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ceeds a certain level. Since then state antitakeover laws have proliferated. Many allow boards of directors to block mergers with hostile bidders for several years and to consider the interests of employees, customers, suppliers, and their communities in deciding whether to try to block a hostile bid.

AlliedSignal vs. AMP

The hostile attacks of the 1980s were rarely repeated in the 1990s, when most mergers were friendly.33 But now and then a battle flared up. The following example illustrates takeover tactics and defenses near the end of the millennium.

In the first week of August 1998, AlliedSignal, Inc., announced that it would bid $44.50 per share, or $9.8 billion, for AMP, Inc. AMP’s stock price immediately jumped by nearly 50 percent to about $43 per share.

AMP was the world’s largest producer of cables and connectors for computers and other electronic equipment. It had just announced a fall of nearly 50 percent in quarterly profits from the previous year. The immediate cause for this bad news was economic troubles in Southeast Asia, one of AMP’s most important export markets. But longer-run performance had also disappointed investors, and the company was widely viewed as ripe for change in operations and management.AlliedSignal was betting that it could make these changes faster and better than the incumbent management.

AMP at first seemed impregnable. It was chartered in Pennsylvania, which had passed tough antitakeover laws. Pennsylvania corporations could “just say no” to takeovers that might adversely affect employees and local communities. The company also had a strong poison pill.34

AlliedSignal held out an olive branch, hinting that price was flexible if AMP was ready to talk turkey. But the offer was rebuffed. A tender offer went out to AMP shareholders, and 72 percent accepted. However, the terms of the offer did not require AlliedSignal to buy any shares until the poison pill was removed. In order to do that, AlliedSignal would have to appeal again to AMP’s shareholders, asking them to approve a solicitation of consent blocking AMP’s directors from enforcing the pill.

AMP fought back vigorously and imaginatively. It announced a plan to borrow $3 billion to repurchase its shares at $55 per share—its management’s view of the true value of AMP stock. It convinced a federal court to delay AlliedSignal’s solicitation of consent. At the same time it asked the Pennsylvania legislature to pass a law which would effectively bar the merger. The governor announced his support. Both companies sent teams of lobbyists to the state capitol. In October the bill was approved in the Pennsylvania House of Representatives and sent to the Senate for consideration.

Yet AlliedSignal discovered it had powerful allies. About 80 percent of AMP’s shares were owned by mutual funds, pension funds, and other institutional investors. Many of these institutions bluntly and publicly disagreed with AMP’s intransigence. The College Retirement Equities Fund (CREF), one of the largest U.S. pension funds, called AMP’s defensive tactics “entirely inimical to the principles of shareholder democracy and good corporate governance.” CREF then took an extraordinary step: It filed a legal brief supporting AlliedSignal’s case in the federal court.35 Then the Hixon family, descendants of AMP’s co-founder, made public a

33By contrast, a number of hostle takeovers took place in continental European countries where such activity had been almost unknown.

34It was a dead-hand poison pill: Even if AlliedSignal gained a majority of AMP’s board of directors, only the previous directors were empowered to vote to remove the pill.

35G. Faircloth, “AMP’s Tactics Against AlliedSignal Bid Are Criticized by Big Pension Fund,” The Wall Street Journal, September 28, 1998, p. A17.

letter to AMP’s management and directors expressing “dismay,” and asking, “Who do management and the board work for? The central issue is that AMP’s management will not permit shareholders to voice their will.”36

AMP had complained all along that AlliedSignal’s bid was too low. Robert Ripp, AMP’s chairman, reiterated this point in his reply to the Hixons and also said, “As a board, we have an overarching responsibility to AMP, all of its shareholders, and its other constituencies—which we believe we are serving on a basis consistent with your interests.”37

But as the weeks passed, AMP’s defenses, while still intact, did not look quite so strong. By mid-October it became clear that AMP would not receive timely help from the Pennsylvania legislature. In November, the federal court finally gave AlliedSignal the go-ahead for its solicitation of consent to remove the poison pill. Remember, 72 percent of its stockholders had already accepted AlliedSignal’s tender offer.

Then, suddenly, AMP gave up: It agreed to be acquired by a white knight, Tyco International, for $55 per AMP share, paid for in Tyco stock. AlliedSignal dropped out of the bidding; it didn’t think AMP was worth that much.

What are the lessons? First is the strength of poison pills and other takeover defenses, especially in a state like Pennsylvania where the law leans in favor of local targets. AlliedSignal’s offensive gained ground, but with great expense and effort and at a very slow pace.

