in the sample made more than two acquisitions, and in all cases with disjoint time spans, the effect of any two acquisitions may be taken as independent. TABLE I . SIZE OF FIRMS IN THE SAMPLE
Size category 1 2 3 4 5
Size £m
Bidding firms
Victimfirms
32 9 8 9 1 59
9 4 17 17 18 65
Over 100 50-100 25-50 10-25 0-10
Note that the bidding firms do not total 65 since 6 foreign-based firms whose assets were not k n o w n were a m o n g them. It is thought, however, that they would fall into the highest category.
When firms merged to form a new company with a new name (nine cases) all but one, which was a reverse take-over (i.e. the bidding firm was the smaller of the two), involved firms in the same size category. Also eight of the nine involved firms with assets valued at less than £100 million. 308
Omega, VoL 1, No. 3
ANALYSIS OF THE SAMPLE The analysis of the sample falls into four main parts: 1. An analysis of the payment used; 2. An analysis of the share price movement both during the merger negotiations and after the merger has been consummated; 3. An analysis of the premiums paid per share over the market price of the acquired firm; 4. A brief analysis (on a reduced sample) of the earnings performance over the three years following the merger.
1. Payment used Once the acquisition of a particular firm has been decided upon and the value of a company ascertained by such methods as discounted cash flow techniques, the acquiring firm must then decide in what form the offer is to be financed. There are numerous formats which an offer may take, but they are mainly combinations, with differing interest rates, on the following five methods: cash, equity, loan stock, convertible debentures and others (e.g. preference capital and warrants). Cash. Cash transactions are relatively rare, since in order to pay in cash a company must be large in comparison with the company it is acquiring; it should also be in a very liquid position financially, or have access to readily available credit. A cash bid will almost always carry a higher premium over the victim's share price than other forms of payment, to offset the capital gains tax to which the receiver will be liable. However, a cash deal may be desirable when the victim's earnings are currently depressed or non-existent. The same result may be achieved by an exchange of capital stock and a concurrent purchase and retirement of shares of stock from existing stockholders of the acquirer. This will preserve the "tax-free" status of the seller. The most significant advantage of using cash is its surprise value. If resistance is shown by the victim firm, a surprise cash bid may win the day and bring a long take-over battle to an abrupt halt. A cash deal also eliminates the problem of having a new group of substantial and possibly controlling stockholders and may increase the leverage for earnings on common stock. Given that a firm has the means to effect a cash bid, it must bear in mind that such a bid may affect its future debt-raising potential. There is usually a limit on the amount of debt a company may raise, and this limit is expressed as a percentage of net tangible assets. If at the time of the merger both firms have availed themselves fully of the opportunity to raise debt, then in certain cases a cash payment by the acquiring company will raise the level of debt in the combined company above the limit, thus affecting the future debt-raising potential. The condition for this to happen is that the cash bid paid exceeds the net tangible assets of the victim firm less the existing debt in the victim firm. 309
Dale A Financial Survey of Mergers Let DA be the debt in firm A DB be the debt in firm B NTA be the net tangible assets of A NTB be the net tangible assets of B then the new debt to tangible assets ratio (called t) in the combined firm will be t
debt
DA + DB
net tangibles
NTA + NTB-
cash p a i d
and the acceptable limit in terms of the old ratio is tA
=
DA/NTA.
Thus the new debt will exceed the limit if t > tA
or
if
cash p a i d > N T B -- D B .
Equity. A merger may be financed by a simple exchange of equity, so that the selling company become stockholders in the combined firm and no tax is payable on the transaction. The difficulty arises in establishing a suitable exchange ratio, by deciding on the relative value of each company and expressing it in terms of the acquiring company's shares. If a company feels that its shares are under-valued on the market, it will be loath to use equity as payment. The relationship between the market price per share and earnings per share of the two companies is also relevant in determining whether the surviving firm will suffer a reduction (:dilution) in earnings and a reduction in return on capital as a conseuqence of the merger. It is generally accepted that earnings per share is one of the most dominant factors in determining the market price and that a dilution of earnings is to be avoided where possible. Unlike cash payment, equity exchange will have no effect on the acquiring firm's future debt-raising potential. Since no net tangible assets have left A's possession, the debt to net tangibles ratio will remain unchanged. Using the terms defined above, if DA/NTA
= DB[NTB
= limit
then it is a simple matter to show that the new ratio is equal to DA + DB/NTA
+ NTB = DA/NTA
:
limit.
