The purpose of these blog posts is to provide commentary for my lecture slides. Lecture slides will only be provided through the university website. If you have any questions or comments, please write them below and I will respond as soon as I can.

Introduction

Welcome to mergers and acquisitions! This is essentially an introductory course into the various topics relating to corporate restructuring. I am excited by the level of interest and the diversity of the student body here in Hong Kong. I am eager to learn from you all as I am sure you are eager to learn more about M&A.

Course Expectations

Let me first talk a bit about course expectations. I want to make sure you all know what you are getting yourselves into before fully committing to the course. All lecture material will be posted on the university course web portal called Canvas.

Grades

Your final grade in the course is determined by 1) group work and 2) the final exam. Group work includes projects and homework assignments that are completed and submitted to as a group. Group work constitutes 60 percent of your final grade, so choose your group mates wisely as everyone in your group will receive the same grade for assignments and projects. Not all group members have to contribute equally for each project and assignment. I know that many of you have part-time jobs or potential future job or internship interviews. So, it is up to each group on how to allocate work efficiently. However, any group members that are simply freeriding and contribute nothing to any group work deserve a 0. So please inform me if such cases occur.

Groups

By this weekend, please form groups of 6 to 8 individuals and send an email to my TA letting her know who are your group members. Any student enrolled in my course that has not joined a group by this weekend will be randomly assigned to one. I am shooting for 8 groups, so if there are too many groups I may disband the smaller ones.

Projects

There will be two projects: 1) the recent merger case analysis and 2) the merger proposal. Due dates and general project guidelines are on the syllabus. I will provide more detailed guidelines in the future. The recent merger case requires you to study a recently completed merger or acquisition. The merger proposal project requires you to write a proposal for a potential merger that you have to sell to an acquirer or target or both. Hopefully near the end of this course you should have the tools necessary to conduct both quantitative and qualitative analysis to support your case.

Why Study U.S. M&A?

Given the long capitalist history of the United States along with its robust legal system, this course will focus primarily on deals and institutional background involving U.S. firms. To give you a sense of why deals done in the U.S. are much more interesting than ones done in emerging economies such as China, for example, I will discuss and compare the nature of the top 3 U.S. deals and the top 3 China deals in 2016.
M&A involving U.S. firms are primarily strategic: they are intended to create value for shareholders for both the target and the acquirer. The top merger by value in 2016 is between Time Warner and AT&T. Time Warner is a cable television company and an internet service provider in the U.S. AT&T is a very large telecom company with a very long history. The purpose of this merger was to hopefully generate new products such as TV shows and create new product delivery channels or platforms to existing customers. The second largest deal involving U.S. firms is between Monsanto and Bayer. Monsanto is an agricultural biotech company and Bayer is a German pharmaceutical company that also has some products in agriculture, namely fungicides, herbicides, and insecticides. A possible reason for this merger is to allow Bayer to gain access to U.S. intellectual property and markets. The third largest U.S. deal is a merger between Level 3 and CenturyLink. Both are telecom companies, but they are small players compared to AT&T. A good reason for this merger to go through is the improvement of survivability and to be able to compete with AT&T and Verizon, which are comparatively giants in terms of market power.
On the other hand, while M&A deals involving Chinese firms are also intended to create value for shareholders or the Chinese government, they are done primarily to increase capital efficiency and gain access to external financing from international markets. The largest deal completed involving Chinese firms in 2016 is between China National Petroleum and Jinan Diesel Engine. China National Petroleum is the largest state-owned oil and gas company based in Beijing and Jinan Diesel manufactures general machinery. The deal was done to provide China National Petroleum engineering assets and gain listing on the Shenzhen stock exchange on which Jinan Diesel was already listed. The merger between SF Holdings, a delivery company, and Maanshan, a manufacturing company, should be puzzling to hopefully everyone at first sight. This deal is a typical “back-door” listing technique to help Chinese firms get listed on the Hong Kong stock exchange. And lastly, the deal between CITIC Real Estate Co, a conglomerate, and China Overseas Land, a Chinese state-owned real estate company, is an example of merger to improve capital efficiency. CITIC sold its residential assets to China Overseas land in order to focus on commercial development.
To summarize, most deals involving Chinese firms that you will come across in the news are still dominated by corporate restructuring to become more efficient or attempts to gain access to financing. U.S. M&A are about corporate strategy and value creation, which I believe is more interesting and worthy of study here.

Merger Movements in the U.S.

