Mergers and acquisitions are mainly of three types, Horizontal, Vertical and Conglomerate. In Horizontal mergers the two firms are in the same line of business and are often undertaken to achieve economies of scale and market share and/or market entry. In Vertical mergers the two firms are at different stages of production. These are often undertaken to improve efficiency and control in the production process and capture a bigger role in the value addition chain of production. In Conglomerate mergers the firms are in unrelated lines of business.
These are usually looked at for inorganic growth prospects by firms in mature industries. To study that in detail we will start by looking at motives and reasons for possible value addition in mergers. 1. Economies of Scale: The aim is to reduce costs by sharing central services and reducing average unit by spreading fixed costs over larger volumes. 2. Economies of Vertical Integration: The aim is to gain greater control over the production process, by moving towards raw material output, or move towards the end user of the product.
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This can be done be merging with a supplier, customer or their competitors. 3. Complementary Resources: The two firms each have something the other needs ND so it makes sense for them to merge. It may also open opportunities they individually might not have pursued. 4. Surplus Funds: Firms having surplus funds can find themselves to be in a position to both acquire and be acquired. Firms with surplus cash and shortage of investment opportunities can look for mergers financed by cash to redeploy capital.
This is often found in mature industries. On the other hand, firms that sit on surplus cash without redeploying it or paying it out to shareholders can be targeted by firms proposing to redeploy said cash more efficiently. 5. Eliminating Inefficiencies: Firms that have unexploited opportunities to cut costs and increase profitability become targets for acquisitions by other firms that believe they can improve efficiency in resource usage through better management. These acquisitions are generally followed changes in management.
Particularly for firms lagging behind industry performance standards it was found that the Chief Executive was four times as likely to be replaced in the year after a takeover than the preceding years (Martin and McConnell, 1991). 6. Industry Consolidation: In mature industries that have a very large number of firms tit too much capacity the conditions trigger a wave of mergers and acquisitions which then push companies to cut capacity and employment in order to release capital which can be utilized elsewhere in the economy for better returns. The takeover accelerates this consolidation. Andre & Stafford 2004) 7. Diversification: This reason has followed on from surplus funds in mature industries as the growth prospects and opportunities are low, managers seek to distribute the capital in new industries with better prospects instead of paying extra dividends. There can also be an argument of them trying to diversify in order to educe the firm’s risk. The problem with that argument is that it is easier and cheaper for shareholders to diversify their risk compared to the corporation (Barley et al). 8. The Bootstrap Game: This strategy is to increase earning per share.
It generates earnings growth from purchase of slowly growing firms with low Price-Earnings ratio instead of capital investment or improved profitability. (S. C. Myers, 1976) 9. Lower Financing Costs: A single larger firm can access debt at lower interest rates than two smaller firms. It is also beneficial to make fewer and larger security issues to main economies of scale. In this case the shareholders gain from the lower interest rates but lose by having to guarantee the other company’s debt. Merging decreases the probability of financial distress.
If increased borrowing can be achieved and increased value of interest tax shields, the merger can give a net gain. (W. G. Ellen, 1971) Market Trends and Scenario Merger activities have historically been volatile and cyclical clusters of merger waves have existed. This has been documented by Mitchell and Mullein(1996) showing clear clustering of waves within industries and tie that clustering to various genealogical, economic, or regulatory shocks to those industries. The industry level clustering has also been confirmed by Andre et al(2001). Still, there is no consensus as to the reason for merger waves.
The neoclassical theory suggests economic disturbances lead to industry reorganization. Cease (1937) was one of the first to argue that technological changes lead to mergers and acquisitions. While performance improvements at the plant- level has also been used to support a neoclassical theory of merger waves by Microcosmic and Phillips (2001). Hartford (1999) supports this argument through empirical evidence indicating that firms that have large cash reserves built up show higher activity in the acquisition market. The behavioral theory links the stock market valuation to merger activity waves.
We notice clustered merger activity because a lot of merger activity is guided by stock market valuations. Bull markets lead groups of bidders with overvalued stock to use the stock to buy real assets of undervalued merger targets. Target managers with short time horizons are willing to accept the bidder’s temporarily overvalued equity. (Shellfire & Vishnu, 2003) Fain capital report expects an increase in mergers and acquisition activity because: Financial capital is plentiful and cheap, and will likely remain so. With real interest rates well below historical levels, the pursuit of higher returns will be unrelenting.
