Mergers and acquisitions as a response to the deregulation of the electric power industry - Essay Example

?Mergers and Acquisitions Introduction “Modern corporations are created by persons, but they are created in the image of their creators” (Donaldson, 1982, p. 3). Despite the fact that they are created by fiction of law, it is corporations that have shaped the way we live and continue to govern our society, economy, and environment. The size of corporations and the complexity of their operations have transcended the power of nations and states that have created them; the matter of their growth and proliferation is therefore an important consideration in the formulation of national policies and the promulgation of laws. Mergers and acquisitions are such modes of growth. Mergers occur when two firms of equal standing concur to combine their operations under one shareholder group; acquisition is when one firm outrightly purchases another and becomes its majority shareholder. As to whether they combine operations or not and the manner they choose to do so are a matter of strategic determination, but it does not detract from the fact of the merger or acquisition as a matter of ownership (Daniel & Metcalf, 2001, p. 216). This report examines the fundamental theories behind mergers and acquisitions and gives a cursory examine of one such undertaking. Motives for firms to enter into mergers or acquisitions: (1) To improve efficiencies by reducing production costs, increasing output, improving product quality, obtaining new technologies, or providing entirely new products. A merger or acquisition may explore both operating and managerial efficiencies. Operating efficiencies come from economies of scale, production and/or consumption economies of scope, enhanced resource allocation, shift to a less costly technology or asset configuration, or acquisition of better skills, use of grand name capital, and so forth (Pautler, 2003, p.122). (2) To explore financial and tax benefits by diversifying the firms’ earnings with dissimilar earnings streams to lessen earnings variation. Depending upon regulations, tax benefits may be realized, as in situations where the law allows offsetting the acquiring firm’s taxable income with the acquired firm’s net operating losses to reduce future taxes (Pautler, 2003, p. 122) (3) To increase market power to the advantage of the merging firms. Where the merging firms each command a significantly sizeable part of the market, then their merger may well trigger a spate of other mergers by the competing firms, which result in virtual monopolies or oligopolies. These so-called “merger waves” were evident in three periods: the successive mergers in the 1887-1904 wave which were viewed by George Stigler as “mergers for monopoly,” the 1916-1929 wave he called “mergers for oligopoly,” and the 1968-1974 wave which Matsusaka termed the “conglomerate merger wave” (Stigler, 1950, and Matsusaka, 1993, both cited in Pautler, 2003, p. 125). After the passage of the antimerger legislation in the U.S. in 1950, preventing the merger of competitors with significant market shares, such mergers were allowed only after review and approval by U.S. antitrust and other regulatory agencies. In the UK, a similar merger wave was seen between 1948 and 1961, when 735 public companies were taken over by other public companies, with two to three hundred other unsuccessful bids during the period, which Kuehn (1969) attributed to the effect of the valuation ratio as a constraint on the managerial utility function (p. 133). (4) Because of management greed, self-aggrandizement or hubris. A study conducted by Morck, Shleifer & Vishny (1990) showed that managerial incentives may account for merger activity that eventually erode the firm’s long-term value. Badly considered mergers may result in over-diversification, an ill-considered pursuit of growth, or merely bad acquisition decision. Oftentimes, the poor quality of the decision is not evident at the time it was made, and only becomes apparent afterwards. Matsusaka found that in the conglomerate merger wave of 1968 to 1974, many of the mergers that were then formed were approved and even praised by an admiring market which over-estimated the values of the transaction. Only later did the mistake become manifest, that the mergers resulted in over-diversification that eventually weakened the acquiring or merged company. Thus, it is not true that the erroneous decisions were not made by “run-away” managers as might be generally thought, but that these decisions seemed right at the time (Pautler, 2003, p. 124). (5) To take advantage of a good buy, because at the time the market had undervalued the asset (Pautler, 2003, p. 128). This would mean that most of the potential acquirers were either not aware of the existing discount, or that they did not have the interest to bid it up at the time. When uncertainties are high and risk averse players are either sidelined or leaving the market, sellers outnumber buyers and the price goes down, not because the underlying asset has receded in its fundamental value, but because of a technical price correction or breakdown. Buyers at this point will realize a quick gain when the market returns to normal, making the purchase more of a technical buy rather than a strategic acquisition. At times, the interest of a single buyer over others is misconstrued (or at times, even rightly construed) to be due to unique information held by the purchasing firms’ managers (Pautler, 2003, p. 129). In a perfect market where all participants are in possession of all the information at all times, then all bidders would have the proper value in mind and bid up the price to that value. In the real world, however, perfect information known by everyone is impossible, making price inefficiencies not only possible but even frequent. (6) For the acquiring firm to expropriate the other stakeholders of the acquired firm. For instance acquiring firms may leverage up to acquire a firm, in the process allowing their risk-return profile to deteriorate at the expense of existing creditors and debt holders. The empirical evidence, however, shows that this is not true and there appears to be no confirmation that in a takeover, management is motivated by a desire to expropriate gains from taxpayers, bondholders, labor or consumers (Romano, 1992, p 133). Market effects of mergers and acquisitions Target