And because M&A in the U.S. is primarily driven by value creation for shareholders, their occurrences correlate very strongly with the performance of the U.S. economy. As firms become more valuable, we see the number of deals increase as many acquisitions during these booms are paid for using stock. However, just like the U.S. economy, the M&A market can become overheated and firms will likely begin overpaying for certain deals, which can lead to events such as the dot com boom in the 1990s. The goal of this course therefore is to understand why deals occur and how to put an accurate price tag on potential acquisitions.

Economic and Social Impacts of M&A

However, the purpose of today’s lecture is to help you realize that the consequences of M&A goes beyond the dealmakers and stakeholders of the target and acquiring firms. I want to convince you that M&A can economically and socially impact society or common everyday people like you and me.
One of the most direct impacts that M&A can have on society is the change in pricing power over goods and services relative to other firms. The best way to understand this is to think about pricing power in the extreme cases. If a firm has no pricing power, then it is a price taker and will sell you goods and services at competitive prices in which it makes zero profits. If a firm has full control over setting prices, then it will set prices at each consumer’s maximum willingness to pay so that consumers are essentially indifferent between buying those goods and services and keeping their money. Consumers in this case have no bargaining power.
I will take businesses in Hong Kong as an example. One way to measure pricing power of a particular industry is to calculate how concentrated revenues or sales are among the top firms. The Hong Kong government sorts all firms by total revenue in a given year, adds up the revenues of the top 50 companies and divide that sum by the total revenues of all firms within that industry. What should shock you is that over 50% of the revenue generated in the apparel, real estate and fast food industries are owned by only 50 companies! And in fact their market power has grown from 2013 and 2014. Chinese food industry in Hong Kong, not surprisingly, remains quite competitive, which is why Chinese food prices are comparatively low.

Course Overview

Therefore, I will try to present M&A from two perspectives: 1) the dealmakers and 2) investors and consumers. Starting from next week I will review the financial concepts and math that you all should have learned from your previous courses. Most importantly, I will help you understand the theoretical underpinnings of the models you will build to find the prices you should offer or accept. Additionally, we will study M&A from the perspective of investors and consumers through the understanding of regulations that were born from several key merger movements in the U.S. We will start this course by looking at M&A from a journalist’s and historian’s viewpoint. Lastly, I will briefly talk about the regulatory setting that should be in the back your mind throughout this course.

Point of View of the Journalists

What kind of information should journalists present to their readers? What should the WSJ report for each M&A transaction? You should think of the WSJ and the Financial Times as business researchers catering to shareholders and investors. As you will discover from reading case studies in this course, news reporting, pitch books, and merger proposals are basically storytelling with numbers. In general shareholders want to know the motivation and rationale for a particular merger deal to justify the deal price. If you are a shareholder of the acquiring firm, you want to know if you are overpaying. On the flipside, shareholders of the target firm want to know if they are getting enough. The following are some questions that journalists typically try to answer:

• What is the economic logic of the deal? Is the purpose of the deal to gain market share or is the merger transformational? Is the acquiring company trying to escape a declining business or are they trying to create greater dominance. Is a new product being created or is the acquirers trying to access new technologies? The logic should be reflected in the price and premium. Some companies overpay for technologies and others make repeated stabs at transformation. Journalists will often check the acquirer’s track record.
• Who is profiting? Deals are driven by money. Bonuses to the managers involved will be tied to stock prices. Since merger announcements can boost stock prices, whether managers cash out or not can be indicative of whether the deal will create value in the long run.
• Where are the savings? Another way to create shareholder value is by improving efficiency. Is there overlap between two companies that can produce reductions in overhead and headcount? Or are there two companies complementary to make integration easier, but make cost reductions tougher? Cost cutting can make or wreck a deal especially for smaller companies with unique culture as it can drive away talent. Talent and IP are hardest to integrate.
• What is the personality fit? For example, having co-CEOs could mean potential paralysis post merger. Is it based on politics or competence? Reporting a succession plan can help mitigate these uncertainties.
• How will it be financed? Is the deal financed through cash, stock, debt, or a combination? Different financing yields different risk for all stakeholders (creditors, equity shareholders, insiders, etc.). For example, debt financing could imply increased default risk and future cuts to R&D. Using cash may not be optimal as well since cash deals are taxed 99% of the time.
• What is the price and premium? The premium or price paid above pre-announcement stock price may rise with cost reductions. Larger companies may pay a larger premium for smaller targets, especially if the technology is involved.
• What kind of merger is it? What is the deal structure? Is it simple cash takeover deal? Or is it complex that involves tax avoidance to placate major interests? Devices like collars, breakup fees, no-shop provisions or warrants are important in volatile economic and financial conditions to reduce risk and uncertainty.
• What are the odds of economic change? It can take up to 8 months to a year to close a deal. Capital markets can change and integration takes years. Synergies and cost reductions may not always come through. If the risk is too high, shareholders can exit and sell their shares.
• Is there an antitrust problem? What do regulators think? Regulators care about overall consumer welfare. Monopoly power often comes at the detriment of consumer welfare through higher prices for the same product. Regulators can block these deals if such is the case.

