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Strategic Management: Mergers and Acquisitions
It seems now more than ever, large corporations, many which were competitors, are joining forces. Look at HP-Compaq, Exxon-Mobil or Morgan Stanley Dean Witter. Each of these new, leaner companies are just a sampling of the myriad of mergers and acquisitions happening around the world. In order to reduce costs, increase revenues and consolidate assets, many corporations have turned to M&As between strategically related firms to increase their net present value. This can occur via competitive advantages, several of which are explored below.
There are 5 primary types of mergers and acquisitions. These are vertical, horizontal, product extension, market extension and conglomerate mergers/acquisitions. A vertical merger is when a company acquires another firm in front of it (such as penzoil buying out Jiffy Lube) or behind it (such as Nordstrom buying out a clothes designer). A horizontal merger occurs when a competitor is acquired (such as Exxon buying out Mobil). A product extension merger occurs when the firm acquires complementary products (such as IBM purchasing Tivoli Systems and Lotus Software). Market extension mergers allow the firm to branch out to other locations (such as Microsoft’s acquisition of Hotmail.com to capture additional e-mail users). Conglomerate mergers are often acquisitions of unrelated businesses that do not fall into any of the aforementioned categories.
Although we briefly defined the different types of M&As, the reasons behind these activities are more complex. In 1983, Lubatkin offered three possibilities. The Technical Economies in marketing and production would allow for more goods produced with the same amount of inputs. The Pecuniary Economies allow firms to set prices because of their great market power. The Diversification Economies allows the company to lower its risk relative to its performance.
That same year, Jensen and Ruback also devised explanations for M&As. One reason was to reduce production and distribution costs via economies of scale, vertical integration, adoption of more efficient production/organization technology, higher use of the management and reducing agency costs. Another overlying reason was for financial benefits to gain access to tax advantages, avoid bankruptcy and to increase leverage. Two other reasons were to gain market power and to eliminate inefficient managers.
As we see, just the strategic similarities between two firms is not enough to for the stockholders of these firms to earn above normal profits. This is especially true if the firm’s potential is well known, many firms are bidding, semi-strong capital market efficiency holds and the owners will only, at best, earn normal economic returns. However, in one study by Jensen and Ruback, when the bidding firm directly makes offers to the equity holders of the target firm, both the market value of the bidding and the target firm increased (4 and 20% respectively).
One might wonder why there are so many of these M&As occurring. Some possible answers to this question are offered by Jay Barney. To ensure survival small firms merger to gain market share and power. Firms that generate large sums of free cash flow may want to invest in businesses that will at least hopefully guarantee normal returns. Agency problems may arise when managers benefit even if the firm does not. Managerial hubris foolishly exists, which is the belief that the bidding firm can better manage the target firms than its own managers can. And, of course, there is always the potential for above normal profits.
As discussed earlier, M&As may occur in order to sustain a competitive advantage. Some may occur because the target firms is worth more to one particular bidding firm than any other, yet no one realizes this value at the time of purchase. Other M&As may happen because the target firm has economies that are too expensive to imitate and one bidding firm may have valuable and rare economies unmatched by other bidders. A third type of M&A can occur, which is by far the most common. This involves the unexpect value of economies of scale. Because the firms are often large and the deals are complex, many unknowns arise and much has to be assumed.
Barney points out six rules for bidding firm managers to follow in order to acquire the best firms at the most competitive prices. First, they should search for valuable and rare economies of scope. To do so, the value of the target should be consider not only from the one bidder’s point of view, but from all bidder’s and what they look for and how they would value the target. Second, keep information away from other bidders. Although difficult with public firms, private firms are easier to keep hidden. Third, keep info away from the targets so they will not try to bilk the bidding firm. Fourth, avoid winning bidding wars because when many firms compete, the derived profit is rarely above normal. Fifth, close the deal quickly. Information can become public, costs increase and value decreases. Lastly, complete acquisitions in “thinly traded” markets. These markets have few buyers and sellers, privately held information on opportunity and other values besides economic profits.
There are also rules for target firms to deter bidding firms from achieving economic profits by acquiring target businesses. First, seek the information held by other bidders to better gauge opportunities and set their own price. Second, invite other bidders to join the competition to eliminate above normal profits for the acquiring firm and to get a better idea for the perceived value of the firm. Third, delay but do not stop the acquisition. This allows the target to accept higher prices and have a more competitive market for controlling purposes.
Some of these actions can reduce, increase and have no effect on the wealth of target firm equity holders. Greenmail, standstill agreements and poison pills can reduce the wealth. Shark repellents, Pac Man defense, crown jewel sales and lawsuits may not have an effect on the wealth. Searching for white knights, creating bidding auctions and golden parachutes can increase the wealth of target companies.
The merger or acquisition between two firms does not end at the signing of the agreement. Just a high school student applying to a university, the college process and life has only begun. The consolidating of departments must ensue. The bidding firm must go through the process of implementing new technologies into their current processes. New managers must be trained and some employees must be released. Accounting practices, HR departments and even business cards must merge as one. Even though this will be a long, often arduous process, distinct cultures, practices and operations must come together and synergistically work better than each firm before the merger/acquisition was able to do. However, the difficulty and cost of implementing this unity must be a factor for determining whether to join with the target firm.
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