The second lesson is the potential power of institutional investors. We believe AMP gave in not because its legal and procedural defenses failed but largely because of economic pressure from its major shareholders.

Did AMP’s management and board act in shareholders’ interests? In the end, yes. They said that AMP was worth more than AlliedSignal’s offer, and they found another buyer to prove them right. However, they would not have searched for a white knight absent AlliedSignal’s bid.

Who Gains Most in Mergers?

As our brief history illustrates, in mergers sellers generally do better than buyers. Andrade, Mitchell, and Stafford found that following the announcement of the bid, selling shareholders received a healthy gain averaging 16 percent.38 On the other hand, it appears that investors expected acquiring companies to just about break even. The prices of their shares fell by .7 percent.39 The value of the total package—buyer plus seller—increased by 1.8 percent. Of course, these are averages; selling shareholders sometimes obtain much higher returns. When IBM took over Lotus Corporation, it paid a premium of 100 percent, or about $1.7 billion, for Lotus stock.

Why do sellers earn higher returns? There are two reasons. First, buying firms are typically larger than selling firms. In many mergers the buyer is so much larger that even substantial net benefits would not show up clearly in the buyer’s share price. Suppose, for example, that company A buys company B, which is only onetenth A’s size. Suppose the dollar value of the net gain from the merger is split

36S. Lipin and G. Faircloth, “AMP’s Antitakeover Tactics Rile Holder,” The Wall Street Journal, October 5, 1998, p. A18.

37Ibid.

38See G. Andrade, M. Mitchell, and E. Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (Spring 2001), pp. 103–120.

39The small loss to the shareholders of acquiring firms is not statistically significant. Other studies using different samples have observed a small positive return.

equally between A and B.40 Each company’s shareholders receive the same dollar profit, but B’s receive 10 times A’s percentage return.

The second, and more important, reason is the competition among potential bidders. Once the first bidder puts the target company “in play,” one or more additional suitors often jump in, sometimes as white knights at the invitation of the target firm’s management. Every time one suitor tops another’s bid, more of the merger gain slides toward the target. At the same time, the target firm’s management may mount various legal and financial counterattacks, ensuring that capitulation, if and when it comes, is at the highest attainable price.

Of course, bidders and targets are not the only possible winners. Unsuccessful bidders often win, too, by selling off their holdings in target companies at substantial profits.

Other winners include investment bankers, lawyers, accountants, and in some cases arbitrageurs, or “arbs,” who speculate on the likely success of takeover bids.41 “Speculate” has a negative ring, but it can be a useful social service. A tender offer may present shareholders with a difficult decision. Should they accept, should they wait to see if someone else produces a better offer, or should they sell their stock in the market? This dilemma presents an opportunity for the arbitrageurs, who specialize in answering such questions. In other words, they buy from the target’s shareholders and take on the risk that the deal will not go through.

As Ivan Boesky demonstrated, arbitrageurs can make even more money if they learn about the offer before it is publicly announced. Because arbitrageurs may accumulate large amounts of stock, they can have an important effect on whether a deal goes through, and the bidding company or its investment bankers may be tempted to take the arbitrageurs into their confidence. This is the point at which a legitimate and useful activity becomes an illegal and harmful one.

33.6 MERGERS AND THE ECONOMY

Merger Waves

Mergers come in waves. The first episode of intense merger activity occurred at the turn of the 20th century and the second occurred in the 1920s. There was a further boom from 1967 to 1969 and then again in the 1980s and 1990s (1999 and 2000 were record years). Each episode coincided with a period of buoyant stock prices, though there were substantial differences in the types of companies that merged and the ways they went about it.

We don’t really understand why merger activity is so volatile. If mergers are prompted by economic motives, at least one of these motives must be “here today and gone tomorrow,” and it must somehow be associated with high stock prices. But none of the economic motives that we review in this chapter has anything to do with the general level of the stock market. None burst on the scene in 1967, departed in 1970, and reappeared for most of the 1980s and again in the mid-1990s.

40In other words, the cost of the merger to A is one-half the gain ∆PVAB.

41Strictly speaking, an arbitrageur is an investor who takes a fully hedged, that is, riskless, position. But arbitrageurs in merger battles often take very large risks indeed. Their activities are oxymoronicly known as “risk arbitrage.”

Some mergers may result from mistakes in valuation on the part of the stock market. In other words, the buyer may believe that investors have underestimated the value of the seller or may hope that they will overestimate the value of the combined firm. But we see (with hindsight) that mistakes are made in bear markets as well as bull markets. Why don’t we see just as many firms hunting for bargain acquisitions when the stock market is low? It is possible that “suckers are born every minute,” but it is difficult to believe that they can be harvested only in bull markets.

