MERGERS AND ACQUISITIONS

Methods by which corporations legally unify ownership of assets formerly subject to separate controls.

A merger or acquisition is a combination of two companies where one corporation is completely absorbed by another corporation. The less important company loses its identity and becomes part of the more important corporation, which retains its identity. A merger extinguishes the merged corporation, and the surviving corporation assumes all the rights, privileges, and liabilities of the merged corporation. A merger is not the same as a consolidation, in which two corporations lose their separate identities and unite to form a completely new corporation.

Federal and state laws regulate mergers and acquisitions. Regulation is based on the concern that mergers inevitably eliminate competition between the merging firms. This concern is most acute where the participants are direct rivals, because courts often presume that such arrangements are more prone to restrict output and to increase prices. The fear that mergers and acquisitions reduce competition has meant that the government carefully scrutinizes proposed mergers. On the other hand, since the 1980s, the federal government has become less aggressive in seeking the prevention of mergers.

Despite concerns about a lessening of competition, U.S. law has left firms relatively free to buy or sell entire companies or specific parts of a company. Mergers and acquisitions often result in a number of social benefits. Mergers can bring better management or technical skill to bear on underused assets. They also can produce economies of scale and scope that reduce costs, improve quality, and increase output. The possibility of a takeover can discourage company managers from behaving in ways that fail to maximize profits. A merger can enable a business owner to sell the firm to someone who is already familiar with the industry and who would be in a better position to pay the highest price. The prospect of a lucrative sale induces entrepreneurs to form new firms. Finally, many mergers pose few risks to competition.

Antitrust merger law seeks to prohibit transactions whose probable anticompetitive consequences outweigh their likely benefits. The critical time for review usually is when the merger is first proposed. This requires enforcement agencies and courts to forecast market trends and future effects. Merger cases examine past events or periods to understand each merging party's position in its market and to predict the merger's competitive impact.

Types of Mergers

Mergers appear in three forms, based on the competitive relationships between the merging parties. In a horizontal merger, one firm acquires another firm that produces and sells an identical or similar product in the same geographic area and thereby eliminates competition between the two firms. In a vertical merger, one firm acquires either a customer or a supplier. Conglomerate mergers encompass all other acquisitions, including pure conglomerate transactions where the merging parties have no evident relationship (e.g., when a shoe producer buys an appliance manufacturer), geographic extension mergers, where the buyer makes the same product as the target firm but does so in a different geographic market (e.g., when a baker in Chicago buys a bakery in Miami), and product-extension mergers, where a firm that produces one product buys a firm that makes a different product that requires the application of similar manufacturing or marketing techniques (e.g., when a producer of household detergents buys a producer of liquid bleach).

Corporate Merger Procedures

State statutes establish procedures to accomplish corporate mergers. Generally, the board of directors for each corporation must initially pass a resolution adopting a plan of merger that specifies the names of the corporations that are involved, the name of the proposed merged company, the manner of converting shares of both corporations, and any other legal provision to which the corporations agree. Each corporation notifies all of its shareholders that a meeting will be held to approve the merger. If the proper number of shareholders approves the plan, the directors sign the papers and file them with the state. The secretary of state issues a certificate of merger to authorize the new corporation.

Some statutes permit the directors to abandon the plan at any point up to the filing of the final papers. States with the most liberal corporation laws permit a surviving corporation to absorb another company by merger without submitting the plan to its shareholders for approval unless otherwise required in its certificate of incorporation.

Statutes often provide that corporations that are formed in two different states must follow the rules in their respective states for a merger to be effective. Some corporation statutes require the surviving corporation to purchase the shares of stockholders who voted against the merger.

Competitive Concerns

Horizontal, vertical, and conglomerate mergers each raise distinctive competitive concerns.

Horizontal Mergers Horizontal mergers raise three basic competitive problems. The first is the elimination of competition between the merging firms, which, depending on their size, could be significant. The second is that the unification of the merging firms' operations might create substantial market power and might enable the merged entity to raise prices by reducing output unilaterally. The third problem is that, by increasing concentration in the relevant market, the transaction might strengthen the ability of the market's remaining participants to coordinate their pricing and output decisions. The fear is not that the entities will engage in secret collaboration but that the reduction in the number of industry members will enhance tacit coordination of behavior.

Vertical Mergers Vertical mergers take two basic forms: forward integration, by which a firm buys a customer, and backward integration, by which a firm acquires a supplier. Replacing market exchanges with internal transfers can offer at least two major benefits. First, the vertical merger internalizes all transactions between a manufacturer and its supplier or dealer, thus converting a potentially adversarial relationship into something more like a partnership. Second, internalization can give management more effective ways to monitor and improve performance.

Vertical integration by merger does not reduce the total number of economic entities operating at one level of the market, but it might change patterns of industry behavior. Whether a forward or backward integration, the newly acquired firm may decide to deal only with the acquiring firm, thereby altering competition among the acquiring firm's suppliers, customers, or competitors. Suppliers may lose a market for their goods; retail outlets may be deprived of supplies; or competitors may find that both supplies and outlets are blocked. These possibilities raise the concern that vertical integration will foreclose competitors by limiting their access to sources of supply or to customers. Vertical mergers also may be anticompetitive because their entrenched market power may impede new businesses from entering the market.

Conglomerate Mergers Conglomerate transactions take many forms, ranging from short-term joint ventures to complete mergers. Whether a conglomerate merger is pure, geographical, or a product-line extension, it involves firms that operate in separate markets. Therefore, a conglomerate transaction ordinarily has no direct effect on competition. There is no reduction or other change in the number of firms in either the acquiring or acquired firm's market.

Conglomerate mergers can supply a market or "demand" for firms, thus giving entrepreneurs liquidity at an open market price and with a key inducement to form new enterprises. The threat of takeover might force existing managers to increase efficiency in competitive markets. Conglomerate mergers also provide opportunities for firms to reduce capital costs and overhead and to achieve other efficiencies.

Conglomerate mergers, however, may lessen future competition by eliminating the possibility that the acquiring firm would have entered the acquired firm's market independently. A conglomerate merger also may convert a large firm into a dominant one with a decisive competitive advantage, or otherwise make it difficult for other companies to enter the market. This type of merger also may reduce the number of smaller firms and may increase the merged firm's political power, thereby impairing the social and political goals of retaining independent decision-making centers, guaranteeing small business opportunities, and preserving democratic processes.

Federal Antitrust Regulation

Since the late nineteenth century, the federal government has challenged business practices and mergers that create, or may create, a monopoly in a particular market. Federal legislation has varied in effectiveness in preventing anticompetitive mergers.

Sherman Anti-Trust Act of 1890 The sherman anti-trust act (15 U.S.C.A. §§ 1 et seq.) was the first federal antitrust statute. Its application to mergers and acquisitions has varied, depending on its interpretation by the U.S. Supreme Court. In Northern Securities Co. v. United States, 193 U.S. 197, 24 S. Ct. 436, 48 L. Ed. 679 (1904), the Court ruled that all mergers between directly competing firms constituted a combination in restraint of trade and that they therefore violated Section 1 of the Sherman Act. This decision hindered the creation of new monopolies through horizontal mergers.

In Standard Oil Co. of New Jersey v. United States, 221 U.S. 1, 31 S. Ct. 502, 55 L. Ed. 619 (1911), however, the Court adopted a less stringent "rule of reason test"to evaluate mergers. This rule meant that the courts must examine whether the merger would yield monopoly control to the merged entity. In practice, this resulted in the approval of many mergers that approached, but did not achieve, monopoly power.

Clayton Anti-Trust Act of 1914 Congress passed the clayton act (15 U.S.C.A. §§ 12 et seq.) in response to the Standard Oil Co. of New Jersey decision, which it feared would undermine the Sherman Act's ban against trade restraints and monopolization. Among the provisions of the Clayton Act was Section 7, which barred anticompetitive stock acquisitions.

The original Section 7 was a weak antimerger safeguard because it banned only purchases of stock. Businesses soon realized that they could evade this measure simply by buying the target firm's assets. The U.S. Supreme Court, in Thatcher Manufacturing Co. v. Federal Trade Commission, 272 U.S. 554, 47 S. Ct. 175, 71 L. Ed. 405 (1926), further undermined Section 7 by allowing a firm to escape liability if it bought a controlling interest in a rival firm's stock and used this control to transfer to itself the target's assets before the government filed a complaint. Thus, a firm could circumvent Section 7 by quickly converting a stock acquisition into a purchase of assets.

