20.4Sources of TakeoverGains

Section 20.2 categorized takeovers according to the sources of takeover gains. This

section examines the various sources in more detail. Result 20.1 summarizes the four

main sources of takeover gains that were discussed briefly.

Result 20.1

The main sources of takeover gains include:

•	Taxes.
•	Operating synergies.
•	Target incentive problems.
•	Financial synergies.

We discuss each of these sources in turn.

Tax Motivations

Tax laws change substantially from year to year and differ from country to coun-

try. As a result, we can provide only a brief overview of the relevant tax issues in

this chapter. Congress passed two very important tax acts during the 1980s which

had important effects on the U.S. takeover market during that decade. These were

the Tax Equity and Fiscal Responsibility Act of 1982 and the Tax Reform Act of

1986.

The Tax Equity and Fiscal Responsibility Act of 1982 and Basis Step-Up.Ofthe

major tax inducements to takeovers, the ability to step up the tax basis on acquired

assets (that is, increase their book values) became somewhat more attractive after

the Tax Act of 1982. Stepping up the basisof the acquired firm’s depreciable assets

increases the depreciation tax shields of the assets, which in some cases creates sub-

stantial tax savings for the acquiring firm. One good example of this was the

$2.6billion acquisition of Electronic Data Systems by General Motors. As a result

of this buyout, General Motors claimed a $2 billion write-up of depreciable assets

that produced a $400 million tax deduction annually for five years.

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The Tax Reform Act of 1986 and Basis Step-Up.The Tax Reform Act of 1986

specifies that firms that elect to write up the value of their depreciable assets are

taxed on the increase in the tax basis. Under this tax law, for example, the $2 billion

write-up of Electronic Data Systems’intangible assets would be considered taxable

income in the year of the write-up. As a consequence, taxable income is realized

sooner. For example, if General Motors were in the 50 percent tax bracket, it would

pay an additional $1 billion in taxes in the year of the merger as a result of this write-

up and would then reduce its taxes by $200 million in each of the next five years.

Since this is equivalent to an interest-free loan to the IRS, the asset write-up is no

longer attractive and, as a result, is rarely done. An exception might occur when the

firm currently has no taxable income and has tax loss carry-forwards that it could

potentially lose.

The Tax Gain from Leverage.Additional tax savings arise in cases where the

acquisitions are funded primarily with debt. The tax gain associated with these leverage-

increasing combinations can be thought of as a financial synergy. As Chapter 14

discussed, a tax gain is associated with leverage because of the tax deductibility of debt

interest payments. However, it is important to ask whether or not a takeover is required

to accomplish this leverage increase before attributing this leverage-related tax gain to

anacquisition.

The typical takeover results in increased leverage for several reasons. First, the

combined firm is likely to be better diversified than the separate firms and thus is less

likely to have financial difficulties or find itself with excess tax shields for any given

level of debt financing. Asecond possibility is that the target and the bidder are

underleveraged and use the takeover as a means of increasing their combined debt-to-

equity ratio. The firms may have been underleveraged because of the incentive reasons

discussed in Chapter 18 or, as Chapter 15 discussed, because of the personal tax costs

associated with increasing leverage.

Taking Advantage of Otherwise Unusable Tax Losses: The Effect of the 1986 Act.

Asecond tax advantage that was associated with acquisitions in the past occurred when

one of the two parties in a merger had past losses. When the firms are combined, the

losses of the unprofitable firm become valuable tax shields that could be used to off-

set the taxes of the profitable firm. However, the acquiring firm can no longer use past

losses of the acquired firm to offset its current and future profits, as it could before

1986.

We thus draw the following conclusion:

Result 20.2

Before the implementation of the Tax Reform Act of 1986, the U.S. Tax Code encouragedcorporations to acquire other corporations. Taxes currently play a much less important rolein motivating U.S. acquisitions. In some cases, however, mergers increase the combinedcapacity of merged firms to utilize tax-favored debt.

