Principal-Agency-Theory in Mergers and Acquisitions

Term Paper, 2015

19 Pages, Grade: 2,0


Table of contents

Table of figures

List of abbreviations

1 Preamble
1.1 Introduction and problem
1.2 Procedure and goal

2 Basics
2.1 Definition of Mergers & Acquisitions
2.2 Definition of principal-agency-theory

3 The principal-agency-theory in M&A
3.1 Hidden characteristics
3.2 Hidden intention
3.3 Hidden actions and information

4 Solution approaches

5 Conclusion

List of literature

Table of figures

Figure 1: Spectrum of M&A activities

Figure 2: The most important M&A transactions

Figure 3: Principal-agency relationship

Figure 4: Solution approaches

List of abbreviations

illustration not visible in this excerpt

1 Preamble

1.1 Introduction and problem

In times of globalization and increasing competition there are a lot of new big challenges for companies and their chief executive officers (CEO). High cost pressure, new competitors and the desire for a growing shareholder value are the challenges of global competitiveness.

After exhausting all opportunities of internal optimization potentials the only way for many companies to grow or to ensure survival is to merge with other companies. The CEOs of the companies try to manage the growing requirements by extending the business portfolios or even acquiring whole companies. So in 2013 in Germany the number of Mergers & Acquisitions (M&A) was the highest for five years.[1] A study of the Boston Consulting Group says that from 1988 to 2010 more than 26.000 transactions were realized.[2] This figure confirms the high importance of that method.

But are M&A the panpharmacon to handle the changing global markets and to ensure the prospective success of the companies? If you have a detailed look at the results you can recognize that a large number of executed M&A did not satisfy the expectations or even destroy value.[3] The risks are all too frequent just underestimated.[4] Often the failure is due to information asymmetry of the acting partners. This effect is called the principal-agency-problem.

What is the reason for that and why do so many M&A fail? What are the real goals of the participants of such an M&A-process? Do all participants pursue the same objectives or are there maybe any other intentions in the case? The following assignment deals with the M&A-process in relation to the principal-agency-theory and shows some solution approaches to avoid bad surprises for all participating companies after an executed M&A-process.

1.2 Procedure and goal

In the first part of the assignment the author goes into detail about the progress and the basics of this written report to ensure that the reader has the right understanding of M&A and the principal-agency-theory. Therefor particular definitions of these notions are formulated in the beginning. Because of the limited size of this report it is not possible to approach the whole topic all-embracing. So it is focused on specific subareas of these two big groups of themes.

After that the influence of the principal-agency-theory on an M&A-process is examined. In doing so only the in the previous chapter explained subject areas are taken into account. Potential problems of ignoring the information asymmetry are shown and possible consequences are demonstrated subsequently. It becomes clear that this effect has a huge impact on success or failure of M&A-transactions.

Because of the big influence of the principal-agency-problem on M&A in the next chapter there are presented some solution approaches to avoid or to minimize the risk of an unsuccessful M&A-transaction. Of course only a small selection of all imaginable variants can be illustrated.

In conclusion the results of the study are summarized and some recommendations are outlined to manage the descripted problems.

2 Basics

2.1 Definition of Mergers & Acquisitions

M&A often enable a company to develop a competitive advantage by increasing flexibility, growth, and shareholder value. Common M&A motives include: strategic growth, talent growth, preparation for an IPO or exit, and entering a new geographic or demographic market.[5] Originally M&A was the description for the reframing of a company.[6] Over the years „the traditional subject of Mergers & Acquisitions has been expanded to include takeovers and related issues of corporate restructuring, corporate control and change in the ownership structure of firms.”[7] The following figure shows the whole spectrum of M&A activities.

Figure 1: Spectrum of M&A activities

illustration not visible in this excerpt

Source: Copeland T., Weston F., Shastri K. (1988), p. 677.

The term “Mergers & Acquisitions” consists of two words and both describe a mean of corporate expansion and growth.[8]

But there are important differences between these both methods so they cannot be used uniform.[9] In Literature there are a lot of ways to determine the distinctive features. Some of them are shown in the sequel. Because of the limited size of this assignment not every definition can be quoted detailed.

A merger is when two or more companies combine to form a single entity under a consolidated management and ownership. A merger can take place through an amalgamation or absorption.[10] It´s also possible to distinguish between the directions of mergers.[11] Potential ways are horizontal, vertical and conglomerate mergers.[12]

For the further progression of the assignment it´s not necessary to define the differences.

Purchasing a company or parts of a company is called acquisition.[13] Usually the purchased company loses its independence.