Loan stock. As long as the interest rate is equivalent to the return on ordinary capital, stockholders may be persuaded to accept loan stock partly or wholly in place of cash or equity. The interest rate required to make the offer attractive will also depend on the risk involved. If the stock being offered is some way down in the scale of priorities for payment, the risk will be greater and a higher return expected. Current trends of other stock yields must also be taken into consideration. The effects of increasing the debt in a company upon the future earnings and share price are complex and somewhat conflicting. Bierman [1] shows that 310
Omega, VoL 1, No. 3 the addition of debt, if issued at an interest rate equal to the return currently being earned on the common stock investment, will not affect the expected return of the common stock but will increase the variance of the earnings per share. This is relevant to the merger situation when a firm issues debt in return for the assets of the acquired firm. Since stability of earnings is thought to be a significant determinant of share price (i.e. the more stable the earnings, the greater the confidence in the stock and the higher the market price) the addition of debt would have an adverse effect. Conversely, payment by loan stock is beneficial from the tax point of view, since interest is deductible for tax purposes. Convertible debentures. The shareholders of the selling firm will often insist upon part of the offer at least being in the form of equity of the combined firm. In cases where, for various reasons, the acquiring firm prefers not to issue new equity at the time of the merger, convertible debentures may be used. The advantage to the seller is that the capital is protected to a much higher degree than on equity security. The stockholder has a virtually guaranteed income plus the advantage of exercising his option to convert into equity at a fixed price if the company prospers. On the other hand, the buyer will gain some leverage on earnings and if the selling firm's earnings are currently depressed, a steady conversion after the merger will offset the dilution of earnings which would otherwise have occurred. Care must be taken by the acquiring company to ensure that the issue of convertibles does not increase the gearing of the company to an unacceptable level. If the company prospers, a large conversion at one time will significantly increase the equity base, dilute earnings, and consequently tend to keep the market price depressed. If the company does not satisfy expectations and the market price is kept low, the unwillingness to convert on the part of the stockholders will cause an "overhang", which will in turn constrain the company in its ability to obtain new finance. Others. There are distinctions between voting and non-voting equities, and mention should be made of debentures convertible to voting and non-voting stock. Non-voting shares are little used since they are unattractive to the shareholders of the selling company, but have obvious advantages to the acquiring firm when it decides on an exchange of equity but wishes to retain control of the combined firm. Finally, preference capital, debentures convertible to preference capital, and warrants may also be used. Again, a warrant to purchase common stock at a given price is not usually acceptable as a form of payment, especially if there has to be a significant price appreciation before the warrant is worth exercising. There is a market for warrants, implying that they do have some implicit worth, but they are usually only included in an offer as an extra bonus. However, warrants to pay in cash at a later date are a good way of spreading the capital gains tax over a period of time. 311
Dale--A Financial Survey of Mergers Combinations. Many bids are composed of two or more of the above financial instruments and in this case, the management concerned must be careful not to nullify their objectives. In an equity exchange it is generally agreed that up to 25 per cent of the shares received may be disposed of without nullifying the "pooling of interests" criteria (i.e. when all the ownership interests in the constituent corporations survive in the combined enterprise). If the part payment is in cash, care must be taken to ensure that the "tax-free" status of the reorganization is preserved. If the preference shares in the acquiring company are valued highly relative to the stock of the seller, the acquirer may wish to offer preference shares together with ordinary stock. The seller then emerges with less voting power, but is induced to accept by virtue of a safer investment and higher dividend yield. Equity exchange is by far the most popular form of payment--81 per cent of all bids used equity to some extent. Cash is used in only 17 per cent of the bids and in nine of the eleven cases accounted for the total offer. Loan stock and convertible debentures are mainly used in part payment, to back up the equity or cash, though in one instance each the bid was financed entirely by loan stock or convertible debentures. All the cash paying firms in the sample came from the largest size category and, with the exception of two, they merged with firms from the smallest two categories (Table 1 above). Of the two exceptions, one was a partial bid to increase the acquirer's holdings to 50 per cent, and in the second case only 16.6 per cent of the value of the bid was paid in cash. It may be concluded that cash bids are made by large companies when acquiring companies considerably smaller than themselves. In such cases the strain on the liquidity of the acquiring firm will be small. It must also be noted that four of the five non-quoted foreign concerns made 100 per cent cash bids. Since the problems associated with evaluating exchange rates become greater when considering stocks of different countries, and also it will be difficult to persuade a shareholder to accept foreign stocks, cash is obviously a good method of payment when buying or selling abroad. In two of the four cash bids contested by third parties the acquiring firm made one successful cash bid after a series of equity/loan stock/convertible bids from other firms. This illustrates the benefits of the surprise element of cash payments. The other two bids followed a series of cash bids. The remaining three considerations (share price variations, premiums and earnings per share) were analysed both generally, taking account of competition and size factors, and from the point of view of the method of payment used. 2. Share price variations The price four weeks before news of the first bid was assumed to give a fair representation of how the market valued the shares at the time of the bid, 312
