Finance of Mergers and Acquisitions:

Valuation and Pricing

Professor Heitor Almeida
Module 1: Overview of M&A Topics and Evidence

Table of Contents
Module 1: Overview of M&A Topics and Evidence .................................................................. 1
Lesson 1-1: Module 1 Introduction ................................................................................................... 2
Module 1 Objectives and Overview ..................................................................................................................... 2

Lesson 1-2: ....................................................................................................................................... 9

Lesson 1-2.1. Good Reasons to Engage in M&A Transactions ............................................................................. 9
Lesson 1-2.2. Bad Reasons to Engage in M&A Transactions .............................................................................. 23

Lesson 1-3: ..................................................................................................................................... 33

Lesson 1-3.1. Private Equity LBOs and Other Restructuring Tools ..................................................................... 33
Lesson 1-3.2. Friendly vs. Hostile Deals, and M&A Regulation .......................................................................... 48

Lesson 1-4: ..................................................................................................................................... 66

Lesson 1-4.1. A Brief History of M&A ................................................................................................................. 66
Lesson 1-4.2. Does M&A Create Value? ............................................................................................................. 78

Module 1 Review ........................................................................................................................... 93

Module 1 Review ............................................................................................................................................... 93

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida
Lesson 1-1: Module 1 Introduction

Module 1 Objectives and Overview

The theory and practice of M&A use knowledge from several different fields of business,
including strategy, management, law, accounting.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

In this course, we will focus on the finance of M&A. We'll be talking about issues such
as the valuation of M&A deals, the financing of deals, pricing, how to price an M&A deal,
deal design more generally.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida
In particular in this first module, we will learn the basic terminology of M&A, which we're
going to use throughout the course. Term such as synergies, what do we mean by
synergies, LBOs, or leveraged buyouts, spin-offs, hostile takeovers, and more. You're
going to be a lot on M&A terminology here.

Then we're going to talk about the key drivers of M&A deals. Why is it that M&A deals
happen? We're going to learn an important idea which is that there are good and bad
reasons that potentially drive M&A deals. It's not only good ones. We will learn how to
identify the good reasons behind M&A deals which then leads to true value creation
from the point of view of the companies involved.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

Then we're going to talk about history. We're going to learn some basic facts about the
history of M&A, which I think are going to be very useful to think about the present times
as well, and to learn about M&A in general, we're going to talk about the idea of waves
that M&A comes in waves. We're going to learn about industry clustering. The idea that
M&A deals tends to concentrate in specific industries in different time periods. We're
going to talk about who gains from mergers, acquirers target. In particular, we're going
to also talk about which types of deals are better for acquirers.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

These are the objectives of Module 1. More specifically, we will learn about the concept
of synergies in mergers and acquisitions. We're going to learn how to distinguish
between good and bad reasons to engage in M&A.

Two, we're going to learn how to distinguish between leveraged buyouts and strategic
M&A deals. Also how to identify options that companies have to restructure, such as
spin-offs. We're also going to learn how to distinguish friendly from hostile view.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

Then we're going to talk about history and we're going to learn several facts. The waves
that M&A activity tend to come in well-defined waves, that these waves tend to cluster in
specific industries each time. Then we're going to learn how to measure whether a deal
creates value or not according to the stock market. That's going to be a very important
notion that we're going to discuss.

Then we're going to talk about the evidence we have that while targets clearly gained

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Professor Heitor Almeida
from mergers, acquirers often do not. This leads to the next question in there are certain
types of deals that appear to create more value for acquirers than others, and we're
going to learn the basic empirical facts on these important question as well.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida
Lesson 1-2:

Lesson 1-2.1. Good Reasons to Engage in M&A Transactions

We're going to talk now about the good reasons why companies engage in M&A
transactions. And really, the most important idea is this concept of synergy. The key
idea is that a merger adds value only if the true merging companies are worth more
together than apart.

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Valuation and Pricing
Professor Heitor Almeida

So the idea of synergy is, which in finance we like to think about it as the 2+2=5 idea,
right? So the sum is greater than the parts, so somehow you add two companies and
you end up with an extra value. That's the one, that's the value of the synergy. The
synergy is the value that is added by the merger that wasn't there before the merger
deal happened. The concept of synergy is very important for M&A deal, we're going to
be talking about synergies throughout this course.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

This leads to the next question, right? I mean, what are the sources of synergies? When
is it that 2+2=5? We call these the rational motives for mergers. The first one is
economies of scale. When companies grow, in some cases, it's not always. But in some
cases, companies can reduce costs by producing at a large scale. And obviously, if you
are able to produce at a lower cost, your profits are going to go up. Another motive that
is related because it also has to do with size is the idea of industry consolidation that is
behind some of the M&A waves that we observed over time. So the idea is that mergers
between competitors in the same industry allow the merging companies to increase
market power, and an increasing market power brings benefits. One of them is to be
able to charge higher prices, which may be good for companies in some cases, it may
not necessarily be good for consumers. But it definitely is a source, whereas we know in
the literature, it's a source of gains in M&A deals that seem to drive M&A deal as well.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

Another possible source is what we call the economies of vertical integration. This has
to do more with the production process. So in some cases, companies can gain
specifically cost advantages by buying a major supplier. Rather than procuring the
product in the market, companies can produce an in-house by buying the supplier, and
in some cases this can lead to cost reduction. And then finally, an important idea as well
is that in some cases M&A deals allow companies to eliminate inefficiency. So, for
example, you can have a situation in which a company has poor management. But the
management is somewhat entrenched that the management does not want to leave the
company, and the shareholders are unable to hire better management. In that case an
M&A can be a disciplining device and bringing new people to manage the asset. Then
we can think about examples of these different types of deals. I think it helps to be a
little bit more concrete and think about some specific examples that you might have
heard of.

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Valuation and Pricing
Professor Heitor Almeida

So in terms of economies of scale, for example, we need to think about using the same
industry. So, for example, the TMobile-Sprint deal that was completed in 2020 is a good
example of that. That seems to have been driven by economies of scale in the
technology industry. Then industry consolidation, again, like I said, it's very, very
common. The merger between HP, Hewlett Packard, and Compaq, which is one of the
most famous merger deals of all time. That is a relatively old one, but it's, like I said,
very famous, and it's used in many courses throughout Academia to talk about M&A
deals. So this is an example of a deal that was driven by industry consolidation. Again,
these are the same industry deals which we also like to call horizontal, right?

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

So when companies merge in the same industry, we call that horizontal deal because
the alternative is what we call a vertical deal, right? So, for example, in 2009, Pepsico
decided to buy the bottling company. Prior to that, the bottling company operated
independently, and of course, its biggest customer was Pepsico. But after 2009, it
became integrated in the same company, and the motivation for that as we discussed it
is a potential reduction in costs. These deals are not in the necessarily in the same
industry, they are in related industries.

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Valuation and Pricing
Professor Heitor Almeida

And then finally, we talked about the inefficiencies, right? What we know from finance
research is that that is a powerful source of value gains in particular in leverage buyout
or LBO deals. Which is something we're going to talk a lot, we're going to discuss this in
the course as well. However, this can happen in any type of deal. It's not just LBOs,
even strategic M&A deals can be driven by eliminating inefficiencies as well.

