It has the ring of a merger-and-acquisition truism: the sale goes to the highest bidder. But as some recent deals suggest, in reality a lower bidder may well prevail.
In 2005's most-watched M&A contest, MCI Corp. repeatedly favored Verizon Communications Inc.'s offers — even though they were worth as much as $2 billion less than Qwest Communications International Inc.'s — and finally chose an $8.4 billion Verizon deal over Qwest's $9.7 billion bid. While leaving that much on the table is extreme, for a while Hollywood Entertainment Corp., too, favored a $700 million offer from Movie Gallery Inc. over a $1 billion bid from Blockbuster Corp.
Certainly, a simple price tag rarely captures the whole M&A story. But why would a public company settle for less than the top bid?
"There are lots of potential reasons," answers Robert Holthausen, Nomura Securities Co. professor of accounting and finance at the University of Pennsylvania's Wharton School. Number one on his list is "a low probability that the higher bidder can obtain financing." Next comes "the form of consideration" — usually the mix of cash and securities — followed by the potential for a government challenge of the high bid. (That was the case with Hollywood Entertainment, which believed the Federal Trade Commission might block a Blockbuster deal at any price. After talking with the FTC, Blockbuster eventually pulled out, and Hollywood valued the final Movie Gallery deal at $1.2 billion.) Other factors that may overshadow the stated price: doubts over the value of securities, questions about tax status, and the appeal of certain closing-related items, such as a suitor's offer of compensation for a decline in business before a deal is consummated (see "Why Go Low?" at the end of this article).
Rejecting a bidder because the target doubts it can actually pay "happens all the time," says Frederick S. Green, senior partner and head of M&A at law firm Weil, Gotshal & Manges LLP in New York. Take the case of a suitor "who comes in after a deal is announced and offers significantly more, then says, 'By the way, it's subject to financing.' The whole offer could be illusory."
Such concerns may arise whether a bid is all-cash, all-stock, or a mix of both. But without question, the broadest range of seller concerns materialize when an offer is wholly or partly in stock — as is true of about three-quarters of all deals these days. When a cash-only auction for a target occurs, in fact, the so-called Revlon rules may apply, based on a court decision that aims to protect shareholders by requiring a board to accept the highest cash bid (see "The Makeup of Revlon," at the end of this article).
When equity is involved, though, the seller's board members must act, in effect, as security analysts, notes Mark Sirower, M&A strategy practice leader for PricewaterhouseCoopers LLP. The directors "really have to understand what the buyer's business plan is," he says. Sometimes, a superior plan may trump a higher offer.
"Not only does the target have to look at the long-term value of the stock being offered, but it also has to look at things from a combined basis," says attorney David Fine, of Ropes & Gray in Boston. That calls for analysis of how the two companies fit together operationally and culturally. A company might thus prefer a slightly lower bid, says Fine, if there are synergies that offset the price difference. While "far and away, the top bid usually prevails," he adds, "taking the lower bid may be legal and defensible in some cases."
Both defensible and desirable, according to CFO Robert Kelly of Wachovia Corp., the Charlotte, North Carolina-based bank formed in 2001 by a $14.1 billion merger after the target rejected a competing $15 billion bid from SunTrust Banks Inc. "Big premiums are flashing red lights to me," says Kelly, at the time the CFO of Wachovia's friendly suitor, First Union Corp. (After First Union's two-for-one exchange of shares, the combined company adopted the smaller Wachovia's name.) When there is too big a gap between the top two bidders, he explains, it tells the target that number one is "an undisciplined acquirer." But that may be only the start of problems after the acquisition is completed.
"If you pay too high a price, it's going to create two tiers of management," creating the sense among managers from the acquired firm that they are second-class citizens. That can lead to more managerial turnover at the combined company, says Kelly, and "when you lose managers, that's usually the kiss of death." In his view, in fact, "the only people benefiting are short-term shareholders who take the money and run. And what you want is long-term shareholders."