By the 1930s, Section 7 was eviscerated. Between the passage of the Clayton Act in 1914 and 1950, only 15 mergers were overturned under the antitrust laws, and ten of these dissolutions were based on the Sherman Act. In 1950, Congress responded to post–World War II concerns that a wave of corporate acquisitions was threatening to undermine U.S. society, by passing the Celler-Kefauver Antimerger Act, which amended Section 7 of the Clayton Act to close the assets loophole. Section 7 then prohibited a business from purchasing the stock or assets of another entity if "the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly."

Congress intended the amended section to reach vertical and conglomerate mergers, as well as horizontal mergers. The U.S. Supreme Court, in Brown Shoe Co. v. United States, 370 U.S. 294, 82 S. Ct. 1502, 8 L. Ed. 2d 510 (1962), interpreted the amended law as a congressional attempt to retain local control over industry and to protect small business. The Court concluded that it must look at the merger's actual and likely effect on competition. In general, however, it relied almost entirely on market share and concentration figures in evaluating whether a merger was likely to be anticompetitive. Nevertheless, the general presumption was that mergers were suspect.

In United States v. General Dynamics, 415 U.S. 486, 94 S. Ct. 1186, 39 L. Ed. 2d 530 (1974), the Court changed direction. It rejected any antitrust analysis that focused exclusively on market-share statistics, cautioning that although statistical data can be of great significance, they are "not conclusive indicators of anticompetitive effects." A merger must be viewed in the context of its particular industry. Therefore, the Court held that "only a further examination of the particular market—its structure, history, and probable future—can provide the appropriate setting for judging the probable anticompetitive effect of the merger." This totality-of-thecircumstances approach has remained the standard for conducting an antitrust analysis of a proposed merger.

Federal Trade Commission Act of 1975 Section 5 of the federal trade commission Act (15 U.S.C.A. § 45), prohibits "unfair method[s] of competition" and gives the Federal Trade Commission (FTC) independent jurisdiction to enforce the antitrust laws. The law provides no criminal penalties, and it limits the FTC to issuing prospective decrees. The justice department and the FTC share enforcement of the Clayton Act. Congress gave this authority to the FTC because it thought that an administrative body would be more responsive to congressional goals than would the courts.

Hart-Scott-Rodino Antitrust Improvements Act of 1976 The Hart-Scott-Rodino Antitrust Improvements Act (HSR) (15 U.S.C.A. § 18a) established a mandatory premerger notification procedure for firms that are parties to certain mergers. The HSR process requires the merging parties to notify the FTC and the Department of Justice before completing certain transactions. In general, an HSR premerger filing is required when (a) one of the parties to the transaction has annual net sales (or revenues) or total assets exceeding $100 million and the other party has annual net sales (or revenues) or total assets exceeding $10 million; and (b) the acquisition price or value of the acquired assets or entity exceeds $15 million. Failure to comply with these requirements may result in the rescission of completed transactions and may be punished by a civil penalty of up to $10,000 per day.

HSR also established mandatory waiting periods during which the parties may not "close" the proposed transaction and begin joint operations. In transactions other than cash tender offers, the initial waiting period is 30 days after the merging parties have made the requisite premerger notification filings with the federal agencies. For cash tender offers, the waiting period is 15 days after the premerger filings. Before the initial waiting periods expire, the federal agency that is responsible for reviewing the transaction may request the parties to supply additional information relating to the proposed merger. These "second requests" often include extensive interrogatories (lists of questions to be answered) and broad demands for the production of documents. A request for further information may be made once, and the issuance of a second request extends the waiting period for ten days for cash tender offers and 20 days for all other transactions. These extensions of the waiting period do not begin until the merging parties are in "substantial compliance" with the government agency's request for additional information.

If the federal government decides not to challenge a merger before the HSR waiting period expires, a federal agency is highly unlikely to sue at a late date to dissolve the transaction under Section 7 of the Clayton Act. The federal government is not legally barred from bringing such a lawsuit, but the desire of the federal agencies to increase predictability for business planners has made the HSR process the critical period for federal review. However, the decision of a federal agency not to attack a merger during the HSR waiting period does not preclude a lawsuit by a state government or a private entity. To facilitate analysis by the state attorneys general, the National Association of Attorneys General (NAAG) has issued a Voluntary Pre-Merger Disclosure Compact under which the merging parties can submit copies of their federal HSR filings and the responses to second requests with NAAG for circulation among states that have adopted the compact.

Merger Guidelines

In the vast majority of antitrust challenges to mergers and acquisitions, the matters have been resolved by consent order or decree. The Department of Justice and the FTC have sought to clarify they way they analyze mergers through merger guidelines issued May 5, 1992 (4 Trade Reg. Rep. [CCH] ¶ 13,104). These guidelines are not "law" but enforcement-policy statements. Nevertheless, the antitrust enforcement agencies will use them to analyze proposed transactions.

The 1992 merger guidelines state that most horizontal mergers and acquisitions aid competition and that they are beneficial to consumers. The intent of issuing the guidelines is to "avoid unnecessary interference with the larger universe of mergers that are either competitively beneficial or neutral."

The guidelines prescribe five questions for identifying hazards in proposed horizontal mergers: Does the merger cause a significant increase in concentration and produce a concentrated market? Does the merger appear likely to cause adverse competitive effects? Would entry sufficient to frustrate anticompetitive conduct be timely and likely to occur? Will the merger generate efficiencies that the parties could not reasonably achieve through other means? Is either party likely to fail, and will its assets leave the market if the merger does not occur?

The guidelines essentially ask which products or firms are now available to buyers, and where could buyers turn for supplies if relative prices increased by five percent (the measure for assessing a merger-generated price increase). The guidelines redraw market boundaries to cover more products and a greater area, which tends to yield lower concentration increases than U.S. Supreme Court merger decisions of the 1960s.

Mergers in the Telecommunications Industry

Beginning in 1980, with President Ronald Reagan's administration, the federal government has adjusted its policies to allow more horizontal mergers and acquisitions. The states have responded by invoking their antitrust laws to scrutinize these types of transactions. Nevertheless, mergers and acquisitions have increased throughout the U.S. economy, and this has been especially true in the telecommunications industry.

Beginning in the mid 1980s and extending to the mid 1990s, each of the three major television networks, ABC, CBS, and NBC, was purchased by another corporation. In 1985, Capital Cities purchased ABC for $3.5 billion. The same year, General Electric (G.E.) purchased RCA, and in 1985, G.E. purchased NBC. Westinghouse purchased CBS in 1994 for $5.4 billion, and the Walt Disney Co. purchased Capital Cities/ABC for $19 billion in 1995. Other mergers also had a major impact on the industry. In 1989, Time, Inc. merged with Warner Corporation to form the largest media conglomerate in the world, and in 1993, Viacom, Inc. purchased Paramount Corporation in an $8.2 billion deal.

These mergers were major news at the time, and they still have an impact on the industry. Congress deregulated much of the industry with the passage of the Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (codified in scattered sections of 47 U.S.C.A.). It was the most significant legislative change in the industry since the passage of the Communications Act of 1934, 48 Stat. 1064. The act called for more open competition among companies within the industry, designed for the purpose of improving services to consumers. The result of the legislation was a wide number of mergers among smaller and larger companies within the industry.

Almost immediately after the passage of the Telecommunications Act, four of the seven Bell telephone regional holding companies announced proposed mergers. More mergers occurred among Bell companies and other local carriers. At least 13 significant mergers in the industry occurred in 1996 alone. Time Warner merged with Turner Broadcasting in 1996 in a $6.7 billion deal, creating the largest media corporation in the world. Worldcom, Inc. purchased MFS Communications for $12.4 billion to become the first local and long-distance telephone company since 1984. Westinghouse/CBS purchased Infinity Broadcasting for $4.9 billion, allowing Westinghouse/CBS to become the dominant power in the radio market.

These mergers continued throughout the 1990s and beyond. For instance, Time Warner merged with America Online, Inc. in 2000 in a $166 billion deal to form the largest convergence of internet access and content in the world. Although some companies and consumer groups complained that the formation of these conglomerate companies could stifle competition and control prices, these mergers have become commonplace.

The Future of Mergers and Acquisitions

Although a number of factors influence mergers and acquisitions, the market is the primary force that drives them. The late 1990s saw an unprecedented influx in mergers. In 1999, companies filed a record 4,700 Hart-Scott-Rodino filings, about three times the number received in 1995. The total dollar value of the mergers announced in 1998—$11 trillion—was ten times the amount since 1992. The rash of mergers in the telecommunications industry accounted for many of these mergers, but companies in other industries were involved as well.

