Hostile Takeover (Hostile Merger) Defence Strategies

A target company has various options on how to fight a hostile takeover, which is also called a hostile merger. The target company generally obtains assistance of an investment banker and lawyer to ensure that fighting the hostile takeover will be successful. Below are the nine common hostile takeover defence strategies used by target companies.

Target companies may inform shareholders why the merger will be disadvantageous for the company.

Repurchase of stock is sometimes undertaken by companies to decrease the attractiveness of the target company for hostile takeover. Mergers can be attractive due to a company’s liquidity position. If the company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, the firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes hostile takeover more expensive.

Greenmail is another defensive strategy against hostile takeover. It leads to the target company buying a large bulk of shares from one or more shareholders which attempted a hostile takeover.

Another strategy to protect itself against hostile takeover is defensive acquisition. The purpose of such action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such acquisition with debt. Due to increased debt of the target company, the acquiring company, which previously planned hostile takeover, will likely lose interest in acquiring now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than the merger with the acquiring company which pursues a hostile takeover.

Finding a white knight is another hostile takeover defence strategy. It involves finding a more appropriate acquiring company that will take over the target company on more favourable terms and at a better price than the original bidder. White knights are seen as a protector of the target company against the black knight which is the acquiring company which attempted a hostile takeover.

Golden parachutes is another way to discourage hostile takeover. This strategy means including provisions in the employment contracts of top executives which will require a large payments to key executives if the organization is taken over. Nevertheless, the amounts to be paid are small relative to the size of the transaction. Therefore, this strategy may not be sufficiently effective on its own but will make the acquisition target less attractive.

Leveraged recapitalization is yet another way to deter hostile takeover. It refers to the distribution of a sizable dividend financed by debt. This increases the financial leverage of the target company and decreases its attractiveness.

The term poison pill was created by mergers and acquisitions lawyer Martin Lipton in the 1980’s and refers to a further hostile takeover defence strategy. It involves an arrangement that will make the target company’s stock unattractive for the acquiring company.

The poison pill strategy includes two main variations. Such variations are flip-in and flip-over. Flip-in tactic occurs when management offers to buy shares at a discount to all investors except for the acquiring company. Such an option is exercised when the acquiring company purchases a certain amount of the shares of the target company. Flip-over occurs where the Target Company will be able to purchase shares of the acquiring company at a discount after the merger is completed. This will decrease the value of the acquiring company’s shares and dilute the company’s control.

The poison pill can be effective in discouraging a hostile takeover and allows the target company more time to find a white knight. Yahoo is a famous example of a company that uses poison pill as a defence strategy. It will be exercised if any company or investor buys more than 15% of its shares without the approval of the board of directors.

The target company may also use the crown jewel defence strategy. Crown jewels refer to the most valuable assets and parts of the company. According to this strategy, the target company has the right to sell its best and most profitable assets and valuable parts of the business to another party if a hostile takeover occurs. This discourages hostile takeover as it makes the target company less attractive.

Pac-Man defence is a hostile defence strategy named after the popular arcade video game of the 1980’s. According to this strategy, the target company “turns the tables” and attempts to acquire an acquiring company which attempted a hostile takeover.

Although these hostile takeover defence strategies may be successful, there are costs such as transaction costs which are involved in undertaking them. Transaction costs may include hiring of investment bankers and lawyers. In making decisions whether or not to undertake any defence actions against hostile takeover, management needs to continue to act in the best interests of shareholders by keeping the maximization of the shareholders’ wealth as the main objective.

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Merger Negotiations

Merger negotiations and mergers, similar to marriages, often fail. Therefore, it is very important to plan and execute merger negotiations properly to improve a merger’s chances for success.

Acquiring firms need to understand the deal very well before approaching the target company. Space for bargaining should be considered. For example, acquiring firm could initially offer somewhere between 75-90% of what it believes the target company is worth. However, it is also important to be reasonable when the initial offer is made. If the price will be too low then the relationship between parties may be severely damaged.