Operating Synergies

In order for mergers to generate operating synergies, the uniting of two firms must

either improve productivity or cut costs so that the unlevered cash flows of the com-

bined firm exceed the combined unlevered cash flows of the individual firms. By def-

inition, a target firm that provides such synergies is worth more to a potential acquirer

than it is worth operating as an independent company.

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700Part VIncentives, Information, and Corporate Control

Sources and Examples of Operating Synergies.There are a number of potential

sources of operating synergy. For example, a vertical merger—that is, a merger

between a supplier and a customer—can eliminate various coordination and bargain-

ing problems between the supplier and the customer.²DuPont’s 1981 purchase of

Conoco, for example, may have been motivated in part by DuPont’s heavy use of oil

for its petrochemicals.³

The gains from a horizontal merger, a merger between com-

petitors, can include a less competitive product market as well as cost savings that occur

when, for example, firms combine research and development facilities, combine sales

forces, or dispose of underutilized computers and sales outlets.

For example, Bristol-Myers’s 1989 acquisition of Squibb, which created the Bristol-

Myers Squibb Company, allowed the merged firm to cut operating costs by combining

jobs in sales and R&D.⁴Another frequently mentioned synergy comes from combin-

ing distribution networks. On the announcement of Gillette’s and Duracell’s intention

to merge, Charles R. Perrin, Duracell’s chief executive, stated, “We were searching for

ways to get broader distribution, and we’ve found our answer in Gillette.” Gillette has

a major presence in developing countries like China, India, and Brazil, and hopes to

use its marketing presence there to sell Duracell batteries.⁵

Additional operating synergies arise when the merged firm can benefit from the

ability to transfer resources from one division to another. For example, both RJR

Nabisco and Philip Morris had extremely profitable tobacco businesses, but their future

prospects were uncertain. Domestic demand was likely to fall in the future as the health

hazards from smoking became more apparent. The magnitude of this future drop, how-

ever, was very uncertain. Offsetting this was a booming, but also uncertain, foreign

demand for American cigarettes.

Although both companies believed that they had developed effective organizations,

especially in marketing, they felt compelled to take steps to protect this organizational

capital in the event of a sharp decline in cigarette demand. Both firms solved this prob-

lem through the purchase of packaged food companies, which also require effective

marketing organizations—organizations that are similar to those of the tobacco com-

panies. If it turned out that demand for tobacco increased substantially while demand

for food products declined, a combined firm could easily transfer personnel from the

packaged food division to the tobacco division. Likewise, if the demand for tobacco

fell and the demand for packaged food increased, the reverse transfer could be initi-

ated. As uncertainty increases, this option to transfer resources becomes increasingly

valuable (see Chapter 12).⁶

Measuring Operating Synergies.Although there is substantial anecdotal evidence

that operating synergies can be large, it is difficult to measure empirically the extent

to which mergers have generated operating synergies, for reasons to be discussed

shortly. Moreover, it is difficult to use the available empirical data to determine the

²For a discussion of these coordination and bargaining problems, see Klein, Crawford, and Alchian

(1978) and Grossman and Hart (1986).

³It should be noted that these expected synergies were never realized and in 1998 Conoco was split

off from DuPont in an equity carve out.

4

The Wall Street Journal,Feb. 9, 1990.

5

Boston Globe,Sept. 13, 1996.

⁶However, both RJR and Philip Morris have recently split their food and tobacco businesses into

separatecorporations. In these cases, the splits may be attributable to the legal liability of their tobacco

units.

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701

extent to which value is created from operating synergies instead of other sources, such

as tax savings or incentive improvements.

Management Incentive Issues and Takeovers

Chapter 18 described a number of ways in which the interests of managers can deviate

from the interests of shareholders. Disciplinary takeovers are generally intended to

correct these nonvalue-maximizing policies.

