Motives behind Mergers and Acquisitions - Literature review Example

MERGERS AND ACQUISITIONS Motives behind Mergers and Acquisitions The existing literature indicates that companies can be grown either through internal expansion or external development. An internal expansion growth is where an entity develops gradually over time and in the ordinary course of its business, through new assets acquisition, replacement of the technologically obsolete equipment as well as the establishment of new products lines. In the case of external expansion, an entity acquires an already running business and grows overnight due to the corporate combinations (Ferris & Petitt, 2013). These combinations are majorly in the form of amalgamations, mergers, takeovers, and acquisitions and have now become essential features in corporate restructuring. Due to the wake of economic reforms, entities are viewing it prudent to restructure their operations around their principal business activities strategically through acquisition because of their burgeoning exposure to competition from both domestic and international arena. According to the existing literature, companies engage in mergers and acquisitions for myriad reasons. Some of these motives are view as being good since they are aimed at maximizing the shareholders wealth while others merge or acquire others for questionable reasons (Ferris & Petitt 2013). Synergistic motives In essence, companies should pursue mergers and acquisitions only if such actions create value. In other words, companies should merge if they are working as a single unit as opposed to working individually offers a greater value. Ferris and Petitt’s (2013) study established that synergies take three forms namely financial, managerial and operating synergies. Financial synergies arise from lower financing cost because big companies have access to a broader and cheaper pool of funds compared to small companies (Malik et al., 2014, p. 528; Koi-Akrofi, 2014, p. 1812). When companies that carry out unrelated businesses merge, there is the reduction in risk that makes them increase their debt capacity and enable them to lower their before-tax financing cost. In this context, there is also the aspect of improved financing in the sense that companies facing financial problems may be forced to look for others that are financially stable to acquire them instead of going out of business or taking bankruptcy. The merger causes the firm to expand which makes it easily get access to debt and equity financing which was initially beyond its reach. According to an analysis done by the New York University Stern School of Business (2015) and Malik et al. (2014, p. 528) mergers enjoy tax advantages in the form of a tax loss carry forward. This arises where one of the merging firms has previously made losses that are offset against the profits made by the other. This is particularly valuable where the merging company is anticipating that it will enjoy operating profits in future in order to benefit from this tax shield (Damodaran, 2005, p. 5). The operating synergies are the added value as a result of an acquisition or a merger that allow firms to boost their operating incomes, growth or both. According to Ferris and Petitt’s (2013) research, the first type of operating synergies is the economies of scale where the companies merge with one another so as to lower the cost of doing its business. This gives rise to a win-win situation as the reduced cost of doing business by the newly merged firm will also be passed on to the customers who pay less. In addition, a merger results in operating economies where the small organizations business functions are much expensive for them but affordable for the combined firm. Operating synergy also arises from the combination of different functional strengths. Specially, entering new markets or products, an entity may be lacking technical skills making it require special marketing skills as well as an extensive distribution network to reach different segments of markets (Damodaran, 2005, p. 4). An entity can acquire an existing entity or entities with requisite infrastructure and skills for a quick growth. Santos et al.’s (2011, pp. 7-9) study found that entities engage in acquisitions in order to accelerate their growth, particularly when their internal extensions are constrained by scarcity of resources as internal growth requires that an entity develops its operating facilities, such as manufacturing, researches, marketing, among other things. But inadequacy or lack of resources and time necessary for internal development constrain an entitys pace of growth. Acquisitions, therefore, enable an entity to acquire production facilities and other resources from outside. The other sources of synergy arise from the enhanced management. According to Ferris and Petitt’s (2013) findings, managerial synergies are realised when a firm with a high performing management acquires a poorly managed company and replaces the poor performing team. The acquirer gets the opportunity to remove the incompetent managers and help in improving the targets performance. The