Download Corporate Financing

Fundamental Characteristics of Financial Industry
and Natural Evolution (II)
Endogenous Solutions
Dr. J.D. Han
King’s College,
University of Western Ontario
Objectives

We have learned stocks (equities) are the
most subject to information asymmetry and
free rider problems.
- Lack of information and monitoring

Government intervention is not warranted, at
least, for now. It is also not desirable.

What are possible endogenous solutions?
Possible Endogenous Solutions for
Information Asymmetry in Financial
Instudstry
1)
Alternative Funding Arrangements with
enhanced Monitoring
2)
Ultimately, M & As
1. Alternative Funding
Arrangements

Alternative Funding Arrangements: Private Equity
Venture Capital
Mezzanine Financing

Alternative Financial System, which may allow for an
enhanced monitoring by investors
eg) Japanese Banks are allowed to be creditors as
well as share-holders
2. M & As
Recent Surge in Mergers and Acquisitions
(M & A)
Recent trend statistics:
http://www.thomson.com/cms/assets/pdfs/financial/league_table/mergers_and_acquisitions/2Q2006/2Q06_MA
_Global_Finl_Advisory.pdf
M & A means a change in management, and
also is usually accompanied with an Increased
Indebtedness(D/E ratio): Debts have become
even more important in corporate financing.
* Exisiting works miss an important
aspect of M & As
Too much focus on the Size (growth) issue of M & As
as a result of Globalization and Global Competition
- by ”big hands” or “rigging the market”
True, but there is another very important, and positive,
aspect to it – by “invisible hands” or “market
forces”
New Kid on the Block: In fact, not a
Kid at all.
Private Equity Firms have joined M & A through their
Pooled Buyout Funds
* By now, you have learned about 3 sub-types of Private Equity
Private Equity Firms account for One of 4 M & A deals in
U.S. in 2006
II. Fundamentals and added
problems
“Principal-Agent Problem”in the financial market and the
corporate world: 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 : an added Problem due
toCorporate Environment of Political Correctness
makes it virtually impossible to change management
III. Two Phenomena may result from the
endogenous, free-market efforts to solve the
fundamental information asymmetry
problems of the financial market
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?
Debt contracts have a better monitoring
through Restrictive Covenant and thus
less moral hazards.
Conversion from Equities to Bonds in the
corporate financing increases the amount
of information generated about the
corporate for the “Principal”.
•One more incentive for increased
indebtedness for the Agent
* Reduced Equities also 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 Restructuring
Debt-Equity Ratio = 0/1 = 0
Capital
Profits
Equity 1

After Restructuring
Debt –Equity Ratio = 9
Capital
Profits
Shareholders’ share
Debts
Shareholders’ share
$9,000
$9,000
$9,000
$ 900
Equity 2
Manager’s share
Equity 2
Manager’s share
$1,000
$1,000
$1,000
$9,100
Total
Total
$10,000
$10,000
*assume
interest rate =10%;
rate of returns on capital =100%
$10,000
$10,000
*Note: Manager’s profit share has
increased by 810%.
3. M & A s as Child of Times
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
Private Equity 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
Securities Firm
Mergers and Aquisitions
Investment Banking
Initial Public Offering
Bought Deal
Underwriting
Marketed Deal
Private Issue
securities dealing and brockerage
***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, and reduces problems related to
information asymmetry
 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 LBO
b) Wage Concessions after M & A
c) Bond holders’ loss: Increased leverage - Increased Default Risk
- Decreased Bond Price
d) 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
1,400
$210
1,200
$180
1,000
$150
800
$120
600
$90
400
Announcements
200
$60
$30
0
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Source: Crosbie & Company Inc.
Value in $ Billions
Announcements
Historical Canadian Mergers &
Acquisition Announcements
M & A at Canadian Cross-Border
YTD March 31, 1999
FY1998
FY1997
# of
Transactions
Value
$millions
# of
Transactions
Value
$millions
# of
Transactions
Value
$millions
Foreign Companies
56
2,997
309
54,176
303
25,362
Canadian Companies
from Foreigners
13
3,503
46
7,081
41
4,491
Total Canadian Buyers
69
6,500
355
61,257
344
29,853
Canadian Companies
50
20,159
152
18,977
142
11,638
Foreign Companies
from Canadians
13
990
60
14,068
52
15,709
Total Foreign Buyers
63
21,149
212
33,045
194
27,347
Canadians Acquiring:
Foreigners Acquiring:
M & A Resulting in Efficiency:
CanadianCases
YTD March 31, 1999
Average
Purchase Price ($mil)
Market Premium
FY1998
Median
$240.6
$29.4
FY1997
Average
Median
Average
Median
$217.1
$34.1
$126.6
$28.0
38%
33%
33%
28%
33%
26%
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
22.4
17.9
31.1
22.2
29.3
24.2
Price Mulitples:
Net Income
3. Case Studies
Case Study I) Excellent Execution - Onex Corporation

