Mergers, acquisitions and the market for corporate control

Mergers and acquisitions, more commonly known as M&A, are components of corporate finance that refer to the buying and combining of independent companies. When one company takes over another it is known as an acquisition or more simply, one company acquires another. Mergers are when two companies agree to form a single company voluntarily. As for the market for corporate control this is essentially the market for acquisitions and mergers where there is active competition for control rights in the form of voting stock. This process is co-ordinated through the mechanism of a regulated and transparent stock exchange. On a daily basis deals are arranged that can have a lasting effect on the stakeholders involved, dictating the fortunes of the respective companies for years to come. High value transactions have regularly made headlines around the world in the past with many well-known brands having been resigned to history at the conclusion of deals. In the merger of Continental Airlines and United Airlines, the Continental brand name, while although world renowned has been discontinued in favour of a consolidation of the new company’s brand architecture. The predominant reasoning behind a takeover, be it friendly or hostile, is the belief that shareholder value would be increased if two companies were to operate synergistically as one, exceeding the value of the two separate companies when combined through added efficiency, increased market share and improved economies of scale. In the wake of the financial crisis companies sought to consolidate their positions at a time of economic uncertainty, looking to M&A as a means to safeguard shareholder interests. In this piece I will examine recent trends in M&A activity and the role of the market for corporate control.

                                                                                                    

If mergers and acquisitions are to improve shareholder value than they must increase the financial performance of the two companies when combined. There are numerous motivating factors that can improve financial performance post-transaction, the most commonly touted of these being economies of scale and scope. Economies of scale refers to the cost advantages of expanding the scale of an enterprises operations or outputs. By combining the operations of two companies that endure the same costs, say for example fuel in two haulage companies, this long run concept stipulates that by joining forces the cost per unit of fuel could be improved by increased bargaining power as per Porters five forces (Porter 1979). While economies of scale refer to the production/use of a single product, economies of scope although conceptually similar but differ in that it is in reference to the reduction in the average costs of producing two or more products (Panzer and Willig 1977). The efficiency of a broad product range can be improved by offering a more complete product range to customers in a particular market. Heineken have regularly highlighted the benefits that come from economies of scope when adding new products to its brand family. Sales teams at Heineken distribute a range of products more cost effectively than smaller competitors with a single product. Equally by adding a new product to its portfolio the company gained access to a set of customers that could be then be exposed to the entire breath of Heineken own brands, thus maximises consumer lifetime value. Economies of scope are a necessary condition for a natural monopoly to flourish.

The period 1965-1989 saw a string of large conglomerates seeking a diverse span of subsidiaries across an array of industries in the hope of  hedging out cyclical downturns in their portfolios. What resulted were bloated and unrefined conglomerates that were unprepared to fully commit resources to industries that their executive leadership did not fully understand. From the 1990’s on this trend changed as companies were now more inclined to acquire those in similar industries to themselves, thus complementing the products/services that they already provided. In recent years there have been few general trends to apply to all industries but more industry specific trends that are driven by opposing priorities. For instance the airline industry has been transformed by the emergence of ‘super airlines’ whereby large legacy carriers have merged or been acquired to maximise cost efficiency.  Beginning in the Europe with Air France-KLM in 2004 a string of mergers have followed including Delta-Northwestern, United-Continental and finally British Airways-Iberia in 2011. In the technology realm companies such as Google and Microsoft are constantly acquiring small start-ups in the hope of capturing the knowledge capital that was responsible for creating these fledgling companies. While Google is still very interested in developing the software assets and patents that these small start-ups possess it is the talent behind them that they really desire, an understandable approach if high levels of innovation are to be sustained.

The market for corporate control along with competition in the markets for products and services play an important role in reinforcing each other in promoting efficiency (OECD 1993). This theory calls for a complete deregulation of the markets under its assumption that the efficient market hypothesis holds true, controlling excesses and generating economic value. However I have found it difficult to fully justify such a stance when one considers recent developments such as LBO’s and their impact on stakeholders. I think it is more prudent to view the market for corporate control with scepticism because of it inconsistencies and its failure to comprehensively deal with the problem of information asymmetry. The theory of the market for corporate control cannot resolve principal-agent problems and that, on the contrary, mergers and acquisitions are manifestations of acts of agency that can exacerbate contradictions between management and shareholders(OECD 2003).