Why do M&A Happen?

There are several ways M&A deals can create value for shareholders.

• Strategic Realignment. Firms may turn out to be more profitable to focusing on their core competency rather than product diversity. An example is IBM divesting its laptop division to Lenovo and focusing on IT consulting.
• Operational Synergy. This type of synergy yields economies of scale and scope. Economies of scale are efficiency gains from becoming larger. Economies of scope are efficiency gains from producing complementary goods together (e.g., laptops and printers).
• Financial Synergy. Financial synergy occurs with the combined firm turns out to be less risky with higher expected returns. In such cases, the combined firm should have a lower cost of capital and higher debt capacity.
• Diversification. Some mergers are motivated by growth into new markets. An example is Facebook making investments into virtual reality through the acquisition of Oculus Rift.
• Financial Considerations. A deal can occur if the acquirer believes the target is undervalued or investors overvalue the acquirer stock. An example is Yahoo’s early ownership stake in Alibaba.
• Market Power. In the absence of innovation, pure competition would eventually lead to zero profits since firms would undercut prices of their competitors until marginal revenue equals marginal cost. One way to escape this game would be to obtain market or monopoly power, which is essentially the ability to increase prices and therefore profitability, all else equal. Imagine the consequences of a merger between Coca Cola and PepsiCo.
• Ego/Hubris. Sometimes CEOs pursue acquisitions due to psychological reasons rooted in overconfidence. These deals can turn out to be extremely bad.
• Managerialism. Managerialism is just another term for the principal-agent problem. There may be too many 3rd party advisors that don’t actually care about the long-run outcome of the merger.
• Tax Considerations. Lastly, a merger can create shareholder value through possible tax benefits, especially M&A deals that span across two countries with different tax systems. For example, tax inversion mergers are done to take advantage of better tax rates in other countries.

U.S. Merger Waves

Merger opportunities did not exist uniformly across time, and the reasons to engage in M&A deals were different at different points in history. I broke the history of U.S. mergers into 6 periods: 1) 1900s where horizontal mergers dominated, 2) 1920s where vertical mergers dominated, 3) 1950s to 1970s where diversified conglomerates engaged in massive acquisitions, 4) 1980s where hostile takeovers were popular, 5) 1990s where M&A deal prices set global records, and 6) the 2000s where corporate restructuring and governance began at the shareholder rather than management level.

Wave 1: Horizontal Mergers

A horizontal merger is a combination of firms operating in the same business activity or level in the production process. Mergers usually achieve economies of scale and pricing power. During this period, the motivating forces include the drive for efficiency, lax antitrust law enforcement, westward migration from the east coast to the west coast, and technological changes. As a result, metals such as steel, transportation such as trains, and mining industries increased market concentrations.

Example: U.S. Steel

U.S. Steel was created through a merger between Carnegie Steel Company (J.P. Morgan) and the Federal Steel Company. Post-merger, they controlled more than two-thirds of the U.S. steel production. This merger is typically viewed as a strategy to acquire monopoly power. However, U.S. Steel eventually lost market share as competitors were more innovative. More specifically, their competitor Bethlehem Steel used a new mill invented by Henry Grey, who was the owner of Federal Steel Company, that produced stronger, lighter, and less expensive steel.

Wave 2: Vertical Mergers

A vertical merger is a combination of firms that increases joint ownership of their upstream suppliers and downstream buyers. Vertical mergers is about controlling costs and blocking new entrants, so it is also monopolistic. A recent example is Amazon’s purchase of Whole Foods, a U.S. supermarket. During this time period, vertical mergers were spurred by entry into WWI and post-WWI economic boom. This period is often characterized by oligopolistic mergers than than monopolistic ones. Thus, competition is not through price, but through product differentiation and marketing.

Example: Middle West Utilities

An example of a company that engaged in vertical mergers during this time was Middle West utilities Co. Middle West was a holding company built by energy magnate Samuel L. Insull, who once worked as a private secretary to Thomas Edison of General Electric. It accounted for one-eighth of total output of electricity and gas in the U.S. Their holdings included utilities, construction outfits, and electrical-equipment makers, which is the entire supply chain. As a result, there were large disparities in the levels of service available in different parts of the country, which is evidence of product discrimination and pricing power. Because of this, they were suspected of manipulating U.S. energy markets.

