ONLINE CHAPTERS
target’s historic cash flows, thereby reducing default risk, target bonds may increase in value. A 2004
study by Billett, King and Mauer^20 provides evidence consistent with this possibility. The bondholders’
gain is a wealth transfer from the merging companies’ shareholders – especially the financially healthier
company’s shareholders – since cash flows that they would have received in the weaker company’s loss
period are instead diverted to pay the bondholders’ claims. The point is that, while corporate managers
may pursue mergers at least in part to reduce financial risk, the benefit sometimes accrues to fixed
claimants (such as existing bondholders), possibly at the expense of shareholders.^21 The study also
demonstrates that when a target is acquired by a less creditworthy bidder, target bondholders experience
negative returns.^22
Bidder bondholders can experience similar outcomes. Given that bidding companies are rarely
experiencing financial distress, bidding bondholders infrequently benefit from merging with a cash flow
rich target; more often, they suffer value loss as a financially weaker target company is acquired.21-3e HOW DO TARGET CEOs MAKE OUT?
Not only do shareholders of target companies do well in M&A deals, so do their chief executives.
Research done in 2004 by Hartzell, Ofek and Yermack^23 documents payments received by target CEOs
as their companies are sold. These target CEOs receive payments equalling 10 to 15 times their annual
salaries and bonus when their companies are taken over. About 55% of the payment comes in the form
of shares and options, with the rest consisting of golden parachute severance payments and additional
bonuses. These payments could be interpreted as a lavish perk to the outgoing executive. Alternatively,
the payments may play the role of encouraging CEOs to, and rewarding them for, taking an action that
creates the most value for target shareholders.20 See Matthew T. Billett, Tao-Hsien Dolly King and. David C. Mauer, ‘Bondholder Wealth Effects in Mergers and Acquisitions: New Evidence
from the 1980s and 1990s’, Journal of Finance, 59, February 2004, pages 107–35.
21 One subtle consideration is whether the target debt can be refinanced at the bidder cost of capital. For example, if a low-risk acquirer buys
a high risk target, can the target’s debt be refinanced at the bidder’s low cost of debt? While this possibility is often implicitly assumed
in models that analyse merger consequences, the most likely outcome is that the target’s securities will be refinanced not at the pre-deal
financing costs of the bidder, but rather at the combined firms’ post-deal costs. This combined cost may in some cases reflect cost-reducing
benefits of diversification of the bidder and target but often will lie between the pre-deal costs of the bidder and target.
22 Another situation in which there are significantly negative returns on existing target bonds occurs when a leveraged buyout occurs, loading
substantial new debt on the target firm.
23 See J.C. Hartzell, E. Ofek, and D. Yermack, ‘What’s In It For Me? CEOs Whose Firms Are Acquired’, Review of Financial Studies, 17 (1), Spring
2004, pages 37–61.CONCEPT REVIEW QUESTIONS 21-3
6 In an M&A deal, both the target and the bidder typically do their own valuations. Which valuation
method do you think target management favours, and which do you think managers of the bidder
advocate?7 Most bidders are much larger than the target companies that they seek to buy. When the bidder is
much larger than the target, why might it appear that the bidder’s shareholders do not profit much
from the deal even if it creates a significant amount of value in total?