LUBIN SCHOOL OF BUSINESS
Pace University
Fin 648 Mergers and Acquisitions
Prof. P.V. Viswanath
Spring 2006
Final Exam

Notes:

1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
3. You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
4. You must explain all your answers. Answers without explanations may get no points or be heavily penalized.

Here are three articles from the BBC website. The first one is from April 13, the second from April 28, and the third from May 4, 2006. Read the articles carefully and answer the questions that follow:

Mitchells & Butlers spurns offer
13 April 2006

The pub group behind the All Bar One and Harvester chains has rejected an informal £2.7bn takeover approach from a private equity consortium.
Mitchells & Butlers (M&B) said it would not consider a takeover until it got a formal written offer from the R20 group, led by tycoon Robert Tchenguiz. The consortium said that M&B had refused to discuss any deal. News of the 550p per share approach sent M&B shares up 7.3% to 497.5p by the close of Thursday trading.

Formal offer
The pub chain emerged as a potential takeover target for Mr Tchenguiz in March, and the Takeover Panel had given him until 8 May to make a formal bid or walk away. R20 said that its offer for M&B would be funded through a mix of equity and debt, and said it could fully fund the pub group's pension deficit. It said it would make the bid formal if it was allowed to undertake further due diligence work and get approval from its financing banks and consortium members. It also needed the M&B board to recommend its offer to shareholders.
According to the Financial Times, R20 has been told to come back with an offer of at least 600p a share, valuing the pub group at £2.94bn. M&B operates more than 2,000 sites and was created when former Bass company Six Continents demerged its hotels and retail divisions in 2002.

M&B confirms Beefeater interest
28th April 2006

Pub and restaurant chain Mitchells & Butlers has confirmed reports it is considering buying 250 Beefeater and Brewers Fayre outlets from Whitbread.
Mitchells & Butlers (M&B) made the announcement as it unveiled a 4.3% rise in quarterly sales, and said it could return up to £500m to investors. Whitbread said on Tuesday that it was selling the under-performing sites. M&B owns the Harvester and All Bar One chains. Earlier this month it rejected a private equity takeover approach. The £2.7bn offer on 13 April came from the R20 group, led by tycoon Robert Tchenguiz.

Debt increase?
M&B chief executive Tim Clark said on Friday morning that the planned £500m return of capital to investors could be scaled back if it buys the Whitbread assets, which are valued at £450m. Investment bank Morgan Stanley said that M&B might choose to buy the Beefeater and Brewers Fayre outlets by raising its debts, thereby still allowing it to return between £250m to £300m to shareholders.
M&B's like-for-like second quarter sales rose 4.3% in the 13 weeks to 22 April, an increase on the 4% rise seen in the first quarter, it said in a trading update. The company operates more than 2,000 sites and was created when former Bass company Six Continents demerged its hotels and retail divisions in 2002.

Pub group M&B snubs bid approach
Thursday, 4 May 2006

Pub and restaurant group Mitchells & Butlers has rejected a £2.7bn ($4.97bn) takeover approach from a consortium led by tycoon Robert Tchenguiz. M&B, which owns the Harvester and All Bar One chains, said the offer undervalued the business. The group operates about 2,000 outlets across the UK. M&B emerged as a potential bid target for Mr Tchenguiz in March, and the Takeover Panel had given him until 8 May to make a formal bid or walk away.

Bid defence
M&B's board met to consider the 550-pence-per-share offer from Mr Tchenguiz's R2O consortium on Wednesday night. The R2O offer proposed combining M&B's pub estate with that of the Laurel Pub Company, which is owned by Mr Tchenguiz and includes the Yates's chain of wine bars.

However, setting out its reasons for rejecting the approach, M&B said its like-for-like sales - a measure which strips out the impact of new outlets - had grown at the fastest rate in the sector over the past two years. It added that sales had risen by 4.1% in the first 29 weeks of the current financial year.

"The board believes that the company has excellent prospects for organic growth and is well placed to take advantage of further consolidation opportunities," the company said.

Questions:
1. (15 points) What connections can you make between the different articles? Focus on strategies that can be employed by targets in a hostile takeover; use theories/analyses developed in class and in the text.
2. (15 points) Comment on the structure of the offer made by R2O for M&B.
3. Here are the closing prices (see below) for M&B stock (from Reuters):

a. (10 points) You need to perform a bargaining range analysis. What date would you use to compute the bargaining range?

R2O is a consortium and is not traded on any exchange. However, treat column 3 as the price per share of R2O, also quoted in pence on the London Stock Exchange, for the purpose of this question (100 pence make a pound(£)). MAB had 490.57 million shares outstanding. Assume that R2O had 540m. shares outstanding. For the purpose of this question, use the closing prices for April 3, 2006. You are told that the parties have estimated the value of the combined firm to be £4.492b.

b. (10 points) What is the amount of the estimated synergy?
c. (10 points) What is the minimum exchange ratio that would be acceptable to MAB shareholders, assuming that they do not have any alternative to R2O’s offer (other than going it alone)?
d. (10 points) What is the maximum exchange ratio that R2O would be willing to offer?