Merger activity tends to be concentrated in a relatively small number of industries and is often prompted by deregulation and by changes in technology or the pattern of demand. Take the merger wave of the 1990s, for example. Deregulation of telecoms and banking earlier in the decade led to a spate of mergers in both industries. Elsewhere, the decline in military spending brought about a number of mergers between defense companies until the Department of Justice decided to call a halt. And in the entertainment industry the prospective advantages from controlling both content and distribution led to mergers between such giants as AOL and Time Warner.

Do Mergers Generate Net Benefits?

There are undoubtedly good acquisitions and bad acquisitions, but economists find it hard to agree on whether acquisitions are beneficial on balance. Indeed, since there seem to be transient fashions in mergers, it would be surprising if economists could come up with simple generalizations.

We do know that mergers generate substantial gains to acquired firms’ stockholders. Since buyers roughly break even and sellers make substantial gains, it seems that there are positive overall benefits from mergers.42 But not everybody is convinced. Some believe that investors analyzing mergers pay too much attention to short-term earnings gains and don’t notice that these gains are at the expense of long-term prospects.43

Since we can’t observe how companies would have fared in the absence of a merger, it is difficult to measure the effects on profitability. Ravenscroft and Scherer, who looked at mergers during the 1960s and early 1970s, argued that productivity declined in the years following a merger.44 But studies of subsequent merger activity suggest that mergers do seem to improve real productivity. For example, Paul Healy, Krishna Palepu, and Richard Ruback examined 50 large mergers between 1979 and 1983 and found an average increase of 2.4 percentage points in the companies’ pretax

42M. C. Jensen and R. S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (April 1983), pp. 5–50, after an extensive review of empirical work, conclude that “corporate takeovers generate positive gains” (p. 47). Richard Roll reviewed the same evidence and argues that “takeover gains may have been overestimated if they exist at all.” See “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business 59 (April 1986), pp. 198–216.

43There have been a number of attempts to test whether investors are myopic. For example, McConnell and Muscarella examined the reaction of stock prices to announcements of capital expenditure plans. If investors were interested in short-term earnings, which are generally depressed by major capital expenditure programs, then these announcements should depress stock price. But they found that increases in capital spending were associated with increases in stock prices and reductions were associated with falls. Similarly, Jarrell, Lehn, and Marr found that announcements of expanded R&D spending prompted a rise in stock price. See J. McConnell and C. Muscarella, “Corporate Capital Expenditure Decisions and the Market Value of the Firm,” Journal of Financial Economics 14 (July 1985), pp. 399–422; and G. Jarrell, K. Lehn, and W. Marr, “Institutional Ownership, Tender Offers, and Long-Term Investments,” Office of the Chief Economist, Securities and Exchange Commission (April 1985).

44See D. J. Ravenscroft and F. M. Scherer, “Mergers and Managerial Performance,” in J. C. Coffee, Jr., L. Lowenstein, and S. Rose-Ackerman (eds.), Knights, Raiders, and Targets: The Impact of the Hostile Takeover,

Oxford University Press, New York, 1988.

returns.45 They argue that this gain came from generating a higher level of sales from the same assets. There was no evidence indicating that the companies were mortgaging their long-term future by cutting back on long-term investments; expenditures on capital equipment and research and development tracked industry averages.46

Perhaps the most important effect of acquisitions is felt by the managers of companies that are not taken over. Perhaps the threat of takeover spurs the whole of corporate America to try harder. Unfortunately, we don’t know whether, on balance, the threat of merger makes for active days or sleepless nights.

The threat of takeover may be a spur to inefficient management, but it is also costly. It can soak up large amounts of management time and effort. When a company is planning a takeover, it can be difficult to pay as much attention as one should to the firm’s existing business.47 In addition, the company needs to pay for the services provided by the investment bankers, lawyers, and accountants. In the year 2000 merging companies paid in total more than $2 billion for professional assistance.

45See P. Healy, K. Palepu, and R. Ruback, “Does Corporate Performance Improve after Mergers?” Journal of Financial Economics 31 (April 1992), pp. 135–175. The study examined the pretax returns of the merged companies relative to industry averages. A study by Lichtenberg and Siegel came to similar conclusions. Before merger, acquired companies had lower levels of productivity than did other firms in their industries, but by seven years after the control change, two-thirds of the productivity gap had been eliminated. See F. Lichtenberg and D. Siegel, “The Effect of Control Changes on the Productivity of U.S. Manufacturing Plants,” Journal of Applied Corporate Finance 2 (Summer 1989), pp. 60–67.