You might be thinking at this point, I mean, are there others, is it all about synergies?

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Valuation and Pricing
Professor Heitor Almeida
And the answer is no, there are a couple other reasons that are perhaps less common
and more specific, but there are also valid motivations for M&A deals. The first one has
to do with liquidity.

The second one has to do with valuation. So deals that are driven by liquidity are deals
that are essentially the driving force is cash, right? So during crisis periods such as the
recent financial crisis of 2008-2009, or the COVID-19 crisis in 2020, financial markets
shut down. It becomes difficult to borrow, the value of cash goes up and in particular
some companies might become financially distressed. In that case, the M&A market can
also work as a cash providing tool, right? So either acquires or more often targets are
bought with the main reason to get access to cash. So the driver here is liquidity, that's
why we call this liquidity deal.

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Valuation and Pricing
Professor Heitor Almeida

So just to give some examples, in the 2008 financial crisis, there is a very famous deal
in which Chase, one of the biggest banks in the US, bought Bear Sterns. Which was
very important investment bank that was undergoing a very important crisis at that point
finding it difficult to raise financing. And what happened is that Chase decided to buy
Bear Sterns, and that is considered to be an example of a deal that is mostly driven by
liquidity. In the recent crisis, there have been several private equity deals that appear to
have been motivated by liquidity. So, for example, Expedia, which as you may know is a
travel agent, it's an online travel agent mostly, was not doing well during COVID-19. And
two private equity fund, Silver Lake and Apollo, bought a significant stake in Expedia by
injecting funds. Actually, both through equity and debt, so it wasn't just equity stakes.
Again, this is an example of a deal that is motivated by liquidity.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

And then the other possible motivation is valuation. And this has to do with the idea that
in some cases acquires or investors may be able to find undervalued targets. In that
case, if you can buy an asset that is undervalued, then the idea is you don't need any
synergies, right? So if you find another valued target, you can create value even if there
are no synergy. For example, if a firm's stock price in the market is $10 a share, but if
you believe that the stock price should be $15 a share, then buying stock is a good
deal, right? So if you're an investor, you should buy stock of this company. Buying the
whole company is even better, maybe you should just buy everything, right? So that
valuation can be an important motivation as well.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

And here are some examples of deals that we have evidence that they were motivated
by valuation. One of them is a very famous leverage buyout. The LBO of Seagate,
which again is a is commonly used throughout Academia as an example of a leveraged
buyout. There are cases that Academia use Seagate. It's a case in which clearly the
main reason for that leverage buyout seems to have been the undervaluation of the disk
drive business of Seagate, okay? And the broad point here that we're going to talk
about later is the fact that undervaluation is a very common source of value gains for
leverage buyouts in particular. Then another example is the Verizon-Yahoo deal that
was completed in 2017. Again, the motivation here appears to have been in part the fact
that the search business of Yahoo was severely undervalued by the stock market.
That's considered to be another example of valuation-driven view.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

And then, perhaps the most salient example is Warren Buffett. Warren Buffett has built
a career, if you think about it, he has built his career as an investor buying companies
without restructuring them, right? So the way I like to think of Berkshire Hathaway as a
private equity company that focuses almost exclusively on valuation. So most deals that
Berkshire Hathaway has executed over the years have been deals in which the buy and
hold type deals in which Berkshire Hathaway doesn't really get involved in the operation
of the company.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

So these are mostly driven by evaluation. And then one point we're going to talk about
in the course as well is the fact that I find it truly undervalued targets is hard. The stock
market is fairly efficient, and as we know, even Warren Buffett has had some blunders
over the year, you're not always right. In some cases, what seems to be another valued
asset may actually not be the case. And since we're talking about valuation, it's
important to talk about the typical premium in M&A deals. That's going to be a very
important number in our course as well.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

We know from history from data that targets that are acquired in a M&A deals tend to
get paid significant premiums. So in fact, we have a number that you can remember, it's
one of the magic numbers of M&A, this 30% premium. Of course, not all deals are going
to have a premium of 30%, but 30% is an important reference point. So, for example,
just to make this more clear, if a target price is $10 a share, then the offer on average is
going to be $13 a share. So the acquire has to be able to pay at least $13, right? And
going back to what we discussed in this section, what that means is that M&A then has
to increase value by at least 30% of the target equity value. Through one of these
mechanisms that we discussed, most commonly is synergies. But in some cases also
liquidity or valuation, there has to be this 30% gain. Otherwise, the acquire wouldn't
benefit by paying this 30% premium. So this 30% number is going to be very important
for us, we're going to go back to that several times in the course.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida
Lesson 1-2.2. Bad Reasons to Engage in M&A Transactions

Let's talk more about the bad reasons why companies do M&A deals. It's important for
us to discuss this because some of these may actually sound reasonable to you when
you start thinking about it. But when you think more deeply about these issues, I hope
you realize that these are not valid reasons for M&A deals, and in fact, they can lead to
value destruction rather than value creation. There are three arguments we are going to
discuss here. The first one has to do with cash, the second one has to do with
diversification and the third one has to do with earnings management or increasing your
earnings per share. The cash argument goes as follows.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

As we know, cash earns low returns. So when companies hold cash, they typically hold
cash in treasury is our bank deposits, and these are assets that do not pay high-interest
rates. In that case, when companies have a lot of cash, it may seem like a good idea to
go out and make investments. For example, acquiring another company must be better
than just having this idle cash sitting around in a low-interest rate bank account. While
these might seem reasonable in fact, what we know from research and from finance
theory is that this is a recipe for disaster.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

Let me give you the empirical evidence first. There is a famous study by Harford, that
was published in 1999 that use the data for M&A deals from 1977 to 1993 and he found
that when companies were cash-rich, companies that have a lot of cash, in fact, they
were more likely to attempt acquisitions. So this idea that cash burns a hole in the
pocket has some bite the data. But then you can look at value creation and what Jarrad
Harford found is that these acquisitions destroy shareholder value.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida
These cash-rich acquires ended up destroying seven cents in value for each dollar of
excess cash that they held in their balance sheet. So these were bad deals. Doing deals
because you have cash is never a good reason.

As we learned already, what matters is whether the merger generates synergies. The
synergy is the true source of value creation. The other idea is if a merger adds value,
then companies should be able to finance it in the market. It doesn't matter if you have
cash or not. You should be able to raise financing. So the idea that you have to spend
cash just because you have it really doesn't make much sense. So this is an important
concept. We're going to go back to that later as well when we talk about the financing of
M&A deals. For now, remember that cash should not be a reason why acquirers should
pursue M&A enables.

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 Finance of Mergers and Acquisitions:
Valuation and Pricing
Professor Heitor Almeida

Then there is diversification. This idea that diversifying risk is good. So we know that
there are companies that have business in many unrelated industries. That's what we
call conglomerates in the US. An example is General Electric that has several different
lines of business, including aircraft engines and other businesses as well. So these
conglomerates are becoming less common maybe, but they're still out there.