resulting combined management and other systems support in strengthening the capacity of the conglomerate entity to withstand the unforeseen economic factors severity that could otherwise endanger the individual entitys survival. However, Santos et al.’s (2011, p. 9) research argued that, from managerialism hypothesis, managers could be motivated to engage in mergers and acquisitions to maximise their utility at the expense of shareholders. There are also instances where the managers of the acquirer in assessing the acquired companys value but choose to continue the deal. According to Motis’s (2007, p. 18) study, the aspect of the managers engaging in mergers can be based on the internal inefficiency theory of the firm which was first analysed in 1966 by Leibenstein. This theory states that a difference arise between how economics predicts the firm should be and what is observed in practice because the modern companies are complex leading to the divorce between their ownership and their management. This is what gave rise to the agency theory and taking into consideration the managers and shareholders; conflicts arise whenever there is asymmetric and incomplete information between them (Malik et al., 2014, p. 528). Conflicts will always arise because managers seek to maximise their wages instead of the shareholders wealth. The empire building motive drives managers into mergers and acquisitions in order to grow their firms and get higher compensations especially where their remuneration is performance- based (Motis, 2007, p. 19; New York University Stern School of Business, 2015). Hubris has also been seen as a motive why managers engage in mergers and acquisitions (McCann, 2004, p. 3). They incorrectly believe that they are superior managers who can successfully manage other firms. These managers are overconfident in their managerial abilities, which make them end up overpaying to acquire the target and make the acquirer lose. Such a move makes the shareholders of the acquirer lose. Another motive why companies engage in mergers and acquisitions is the need to raise entry barriers. According to Motis’s (2007, p. 15) research, post-merger pose higher entry barriers since there will be enhanced market power, especially where such a merger unifies two potentially competing technologies. They will also be able to exercise unilateral effects on prices. Diversification is another motive for mergers and acquisitions and is related to the modern portfolio theory that posits that the firms market value can be increased by incurring optimal risk by investing in several uncorrelated instruments. Motis’s (2007, p. 13) study states that under diversification, managers assemble a portfolio comprising the selected portfolios from the merging entities based on their overall risk-return appetite. According to Santos et al.’s (2011, p. 7) findings, an entity is able to diversify its risks, particularly where the acquisition is of those businesses whose income streams differ from those of the acquirer, leading to growth. Bendeck and Waller’s (2007, p. 15) study on bank acquisition announcement note that shareholders diversify their portfolios with a view to obtaining geographical balance since they expose them to new markets that improve their profitability. This diversification results in total risks reduction as there is a substantial reduction of operations cyclicality. Effect on the stock price of acquirer pre and post-merger and acquisition To establish the effect that mergers and acquisitions have on the acquirer as well as on the target firm, accounting variables that measure performance or the stock performance are used (Yildirim, 2014, p. 4). In their study on the Turkish acquirers performance as a result of mergers and acquisition, Akben-Selcuk and Altiok-Yilmaz’s (2011, p. 2) analysis used both the accounting approach and the stock market approach. Through the stock market approach, an investigation is done to assess whether there are abnormal returns earned by the security holders as around announcements of mergers and acquisitions. Using the accounting approach, some profitability ratios are computed, and they include the return on assets, return on net sales, and the return on total equity. From this study using the stock market approach, Akben-Selcuk and Altiok-Yilmaz’s (2011, p. 5) findings were; the returns for the Turkish companies’ stocks involved in acquisitions was above the average industry returns. However, using the accounting approach to the same study, they established that post acquisition return on net sales and return on assets values were materially lower than pre-acquisition values. This was in agreement with some existing studies and literature that posit that acquirers do not typically experience any positive abnormal returns around the announcement of mergers and acquisitions. Different and mixed findings have been established and as reported by Yildirim (2014, p. 4), Dodd 1980, Malatesta 1983, Bradley and Sundaram 2006, and Franks and Harris 1989, whereby the acquirer do not benefit from acquisitions. Contrary to these findings, Yildirim’s (2014, p. 4) study