Another factor in the rise in mergers during the late 1990s was a booming economy, which grew at unprecedented levels. As the country faced recession in the following decade, many companies were forced to downsize, and the number of major mergers decreased accordingly. Improvements in the economy, as well as potential legislative changes, could very well spark another wave of mergers.

further readings

Ginsburg, Martin D. and Jack S. Levin. 1989. Mergers, Acquisitions and Leveraged Buyouts. Chicago: Commerce Clearing House.

Marks, Mitchell Lee. 2003. Charging Back up the Hill: Workplace Recovery after Mergers, Acquisitions, and Down-sizings. San Francisco: Jossey-Bass.

cross-references

Antitrust Law; Bonds "Michael R. Milken: Genius, Villain, or Scapegoat?" (Sidebar); Golden Parachute; Junk Bond; Restraint of Trade; Scorched-Earth Plan; Unfair Competition.

Mergers and Acquisitions

A merger takes place when two companies decide to combine into a single entity. When the merger is forced through buyouts or financial leverage, it is referred to as an acquisition (also called a takeover ). While the motivations may differ, the essential feature of both mergers and acquisitions involves one firm emerging where once there existed two firms.

Essentially, the difference rests in the attitude of the incumbent management of firms that are targeted. A so-called friendly takeover is often a euphemism for a merger. A hostile takeover refers to unwanted advances by outsiders. Thus, the reaction of management to the overtures from another firm tends to be the main influence on whether the resulting activities are labeled friendly or hostile.

Many kinds of mergers increase the emerging company's Herfindahl-Hirschman Index (HHI), the concentration rating of their industry. If the merger raises the HHI by 100 points or more (especially in industries rated 1800 or higher), the Justice Department may take steps to prevent the merger. This is done primarily to discourage monopolistic practices, as the combining firms often lessen competition. Although the HHI Index is used primarily by the United States, it has applications internationally in providing checks and balances for merger activity. For instance, in 2007 Ireland adopted the HHI Index as a guide in restraining monopolistic mergers in its private health insurance industry.

MOTIVATIONS FOR MERGERS AND ACQUISITIONS

There are a number of possible motivations that may result in a merger or acquisition. One of the most oft-cited reasons is to achieve economies of scale. Economies of scale may be defined as a lowering of the average cost to produce one unit due to an increase in the total amount of production. The idea is that the larger firm resulting from the merger can produce more cheaply than the previously separate firms. Efficiency is the key to achieving economies of scale, through the sharing of resources and technology and the elimination of needless duplication and waste. Economies of scale sounds good as a

rationale for merger, but there are many examples to show that combining separate entities into a single, more efficient operation is not easy to accomplish in practice.

A similar motivation is economies of scope, often found when the merger involves vertical integration. This involves acquiring firms through which the parent firm currently conducts normal business operations, such as suppliers and distributors.

By combining different elements involved in the production and delivery of the product to the market, acquiring firms gain control over raw materials and distribution outlets. This may result in centralized decisions and better communications and coordination among the various business units. It may also result in competitive advantages over rival firms that must negotiate with and rely on outside firms for inputs and sales of the product.

Horizontal integration is a merger or acquisition to achieve greater market presence or market share. The combined, larger entity may have competitive advantages such as the ability to buy bulk quantities at discounts, store and inventory needed production inputs, and achieve mass distribution through sheer negotiating power. Greater market share also may result in advantageous pricing, since larger firms are able to compete effectively through volume sales with thinner profit margins. This type of merger or acquisition often results in the combining of complementary resources, such as a firm that is very good at distribution and marketing merging with a very efficient producer. The shared talents of the combined firm may mean competitive advantages versus other, smaller competition.

The ideas above refer to reasons for mergers or acquisitions among firms in similar industries. When two unrelated firms join without an industrial relationship, it is referred to as a conglomerate merger. Since conglomerate mergers do not involve noticeable vertical or horizontal integration, they are more rare than other types of mergers.

Conglomerate mergers were especially popular in the 1960s wave of merger activity, when companies believed that combining certain departments—such as accounting or human resources—would streamline even unrelated businesses. Yet conglomerate mergers developed a history of being unsuccessful, and their use has faded. There are very few restrictions against conglomerate mergers today, since the combination of unrelated companies does not radically interfere in many industries. However, in Europe, legislation passed in 2007 which restricted even conglomerate mergers if (upon examination) they threatened to create monopolies.

There are several additional motivations for firms that may not necessarily be in similar lines of business. One of the often-cited motivations for acquisitions involves excess cash balances. Suppose a firm is in a mature industry, and has little opportunities for future investment beyond the existing business lines. If profitable, the firm may acquire large cash balances as managers seek to find outlets for new investment opportunities. One obvious outlet is to acquire other firms. The ostensible reason for using excess cash to acquire firms in different product markets is diversification of business risk.

Management may claim that by acquiring firms in unrelated businesses the total risk associated with the firm's operations declines. However, it is not always clear for whom the primary benefits of such activities accrue. A shareholder in a publicly traded firm who wishes to diversify business risk can always do so by investing in other companies' shares. The investor does not have to rely on incumbent management to achieve the diversification goal. On the other hand, a less risky business strategy is likely to result in less uncertainty in future business performance, and stability makes management look good. The agency problem resulting from incongruent incentives on the part of management and shareholders is always an issue in public corporations. However, regardless of the motivation, excess cash is a primary motivation for corporate acquisition activity.

To reverse the perspective, an excess of cash is also one of the main reasons why firms become the targets of takeover attempts. Large cash balances make for attractive potential assets; indeed, it is often implied that a firm with a very large amount of cash is not being efficiently managed. While that conclusion is situation specific, it is clear that cash is attractive, and the greater the amount of cash the greater the potential to attract attention. Thus, the presence of excess cash balances in either acquiring or target firms is often a primary motivating influence in subsequent merger or takeover activity.

Another feature that makes firms attractive as potential merger partners is the presence of unused tax shields. The corporate tax code allows for loss carry-forwards; if a firm loses money in one year, the loss can be carried forward to offset earned income in subsequent years. A firm that continues to lose money, however, has no use for the loss carry-forwards. However, if the firm is acquired by another firm that is profitable, the tax shields from the acquired firm may be used to shelter income generated by the acquiring firm. Thus the presence of unused tax shields may enhance the attractiveness of a firm as a potential acquisition target.

A similar idea is the notion that the combined firm from a merger will have lower absolute financing costs. For example, two firms, X and Y, have each issued bonds as a normal part of the financing activities. If the two firms combine, the cash flows from the activities of X can be used to service the debt of Y, and vice versa. Therefore,

with less default risk the cost of new debt financing for the combined firm should be lower. It may be argued that there is no net gain to the combined firm; since shareholders have to guarantee debt service on the combined debt, the savings on the cost of debt financing may be offset by the increased return demanded by equity holders. Nevertheless, lower financing costs are often cited as rationale for merger activity.

During the U.S. merger wave in the 1960s, many firms attempted to acquire other companies to artificially boost their earnings per share. Consider two firms, A and B. Firm A has earnings of $1,000, 100 shares outstanding, and thus $10 earnings per share. With a price-earnings ratio of 20, its shares are worth $200. Firm B also has earnings of $1,000, 100 shares outstanding, but due to poorer growth opportunities its shares trade at 10 times earnings, or $100. If A acquires B, it will only take one-half share of A for each share of B purchased, so the combined firm will have 150 total shares outstanding. Combined earnings will be $2,000, so the new earnings per share of the combined firm are $13.33 per share. It appears that the merger has enhanced earnings per share, when in fact the result is due to inconsistency in the rate of increase of earnings and shares outstanding. Such manipulations were common in the 1960s, but investors have learned to be more wary of mergers instigated mainly to manipulate per share earnings. It is questionable whether such activity will continue to fool a majority of investors. The use of this ploy has faded since the 1980s.

Finally, there is the ever-present hubris hypothesis concerning corporate takeover activity. The main idea is that the target firm is being run inefficiently, and the management of the acquiring firm is likely to do a better job of utilizing the target's assets and strategic business opportunities. In addition, there is additional prestige in managing a larger firm, which may include additional perquisites such as club memberships or access to amenities such as corporate jets or travel to distant business locales. These factors cannot be ignored in detailing the set of factors motivating merger and acquisition activity.

TYPES OF TAKEOVER DEFENSES

As the previous section suggests, some merger activity is unsolicited and not desired on the part of the target firm. Often, the management of the target firm will be replaced or let go as the acquiring firm's management steps in to make their own mark and implement their plans for the new, combined entity. In reaction to hostile takeover attempts, a number of defense mechanisms have been devised and used to try and thwart unwanted advances.