There a lot of ways to differentiate the procedure of an acquisition. For example you can make a difference between Share Deal and Asset Deal but for the further process of the assignment this is not relevant. Another possibility is to differentiate between friendly and hostile takeover. Hostile takeover means that a company acquires a firm despite the disapproval of its board of directors.[14]

In this assignment hostile takeovers will not be taken into account.

In addition to mergers and acquisitions cooperations can be mentioned as third important area of M&A-activities.

Cooperation means that two or more entities work together voluntarily for a common purpose.[15] The most frequent forms are Joint Ventures and strategic alliances. For a detailed definition of these two terms please check specialized literature.

The following figure gives a summary of the most common M&A activities.

Figure 2: The most important M&A transactions

illustration not visible in this excerpt

Source: own illustration; referring to: Vogel D. (2002), p.5 and Wirtz B. (2003), p. 13.

Furthermore the process of M&A-activities can be divided into specific phases. The phases are not content of this assignment.

2.2 Definition of principal-agency-theory

As in the introduction implied the principal-agency-theory (PAT) has a huge impact on success of M&A-transactions. Subsequently the PAT is particularized. Thereby the author focusses on the for this assignment relevant information.

The PAT does not only occur in M&A transactions but also in everyday life. Everybody is frequently confronted with this phenomenon. But what exactly is a principal-agency-relationship?

Broadly defined there is a principal-agency relationship „whenever one individual depends on the action of another.“[16] For this assignment the definition has to be narrowly defined.

The PAT is a cooperation form of two or more subjects with their own interests. Both try to achieve their optimal goals.[17] The objectives of the subjects interact and are in conflict. One of the subjects performs an action to achieve its goals. This action affects on the interests of the other subject. The acting subject is called “agent” and the affected one is called “principal”.[18]

You can say that the subjects act opportunistically. Opportunistically means that the subjects pursue their goals without regard for the goals of the other subject. Often times tricks and perfidies are used in this relationship to maximize the own benefit at the other subject`s expense.[19] Therefor information and knowledge are kept to oneself or even falsified to deceive the counterpart.

The PAT is a method for analyzing problems where one party (the principal) hires another party (the agent) to perform a certain task for her. It investigates the phenomenon of opposed interests and information asymmetry which is quite often the reason for unsuccessful M&A-transactions.

Exemplarily for a Principal-agency-relationship the relationship between lender and borrower or shareholder and CEO can be mentioned.[20] The following figure shows the structure of a principal-agency-relationship.

Figure 3: Principal-agency relationship

illustration not visible in this excerpt

Source: Anderson B., Dovey L., In: Working Paper Series (2003): p. 6.

3 The principal-agency-theory in M&A

As described the basis of the PAT is information asymmetry between principal and agent. In this chapter we will have a look at the PAT in M&A-transactions. In the M&A-process there are a lot of principal-agency-relationships. The principal needs the agent for a special task. The agent carries out an action or an effort on behalf of the principal.[21]

The author focusses on the relationship between two companies. Company A (principal) wants to purchase Company B (agent). The circumstances are regulated by a negotiated contract.[22] The contract contains regulations about the principal`s payments and the agent`s duties but it´s legitimate for both parties to press for a more favorable position within the zone of agreement. In these problems the principal is the uninformed party and the agent is the informed party. So the agent is capable to use the information asymmetry for his advantage.[23]

Hillier describes the problem as follows: “We assume […] that the agents are purely self-interested and are willing to lie to the principal about the information they have but which the principal does not have, whether they have this information prior to signing a contract with the principal or acquire it after signing a contract. Similarly, we assume that the agents are willing to deceive the principal about their actions if they perceive it to their average to do it.”[24]

In our case the principal is looking for a low purchasing price and high utility by the acquisition. The agent is looking for a high purchasing price and low work effort. Subsequently the most important varieties of information asymmetry are explained. Information asymmetry is concerned with three main asymmetries:

1. Hidden characteristics
2. Hidden actions and hidden information
3. Hidden intention

3.1 Hidden characteristics

Hidden characteristics are things that one side of a transaction knows about itself that the other side would like to know but does not. The principal can´t value the characteristics and qualities of the agent before the contract is made.[25] The hidden characteristics of the agent can be wanted or unwanted by the principal. The principal is looking for an agent with good skills because the principal´s return depends on the agent´s qualities. Because of the uncertainty about the agent`s skills and his pursuit of utility maximization there is a risk of selecting a bad agent. This is called adverse selection.[26]

