M&A Review - Theory Develop a framework for understanding acquisitions and buyouts along the following dimensions of risk:

Valuation Legal Accounting Tax Transaction Mechanics Seven Recurring Corporate Themes From Copeland et al., Valuation:

Chand Sooran

The Industry Shaper: Repeatedly spots discontinuities in industries and acts pre-emptively to shape the emerging new industry to its own advantage (e.g. Amazon.com) The Deal Maker: Systematically beats the market through superior skill at spotting and executing deals. This could be either through superior insight into the inherent value of companies or through superior insight into specific industries (e.g. Cisco). The Scarce Asset Allocator: Efficiently allocates capital, cash, time and talent across multiple business units (e.g. ABB) The Skill Replicator: Repeatedly transfers particular skills across business units. The skill of lateral transfer is a distinct skill from the functional skill itself (e.g. GE) The Performance Manager: Has proven skills at instilling a high performance ethic with matching incentives and MIS processes across multiple business units (e.g. Intel) The Talent Agency: Institutionalizes a model for attracting, retaining and developing talent that is truly distinctive relative to all others in the industry (e.g. BCG) The Growth Asset Attractor: Possesses a proven and sustained record of consistently leading in innovation in multiple businesses (e.g. IBM) Some M&A Facts Global M&A is growing exponentially, with particular growth in Europe

Big deals are advised, smaller deals (greater number) are not Typical investment bank compensation: 0.25% for very big deals, 1% norm, 2-3% for smaller deals Most corporates have M&A teams Investment bank advantage: ability to raise capital Three types of mergers: vertical mergers, horizontal mergers and conglomerate mergers Mergers occur in waves (six in the 20th century) Waves track periods of rising equity values Out-of-market acquisitions are a recipe for disaster Mergers typically do not work but when they do, their success is spectacular 7% underperformance in the first year 70% of the time, the merged company's PAT is less than the sum of the separate PATs from the previous year It takes 5 years on average for margins to return to the industry average Common justifications for mergers: Changing industry economics (technological shifts; regulatory shifts) Synergy (economies of scale and scope; efficiencies in production, distribution and procurement; reduction in SG&A) Financial synergies (lower costs of financing with larger, putatively safer, firms) Managerial inefficiencies (oust bad management) Valuation errors (cheap are targets and overvalued use stock as currency) Value transfers (tax; monopoly rent-seeking; union busting; from bondholders - buy a highly leveraged company) Hubris WACC DCF Valuation Methodology Objective: To obtain the present value of cash generated by net assets, thereby valuing debt and equity Net Assets = Total Assets -(Current Liabilities - Short Term Interest Bearing Liabilities) Net Assets = Net Working Capital + PP&E + Other Assets Net Assets must be equal to the sum of Interest Bearing Liabilities and Equity Value of Net Assets = Value of the Firm = Value of Debt (I.e. Interest Bearing Liabilities) + Value of Equity Approach: 1. Determine the cash flows for years 1 to N 2. Calculate the appropriate discount rate

3. Calculate the terminal value at end of year N 4. Calculate the present value of the cash flows and of the terminal value and sum these two numbers, which is equal to the value of the firm 5. Subtract the value of debt to obtain the value of equity Free Cash Flow to the Firm: Cash generated that is available for creditors and shareholders Free Cash Flow to Equity: Cash generated that is available for shareholders Determining the Cash Flows: Sales -COGS = Gross Profit (EBITDA) - SG&A = Operating Profit (EBITDA) - Depreciation - Amortization = PBIT (EBIT) - Interest = PBT (EBT) - Taxes = Net Income Calculating the Appropriate Discount Rate: We want to have a discount rate that is appropriate to the risks of the project under consideration and that incorporates the tax shield of debt WACC = k D (1-t)(%D) + k E (%E) kD kE %D t The opportunity cost of debt; what creditors could earn by lending to similar projects The opportunity cost of capital; what shareholders could earn by investing in similar projects The post-execution target capital structure The tax rate for ordinary income EBIT x (1 - Tax Rate) + Depreciation + Amortization + Other Non-Cash Charges - Change in Net Working Capital - Change in PP&E (CapEx) - Change in Other Assets = Free Cash Flow