46Maintained levels of capital spending and R&D are also observed by Lichtenberg and Siegel, op. cit.; and B. H. Hall, “The Effect of Takeover Activity on Corporate Research and Development,” in A. J. Auerbach (ed.), Corporate Takeover: Causes and Consequences, University of Chicago Press, Chicago, 1988.

47There is some evidence that, while acquisitions lead to improvements in the productivity of the new plant, productivity in the firm’s existing plant languishes. See R. McGuckin and S. Nguyen, “On Productivity and Plant Ownership Change: New Evidence from the Longitudinal Research Database,”

Rand Journal of Economics 26 (1995), pp. 257–276.

A merger generates an economic gain if the two firms are worth more together than

apart. Suppose that firms A and B merge to form a new entity, AB. Then the gain SUMMARY from the merger is

Gain PVAB 1PVA PVB 2 ∆PVAB

Gains from mergers may reflect economies of scale, economies of vertical integration, improved efficiency, the combination of complementary resources, or redeployment of surplus funds. In other cases there may be no advantage in combining two businesses, but the object of the acquisition is to install a more efficient management team. There are also dubious reasons for mergers. There is no value added by merging just to diversify risks, to reduce borrowing costs, or to pump up earnings per share.

In many cases the object of merging is to replace management or to force changes in investment or financing policies. Many of the takeovers in the 1980s were diet deals, in which companies were forced to sell assets, cut costs, or reduce capital expenditures. The changes added value when the target company had ample free cash flow but was overinvesting or not trying hard enough to reduce costs or dispose of underutilized assets.

You should go ahead with the acquisition if the gain exceeds the cost. Cost is the premium that the buyer pays for the selling firm over its value as a separate entity. It is easy to estimate when the merger is financed by cash. In that case,

Cost cash paid PVB

When payment is in the form of shares, the cost naturally depends on what those shares are worth after the merger is complete. If the merger is a success, B’s stockholders will share the merger gains.

The mechanics of buying a firm are much more complex than those of buying a machine. First, you have to make sure that the purchase does not fall afoul of the antitrust laws. Second, you have a choice of procedures: You can merge all the assets and liabilities of the seller into those of your own company; you can buy the stock of the seller rather than the company itself; or you can buy the individual assets of the seller. Third, you have to worry about the tax status of the merger. In a tax-free merger the tax position of the corporation and the stockholders is not changed. In a taxable merger the buyer can depreciate the full cost of the tangible assets acquired, but tax must be paid on any write-up of the assets’ taxable value, and the stockholders in the selling corporation are taxed on any capital gains.

Mergers are often amicably negotiated between the management and directors of the two companies; but if the seller is reluctant, the would-be buyer can decide to make a tender offer or engage in a proxy fight. We sketched some of the offensive and defensive tactics used in takeover battles. We also observed that when the target firm loses, its shareholders typically win: Selling shareholders earn large abnormal returns, while the bidding firm’s shareholders roughly break even. The typical merger appears to generate positive net benefits for investors, but competition among bidders, plus active defense by target management, pushes most of the gains toward the selling shareholders.

A pure conglomerate merger is one that has no effect on the operations or profitability of either firm. If corporate diversification is in stockholders’ interests, a conglomerate merger would give a clear demonstration of its benefits. But if present values add up, the conglomerate merger would not make stockholders better or worse off.

In this appendix we examine more carefully our assertion that present values add. It turns out that values do add as long as capital markets are perfect and investors’ diversification opportunities are unrestricted.

Call the merging firms A and B. Value additivity implies

PVAB PVA PVB

where

PVAB market value of combined firms just after merger;

PVA, PVB separate market values of A and B just before merger.

For example, we might have

PVA $100 million 1$200 per share 500,000 shares outstanding2

and

PVB $200 million 1$200 per share 1,000,000 shares outstanding2

Suppose A and B are merged into a new firm, AB, with one share in AB exchanged for each share of A or B. Thus there are 1,500,000 AB shares issued. If value additivity holds, then PVAB must equal the sum of the separate values of A and B just before the merger, that is, $300 million. That would imply a price of $200 per share of AB stock.

But note that the AB shares represent a portfolio of the assets of A and B. Before the merger investors could have bought one share of A and two of B for $600. Afterward they can obtain a claim on exactly the same real assets by buying three shares of AB.