Omega, Vol. 1, No. 3 taking into account all factors relevant to share price valuation except the effect of the merger itself. Consequently the point in time four weeks before the first bid was used as a "reference" point from which certain merger effects could be established. The prices were adjusted to allow for scrip issues but since the effects of a dividend pay-out are not so easily quantifiable, the exdividend prices were left unaltered. Firstly, changes in the share prices of the bidding firm and victim firm over the period of merger negotiations were analysed. Then a follow-up study of the six-month period after the merger was made. The final prices in uncontested mergers were on average 21.4 per cent higher than the reference price; the mean increases for contested bids were much higher: 60"5 per cent in the case of those contested by directors and 63.9 per cent where third parties were involved. The variance about the mean was high in all cases and highest where there was competition from a third party. When looking at the changes in the bidding firms' share prices, in general no large increases or decreases occurred. The average increase for the whole sample was 0.8 per cent, or categorizing as before, a mean decrease of 0.9 per cent for third party involvement, a mean increase of 6.6 per cent when contested by directors and a mean increase of 0.3 per cent for uncontested bids. The variance for the changes for uncontested bids was very much smaller than that for contested bids, indicating much less variability of the observations underlying the mean. One conclusion from the study is that the share price of the victim firm engaged in merger negotiations is likely to increase appreciably over the negotiating period, while the price of the bidding firm is not greatly affected. As with any purchase, the effect on the purchaser is likely to depend on the relative size of the purchase. A large firm acquiring a firm of comparatively much smaller size will absorb the acquisition without too many external effects. However, if the two firms are near equal size, the acquirer is nearly doubling in magnitude and the effect will be significant. Effects will also occur when the bidding firm is the smaller of the two. It is possible that similar differences in effect will occur amongst the victim firms. Consequently, the changes in price over the merger span were categorized into three main divisions, namely firms in the "same size" category, "reverse take-overs" and "others" (i.e, where the acquiring firm is in a higher size category than the acquired firm). The mean change in "same size" mergers was a decrease of 0.9 per cent and for "reverse take-overs" a decrease of 10.4 per cent, whilst that for the "others" was an increase of 1"4 per cent. For the victim firms the most noticeable difference was that between "same size" mergers (a mean increase of 17.4 per cent) and "others" (a mean increase of 39.7 per cent). The mean increase for "reverse take-overs", rather than exhibiting the same trend as in the bidders, lay between the "same size" and "others" categories at 31.6 per cent. 313
Dale A Financial Survey of Mergers Thus it may be concluded that the victim firm in a "same size" merger will not experience such great increases in its share price over the period of merger negotiations compared with other firms. From the bidder's point of view, however, a "reverse take-over" is most likely to depress the share price. Thirdly, the changes in share price were summarized according to method of payment. The highest mean percentage change amongst the victim firm is achieved by mergers financed with cash. This is reasonable since cash bids usually carry a higher premium over the victim's share price and this premium will cause the price to rise until the shareholder is indifferent between selling his shares on the market and exchanging the shares for cash from the bidding firm. As will be seen later, the mean premium on cash bids was 63.9 per cent based on the reference prices, compared with a mean increase in price during the merger of 61"2 per cent. The remaining single instrument bids induced price rises of decreasing magnitude in the order equity, loan stock and convertibles, all significantly lower than that corresponding to cash bids. Generally, the only outstanding difference in the increase in price is achieved by the cash bids and this is attributed to the higher premium paid. From the bidding firm's point of view, loan stock seems to have the most beneficial effect on the share price, followed by equity and cash. Hence it is apparent that the shareholders approve of the single instrument bids in the decreasing order of cash, equity and loan stock, and the shareholders of the bidder show approval in the opposite order. Thus 26 of the 65 firms studied used a combination of instruments to obtain a balance between gaining the approval of their own shareholders and those of the firm they wished to acquire. However, such combination bids produced actual decreases in the share price, suggesting that the share price analysis should be followed up and extended for some time after the merger has been effected. The share price of the combined firm was taken at monthly intervals for six months after the merger had taken place, and analysed according to competition, size and method of payment as before. The results