4. (20 points) Suppose MAB believes that demand for beer worldwide will be rising over the next year, and, as such, it demands a higher price for its shares. R2O does not believe that this is so. If this is the main source of disagreement between MAB’s management and R2O, how can they come to an agreement?

5. (20 points) Read the following article from the Economist of April 6, 2006 and answer the following question:
Why are there more hostile deals in this cycle of mergers and acquisitions? Explain with reference to the two theories discussed in class of profiles of hostile targets.

Once more unto the breach, dear clients, once more
WHITE knights, suitors, raiding parties, poison pills—the mergers and acquisitions (M&A) boom is in full swing, with all the usual swashbuckling imagery. This week alone, there was plenty of action. Alcatel and Lucent, two telecoms-equipment makers, ended five years of dallying with a €30 billion ($36 billion) Franco-American deal. General Motors offloaded 51% of its financing arm, General Motors Acceptance Corporation, to a consortium led by Cerberus, a distressed-debt fund turned private-equity firm. And Sir Richard Branson may net about £700m ($1.2 billion) in cash and shares from selling his stake in Virgin Mobile, a mobile-phone company, to NTL, a cable operator.

The pace of dealmaking in the first quarter of 2006 was feverish. Globally, the value of M&A averaged $10 billion a day, the highest for six years (in other words, since the height of the dotcom frenzy). This time, Europe accounted for more activity than America. According to Dealogic, a data provider, purchases of European companies added up to $418 billion, the most ever in a first quarter and more than twice as much as at the start of 2005. In America the total was $311 billion, up by 5% on a strong quarter last year.

Globally, the deals were big and brass-knuckled: led by AT&T's $67 billion acquisition of BellSouth, 14 were worth more than $10 billion; and many more bids were hostile than in the recent past. But in contrast to the last merger boom, deals were far more likely to be financed by cash than by shares. Two-thirds of all M&A in the quarter was cash only.

It is partly this use of cash that encourages bankers to claim, as they so often have in the past, that this time is different—that these transactions will not end up destroying value for everyone (or almost everyone: the bankers themselves always seem to come out ahead). Cash, indeed, is abundant, debt is cheap and equity markets so far have applauded many mergers, so the bankers have half a point. But it is human, as much as financial, frailty that has undermined many deals in the past—and it may be only a matter of time before once again, fear and greed trip corporate chiefs into a new cycle of excess.

For now, however, the financial underpinnings of the takeover boom appear more solid than at comparable times in the late 1980s and late 1990s. Companies in America and Europe have been through a long period of cost-cutting and balance-sheet repair since the dotcom boom ended. This has helped generate bumper profits and cash, which shareholders have decided they can trust companies to spend wisely—through either capital expenditure or acquisitions. “In the last 18 months, the equity markets have done a 180-degree flip,” says Anthony Burgess, head of European M&A at Deutsche Bank. “They've become very positive about giving management the licence to do M&A.”

By way of illustration, consider how stockmarkets have taken the rare step of rewarding predators for their bravery, as well as pushing up the share prices of their prey. Frank Yeary, global head of M&A at Citigroup, notes that the share prices of companies in the S&P 500 that have recently launched takeover bids worth $1 billion or more have outperformed the market in the 90 days after deals are announced. One reason for this unusual performance, he believes, is that takeover premiums have been modest. The difference between an offer price and the target company's previous share price is averaging around 20%, compared with 35-40% at past peaks of merger activity, he says. “It's a good environment to do deals.”

Another reason for encouragement from shareholders is the cheap, plentiful debt that companies are, for the moment, able to use for deals, thereby lowering the cost of capital and increasing earnings per share. Although bankers are reluctant to say that there is a credit bubble, there are certainly signs of one.

For a start, it is easy to raise money even if the leverage cuts a borrower's credit rating. Credit quality is thus starting to slip. For example, Standard & Poor's, a rating agency, notes that the number of AA-rated (ie, very creditworthy) issuers has slid from 39 to 23 since 2001, while the number of much riskier BB credits has doubled.

Listed acquirers are having to dig deeper to compete against private-equity rivals flush with debt. Already, there are signs that the listed buyers are starting to gain the upper hand, as they should with the cost savings they can expect to make. According to Dealogic, the value of private-equity-backed M&A shrank to 14% of the total in the quarter just completed, compared with more than 25% in 2004.

Companies are being told that they have too little debt on their balance sheets. Last month analysts at Goldman Sachs estimated that European companies alone could draw upon €630 billion of funds, partly by raising their ratio of net debt to equity to the long-run average of 43%. That is equivalent to more than 8% of the value of Europe's stockmarkets.

