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Fundamental Characteristics of Financial Industry
and Natural Evolution (II)
Dr. J.D. Han
King’s College,
University of Western Ontario
Objectives
Learn the basic concepts
securities firms, investment banking, securities trading and brokerage, M & A, etc.
Find an answer to puzzling questions such as,
“ Why are debts, as opposed to equities, getting more important in corporate financing?”
I. Two Latest Phenomena of Corporate Financing
1) Surge in Mergers and Acquisitions
(M & A)
2) An Increased Indebtedness(D/E ratio):
Debts have become more important in corporate financing.
II. Fundamental Driving Forces for the Two Phenomena
“Principal-Agent Problem”: Old Problem
-“Information Asymmetry” leads to “Principal-Agent Problem in Equities
* separation of ownership(principals=shareholders) and management(agents=managers)*Agent often works for his own best interests at the expense of the principals’
-The more severe Moral Hazard’ problem.
An Increased Legality : New Corporate Environment of Political Correctness
makes it virtually impossible to change management
III. Solutions to these Problems
We will explain that
An increase in M & A combined with
An Increased Indebtedness
may resolve or reduce these problems
of Corporations.
How?
1. How does M & A help solve Principal-Agent Problem?
M & A leads to a change to a new and better management and thus to an enhanced EFFINCIENCY
A just credible threat will wake up the existing stale management.
* Target for M & A: How do you know whether a firm’s management is stale?
Free Cash Flow Theory
by Michael C. Jensen at Harvard Business School
In his paper entitled “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers”, American Economic Review (1986)
* * Free Cash Flows as a Litmus Test
He defines Free Cash Flows:Free Cash Flows = Cash Receipts - Cash Expenditures - Profitable (Constructive) Investment Opportunities
His Observation:FCFs are the likely object of the Management’s abuse and a good indicator of the Principal-Agent Problem- The larger the FCF of a firm, the more severe the Principal-Agent
Problem.
*** Jensen’s FCF Theory in Reverse Gear
Dictum
“ The Larger the Free Cash Flow of a Firm, the More Severe the Principal-Agent Problem, and thus the Larger the Potential Benefits from M & A and Corporate Restructuring”
Prediction
We can also identify which firm is likely to be a target of M & A.
2. How does an Increased Indebtedness enhance Corporate Efficiency?
1) Debt contracts have a better monitoring through Restrictive Covenant and thus less moral hazards.
2) Reduced Equities increase Management’s portion of Profits
- “Incentive-Compatible” - It enhances Management’s work efforts
*Numerical Example of an Increased Indebtedness enhancing Management’s Rewards
Restructuring is “Leveraged” Buyout (of Shareholders) by Management
Before RestructuringDebt-Equity Ratio = 0/1 = 0
Capital Profits
Equity 1 Shareholders’ share
$9,000 $9,000Equity 2 Manager’s share
$1,000 $1,000Total
$10,000 $10,000*assume
interest rate =10%;
rate of returns on capital =100%
After RestructuringDebt –Equity Ratio = 9
Capital ProfitsDebts Shareholders’
share
$9,000 $ 900Equity 2 Manager’s share
$1,000 $9,100Total
$10,000 $10,000*Note: Manager’s profit share has
increased by 810%.
3. Two Structural Changes as Prerequisites for a Surge of M & A
Lowering Legal Barriers-Weakening of Anti-Trust Act(USA) Competition Act(Canada)
Development of Financial Institutions, Market & Debt Instruments
- Investment Banks, Securities Houses, Junk Bonds, (Debt-Equity) Swap, etc.
*Who are the Big Players?
Securities Firms Banks’ M & A Division of Investment Banking Department For instance
- Morgan Stanley
- Goldman Sachs
- Salomon Smith Barney
- Merrill Lynch
- Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium)
**Organization of Securities Firm
M erg ers an d A q u is it ion s
B ou g h t D ea lU n d erw rit in g
M arke ted D ea l
In it ia l P u b lic O ffe rin g P riva te Issu e
In ves tm en t B an k in g secu rit ies d ea lin g an d b rockerag e
S ecu rit ies F irm
***Glossaries
Investment Banking -helps issue new securities in the primary market
- Merchant Banking Securities Trading and Brokerage
- helping trade securities in the secondary market - Dealer versus Broker- Discount Brokerage versus Full Service Brokerage
Investment Dealer-dealer is principal, not agent
- applicable for Bought Deal and Securities Dealer
4. Pros and Cons of M& A 1) Pros: Advocate for M & A
M & A enhances Efficiency of Corporate Management
Natural Part of Globalization Trend Strategy for Survival from International
Competition(evidence) Share price of Target Firm goes up by 30-50%
before and after M & A
2) Criticism of M & A
(1) Zero Sum Game for the entire economy: gains for shareholders come from someone’s loss
a) Government Loss of Tax Revenues in LBOb) Wage Concessions after M & Ac) Bond holders’ loss: Increased leverage - Increased Default Risk
- Decreased Bond Priced) Consumers’ loss: Increased monopoly power - Higher price
(2) Economic Frailty Increases(3) M & A could be costly: A High Transactions Cost
(3) A Costly M & A: “ Shark Repellants”
-Setting up costly barriers against M & A Green Mail-bribe to a raider away
Scorch Earth- make yourself unattractive
Poison Pills- sell stock under market price in case of danger
Golden Parachute- big severance package for leaving executives
IV. Canadian Context
M & A will continue to increase
M & A take on Globalization trends
Source: Crosbie & Company Inc.
