Sunday, December 12, 2010

Theories of Mergers and Acquisitions

Theories of Mergers and Acquisitions
Reasons or theories for M & A
Many theories exist to explain the reasons of mergers and acquisitions.
Reason may be due to increase buying power with suppliers, backward integration, achieve distribution net work etc.
One common desire – strength the existing business and create growth /synergy.
These explanations have later become testable hypotheses/theories.
But, acquirers have their own agenda which is not visible to market. It may be over confidence/personal gain etc.
Reasons or theories for M & A
WHY are some corporate heads so gung-ho about mergers and acquisitions (M&A) when the empirical evidence available strongly suggests that the value created by these exercises accrues almost completely to shareholders of the target company rather than to those of the acquiring firm?
If the popular assumption that corporate chiefs act rationally is valid, why do so many mergers and acquisitions nevertheless take place? Does this mean that the assumption about the rationality of all corporate heads may, not be entirely valid?
These are some of the questions addressed in a recent study titled Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction, by Ulrike M. Malmendier, assistant professor of finance at the Graduate School of Business, Stanford University, and Geoffrey A. Tate, assistant professor of finance at the Wharton School of the University of Pennsylvania.
Reasons or theories for M & A
In their study, which has been in circulation in the US as a National Bureau of Economic Research working paper, the authors argue that "overconfidence among acquiring CEOs is an important explanation of merger activity", which they describe as "among the most significant and disruptive activities undertaken by large corporations."
Reasons or theories for M & A
Strategic realignment. Due to dynamically changing environment, mergers provide perhaps fastest route to respond the changes in industry and market.
Undervaluation by market. This means the target is generally undervalued by the market. This may not be due to inefficiency of the target and that is what differentiate this theory from the inefficiency theory. The undervaluation may be only due to non-release of private information which only the bidder have at that point of time.
Information and signaling. There are two versions of this theory. Sitting on the golden mine. The tender offer by a bidder it self signifies undervaluation and lead to revaluation of shares by market.
Second, kick in the pants, which means, the offer itself inspires the target to implement more powerful strategy. The tender offer on target firm signals that there is a potential untapped in the target. Use of stock by bidder to finance acquisition, means, one, stock is over valued and second, the expected benefits from the acquisition is not certain.

Reasons or theories for M & A
Agency and managerialsm. As explained earlier, managers initiate mergers to gain private benefits from the transaction irrespective of loss (or loss of profit) to the shareholders. Managers also tend to involve in mergers as they tend to be arrogant or overconfident about the success of the deal and land up entering into often inefficient transactions. This is also called HUBRIS hypothesis.
Market power. Mergers are initiated by dominating the market. This is different from economies of scale discussed earlier. Increased relative market share of the bidder provides it a potential to realize monopoly gains.
Through market power, a firm gets the ability to set prices at levels that are not sustainable in competitive market. E.G. WALL Mart.
Market power can be achieved through product differentiation, entry barriers and market share.
Reasons or theories for M & A
The q – ratio and buying under valued shares.
The q ratio is defined as ratio of market value of acquiring firm’s shares to the replacement cost of its sales.
Firms which are interested in expansion always look to acquire a firm whose market value is less than the replacement cost of its assets. This is the main reason more M & A in 1970s since inflation and high interest rates hiked up the replacement cost. Further, time involved in acquiring the cost.
E.g. TATA- CORUS – it would have taken 30 years for TATAs to build the green field plant similar to the size of CORUS – Mr. Muthuraman, CMD, TATA Steel.
Reasons or theories for M & A
The valuation theory: Acquisitions or mergers are carried out by executives who have access to more accurate information on the real value of the company to be taken over than can be found from the investment market.
* The empire-building theory: managers who are responsible for formulating and applying strategies, have one aim in mind: to maximize their use.
Theories of M & A
The process theory: attempts to justify acquisitions and mergers by attributing them to
the limited rational of management teams that
make this decision, without bothering to carry
out a deeper analysis of the alternatives.
The economic disturbance theory: acquisitions
and mergers succeed one another in waves.
They are caused by economic disturbances that
modify individual behavior patterns and expectation
Differential efficiency theory
It is nothing but extension of managerial synergy. Theory assumes that management not performing up to potential.
According to this theory, if one firm is more efficient than the other , efficient shall acquire less efficient firm and bring it up to level of own standards. It is question of relativity in efficiency
Underlying logic/reasoning – less efficient is more vulnerable since efficient will identify such firms. It will help to utilize surplus resources and improve the less efficient firm’s performance. Thus , merger may create synergy since surplus managerial resources of the acquirer combine with non managerial capital of acquired firm.
E.g. Jet & Sahara Airways.
Some times firms looking for diversification compulsion (due to saturation in own industry/country),may try to gain foot hold in another industry so that acquiring firm's organizational capital can be exploited.
Caution – acquiring firm is over optimistic and over estimation to improve firm’s performance. This may result in over estimation of value also and performance not happening as per assumptions.
Inefficient management theory
Inefficient management means incompetent in complete sense.
It could be the basis for conglomerate mergers.
Another firm is in position to manage more efficiently.
This is the strategy of L N Mittal – acquiring weak firms and make them viable and profitable