We use the CAPM model to determine kE kE = rf + b(Market Risk Premium) rf = Long-term Treasury rate - 1% <-- trying to get a proxy for the long-term bill rate because the market risk premium relates to bills The 1% is the liquidity premium Market Risk Premium = 8.8% (from historical performance of market relative to bills) b found by looking at comparables Find comparables Compare debt structures --> Look at the ratio of MV Equity to (MV Equity + BV Debt) <-- assuming BV Debt = MV Debt For each comp, unlever its b --> bunlevered = blevered x (MV Equity)/(MV Equity+BV Debt) Calculate the average bunlevered Relever this average --> blevered = blevered average x (MV Equity + BV Debt)/(MV Equity) <-- use target capital structure Calculating the Terminal Value: There are three methods to calculate terminal value: Liquidation Perpetuity Multiples The Liquidation method: The termination value is assumed to be the book value of net assets in year n TV = NWC + PPE + Other Assets The Perpetuity method: g = annual growth rate in cash flows from year N to infinity (by assumption) FCFn = FCF at year n Best for low growth firms Best for stable cash generating firms Best for high growth firms

TVn = (FCFn) x (1-g)/(WACC - g) The Multiples method: Determine multiple of pre-interest earnings (EBIAT) at which comparables trade and apply to own project's EBIAT Multiplecomparable = (MV Equity + BV Debt)/EBIATand compute average multiple TVn = Multiple x EBIAT (or Revenues, or whatever other index used) Putting It All Together: Value of the Firm = Value of Equity + Value of Debt --> Value of Equity = Value of the Firm - Value of Debt Value of the Firm = S PV FCF + S PV TV Implementation Notes (from Cases): 1. You want to use the capital structure that is unique and appropriate to the project 2. There are two sorts of systematic risk in the blevered: operating risk and financial risk (which comes from leverage) 3. The bunlevered reflects the operating risk of the assets 4. Only count as debt interest-bearing liabilities 5. If there is recourse debt, then you use the parent's cost of debt; if no recourse, then use the project's cost of debt 6. Don't just focus on valuation; consider other statistics as well 7. Don't forget to deduct the value of the debt when calculating the value of the equity 8. There are conditions under which multiples are inappropriate Cyclical industry --> volatile multipliers Multiples may not take into account any step-up 9. If you use a 5-year b, then use a 5-year capital structure APV Valuation Methodology Useful in situations in which the firm is highly leveraged

1. Pretend the firm has a certain % of debt (the target %)

2. Value the all equity company, discounting at kA 3. Subtract the MV of debt it does have 4. Add the tax shields --> estimated value of the equity For each tranche of debt --> the tax shield of debt is equal to the interest payment (using average debt balances) x tax rate Discount the tax shield of debt stream using the yield on that tranche Note: Unleveraging companies caluses P/Es to go up

Source: www.victoryrisk.com

Execution and Legal There are 2 ways to gain control of a company: 1. Acquire enough shares to constitute control according to the laws of the state in which the target is incorporated This can vary from 50.1% to 90%+ (some states don't want outsiders to control their companies) Typically executed via a tender offer to the public (e.g. Offer to pay $x/share in cash for y% of the outstanding equity) Or, a private offer to a major holder (e.g. an institution) Or, by acquiring shares in the open market quietly, using a creeping tender offer 2. Gain control of the Board of Directors (and then force the company to sell) Technically, you do not need to own shares in order to be a Director (beyond some token amount) Annual shareholders' meeting has elections for Directors Propose a slate of Directors at the annual meeting --> shareholders vote Practical considerations: staggered elections, different classes of Directors, etc.) Having gained control of a company, there are 3 possible things can happen subsequently: 1. Election is made to do a statutory merger of the target with the acquirer (most exposure to unknown) 2. Make selected asset purchases and selected assumption of liabilities (implying limited liability) 3. Do nothing and keep as is --> target becomes a subsidiary of the acquirer (a stock deal) (least exposure to unknown) A merger is a combination of the two companies terms of assets, liabilities and equity, referring to the liabilities both known and unknown 2 old companies cease to exist, replaced by a new company All old contracts etc. of old companies revert to the new company Requires votes and approval of both sets of shareholders (generally, a simple majority) Minority squeeze-out: merger consideration is forced on a dissenting minority Some shareholders may object because they are being forced to surrender their economic interest in the target for a different economic interest in the merged companies Often goes to state court, minority arguing that they did not receive fair consideration