Many companies are flush with cash and well positioned to capitalize on these opportunities-?but organic growth alone is unlikely to produce the returns investors expect. Value Creation Like any business decision, the decisions for mergers and acquisitions are mixed bag of good and bad. From the numerous studies and analysis done on this topic, there is nonsense at least on the fact that the shareholders of the target firm experience overall gains in value. Empirical studies on shareholder returns for target firms’ shareholders by Acquits, Burner and Mullions (1983) reported results consistent with the size effect.
In mergers where the target’s market value was equal to 10 percent or more of the buyer’s market value, the return to the buyer was 4. 1 percent. But where the target’s value was less than 10 percent, the return to the buyer was only 1. 7 percent. The shareholders of the acquiring firm, however, have not necessarily mined above average returns over industry standards in the long run by merging the firms as compared to the two firms running individually. Some believe that investors’ reaction to mergers in the short term is enthusiastic while not giving enough critical attention to long-term prospects.
Since we cannot accurately measure how the two firms would have faired individually without the merger, it is difficult to ascertain long-term effect on profitability. Empirical studies for both arguments, improved performance and declined performance, have been done and provide opposing views and therefore inconclusive results. KEMP (2011) analyzed a large sample of M&As completed between January 2007 and July 2009 and showed that, in 44 percent of the transactions, the acquirer achieved either none or very little of the anticipated synergies. However, this study was done during economic downturn and that must be taken into account.
Douses Epitomes (2007) noted that post acquisition stock performances of I-J private company acquisitions by I-J public companies have deteriorated over three years of the analysis into negative abnormal returns. Considerable negative movement noted in third year in particular. Burner (2002) notes that there can be three outcomes on shareholder wealth after mergers and acquisitions; 1 . Value Conserved: The investors get the rate of return they required. The NP of the acquisition will be zero. There are no abnormal gains or losses but only normal returns. 2.
Value Created: The return on investment exceeds the required rate of return of the investors. The investment has a positive NP. The investors wealth grew more rapidly than the required rate of return. 3. Value Destroyed: The return on investment is lower than the required rate of return of the investors. The NP of the investment is negative. The investor could have earned a better return on other investment opportunities of similar risk. Gaffe et al. (1992) have noted positive returns on acquiring firms performance studied 5 years post merger while still noticing statistically significant cumulative abnormal return of -10. 6%. The majority of statistical analyses on the subject do not show an average abnormal positive returns. There still is the point of value conservation raised by Burner (2002). If the investors get the required rate of return, is the merger still a failure ? The above analysis by Accentuate again shows a mixed result. The point to be noted is that it only takes into account two years performance whereas in Douses & Epitomes (2007) the use of fame French model showed that third year results were lower for first deals of multiple acquirers and negative abnormal returns were noted.
Healy et al. (1992) (table 1) also noted drop in post merger performance compared to industry benchmark in year time period of years one to four for cash flows growth rate and better for the merged firm before that period while post merger performance of the rim in asset growth rate as compared to industry fell in the period of years one to three. Accentuate reports the median industry returns on the mergers and acquisition deals. Some industries have consistently outperformed other industries in the returns on Mergers and acquisition investments.
Banking sector has done consistently well from 2002 to 2009 but it was clearly in need of consolidation after the recession in 2008 and as per the neoclassical theory fundamental economic needs for mergers would tend to result in better results for acquirers. Points To Look Out For 1 . Diversification: Diversification as a reason for mergers and acquisitions can potentially destroy value. The value additively principle shows that shareholders have easier and cheaper access for diversification through stock markets. Berger and Book (1995) found an average loss in value from diversification of between 13 and 15 percent. . Expected Synergies: Houston, et. AY. (2001) found a significant relationship between the present value of benefits from cost saving and revenue enhancement, and the announcement day returns in bank mergers. The market discounts the value f these benefits and applies a greater discount to revenue-enhancing synergies, and a smaller discount to cost-reduction synergies. 3. Human Capital: Managing synergies and getting improvements in new organization with an existing culture is a tough task and has to be handled carefully. . Payment through stock: When acquiring firms manager pay using stock instead of cash they might send out a signal that they believe their stock to be overpriced. The market might react to this by lowering the stock price. This also shows asymmetric information problem as the angers of the acquiring firm have better knowledge of future plans and prospect and if they believe the merger potential to drive the firms performance and stock upwards they would not like to pay through stock instead of cash. 5.