Historical Canadian Mergers & Acquisition Announcements
Valu
e in
$ B
illion
sAn
nou
ncem
en
ts
1,400
1,200
1,000
800
600
400
200
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
$210
$180
$150
$120
$90
$60
$30
0
Announcements
M & A at Canadian Cross-Border
# of Value # of Value # of ValueCanadians Acquiring: Transactions $millions Transactions $millions Transactions $millions
Foreign Companies 56 2,997 309 54,176 303 25,362
Canadian Companiesfrom Foreigners 13 3,503 46 7,081 41 4,491
Total Canadian Buyers 69 6,500 355 61,257 344 29,853
Foreigners Acquiring:
Canadian Companies 50 20,159 152 18,977 142 11,638
Foreign Companies from Canadians 13 990 60 14,068 52 15,709
Total Foreign Buyers 63 21,149 212 33,045 194 27,347
YTD March 31, 1999 FY1998 FY1997
M & A Resulting in Efficiency: CanadianCases
Average Median Average Median Average Median
Purchase Price ($mil) $240.6 $29.4 $217.1 $34.1 $126.6 $28.0
Market Premium 38% 33% 33% 28% 33% 26%
Price Mulitples:
Revenue 4.1 1.9 3.3 2 3.3 2
Net Book Value 3.8 2.1 2.8 2.3 3.7 2.3
Net Income 22.4 17.9 31.1 22.2 29.3 24.2
YTD March 31, 1999 FY1998 FY1997
Classic Study Case of M & A– The Company’s objective is to build value for its
investors through the acquisition of underperforming businesses( with a large amount of Free Cash Flow) financed largely with debts borrowed from third party lenders.
Performances. - Acquired Celestica for C$750mm in October, 1996 which
now has a market value of C$4.6 billion.
- Onex announces a bid for Air Canada and Canadian Airlines during a time when the industry is struggling.
3. Case Studies Case Study I) Excellent Execution - Onex Corporation
Case Study - Excellent Execution - Onex Corporation
Stock Price Performance September 29, 1994 - September 30, 1999
5.00
10.00
15.00
20.00
25.00
30.00
09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999
Onex Corp Sub Vtg
Oct 1/96: Onex acquires
Celestica for C$750mm
Nov 13/96: ProSource
completes IPO of US$48mm
Oct 1/98: Onex
announces
SoftBank acquisition
May 29/98: Onex sold
ProSource Inc. to
AmeriServe Food
Distribution for
C$123mm
Jan 29/99: Onex announces
LCS Industries acquisition
Mar 11/99: Onex announces
that it will sell 23%
of its stake in Sky
Chefs to LSG
Mar 25/99: Onex announces
C$1.5bn Telecom Fund
with Telefonica
May 11/99: Onex purchases
American Buildings
Aug 24/99: Onex
announces bid
for Air Canada
and Canadian Airlines
Case Study 2) - Disastrous Execution - Extendicare
Stock Price Performance September 29, 1994 - September 30, 1999
3.00
6.00
9.00
12.00
15.00
18.00
21.00
24.00
09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999
Extendicare Inc Cda Sub Vtg Shs
Nov 26/97: Extendicare acquired
all outstanding shares
of Arbor Health Care Co.
for US$419mm
Sept 17/98: Extendicare sells
its U.S. pharmaceutical
operations to Omnicare
Inc. for US$265mm
Nov 24/98: Extendicare intends
to buy back up to 3mm
of company's subordinate
voting shares
Feb 2/99: Extendicare's
stock dropped from TSE 100
Case Study 3 - High Yield Debt - Rogers Communications
Stock Price Performance September 29, 1994 - September 30, 1999
5.00
15.00
25.00
35.00
09/29/1994 04/20/1995 11/07/1995 05/29/1996 12/16/1996 07/08/1997 01/27/1998 08/17/1998 03/09/1999 09/27/1999
Rogers Communications Inc Cl B
Nov 11/95: Rogers Cablesystems
announces two new high yield
debt issues of US$150mm and US$125mm
Jan 16/96: Issues US$100mm
high yield debt
Jan 25/96: Issues
C$75mm high yield debt
July 17/97: Two new high yield
debt issues of US$330mm
and C$165mm announced
May 21/98: Rogers sells local
telephone services to
Metronet for C$1bn
July 12/99: Microsoft makes C$600mm
investment in Rogers; Aug 16/99: Completes
sale of 33% interest of Rogers Cantel to
AT&T Corp and BT PLC for C$1.4bn
Sep 9/99: Rogers repurchases
C$1.3bn in debt