The question you have to ask yourself is if you're thinking about M&A deals, should a

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Professor Heitor Almeida
company buy another company in a different industry simply to reduce risks for
shareholders? The answer if you use basic finance theory, is no and the main reason is
because shareholders can diversify risks on their own by buying stock directly. So think
about the following. It doesn't make sense for General Electric to buy an unrelated
company to reduce risk for shareholders, because shareholders can buy shares directly
in that company. You don't need the CEO of General Electric to be doing this for you.

In fact, what's happening at least in the US economy in recent years is that there is
an increasing trend towards focus. Existing conglomerates such as General Electric are
actually focusing and they are selling business. For example, General Electric has
recently retreated from finance. It used to have a very significant financial arm that now
is not part of the company anymore.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

Then there is the earnings per share motive. Earnings- Earnings per share is another
important idea that we're going to talk about in this course. It is of course the main
metric of profits that analysts tend to focus on. There is the potential as this example is
going to show you, there is a potential for earnings per share management to drive M&A
deals. Consider the following, there is some numbers there for you, we have Firm A and
Firm B, and the idea of this example is that Firm A, is acquiring Firm B. Besides the
basic data on earnings, shares outstanding, price per share for Firm A and Firm B, I
also gave you some numbers for the merged firm, pay attention to that as you think
about the following question.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

When you look at this data, does it look like this merger creates value for the
shareholders of Firm A or not? Also, think about why might that be?

The answer is that this merger does not create value. If you look at the earnings, Firm A
had $100 in earnings, Firm B had 40, it can be whatever unit you want, let's say million,
100 million for Firm A, 40 million for Firm B, the merged firm has 140 million, this is not
a two plus two equal five case, in fact, this is a two plus two equals four case. The

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Professor Heitor Almeida
companies have not generated any new profits by merging, they have basically put
them together, but look at the earnings per share data. Firm A had earnings per share
of $1 a share, Firm B had earnings per share of two when you merge the companies,
the EPS is going to 1.17, from the point of view of the acquirer of Firm A, Firm A was
able to increase its earnings per share by 17 percent through a deal that has no
synergies. Earnings-per-share has gone up, but there are no synergies, there really is
no reason for these merger to happen.

What's going on, if you think about this example a bit, what you realize is that this is just
weighted averaging. What's happening here is, you have a company that has low
earnings per share, and they are acquiring another company that has high earnings per
share, and earnings per share is a mechanical metric. What's going to happen is, once
you average it out, earnings per share will go up from the point of view of the acquired.
It looks like the CEO of the acquire is creating value easily by doing nothing, just buying
another company and not really restructuring. But what this example is really showing
us is that earnings per share is the wrong metric to look at. When CEOs or CFOs look
for good deals, try to decide on which deals should we execute, you should actually not
be concerned with earnings per share at all. It doesn't really matter if EPS goes up or
down, what matters are the underlying scenery.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

This is the theory, the problem is that there is some evidence that earnings per share
does seem to drive merges in the real-world, very similar to our cash discussion. We
know that cash per se, just because acquires have a lot of cash, they shouldn't go out
buying companies in general, but there is some evidence that they do from the Harford
paper we talked about, but it's very similar here for earnings per share, it's still an open
research question, there is less research on this, but what we have seems to suggest
that EPS does seem to drive M&A using the real-world. Acquires tends to prefer deals
that increase EPS, in particular, when executive compensation is tied to earnings-per-
share. My view is that this is actually a problem, that CEOs and CFOs, as I said, should
avoid looking at earnings per share when deciding which companies to acquire, just as
they should not worry about whether they have cash or not, they can just finance using
the market, but in practice, both cash and EPS seem to be important drivers of mergers,
which makes it even more important for us to be talking about it. I hope you remember
that neither cash nor diversification nor earnings per share are good reasons to conduct
M&A deals.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida
Lesson 1-3:

Lesson 1-3.1. Private Equity LBOs and Other Restructuring Tools

Now we're going to talk about the, what you can think of as other deal types. So, the
most common type of M&A deal that you might be thinking of is what we call Strategic
M&A. So, strategic M &A is a deal in which you have an acquiring the target, there are
two companies. And, the acquirer buys the target and they become a single company.
This deal, as we talked about already, these strategic deals are usually driven by
synergies. And these are probably the most common type of M &A deals out that you
might have heard of. However, there are other types of deals that are important as well
that we need to discuss, and that we are going to focus on in our course. The, first one
are the private equity LBOs are leveraged buyouts, which is very important and of
growing importance is the market of growing importance, in many different parts of the
world. And then there are restructuring deals that we're going to talk about as well.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

Let's start with leverage buyouts. So what is specific about leveraged buyouts? So, the
name says everything right? So leverage buyouts, so as we're going to talk more about
as well, later we're going to cover LBOs in detail, but for now just think about the name
and then how it relates to different aspects. So, LBOs are typically paid in cash. So,
these are deals that are financed by debt. So, they tend to be highly leveled, and that's
where DL comes from, right? And then typically what happens is that these are deals in
which public firms are taken private. So that's the buyout part the public firm has has
stock outstanding. But what happens is that this, this firm is taking private. So, the
acquire buys out all of the shares outstanding in the market. And there is a third
characteristic that is very important as well, which is the fact that in LBOs the acquire is
typically not another company. The acquire is an investment company. That's what we
call private equity business, you know? So these are not companies that are, they are
neither in the same industry or or or or not even in a related industry. These are
investment business, okay?

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Professor Heitor Almeida

So, this is what private equity partnerships look like. You have the limited partners who
are the investors that provide capital, to the private equity forum. And then you have the
general partners who are the managers that are responsible for selecting investments.
What the general managers do is they use the cash that is invested by the limited
partners, to invest in these new business together with the leverage that is raised from
financial.

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida
Alright, so, and then there is a typical fee structure that the private equity works with.
There is some variation of course, but in general, what happens is the general partners,
the specialists who invest the money, keep 2% of the invested capital, and they also
keep 20% of the profits. So, if a certain deal generates profits for the private equity
company, 80% goes to the limited partners to any percent go to the general part.

Many companies that you know of are either owned by private equity through LBOs, or
they have been through LBOs in recent years. So for example, Budweiser, there are
other examples as well, but these are true examples of very well known companies that
are actually on that went through leverage buyouts in recent years. So like I said, it's a
very important market in the US, and it's actually of growing importance. I want to talk a
little bit about value creation in LBOs. There is an interesting question here that I
actually want you to think about. Now that we learned, the characteristics of level of
leverage buyouts, let's think about the following question right?

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 Finance of Mergers and Acquisitions:
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Professor Heitor Almeida

So we talked about synergies, and we talked about premium, when we were talking
about strategic M&A. In the case of leverage buyout, the premium is actually fairly
similar to what we talked about for strategic, I mean, this 30% number, right? The magic
number, that's actually similar in leveraged buyouts as well. The average premium,
stayed to target shareholders during this period of 1973-2006, it is approximately 37%,,
the median is 32. So, as you see very close to the 30% magic number.