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.
Case Study - Excellent Execution - Onex Corporation
Stock Price Performance September 29, 1994 - September 30, 1999
30.00
Mar 25/99: Onex announces
Mar 11/99: Onex announces
that it will sell 23%
C$1.5bn Telecom Fund
May 11/99: Onex purchases
American Buildings
with Telefonica
of its stake in Sky
25.00
Chefs to LSG
Jan 29/99: Onex announces
LCS Industries acquisition
20.00
Aug 24/99: Onex
announces bid
15.00
Nov 13/96: ProSource
for Air Canada
completes IPO of US$48mm
and Canadian Airlines
Oct 1/96: Onex acquires
May 29/98: Onex sold
Celestica for C$750mm
10.00
Oct 1/98: Onex
announces
SoftBank acquisition
ProSource Inc. to
AmeriServe Food
Distribution for
C$123mm
5.00
09/29/1994 04/20/1995
11/07/1995 05/29/1996 12/16/1996 07/08/1997
Onex Corp Sub Vtg
01/27/1998 08/17/1998 03/09/1999 09/27/1999
Case Study 2) - Disastrous Execution - Extendicare
Stock Price Performance September 29, 1994 - September 30, 1999
Nov 26/97: Extendicare acquired
24.00
all outstanding shares
of Arbor Health Care Co.
for US$419mm
21.00
18.00
Nov 24/98: Extendicare intends
to buy back up to 3mm
of company's subordinate
15.00
voting shares
Sept 17/98: Extendicare sells
its U.S. pharmaceutical
12.00
operations to Omnicare
Inc. for US$265mm
9.00
Feb 2/99: Extendicare's
6.00
stock dropped from TSE 100
3.00
09/29/1994
04/20/1995
11/07/1995
05/29/1996
12/16/1996
07/08/1997
01/27/1998
Extendicare Inc Cda Sub Vtg Shs
08/17/1998
03/09/1999
09/27/1999
Case Study 3 - High Yield Debt - Rogers Communications
Stock Price Performance September 29, 1994 - September 30, 1999
Sep 9/99: Rogers repurchases
35.00
C$1.3bn in debt
Nov 11/95: Rogers Cablesystems
July 12/99: Microsoft makes C$600mm
announces two new high yield
investment in Rogers; Aug 16/99: Completes
debt issues of US$150mm and US$125mm
sale of 33% interest of Rogers Cantel to
AT&T Corp and BT PLC for C$1.4bn
25.00
Jan 25/96: Issues
C$75mm high yield debt
July 17/97: Two new high yield
debt issues of US$330mm
15.00
and C$165mm announced
May 21/98: Rogers sells local
Jan 16/96: Issues US$100mm
telephone services to
high yield debt
Metronet for C$1bn
5.00
09/29/1994
04/20/1995
11/07/1995
05/29/1996
12/16/1996
07/08/1997
Rogers Communications Inc Cl
B
01/27/1998
08/17/1998
03/09/1999
09/27/1999