Disciplinary Takeovers and Leveraged Buyouts.In the early 1980s, integrated oil

producers spent roughly $20 per barrel to explore for new oil reserves (thus maintain-

ing their large oil exploration activities) when proven oil reserves could in effect be

bought by taking over existing firms for around $6 per barrel. For example, Gulf Oil,

mentioned earlier, was spending over one-third of its oil and gas revenues on negative

NPVoil exploration, causing Gulf’s stock to trade at a price substantially below the

value of its assets. In 1984 Chevron took over Gulf and the combined Gulf/Chevron

exploration budget was cut substantially after the merger. In this case, the merger

created value because it led to less oil exploration.

Disciplinary takeovers are usually hostile, often lead to the breakup of large

diversified corporations, and result in job losses for a number of the target firm’s top

managers. For these reasons, disciplinary takeovers are more controversial than synergy-

motivated strategic acquisitions. Disciplinary takeovers are particularly controversial

when the acquirer, often referred to as the raider, is a relatively thinly capitalized indi-

vidual or firm seeking to acquire a much bigger enterprise using debt financing. These

takeovers are generally structured as leveraged buyouts (LBOs).

LBO financing also has been used, albeit in a friendly way, by the top managers

of firms who wish to buy their own firms and take them private. This type of LBO is

often referred to as a management buyout (MBO). In contrast to the disciplinary

takeover, the firm’s top managers remain the same after an MBO.

In MBOs as well as in hostile LBOs that do not involve management, we do not

observe a union of two firms, so there can be no synergies. The gain from these

takeovers then has to come from either tax savings or management improvements. Pro-

ponents of LBOs argue that firm value can still be improved by changing management

incentives, even when the top managers are not replaced. These proponents argue that

it is the change in ownership rather than the change in the actual managers that creates

value in these transactions.

The changes in ownership structure can result in dramatic changes in management

incentives following LBOs. Specifically, executives who had previously owned less

than 1 percent of the firm often find themselves owning more than 10 percent; with

additional stock options, they have the opportunity to accumulate substantially more

stock in the event that the firm does well. Although the potential gain to executives is

clearly greater following an LBO, there also is much less protection on the downside.

Given the high leverage ratio of the post-LBO firm, the margin of error is much lower.

If the firm is not successful, it will soon be bankrupt and the top executives will lose

everything. Hence, following LBOs, executives have a much greater incentive to make

the firm more profitable.

An excellent example of an incentive problem that was corrected after an LBO was

reported in the description of the RJR Nabisco LBO in Barbarians at the Gate.The

head of the Nabisco unit, John Greeniaus, reportedly told Paul Raether, general part-

ner at Kohlberg Kravis Roberts (KKR), that operating profits at Nabisco could be

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Strategy, Second Edition

702Part VIncentives, Information, and Corporate Control

increased 40 percent if necessary. He argued that before the buyout there was no incen-

tive to increase earnings more than 12 percent in any single year because his biggest

incentive was to keep earnings predictable. As a result, money was spent on excess

promotion and marketing to keep earnings down in good years—to provide slack—so

that in bad years, the company wouldn’t have to report large drops in earnings.⁷

Incentives and Wealth Transfers.When firms are acquired, losers as well as winners

emerge. For example, when KKR took over RJR Nabisco in a leveraged buyout, exist-

ing RJR Nabisco bonds lost 16 percent of their value because of the perceived increase

in the probability of their default. Employees, however, are often the more visible los-

ers in takeovers. Critics of these takeovers have argued that a large part of the observed

gain in many hostile takeovers comes at the expense of the target’s employees, either

through layoffs or salary reductions. For example, Shleifer and Summers (1988) calcu-

lated that almost the entire premium offered by Carl Icahn in his takeover of TWAcould

be justified by the salary reductions imposed on TWA’s union employees.

The relation between hostile takeovers and employee layoffs may simply reflect

the need for a different type of manager at different stages of a corporation’s growth.