The Wachovia-First Union deal certainly rewarded its investors. The combined company produced an 84 percent return over three years, Kelly notes, and exceeded its expectations in cost reductions and branch eliminations. "We promised $890 million in expense synergies, and came up with more than $900 million," he says, in large part by cutting 7,000 jobs. Revenue synergies were significant, too, he adds, with First Union's more-advanced investment-banking services being introduced into the smaller Wachovia system, for example.
The merger also delivered on the former Wachovia management's hopes for a relatively seamless blending of the two banking systems. Comparing the hostile SunTrust offer with First Union's friendly one, "the bigger issue for Wachovia wasn't so much the premium," according to Kelly. "What they were interested in was the cultural fit and who had the greater long-term franchise."
Campaigning for Less Money
Such positive views may be expected from the CFO of the acquirer. But in Wachovia's case, the target's vice chairman and finance chief shares them fully — even though the winning bid was nearly $1 billion lower than SunTrust's. "If you compare our deal with others, in which high premiums were paid, we did very well," says Bob McCoy, who retired after serving as co-head of the First UnionWachovia integration effort. Indeed, he credits the lower price for aiding the integration in several ways.
A merger priced too high, he says, "tells Wall Street that you are going to cover that premium quickly, say, in two years," rather than the lengthier time that a solid integration may require. Under such pressure, with investors driving down the postacquisition share price in pursuit of a higher rate of return on invested capital, goals like retaining management are harder to meet. In McCoy's view, "the lower premium gave us time to do it right, and the result was a very well done integration and an increase in our customer base, which is something that's almost unheard-of in banking mergers."
The fight that First Union and Wachovia waged to get shareholders to pick their merger over the higher-priced SunTrust deal also led to something of a surprise windfall: employee camaraderie. "We discovered that this 'common enemy' became a theme with both companies," says McCoy. Employees agreed "that we'd be damned if we'd let anyone take this deal away from us, because we think it's best."
Selling the merger to shareholders was "like [waging] an election campaign," adds Kelly. "We were on the road constantly, explaining why our deal made more sense than the other deal." They issued a strong warning to shareholders on the dangers of shortsightedness: "In the end, it's not the amount of money you make on day one," he says. "It's the amount you make over the long term, and what you can do to reduce the volatility of earnings."
"What the board is really doing by selecting a lower offer is challenging the stated dollar value of the high bid," says PwC's Sirower, who agrees that "just because it has a higher number doesn't mean it's necessarily the best bid." He notes also, of course, that the market will penalize a company that overbids for a target—knocking down its stock price so that the gap between bids is naturally narrowed.
Still, when two offers involving stock have announced values that differ, it is expected that many shareholders will be drawn to the higher dollar value if they want to cash out right away. That certainly seemed the case when a number of vocal MCI holders took issue with the board's support of Verizon's lower offer.
A Farewell to Arms
If two offers for a company seem identical, such elements as perceived synergies, cultural advantages, and the underlying quality of the stock being offered may become something of a tiebreaker.
Roxanne Austin, former CFO of El Segundo, California-based Hughes Electronics Corp. and later president and COO of its DirecTV Inc. unit, suggests that this was the case when Hughes and its General Motors Corp. parent decided to exit the defense business — ultimately selling the missiles and electronics operations to Raytheon Co. "If your shareholders are going to be getting a substantial piece of equity along with cash," she says, "you have to do due diligence on that company, including what the new management's plans are for the company."
In pursuit of the Hughes operations, Waltham, Massachusetts-based Raytheon reportedly fought it out with Los Angeles-based Northrop Grumman Corp. and other suitors. The final price soared to $9.8 billion in stock and cash. "It was a toss-up," Austin says of the top two bids Hughes and GM considered, although she doesn't specifically identify Northrop Grumman. In their intense study of the competing securities, she says, "we asked what things were going to affect the value of the company going forward." Hughes reviewed the quality of the suitors' managements, how well the two teams were likely to work together, and the overall capacity for operational integration. "All kinds of things come into play, like the leases on buildings involved in a deal," says Austin.