How do firms finance themselves in theory and in practice?

The primary goal of corporate finance is to maximise shareholder value while at the same time ensuring that the firm’s financial risks are managed in a satisfactory manner. Generally speaking the sources of finance that a corporation relies upon fit into two independent categories, internal and external sources. Internal finance consists of capital generated by the firm itself in the form of retained earnings while external sources refer to debt and equity attributed to outside investors. The financing of a corporation is the concern of the chief financial officer and it his/her responsibility to make the necessary capital budgeting and capital structure decisions required to ensure long-term financial stability. The manner in which firms finance themselves in theory is not always consistent the practical application of finance theory and there has been a considerable number of empirical research studies conducted that attest to this disparity. The role of company characteristics such as size, leverage, industry and credit rating are undeniable components in the irregularities and disparities that occur between theory and real world practice. Of note is the fact that capital budgeting in corporations tends to be aligned relatively close to academic theory, following notable techniques such as the renowned Discounted Cash Flow and Net Present value to weigh up potential investments. On the other hand capital structure decision making does not necessarily follow a prescribed path as finance theory would suggest. As I endeavour to examine in greater detail during the latter parts of this piece, capital structure decisions are often made at the discretion of the chief financial officer and the rules of thumb that he/she dictates as an informal benchmark.

There are two main theories that dominate corporate structure decision making in the corporate realm. The first of these is the trade-off theory (Kraus and Litzenberger 1973) which stipulates that the respective level of debt and equity chosen by a firm is decided by weighing up the relevant costs and benefits. The result is an optimal debt to equity ratio that finds a balance which facilitates financial flexibility and maximises earnings per share. Early forms of theory highlighted the benefits of taking on debt, including the tax deductibility of interest sustained upon debt. In more recent examinations of the theory Jensen’s free cash flow hypothesis has been incorporated to create a more rounded theory. The hypothesis states that ‘managers endowed with free cash flow will invest it in negative net present value investments’/projects rather than pay it out to shareholders in the form of dividends (Jensen 1988). This is particularly relevant for mature firms that have the benefit of a sustainable free cash flow and have already invested in suitable positive net present value investments in the course of their expansion.

The trade-off theory has been criticised for its inaccuracy and none more staunchly than Stewart C. Myers who argued that the theory does not match reality because it suggests corporations take on more debt than they actually do. In its place he proposed the second of the aforementioned theories that dominant corporate structure theory. The Pecking-order theory states that firms order their sources of finance according to preference as per the principle of least resistance/effort. Accordingly the preferred option for corporations would be to utilise internal sources that are self-generated but if this proves impossible then debt would be issued and when this option proves to be unviable then equity is issued as a last resort. The decision to issue further equity is not generally taken lightly because of the transaction costs that are involved and the signals that it would send to the markets. A stock issue is often interpreted as a sign that management view the stock as overvalued thus leading to a decline in the price of the stock upon announcement. However if the management in reality is forced to issue stock that is already at a fair value out of necessity then the subsequent decline would be detrimental to investor interests. Equally if a stock is over-priced the decline following an issuance would actually help to correct the disparity between the fair value and the market value.

A notable difference between finance theory and practice is in the calculation of ratios and in particular those that pertain to leverage. Theory would suggest that it is expedient to calculate leverage as a percentage of the market value of the firm while in reality it is common practice to actually work these ratios using the book value of assets. A practice that is also used by the very rating agencies that assess the risk attached to company credit. The frequent rebalancing that is required and the transaction costs that go with it in the use of market values makes it an unfeasible option, especially if accuracy is to be attained. Similarly empirical research in the field suggests that there is little evidence supporting the Pecking-order’s claim that information disparities has a significant role in the decision making process (Graham and Harvey 2002). The role firm size plays in defining the difference between theory and practice is considerable. While theory does appear to be very consistent with large companies in practice it does not fit as well with small and medium companies. The unsophisticated and unstandardized decision making process often taken my small firms does not bode well with the assumptions of finance theory.