reported that a study carried by Cornett and Tehranian 1992 found that acquirers performance improved after the merger. According to Sapunji and Friedrichsen’s (2011, p. 3) study, the share price of the acquirer does not perform better compared to that of the target. The argument is that the target’s performance improves especially where poor management is replaced with high performing management. From the differing views, Sapunji and Friedrichsen’s (2011, p. 3) findings agreed that there lacks a consensus about the acquirers stock reaction to the announcement of mergers and acquisitions. A study conducted by Moeller et al. (2004), found a negative return of -1.6% for acquiring firms. In their study on a sample of 12,023 acquisitions from 1980 to 2000 by Stulz et, al. (2004) found positive significant returns of 1.1% to acquiring firms upon the announcement of mergers and acquisitions. In their work study where they analysed a sample of 519 successful completed takeovers in the UK over the period of 1983-95,Sudarsanam, Ashrav and Mahate (2003) found that acquirers experienced negative abnormal returns of -1.4% (Sapunji & Friedrichsen, 2011, p. 4). Conn et al.’s (2005) study examined the announcement and post-acquisition returns of UK acquirers’ shares in over 4,000 acquisitions involving domestic and cross-border targets and established that there was a positive announcement abnormal return of 0.59%. Contrary, Franks, Harris and Titman’s (1991) study examining the share price performance for a sample of 399 mergers and acquisitions for the period of 1975-1984 found an abnormal return of -11%. So, from these empirical results on the share price reaction of acquiring firms are contradictory. A recent practical case for a successful acquisition involved the acquisition of URS Corporation by the AECOM for a price of $6 billion with the deal being closed on October 17, 2014 (AECOM, 2014). According to Ben’s (2014 research the acquisition was aimed at increasing the operating efficiency of AECOM as it would save up to $250 million. The resulting efficiencies will originate from their combined talents to would enable AECOM to serve its clients in a much better manner. In addition, AECOM would benefit from the strong market presence by URS in over 150 countries. According to Caelainn et al.’s (2014, July) analysis, this announcement of the planned acquisition made the share price of AECOM rise. The share surged by 10% to $37, the biggest increase in its last two years. From figure 1 below, it is clear that the share price continued to increase to October when it dropped. The post-merger effect is that the stock price slightly increased before falling again since then. Prices Date Open High Low Close Avg Vol Adj Close* Apr 1, 2015 30.79 33.93 30.66 31.56 1,283,300 31.56 Mar 2, 2015 29.97 31.32 28.61 30.82 1,655,200 30.82 Feb 2, 2015 25.65 30.23 25.48 30.06 1,994,000 30.06 Jan 2, 2015 30.37 30.97 24.82 25.42 1,975,200 25.42 Dec 1, 2014 31.83 31.90 28.17 30.37 1,535,000 30.37 Nov 3, 2014 32.68 34.24 30.13 32.01 1,808,400 32.01 Oct 1, 2014 33.79 33.84 27.23 32.55 2,485,000 32.55 Sep 2, 2014 37.82 38.00 33.73 33.75 1,023,400 33.75 Aug 1, 2014 33.84 38.24 33.25 37.84 1,635,300 37.84 Jul 1, 2014 32.20 37.00 31.19 33.95 2,301,200 33.95 Jun 2, 2014 32.09 33.74 31.36 32.20 645,000 32.20 May 9, 2014 31.81 33.02 29.93 32.14 746,000 32.14 * Close price adjusted for dividends and splits. Source: Finance Yahoo (2015) Effect on the wealth of acquirer pre and post-merger and acquisition Similarly to the effect of mergers and acquisitions on the share price on the acquirer, there are concerns about its effect on the wealth of the shareholders. According to Ferris and Petitt’s (2013) research, the equity markets are always sceptical about the acquirers’ ability to create their shareholders value. Even though the offer prices could be seen as being excessive, the proposed and anticipated synergies might fail to materialise. In addition, the equity markets view the current management as incapable of successfully merging the different cultures, consequently doubting the value associated with most mergers and acquisitions transactions. This view by the equity market markets is correct. A study conducted by KPMG between 2007 and 2009 on a large sample of mergers and acquisitions found that 44% of them achieved zero or very little of the projected synergies. Reporting on Kengelbach, et al.’s (2012) study conducted in 2011, Ferris and Petitt’s (2013) study confirmed that divestitures characterised the mergers and acquisitions that had been done and made up 45%. Sapunji and Friedrichsen’s (2011, p. 1) study argued that it is empirical that mergers and acquisitions have been failing to lead to value creation, an issue that is contrary to initial projections, thereby leading to value destruction. This is attributed to the fact that, similar to any other process, mergers and acquisitions are prone to many obstacles and difficulties during acquisition phase as well as post acquisition period. To some extent however, these difficulties are caused by those initiating the deals making them to be hidden in