CORPORATE FINANCE FOR LONG-TERM VALUE

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The BIG Picture 3  M&As are very large investments in which a company takes over another company Discussion  Value creation is more likely if there are synergies between the companies involved  There are many dubious motives for M&As  Financial sanity of M&A activity can be assessed with the NPV method  Large numbers and big stakes in M&A make behavioural issues more problematic  If not properly understood and considered, E and S issues can reduce the company's financial value  An integrated perspective on M&A valuation is needed -> integrated value method

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 In a takeover or acquisition, one company buys another company and it is typically quite clear who is the buyer and who is the seller  In a merger, it is supposed that companies of roughly equal size together decide to continue as one company, without a clear buyer or seller  Sometimes a deal may be called a merger for political reasons, whereas it is quite clear who is the senior party and who the junior  The buyer is called the bidder during the bidding process and called the acquirer if the deal happens  The company that is sold, is called the target during bidding and becomes the acquired company once the deal is done  Manager's assessment (does not need to equal market value) The measures that acquirer intends to take (i.e.cost-cutting, using new market channels) Price paid by acquirer on top of market value of target (driven by expectations and behaviour)

M&A waves 10 
M&A activity comes in waves and are linked to the state of the economy  During an upswing, M&A activity increases  During a downturn, M&A activity declines and Wessels (2020) define the M&A value creation as follows:

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Payment in stock mitigates undervaluation and overvaluation of both companies  In overvaluation, target and acquirer stockholders share in the losses  In undervaluation, target and acquirer stockholders share in the gains Behavioural issues in M&A valuation 14 Behavioural issues can be internal or external errors  Internal errors: managers overvalue their own company, the target or the synergies  Before companies make their bid, they can overestimate synergies or underestimate risks  In a bidding context, management can succumb to the winner's curse: winning by overpaying  External errors: the market overvalues the target or the bidder  Shleifer and Vishny (2003) assume that acquirers are overvalued and the motive of acquisitions is to preserve some overvaluation for long-runs shareholders  Market-level mispricing proxies and merger volume are positively correlatedHedge fund activism15 Activist hedge funds specialise in hostile M&A activity, and have a highly concentrated portfolio of holdings in companies that they want to shake up  Boyson, Gantchev and Shivdasani (2017) find that shareholder value creation from hedge fund activism occurs primarily by influencing takeover outcomes for targeted firms  Even failed bids lead to improvements in operating performance, financial policy, and positive long-term abnormal returns at targets of activism, which suggests that activism enhances value  Brav, Jiang, Ma and Tian (2018) find that companies targeted by activists improve their innovation efficiency over the five-year period following hedge fund intervention E and S effects on M&A before valuation 16 Managers can see E and S issues as drivers of risks and opportunities in their product markets ❑ Risks: certain assets can be considered too risky operationally or to be bringing reputation risks ❑ Opportunities: driving strategic preferences (i.e.sustainability skills, renewable energy assets)❑ Companies can become targets because of their sustainability skills ❑ Companies with higher CSR scores are more likely to be acquisition targets ❑ High CSR acquirers take less time to complete and are less likely to fail than mergers by low CSR acquirers ❑ Stronger CSR profile of the bidder means higher probability of closing the deal ❑ High carbon emitting acquirers are more likely to buy firms in countries with low GDP E and S effects on M&A valuation 17 ❑ E and S can affect the value drivers and hence the attractiveness of M&A deals ❑ Also important to do E and S due diligence (see Monsanto take-over below) ❑ Research finds a positive link between targets' overall CSR (and environmental) performance and acquisition premiums ❑ High CSR acquirers realise higher merger announcement returns, compared with low CSR acquirers ❑ E and S can also have impact on post-deal performance: ❑ Compared with low CSR acquirers, high CSR acquirers realise larger increases in postmerger long-term operating performance ❑ The underestimation of E and S effects can be extremely costly  importance of E and S due diligence ❑ Bayer, the German pharma and biotechnology company, announced the takeover of the agrichemical company Monsanto in 2016 The final cash offer amounted to $63 billion ❑ Soon after finishing the deal, the first lawsuits on Monsanto's Roundup weed killer started, internalising the negative health issues ❑ A chemical ingredient of Roundup is glyphosate, which was shown by a 2015 WHO report to cause cancer in animals as well as damaging effects on human cells ❑ Monsanto has settled over 100,000 Roundup lawsuits worth over $10 billion; over 30,000 lawsuits are still pending ❑ Bayer cut its dividend to zero in 2021 after litigation on health issues hit 2020 cash flows and profits E and S driven M&A activism 19 The past years have seen the emergence of sustainability-driven activism by hedge funds ❑ Jana Partners pressured Apple to address the potential negative effects of iPhone use on children ❑ Trian Partners has pushed companies to promote workplace diversity, adopt supplier codes of conduct, and reduce emissions and waste ❑ Some hedge funds went further, and put companies under pressure to do E and S driven M&A deals ❑ Bluebell asked Glencore to separate its coal mines ❑ Third Point called for a breakup of Shell ❑ DesJardine and Durand (2020) found that hedge fund activism between 2000-2016 yielded benefits that were: ❑ Shareholder-centric and short-lived ❑ With immediate increases in market value and profitability ❑ Coming at a mid-to long-term cost to other stakeholders ❑ Captured by decreases in operating cash flow, investment spending, and social performance E and S valuation of M&A 20 Market power is becoming an important source of value, reducing consumer surplus ❑ Incumbent firms may acquire innovative targets solely to discontinue the target's innovation projects and pre-empt future competition (called "killer acquisitions") ❑ Acquired drug projects are less likely to be developed when they overlap with the acquirer's existing product portfolio ❑ To determine the E and S valuation effects of M&A, one needs to calculate: ❑ The pre-deal EV and SV of the target and the bidder ❑ EV and SV of the resulting combination E and S valuation of M&A 21 In this example,  + ,  − , and  − deteriorate as a result of the deal ❑ Likely because the bidder imposes its exploitative business model and lower standards on the target ❑ The loss of SV and EV in synergies is substantial: ❑ -15 on SV (top