Synergy Theory
One of the main reasons for M & A is synergy which may arise in
1.Finanacial synergy -
2. Operating synergy – King Fisher – Air Decan
3. Cross border synergy – Birla acquiring Novalis , an American company who has the client base of Pepsi, Coke etc
4. Distribution synergy - P & G & Gillette
5. R & D synergy. TATA - CORUS
Synergy Theory – expects that there is really “something out there” which enables the merged entity to create shareholders value
Simply defined, it means that the whole is greater than the sum of the individual parts
Drivers of Synergy
Synergy - WHAT IS IT?

*Popular definition: 1 + 1 = 3
*Roundabout definition: If am I willing to pay 6 for the business market-valued at 5 there has to be the Synergy justifying that
*More technical definition: Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities
Means type of benefit that may happen when 2 firms may create more value which is greater than the individual values of both.
It means 2+2 = 5
in anticipation of such synergy, acquirer is prepared to pay premium and incur acquisition expenses.
NAV = VAB (VA + VB) – P – C
VAB = combined value of 2 firms.
VB = market value of firm B
VA = market value of firm A
P = premium paid for B
C = Cost of acquisition

Synergy – failures
operating synergy.
This states that even when both the target as well as bidder are equally efficient, simply combining their resources would lead to synergistic benefits due to economies of scale and complementary benefits. Thus, mergers are driven by synergy.
It may result in economies of scale. Individually it may not be possible to exploit such synergy.E.g. spreading of fixed cost over increasing level of production in a industry having substantial over head expenses.
Operating economies of scale is achieved through Horizontal, Vertical and conglomerate mergers. Operating economies may occur when fixed assets such as men. Material are indivisible.
E.g. an expensive equipment in a pharma company.

operating synergy.
Operating economies may be achieved through R & D , marketing etc.
E.g. P&G marketing skill with Gillette distribution net work will give an competitive edge vis-à-vis HLL & Colgate & Unilever in global market.
Operating economies is achieved through in management for planning and controlling since it requires minimum staff to get that. A mid size firm may not have that. But acquirer may have that.
Vertical merger ( acquiring a supplier) may save in terms of price, time etc. E.g. RIL & RPL.
Financial synergy
Tax saving
Increasing the debt capacity
Companies with different cash flows – if cash flows are not perfectly co related , it may reduce the risk. Instability in cash flow may reduced by acquired firm. E.g. Conglomerates – one cyclical and another in non cyclical industry.
This is based on principle of diversification per se. Diversification may have value in reducing the risk of overall business portfolio. Demand for diversification may be by managers, employees, for preservation of organisation, and reputation capital.
Diversification through external growth rather than internal is preferred because firm may lack internal resources or capabilities.
Employees – employees have a specific skill set developed over a period of time and it is only valuable only to that firm No alternative employment . But share holders can diversify. Employees seek job security , stability and growth. These needs to be fulfilled through diversification.
Owner manager - diversify and reduce risk but also keep corporate control.
Firm and employees – firm has full information on employees about skill profile. It may shift from un productive activities to productive ones through diversification
Financial and tax benefits – utilize huge cash surplus . Reduce tax liability etc.

Cost & benefit of M & A
A plans to acquire B.
Merger is expected to bring in PV of Re 10 million.
A offers 2,50,000 shares in exchange for 5,00,000 shares of to B share holders
Cost and benefit
Cost = aPVAB – PVB
a represents a fraction of the combined entity received by share holders of B.
Share of B in the combined entity is
A = (2,50,000/ (10,00,000+2,50,000)) = 0.2
PVAB = PVA + PVB + Benefit.
= 100 +20+10 = Re 130 Million
Cost = aPVAB – PVB = 0.2 x 130 – 20 = 6
NPV to A = benefit – cost = 10-6= Re 4 million
NPV to B = Re 6 million

Changing business environment
Change in business environment may necessitate M & A.
Changing environment may include regulatory, tax, technology / Globalization impact etc.
E.g. Banking/Insurance/Telecom/ Pharma /FMCG/Aviation etc
Some times the firm may have limited period of growth.
Adjustment through internal adjustment may take time. So, external acquisition will help to reduce time involved.
Otherwise, competitors may exploit the situation

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