firms enjoy a significant wealth gain at the time of the announcement; however, the results are mixed for wealth effects from the point of view of acquiring firms – that is, acquiring firms may get significant wealth gain around the time of the announcement date, which generally tapers off to a negligible or even negative return to investors as time passes after the announcement. (Zhu & Malhotra, 2008, p. 26). These findings appear to be consistent over time. In 1968, a study by Block had determined that for the period 1961 to 1965, the occurrence of mergers had caused a significant rise in the price of stocks of the acquired firm, within the time period beginning three months before announcement, until one month before the announcement. About one month prior to announcement the price surges, and remains high until the announcement date. Similar findings are arrived at by Balog (1975). For acquiring firms, the reaction is the same, that is, eventually stock prices show little or no appreciation. Thus, in the three studies Zhu & Malhotra (2008), Balog (1975) and Block (1968), and numerous studies in between them, the effect of the merger on the acquiring companies’ stock price is neutral, while it is significantly positive for stock prices of acquired companies. The reason for the neutral effect of merger announcements on the prices of acquiring companies and the positive effect on the acquired firm is that the market factors in the premium paid by the acquiring firm (at an average of about 25 per cent throughout several mergers) in the course of the purchase. The premium paid raises the price of the target company, but leaves the price of the acquirer unchanged. The acquiring company is seen to pay more than the target firm’s true value, and besides, the merger effect on earnings per share (EPS) is anticipated (Madden, 1981). Studies have shown that the EPS of acquiring companies increases one year after the merger, but the increase does not exceed the norm of market growth for all other firms during the same period (Pautler, 2003). For this reason, potential acquirees are perceived to represent good investments, which perception does not apply to acquiring companies. Contagion and capacity effects of mergers Aside from technical market reactions centered on the merger announcement, the actual merger also has effects on the fundamental value of the merged business. Shaver (2006) found that in synergy-based mergers and acquisitions, actions taken to facilitate synergy capture also amplified threats and may compromise the ability of the merging firms to react to favourable conditions that emerge in the business environment (p. 962). The rationale of synergistic mergers is that the merged entity is expected to realize profits that are higher than the sum of the profits of the two companies as separate entities. The synergy is realized by either an increase in production production capacity, or by its more efficient use. In order to reach this end, however, a series of integrating processes to capture synergy must be undertaken, such as the rationalization of production, the possible relocation of production units, development of systems to integrate and share information, the reorganization of people, and the coordination of brand strategies and marketing efforts. In the course of this integration, however, there are two adverse effects. The first is that the two companies become necessarily interdependent; because of this, negative shocks on one of the businesses (i.e., due to competitor action or environmental changes) will likely create a contagion effect across the businesses of the integrated firm which would not have occurred had they remained two distinct entities. The second effect is that the integrated firm often uses more of its underlying resources, which is the case for a more efficient company. Therefore, when opportunities present themselves in the industry environment, the merged firm is less capable of taking advantage of this opportunity due to the greater constraint on its resources because of the merger. This is the capacity effect (Shaver, 2006, p. 962). These two effects impact the firm’s fundamental value because they impact on the merged firm’s productivity. This in turn would have repercussions on earnings, and a reduction in earnings would justify expectations of a lower stock price level based on the industry average PER (price-to-earnings ratio). Strategies and defences for both hostile and friendly takeovers There are two general classes of corporate takeovers, namely friendly takeovers (i.e., when the board of the target firm supports the bid), and hostile takeovers (i.e., when the board of the target firm contests the bid). In the case of friendly takeover bids, the potential acquirer approaches the target firm’s board and makes a tender offer. During the negotiations, both parties enter into a standstill agreement wherein the bidder commits to make no further investments in the target firm that may increase its holdings, for a specified period of time, and in exchange for a break-up fee from the target firm. (Depamphilis, 2011, p. 77). In the case of hostile takeovers, the following tactics are mentioned by Depamphilis (2011, p. 56) as being frequently employed: (1) Bear hugs – These are attempts by the bidder to limit the target’s options by publicly announcing a formal proposal for the latter’s acquisition; (2) Accumulation – This involves the gradual purchase of target stock ahead of the formal bid, in order to obtain a substantial volume of stock at lower than the prospective offer price; (3) Street sweeps – This involves purchasing as much stock as possible in the open market, and as rapidly as possible by aggressively seeking out substantial blocks of target stock; (4) Proxy contest – This involves the solicitation of the votes of other shareholder by a dissident shareholder, in an attempt to change the board’s composition, thereby effecting the payment or dividends or buy back of stock, and otherwise influencing management decisions. (5) Tender offers to shareholders – In this tactic, the acquirer bypasses the board and management of the target and proceeds directly to the shareholders with an offer to purchase their shares. In order to counter these hostile takeover tactics, there are a number of defences that target firms may employ (Depamphilis, 2011, p. 56) (1) Poison pills – This is a new