showed that the mean change over the six-month period was a decrease of 4.9 per cent based on a sample of 57. The sample size was reduced for this analysis since some mergers were too recent to allow a six-month follow-up study. Mergers involving competition from a third party showed the most significant increase in price, perhaps because the effects of inflated offers on the part of the bidding firm were beginning to tell. When classified according to size, the significant result was a 14"2 per cent mean increase where reverse take-overs had been effected. This compares with a decrease of 4.2 per cent and 6.7 per cent in the "same size" and "others" categories respectively. All single instrument methods showed further mean decreases with exception of loan stock with a 1.3 per cent increase. Again, four of the five combination methods showed decreases. In terms of the net change over the whole time period studied, a total of 314
Omega, VoL 1, No. 3 27 increases compared with 30 decreases implies that no conclusions can be drawn as to whether mergers in general are useful tools for increasing a firm's share price. However, there are indications that as the proportion of the offer expressed in equity increases so the likelihood of the share price depreciating becomes greater. Cash payment will have a similar effect, whilst loan stock exhibits a reverse trend.
3. Premiums The analysis of the total price paid was carried out in terms of the premiums paid per share. When a firm A makes an offer for firm B, the shareholders of B are induced to accept because the offer, when translated into its cash equivalent, is worth more than the current market price of these shares. This difference in the value of the price paid on the market price is known as the share premium. In this analysis the premium was expressed as a percentage of the market price. The premium, then, is some measure of the gain to a victim shareholder if he accepts an offer. Consequently the higher the premium the more likely is the bidder to gain acceptance, and in a competitive situation share premiums may be considered major elements of persuasion. The share premiums exchange of equity was evaluated both using the reference price and the price on the Friday after the bid was announced, called the "at bid price". (An analysis using daily prices showed that significant errors would not be introduced if prices were taken on a weekly basis. The closing price on a Friday was chosen for convenience.) The nominal price of the loan stock was used and the convertibles were valued as if they could be converted into equity immediately. These definitions of the cash equivalent of the financial instruments used do not in all cases assign the true value. The real worth of the loan stock will depend on its rate of interest, priority rating and proximity to redemption. A convertible debenture again should be valued according to its interest rate before conversion, together with the expectation of future trends in the price of the stock to which it is convertible. For these reasons a bid may be accepted at a low premium because the premium understates the true value of the bid. Premiums are important in merger analysis because if a firm is forced to pay an unduly high premium in order to gain acceptance, the total price paid may be so high that an unreasonable growth in earnings, as a result of the merger, is required if the merger is to be justified on a return on capital basis. The average premium for the sample was 38.4 per cent, the mergers involving competition producing much higher mean premiums (64.4 per cent) than the mean premium of the uncontested bids (21.2 per cent). When based on the "at bid price" all types produced similar means at a much lower level of 6"2 per cent. This is an indication of how the share price adjusts towards a level at which the shareholder is indifferent to accepting the offer of selling his shares on the market. 315
Dale A Financial Survey of Mergers The mean premium for cash was 63.9 per cent compared with 34.6 per cent for equity, 34.5 per cent for combinations of equity and loan stock and 37.2 per cent for equity combined with convertibles. Since the variances are again large, the only significant difference is between the premium on cash bids and the premiums on each of the other three. As the spread of premiums based on the "at bid prices" is very small, little information can be gained by classification according to the method of payment used. The premiums were calculated for each bid in a competitive situation. The average premiums for the first bids where there was opposition from the directors was 43.1 per cent compared with 55"8 per cent for the final bids. This substantiates the hypothesis that if directors oppose a bid, there is a good chance of obtaining better terms for the shareholders. With one exception the largest increase in percentage premium from the initial to the final bid occurred in mergers where a single financial instrument was offered throughout. In the three cases where a combination of equity and loan stock was offered initially, the greatest increase in premium based on reference prices was achieved over four consecutive bids. By continually opposing the bid the directors obtained for their shareholders a 36.5 per cent increase in premium and a final offer wholly in equity. It must be noted, however, that only by continuous buying of shares on the market over a period of a year and accumulating over 50 per cent of the voting equity, did the bidding firm finally persuade the shareholders of the victim firm to accept. Hence the motive for opposition was survival and not to increase the premium, the increase being merely a consequence of the opposition. The consequence, however, is significant and should be noted by all firms who are the object of a take-over bid. Where a third party was involved, the premiums based on reference prices again increased substantially as the bidding progressed. Bids finalized with cash offers all showed an increase in premium of over 40 per cent.
