Mergers. Value Creation or Destruction?

Table of contents

1. Introduction

2. Reasons to merge
2.1. Financial Synergies
2.2. Operating Synergies
2.3. Management Incenvtives

3. Do mergers create value?

4. Important factors for value creation
4.1. Bidder characteristics
4.2. Target characteristics
4.3. Deal characteristics

5. Merger Waves

6. Conclusion

References

1. Introduction

Mergers and acquisition (M&A) are one of the most important topics in the business world. They provide so many news that online newspapers like the New York Times dedicate own sections to them. Some of the largest mergers did cost more than 100 billion US dollars. In consideration of this public interest and these enormous dollar amounts, a lot of research has been conducted to answer a fundamental question: Do mergers really create value?

In order to answer this question, this paper gives an overview of influential research in the wide field of M&A. It is necessary to first provide a theoretical framework to show how a merger between two firms creates synergies. In other words, how can the value of two merged companies be larger than their independent sum? With this framework in mind, it is possible to look at results of academic research on whether mergers create value in practice and the determinants of success and failure. Another interesting topic in the field of M&A is merger waves, periods with abnormally high merger activity. Several of such waves have been observed, but their cause and return are still topic of academic debate.

The remainder of this study is structured as follows. The next section reviews the most important reasons to merge in order to understand the theoretical value-creating potential. The third section discusses whether mergers also create value in practice and who benefits the most. Section four describes how merger success or failure depends on different properties of involved parties and deal characteristics. The fifth section gives a brief summary of the last three big merger waves and depicts how the occurrences of such waves are explained by two competing theories. The last section concludes the study.

2. Reasons to merge

In academic literature one can find a variety of good and bad reasons to merge. These reasons show the potential of mergers to create value. In order to provide a clear framework on how mergers do so in theory, reasons are assigned to three categories: financial synergies, operating synergies and management incentives. Financial synergies include a lower cost of capital and reduced tax liabilities. Many firms also believe that mergers can improve their internal capital markets, so that projects can be financed internally in a more efficient way. Operating synergies increase profitability through a more efficient use of resources, transfer of expertise and increased market power. The last category, management incentives, contains reasons to merge that are based on managers’ personal intentions. These intentions can divert from shareholder objectives and are often harmful to firm value.

2.1. Financial Synergies

Financial synergies are mainly a result of diversification. Although much of the academic literature is very sceptical about diversification as a reason to merge, its effects can include a “lower cost of capital, reduced tax liability, or better efficiency of the internal capital market” (Renneboog & Szilagyi, 2008, p. 798). The following describes each effect and how it creates or destroys value for the stakeholders of a merging firm.

Diversification yields a lower cost of capital, because a diversified company is less likely to go bankrupt. A diversified company generates income from different and uncorrelated sources and is hence less risky. This in turn leads to a higher debt capacity and lower borrowing costs (Berk & DeMarzo, 2007); the company will be more profitable. Simplifying the effect in terms of European options shows that bondholders are, in a sense, holding a short put position, while stockholder hold long call options. Both have a strike price equal to the amount of debt. A risk reduction of the underlying asset, i.e. the firm, clearly benefits bondholders. However, the value of a long call option increases with volatility, or risk. From a shareholder’s perspective, the effect of diversification depends on whether a lower cost of capital can outweigh the decrease in volatility and is, therefore, a partial transfer of shareholder value to creditors.

Tax liabilities decrease since the company is able to offset taxable profits with losses from new divisions. This is, however, not a creation of value. Devos, Kadapakkam and Krishnamurthy (2009) find that it is rather a wealth transfer from the government to the company. They also find the benefits from an increased income tax shield to be so low, in comparison to operating synergies, that they do not consider it an important reason to merge.

The effect on internal capital markets is probably the most controversial aspect of financial synergies. Rajan, Servaes and Zingales (2000) provide a model that shows how diversification can lead to an improvement of internal capital markets, as long as incentives within the firm are aligned. If diversification increases, however, incentives diverge and resources will be allocated inefficiently. Rajan et al. (2000) also give a behavioural explanation stating that a firm’s CEO will try to distribute resources in way that satisfies every division. To minimize discrepancy, the CEO tends to favour smaller divisions at larger divisions’ costs. This is, however, no longer a value-maximizing allocation of resources and hence destroys firm value. In accordance, Chevalier (2004) states that some diversifying mergers do indeed create value, while others destroy value. She asks for further research on what affects this outcome.

2.2. Operating Synergies

Operating synergies are the largest fraction of total synergies (Devos et al., 2009). They arise from economies of scale, a more efficient allocation of resources, market power or a transfer of knowledge and technology. In the following, their potential to create synergistic gains will be presented.

Merging firms hope to reduce their average cost per unit, a concept known as economies of scale, by increasing their revenues at a rate higher than the increase in costs. Input bought in bulk can usually be obtained at lower prices. Overhead costs and costs associated with marketing etc. can be spread over a larger amount of units. This cost efficiency can be achieved through an expansion in form of a merger.