earlier made decisions such as how much to pay, when to pay how to pay, whether to seek the advice of an external expertise or not, and other aspects related to the acquired firm such as its size, location and industry relatedness (Sapunji & Friedrichsen, 2011, p. 2). Therefore, the right decisions are good ingredients for the value creation after mergers and acquisitions. According to Uzunski and Skovmand’s (2011, p. 10) evaluation, the strategy involved have an impact on the price of the share, as well as the value creation after the mergers and acquisitions. Cross-border mergers and acquisition have shown a positive influence on the acquirers value because of an acquirers greater flexibility in resources allocation, and because of greater economies of scale as well as of scope (Damodaran, 2005, p. 4). However, there are instances where negative implications on the acquirers value arise. In the first case, cross border bidders might be lacking the country-specific skills and knowledge that domestic bidders possess. The second cause for the value loss could arise from the complexities involved in the coordination of activities and resources. Third, there are instances of cost inefficient in foreign companies. The national borders may facilitate or impede mergers through the addition of new determinants influence shareholders value. In the case of AECOM acquisition of URS, Benoit’s (2014) study reported that the combination of the two giant companies would create an industry leader capable of delivering more from a broad global platform to more clients in more markets. According to the US Securities Exchange Commission’s (2014) analysis, AECOM and URS combined because they realised that they had to continue succeeding and growing in the future through market expansion and geographical footprint. Given their market coverage, there is no doubt that there will be shareholders value creation. Another case was witnessed when news about a planned acquisition of TSB by Banco made the share price of Banco drop by 6.6% to close at €2.32 (Kollewe, 2015). And as is the case with other targets, the share price of TSB rose by more than 23%. Effects of mergers and acquisition on the stock performance of a competitor Mergers and acquisitions have got an array of impact ranging from those affecting the merging firms to those that affect the firms competing with them. According to Motis’s (2007, p. 13) findings, the merging firms are motivated to come together through horizontal mergers resulting in unilateral effects. These firms tend to raise their prices after the merger, despite the fact that the existing rivals increase their outputs because the merging companies limit their levels of production. Reporting on the findings of Fee and Thomas 2004 on the effect of horizontal mergers on the rivals, Bernile and Lyandres’s (2013, p. 1) study confirmed that the horizontal mergers decreased the number of competing firms in the given industry leading to a reduction in the industry’s competitiveness. The values of the rivals of the merging entities tend to increase upon the announcement of horizontal mergers. These findings were established by studies conducted by Eckbo (1983, 1985), Song and Walkling (2000), Stillman (1983), Shahrur (2005), and Fee and Thomas (2004). From the study carried out by Bernile and Lyandres (2013, p. 27), it was established that the value of the merging companies rivals response to the announcement of possible mergers and acquisitions were close to zero and insignificant. The authors further determined that the changes in the returns of the merging entity’s’ rivals after the merger were negative. According to Nikola’s (2008, p. 4) research, there is an unfamiliar notion on the competitive impact of acquisition in that, the share price of the merging firms rivals are expected to fall since the acquirer is assumed will attain more efficiency and make their prices to rise. From the study carried out by Cartwright and others in 1987, the prices and returns of stocks of the merging companies rivals were confident in challenged mergers compared to uncompetitive ones. Indeed, when the merger was horizontal, there were positive abnormal returns than was the case with vertical acquisitions or by simple competitor buy-out. This increase in the competitor’s share price was reported by Owens’s (2014) findings on the announcement of a possible merger between the eBay, Inc. and the Google Inc. As their competitor, Yahoo’s stock increased by 4% to close at $39.11 on March 17, 2014. References AECOM, 2014. AECOM completes acquisition of URS Corporation - Investors. [Online] Available at: HYPERLINK "http://investors.aecom.com/phoenix.zhtml?c=131318&p=irol-newsarticle&ID=1978957" http://investors.aecom.com/phoenix.zhtml?c=131318&p=irol-newsarticle&ID=1978957 [Accessed 30 April 2015]. Akben-Selcuk, E. & Altiok-Yilmaz, A., 2011. The Impact of Mergers and Acquisitions on Acquirer Performance: Evidence from Turkey. Business and Economics Journal, 22, pp.1-8. Ben, v.d.M., 2014. What AECOM acquisition of URS means for local offices. 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