Companies that might otherwise balk at taking on more debt are being told by silver-tongued bankers that there are good reasons to do so. One such was Linde, the German chemicals company which made an agreed €11.6 billion takeover of Britain's BOC that will, if not blocked on antitrust grounds, create one of the world's top industrial-gas companies. The takeover will enable it to remove overlapping costs, and its increased size may also give it pricing power.

Bankers say such “horizontal integration” is a prime reason why dealmaking is busier in Europe than in America. In the United States, industries such as telecommunications and defence have already been consolidated and now contain only a few enormous companies. In Europe, only now is cross-border integration happening with the zeal that had been expected at the birth of the euro.

For the moment, the bulk of cross-border activity in Europe has been in utilities and energy, two industries that have raised the hackles of protectionist politicians, especially when the bidders come from abroad. In a few instances activist shareholders, too, have voiced opposition to transactions. VNU, a Dutch business-information group, is facing its second shareholder rebellion in less than six months.

But generally, as long as deals look as if they will create industrial powerhouses, cost synergies or pricing power, the markets are still supportive. They will stay that way until money gets tighter, profits ebb or managers lose their heads. The trouble is that, on past form, it wouldn't be surprising if all those things happened at once.

Solutions

1.We can conceive of different classes of strategies -- one, strategies that decrease the perception of intrinsic value of target to attacker; two, increase the price paid by attacker; three, increase transactions costs of attacker by defensive litigation and defensive appeals to regulators.
In the case of M&B, we see the target using primarily strategy one. Paying a dividend of £550m. could reduce the value of M&B to R2O because it would have less liquidity. Buying the Beefeater and Brewers Fayre outlets and taking on additional debt would also essentially fall in the same category.
It is very clear in this instance that M&B is reacting to the takeover attempt by R2O because it is only two weeks after the announcement of the offer from R2O, that we see M&B considering its own investment and dividend distribution plans.

2. R2O is offering cash, which is quite suitable for a hostile acquisition, which is what this is developing to be. Clearly, R2O realized this even when it made its initial informal bid. With cash, the target shareholders will be more likely to accept the bid, since there is no uncertainty of the value of the bid. The cash tender offer could probably also be prosecuted much more quickly, thus giving M&B less time to find a white knight.

3. a. The initial offer was made Thursday, April 13th. Prices after April 13th would, obviously, be affected by the market's evaluation of the likelihood of success of the acquisition. Hence the date to use to perform a bargaining range analysis would have to be based on prices as of April 12th, 2006.
b. According to the prices on April 3, 2006, the value of R2O is 540x351.68 or £1.899b. The value of M&B is 490.57x485 or £2.379b. The sum of the values of the two is £4.278b. Hence the amount of the estimated synergy is £4.492b. - £4.278b. or £213.66m.
c. MAB shareholders would want to end up with a share price greater than 485p. With an exchange ratio of e, the price per share of the combined company would be 4492/(490.57e+540). Since they would get e times this number for every share that they currently have, the condition is that 4492e/(490.57e+540) > 485p, i.e. e must be greater than 1.2396.
d. R2O shareholders would want to also end up with a price greater than 351.68; hence 4492/(490.57e+540) > 351.68, which means that e < 1.50294.

4. The payments for MAB could be structured to be increasing in the price of beer. For example, the price could be 550p +1.5(Price of beer in 1 year - Current price of beer). In addition, if MAB shareholders wanted a floor, the pricing structure could be something like 550p +Max[0,1.5(Price of beer in 1 year - Current price of beer]. In this way, if the price of beer were to rise, MAB shareholders would get a higher price; if not, they would get exactly 550p. It is important to note that the disagreement is about something objective and external to the firm; hence it makes sense to use an outside standard, such as the price of beer (or worldwide beer consumption), rather than a standard earnout.

5. There are two different profiles of targets of hostile takeovers -- one theory holds that targets are inefficiently run firms; the other theory holds that targets represent attractive investment opportunities for the prospective acquirer. The article actually focuses on the easy availability of cash, either directly from acquirer balance sheets or indirectly through the issue of more debt as the reason for the spate of hostile takeovers. However, some pointers as to which of the two theories are operative can be gleaned from the article. For example, it is likely that targets are as underleveraged as acquirers -- this, in a sense, is inefficient financial management. Similarly, if acquirers are flush with cash, targets probably are also flush with cash -- if so, they might not be using the available cash as efficiently.

On the other hand, the last line notes: "..as long as deals look as if they will create industrial powerhouses, cost synergies or pricing power, the markets are still supportive." This suggests that the motivation for the mergers is the existence of cost and revenue synergies, which says less about the inefficiency of target management than about profitable investment opportunities for the acquirer. However, there must be some element of resistance by target management to the unlocking of this value, else there would be no need for a hostile takeover.