Wave 3: Conglomerates

A conglomerate is a combination of firms engaged in entirely different businesses that fall under one corporate group, usually involving a parent company and many subsidiaries. During this era, conglomerates bought other companies’ earnings streams to boost their share price. Conglomerates became overvalued and took advantage of their inflated stock prices to buy undervalued high growth firms. However, the number of high-growth undervalued firms declined as conglomerates bid up their prices. Conglomerates eventually became overleveraged and overpaid for firms that eventually didn’t grow enough.

Example: Ling-Temco-Vought

Ling-Temco-Vought (LTV) is an extreme example of a conglomerate that existed between 1961 to 2000. Ling was an electric company, Temco manufactured aircrafts and missiles, and Vought was an aerospace company acquired through a hostile takeover. By 1969, offered 15,000 separate products and services and was one of the 40 biggest industrial corporations. Because of low interest rates, LTV was able to finance acquisitions through debt issuances to increase earnings, which gave the appearance of growth. However, the conglomerate did not grow any faster than the individual firms before their acquisition and therefore eventually went bankrupt and went into a series of divestitures.

Wave 4: Takeovers and LBOs

What spurred the leverage buyout craze in the 1980s was the realization that the default rates of junk bonds up till that time was not much different than investment grade corporate bonds. Therefore, the ability to issue junk bonds cheaply gave corporate raiders access to capital to buy firms. However, much like the conglomerate era, several LBOs failed because of overpayment of targets.

Example: RJR Nabisco

An example is the leveraged buyout of Nabisco. Nabisco was an attractive LBO candidate as it had steady growth unaffected by business cycles and low debt levels. Demand for Tobacco and food products is fairly constant regardless of market boom or busts. Many private equity firms engaged in a bidding war to buy Nabisco that raised its original price from 75 dollars per share to 109 dollars per share. KKR, a famous private equity firm, eventually won the bid, but had to sell more than $11 billion dollars to finance the buyout.

Wave 5: Strategic Mega-Mergers

M&A deals in the 1990s were largely speculative in nature due to the technological innovations driven by the invention of the internet. Many tech and non-tech firms took advantage of their high stock prices to buy growth targets.

Example AOL and Time Warner

The AOL and Time Warner merger is an example. AOL wanted to convert its stock price into tangible assets and Time Warner wanted to embrace the internet. However, synergies never materialized and little innovations were actually born out of this deal.

Wave 6: Shareholder Activism

Lastly, the most recent era can be characterized by shareholder activism. Because of several scandals (e.g., Enron,WorldCom) and market crises (e.g., subprime mortgage crisis) due to poor management, shareholders are much more skeptical of corporate leadership and have taken corporate strategy into their own hands. An estimated 100 hedge funds have adopted activist tactics as part of their investment strategies as of 2013. To increase firm value, activist hedge fund managers often attempt to gain seats on boards to replace underperforming executives.

Actavis and Forest Laboratories

Carl Icahn is a prominent activist shareholder who has influenced several corporate restructurings at many firms, including Apple and Forest Laboratories. Owning an 11% stake, he ran several rounds of “proxy contests” or competing director election ballots in order to nominate his own hand-picked directors who would take orders from him. With board representation, he was able to orchestrate the acquisition of the company by Actavis, an Irish company, to avoid paying higher U.S. taxes.

Similarities and Differences Among Merger Waves

Across these time periods, you should have noticed several similarities in the setting in which these M&A deals took place. All these merger waves occurred during periods of sustained high economic growth, low or declining interest rates, and a rising stock market. These factors allow firms with high stock valuations to go on an acquisition spree (i.e., using stock to buy companies). However, what differed across these time periods is that new technologies emerged in specific industries and therefore M&A activities shifted from one industry to another, specifically from manufacturing to technology or growth industries. As a result, the motivation for mergers also shifted from obtaining pricing power to strategy and innovation.

Reasons M&A Fail to Meet Expectations

From these merger waves, we learn that like in all your corporate finance related courses, there are two fundamental economic frictions that can undermine M&A deals. Unrealistic expectations and poor due diligence arise from agency problems. Dealmakers, investment bankers, and managers may only be maximizing their short-term profits rather than shareholder value. Moreover, their decision making ability could be biased due to hubris or overconfidence. Bad strategy, bungled integration, and overpayment are the result of asymmetric information. Better information can prevent bad strategy, overpayment, and poor execution.