To any offer for the firm's shares, several actions may be taken which make it difficult or unattractive to subsequently pursue a takeover attempt. One such action is the creation of a staggered board of directors. If an outside firm can gain a controlling interest on the board of directors of the target, it will be able to influence the decisions of the board. Control of the board often results in de facto control of the company. To avoid an outside firm attempting to put forward an entire slate of their own people for election to the target firm's board, some firms have staggered the terms of the directors. The result is that only a portion of the seats is open annually, preventing an immediate takeover attempt. If a rival does get one of its own elected, they will be in a minority and the target firm's management has the time to decide how to proceed and react to the takeover threat.

Another defense mechanism is to have the board pass an amendment requiring a certain number of shares needed to vote to approve any merger proposal. This is referred to as a supermajority, since the requirement is usually set much higher than a simple majority vote total. A supermajority amendment puts in place a high hurdle for potential acquirers to clear if they wish to pursue the acquisition. This is sometimes referred to as a fair price amendment.

Finally, another preemptive strike on the part of existing management is a poison pill provision. A poison pill gives existing shareholders rights that may be used to purchase outstanding shares of the firms stock in the event of a takeover attempt. The purchase price using the poison pill is a significant discount from fair market value, giving shareholders strong incentives to gobble up outstanding shares, and thus preventing an outside firm from purchasing enough stock on the open market to obtain a controlling interest in the target. Such strategies as staggering director terms, fair price amendments, and poison pills are sometimes referred to as “shark repellents.”

Once a takeover attempt has been identified as underway, incumbent management can initiate measures designed to thwart the acquirer. One such measure is a dual-class recapitalization; whereby a new class of equity securities is issued which contains superior voting rights to previously outstanding shares. The superior voting rights allow the target firm's management to effectively have voting control, even without a majority of actual shares in hand. With voting control, they can effectively decline unsolicited attempts by outsiders to acquire the firm.

Another reaction to undesired advances is an asset restructuring. Here, the target firm initiates the sale or disposal of the assets that are of primary interest to the acquiring firm, usually called the “crown jewel.” The divestiture of the crown jewel results in an end to the acquisition activity. On the other side of the balance sheet, the firm can solicit help from a third party, friendly firm. Such a firm is commonly referred to as a “white knight,” the implication being that the knight comes to

the rescue of the targeted firm, or “maiden.” A white knight may be issued a new set of equity securities such as preferred stock with voting rights, or may instead agree to purchase a set number of existing common shares at a premium price. This is called the lockup defense. The white knight is supportive of incumbent management; by purchasing a controlling interest in the firm unwanted takeovers are effectively avoided.

There are other drastic measures that targeted firms can take. Professor Michael Baye, in his 2008 book Managerial Economics and Business Strategy, names several other options. One is the golden parachute strategy, in which leading managers retaliate against the takeover by creating contracts for themselves with provisions for significant severance pay or compensation in case they lose their jobs through an acquisition. If the takeover is successful, the golden parachute will grant top managers enormous gains upon their release from the new firm.

The targeted firm may also use the strategy called greenmail, in which it buys back the shares the hostile firm owns. If this practice is successful, the raider will sell its stock in the firm, usually at a very inflated price, to gain a significant profit. This leaves the targeted firm safe with its own shares, if also in debt.

Lastly, a maiden firm may use the going private defense as a last resort. They find a buyer (less agreeable than a white knight) to buy the public stock in the firm and delist it as a public firm. Stock trading is then no longer possible, and the firm, though privately owned, is safe from the raider.

Baye also lists several practices used by a hostile firm upon attempting a takeover. These include stripping, which is the practice of selling off the assets of the targeted company to create extra cash when the takeover is complete, and the less aggressive standstill agreement, which is a last-minute contract in which the hostile company ceases the acquisition process and ends the takeover, keeping only its current holdings in the company.

One of the most prominent takeover activities associated with liability restructuring involves the issuance of junk bonds. “Junk” is used to describe debt with high default risk, and thus junk bonds carry very high coupon yields to compensate investors for the high risk involved. During the 1980s, the investment-banking firm Drexel Burnham Lambert (led by Michael Milken) pioneered the development of the junk-bond market as a vehicle for financing corporate takeover activity. Acquisition groups, which often included the incumbent management group, issued junk bonds backed by the firm's assets to raise the capital needed to acquire a controlling interest in the firm's equity shares. In effect, the firm's balance sheet was restructured with debt replacing equity financing. In several instances, once the acquisition was successfully completed the acquiring management subsequently sold off portions of the firm's assets or business divisions at large premiums, using the proceeds to retire some or all of the junk bonds. The takeover of RJR Nabisco by the firm Kohlberg Kravis Roberts & Co. in the late 1980s was one of the most celebrated takeovers involving the use of junk-bond financing.

VALUING A POTENTIAL MERGER

There are several alternative methods that may be used to value a firm targeted for merger or acquisition. One method involves discounted cash flow analysis. First, the present value of the equity of the target firm must be established. Next, the present value of the expected synergies from the merger, in the form of cost savings or increased after-tax earnings, should be evaluated. Finally, summing the present value of the existing equity with the present value of the future synergies results in a present valuation of the target firm.

Another method involves valuation as an expected earnings multiple. First, the expected earnings in the first year of operations for the combined or merged firm should be estimated. Next, an appropriate price-earnings multiple must be determined. This figure will likely come from industry standards or from competitors in similar business lines. Now, the PE ratio can be multiplied by the expected combined earnings per share to estimate an expected price per share of the merged firm's common stock. Multiplying the expected share price by the number of shares outstanding gives a valuation of the expected firm value. Actual acquisition price can then be negotiated based on this expected firm valuation.

Another technique that is sometimes employed is valuation in relation to book value, which is the difference between the net assets and the outstanding liabilities of the firm. A related idea is valuation as a function of liquidation, or breakup, value. Breakup value can be defined as the difference between the market value of the firm's assets and the cost to retire all outstanding liabilities. The difference between book value and liquidation value is that the book value of assets, taken from the firm's balance sheet, are carried at historical cost. Liquidation value involves the current, or market, value of the firm's assets.

Some valuations, particularly for individual business units or divisions, are based on replacement cost. This is the estimated cost of duplicating or purchasing the assets of the division at current market prices. Some premium is usually applied to account for the value of having existing and established business in place.

Finally, in the instances where firms that have publicly traded common stock are targeted, the market value of the stock is used as a starting point in acquisition

negotiations. Earlier, a number of takeover defense activities were outlined that incumbent management may employ to restrict or reject unsolicited takeover bids. These types of defenses are not always in the best interests of existing shareholders. If the firm's existing managers take seriously the corporate goal of maximizing shareholder wealth, then a bidding war for the firm's stock often results in huge premiums for existing shareholders. It is not always clear that the shareholders interests are primary, since many of the takeover defenses prevent the use of the market value of the firm's common stock as a starting point for takeover negotiations. It is difficult to imagine the shareholder who is not happy about being offered a premium of 20 percent or more over the current market value of the outstanding shares.

SEE ALSO Financial Ratios

BIBLIOGRAPHY

Baye, Michael R. Managerial Economics and Business Strategy. 6th ed. Boston, MA: McGraw-Hill/Irwin, 2008.

Brealey, R.A., and S.C. Myers. Principles of Corporate Finance. 7th ed. Boston, MA: McGraw-Hill/Irwin, 2003.

Bruner, R.F. Applied Mergers and Acquisitions. Hoboken, NJ: J. Wiley, 2004.

Coy, P., et al. “Shake, Rattle, and Merge.” Business Week, 10 January 2005, 32.

Harrington, D.R. Corporate Financial Analysis in a Global Environment. 7th ed. Mason, Ohio: Thomson/South-Western, 2004.

MERGERS AND ACQUISITIONS

Between 1980 and 2002 there were an unprecedented number of healthcare mergers and acquisitions in the United States, affecting hospitals and hospital systems, nursing facilities, clinics, physician group practices, pharmaceutical manufacturers, and managed-care and other health insurance providers. Predictably, this headlong rush toward consolidation and concentration has triggered increased scrutiny of such transactions by those state and federal agencies responsible for antitrust and tax regulation. It has also spurred increased reflection on the ethical issues at stake in these merger and acquisition decisions. Such issues include concerns about fidelity to organizational mission; effects of organizational restructuring upon community access to services and other benefits; impact upon the welfare, working environment, and overall culture of affected employees; and the prevention and resolution of conflicts of interest among involved parties.

The number and frequency of hospital mergers and acquisitions increased dramatically during the 1980s and early 1990s. The trend peaked in the period 1994–1997, according to data from Irving Levin Associates, with 163 deals completed in 1996 and a record 197 deals in 1997. During that period the number of hospitals belonging to health networks or systems also increased significantly, from 56.2 percent in 1994 to 70.9 percent in 1998. By the beginning of the new century, the frequency of deals had declined somewhat, to 86 in 2000 and 83 in 2001, yet these numbers remain much higher than pre-1990 levels. Among the factors apparently driving this high rate of merger and acquisition activity are reduced Medicare reimbursement rates, significantly increased managed-care pressures to provide more services at lower prices, and a declining market for inpatient hospital services.