Dividends, dividend policies and sustainability

Dividends by definition are a distribution of a segment of a company’s earnings that are issued to shareholders who hold a stock on the record date. The decision to release dividends to shareholders can only be taken and vetted by the board of directors This record date differs from the well-known ex-dividend date which is the first date after the declaration of a dividend that the buyer of a stock is not entitled to receive the next dividend. Due to the high level of volume with which many stocks are traded, the ex-dividend date is usually two days prior to the record date to allow for considerable processing undertaken by stock exchanges. The issuance of dividends is a considerable decision taken in line with other capital deployment priorities and allocation alternatives such as buybacks or acquisitions. Of late dividend policy has received a lot interest from investors and executive boards as a result of the circumstances that many companies now find themselves in the aftermath of the global recession that broke in 2008. With an environment that encourages executives to examine their dividend policy it is no wonder that there has been a recent resurgence of dividend increases and initial issues in 2011, while S&P dividends still remain only at 80% of what they were pre-crisis.

There are numerous factors that play a role in driving dividend policy in today’s financial environment. One must remember that a great deal has changed as regards the health of corporate balance sheets, capital markets, investment opportunities and investor demands. Corporations across the globe have been striving to shore up their own cash or cash equivalent positions since the onset of the financial crisis. The result?, record amounts of cash are now held on company balance sheets, in a manner not seen since the 1950s. Nowhere is this highlighted more than in the United States where an estimated one trillion dollars of cash or cash equivalents was held as early as the first quarter of this year. Excess liquidity could potentially be used to distribute dividends to shareholders, many of whom bore the brunt of poor equity returns in recent years.

With the good health of corporate balance sheets and historically low treasury rates, debt yields have been relatively low in 2010 and less so in 2011. As result companies have been taking advantage of these favourable rates to refinance their existing debt and explore the possibility of funding new investment opportunities. Indeed those companies that have the added bonus of a strong credit rating have almost unlimited access to credit markets, thus adding another dimension of liquidity and in turn flexibility. This flexibility opens the door to numerous investment opportunities that could act as a comparative advantage over competitors with less manoeuvrability at this point in time. Abbott Laboratories(ABT:NYSE) epitomizes a company that took such a brave and proactive approach to capital distribution. In 2010 Abbott spent approximately 8.5 billion dollars on inorganic growth, including the acquisition of Piramal Healthcare, making Abbott the largest pharmaceutical company in India. It was hoped that the acquisition would act as a base from which to grow the company’s emerging market business. Modest GDP growth in developing nations has forced companies such as Abbott to look further afield for acquisition opportunities, a tactic that has not always proved successful in the past due to large corporations failing to grasp the realities of foreign operating environments etc. Also of note are the changing demands of investors, when faced with economic uncertainty, are becoming more risk averse and are looking to the likes of dividend aristocrats for steady, consistent yields. A company that can provide over 25 consecutive years of dividends speak volumes about its capital discipline and fortitude.

There has been considerable empirical studies conducted over the years on Dividend policy which strove to identify the primary factors that influenced the setting of dividends from the perspective of management. Lintner from his piece in the 1956 American Economic Review argued that firms only have four distinct concerns when it came to setting dividends. Firstly every firm had a target dividend pay-out ratio that it sought to meet in the long term. Initial dividends would often be set to a low pay-out ratio in a growing company to facilitate capital flexibility and relatively high in a mature company that had consistent revenue streams. Secondly changes in the dividend would only reflect changes in the long-term revenues of the firm, thus embedding a sustainable dividend policy. Thirdly management are highly concerned with the perceived impact and reaction of investors when changes occurs to the pay-out ratio. A reduction in dividend is often perceived by investors as an indication of lessened future revenues and managements negative outlook. Also of note is the fact that a reduction has a more lasting impression than an increase of a dividend from an investor viewpoint (Lang and Litzenburger 1989).Lastly once management decide to set a dividend they do so with the intention of it remaining intact for the foreseeable future, out of fear of how a reversal may be taken by the markets. This framework was given added backing from (Fama and Babiak 1968) who rigorously applied it in numerous test and found it to be relatively consistent with decision making processes observed by mainstream management.

