GDV
INVESTMENT
BANKING
Alain Praet 2021-2022
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CH1: INTRODUCTION TO MERGERS, ACQUISITIONS AND OTHER
RESTRUCTURING ACTIVITIES
M&As are part of corporate restructuring.
Operational restructuring: changing the
way the assets are composed.
Joint venture: creation of a new firm and
the two parties have 50% of its shares.
Workforce
Reduction
Strategic Alliance: working together
Joint without being part of each other.
Venture/Strategic
Alliance
Operational
Restructuring Divestiture: diversification
Divestiture, Spin- Hostile Tender
Hostile Takeover
Off or Carve-Out Offer
Spin-off: creation of independent
company through the sale of new shares
Takeover or Buyout Merger
Corporate
Restructuring
of a parent company to a segment.
LBO/
MBO
Friendly Takeover Consolidation Carve-out: sale of shares of a segment of
the company through IPO.
Financial Reorganization Acquisition
Restructuring Liquidation
LBO: Leverage Buyout: acquiring a new
firm using debts to finance the
Stock Buyback
transaction.
MBO: Management Buy-Out: example of
LBO (management wants to buy shares of
a firm and need leverage to do so).
1.1 Corporate restructuring: terminology
A merger is a combination of two or more firms often comparable in size, in which all but one ceases
to exist. Mergers are mostly friendly and legally simple but require both approvals of the shareholders
of the companies. It can therefore lead to deep negotiations.
Legal terminologies:
Statutory merger: surviving firm assumes all assets and liabilities of the target firm
Subsidiary merger: target firm becomes a subsidiary of the parent. It is operated under its brand name
but is owned and controlled by the acquirer.
Consolidation: creation of an entirely new firm from the combination of both existing firms (technically
not a merger).
Acquisition (takeover): purchase of shares of another firm. An acquisition can be hostile (tender offer
though it is not approved by one of the boards).
A tender offer is a public bid to purchase the shareholders’ stock of a company.
Economic terminologies:
Horizontal merger: combination of firms in the same business activity. This kind of mergers has
government regulation due to the potential anticompetitive effects (if company has too much power and
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crushes the -new- competitors). Economies of scale/scope and synergies are examples of horizontal
mergers.
Vertical merger: combination of firms at different stages of a business activity (e.g., company and its
supplier). The main goal of a vertical merger is to increase the information and transaction efficiency.
Conglomerate merger: combination of firms in unrelated business activities. Companies are not related
even after the merger, each work on its own but share the same board of directors.
1.1.1 Diversification
On average, Berger and Ofek have discovered that diversification destroys value. Nonetheless, the value
destruction is less in horizontal mergers than in vertical ones. It is said that the main cause of value
destruction is overinvestment and cross-subsidization.
Overinvestment: too much investing in a particular segment as compared to its investment
opportunities.
Cross-subsidization: some segments are subsidized by other segments of the company. Can lead to
problems when a segment that does not deserve the money still receives it.
Diversification discount: between 13 and 15%, percentage of unsuccessful M&As.
Assume a firm with a value of 1.500 euros and sales equal to 100 euros with 3 segments.
Value/sales: average of the firm on the sales ratio
SIC (ID) Sales Value/Sales Sales* (e.g., the sales of 3212 are 10 times its value).
Data is given.
3212 50 10 50x10=500
Sales*: Sales x Value/sales: segment value if not
4825 30 15 30x15=450 part of a conglomerate.
Imputed value: total value if firms were not in a
5842 20 18 20x18=360 conglomerate.
IV = 1310 IV<MV = diversification premium =
conglomerate is worth more. On average, the
Imputed Value is worth more than the Market
Value (IV>MV).
The excess value would be ln(1500/1310) = 13,54%
1.1.2 Sources of value destruction
Capital misallocation
The potential benefit of a conglomerate is the internal capital market, where cash flows are shifted from
the segments that have too much cash to the ones with cash flows’ needs. According to Shin and Stulz,
this shifting process only works in theory and not in practice; a segment is more dependent on its own
cash flows. The internal capital market does not seem to be well working because it mostly depends on
what are generating each segment individually.
Moreover, the other segments’ cash flows do not depend on investment opportunities. You would
expect that the more investment opportunities, the more you would generate and therefore the more
cash flows you would receive from the investments, but it has not been confirmed in their theory.
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Misallocation and diversification are related to the diversity of investment opportunities. To allocate
your funds efficiency within a conglomerate, it is better to avoid having some segments with a lot of
investment opportunities and some with none.
Overinvestment
Firms with a lot of cash flows tend more to invest in other segments with no regard to the investment
opportunities. As a result, when the income of the main segment fall, management decreases the
investments of other segments (e.g., oil firms decrease their investments in non-oil segments when
income fell in the oil segment).
Corporate governance
Corporate governance: set of rules that must make sure decisions are made in the interest of all
shareholders.
If management ownership increases, managers will start thinking as shareholders and agency problems will
decrease. Lower agency problems lead to less diversification and lower diversification discount. If the
manager owes more shares, [s]he will do less value destruction.
Smaller boards are associated with better governance and again with lower diversification discount.
Lower efficiency
The management of many different segments lower the productivity of these segments.
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According to some other studies, if conglomerate firms suffer from a diversification discount, it is
because they were already different before the diversification; firms behaved poorly before the
diversification. This can be explained by seeing the diversification as a solution of poor performances.
Another reason of firms suffering from diversification discount is the high expectations management
has before the process. As a result, the ROI can be lower than expected and thus can lead to lower cash
flows.
Finally, diversification discount can also be because of the firm’s characteristics and measurement
errors of the q.
1.1.3 Value creation?
Diversification might as well create value.
The definition of a business segment is flexible and therefore, management can decide to group some
segments together (though they do not belong together) before reporting and as a result, the company
seems less diversified than what it actually is. These companies have lower q ratios than stand-alone
ones because they are larger.
Only segments that represent more than 10% of sales, assets or profits are to be reported and are self-
reported.
According to Villalonga, who is using more detailed level data, diversified firms trade at a premium
(IV<MV, opposition to Berger and Ofek). As a diversified firm, there can be co-insurance; one segment
insures the liabilities of another one and therefore have better access to the capital market (as a borrower,
you can give more certainty that the debt will be paid off).
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