Benefits and Burdens of Consolidation

Hospital mergers and acquisitions can provide substantial benefits for institutions, their employees, and the communities they serve. They can bring needed capital into a healthcare organization, providing economic vigor and repositioning in a difficult marketplace; offering opportunities for new or expanded service lines; and even ensuring survival and the capacity to provide services to those in need. They can strengthen an organization's bargaining power and provide economies of scale and increased efficiency, all of which could lead to decreased costs to consumers. And they can bring standardization to, and better assessment of, the quality of care delivered.

A 2002 study by Bazzoli and colleagues examined the self-reported reasons for merger cited by involved hospitals during the periods 1983–1988 and 1989–1996. For both groups, the top three reasons for merger were identical: to strengthen the institution's financial position, to achieve operating economies, and to consolidate services. Expansion of market share was another reason cited by a majority of respondents. Yet there were also certain changes in emphasis between the two study periods. Those citing expansion of visibility and service availability across the hospital's service area as a significant reason for merger increased from 33.3 percent in 1983–1988 to 53.2 percent in 1989–1996, while those citing expansion of provided service areas as a reason for merger decreased from 63.9 percent to 44.3 percent. In addition, respondents in the more recent period indicated an increasing emphasis upon nursing-staff downsizing as an intended cost-saving outcome of merger activity.

While the potential benefits of hospital consolidations via merger and acquisition can be manifold, these transactions can also create concerns about potential burdens for various stakeholders. One such concern has to do with the consequences of giving up local hospital control. When a community-based hospital merges with or is acquired by an organization or system headquartered elsewhere, especially out of state, what will the loss of local control mean in terms of the new organization's responses to the local community's specific needs? And what will be the postconsolidation status and level of service at the community-based hospital? Many consolidations, especially those involving a for-profit organization, include plans to increase profitability and market position by phasing out unprofitable service lines in favor of more profitable specializations. This can create hardships for communities—access to much-needed yet unprofitable services becomes more difficult, or the burden of providing these services is shifted to others. Another potential service limitation emerges when a merging or acquiring organization takes a strong religious or other principled position against providing certain services. Such consolidations raise understandable public concerns about whether reasonable access to those services will remain available within the community after consolidation.

Further, an increase in the price of services can be another potential community burden resulting from hospital merger or acquisition transactions. While consolidationrelated efficiencies may allow for price reductions, or at least a hold on price increases, the newly consolidated and concentrated hospital organization will also have stronger market positioning and greater market power, and that power may be expressed through price increases. A 2000 study by Young and colleagues examined the relationship between market concentration and pricing patterns for three types of nonprofit hospitals: independent hospitals under local control, members of local hospital systems, and members of nonlocal hospital systems. The study showed that, in more concentrated markets, all three types of nonprofit hospitals exercised market power in the form of higher prices—and that hospitals that are a part of nonlocal systems were more aggressive in exercising this market power than either of the other hospital types.

Yet another community concern regarding hospital consolidations is their effect on the provision of charity care. According to American Hospital Association data, overall U.S. hospital expenses for uncompensated care (bad debt and charity care) were $18.5 billion in 1997, up from $6 billion in 1980 (Hall). Yet access to needed care remains difficult for many of the more than 42 million uninsured Americans who cannot afford that care. Thus, communities are often concerned about the effect of consolidation upon a local hospital's willingness to continue providing charity care, especially when a nonprofit community hospital is merging with or acquired by a for-profit hospital or system. There is evidence that for-profit hospitals are less likely to be accessible to the medically indigent and uninsured than nonprofit hospitals are, and that they tend to carry a smaller indigent-care load (Darr). One study of California nonprofit hospitals that were consolidated into for-profit organizations found that charity care declined in almost all cases analyzed. Moreover, in none of the deals did the sale proceeds, usually set aside in a foundation to provide charity care and other community benefits, sufficiently replace the community benefits provided by the former nonprofit hospitals (Mateo and Rossi).

One final area of community concern has to do with how consolidation might affect particular groups of internal stakeholders, namely hospital staff, trustees, and executives. Merger and acquisition activity can, and often does, involve downsizing and the loss of employment for some staff members. It can also lead to negatively perceived changes in working conditions, mission loyalty, and overall organizational culture. On the other hand, hospital executives and trustees, who are responsible for negotiating any possible consolidation, may be subject to various positive inducements, financial and otherwise, for their support of a transaction. Such a possibility appears all the more threatening to a community in which the actual details of a proposed consolidation have not been made public during the planning process.

Moral Obligations of Hospital Leaders

Community concerns have led to some significant changes in legal oversight of hospital consolidations at both state and federal levels, including transactions among nonprofit hospitals and between nonprofit and for-profit hospitals (Peregrine). Yet it is clear that legal regulation cannot and will not ensure the fulfillment of healthcare leaders' moral obligations to the community as hospital consolidations are contemplated, planned, and executed. Nonprofit hospital trustees and executives, who are accountable for more than 80 percent of U.S. hospital beds, have particular fiduciary responsibilities to the communities served by their institutions, and there are specific moral obligations that should govern their participation in merger and acquisition activities.

MISSION PROTECTION. First, trustees and executives are responsible for upholding and protecting the mission and values of the institution they are already serving. According to the American Hospital Association Board of Trustees, a hospital's mission includes both caring for the sick and injured and improving community health, and any decisions regarding consolidation should thus emphasize the community's future health needs and the best overall organizational arrangements for meeting those needs. Trustees and executives, therefore, bear the moral obligation of participating in any proposed merger or acquisition as representatives of the community and its interests (Wilkins and Jacobson). They must ask how any proposed transaction would affect access to and delivery of health care in the community, seek independent assistance in assessing the impact of the transaction on the community, and work to avoid any unnecessary harmful effects upon quality of life in the community.

A critical aspect of a hospital's mission that should be protected, of course, is the provision of uncompensated care. Trustees and executives must consider the community's future health needs by ensuring that access to charity care will not be diminished or eroded by a merger or acquisition transaction, particularly when a nonprofit hospital is contemplating consolidation with a for-profit hospital or system. Further, as Leonard Weber points out, if a generally beneficial consolidation will also entail certain new community burdens, such as less-convenient location of services, then those segments of the community already experiencing greater social ills (such as poverty and environmental degradation) have a greater claim to be spared new social burdens than do better-off segments of the community.

In some instances a hospital's mission and values will involve specific principle-based exclusions from certain practices, as in the case of most Catholic hospitals' refusals to provide various reproductive services. When such an institution seeks a merger with or acquisition of another community hospital whose mission and values do not entail these service exclusions, then the obligation to consider the community's overall future health needs becomes somewhat more complex. Certainly the conscientious refusals of hospital leaders and sponsors to engage in certain practices should be respected. Yet the general obligation of hospitals to ensure adequate community access to those services normally and legally available in other communities places a potential limit upon the moral right of hospitals to restrict permissible practices (Weber). This becomes an especially strong concern where the postconsolidation institution would be the community's sole provider. In such circumstances, the costs of consolidation may simply be too high.

AVOIDING CONFLICT OF INTEREST. Second, trustees and executives have a moral obligation to disclose any potential conflict of interest and to avoid any private benefit in a proposed consolidation. They should not receive money during a consolidation process—nor should they accept any other incentive offered as a means of securing support for the transaction, such as promises of a job or board membership after consolidation. Any such offers should be disclosed to all involved parties, and negotiation practices should be utilized that will fully separate decisions about the transaction from decisions about positions in the post-transaction institution (Weber). Trustees and executives must be able to assure the community, which they serve as fiduciaries, that personal gain incentives have been removed from the negotiating table, and that the community's best interests are represented there.

PUBLIC DISCLOSURE AND HEARINGS. Third, hospital leadership should make the consolidation process fully public. Trustees should ensure that all objectives and processes of the transaction are made available to the general public and the state attorney general, and they should require public hearings and suitable waiting periods so as to hear and respond to community concerns about the transaction. Community-based consumer organizations should also be consulted in order to assess implications of the proposed consolidation that may not be immediately apparent to trustees and executives (Wilkins and Jacobson).