Suppose that the opening price of AB shares just after the merger is $200, so that PVAB PVA PVB. Our problem is to determine if this is an equilibrium price, that is, whether we can rule out excess demand or supply at this price.

For there to be excess demand, there must be some investors who are willing to increase their holdings of A and B as a consequence of the merger. Who could they be? The only thing new created by the merger is diversification, but those investors who want to hold assets of A and B will have purchased A’s and B’s stock before the merger. The diversification is redundant and consequently won’t attract new investment demand.

Is there a possibility of excess supply? The answer is yes. For example, there will be some shareholders in A who did not invest in B. After the merger they cannot invest solely in A, but only in a fixed combination of A and B. Their AB shares will be less attractive to them than the pure A shares, so they will sell part of or all their AB stock. In fact, the only AB shareholders who will not wish to sell are those who happened to hold A and B in exactly a 1:2 ratio in their premerger portfolios!

Since there is no possibility of excess demand but a definite possibility of excess supply, we seem to have

PVAB PVA PVB

That is, corporate diversification can’t help, but it may hurt investors by restricting the types of portfolios they can hold. This is not the whole story, however, since investment demand for AB shares might be attracted from other sources if PVAB drops below PVA PVB. To illustrate, suppose there are two other firms, A* and B*, which are judged by investors to have the same risk characteristics as A and B, respectively. Then before the merger,

rA rA* and rB rB*

where r is the rate of return expected by investors. We’ll assume rA rA* .08 and

rB rB* .20.

Consider a portfolio invested one-third in A* and two-thirds in B*. This portfolio offers an expected return of 16 percent:

r xA*rA* xB*rB*

A similar portfolio of A and B before their merger also offered a 16 percent return. As we have noted, a new firm AB is really a portfolio of firms A and B, with portfolio weights of 1/3 and 2/3. Thus it is equivalent in risk to the portfolio of A* and B*. Thus the price of AB shares must adjust so that it likewise offers a 16 percent return. What if AB shares drop below $200, so that PVAB is less than PVA PVB? Since the assets and earnings of firms A and B are the same, the price drop means that the expected rate of return on AB shares has risen above the return offered by the A*B*

portfolio. That is, if rAB exceeds 1/3 rA 2/3 rB, then rAB must also exceed 1/3 rA* 2/3 rB*. But this is untenable: Investors A* and B* could sell part of their holdings (in a 1:2 ra-

tio), buy AB, and obtain a higher expected rate of return with no increase in risk.

960PART X Mergers, Corporate Control, and Governance

b.“Merge with Fledgling Electronics? No way! Their P/E’s too high. That deal would knock 20 percent off our earnings per share.”

c.“Our stock’s at an all-time high. It’s time to make our offer for Digital Organics. Sure, we’ll have to offer a hefty premium to Digital stockholders, but we don’t have to pay in cash. We’ll give them new shares of our stock.”

4.Explain how you would estimate the gain and cost of a merger financed by stock. What stock price should be used to calculate the cost?

5.Sometimes the stock price of a possible target company rises in anticipation of a merger bid. Explain how this complicates the bidder’s evaluation of the target company.

6.Suppose you obtain special information—information unavailable to investors— indicating that Backwoods Chemical’s stock price is 40 percent undervalued. Is that a reason to launch a takeover bid for Backwoods? Explain carefully.

7.As treasurer of Leisure Products, Inc., you are investigating the possible acquisition of Plastitoys. You have the following basic data:

You estimate that investors currently expect a steady growth of about 6 percent in Plastitoys’ earnings and dividends. Under new management this growth rate would be increased to 8 percent per year, without any additional capital investment required.

a.What is the gain from the acquisition?

b.What is the cost of the acquisition if Leisure Products pays $25 in cash for each share of Plastitoys?

c.What is the cost of the acquisition if Leisure Products offers one share of Leisure Products for every three shares of Plastitoys?

d.How would the cost of the cash offer and the share offer alter if the expected growth rate of Plastitoys were not changed by the merger?

8.The Muck and Slurry merger has fallen through (see Section 33.2). But World Enterprises is determined to report earnings per share of $2.67. It therefore acquires the Wheelrim and Axle Company. You are given the following facts:

Once again there are no gains from merging. In exchange for Wheelrim and Axle shares, World Enterprises issues just enough of its own shares to ensure its $2.67 earnings per share objective.

a.Complete the above table for the merged firm.

b.How many shares of World Enterprises are exchanged for each share of Wheelrim and Axle?