While sellers may wonder if a bidder can pull off a deal, Hughes "didn't have an issue with any company being able to execute," says Austin. Although she doesn't have specific knowledge of the MCI deal, she adds: "If you look at Qwest, some people were saying its bid wasn't worth the same" as Verizon's, because Qwest "may not have that ability to execute."
The Second Time Around
Bob Davis, executive vice president and CFO of Islandia, New York-based software company Computer Associates, thinks the pressure on the MCI board may have become too intense as Qwest kept boosting its bid over what had been the favored Verizon offer. "Verizon is a much stronger company than Qwest. That's something you have to consider in weighing offers," along with cultural fit, he says. But "as soon as the delta between Qwest's bid and Verizon's got to be 25 to 30 percent, it was hard to dismiss."
Davis has personal experience at MCI, from an earlier time in its history — one very clearly illustrating that a high bid doesn't guarantee success. He was MCI's assistant corporate controller when a merger proposal first put the company in play back in 1996. That bidding war was eventually won by WorldCom Inc. with a $37 billion all-stock bid, topping a GTE Corp. offer of $28 billion that at the time was the largest cash bid in history. "Hindsight is always 20-20," says Davis, who had left for Dell Computer by the time the MCI-WorldCom merger finally occurred. In addition to liking the higher price, he says, MCI early on believed that "the wild and woolly MCI culture" might fit best with WorldCom, rather than with another, more-staid phone company. (GTE has since merged into Verizon.)
Still, says Sirower, "MCI took the highest bid, and its shareholders ended up losing everything." When it comes to the need for a seller to understand the buyer's business plan, he says, "that's about as strong an argument as there is."
Roy Harris is senior editor of CFO.
The Makeup of Revlon
Short-term holders get little support from the Delaware ruling.
Investors who want boards to pick the high bid for their company — including some holders of MCI Inc. — sometimes cite a 20-year-old Delaware Court ruling in MacAndrews & Forbes Holdings Inc. v. Revlon Inc. The 1985 case, involving Ronald Perelman's acquisition of Revlon, established conditions in which a board must take the higher price, acting merely as "auctioneers" on the stockholders' behalf.
But the limitations of the Revlon rules are severe. They apply when "there are two or more bidders, it's an all-cash deal, and both have the financing," says Frederick Green, a senior partner at New York law firm Weil, Gotshal & Manges LLP. "If that's the path you're going down — with no other major differences in the bids, like antitrust problems — then a board would not be able to justify choosing the lower bid."
But "what's going on in the Verizon-MCI case was not a Revlon issue," he notes. "The board of MCI was comparing two offers. And because there's a big stock component in both, they were looking at the issuer and its future, and making a qualitative judgment about its worth and the value of the combined MCI-Verizon or MCI-Qwest."
Shareholders citing the Revlon rules to support overruling the business judgment of a board aren't likely to win, Green says. "It's always easy to challenge," but it's really "sour grapes," he says. The board's job remains to value competing offers fully.
"Look at it this way," suggests Green. "If I told you I was offering $13 and a Steinway piano, you'd have to put a value on the piano." —R.H.
Why Go Low?
One expert's opinion of reasons to rule out a high bid in deals involving stock.
- Where cash is included, the bidder may not be able to obtain financing.
- The bid may contain too little cash relative to a lower bid, or have other disadvantages in terms of the form of consideration.
- The target may disagree with the value assigned to preferred or restricted stock, bonds, notes, or other related securities or claims.
- Completion of the deal with the higher bidder may be blocked or complicated by antitrust problems.
- It may be less advantageous for tax reasons.
- A lower bidder may offer price protection for shareholders if stock prices decline during the merger-and-acquisition process.
- A lower bid may be more acceptable if a seller can adopt weaker representation and warranty terms, or if the buyer's terms are stronger.
- The high bidder may have issues with various conditions of closing, such as a requirement for a third party to forgo successor liability.
Source: Prof. Robert Holthausen, Department of Accounting, The Wharton School, University of Pennsylvania