Theories of and Gains from Mergers

THEORIES of MERGERS
The theories of mergers can be summarized into three major explanations.
The first category is synergy or efficiency, in which total value from the combination is greater than the sum of the values of the component firms operating independently.

• Gains to Target Positive
• Gains to Acquirer Positive
• Total value Positive

Hubris (the second category) is the result of the winner’s curse, causing bidders to overpay; it postulates that value is unchanged. Of course, in a synergistic merger, it would be possible for the bidder to overpay as well.

• Gains to Target Positive
• Gains to Acquirer Negative
• Total value NIL

The third class of mergers comprises those in which total value is decreased as a result of mistakes or managers who put their own preferences above the well-being of the firm, the agency problem.

• Gains to Target Positive
• Gains to Acquirer Negative
• Total value Negative

So as we see, gains to targets are always positive. The acquired firm is usually paid a premium, so there are pluses under each type of takeover theory.
Next, we consider gains to acquirers; In case of synergy or efficiency, total value can be increased sufficiently to provide gains to acquirers. With hubris, by definition, total value is not increased, so acquirers lose. With mistakes or agency problems, total value is decreased, so that the gains to targets imply severe loses in value for acquirers.

Sources of Gains in M&As

A. Strategy
1. Develop a new strategic vision
2. Achieve long-run strategic goals
3. Acquire capabilities in new industry
4. Obtain talent for fast-moving industries
5. Add capabilities to expand role in a technologically advancing industry
6. Quickly move into new products, markets
7. Apply a broad range of capabilities and managerial skills in new areas

B. Economies of scale
1. Cut production costs due to large volume
2. Combine R&D operations
3. Increased R&D at controlled risk
4. Increased sales force
5. Cut overhead costs
6. Strengthen distributions systems

C. Economies of scope
1. Broaden product line
2. Provide one-stop shopping for all services
3. Obtain complementary products

D. Extend advantages in differentiated products

E. Advantages of size
1. Large size can afford high-tech equipment
2. Spread the investments in the use of expensive equipment over more units
3. Ability to get quantity discounts
4. Better terms in deals

F. Best practices
1. Operating efficiencies (improve management of receivables, inventories,
fixed assets, etc.)
2. Faster tactical implementation
3. Incentives for workers—rewards
4. Better utilization of resources

G. Market expansion
1. Increased market shares
2. Obtain access to new markets

H. New capabilities, managerial skills
1. Apply a broad range of capabilities and managerial skills in new areas
2. Acquire capabilities in new industry
3. Obtain talent for fast-moving industries

I. Competition
1. Achieve critical mass early before rivals
2. Preempt acquisitions by competitor
3. Compete on EBIT growth for high valuations

J. Customers
1. Develop new key customer relationships
2. Follow clients
3. Combined company can meet customers’ demand for a wide range of
services

K. Technology
1. Enter technologically dynamic industries
2. Seize opportunities in industries with developing technologies
3. Exploit technological advantage
4. Add new R&D capabilities
5. Add key complementary technological capabilities
6. Add key technological capabilities
7. Add new key patent or technology
8. Acquire technology for lagging areas

L. Shift in industry organization
1. Adjust to deregulation—relaxing of government barriers to geographic and
product market extensions
2. Change in strategic scientific industry segment

M. Adjust to industry consolidation activities
1. Eliminate industry excess capacity
2. Need to cut costs

N. Shift in product strategy
1. Shift from overcapacity area to area with more favorable sales capacity
2. Exit a product area that has become commoditized to area of specialty

O. Industry roll-ups—taking fragmented industries, and because of improvements
in communication and transportation, rolling up many individual firms into
larger firms, obtaining the benefits of strong and experienced management
teams over a large number of smaller units

P. Globalization
1. International competition—to establish presence in foreign markets and to
strengthen position in domestic market
2. Size and economies of scale required for effective global competition
3. Growth opportunities outside domestic market
4. Diversification
a. Product line
b. Geographically—enlarge market
c. Reduce systematic risk
d. Reduce dependence on exports
5. Favorable product inputs
a. Obtain assured sources of supply—sources of raw materials
b. Labor (inexpensive, well-trained, etc.)
c. Need for local manufacturing
6. Improve distribution in other countries
7. Political/regulatory policies
a. Circumvent protective tariffs, etc.
b. Political/economic stability
c. Government policy
d. Invest in a safe, predictable environment
e. Take advantage of common markets
8. Relative exchange rate conditions

Q. Investment – acquire company, improve it, sell it

R. Prevent competitor from acquiring target company

S. Create antitrust problem to deter potential acquirers of our firm

Source: Mergers & Acquisitions by J. FRED WESTON and SAMUEL C. WEAVER, Mc Graw Hill Publications