FAIR MARKET VALUE. Fourth, nonprofit trustees and executives are responsible for ensuring fair market value for their institution in the transaction, particularly when a nonprofit hospital is being acquired by a for-profit hospital or system. This requires, among other things, ensuring independent valuation by a third-party firm with experience in the healthcare field. In addition, the methodology used in determining fair market value should be made a part of public disclosure of the negotiations. A significant portion of a nonprofit hospital's value that must be included in any assessment of fair market value is the community benefit it provides: the hospital's value to community members (as owners of it), the value it provides in uncompensated care, and the value it holds from past publicly funded investment are all part of its value.

Trustees and executives, as fiduciaries of the community, must ensure that community-benefit value is not lost in consolidation transactions and that community benefit in the form of charity care and other community health initiatives is guaranteed into the future. In the sale of a nonprofit hospital to a for-profit, this usually involves using that portion of the sale price designated as the communitybenefit value to establish a nonprofit charitable foundation or trust whose assets will be used to fund charity care and community health ventures. Nonprofit executives and trustees should require that the terms of the foundation—particularly regarding who will control its assets and the specific purposes for which they may be expended—be detailed and clear before consolidation can be completed, and that the foundation will provide regular public reports on its efforts to promote community health (Wilkins and Jacobson).

STAFF AND EMPLOYEE INTERESTS. Fifth, in addition to their community-oriented fiduciary responsibilities, hospital trustees and executives also have responsibilities to their institutional and medical staffs. When any consolidation is considered, staff and employees must be fully informed and educated about its perceived need and its intended goals and processes—and their responses and concerns must be heard. Just as a community assessment is necessary to determine the community interests that are at stake in any proposed transaction, an organizational assessment is necessary to recognize specific organizational cultures and how they may or may not fit with the cultures of other merging or acquiring facilities. The employees and staff in each facility should be oriented to the culture, history, and mission of the other facility or system.

Further, employees of institutions facing consolidation may have concerns not only about postconsolidation culture and working conditions, but also about the prospect of staff downsizing and loss of employment. Quite often these concerns are well founded. If the organization's ability to continue serving the needs of the community will necessarily require staff downsizing, then the trustees and executives have an obligation to ensure, among other things, that: (1) all employees to be laid off will be given advance notice that includes detailed explanation of the necessity of and criteria for their selection; (2) employees to be laid off will have opportunity to appeal their selection if they have reason to believe the criteria were inappropriately applied; and (3) laid-off employees will be provided with significant outplacement services and interim benefits (Weber).

Exit Provisions

Perhaps predictably, the large number of hospital mergers and acquisitions have produced not only many successes, but also quite a few organizational and financial failures. As Michael Peregrine has noted, this reality may suggest a final obligation of nonprofit hospital trustees negotiating a consolidation—namely to incorporate termination provisions (known as exit or unwind provisions) within the transaction terms. These terms might specify what particular events would indicate a failure of the consolidation's objectives and thus trigger an unwinding, any required mediation or arbitration related to the implementation of the unwinding, the time period during which the trigger would remain effective, and the actual mechanisms for implementing the unwinding if the consolidation fails to achieve its objectives.

Hospitals are, as Kurt Darr notes, "social organizations with an economic dimension, rather than economic organizations with a social dimension." The recent history of U.S. healthcare offers many examples of how the economic dimension of hospitals may be enhanced through mergers and acquisitions. Yet a recognition of the primary social dimension of hospitals illuminates a variety of communityoriented moral responsibilities and obligations that must not be ignored in such transactions, even for the sake of economic enhancement.

james b. tubbs, jr.

SEE ALSO: Access to Healthcare; Healthcare Systems; Profit and Commercialism

BIBLIOGRAPHY

Bazzoli, Gloria J.; LoSasso, Anthony; Arnould, Richard; et al. 2002. "Hospital Reorganization and Restructuring Achieved through Merger." Health Care Management Review 27(1): 7–20.

Boyle, Philip J.; DuBose, Edwin R.; Ellingson, Stephen J.; et al. 2001. Organizational Ethics in Health Care: Principles, Cases, and Practical Solutions. San Francisco: Jossey-Bass.

Darr, Kurt. 1997. "The Social Responsibility of Hospitals." Hospital Topics 75(1): 4–7.

Hall, Robert T. 2000. An Introduction to Healthcare Organizational Ethics. New York: Oxford University Press.

Hofmann, Paul B. 1996. "Hospital Mergers and Acquisitions: A New Catalyst for Examining Organizational Ethics." Bioethics Forum 12(2): 45–48.

Hofmann, Paul B. 2000. "Incentive in Mergers and Acquisitions." Healthcare Executive 15(5): 61–62.

Kassirer, Jerome P. 1996. "Mergers and Acquisitions—Who Benefits? Who Loses?" New England Journal of Medicine 334(11): 722–723.

Peregrine, Michael W. 2001. "Legal Issues in Mergers and Acquisitions." Health Progress 82(3): 57–61.

Rubin, Susan, and Zoloth-Dorfman, Laurie. 1996 "Health Care Consolidation Raises Ethical Questions." Modern Healthcare 26(32): 76.

Weber, Leonard J. 2001. Business Ethics in Healthcare: Beyond Compliance. Bloomington: Indiana University Press.

Werhane, Patricia H. 1990. "The Ethics of Health Care as a Business." Business and Professional Ethics Journal 9(3/4): 7–20.

Wilkins, Aaron S., and Jacobson, Peter D. 1998. "Fiduciary Responsibilities in Nonprofit Health Care Conversions." Health Care Management Review 23(1): 77–90.

Wolff, Marie. 1993. "'No Margin, No Mission': Challenge to Institutional Ethics." Business and Professional Ethics Journal 12(2): 39–50.

Young, Gary J.; Desaum Kemal R.; and Hellinger, Fred J. 2000. "Community Control and Pricing Patterns of Nonprofit Hospitals: An Antitrust Analysis." Journal of Health Politics, Policy and Law 25(6): 1051–1082.

INTERNET RESOURCES

American Hospital Association Board of Trustees. 1997. "Community Accountability with Changes in the Ownership or Control of Hospital or Health Systems." Available from <http://www.hospitalconnect.com/aha/advocacy-grassroots/advocacy/position/ownership.html>.

Irving Levin Associates. 2002. Press releases regarding Health Care Mergers and Acquisitions. Available from <http://www.levinassociates.com/pressroom/>.

Lahiri, Indra, and Sedicum, Austin. 2000. "Mergers and Acquisitions as a Diversity Issue for Health Care—WDG." Workforce Development Group. Available from <http://www.workforcedevelopmentgroup.com/>.

Matteo, Julio, and Rossi, Jaime. 1999. "White Knights or Trojan Horses? A Policy and Legal Framework for Evaluating Hospital Consolidations in California." Consumers Union. Available from <http://www.consumersunion.org/health/>.

Mergers and Acquisitions

Mergers and acquisitions (M&As) is a phrase used to describe a host of financial activities in which companies are bought and sold. In an acquisition one party buys another by acquiring all of its assets. The acquired entity ceases to exist as a corporate body, but the buyer sometimes retains the name of the acquired company, indeed may use it as its own name. In a merger a new entity is created from the assets of two companies; new stock is issued. Mergers are more common when the parties have similar size and power. Sometimes acquisitions are labeled "mergers" because "being acquired" carries a negative connotation (like "being eaten"); a merger suggests mutuality. M&A activity involves both privately held and publicly traded companies; acquisitions may be friendly (both entities are willing) or may be hostile (the buyer is opposed by the management of the acquisition target).

WHY M&A?

M&A activity is invariably explained as creating greater stockholder value. Stockholder interests are, indeed, central, because these transactions must have the approval of a majority of stockholders, and stockholders are unlikely to vote their shares in favor of a sale, purchase, or merger unless they believe that they will benefit. The real motivation behind M&A activity, however, is almost always a mixture in which financial, structural, institutional, and even personal aims are present. Companies make acquisitions to grow more rapidly, to gain control over their raw materials, to obtain new technology, to pump up their stock, to take advantage of weaknesses in others, to diversify, etc.

A major element of M&A activity in hostile acquisitions is resistance to being acquired. It is motivated by the management's fear of losing control, distrust of the buyer's motivation, disagreement with the buyer's methods and strategy, etc. Frequently management resists an acquisition although their stockholders would clearly benefit; thus they try to persuade the stockholders that "in the long run" the stockholders will suffer. Resisting managements are frequently correct—but often lose because stockholders look at the bird in the hand.

Motivations for selling a company are equally complex. Retiring founders of small businesses sell companies to realize the business's cash value after a life-time of work. Companies projecting failure sell before the failure is actually knocking on the door. Companies reach the limit of their resources, financial or technical, and see great benefit in joining a larger company able to fund growth and to enhance their own art by major engineering inputs. In the first two cases the motives are liquidity and fear of bankruptcy respectively. The third case is mixed, with structural, institutional, and opportunistic motives leading to a sale. In periods of M&A frenzy (common in expansionary periods) a company may also face an offer it just can't refuse.