Before two similar firms merge, there are many duplicate tasks or even divisions that both companies have. After a merger the new firm can slash these duplications and reduce its expenditures, while keeping revenues constant. Resources are used more efficiently and profitability increases. There are, of course, more opportunities to eliminate duplications in a merger between related firms as they have more similarities. This explains why Devos et al. (2009) find that operating synergies are mainly due to reductions of expenditures and that these reductions are especially high in focused mergers. A more efficient allocation of resources thus leads to a real creation of value.

A merger of two firms creates a bigger, more powerful company with fewer competitors. The new company can take advantage of this increase in market power by charging higher prices for their products or paying less to their suppliers. The value created for the company is, therefore, offset by the negative impact on customers and suppliers. Basic micro-economic theory even shows that there will be a deadweight loss to society due to anticompetitive mergers (Perloff, 2009). Thus, an increase in market power does not create value and, from an economic perspective, cannot be considered a good reason to merge. Moreover, Devos et al. (2009) do not find economically significant synergies caused by an increase in market power and conclude that antitrust legislations are effectively preventing anticompetitive mergers.

Another operating synergy arises from the transfer of knowledge and technology. Firms hope to gain additional expertise and benefit from technological improvements. To have a real synergistic effect, the combination of merging firms’ knowledge and technology has to be greater than its sum. The combination needs to create something new in order to be a real gain.

2.3. Management Incenvtives

Apart from financial or operating gains that can be achieved through a merger, an amalgamation of firms also always affects management. Managers can have their very own interests and reasons to merge, because their incentives are not completely in line with those of other stakeholders. While stockholders prefer value maximization, managers might be looking for prestige and personal security. Morck, Shleifer and Vishny (1990) studied two typical expansion strategies that self-serving managers can follow: unrelated diversification and buying growth. They also showed that these strategies can be very costly to shareholders.

As discussed before, diversification usually hurts shareholders, while managers benefit from the risk reduction. Executives find their jobs to be more secure. Diversification is one way for a CEO to build his own empire and entrenchment (Renneboog & Szilagyi, 2008). Another way is to buy growing companies since it ensures the survival of the acquirer in the future. To meet their personal objectives, managers might even be willing to overpay for their targets, destroying even more shareholder value.

Another finding of the study conducted by Morck et al. (1990) is that underperforming managers are especially prone to follow these strategies described before, because they have more incentives to reduce risk and buy into growing businesses. Bad managers, therefore, make even worse acquisition decisions than their more successful counterparts. We can infer from this result that replacing bad management is another good reason to merge.

3. Do mergers create value?

The previous section presented several good, value-creating reasons to merge. In theory, mergers motivated by the right objectives should, therefore, lead to a real creation of value through efficiency-increasing synergies. However, large parts of academic literature are sceptical about managers’ abilities to realize synergistic effects and to correctly estimate their value. The hubris hypothesis by Richard Roll (1986), for example, states that decision makers of bidding firms overestimate synergies and target value. Managers overestimate their own abilities when trying to identify mispriced companies, because such mispricing does not exist when assuming efficient capital markets. Accordingly, they pay too much for the target, hence destroying firm value. Similarly, the Winner’s curse predicts that the winner of an auction overpays for the auctioned asset. If we assume the average bid to be the true value of the asset, the winner’s estimate must always be too high.

The underlying assumptions that markets are efficient, and that the average bid is the true value, are very strong and already present limitations to both theories. Additionally, Akdogu (2011) adds a “cost of losing” and argues that bidders are, under certain circumstances, willing to overbid for sound reasons. A merger of a firm’s competitors, for example, could be more harmful than overpaying to acquire the competitor. Hence, the occurrence of hubris or Winner’s curse can lead to some value-destroying mergers; however, they do not exclude the existence of value-creating company acquisitions. Devos et al. (2009, p. 1179), for instance, find “synergy gains in a broad sample of 264 large mergers between 1980 and 2004 to be 10.03% of the combined equity value of the merging firms”. Moeller, Schlingemann and Stulz (2005) also find the majority of mergers between 1980 and 2001 to be value-creating, while only a small percentage of deals with highly value-destroying outcomes deteriorates their overall outcome. They argue that many of these large-loss mergers did not even destroy value because of the merger per se. Instead, the merger announcement signalled to the market an overvaluation and a lack of growth opportunities on the part of the bidding company. Markets revaluated the bidders’ true value, which led to declines in their stock prices.

The “information dissemination hypothesis” (Draper & Paduyal, 2008) uses the same logic to explain increases in stock prices. Rather than being caused by synergies, higher stock prices could be explained by new information entering the market through merger announcements. Bidders obtain more attention and are revaluated by market participants. Undervalued firms would thus increase in firm value. However, this hypothesis only holds for firms that suffer from information asymmetry, otherwise there is no need for a revaluation. Draper and Paduyal (2008) find supporting evidence, showing that the information dissemination hypotheses is partly able to explain merger gains, while still leaving room for the existence of real efficiency gains.

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