Regulatory Environment Born from Merger Waves

The last topic I want to talk about in this lecture is the regulatory environment that came about as a result of these merger waves in the U.S.

• Sherman Act (1890): Section 1 of the the Sherman Act prohibits specific anti-competitive conducts such as price fixing or coordinating with other firms to sell something at a fixed price. Section 2 defines monopolizing trade as a federal crime subject to penalties.
• Clayton Act (1914): The Clayton Act outlawed price discrimination (different prices for the same good for different people or quantity), tying or bundling goods together, and exclusive dealings if it created monopolies.
• Federal Trade Commission Act (1914): FTC Act created the FTC, a regulatory agency that studies and stops anti-competitive behavior.
• Cellar-Kefauver Act (1950): The Cellar-Kefauver Act outlawed mergers by acquisition of assets if lessened competition.
• Hart Scott Rodino Act (1976): TheHSR Act required pre-notification of big mergers to the FTC and DOJ.

Horizontal Merger Guidelines (2010)

Both the FTC and the DOJ follow the Horizontal Merger Guidelines to determine whether certain mergers should be allowed to complete. In general, they will 1) define a relevant market, which I will discuss in the next section, 2) identify potential adverse effects to consumer welfare and possibly national security, 3) identify possible new barriers to entry into the defined market that could allow two combined companies to become a monopoly, 4) identify potential cost efficiencies for permitting some market power consolidation (e.g., music licensing), and 5) determine whether the merger is necessary to keep important firms from going bankrupt (e.g., hospitals).

SSNIP Test

Regulators often use the SSNIP test to define the relevant market based on a particular set of products to conduct post-merger analysis. The task is to identify the smallest set of firms in which a monopoly over them would be profitable given a permanent increase in product prices. The set of firms is considered too small if consumers substitute away from those set of firms given a 5% increase in prices, for example. To “pass” the SSNIP Test at the 5% level, you would need to enlarge this set of firms until total profits given the markup exceeds total profits without the markup.

Example: Oranges

Consider firms A, B, and C that all produce oranges with the following production information:

Firm	Price per Unit	Units Sold	Cost per Unit
A	$10	1000	$5
B	$13	800	$4
C	$9	1100	$4

Given that we want to know if products A, B, and C constitute a relevant market, the exercise would consist in supposing that a hypothetical monopolist X would control all three products. In that case, the monopolist would make profits of:
10 * 1000 - 5 * 1000 + 13 * 800 - 4 * 800 + 9 * 1100 - 4 * 1100 = 17700
Now suppose the monopolist X decides to increase the price of product A, maintaining the price of B and C constant. Suppose that a 10 percent increase in the price of A provokes the following situation:

Firm	Price per Unit	Units Sold	Cost per Unit
A	$11	800	$5
B	$13	900	$4
C	$9	1200	$4

This means that the price increase of A would provoke that 200 units less of A be sold and instead, 100 more units of B and C will be sold respectively. GIven that our hypothetical monopolist controls all three products, its profits will be:
11 * 800 - 5*800 + 13 * 900 - 4 * 900 + 9 * 1200 - 4 * 1200 = 18900
As can be seen, the monopolist controlling A, B, and C would profitably increase the price of A by 10 percent, in other words, these three products do constitute a market “worth monopolizing” and therefore constitutes a relevant market. This result is because X controls all three products which are the only substitutes of A. Thus, X knows that even if its increase in price of A will generate some substitution, a significant share of these consumers will end up buying other products which eh controls, therefore overall, his profits will not be reduced but rather increased.

Herfindahl-Hirschman Index

Once you have defined a relevant market, you can start measuring market power. One popular measures is the Herfindahl Index (HHI). HHI is calculated by summing the squares of the individual firm's market shares (e.g., sales), and thus gives proportionately greater weight to the larger market shares. An increase in HHI generally indicates a decrease in competition and an increase of market power consolidation. According to the FTC and DOJ, transactions that increase the HHI by more than 200 points in highly concentrated markets are presumed likely to enhance market power.

Example: Coffee

Suppose Starbucks (700 mil USD), Pret A Manger (300 mil USD), and Pacific Coffee (500 mil USD) make up the entire coffee industry in Hong Kong. What is the HHI the coffee industry in Hong Kong?
Total Revenue = 1500
HHI = ((700/1500) * 100)^2 + ((300/1500) * 100)^2 + ((500/1500) * 100)^2 = 3689