Good atmosphere and a respectful and positive tone of negotiations should be created. A Win-win mindset in negotiation should be maintained, not a win-lose mindset.

It is also important for the acquiring firm not to show its eagerness as this will decrease its bargaining power. Another essential point is the vital importance of being completely ethical and honest in conducting negotiations. Conflicts of interest also should be carefully avoided.

Negotiations should also be seen as an extension of the due diligence. It should be used to find explanations to unclear issues. It is important to remain sceptical and to check the information provided by the other party.

It is also recommended to engage competent advisors to attend to various important areas associated with merger negotiations. Such areas include, but are not limited to, due-diligence, tax, legal, regulatory matters and the valuation of the company.

Investment bankers are often hired to manage merger negotiations. Investment bankers may be hired by the acquiring company and/or target company and assists either party from the very beginning of the process by finding a target or a buyer all the way throughout assisting in merger negotiations, use of tender offers and in the execution of hostile merger defence strategies. The compensation of investment bankers may be commission-based, fixed fee or a combination of both.

In terms of personnel issues, it is imperative to be aware of the sensitivity with which employees of the target company are likely to approach possible relocation, changes in management, changes in the way operations are conducted and titles.

A good way for the target company to secure a good price is to follow a closed auction strategy. According to a closed auction strategy, the target company invites all interested parties to submit their sealed bids before the deadline. This is in comparison to open auction where all parties are aware of the previous bids submitted by other interested parties.

Prior to the submission of bids, all interested parties should receive a memorandum and an ability to undertake a limited due diligence. A closed auction strategy usually involves few rounds and concurrent negotiations with various interested parties.

The target company may even follow this strategy if there is only one company interested in the acquisition. This is possible because interested parties have no access to information regarding how many organizations are involved in a closed auction.

If a friendly takeover is not welcomed by the target company, the acquiring company may undertake a hostile takeover (hostile merger). The acquiring company will do so by using a tender offer. Tender offers refer to a formal offer made to the shareholders in the market place to obtain certain amount of shares at a given price which is above the current market price.

 

Stock Swap

Stock swap transactions are one of the popular ways in which mergers can be financed. Stock swap refers to the situation when an acquiring company exchanges its common stock shares for common stock shares of the target company at the agreed upon ratio.

The ratio, which is called ratio of exchange, is determined during merger negotiations. The acquiring company often needs to repurchase shares in the market place to obtain an adequate amount of shares to be able to complete the stock swap transaction.

To find the ratio of exchange, the dollar amount required to be paid per share of the target company must be divided by the market value of the shares of the acquiring company.

Ratio of exchange = amount required to be paid per share of the target company/market value of the shares of the acquiring company

Test yourself:

ABC Company would like to acquire company BCD by using a stock swap transaction to finance the merger. ABC’s shares currently trade for $60 per share. BCD’s shares are traded for $55. However, in merger negotiations, it was agreed that BCD’s shares should be valued at $90 per share. What is the ratio of exchange in this merger stock swap transaction?

Solution:

The ratio of exchange is 1.5 (90/60). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction where it will exchange 1.5 shares of common stock for each common stock share of BCD. ABC’s shares trade at $60 per share. It was agreed during merger negotiations that BCD’s shares will be valued at $90 each. The real market price of BCD’s shares is $55 per share. Find out how many shares does ABC need to exchange in the stock swap transaction if BCD needs to obtain 15,000 shares?

Solution:

ABC needs 22,500 (15,000*1.5) to complete stock swap transaction with BCD at a ratio of exchange of 1.5:1.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s earnings before the merger were $400,000 per year and it has 110,000 of shares of common stock outstanding. ABC will have to issue 22,500 shares of additional common stock to complete the stock swap transaction with BCD. BCD’s earnings before the merger are $65,000 and it has 15,000 shares of common stock outstanding. The ratio of exchange is 1.5 of ABC’s shares for 1 share of BCD.