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Professor Heitor Almeida
And here's the question, remember, the acquire is an investment company, this is not a
strategic deal. So ask yourself, are there synergies in leverage bio? And the answer is
not clear maybe there is no acquire, right? So, it's not clear how we can have 2 plus 2
equal 5, if there is no acquire right? There is no consolidation, there is no vertical
integration, it's basically an investment company, buying a business.

So, a very important research topic in finance and meaning it's important for us as well.
They have very important, practical implications, is what are the major sources of gains
in LBOs right? So, we have research on this, we have examples, what we know is that,
private equity funds are focused a lot on operational performance. So many LBO deals,
seem to be driven by increased efficiency, so basically, finding ways to cut costs.
Another possible motivation is what we call long term restructuring. So, there's this
notion that somehow moving away from public markets, remember in an LBO the farm
mistaken private. So moving away, from public markets like Dell, right? That's what
happened when the computer company Dell went through a leveraged buyout, allows
the management to execute a long term change in strategy, without having having to
worry about quarterly earnings report, having to worry about short term profits are all
right. So, it makes it easy to do a long term restructure.

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Professor Heitor Almeida

And then, finally there is the undervaluation as well, right? We talked about valuation as
a driver of M&A. There is yes, definitely an important motivation for private equity deals.
I mentioned already the war Warren Buffett's example, I like to think of Warren Buffett's
Berkshire Hathaway, as a private equity firm, that focuses mostly on other valuation. So
the idea is by cheap assets. If you can find the cheap asset, then you can generate
value even without spinoffs.

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Then there are also some other types of deals that have to do with restructuring. And
the idea here is that, companies divest assets almost as frequently as they acquire
them. Alright, so we tend to think of M&A as an acquisition, so you want to growth M&A
et cetera, but then there's the seller, right? Sometimes companies are selling
businesses, they're selling us. And there are three types of transactions that are
important in the M&A market. I mean two of them are more important than the third one,
we're going to talk about why. So, companies in some cases sell assets, and then
companies execute spinoffs, so what are these?

An asset sale is pretty simple. So it's a situation in which a company buys an asset from
another company. So, for example, you have here the example of Microsoft in 2012,
Microsoft bought patents that belonging to America online, right? So, here you have a
chart as well, the parent creates a subsidiary with the asset in the case of American
line, the patterns, and then these patterns are sold to a buyer, it's Microsoft, right? In
exchange, Microsoft pace, either with cash or stock, and give some payment to the
parent, in this case it's America Online, okay?

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Spin offs are more interesting, perhaps, that's a more financially term. What happens in
a spin off, is a situation in which assets are detached from the parent. And in this case,
there is not necessarily a sale, the in a pure spin off, the shares are distributed to
existing shareholders. So for example, in 2011 we had a very famous spinoff in the us
craft. The food business split into two separate companies. The global's neck business
that was called after the Spinoff was called Mandalas and the new craft, it maintained
the craft name, but it started to focus only on north american grocery business.

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So mandalas was spun off from from craft, but the shares belonged to the same
shareholders. So here is a chart for to make it to make it clear that, to make it more
clear for you, basically, there is no buyer in this case, so that the parents splits part of
the business, right? And since there's no new shareholders, the existing shareholders of
the parents are going to own both business. And, if a company splits into two, typically
what happens is of course, that the company changes. So that's why I like to think of
craft as a, as a situation in which you spin off Monolith, right? You spin off the global
neck business and then what's left is not really craft anymore right, it's the new craft. It's
a new craft that focuses only on North American growth, and that's typically what
happens in a spin off, okay?

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And then finally, there is this notion of an equity carve out, which is a combination really
of a spin off in an asset sale. What's happening in a carve out is that you have a spin
off, but then a fraction of the shares of the new company are sold to new shareholders.
So now we have, the subsidiary gets split, but then there are new shareholders that by
some of the shares in the subsidiary and then of course, give cash to the shareholders
of the parent.

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In terms of synergies, right? We talked a lot, we talked about synergies already. So in
the assets, say, okay, the synergies are very simple, right? There is no merger, but
what needs to be the case is that the assets that is purchased has to have a higher
value for the buyer than the acquired. So, in the case of Microsoft, for example the
patents that Microsoft bought from America Online, they have to be worth more for
Microsoft than for American Online, that's where the value creation comes from, right?
You're buying an asset that will benefit you more than than what it currently benefits the
sellers and in that case there is value creation, both parties can, can can gain from from
this transaction.

Alright, in spinoffs, the discussion is a lot more interesting because there is no buyer
writers, basically, companies is splitting into two business and if this creates value, if
this strategy creates value, then it must be the case that the two parts have to be worth
more than the original company. So for example, in the case of craft, the example, we
are using here, the new craft plus more the less, which is what the shareholders own
after the spinoff have to be worth more than the old graph. But this is interesting
because you know, in principle nothing changed, you just split the business isn't true.
So similar to leverage buyouts, there is an interesting question in spin offs, which is
really where does the value creation come from? If companies are executing spinoff, it
must be the case that in some cases they create value, but where does it come from?

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You might think that has to do with restructuring of the strategy management, etcetera
right? So for example, so graft may want, it may have wanted to restructure the global
neck business. And the question you have to ask yourself though, I mean, do you really
need to split into two companies in order to separate the global next from the grocery
business? And the answer is that that's not necessarily the case, right? You could do
that even inside the same umbrella, even inside the same company. You can give, for
example more autonomy to the management of the of the of the global next business.
Maybe don't call it Mondelez, but you have a separate ceo right? And you give the
management total independence and you can do the restructuring that way. But there is
a very important aspect of the spinoff, remember a spinoff? The situation in which you
are splitting the company into right? And what that means is that the companies will
then have distinct stock prices. So, both craft and Monda lairs are separately traded in
the stock market. And that can confirm advantages because it becomes easier to help
to measure the performance of the decisions right? So the, you know, you're going to
have the market discipline, you're going to have market measures of how the two
decisions are doing, You have distinct stock, right?

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And as we discussed it before, conglomerates are out of fashion, right? There is the
tendency in modern finance in the U S, and in other places in the world, is to split
business into focus part. And this has to do with spinoffs, because spin off is a very
common way through each company's split businesses by simply, creating two separate
business right? You don't necessarily have to have a buyer. And one argument that
we're going to go back to this in the course later as well, is that splitting business into
focus parts, can facilitate financial analyst. Analysts have to be able to analyze to
provide valuations to do forecasting, right? And when you have more focused business,
the analysts, the work becomes easier and that can create a premium for the valuation
of the company. So in some sense, this is financial engineering, right? So there is an
increasing value that really doesn't have anything to do with restructuring, it's simple
financial engineering.

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And finally, carve outs what we know in finances that equity carve outs are relatively
rare. In fact, you might have noticed, I didn't give any recent examples because there
really isn't a lot of well known examples. They're similar to spin off, so, you might ask
yourself why? The main difference is the ability to raise funds, but if you think about it,
maybe the ability to raise funds does not matter that much. That might not be a very
important driver, right? It's important to split companies into different business to
increase focus, improved valuation. But the ability to raise funds separately through the
subsidiary may not be that important companies could have raised funds even before
they executed the the the spinoff by pledging assets, for example. So that's a possible
explanation. This is one of the main reasons why finance academics. Explain, the fact
that carve outs are now relatively rare in the US?