Predictably investors like consistency and this is where a sustainable dividend becomes highly attractive, whereby a firm’s dividend regularly increases and shows little indication of a decrease. Investors can usually determine if firm’s dividend is sustainable based on cash-flow analysis such as discounted cash flows. The transparency of dividend policy and strong longer-term value implications means that the decision making process must be calculated and well executed. By ring-fencing future cash flows for use as dividends firms can display capital discipline by only utilising excess cash flows for other uses such as the maintenance of debt, buybacks or simply added liquidity.

The Capital Asset Pricing model and its successors……useful or useless?

Capital market theory is an integral part of an investor’s decision making process and this is overtly evident in the popular use of the Capital Asset Pricing Model or CAPM. The CAPM has been the most prolific theory in its field for the last forty years with its creator Professor William Sharpe receiving the Noble prize in economics in 1990. Following on from last blog posting the CAPM is a financial model that seeks to further develop an explanation of the relationship between risk and return. It provides investors with what they crave, through a logical and common sense approach, a trade-off between risk and return that gives a consistency to risk premiums. However of late, the CAPM and its primary successor the Arbitrage Pricing Theory are now considered to encompass a more traditional set of theories. Indeed both lack empirical academic support and rely upon some very strict assumptions that are not routinely found in financial markets. Both CAPM and APT form a very specialised branch of portfolio theory that while highly useful through the insights they provide are too flawed to be used on their own. The dynamism and evolving nature of financial markets has meant that these theories have been resigned to playing a lessor role to more modern financial models such as Tonis Vaga’s Coherent Market Hypothesis. With its multiple detractors the CAPM has received widespread criticism throughout the years, primarily linked to the inaccuracy of its component parts thus consequently I hope to clarify its shortcomings while acknowledging what it still offers a modern investor.

 

CAPM

   

Essentially CAPM epitomizes a reductionists approach to the understanding of the basic market mechanics. It is an equilibrium model that provides a snapshot of the market at any given time. In order to do this it must isolate three key components, the risk free rate, the beta and the expected market return. By manipulating and equating these inputs through the formula one can theoretically determine the required rate of return of an asset in a well-diversified portfolio. Its logical appeal is evident when the results of the model graphically represented in the form of the Security Market Line. It sheds light on the relationship between the beta and the required return of the asset in question.

The slope of this line represents the market risk premium required by investors and in a perfectly efficient market assets would be placed somewhere along this line. According to the model if an assets expected return in relation to its risk is plotted above the line then it is said to be undervalued. By undervalued I am referring to the fact that an investor could expect a larger return for the inherent risk it is exposed to. Similarly the opposite would apply for an asset that was plotted below the SML and thus, as dictated by CAPM, overvalued.

However by isolating these components, the CAPM makes numerous and contentious assumptions about investors and the market, not to mention the accuracy of its inputs. Of investors the model assumes that all active participants are rational, risk averse and utility maxi misers with homogenous expectations and requirements. This is certainly not the case in reality, if we were to hold these assumptions as true then the markets would consistently enter a pattern of boom and systemic destruction over the course of time. It is precisely the fact that independent investors hold opposing views enables a financial market to operate as per the zero sum hypothesis. Even the volatility of late and the massive slump witnessed across financial markets in 2008 still fall under the realm of stable market operation in relative terms. The simple rational investors that traditional theories chose to rely upon are ideal actors that do not represent the complexities of investor behaviour. Differing investment goals bring about varying investment strategies that span the entire market spectrum, utilising numerous asset classes. For instance everyone investor who shorts an equity on the back of a recent development, a strategy often employed by day traders, there are those such as institutional investors who are prepared to weather the storm and hold a long term position. Equally the amount of resources available to investors differs hugely and can play a major role in determining risk appetite. Quite simply an investor with ample resources can afford to take on additional risk and the potential for financial loss that goes with it.

 Of the markets it assumes that tax or transaction costs do not exist and that all information pertaining to the market is freely available to every investor all the time. Information costs mean that investors must do with varying levels and quality of information in the course. It also ignores the fact that some securities are not easily divisible and that the standard deviation of past returns may not necessarily provide a solid base for future risk assessment.

What about diversification? How can we deal with risk in assets and what is risk anyhow?