class of stock that the company issues to its shareholders. The issue has no value until an investor accumulates a particular percentage of the voting stock of the firm. Once this happens, the stock activates and shareholders are entitled to purchase additional shares at a discount to the prevailing market price of the stock. (2) Shark repellants – These are a class of takeover defences which include staggered boards (i.e., so that not all positions are vacated at any one time) and cumulative voting rights, which are amended into the corporate charter or by-laws; and (3) Golden parachutes – These are employee severance arrangements that come into effect when the company undergoes a change in control; it is designed to paralyze the company from being able to resume regular operations after a hostile takeover. Practical application A relatively recent acquisition that received high profile publicity is the purchase by Google of the consumer media company YouTube. In 2006, Google purchased You Tube, a web company the business of which is to provide a medium for people to watch and share original videos through the internet. The transaction was executed through a stock-for-stock transaction, at a cost of $1.65 billion. After the acquisition, YouTube continued to operate independently “to preserve its successful brand and passionate community” (Google, 2006). The acquisition was intended by Google to gain control of the “largest and fastest growing online video entertainment communities,” a perception that five years later continued to prove accurate. You Tube provided Google with the capability to offer a comprehensive range of internet services in its already broad array of offerings to its customers. On the other hand, YouTube has the benefit of Google’s expertise in organising information and creating new models for advertising on the internet, effectively mass marketing YouTube’s internet video in a mass market (Bentley, 2006). The two businesses, which the company management perceptively kept autonomous, nevertheless complement each other and thereby provide a strategic advantage in service and content delivery to an online, real time, global audience (Google, 2006). At the time Google bought YouTube, there were no assurances that the fad of anonymous individuals sending out their amateur home videos to the wide unknown would catch on; after all, a great proportion of the contents then were created on a whim, the entertainment content of which was not certain to last. However, five years hence, YouTube has not only persisted but grown; evidently, even if only a small percentage of all the available videos were worth watching, it merited more than 100 million page views per day, allowing prospective sponsors repeated access to an unlimited audience (Schwartz, 1008). The success of YouTube has also provided exposure to ordinary individuals and enabled their careers to take off in the realm of show business. Another development unforeseen at the time is the emergence of “vlogging,” or video blogging, as a widespread phenomenon in internet communication. According to Gao et al. (2010), “blogging has become an exploding passion among Internet communities.” YouTube’s popularity is bolstered by the vlogging phenomenon; its income stream comes in a six-figure revenue each day, from the rich-media ads that it has been selling atop its home page, and which is consistently 90% sold out at the start of each quarter (Advertising Age, 2009). This has strengthened Google’s market performance against its nearest competitors, as shown in the table below: Major competitors, internet information providers Comparison with competitors (Yahoo Finance, 2011) The revenues and net income of the above competitors are depicted in the next two graphs following: Revenue comparison in US$m Author-created Net Income comparison in US$m Author-created Today, Google’s initial $1.65 billion investment is a leading online media platform, serving over two billion videos each day from a selection of over 500 million (Datamonitor, 2011, p. 6). There are signs that YouTube’s mass appeal coupled with Google’s information models will take off as the standard format in the business sector soon. Google has already developed click-to-play internet video advertisements in the US and began marketing them to a European market. Very soon, businesses which have not adapted their marketing efforts to include internet video formats will lose out to its competition hooked onto this fast-growing, far reaching advertising and communications medium (Bentley, 2006). The advantage to shareholders is immediately apparent in the form of added value and earnings. Google customers, referring to the businesses that choose to advertise in Google, have the obvious advantage of a wider global audience by gaining access to YouTube ad space and, soon, YouTube advertising videos. The online audience also benefit from the acquisition because of the integration of additional features (i.e. YouTube videos) made more easily accessible to them through Google’s data management system. Content suppliers are particularly benefited by the wider audience Google commands and the easier access they have to particular videos. Finally, the online community gains from the synergies created, resulting in more efficient and economical service. Conclusion Mergers and acquisitions have transcended the mere combining of ownership or the purchase of a productive undertaking; decades of corporate activity have accumulated observations and evolved principles that appear to persist in situations surrounding mergers and acquisitions. The decision to merge or acquire is prompted by several motives, which rightly or wrongly will tend to affect the future profitability and operational stability of the acquiring or merged firm. The manner in which the takeover is undertaken also influences the value created and the eventual benefit both firms derive from the transaction. The acquisition described, Google’s takeover of YouTube, is an example of a synergistic combination which was best served by keeping operations separate and autonomous, and in the intervening five years has created greater value for the combined entity than the sum of the individual corporations prior to the acquisition. It is an example of the advantages that a merger or acquisition may create for a business. 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