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Lesson 1-3.2. Friendly vs. Hostile Deals, and M&A Regulation

Now, let's talk about negotiating an M&A deal. Suppose that a company is considering
whether to acquire a target or not, in principle, the acquirer believes that there are
significant synergies to be realized. As we learned, synergies are the main driver of
M&A. There is the potential for value creation, but we also need to think about the
negotiation process. How should the acquirer move, what should be the first step,
and I think this will lead to an interesting discussion in this section. The initial approach
for an M&A deal is always a friendly negotiation.

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That's always the first step that the acquirer takes, is to approach the board of the target
and propose the deal. It could also be that for some companies, for example, for a
private company, they may not have a board, you may just approach the owner directly,
or you may approach the largest shareholder. There are several reasons why a friendly
negotiation is optimal, why it's always the first approach. Let me just cite a couple here.
It's important to analyze the potential benefits of an M&A deal, it's important to analyze
data. The acquirer is going to need to do the due diligence to think about the prospects
of the target, to do some forecasting and the target company is going to have
proprietary data that you may not be willing to share. If you just go to Capital IQ, for
example, or any other data source, you're not going to have access to the same data
that the target can provide. The access to data is important, but maybe even more
important is that if you think about it, that's always an easier approach. Rather than
starting hostile, it's always easier to start with a friendly approach and it turns out we
have evidence that it's cheaper as well. Friendly deals then should be executed at lower
premium than hostile one.

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Since this is the first step, not surprisingly, what we've seen the data is that the vast
majority of deals is a result of a friendly negotiation, so 95 percent plus, so it's a little bit
more than 95 percent, in fact, are friendly deals. These are deals that are negotiated
between boards in which the board of the target agrees that the target should be sold to
the acquirer.

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However, friendly deals can still fail, and it's important that we identify the sources of
failure for friendly deals.

The first one is opposition from shareholders, the second is anti-trust regulation, and
then there is other regulatory hurdles as well.

Remember that a friendly dealing principle is a deal that is negotiated between the

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board of the acquirer and the board of the target. But if we're talking about large public
companies, then eventually these deals have to be approved by shareholders as well.
While this is not common, there are instances in which large shareholders may not
necessarily agree with the point of view of the board. This can happen both from the
acquirer's point of view and also from the target's point of view. There is a very famous
example in the history of M&A, which is the Hewlett-Packard Compaq merger.

This is a case in which Hewlett-Packard was buying Compaq as the acquirer and the
board of Compaq and the shareholders of Compaq were on board with the deal, they
wanted the company to dissolve. But the deal was opposed by one of the major
shareholders of Hewlett-Packard, who was actually a member of the founding family.
Walter Hewlett was a vocal opposer of the view and he managed to gather support from
many other shareholders. In the end, the HP-Compaq merger had to come to a vote
and 51.4 percent of the shareholders decided to approve. You can see this is a very
closely contested election. In the end, this deal went through, but it could have been
also the case with one percent of votes going the other direction, this deal would have
been stopped by shareholders despite the fact that it was a friendly deal that was
negotiated between the board. This is an important source of failure.

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Perhaps the most common one is antitrust. There are important regulatory agencies
that are on the lookout for deals that might not be desirable for society. Despite the fact
that deals might be good for companies in some cases, they may not be desirable for
society, and the name says everything, antitrust. I think that's going to give you a hint
about the question I'm going to ask you to think about here. In the US, the regulatory
agencies that oversee the M&A market are the Antitrust Division of the Department of
Justice and the Federal Trade Commission.

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We already learned the different types of M&A deals, LBOs, strategic M&A, vertical,
horizontal, et cetera. This is a good opportunity for you to think about what you learned
and try to answer this question. Which type of deal is most likely to be blocked by the
DOJ or the FTC? Clearly, the DOJ and the FTC are going to be focusing mostly on what
we call horizontal view. Those were deals that happened in the same industry. There
are motivated by consolidation and market power. Market power allows companies to
raise prices. While this may be good for the companies, it's probably bad for consumers.
The mandate of the DOJ and the FTC is to make sure that deals that are really bad for
consumers are not allowed to happen.

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There are many examples of deals that fail because of regulation. The role of regulation
can be actually more important than what it seems because in some cases what
happens is this notion of threat. Even if a deal is not explicitly blocked, companies know
that the DOJ and the FTC are out there and that they may block deals so when they are
negotiating deals, the acquirer and the target have to think about the likelihood that
these deals is going to be blocked by regulators. If they think that the deal is very likely
to be blocked, then it's not worth thinking about it to begin with. You might never see the
DOJ and the FTC in action even if they are very effective, so it might be through threat.
However, there are examples of deals that were blocked by regulators, specific
instances in which companies thought that they could pull it off but then in the end,
these deals were blocked.

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In the healthcare industry, there is a recent example of a failed merger between Aetna
and Humana. Then there is a similar case in which the Staples/Office Depot merger
was blocked on antitrust basis as well. There are examples. Then there is another
regulation.

By that, I really mean politics that may not necessarily have to do with antitrust, but
politicians do have a broader role in affecting the M&A market. Two recent examples

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are the Qualcomm-NXP merger that it's as we know. This is probably not the official
story, but what about everybody believes is that this deal was blocked by the Chinese
government, presumably because of antitrust. But really the real reason was because of
the trade war. It was a way of giving it back to the US government. Then the Chinese
government decided to block the deal. Then there is the Pfizer- Allergan merger in that
happened in 2016. That one was blocked by the US, by the Obama government, was
the president at that time because one of the motivations of the deal was to move the
headquarter of Pfizer to Ireland. It's a deal that is motivated by taxes and the Obama
government didn't really like this idea, and it put enough pressure that this deal was
basically Pfizer and Allergan gave up on the deal even before it came up for antitrust
review.

Politics have a broader role as well. Now we need to talk a bit about hostile deals. The
initial approach is always friendly, 95 percent of the deals are friendly. But there are
some really interesting examples of hostile deals that we need to learn about as well.
Hostile deals are those in which the board of the target does not agree to the deal, so it
becomes hostile. The acquired tries to buy the target, but then the target says no, we
think this is a bad idea.

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Hostile deals have a typical timeline and then there is some terminology here that we
need to talk about as well. Toeholds, that's typically the initial approach which is
basically buying shares in the market. A question I always get from students is, why
can't the acquirer simply buy target shares in the market? If the board doesn't want to
sell we can just go to the market and buy the company. It turns out that this is illegal.
There are laws that protect targeting investors from this market approach. In fact, in the
US, for example, any investor who acquires more than five percent of the shares of any
company has to disclose the intentions. If your intention is to ultimately gain control of
the company, the moment that the investor crosses the five percent threshold, you have
to disclose interests, and then it becomes an M&A.

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Regulators do not allow you to just go in the market and buy shares. Five percent is the
maximum, that's what we call toehold. In many cases, companies buy this initial stock
as an initial approach, and then you have to stop there because you can't get more than
five percent. Then you have the bear hug, is one of the more interesting terminology in
M&A.