TYPES OF ACQUISITIONS

Acquisitions are classified by their structural effects, the attitudes of the parties, and by the mechanisms of the transaction. The classifications are not mutually exclusive, just different ways of looking at M&A.

Acquisitions can be horizontal, vertical, or conglomerative. The first case involves a company that simply expands by purchasing another company in its own field: two real-estate firms merging or one buying the other. The second case, the vertical, involves a company buying another which heretofore supplied it: a construction company buying a lumber yard or a brick yard. In a conglomerative acquisition the buyer's business has nothing to do with that of the purchased company's: a steel mill buying a chain of clothing stores. The building of vast conglomerates by acquisition is a cyclic corporate fad, viewed as a way of diversifying, justified by the notion that management is fundamentally a financial enterprise.

Acquisitions are classified as "friendly" or "hostile" depending on the attitudes of the managements on either side. In a friendly merger or acquisition both parties are willing participants and negotiate in that spirit. Hostile acquisitions tend to be launched by dissident stockholder groups (or raiders who first buy in to have a share); the targeted company may have a large amount of cash, may be paying thin dividends, may (in the opinion of the hostile bidder) be favoring growth over stockholder return, etc. In friendly acquisitions management teams cooperate in communicating with stockholders; in hostile takeovers, the acquiring group solicits the votes of the target's stockholders in order to obtain enough votes to prevail.

Classification by mechanism involves how the buyer pays for the seller. Payment may take the form of cash, stock, or a combination. Cash-for-stock is the simplest method but more costly for the stockholder: the transaction is taxable, the stockholder having to pay capital gains taxes. The stock-for-stock method is the most popular because it is tax free; the seller's stockholders receive stock in the buyer's company; if the action is a merger, stock in the new entity is issued in payment instead. If the deal is a combination, the cash portion of the deal is taxable.

VALUING THE CANDIDATE

What is a company worth? The balance sheet provides a partial answer. The company's assets less its liabilities produce the company's net worth. Very few companies, however, are willing to sell for net worth. It represents a static value, a snapshot in time. A company is a dynamic entity expected to produce earnings in the future.

A common measure used for valuation is the price-earnings ratio (P/E Ratio) in which the price of a share of stock is divided by the company's after-tax earning per share. A $100 share earning $10 per share a year, is said to have a 10:1 ratio. The market, in other words, is willing to pay $10 for every $1 of earnings. A company with an annual after-tax earnings of $500,000 and a P/E Ratio of 7 would thus be valued at $3.5 million.

Another ratio used is the enterprise value to sales ratio (EV/Sales Ratio). Enterprise value is calculated by taking the company's outstanding stock, adding its debt, and deducting its cash or cash-equivalent assets. This value is then divided by the company's sales (not earnings) to arrive at an EV/Sales Ratio. The concept here is to treat both stock and debt as values that need to be paid back with sales. If the ratio is low, the value of the company is high. If the company has a lot of cash, the ratio may be negative, indicating that the target can be bought using its own cash.

The most common method of valuation used in M&A is discounted cash flow (DCF) analysis. The method is described in detail in this volume (see Discounted Cash Flow ). It involves projecting the financial performance of the company over some period, typically ten years, and then calculating net cash flow for every year. The analyst then discounts (reduces) future earnings using the purchaser's actual rate of return on capital. The logic here is that capital invested now would earn the buyer interest in future years. That same interest is deducted from the projected cash flows. The sum of discounted cash flows is then viewed as the acquisition target's current value. The analyst usually assumes that the company will be sold in the 11th year for a conservative multiple of earnings; this residual is also discounted and added. The drawback of DCF is its complexity—above all the need to project all of the complex financial flows into the future. Its benefits are greater detail which typically requires a very full understanding of the candidate.

In virtually all valuations of companies, the prospective buyer also factors in so-called synergies which will help it increases in market share and sales, lower costs, and increased profitability. Projected synergy gains are then used as part of the valuation. Following many acquisitions, large layoffs are announced because the merger of functions eliminates duplications. Such layoffs are an example of a "synergy"; often the announcement lifts the stock.

SUCCESS AND FAILURE

Are mergers and acquisitions a success or a failure? The answer is that results are mixed. Many smaller companies are successfully sold to larger operation and, transformed (often beyond recognition), continue to operate and grow. Larger deals are evidently less successful. Investopedia.com, in its article regarding M&A states: "Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means that they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases the problems associated with trying to make merged companies work are all too concrete."

Results for stockholders depend on which side of the deal they are on. There is substantial empirical evidence that the shareholders in acquired firms benefit substantially. Gains for this group typically amount to 20 percent in mergers and 30 percent in tender offers above the market prices prevailing a month prior to the merger announcement. Most small company owners realize substantial gains when selling successful, privately-held corporations to a public buyer. The gains of stockholders of acquiring firms are difficult to measure, but the best evidence suggests that shareholders in bidding firms gain little. Losses in value subsequent to merger announcements are not unusual. In post-acquisition periods, managements are often distracted with cost cutting and integration processes and spend less time on the business, sometimes with unfavorable results. This seems to suggest that overvaluation by bidding firms is common. Managers may also have incentives to increase firm size at the potential expense of shareholder wealth. If so, merger activity may very often happen for structural, "legacy," and other reasons as already indicated above.

see also Discounted Cash Flow; Leveraged Buyout

BIBLIOGRAPHY

Burt, Erin. "Five Money Rules for Moving in Together." Kiplinger's Starting Out Web Column. 6 April 2006.

Davenport, Todd. "Pent-up M&A Demand, But Pricey Supply." American Banker. 20 March 2006.

Hoover, Kent. "Bill Would Aid Mergers of Small Businesses." Sacramento Business Journal. 21 July 2000.

"Hospital Mergers Result in Price Hikes and Drops in Quality: Study." Healthcare Financial Management. April 2006.

Kilpatrick, Christine. "More Owners Put Small Businesses on the Sale Block." San Francisco Business Times. 9 June 2000.

"Mergers and Acquisitions: Introduction." Investopedia.com. Available from http://www.investopedia.com/university/mergers/. Retrieved on 21 April 2006.

Miller, Karen Lowry. "Deals That Work: With the world caught up in merger mania again, studies suggest fewer tie-ups will fail, this time." Newsweek International. 24 April 2006.

Pablo, Amy L. and Mansour Javidan. Mergers and Acquisitions: Creating Integrative Knowledge. Blackwell Publishing Ltd., 2004.

                                        Darnay, ECDI

MERGERS AND ACQUISITIONS

Mergers and acquisitions (M&A) are often the means chosen by company boards of directors to meet strategic goals such as expansion of products, services, or revenues. As the terms imply, a merger is a combination of two existing businesses; an acquisition is a purchase of a company by another company. Since both processes legally unite companies, the transactions are called consolidations. Since the two processes are similar, the term mergers and acquisitions is the typical reference used for consolidations in the United States. The detailed differences of such transactions, though, influence the accounting treatment in the company's records. The Financial Accounting Standards Board (FASB) has promulgated rules and practices for the accounting treatment for each of the four variations of consolidations recognized in U.S. accounting standards.

The sections that follow include: consolidation movements in the United States, motivations for M&A, the process, accounting for M&A, and after the merger or acquisition. The range of strategies used by companies to undertake cooperative ventures is not discussed here. Furthermore, the potential tax effects of consolidations are beyond the scope of the discussion provided in this article.

CONSOLIDATION MOVEMENTS IN THE UNITED STATES

Distinct periods for consolidations have been identified in the United States. J. Fred Weston and Samuel C. Weaver, for example, identified four periods with the circumstances that initiated each:

1. 1893–1903—Fueled by consolidation of railroads and industrial enterprises
2. 1920s—Motivated by interest in vertical consolidation to control the entire supply chain
3. 1960s—Spurred by interest in diversification, the building of conglomerates
4. 1980s—Stimulated by availability of junk-bond financing

Writers in the early twenty-first century identified a fifth wave that began in the mid-1990s. For example, Patrick Gaughan noted that by "1993 we were once again in the throes of a full-scale merger wave" (2002, p. 3). The literature about events since 2000 has demonstrated mixed judgment, with some writers indicating that the fifth wave was continuing (as of 2006).

CONTEMPORARY MOTIVATIONS FOR M&A

Consolidations that began in the 1990s have had common motivations identified in the press and in empirical reviews of M&A activity in the United States.