What are current earnings per share (EPS) of ABC and BCD and what will be the initial earnings per share of ABC after the merger, if earnings are assumed to stay unchanged?

Solution:

Current (before the merger) earnings per share (EPS) of ABC is $3.6 (400,000/110,000).

Current (before the merger) earnings per share (EPS) of BCD is $4.3 (65,000/15,000).

Initial earnings per share of ABC after the merger is:

= ((400,000+65,000)/(110,000+22,500))

=485,000/132,500

= $3.5

It is common for earnings per share of acquiring company to initially decrease. This happens because acquiring company pays a large premium above the target company’s market price. In the long run, however, earning per share will likely be higher than it would be without the merger.

If the price/earnings ratio (P/E ratio) paid for the target firm by the acquiring firm is greater than the P/E of acquiring firm then, the EPS of the acquiring firm will initially decrease and vice versa. However, in the long term, the EPS of acquiring firm should increase. The P/E Ratio is found by dividing the market price per share by earnings per share (EPS).

Test yourself:

ABC (acquiring company) is acquiring BCD (Target Company) with the use of a stock swap transaction. ABC’s market price is $60 and its earnings per share are $3.6. BCD’s market price is $55 and its earnings per share are $4.3. However, during merger negotiations ABC agreed to a 1.5 ratio of exchange where it value BCD’s shares at $90.

A. Explain how ratio of exchange was determined.

B. Calculate the P/E ratio for ABC and BCD before the merger at market prices per share.

C. Calculate the P/E ratio of BCD at the agreed upon price per share for the merger.

Solution:

A.

The ratio of exchange of 1.5 is calculated by dividing $90 (the agreed upon price of BCD’s share) by $60 (the market price of ABC’s share). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

B.

P/E ratio of ABC before the merger is $60/$3.6=16.6

P/E ratio of BCD before the merger is $55/$4.3=12.7

C.

The P/E ratio of BCD at the agreed upon price per share for the merger is:

$90/$4.3=20.9

The P/E ratio paid by ABC for target company (BCD) was larger than the P/E ratio of ABC. This was due to an agreed upon price for BCD common stock shares which was $35 ($90-55) or 63.6% (35/(55/100)) above the  target company’s market price. It is common for an acquiring firm to pay approximately 50% above the target company’s market price. Consequently, in such situations the P/E ratio paid is often higher than the acquirers P/E ratio. This results in the initial earnings per share to be lower after the merger.

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Types of mergers

There are four types of mergers, which are presented below:

Conglomerate merger – acquisition of businesses in different lines of business to diversify risk.

Congeneric merger – acquisition of company in the same general industry to cross-sell products and services. It can be further subdivided into:

a. Market-extension merger – which refers to acquisition of company which operates in different market.

b. Product-extension merger – which involves acquisition of company that operate within same market but which product and service mix is different but related to that of the acquiring company.

Horizontal merger – acquisition of company in the same line of business which operates in the same market. This refers to acquisition of the direct competitor.

Vertical merger – acquisition of a supplier or customer.

 

8 Specific Motives for Mergers and Acquisitions

Mergers are undertaken if it is believed two or more companies which are merging will be greater together than sum of its parts. The math of a merger is “1+1=3” or “2+2=5”. Specific motives for mergers for strategic and financial reasons include the following:

Tax advantages – Tax advantages in mergers will differ from one location to another. In US it can be utilized if the acquiring firm or target company has a tax loss carry-forward. Tax loss carry-forward refers to the ability to deduct past losses from the taxable income. This advantage is available in mergers but not for holding companies. To decrease the attractiveness of this motive, the US and many other countries limit the amount of tax loss carry-forward that can be deducted annually from the taxable income of merged companies.

For example, assume the acquiring company is a profitable company and the target company is a loss maker which incurred losses in the past two years. When the merger is completed, the operating results of a merged company, which probably will have the identity of the acquiring company, will be reported on a consolidated basis.