The idea as we learned is that to buy more than five percent, you will have to formalize

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an offer. You can't just buy in the market, you have to make a formal offer.

Before you actually formalize the offer, what buyers typically do is they try to approach
the board with a public proposal. The details here matter. We talked about a friendly
approach is a board-to-board approach that is not public, that is private. You actually
don't want the shareholders or the newspaper, the market to learn about this. But in the
case of a bear hug, the goal of the acquirer is to make the attempt public. The acquirer
goes out in the newspaper, for example, and says, look, I want to acquire Company X at
a 30 percent premium. The advantage of that for the acquirer is that that's going to put
pressure on the board and the shareholders of the target. That's why we call that a bear
hug. You're really putting pressure because now the board has to do something about it.

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Then we have the tender offer. That's the final tool that acquirers have. The tender offer
is a formal offer. It's an offer to buy shares directly from target shareholders bypassing
the board. Remember, these are hostile deals. The board doesn't want to sell. But the
M&A markets in most countries allow acquirers to buy companies directly in the market.
Of course, the tender offer is subject to very strict regulations. As we're going to learn
later on in the US, there is something called the Williams Act that's passive, that has
very clear rules about what acquirers and target can and cannot do in the middle of a
tender offer battle.

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Then of course there is outcomes. One possible outcome is that the shareholders
basically vote. It's an offer to buy shares, the shareholders can decide whether to sell or
not, that's essentially a vote in the merger. Or in other cases, what happens is the board
capitulates. The board gives up. This is an unfriendly board that when the tender offer is
out there and the board realizes that the deal is going to happen anyway, it may be in
the interest of the board to just capitulate and sell the vote. Here's an example. It's a
famous example of a tender offer of a hostile deal actually in general.

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It's the acquisition of Cadbury by Kraft, and the timeline is a good example of what
we've talked about. In August 28th, 2009, Cadbury's board rejected the friendly
approach. So Kraft CEO approached the Board of Cadbury proposing this deal, but
Cadbury decided that this was not in the best interest of the company. Then the next
move is the bear hug, so on September 7th, Kraft decided to make the bid public.
Remember, this is not a formal offer yet, it's basically an announcement to the public
that Kraft is looking to acquire Cadbury. That again was rejected.

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That leads to the final step, which is the tender offer. In November 9th, Kraft made a
formal offer. This is really when the bid becomes officially hostile, but it's been hostile
ever since the Cadbury board rejected it. They were in the same terms of the initial bid,
but Cadbury again rejected the offer as derisory, so the price is too low. However, in
January 20 of 2010, what happened is capitulation. The board of Cadbury gave up
realized that this deal was going to happen no matter what, and Kraft and Cadbury
ended up agreeing to a sweetened deal. Kraft raised the price, Cadbury decided to sell.

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One of the key issues in corporate governance that we're going to talk about later in the
course is why do deals become hostile. It's actually a very interesting corporate
governance research topic in finance. Think about it. There is a very significant
premium. M&A deals happen at 30 percent. If you sell a company to an acquirer, your
shareholders, immediately they make 30 percent premium. Why would a board reject
that? It may be that is because of valuation. There is a premium, but if the target is
undervalued, it may be the case that even the 30 percent premium is not really a fair
valuation for the target. Or the board of the target may think that they were able to
negotiate a higher price. That is a valuable reason why a board of a target may say no,
is just basically trying to get a higher price. But then there is also what we think of as an
agency problem. In some cases, the reason why deals become hostile is because the
board of the target may not be acting in the interest of the shareholders. They may be
trying to protect the management rather than maximizing shareholder value. Later on,
we're going to talk about this tension and what do we know from finance research
regarding this.

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Lesson 1-4:

Lesson 1-4.1. A Brief History of M&A

Let's talk about history now and some basic facts that we know from the history of M&A.
The first one is that M&A activity tends to come in waves and it becomes clear. Anytime
you see a picture of M&A activity, what you see is over the years, there are periods in
which the M&A market is very active, and then the M&A market dies down. There are
periods in the 1960s, in the 1970s, there's these different waves and any chart that you
look at is going to show you this. There is this chart, for example, shows you that there
was an M&A wave in the 1960s. Then there is another M&A wave in the end of the
1980s. There is another M&A wave here at the end of the period, at the end of the
1990s. We're going to talk about these waves in a second.

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Then if you go forward, you see that there is another wave here at the end of the 1990s,
the beginning of the 2000, and then finally, even more recent data will show you that
this tendency of M&A to come in waves is still there.

There are two recent M&A waves, one right before the financial crisis and then an M&A
wave that ended up with the COVID 19 crisis in 2020.

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In fact, this M&A waves have names in the finance literature. The M&A wave of the end
of the 1960s is typically called the conglomerate wave. That is the time when the big US
conglomerates were created, like General Electric for example, where companies were
buying business in non-related investors. In the mid 1980s, what happened is what we
call the first leveraged buyout wave. This is the time when the junk bond market was
actually invented by Michael Milken and that allowed leveraged buyout deals to be
financed. So many companies were restructured through leveraged buyout. The end of
the 1990s is, of course, the Internet wave. That's when the internet became big
business. Of course it ended up leading to the crash in 2000. In the mid 2000s, right
before the financial crisis as that wave ends in 2007, we call that the second leverage
buyout wave. The wave of M&A deals that happened right before the 2008 financial
crisis is characterized by having a very significant fraction of leverage buyout. Then
there is a wave at the end of 2010s and this has been called the wave of mega deals.
This is a wave in which there is a lot of consolidation and companies are trying to
increase market power.

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You might be asking yourself, why does M&A come in waves? Why don't we have a flat
picture? There are explanations in the finance literature. Possibly the most important
one has to do with industry shocks. There are technological, economic, or regulatory
changes in specific industries that drive M&A wave. For example, the Internet wave is
pretty easy to understand. The Internet is created. That's going to lead to a lot of activity
companies trying to gain advantage by Internet business, creating new business and
selling to other companies, etc., so technology is a big driver.

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Regulation or deregulation can be a big driver as well. For example, the deregulation of
banking in the mid 1980s is well known to have been an important contributor to the
wave of M&A deals in that time. Then there are economic shocks. At the end of the
2010s, what seemed to have happened is that the benefit of consolidation increase in
several industries and that layered companies to try to merge with competitors, try to
increase their market power.

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All of these sources could be examples of shocks that create M&A wave. The other fact
that we know is that M&A waves tend to be associated with high valuations and low
interest rates. At times, M&A waves happen are typically times when stock markets are
in the boom. Why? One possible answer has to do with financing, which is something
we're going to talk a lot, later on in the course we're going to discuss the financing of
M&A in detail, but briefly now M&A deals can be paid with either cash or stock.

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Cash is, of course, typically raised by issuing debt. When companies pay in stock,
they're basically issuing stock to pay for the target. At first glance, it seems that M&A is
easier to finance when stock prices are high and interest rates are low because you are
paying with stock or you're borrowing money. That's a simple explanation for why these
waves tend to coincide with the boom periods, but it's not clear. If you go a little bit
deeper on finance theory, it becomes a little less clear that is the case.