To Enhance Market Position Quickly

The board of directors, viewing a high level of cash reserves and high market value for the company stock, may determine that acquiring a company that has a particular product line or customer base will heighten its position in the market. For example, ConocoPhillips, formed through a series of mergers, continued to grow through mergers through 2005. As of November 2005, it realized that it could become the third-largest oil company with the contemplated purchase of one of the largest independent oil companies in the United States. The target of their interest, Burlington Resources, was attractive owing to Burlington's use of new drilling technologies and because of the possibilities of expanding internationally by gaining access to this company's inroads in countries such as Canada and Ecuador. The outcome of a possible acquisition is seldom clear because other interested parties could appear before the completion of the process.

Larger Size Can Meet Perceived Demand

Businesses such as banks, accounting firms, law firms, and management consulting firms have all experienced mergers and acquisitions during the economic development of the United States. Banks, for example, undertake mergers and acquisitions as customers and potential customers required larger pools of funds than available in a bank with limited resources.

Technological Shifts

A period of intense technological changes encourages mergers and acquisitions. It is not uncommon for a mature company to identify the innovation of an emerging company as a good match to extend their product lines or provide new services. In December 2005 the New York Stock Exchange (NYSE), a traditionally functioning stock exchange that began operations in 1792, concluded that expansion of services electronically was critical for its future. Thus, their acquisition of Archipelago, an electronic trading network, is illustrative of this motivation. As of early 2006, the newly formed NYSE Group Inc. was scheduled to shift from a not-for-profit organization to a publicly owned entity with extended services for clients.

Growth in Revenues

Sometimes competitors realize that they can achieve far more together than separately. The extensive number of mergers and acquisitions during the final decade of the 1800s and the first years of the 1900s is often cited as a key factor in the establishment of a national economy in the United States.

THE PROCESS

There are many aspects to the achievement of a successful merger or acquisition. The process may take a relatively brief period or an extended period of several years. The nature of the initial interest influences the initial process. Experts in the field of M&A who are able to meet the reporting phases mandated by legal requirements in the United States are generally needed. Company charters and bylaws provide policies and procedures that must be met in the event of a sale or merger. For certain types of mergers or acquisitions, the shareholders have the right to cast a vote to support or reject the bid.

Initial Attitudes of Participants

Interested parties—the target company executives and the potential buyer—may be friendly or hostile to each other. If friendly, the leaders of two companies may engage in informal discussion that leads to a more serious assessment of the advantages to each if their company resources were combined.

If the company executives of the target company do not find the efforts of the potential buyer appealing, strategies to undermine the potential takeover may be introduced. The use of poison pills (securities issued to shareholders that become available if purchases of stock reach a specified level) raises the cost of acquisition. Changes in the company bylaws and charter, including the issuances of gold or silver parachutes—high payouts to current executives of target companies—impede progress in hostile takeover efforts. The business press often reports the types of strategies in use by major companies facing hostile takeovers.

The potential buyer, to overcome the reluctance of the target company, may make a tender offer, which is to advertise its interest in buying the target company stock from current stockholders at an attractive price.

Need for Expert Assistance

Companies that engage in mergers and acquisitions on a relatively regular basis may have professional staff members in house that participate in the process. Even with in-house staff, however, the engagement of outsiders is common. Investment bankers are frequently engaged to serve as the key drivers of the total process. Additionally, the companies involved seek the guidance of lawyers, accountants, and proxy solicitation companies, as well as public relations firms.

Review by Regulatory Agencies

Companies with publicly traded securities participating in mergers or acquisitions must submit documents to relevant governmental agencies at the federal and state levels. All such companies must meet federal securities laws that deal with adherence to provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, which deal with disclosure requirements and the regulation of tender offers. The U.S. Department of Justice and the Federal Trade Commission are responsible for enforcing antitrust laws. Regulated industries, such as banking, insurance, communications, utilities, airlines, and railroads, must meet special regulatory requirements beyond the general rules.

The purposes of such review reflect the interest of the U.S. government in ensuring that the business environment in the United States is favorable to an open, competitive, fair style of behavior by business entities. Furthermore, such reviews include gaining assurance that laws related to employee benefits and environmental requirements are honored by participants in a merger or acquisition.

ACCOUNTING FOR M&A

Mergers and acquisitions fall under the general technical description of "business combinations" in accounting terminology. Two financial accounting standards govern the accounting for business combinations. They are the Statement of Financial Accounting Standards No. 141, "Business Combinations," and the Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," both of which were issued by the FASB in 2001.

The definition of a business combination from FASB Statement No. 141 is: "a business combination occurs when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities."

The most frequent method for entering into a business combination is acquisition of an equity (common stock) interest of over 50 percent of the outstanding stock of the acquired company. The acquired company does not go out of business. The acquiring company (now called the parent) usually has complete control of the acquired company (now called the subsidiary). Because of this controlling relationship, accounting standards require that consolidated financial statements be prepared for the parent and subsidiary as if they were a single entity. The parent may have many subsidiaries, in which case all would be consolidated with the parent in the consolidated financial statements.

Commonly, the parent acquires the stock of the subsidiary with cash, exchange of stock, and/or debt. The total paid (the cost) is then compared to the book value acquired. Normally, there is an excess of cost over book value acquired for two reasons—book value of long-lived assets is based on historical cost less accumulated depreciation, and intellectual assets are not permitted to be on the balance sheet of the newly acquired subsidiary according to generally accepted accounting principles.

An appraisal of the subsidiary is made and a part of the excess of cost over book value acquired is allocated to all identifiable assets. Nevertheless, because intellectual assets—such as value of employees—are not permitted to be recorded as assets, there is generally a residual value of the excess of cost over the book value acquired after the allocations to bring net assets of the acquired subsidiary to fair value. This residual value is called goodwill. When consolidated statements are prepared, both the fair values of the subsidiary's assets and the goodwill are shown.

There are three other methods for achieving business combinations. One method is for one company to acquire the assets of another. The other two methods use statutory mergers and statutory consolidations. Note that although in common language mergers and acquisitions are used as synonymous terms for consolidations, in accounting these are technical terms. A statutory merger occurs when Company A acquires Company B and dissolves Company B. A statutory consolidation occurs when Companies A and B create Company C and dissolve companies A and B. The accounting for business combinations achieved via asset acquisitions, statutory mergers, and statutory consolidations is similar to the accounting for a business combination via equity acquisition.

AFTER THE MERGER OR ACQUISITION

After the legal functions have satisfactorily concluded, the new entity has the demanding task of integrating the components of the new entity so that the goals anticipated at the time of consolidation are realized. The evidence on the success of mergers meeting their goals is ambiguous. In a summary of several empirical studies, Günter Stahl and colleagues noted, "Despite their popularity and strategic importance, the performance of most M&A has been disappointing" (Stahl, Mendenhall, Pablo, and Javidan, 2005, p. 1).

There are many instances of earlier mergers and acquisitions being spun off. For example, First Data Corporation, which acquired Western Union in 1995, announced in January 2006 that it planned to spin off its purchase of more than a decade earlier. This decision was made even though Western Union had been a fast-growing money-transfer business for the acquirer.

Both Cendant and Tyco, which expanded through mergers and acquisitions over a decade, announced plans to split their companies. In October 2005 Cendant reported it would become four independent companies. In early January 2006 Tyco International reported plans to split itself into three publicly traded companies.

Reconsideration of company strategy leads to mergers and acquisitions as well as to the undoing of earlier mergers and acquisitions. The dynamic characteristic of contemporary business is clearly reflected in these two seemingly contradictory processes that are evident in the economic environment at the same time.

bibliography

Dash, Eric (2006, January 27). Western Union, growing faster than its parent, is to be spun off. The New York Times, Section C, p. 3.

DePamphilis, Donald M. (2003). Mergers, acquisitions, and other restructuring activities (2nd ed.). Amsterdam: Academic.

Gaughan, Patrick A. (2002). Mergers, acquisitions—Corporate restructuring (3rd ed.). New York: Wiley.

Stahl, Günter K., Mendenhall, Mark E., Pablo, A. L., and Javidan, M. (2005). Sociocultural integration in mergers and acquisitions. In Günter K. Stahl and Mark E. Mendenhall (Eds.), Mergers and acquisitions: Managing culture and human resources. Stanford, CA: Stanford Business Books.

Statement of Financial Accounting Standards No. 141. (2001). Business combinations. Stamford, CT: Financial Accounting Standards Board.

Statement of Financial Accounting Standards No. 142. (2001). Goodwill and other intangible assets. Stamford, CT: Financial Accounting Standards Board.

Weston, J. Fred, and Weaver, Samuel C. (2001). Mergers and acquisitions. New York: McGraw-Hill.

Bernard H. Newman

Mary Ellen Oliverio