4. Earnings per share It is a common belief that an exchange of equity should not be made between two firms where the bidding firm has the lower price to earnings (P/E) ratio, because a dilution of the acquiring company's earnings will result. However, as Newbould [5] shows, if the rate of growth of the seller is higher than that of the buyer (and this will be the case if the market's expectations for future growth are correct), then an initial dilution will become an earnings accretion in subsequent years. Conversely, if the required earnings accretion in the first year is achieved because the acquired firm has the lower P/E ratio and again the market expectations for growth are correct, dilution will occur in the future. The only case in which this will not be so is if the synergistic effects produce higher earnings than the sum of the expected earnings. An empirical investigation of earnings, i.e. the total amount available for distribution to the ordinary shareholders after tax, interest and other deductions, 316
Omega, VoL 1, No. 3 was carried out on a reduced sample of 25 mergers during 1968. The price to earnings ratios were calculated on the earnings per share of each firm at the time of the last publishing of accounts before the merger took place and the market price per share four weeks before news of the first bid was published. The earnings per share three years after the merger compared with that of the bidding firm just before the merger are summarized in Table 2. PEB and PEV refer to the P/E ratio of the bidding firm and victim firm respectively. TABLE 2.
Relative
EFFECT OF RELATIVE
PIE RATIOS ON
RESULTS
Subsequent PIE ratio Number decreasing
PIE ratios
Number increasing
PEB > PEV PEB < PEV P E B "~ P E V
3
7
10
6 3
3 3
9 6
12
13
25
Total
This would seem to question the belief that a firm should not acquire one with a higher PIE ratio. However, three years is a short time span and perhaps more important is the movement of earnings over the period. Where the bidding firm had the highest PIE ratio, six firms at the end of the three years were showing a tendency for the yearly earnings to increase. In two of these cases, however, an unexpected initial dilution occurred. One of the offers carried an above average premium, which may mean that the acquiring firm had paid a sufficiently high price to cause such dilution. Alternatively, the fact that both offers included loan stock, thus increasing the interest payments to be made, may have been responsible for the dilution in earnings for the ordinary shareholder. Three other firms showed initial earnings accretion, followed by a fall in earnings to a level just below that before the merger. Two of these carried exceptionally high premiums based on the reference price of over 80 per cent and it is not surprising that the growth required to maintain a growth in earnings could not be achieved. Where the bidding firm has the smaller P/E ratio, two firms which made acquisitions solely by equity exchange performed in a similar manner to Newbould's example (i.e. an initial earnings dilution followed by accretion). A further four, however, followed the opposite trend. One was a bid solely in cash and though a high premium of 76.2 per cent based on reference prices was paid an increase in earnings in the first year was achieved. Similarly, though perhaps more surprising, the all equity bid carded a premium of 89"4 per cent and yet there was still considerable earnings accretion in the first year. The other two bids in this category both included loan stock and the consequent 317
D
Dale A FinancialSurvey of Mergers increase in gearing will cause the earnings movement. Where the PIE ratios are very similar or the earnings oscillate, few conclusions can be drawn. Thus while the sample is small, it suggests that PIE ratios are not the sole determinant of future earnings, though in an exchange of equity they may be relevant.