One very simple argument is that, acquirer prices are high because we are in a boom,
but the target prices are high too. As we discussed that our evaluation is important is
much better to buy a cheap target than an expensive one. The fact that stock prices are
high is not necessarily a reason why you're going to see a lot of M&A deals. The other
notion is that we know in corporate finance, it might seem intuitive this notion of low-
interest rates, but really there is no such thing as cheap there. The fact that interest
rates are low doesn't really mean that is more beneficial to issue debt. In fact, if you look
at the history of leveraging, the US leverage tends to be higher when interest rates are
high in nominal terms, that's something we're going to talk about later in the course as
well. It's not clear that this is a good explanation. More broadly we've discussed this
concept of synergies. Do you know synergy should be the main driver of M&A?
Synergies don't really depend on financing conditions, it has to do more with whether
you can create value by merging two companies together.

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The synergy cash flow, in principle, is not going to depend that much on whether the
stock market is high or low but here's an important idea. Did the net present value of the
synergies rise? We're going to learn later when we value synergies how to calculate the
net present value of synergy, and what we're going to learn is that the net present value
of synergies can go up even when the cashflow doesn't change. That happens because
the discount rates depend on market risk premium. We have some evidence in finance
that suggests that risk premiums tend to increase in bad times and by the same token,
they can decrease in good time. In the bad times when the stock market is loaded, the
net present value of synergies can change as well, so that's a possible explanation.
Then there are explanations that are more behavioral in nature. Behavioral finance, of
course, has become a very important branch of finance.

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And there are several theories and arguments trying to explain how the cyclicality of
M&A can be affected by behavior. Let me give you an example, suppose you are the
CEO of a target firm. Your stock price was $40 a share on December 19, and then we
know what happened in 2020, is the major COVID 19 crisis in particular, in the
beginning of 2020, in April when the lockdown started. That's why the stock markets fail
a lot so now your stock price is down to $10 a share.

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Valuation and Pricing
Professor Heitor Almeida
Suppose an acquirer approaches with an offer to buy your company at 15, so remember
your stock price was 40 back in December it came down to 10, and now the acquirer
wants to buy it at 15. Just think about this for a second should you accept or not?

Also the premium looks pretty attractive, it's a 50 percent premium, which is higher than
the [inaudible] a premium of 30 percent. But what we've seen that data is that most
companies are actually not going to sell at that price. What happens is that the $40 that
the company was worth in December it works as a reference point as well. The target
shareholders, they don't think that company is worth $10 you still remember that $40
valuation. It seems that selling at 15 may be a bad idea.

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Valuation and Pricing
Professor Heitor Almeida

In fact, there is a very famous paper in finance that finds that the targets actually tend to
look at the 52-week high, so target shareholders will look at the entire year, the previous
year, and look at the high price, let's say it's a $40 we talked about, and they are not
going to sell if the offer is less than the 52-week high. That's clearly a behavioral story
because the past shouldn't really matter, you had COVID-19. The world changed it, your
stock price may not be worth $40 anymore, but the target still think about those, about
the $40 there's a very important reference point for a medium.

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Valuation and Pricing
Professor Heitor Almeida

Since we're talking about COVID-19 what we saw is of course, that the M&A market
basically collapsed during 2020 and you can think of this as a case study for some of
these arguments we talked about. It's clear that synergies didn't go away. If deals that
were good before COVID-19, we're probably still good, the grade was not expected to
last forever. Synergies are still there but the arguments we talked about are important.
Risk premium went up, the valuations, the net present value of synergies could be low,
valuations were low, so maybe targets were unwilling to sell at low stock prices, and
financing was tight. Despite the fact that there is no such thing as cheap there, if it's
very hard for companies to raise financing that might impose constraints on the M&A
market as well.

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Valuation and Pricing
Professor Heitor Almeida
Lesson 1-4.2. Does M&A Create Value?

As we talked about in this module already, M&A deals are typically priced at a 30%
premium. The target shareholders get a 30% premium for their shares, meaning that the
equity value of the target should go up at least by that amount. But we can also look at
data right, to see what happens in the data, is it the case that that many deals do create
value of this magnitude?

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Valuation and Pricing
Professor Heitor Almeida

And really there are two ways we can look at this, the first one is value creation
according to the management. And what happens is when an M&A deal is announced,
management will often announce the expected increase in future profits or cash flow.
So this is what we call the synergy, cash will remember the concept of synergy is the
idea, this new by two plus two, equal five. The the news cash flow that is created by the
merger managers will typically announce it. And what we can do is we can use these
cash flows to come up with the net present value or NPV of the synergies.

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Valuation and Pricing
Professor Heitor Almeida

And what we should expect is that the NPV of the synergy should be greater than the
premium because otherwise the acquire is not going to make money by executing this
acquisition.

So, what I want to do is to look at an example which is the acquisition of Bucyrus by

Caterpillar in 2010. Again, what happened is if you look at the data for that acquisition,
the management of Caterpillar gave us an estimate. At that time before the deal was

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Valuation and Pricing
Professor Heitor Almeida
was executed, Caterpillar estimated that the deal was going to create more than 400
million in annual synergies beginning in 2015. As we discussed already, synergies
come from different sources in this case, Caterpillar was talking about the combined
financial strength. And the complementary product offerings of the combined mining
equipment businesses of CAT and Bucyrus.

What we can do is we can use these schedules to come up with a net present value.
This calculation is an important calculation in NMA and they were going to have lectures
in the future in which we're going to talk about how we do these calculations. If you
know how to calculate NPV already, you can go ahead and try to do it. If we do the
calculation the NPV of the synergies come up to around $3 billion dollars as of the end
of 2010 when the acquisition was announced. And if we compare it to the premium, the
premium paid for Bucyrus in dollars was 1.8 billion. So, supposedly Caterpillar is making
$1.2 billion the NPV for the acquire is the difference between the synergy and the
premium. Again, this is something we're going to go back to later on in the class.

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Valuation and Pricing
Professor Heitor Almeida

Is the management right, is it the case that this deal really creates $1.2 billion and the
answer is maybe right. This is based on an estimate, this is based on a forecast that
managers make at the time of the acquisition there is a turns out there is another source
we can look at. We can also look at the market, we can look at stock price, one of the
key concepts of finances that if an investment is positive net present value. If the deal in
this case is positive NPV, then stock prices should increase. The market should react to
the announcement of the deal by increasing the stock price of Caterpillar of the
acquired.

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Valuation and Pricing
Professor Heitor Almeida

And it turns out that we can use market efficiency to look at the announcement to the
deal, right? Market efficiency implies that the market should immediately incorporate the
information about the value creation associated with this deal. Meaning that we can ask
ourselves, how did the stock prices of the acquire and the target as well change on the
date that the market learned about the deal? So in essence, we are looking at the
immediate effect on stock prices. If markets are perfectly efficient, that should be one of
the best ways to gauge the effect of the deal on value creation, right?