Miscellaneous: 1. The Williams Act of 1968 stipulates that tender offers have to be open for a minimum of 20 business days (30 calendar days) 2. If you own more than 80% of a target company, you can report its financial results as part of your consolidated financial statements 3. A White Knight is a third-party who intervenes on a target-friendly basis with a competing bid 4. Rule of Tender: You have until the last minute to revoke tender subscriptions 5. An exchange offer is an offer of stock-for-stock Non-taxable to shareholders of target as they transfer old share basis to new stock Non-taxable to target company since no realized P/L on assets 6. Rule 16(b) - "No Flipping/Short Swing Rule": Anyone who owns more than 10% of the stock is a constructive insider Insiders cannot buy and sell within 6 months If insiders trade, they must give back all profits and stand criminal trial 7. Rule 13(d) - "D is for Disclosure: Must disclose ownership and intention above 5% 8. "Sweeping the Street": Getting block shares (typically from institutions or arbs) in a single day (or a short period of time) 9. A Type C reorg: asset purchase in consideration for 100% stock, after which target liquidates and goes out of business 10. A 338(h)(10) Election is as if the acquirer sells the acquired assets to himself on Day 1 Assets are written up Tax payable (at ordinary rates) Used typically if acquirer has NOLs that it can monetize (I.e. by transforming into the step-up stream) 11. Greenmail: Money paid to a putative bidder to make him go away 12. Problem: How can you structure the deal in order to meet the interests of all of the parties? 13. Conglomerate Theory: Under sophisticated management, conglomerate forms an umbrella under which the companies can be operated more efficiently and access capital markets more efficiently 14. Every state has rules that preclude the Board of Directors from deals that would leave the firm with negative equity pursuant to an action by the board 15. A triangular merger is one in which one of the acquirer's subsidiary companies is merged into the target company Statutory Mergers: Generally structured as a Type A reorganization (from S. 368 (a)(1)(A) of the IRS Code of 1954 Requires that shareholders maintain their continuity of interest Exchange shares-for-shares pursuant to the transaction No taxes at the individual level No taxes at the corporate level

Leveraged Buyouts Use the target company's debt capacity to finance its acquisition, structuring the deal so as to take on as much debt as you think you can handle, so that you as you pay down the debt, your equity slice becomes more valuable Typically, LBOs or MBOs are executed where the target company has the following characteristics: Stable cash flows growing at the rate of inflation Brand does the workd, not necessarily the steward Profitable if you can fund with debt and earn a positive spread (leverage) Lots of cushy overhead and a casual ex-ante management attitude Trim fat and waste (agency problem) Transaction Mechanics: Example Transaction: Kelly/KKR group want to do a LBO of Beatrice Start with an acquisition vehicle P (a single purpose vehicle) P borrows $6 bio from a syndicate of banks and investors Kelly and KKR together contributed $400 mm in consideration for equity in P This leaves them with a single asset of $6.4 bio in cash Create a subsidiary S and put all the cash into the sub in consideration for stock The subsidiary must guarantee P's loans (using an off-balance sheet item) P makes a tender offer of $6.4 bio to Beatrice shareholders, conditional on receipt of Beatrice shares and a triangular merger of S into Beatrice Approval required by both sets of shareholders (P's Board and Beatrice's shareholders) P becomes the de facto owner of Beatrice S* (S+Beatrice) has a clean balance sheet, carrying only Beatrice's ex-ante debt

Valuation Issues: 1. Will cash flows be able to service debt and with what cushion 2. Need an exit multiple (IPO, typically) 3. Possible to have huge swings in valuation, bigger than size of equity piece 4. How do you pick a WACC with a dynamic capital structure (becoming progressively less leveraged) Unlevered b theoretically overestimates the riskiness of equity at high levels of debt because debt becomes like equity FCF methodology is very poor in valuing highly levered transactions --> APV is better Two-tiered offer: Make a tender offer at one price for 50.1% (or control) and a second tender offer at a second price for the remainder (often thought of as a coercive technique) White Knight: A company that is friendly to the target company's management and that intervenes with a competing takeover proposal Generally, if there is the potential for competitive bidding, the best chance for winning is with offering the best bid up front. Incremental savings don't outweigh the risk of losing the first-mover surprise advantage Anti-takeover techniques: Staggered board election Share buyback --> puts more shares in control of target firm and out of circulation Issue of different classes of shares with voting rights contingent upon the period holding the stock Reclassification of different classes of stock --> dilution of voting rights of potential acquirer Make owning stock unattractive to the arbs Share buyback premium --> pay exiting shareholders at the expense of those who are staying (since price will drop next day) Sell the crucial asset in the target firm --> unattractive to the unwanted bidder

Accounting There are two types of accounting treatment (as disconnected from tax treatment) The desired treatment is Pooling of Interests Add up the balance sheets of the two companies at historical cost (assets, liabilities, other equity) <-- very simple A marriage of two companies Difficult to pass all of the requirements that FASB has set up for pooling (7 tests), including: No assets sales for x # of years No pre-agreed buyouts for a group of shareholders Cannot merge acquired company into a sub Cannot acquire a sub of a bigger company, merge it and call it a sub Generally, only financial institutions qualify for pooling (Fed requires an immediate writeoff of goodwill ag. Reg. Capital) Tax and accounting treatment very similar Tax basis not adjusted, simply carried over Biggest failure to qualify for pooling: A subsidiary, contrived acquisition vehicle ( a single purpose acquisition entity) typically bids Not a true merger of equals, per se Alternative is Purchase Treatment Assets of one (and possibly both) must be written up to their Fair Market Value Liabilities are restated at market Any difference between FMV and the purchase price becomes goodwill Goodwill is expensed --> lowers earnings Book value is written up Possible to have tax-free carryover of basis while writing up the basis for accounting purposes --> 2 sets of books Statutory Merger: Tax Treatment: If pooling --> tax basis not adjusted, just carried over; tax-free transaction If purchase --> could be either taxable or tax-free