S U M M A R Y OF RESULTS General results Since confidence in the firm, and consequently the ability to raise more capital when necessary, is reflected in the share price, this was the first area of investigation. During the period of merger negotiations the share price of the victim firm was found to increase considerably, the major part of the increase occurring on news of the first bid. Competition, either by directors or by a third party, increased the price even more. Differences were also found where the relative sizes of the firms involved differed: mergers involving firms of equivalent size showed a considerably lower increase in the victim firm's share price than mergers in which the bidding firm was substantially larger than the victim firm. The fluctuations in the bidding firm's share price were remarkably small, with a slight overall tendency for the shares to fall in price. The most substantial decrease occurred when the bidding firm was effecting a reverse take-over, i.e. acquiring a firm larger than itself. On average, during the six months following the merger, the share price of the combined firm decreased further, with mergers involving competition from third parties displaying the most significant falls. In general, significant increases occurred only where reverse take-overs had been effected. When comparing the share price six months after the merger with that of the bidding firm's reference price (four weeks before news of the first bid) 27 firms showed increases compared with 30 decreases. Thus no conclusions could be drawn as to whether mergers in general are useful tools for increasing a firm's share price, but six months is too short a time for the full benefits of the merger to be realized. A second factor important in determining the success or otherwise of a merger is earnings performance. It was found that an exchange of equity may produce initial earnings dilution if the bidding firm has the lower PIE ratio. However, if the growth rate of the victim firm is good and synergy can be created, the earnings are likely to increase subsequently. Conversely, where the bidding firm has the higher PIE ratio, an initial earnings accretion is likely to be followed by earnings dilution. Twelve of the reduced sample of 25 (Table 2) achieved an increase in earnings by the third year after the merger (compared with the bidding firm's earnings in the year before the merger) and thirteen 318
Omega, Vol. 1, No. 3 showed decreases. Similarly, at the end of the time period studied, twelve firms showed a tendency for earnings accretion, eight for earnings dilution and five showed no trend. Again, no general conclusions could be drawn as to whether a merger will increase earnings or dilute them. Both the share price and earnings performance will be affected according to whether the bidding firm pays a bargain price or an exceptionally high price. It was found that substantial premiums over the market price (based on reference prices) were paid in the majority of bids, and where a bid found opposition, the final premium tended to be even higher. When based on the share prices immediately after the final bid, the premiums were reduced to an average of 6.2 per cent because of a tendency for the share price to adjust towards the value of the bid.
The significance of the method of payment used When classified according to the method of payment used, a strong correlation was found between share premiums and increases in the share price of the victim firm. As anticipated, cash bids received the highest premiums (based on reference prices) and consequently the highest price rises, inducing a fall in the share price of the combined firm of 6.6 per cent during the six months after the merger. Equity bids carded substantially lesser premiums but induced a similar decline in price after the merger. From the bidding firm's point of view, payment in loan stock had the most beneficial effect. The loan stock bid produced an increase in price during merger negotiations and a further increase subsequently. When combined with equity, the decline in price after the merger was not as marked as with other forms of payment. Similarly, convertibles seemed to produce a greater decline in share price during the merger compared with equity and a slower decline subsequently. Combination bids were unfavourable during bidding but showed lesser declines in price afterwards. Dilution of earnings may result from equity bids which increase the share base, or from loan stock which involve high interest payments. Convertibles spread the increase in share base over a number of years and usually carry lower interest rates, while cash payment in theory should not affect future earnings, provided the merger is followed by an appropriate rate of growth.
CONCLUSIONS Over half the sample had not achieved an increase in share price six months after the merger, and over half the smaller sample had not increased their earnings three years after the merger. It can be concluded that only in a minority of cases are these objectives (considered to be two of the most important) fulfilled. 319
Dale--A Financial Survey o f Mergers
High premiums were paid for the firms which were acquired and the analysis of method of payment shows that some methods are preferable to others. Payment by loan stock and, to a lesser extent, convertibles have advantages to the bidding firm, whereas equity and cash have value in persuading the victim firm to accept, the latter applying especially where competition is involved. Thus in many cases it could be said that the bidding firm was too anxious to gain acceptance and could have achieved better results by paying less through a different "package".
REFERENCES I. BIERMANH Jr, (1970) Financial Policy Decisions. Macmillan, London. 2. DALI~PM (1971) A Financial Survey of Mergers During the Years 1968-70. MSc. Thesis, Imperial College of Science and Technology, London. 3. LF.WEI.LENWG (1971) A pure financial rationale for the conglomerate merger. J. Fin. 26 (2), 521-538. 4. McC^RTnV GD (1963) Acquisitions and Mergers. The Ronald Press, New York. 5. NEWnOULDGD (1970) Management and Merger Activity. Guthstead, Liverpool.
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