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Valuation and Pricing
Professor Heitor Almeida

So in the case of CAT and Bucyrus, we have the data here. The data is in dollars, this is
total equity value rather than stock prices, Caterpillar closed on November 12, 2010,
that was a Friday at $51.4 billion. Bucyrus closed As $5.6 billion, that was again the
equity value for those two companies. When the market opened on November 15, the
stock price of Caterpillar actually decreased a bit. So you can see that CAT opened at
$50.7 billion, Bucyrus opened at 7.3. So a significant increase in the value of the target,
if you're sum CAT and Bucyrus, remember two plus two equal five, right. So were kept
to sum of the companies, the differences, the synergy, right? Then what you find out is
that the value of the company's combined went up by $1 billion, right?

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Valuation and Pricing
Professor Heitor Almeida

So, it's interesting to compare these data, right, according to the management of
Caterpillar, the NPV of the synergy was $3 billion. And given the premium of 1.8, that
gives us an NPV for Caterpillar of 1.2 billion is the difference, right? But according to the
market, the NPV of the synergy was only one billion, the market was significantly less
optimistic about this deal, meaning that the net present value for CAT was -0.8 billion.
So, the market was actually calculating a negative, so that the market's estimate for the
NPV for the acquiring this case is negative and that's why the stock price went down,
right. The market believes that this due is destroying value for Caterpillar.

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Valuation and Pricing
Professor Heitor Almeida

You might think that this is not typical, I just came up with weird example, but it turns out
that this is a fairly typical situation. We have significant research in M&A that we can
look at, looking at what happens to acquire stock prices and targets as well, right?
When M&A deals are announced and what the research finds is that on average
acquire stock prices typically do not increase when an M&A deal is announced. And of
course, the management begs to disagree, the management always thinks that the
market is wrong, okay?

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Valuation and Pricing
Professor Heitor Almeida

If we look at targets, on the other hand, it's pretty clear that deals are going to be
positive NPV for targets, right? Their targets will always earn a significant premium,
right? As we discussed already, the premium is on average, 30%, so if you look at the
data, the announcement return for targets is significantly positive. So targets make
close to 20% on average when the deal is announced.

But when we look at acquires, as I mentioned out already, what we see is that on
average, there is no reaction. So, stock price will acquire forms when deals are

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Valuation and Pricing
Professor Heitor Almeida
announced that actually does not change, the bottom line then mergers do create value,
right? But according to the market, most of all of their games are actually going to the
target form. One way to interpret this is that the acquires are paying too much, right. On
average, the acquirers are transferring all the NPV of this synergy to the target and they
are left with nothing, they're left with zero, right?

You might think now, okay, this is just the average, right, and it's true, it's just the
average. In fact, we do have evidence on different types of deals and we know from
finance research that some deals actually do better than others. For example, we can
divide deals into cash and stock, right? So acquires can pay cash and acquires can pay
by issuing stock, which is again something we're going to study later in the course as
well. What we see is that cash deals generated 0.7% increase in the acquire stock
price. So, acquires do make money when they pay cash on average, it is the stock
deals that generate that are the bad ones. Okay, so stock deals generate the -2.3%
decrease in stock prices on average. So, you might be thinking at this point, why is it
that acquires pain stock, right? If these deals are typically bad, then that's something
we're going to talk about later in the course as well.

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Valuation and Pricing
Professor Heitor Almeida

The other piece of research that we know is that acquiring private targets generates
higher returns for the acquired than acquiring public targets. So when the target is
publicly traded, these deals tend to be worse. And again, there's a very interesting fact
that we're going to go back to later on in the course as well, but that's another sort of
important variations.

So, when you look at the data, they returned to private acquisitions ranged from 1 to 3%

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Valuation and Pricing
Professor Heitor Almeida
on average, whereas returns from public acquisitions range from 0% or nothing right to -
3%. So private deals tend to do better than public. Okay, so those are just two
examples, and so far we've looked at short term stock price react. And you might be
thinking, our short term is right. It's not only about the short term, what we really care
about is the long term. We should be able to look at long term stock prices should
decide, for example, in the case in which there is a disagreement between management
and the market.

So the management thinks it's a great deal the market does not, stock prices in the long
term should decide, right? So, we should be able to tell, it turns out though that
interpreting long term returns can be very difficult. It is very simple to look at an
announcement return and interpret what it means because in the day that an M&A deal
is announced, it's very uncommon that there's other things happening that will drive that
will cause such high changes in stock prices. For example, targets are going 20% up
and it's very unlikely that this is confounded by other factors. But when you look at the
long term, there are many possible confounding factors.

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Valuation and Pricing
Professor Heitor Almeida

So for example, we can look at the long term stock price reaction of Caterpillar. So what
happened to caterpillar stock prices in the long term, right, this is what this graph is
showing you. And if you interpret the graph, what you learn is that right after the merger,
Caterpillars seem to be overperforming the index. So in this case, what I used in the
graph is this SNP construction and engineering index and we see over performance.
But, how do we know that it's because of the merger, it's a two year period.

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Valuation and Pricing
Professor Heitor Almeida
There are other things happening in the economy, there are other things happening with
Caterpillar, there are other things happening to the industry. It's very difficult to separate
the part of the return that comes from the merger itself. And then if we look two years
later, then CAT starts underperforming the index. Again, it's an interesting observation,
but we really cannot measure what part of the other performances coming from the
merger. So, because of these confounding factors, it is very difficult to look at long term
return.

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Valuation and Pricing
Professor Heitor Almeida
Module 1 Review

Module 1 Review

What have we learned in this module 1? So we talked about many interesting concepts
and evidence about M and A. We started talking about synergies, right? So we learned
why synergies are the main driver of value creation in M and A. And we talked about
how to distinguish between good and bad reasons to engage in M and A as well. So
what are real sources of synergies? And what are dubious or wrong arguments, wrong
reasons to engage in M and A? Then we talked about how to distinguish between
leverage buyouts and strategic M and A deals.

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Valuation and Pricing
Professor Heitor Almeida

And we also discussed other options that companies have to restructure operations
such as spinoffs and asset sales. Then we talked about hostile youth, right? We learned
the difference between friendly and hostile M and A deal. And then we talked about
history. We talked about the fact that M and A activity comes in well defined waves. We
talked about the names of some of these waves and the specific characteristics.

One thing we know about M and A waves is that they tend to cluster in specific

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Valuation and Pricing
Professor Heitor Almeida
industries each time. For example, the wave at the end of the 1990, it was the Internet
wave etcetera which characterized that I think pretty much every M And A wave that
happened since 1960. Then we learned how to measure value creation. How do we
know whether it do creates value or not according to the stock market.

And then we talked about some facts, right? We have empirical facts from research that
show us that while targets clearly gained from mergers acquirers often do not. And then
we talked about the fact that certain types of deals appear to create more value for
acquirers than other types of deals. For example, cash private deals are better than
stock deals for public, right? This is just an introduction to M and A right? We're going to
talk about many of these other ideas later on as well, but I think this first module is
important because it introduces a lot of the terminology where we're going to use and
gives us an overview for many, many issues we're going to discuss later on as well.

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