In M&A-transactions company A cannot be sure to have all information about the quality of company B before the contract is made. Sometimes the acquiring party experiences bad surprises after an executed transaction. To minimize this risk principals offer an average purchasing price. So the loss is not that big if the quality of the agent is bad. As a consequence the bad-skilled agents will accept the average offer because they feel well-paid and the high-quality agents will not accept the offer because they expect better quotations. In the worst cast that effect can destroy a whole market. This phenomenon was firstly described by George Akerlof in his “Lemon-Problem”.[27]

3.2 Hidden intention

The problem of hidden intentions is quite similar to the hidden characteristics. The principal cannot quote the intentions and objectives of the agent before the contract is made. By making irreversible concessions the principal depends on the loyalty of the agent. After the contract is made the principal doesn´t have any possibilities to influence the acting of the agent.[28] The effect of sunk cost plays a decisive role in this context. The agent can take advantage of this situation for his own utility. The agent´s activities can differ largely from the principal`s expectations.

This phenomenon can occur in M&A-transactions, too. After the purchase contract for a company B is signed the agent can remove assets from the company without being noticed by the principal.

3.3 Hidden actions and information

When the relationship is established the participants have the same information and the informational asymmetry arises when the contract has been made. The problem of hidden actions describes that the principal can´t control or observe the actions and effort of the agent completely.[29] In contrast to the problem of hidden information the principal can evaluate the result of the agent`s activities. But he cannot judge if the result is a consequence of the agent`s effort or the result of changed states of environment.[30] There is the risk that the agent doesn`t observe agreements. This can have negative effects on the principal´s return. This phenomenon probably occurs when the agent expects a higher return by acting (unnoticed) nonconforming.[31] This behavior is called Moral Hazard. “A Moral Hazard problem exists when the agent’s action is not verifiable, or when the agent receives private information after the relationship has been initiated.“[32]

Receiving private information describes the problem of hidden information. The agent can abuse the information opportunistically for his advantage. The principal can observe the agent`s activities but he cannot evaluate the result because he doesn`t know the agent´s information.[33]

The problem of hidden actions and hidden information can arise in M&A-transactions, too. For example the CEOs of purchased company B receive information about changing economic circumstances the CEOs of company A do not have. In this case the management of company A can observe the activities of company B but they are not capable to evaluate the result.


[1] Cf. Ollrog M. (2014).

[2] Cf. Boston Consulting Group (2011), p.5.

[3] Cf. Ernst & Young (2006).

[4] Cf. Deloitte (2007), p. 25.

[5] Cf. PrivCo (2015).

[6] Cf. Vogel D. (2002), p. 3.

[7] Copeland T., Weston F., Shastri K. (1988), p. 676.

[8] Cf. Sudarsanam S. (1995), p. 1.

[9] Cf. Jansen S. (2008), p. 92.

[10] Cf. PrivCo (2015).

[11] Cf. Wirtz B. (2003), p.19.

[12] Cf. US Department of Commerce (2015).

[13] Cf. Vogel D. (2002), p. 9.

[14] Cf. Business Dictionary (2015).

[15] Cf. Dictionary (2015).

[16] Barnea A., Haugen R., Senbet L. (1985), p. 25.

[17] Cf. Barnea A., Haugen R., Senbet L. (1985), p. 25.

[18] Cf. Fischer T. (1999), p. 29.

[19] Cf. Williamson O., In: Journal of Law & Economics (1993), p. 458.

[20] Cf. Thomas J., Worrall T. In: Journal of economic theory (1990), p. 368.

[21] Cf. Macho-Stadler I., Pèrez-Castrillo D. (2001), p. 5.

[22] Cf. Picot G. In: Picot G. (2012), p. 297.

[23] Cf. Arrow K. In: Pratt J., Zeckhauser R. (1985), p. 38.

[24] Hillier B. (1997), p. 5.

[25] Cf. Welge M., Eulerich M. (2012), p. 12.

[26] Cf. The Economic Times (2015) and Macho-Stadler I., Pèrez-Castrillo D. (2001), p.11.

[27] Cf. Akerlof G. In: Quarterly Journal of Economics (1970), p. 488-500.

[28] Cf. Welge M., Eulerich M. (2012), p. 12.

[29] Cf. Macho-Stadler I., Pèrez-Castrillo D. (2001), p. 51.

[30] Cf. Macho-Stadler I., Pèrez-Castrillo D. (2001), p. 37.

[31] Cf. Welge M., Eulerich M. (2012), p. 12.

[32] Macho-Stadler I., Pèrez-Castrillo D. (2001), p. 9.

[33] Cf. Macho-Stadler I., Pèrez-Castrillo D. (2001), p. 37.

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Principal-Agency-Theory in Mergers and Acquisitions
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Tobias Marsch (Author), 2015, Principal-Agency-Theory in Mergers and Acquisitions, Munich, GRIN Verlag,


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