To build an effective organization, a growing firm requires managers who are

goodteam players and who have a sincere interest in helping other individuals

develop the skills needed to make the firm prosper. In most cases, however, the indi-

viduals best suited for nurturing and developing others are not particularly well

suited to fire these same employees when downsizing is necessary. “Nice-guy,”

team-playing managers will find themselves recipients of unwanted takeover offers

as a consequence of their reluctance to downsize their organizations. When these

hostile bids are successful, “more ruthless” managers (for example, Carl Icahn at

TWAor Frank Lorenzo at Eastern Airlines⁸

) are better suited to carry out the task

of shrinking the organization.

Investors recognize that most managers are reluctant to cut jobs, and they bid up

the stock prices of firms that bring in CEOs with a reputation for cutting costs by

cutting jobs. For example, when it was announced that Albert Dunlap was hired in

July 1996 to be CEO of Sunbeam, Sunbeam’s stock price increased by almost 40 per-

cent. Dunlap earned the nickname “Chainsaw” Dunlap for his ruthless job cutting in

eight different restructurings. When Dunlap was previously CEO of Scott Paper, more

than 11,000 jobs were cut in 1994 and 1995, and the firm’s stock price more than

doubled.⁹

It should be noted, however, that policymakers and journalists may have overem-

phasized the relation between takeovers and job losses. First, many takeovers resulted

in more efficient organizations and increased employment. Second, the downsizing that

occurred subsequent to many hostile takeovers also occurred at firms that were not

taken over. Indeed, at Scott Paper, the job cuts occurred before, not after, their takeover

by Kimberly-Clark. Hence, one should not necessarily view the takeovers as the cause

of the job losses. Instead, takeovers should be viewed as one means by which inefficient

organizations downsize.

⁷Bryan Burroughs and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco(New York:

HarperCollins, 1993).

8

See Chapter 17 for further discussion of Eastern Airlines.

⁹Although Scott Paper, which was subsequently taken over by Kimberly-Clark in 1995, was a big

success for Dunlap, Sunbeam was not. Sunbeam’s initial success after hiring Dunlap was attributed to

accounting fraud, its stock price plummeted, and Dunlap was fired.

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BidderIncentive Problems.Takeovers can be a symptom of as well as a cure for

managerial incentive problems. Recall from Chapter 18 that managers often have the

incentive to take on projects that benefit them personally even when they do not

improve stock prices. For example, managers in declining industries may want to pro-

tect their jobs by acquiring firms in industries with better long-term prospects. In addi-

tion, some managers may simply want to manage bigger enterprises, and the takeover

market may be the most expedient way to accomplish this goal.

Lang, Stulz, and Walkling (1991) suggested that firms acquiring other firms for

nonvalue-maximizing reasons are characterized by low stock prices relative to their

book values and cash flows. Such bidder firms are currently profitable, but their low

market-to-book ratios (as well as related ratios) indicate that they are not expected to

do particularly well in the future. Lang, Stulz, and Walkling found that when firms with

these characteristics announce their intentions to acquire another firm, their stock prices

generally decline. They interpret these stock price declines to mean that the market con-

siders the acquisitions to be either unwise or based on management incentives that are

inconsistent with value maximization.

Mitchell and Lehn (1990) also examined what they call “bad bidders,” which they

identify as firms that experience large stock price declines when they announce plans

for a major acquisition. They find that a large number of these bad bidders subsequently

became targets of disciplinary takeovers. Mitchell and Lehn argue that one motivation

of takeovers is to oust managers who have a tendency to make bad acquisitions. Bhagat,

Shleifer, and Vishny (1990) showed that the target in many of these disciplinary

takeovers is broken up and some of the former bad acquisitions are sold off.