Excess Cash: Unless the merger changes the acquiring firms debt ratio and provide interest tax shields mergers for the sake of using excess funds could destroy value to shareholders who lose out on opportunity cost for possible dividends as well. 6. Hubris Hypothesis: There is a tendency for acquiring companies to pay too much as hey are over optimistic about their ability to add value to the merged company by improvements. This is the case as the bidding is always over the market price of the shares.
The managers believe that the market has undervalued the company or they can gain synergies or cost reductions through reorganization. (Roll 1986) 7. Integration: Post Merger integration of the previously separate firms to align and work towards a common goal is easier said than done. The strategy needs to be relayed clearly and territorial behavior of managers for previous assignments in charge to be controlled. 8. Self Attribution Bias: Managers and decision makers who have experienced success in the past tend to be overconfident and fall into the same trap as the Hubris hypothesis.
Their belief in their own ability to Judge and valuate a merger and acquisition deal along with adding value to it through superior management skill they believe to have because of past success leads them to overprice bids and overestimate their ability to derive benefits through synergies and reorganization. 9. Subjectivity in Valuations: There are three main methods of valuation of firms, Market Multiple, Discounted Cash Flow and Net Asset Value. The market multiple approach requires an identical public company.
This may not always be possible and the premium paid for control of the company is tough to ascertain with surety. The discounted cash flows again are subjective due to expectation and forecasting of future cash flows and may face problems in case of lack of information that may lead to uninformed decisions. In the NAVA approach the market price is tough to ascertain and may not always be the fair price and have to be negotiated upon. Some assets included may not be divisible and/or currently usable.
Graham ND Dodd method has proved successful in the past for investors like Warren Buffet and more people should look to use it when valuating an investment. It can be linked with strategy unlike the other valuation techniques as it faces the assumptions upfront and as many assumptions are strategic and may require strategic input. (Calendar, 2010) 10. Tender Offers: A number of studies included in Burners (2002) analysis like Gregory (1997) found significant positive returns for tenders and hostile takeovers. They bypass the target firms management and offer take or leave rapports saving negotiation costs.
They also avoid a bidding war. 11 . Agency Relationship: The firm that has excess funds at their disposal always has the option of buying back shares or paying out extra dividends as they believe it goes against maximizing firm value and as managers looking to promote self interest over shareholder interest could be looking for empire building over shareholder value. On the buyers side in mergers and acquisitions it is noted that mergers and acquisitions are often followed by management turnover and industrial reorganization to improve efficiencies and cut costs.
They might look to avoid being acquired as it would effect the management negatively even though it is beneficial for the shareholders. The case of Oracle’s takeover bid for Peoples is a good example of how management can avoid takeovers using “poison pill”, allowing to flood the market with extra stock, and the customer guarantees it offered. The court had to be involved as the shareholders interests were not being looked after by the management. Other tactics management can use to avoid takeovers are ‘Shark-Repellent” changes to the reporter charter making it necessary to get superiority considerably above the normal 50%.
Companies can reduce this conflict of interests by using “Golden Parachutes” offering generous payoffs to managers who may lose their Jobs because of a takeover. In addition some Behavioral Finance study can also throw some light upon managerial decision making process in case of mergers and acquisitions. Heuristic Dealing with information in fast moving times with quicker information availability and spread the decisions are made on fast, selective interpretations of information. Preference for Certain News stems from the attachment to a position already taken and tendency for new information to be played down in favor of it.
Disposition Effect is the general tendency of selling winners early and riding losers too long. In case of Merger bids the latter part can be applicable as managers tend to stick with the takeover bid even if prices change to make it less favorable than before. Conclusion Mergers and Acquisitions are a part of today’s business world whether they always add value or not. The value addition to shareholders of buying firms is uncertain but he value addition to shareholders of target firm is agreed upon by most studies.
There still are deals that add value to shareholders of buying firm as well. There are examples like Disney-Paxar and AOL-Time Warner at opposite ends of the spectrum. The case of Jaguar Land Rover is an interesting one in this regard as they have experienced the good and bad of mergers and acquisitions. JELL was bought by Ford Motors in 1989 and difficult relationships between US owners and I-J firm contributed to poor performance. Data bought JELL from Ford in March 2008 for over 1 billion GAP. The deal took over a year to agree – which may have helped with the post-merger integration.