This means the acquiring company will be able to deduct past losses of the target company from the consolidated taxable income, within limits. Merged firms will continue deducting the tax loss carry-forward (within limits) until it is recovered completely over a duration of up to 20 years.

Increases liquidity for owners – If the acquiring firm is a large company and target company is a small organization then the target company’s shareholders may find it very appealing that after merger their shares’ liquidity and marketability will likely be considerably better.

Gaining access to funds – The acquiring company may have high financial leverage (a lot of debt) thereby making access to additional external debt financing very limited. Therefore, one of the motives of the acquiring company to undertake the merger is to merge with a company which has a healthy liquidity position with low or non-existent financial leverage (very little or no debt).

Growth – This is one of the most common motives for mergers. It may be cheaper and less risky for the acquiring company to merge with another provider in a similar line of business than to expand operations internally. It is also much faster to grow by acquisition.

Sometimes an organization may have a window of opportunity that will be closing fast and the only way the organization can take advantage of this opportunity is by acquiring a company with competencies and resources necessary to take advantage of the opportunity. Additional benefits of growth motivated mergers are that a competitor or potential future competitor is eliminated.

Diversification – Diversification is an external growth strategy and sometimes serves as a motive for a merger. For example, if an organization operates in a volatile industry, it may decide to undertake a merger to hedge itself against fluctuations in its own market. Another example can be when an acquiring company pursues a target company which is located in different state or country. This is called a geographical diversification.

Related diversification seems to have a better track record. It refers to expanding in the current market or entering new markets and adding related new products and services to the product or service line of the acquiring company.

Diversification usually does not deliver value to the shareholders because they can diversify their portfolio on their own at much lower cost. Therefore, diversification on its own is unlikely to be sufficient motive for a merger.

Synergistic benefits – Synergy occurs when the whole is greater than sum of its parts. For example, in terms of math it could be represented as “1+1=3” or as “2+2=5”. Within the context of mergers, synergy means the performance of firms after a merger (in certain areas and overall) will be better than the sum of their performances before the merger. For example, a larger merged company may be able to order larger quantities from suppliers and obtain greater discounts due to the size of the order.

In the context of mergers, there can be two types of synergy. The first type of synergy results in economies of scale, which refers to decreased costs. Another type of synergyresults in increased revenues such as cross-selling.

As per the above, economies of scale are derived from synergy. For example, merging businesses in the same business line will allow elimination of some of the duplicated overhead costs. A new business will not need two human resources and public relations departments. Instead, the best employees will be kept and the rest of personnel and unused office space will be reallocated or no longer used.

Cross-selling is another benefit derived from synergy. If some of the products and services of merged companies differ then cross-selling those products and services to the other firm’s customer base can be a cost effective way to increase sales. Being able to effectively meet more of the customers’ needs may also increase customer loyalty due to higher customer satisfaction which can occur by effectively providing customers with a broader spectrum of products and services which meet customers’ needs.

Synergy benefits with regard to an increase in revenue are usually more difficult to achieve than synergy benefits with regard to decreasing costs. Management also needs to be careful to ensure that potential synergy benefits are not overestimated as this may result in overpayment for the target company.

Protection against a hostile takeover – Defensive acquisition is one of the hostile takeover defense strategies that may be undertaken by target of the hostile takeover to make itself less attractive to the acquiring company. In such a situation, the target company will acquire another company as a defensive acquisition and finance such an acquisition through adding substantial debt. Due to the increased debt of the target company, the acquiring company, which planned the hostile takeover, will likely lose interest in acquiring the now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with the acquiring company which started off the whole process by proposing a hostile takeover.

Acquisition of required managerial skills, assets or technology – The target company may have managerial skills, assets and/or technology that the acquiring company needs to improve its performance, profits, revenue, cut costs, reduce productivity etc. This can become a motive for merger.