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An IPV analysis of the synergies based on a DCF model showed a value destruction of €63 billion (right column) ❑ Conclusion: the estimated synergies depend very much on how the valuation analysis is conducted ❑ Two main reasons for the differences:❑ IPV analysis includes not just financial value but all three value dimensions Financial analysis was based on EPS maximisation strategy (achieving sales growth while cutting costs) while IPV analysis was based on DCF valuation (long-term fundamental value) As long as    > 0 is the main criterion to judge the soundness of an M&A deal, the change in SV and EV is more likely to be negative than positive ❑ Applying the IPV criterion (below) to M&A deals can improve the value profile of the company across the three value dimensions  =  +  •  +  •  > 0 The incidence of M&A deals that do improve SV and/or EV is likely to increase with: ❑ SV and EV being measured or at least seen ❑ Lower discount rates on SV and EV ❑ Higher values for the parameters b and c to weight SV and EV Integrated takeover test 25 The aftermath of the aborted takeover of Unilever by Kraft Heinz generated a debate on the 'protection' of companies steering on integrated value ❑ Without protection, financial considerations (F) would always dominate social and environmental considerations (S+E) ❑ De Adelhart Toorop, De Groot Ruiz and Schoenmaker (2017) propose a integrated value test for takeovers: ❑ It is the responsibility of the management of both the acquiring and target company to conduct this test to obtain the integrated value of the joint companies ❑ An independent advisor would give a fairness opinion on the outcome of the integrated takeover test DSM's transition through M&As 26 When the coal mines were closed in the 1970s, the Dutch government helped the transformation of DSM (Dutch State Mines) into a base chemicals company ❑ Since the 1990s, DSM has transformed itself again, becoming a global sciencebased company for nutrition and health through a string of M&A deals ❑ The DSM -Firmenich merger combines the health and nutrition divisions of DSM and the taste and perfume divisions of Firmenich ❑ This merger completed the transition of DSM into a global leader in nutrition, beauty and wellbeingIntegrated view on M&A activism 27 M&A activism is typically justified by claims of value creation, but the key question is whether that value creation benefits all stakeholders (FV, SV and EV all rise) ❑ It would be helpful if this distinction would already be made by managers, analysts, M&A are very large investments in which a company absorbs another company, which can dramatically change the profile of a company's assets  Value creation is often more likely if there are synergies between the companies involved  Large numbers and big stakes in M&A make behavioural issues more problematic  If not properly understood and considered, E and S issues can reduce the company's financial value (illustrated by Bayer's acquisition of Monsanto)  An integrated perspective on M&A valuation is needed  For large M&A deals, an integrated value test should be required

operating in the domain of losses: negative results may lead to overvaluation of takeovers  Overoptimistic managers: overconfident CEOs overestimate their ability to generate
The market's assessment of a potential M&A transaction is expressed in the stock price reactions of the target and the bidder, which reflects:  Due diligence is carried out in which the bidder scrutinises the target's accounts under strict non-disclosure agreements  Bids can be friendly (with consent of target management) or hostile (lacking consent)  A deal can be stopped by regulators if it is deemed to be anti-competitive or contrary to national interests  Example: in August 2020, the UK government blocked the takeover of electronic design company Pulsic by a Hong Kong rival over national security concern   The value creation for shareholders  The likelihood that the transaction will happen  M&As can be classified in terms of business activity:  Horizontalsame line of business  Verticaldifferent parts of the same value chain  Conglomerateunrelated business Motives for M&A 7  M&A deals can be done for several reasons, some deemed more valid than others  The search for synergies is typically deemed a valid reason  Cheap funding and increased earnings per share (EPS) are seen as poor reasons  Synergies mean that the cooperation of two organisations provides better results than the sum of their parts  There are several sources of synergies:  Economies of scale: as production volumes go up, costs tend to fall  Economies of scope: combining similar products could lead to spill-over effects  Vertical integration: acquiring other parts of the value chain can improve streamlining  Industry consolidation: reducing competition means a larger part of consumer surplus is taken  When  Operational specialists evaluate the different value drivers of the target  Lawyers review critical company contracts and prepare non-disclosure agreements and purchase agreement In a stock offer, effective price of merger or takeover is affected by M&A gains or losses Cash financed M&A deal: acquirer offers original share price plus acquisition premium to target's shareholders  Many deals are (partly) paid in acquirer's stock, with stockholders receiving a fraction  of combined 

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Kraft Heinz's strategy was to maximise shareholder value, measured by EPS (earnings per share) ❑ Using EPS multiples, Kraft Heinz estimated the financial value of the synergies to be €46 billion(left column) ❑ -7 on EV (bottom table)❑ Bottom table shows the IV for a high-quality bidder ❑