In finance risk is an unavoidable reality that must be taken on taken if a return of any description is to be attained. However the level of risk exposure can be mitigated through astute risk management, tailored to investors needs and appetite for risk. An investor must understand the relationship between risk and return if he/she is to be successful. It is very prudent to examine risk and diversification at a time of considerable economic instability, primarily highlighted by volatility, a reflection of market risk, in financial markets of late. The Eurozone crisis is entering a critical stage, major European economies such as Italy and Spain have seen their government debt trade above 6%, a level that makes the costs of borrowing for these respective countries unsustainable. Yet sadly it appears that until these countries display serious fiscal discipline going forward the European core of France and Germany look unlikely to foot the bill. A break up of the euro, no matter how implausible would have a devastating effect on the global economy, almost certainly leading to a worldwide recession. This systemic risk has prevented US stocks from going higher in recent weeks despite the US economy showing promising signs that have indicated a steady recovery. While all portfolios must contend with this unavoidable risk the more risk averse investors may seek to remove unnecessary risk by following an investment strategy that follows modern portfolio theory.

For the sake of clarity it is probably wise to begin with risk itself and its defining features. When I refer to risk in this piece I am talking about the umbrella term of financial risk unless otherwise stated and the various types of risks that are associated with finance in general, be it personal or corporate. While there is no specific definition of risk in finance it is generally regarded as the probability that an investments return would be different to what was expected. This includes the probability that a considerable portion or indeed all of the original investment could be lost.

An investor’s appetite for risk can be effectively highlighted in the trade-off between risk and return, a trade-off that will dictate the level of diversification in a portfolio. Low risk is more than often than not inextricably linked to low returns and the same can be said about the high risk and its expected returns. The following chart displays this relationship excellently, a portfolio with a high standard deviation is unavoidably linked to high risk and the potential pitfalls that go with it.

At the lower end of the spectrum one could, in theory, chose an investment with no risk of financial loss as defined by the risk-free rate of return. Essentially it represents the minimum rate of interest that an investor could expect from a risk-free investment, the best known of which would be interest from three month U.S. treasury bills. However in practice this is not the case as even the safest investment must carry a minimal amount of risk. For instance U.S. treasury bills have been linked to the risk-free rate of return because the likelihood of the U.S defaulting upon its debt obligations is considered extremely unlikely. That being said one must recall July 29th this year and how close the U.S. came to defaulting upon its debt, the U.S. house of representatives finally passed a bill allowing a raising of the debt ceiling just two days before the country would be unable to meet its debt obligations. This event brought into focus the credibility of U.S. treasury bonds and its position as a benchmark for the risk-free rate of return.

While I may have alluded to specific risks in the proceeding paragraphs, one cannot grasp the realities of risk in finance without understanding the two fundamental types of risk that investors must tackle. Firstly systematic risk is the risk that is linked to aggregate market performance and cannot be removed through diversification. It is a risk which is caused by factors that affect the prices of virtually all securities, although in different proportions (Scott 2003). An asset’s exposure to systematic risk/market risk can be measured mathematically and expressed as a beta, a coefficient which examines the sensitivity of a given stock when compared with the market as a whole.

To help lessen the effect of risk, diversification is employed by spreading an allocation of investments over a variety of asset classes, industries and categories. A perfectly diversified portfolio is characterized by little or no correlation between individual investments. Thus the impact of any one event is effectively hedged by the remaining investments. It is generally the case that bond and equity markets move in opposite directions to one another, thus a combination of the two asset classes could potentially negate the impact of unwanted market swings. The above graph examines the effectiveness of diversification on systematic and unsystematic risk within a portfolio. In addition it also takes into account portfolio variables such as the average annual standard deviation of stocks and the number of stocks contained within a portfolio. Unsystematic risk refers to a specific risk that is unique to a particular asset or investment, a common example is the strike of company employees having an adverse effect on a company’s share price. As the graph displays, unsystematic risk can be diversified away but the standard deviation of the portfolio follows the law of diminishing returns. Despite ones best efforts, diversification becomes ineffective once it reaches the base level of systematic risk, in this case 19.2.

      As we have examined thus far investors are forced to confront risk in two distinct forms, systematic and un-systematic, the latter being the only one which can be successfully diversified through astute portfolio management.