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Types of Corporate Restructuring

Mergers and Consolidations

Consolidation is a type of corporate restructuring and occurs when two or more organizations come together to form a completely new corporation. This new corporation typically include all assets and liabilities of the combined separate companies. Consolidations usually occur between organizations of similar size.

Merger is also a type of corporate restructuring and occurs when two or more organizations merge into one. Organizations that merged into one usually maintain the identity of most important organization.

Merger often involves one or more smaller organizations merging into a larger organization and becoming part of that larger organization. Merging involves absorption of assets and liabilities of all firms merged. Mergers also can be called acquisitions, buyouts or takeovers.

Within a merger, the acquiring company (generally larger and more important company) usually will approach a target company (smaller and less important company) to arrange a merger.

Sometimes, however, the target company may approach acquiring company. The key outcome that the acquiring company seeks from a merger is synergy, leverage, key staff, technology or even preventing a competitor from acquiring a particular company.

Government and mergers

Governments regulate mergers. The main concern of the government is to ensure that competition is not eliminated. This concern is especially relevant if one direct competitor attempts to acquire another direct competitor. Such a merger could result in higher prices for consumers and lower output of combined organizations (fewer product or service options or inferior customer service). If such a situation occurs then population may end up worse off than it was before the merger.

Mergers, of course, also may provide social benefits. Such benefits include economies of scale and scope, better utilization of resources, higher output and improved quality.

Therefore, government usually prohibits only those mergers in which anticompetitive disadvantages outweigh social benefits.

Hostile and Friendly mergers (takeovers)

Hostile merger (hostile takeover) usually occurs when the acquiring company approaches target company but management of the target company or the board of directors of the target company do not support the proposal for acquisition. In such a situation, the target company may take actions to make it harder or impossible for the hostile merger to take place by executing hostile merger defence strategies.

Acquiring company then attempts to obtain the required amount of shares in the market place via tender offers. Tender offers refer to formal offers made to the shareholders in the market place to obtain a certain amount of shares at a given price which is above the current market price.

The acquiring company may also undertake a creeping tender offer by silently purchasing enough shares in the market place before making their intentions known.

Hostile mergers (hostile takeover) also occurs if the acquiring company approached shareholders directly without firstly approaching the management and board of directors of the target company.

Another way a hostile merger can occur is if the acquiring company engages in a proxy fight by trying to obtain support of enough shareholders to replace management with new management which will endorse the takeover.

Certainly hostile mergers are more difficult to undertake. The acquiring company may struggle to obtain a loan if it needs to borrow to finance a hostile takeover as banks usually are not supportive of hostile takeovers.

The acquiring company is also at greater risk under a hostile takeover because it cannot undertake an in depth due diligence of the target company and will have to rely completely on the publicly available information to make a decision to acquire a target company. Nevertheless, hostile takeovers also take place.

Friendly merger (friendly takeover) involves a situation where the acquiring company approaches the management of the target company with the proposal for acquisition. If management supports such an acquisition and if the board of directors sees a merger to be in best interests of shareholders, then the board makes such a recommendation to the shareholders. If shareholders approval is obtained then a friendly merger occurs and it is completed by the acquiring company obtaining shares in the target company.

Motives for mergers

Any action undertaken by business must be based on achieving the main objective of the enterprise which is the wealth maximization of the owners of the enterprise.

The main objective of a merger should be the same as the main objective of the firm. Namely, the maximization of the owners’ wealth by improving the share value.

There are two driving forces for mergers, which should be consistent with the main objective. They include strategic and financial reasons.

Under a strategic merger the performance of firms after the merger is higher than performance of firms before merger. The strategic merger involves economies of scale due to combining two or more firms to achieve greater productivity and profitability.

Financial mergers are conducted due to a perception by the acquiring company that the target company can be managed and structured better after acquisition. In this way the acquiring company anticipates to unlock unrealized value from the target company. Such mergers rely significantly on debt to finance acquisition. A leveraged buyout (LBOs) is an example of financial mergers. Strategic mergers are more prevalent than financial mergers.

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