Financial Synergies

Acommon argument in support of diversification is that lowering the risk of a firm’s

stock increases its attractiveness to investors and thereby reduces the firm’s cost of cap-

ital. However, both the Capital Asset Pricing Model (CAPM) and the Arbitrage Pric-

ing Theory (APT) suggest that investors are unlikely to be willing to pay a premium

for the reduced risk of a diversified firm, since they can easily form a well-diversified

portfolio on their own by holding the stocks of a number of different firms in differ-

ent industries (see Chapters 5 and 6). Hence, for a diversification strategy to increase

the value of a firm’s shares, it must do more than simply reduce risk. Diversification

must create either operating synergies or financial synergies.

The discussion of optimal capital structure in the previous chapters provides

some intuition about possible financial synergies. We have already discussed the

financial synergies associated with the tax gains to leverage. Since diversification

reduces the risk of bankruptcy for any given level of debt, it can increase the amount

of debt in the firm’s optimal capital structure, which in turn can lower the firm’s

cost of capital.

Financial synergies also can arise because of the personal taxes on cash

distributions (see Chapter 15). Consider, for example, Joe’s Pizza House, which is gen-

erating significant cash but has no investment opportunities, and Bob’s Biotech, which

has excellent investment opportunities but no internally generated cash. With perfect

capital markets, capital will flow costlessly from Joe, who has only negative NPVproj-

ects, to Bob, who has projects with high NPVs. Personal taxes, however, significantly

impede this flow since the dividends paid from Joe’s profits are taxed before they are

reinvested in Bob’s Biotech. These personal taxes can be avoided if the two firms merge

to form Bob and Joe’s Biotech Pizza.

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704Part VIncentives, Information, and Corporate Control

Information and incentive problems provide additional impediments to the flow of

capital from Joe to Bob (see Chapters 18–19). Because of these problems, firms with

investment requirements that significantly exceed internally generated funds may have

to pass up positive net present value projects, while cash-rich firms tend to overinvest,

taking on negative net present value projects. This suggests, at least in theory, that there

is a potential to create value by combining the cash-rich firms having excess invest-

ment capital with the cash-starved firms that are underinvesting. This is illustrated in

Example 20.1.

Example 20.1:The Advantage of Internal Capital Markets

TWT Technologies has an investment opportunity, based on proprietary technology, that

requires it to raise $100 million in capital.TWT Technologies is currently priced at $22 per

share.However, John Jacobs, its CEO and largest shareholder, believes that this technol-

ogy will be very successful and that the company’s shares will be worth $40 per share when

it demonstrates the technology publicly.Unfortunately, because competitors may attempt to

clone the technology after seeing it demonstrated, TWT cannot demonstrate the technology

prior to raising the capital.What are the company’s financing options?

Answer:It clearly is unattractive to issue TWT stock at $22 a share if Jacobs believes

the shares will soon be worth $40.However, the firm may be too risky to issue debt, and

its ability to license the technology later will be more limited if the firm has difficulties meet-

ing its debt obligations.Perhaps its best opportunity would be to find a cash-rich firm with

which to merge.

Result 20.3

Conglomerates can provide funding for investment projects that independent (smaller) firmswould not have been able to fund using outside capital markets. To the extent that positiveNPVprojects receive funding they would not have otherwise received, conglomerates cre-ate value.

Example 20.1 and Result 20.3 suggest that the capital allocation process within a

firm may be more efficient than outside capital markets when firms have proprietary

information that they do not wish to disclose. TWTTechnologies’possession of pro-

prietary information suggests another advantage associated with diversification. An

independent firm like TWTTechnologies might be obligated to reveal information to

its investors.¹⁰However, the disclosure of information to investors also reveals it to

competitors, which could put the firm at a competitive disadvantage. Even if the pro-

prietary information is not revealed directly, potential competitors can certainly

observe the firm’s financial performance, enticing them to become competitors when

the performance of TWTis exceptional. This problem would be much less severe if

TWTwere a small division of a large conglomerate, where proprietary information

can be more easily hidden.