Accounting Treatment Could be either pooling or purchase Asset Purchase: Tax Treatment Almost always taxable Acquirer writes up the value of the assets and enjoys a depreciation benefit ("step up") going forward Seller pays tax on any difference between price and basis at ordinary rates if asset is depreciable, capital gains otherwise Accounting Treatment Must use purchase accounting Stock Acquisition: Occurs when the acquirer obtains stock in the target in consideration for cash Tax Treatment Selling shareholders pay capital gains tax Acquiring company does not revalue the assets of the target, carrying over the old basis in assets and liabilities Unless the acquirer makes a 338(h)(10) election in which they have a deemed sale and repurchase of the assets, effectively marking-to-market the position Accounting Treatment Purchase accounting Accounting Treatment Pooling or Purchase Purchase Purchase Tax Treatment Follows accounting treatment Taxable with step-up and taxable to selling shareholders Tax-Free (no write-up) unless 338(h)(10) election; CG tax to selling S/H

Stat. Merger Asset Purchase Stock Acquisition

Corporate Governance Directors have a responsibility to show: 1. Loyalty Put shareholder interests above their own, acting in a disinterested manner 2. Care Be well informed Must not be negligent or close their eyes to the facts Business Judgment rule: Directors are assumed to meet these standards unless proven otherwise Principle: Courts do not want to second-guess board decisions You can have a stupid board, but you can't sue them unless they acted in their own self-interest or they violated their duty of care Penalties: 1. Personal liability (rare) 2. Injunctive relief (much more common) Enjoin (or reverse) the decision of the directors, by the court There are 3 big cases in M&A: Revlon Unocal Society for Savings Case Revlon Unocal SOCS Pressure Most onerous Middle Least onerous Application Auctions Unsolicited hostile offers Strategic combinations Court Finding Directors must maximize short-term value --> must take highest price The takeover defense must be proportional to the threat Not obliged to maximize short-term value in a strategic combination

Revlon Principle Directors must maximize short-term value in the following situations: Auctions of the company A break-up transaction in response to a bid Engaging in a sale transaction that results in a change of control Last condition can be tricky if there are a large # of shares held in the hands of the public, freely trading them Example: Paramount Had a deal with Viacom (controlled by Sumner Redstone) QVC (controlled by Barry Diller) makes an offer for Paramount that matches and/or beats the Viacom deal Paramount and Viacom try to "put the deal away" (I.e. to make it impregnable to a third-party bid) Termination fee of $100 mm payable to Viacom if deal is unfulfilled Lockup option on Paramount stock granted to Viacom in respect of 19.9% of Paramount common Note: If there is an increase in shares outstanding by > 20% without a S/H vote, NYSE will delist the stock 17(e) Ensures Viacom handsomely compensated if QVC wins No shop clause: Paramount couldn't talk to another party unless that party had the ability to finance the deal immediately Court held that the directors of Paramount were bound by Revlon If Viacom had succeeded, it would have been a change of control Rescinded the protective provisions Example: Society for Savings SOCS starts soliciting bids in 1991 Received 9 bids, 2 of which are prominent Goldman - leveraged deal, complicated, $19.25/share Bank of Boston - all stock-for-stock deal May 1992: Board of SOCS says that they want to be independent --> no bid accepted August 1992: SOCS announces merger with BKB, stock-for-stock at $17.30/share Goldman reiterates its $19.25/share bid in cash

SOCS directors tells GS no --> BKB deal is a better strategic fit SOCS investors sue under the Revlon principle Court: Not obligated to take the higher price in a strategic combination Strategic combination: --> stock-for-stock as evidence of joint economic interest Problem: Wasn't it an auction? Was there a 'decent' interval of time? Example: Unocal Precedent in Unitrin Unitrin --> 23% owned by Henry Singleton (also the CEO of Teledyne) American General offers a 30% premium for Unitrin (skimpy-ish premium) Unitrin response Announces a shareholder rights plan in which anyone with over 15% of the stock needs a 75% S/H vote to do a merger Announces a buyback of shares which if successful will give Singleton over 25% ownership (a blocking minority) Court decided that the Unitrin response was excessive Preclusive of a merger Benefited a member of the Board