Determinants of Value Creation through M&As
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Published: Thu, 15 Mar 2018
Crude oil and natural gas are major commodities traded in international markets. Refined products are used in a variety of ways, such as motor fuel (which is the most significant product derived from crude oil) and power generation. Broad research exists on how the oil market is Influenced by price and demand, and its interactions with the world markets (Jiméez-Rodriguez R. and Sancchez M. (2004), “Oil Price Shocks and Real GDP Growth: Empirical Evidence for Some OECD Countries”). Differences exist on how the economic trends affect the Oil & Gas sector depending on the geographical area. For instance, the recent crisis is proving to be less harmful on the emerging markets , concerning the Energy sector (cfr. Charts below  ). This trend is observable by looking at the MSCI Energy Index and its components divided by geographical area (“World” and “Emerging Markets”). The World index lost more than 6% since 2007 both in the broad energy sector and in the Oil & Gas industry. On the other hand, the impact on the emerging markets was weaker: from the levels of 2007, the Emerging Markets index lost less than 0,5% with regard to the broad Energy Sector and less than 0,2% with regard to the Oil & Gas industry.
Emerging countries are becoming the more and more important in today’s economy. Their rising strength not only impacts macroeconomics fundamentals, the wealth of their people and their political influence, but also the growing interest of M&A activity. Although this trend has begun long ago, the research on this topic is still lacking. Mainly, research on the creation of value of mergers and acquisitions focuses on domestic deals in developed countries, or in cross-border deals where the acquirer company is based in a developed country, mainly the US (Trahan, 1993, and Sorenson, 2000), United Kingdom (Hay and Liu, 1998) and European Countries (Luypaert and Huyghebaert, 2007). Few research has targeted emerging markets. For example, Kale (2004) has developed a research on Indian companies. Furthermore, research on deals from Emerging Market companies to developed countries is at an early stage (Chari et al., 2009). Furthermore, few research is focused on one singular sector. It is generally argued that M&A come in waves  , and that there are characterising factors for each industry as outlined by Koetter (2005), “Evaluating the German Bank Merger Wave”. The aim of this paper is to build on what has already been done, in order to deepen academic knowledge on the subject and to put the basis for future research.
As the drivers and value creation of M&A deals may differ from one industry to another, the paper will focus on the Oil & Gas industry. As Andrade et al. (2001) points out, given that mergers come in waves and that in each wave we find a different industry composition, we should deduct that, at least in part, M&A deals might be influenced by shocks which are specific to an industry. Also, Mitchell and Mullherin (2000) links M&A trends to factors such as the oil price. The research developed by this paper will prove of particular interest, as the oil prices have been importantly unstable during the last years, after a long period of stable growth.
The analysis will be based on a sample of relevant deals registered from 1980 to 2009 involving at least 50% of capital. These deals have been selected in the Oil&Gas mid industry. For the list of deals, we used the database of ThomsonOne Banker. For the financial data, we used instead the database provided by Datastream. For part of the analysis, Stata has been used. Further indication on how we analysed the sample are in the Methodology section of this paper.
In Chapter 1 the paper will give an introduction to the Mergers & Acquisitions industry, providing a short description of the phenomenon of the so-called “M&A waves”, and of the main motivations which drive external growth for companies. A brief preamble on the Oil & Gas industry will be given, in order to outline the main dynamics and players. In Chapter 2, the paper will take into exam previously existing literature on M&A deals and value creation, putting the basis for a further analysis. Chapter 3 will deal with the main hypothesis which are the foundation of this research. In Chapter 4, the methodology will be presented, together with an analysis of the data included in the sample studied in this paper. Chapter 5 will then show the results of the analysis. Chapter 6 will finally draw the conclusions.
In the last decades the mergers and acquisitions activity has become a two way process: instead of going only from developed countries to emerging economies, always more acquirer companies are based in the so-called emerging countries and are seeking external growth towards developed countries.
Since 2001, for example, the share of US inbound M&A as a percentage of total cross-border M&A increased from about 6% to almost 8%, while US the share of US companies of outbound cross-border M&A declined from more than 7% to 5% (Zenner et al., 2008). Historically, M&A activities wave following economic cycles. Exhaustive research (Andrade et al., 2001) shows that, within each wave, the trend of M&A varies by sector. Further research on this topic is lacking, and the purpose of the paper is to start investigating on the drivers for value creation in a specific sector, namely Oil & Gas.
This research aims at studying the determinants of value creation of M&A deals by focusing on the Oil & Gas industry. Its objective is to determine whether mergers and acquisitions create value, and to analyse this from an operational point of view. The main question is if these deals really create value, in terms of profitability.
Do the operations of mergers and acquisitions create value in the oil sector in terms of operational profitability?
Is this marginal operational profitability statistically significant?
In order to measure operational profitability, in this paper it will be used the EBITDA/Total assets indicator.
I decided to conduct a research on the subject of M&A deals in the Oil & Gas industry because of my previous professional experience in this field. I completed in fact an internship within Natixis in Paris in the Structured and Commodity Finance department, working on Africa and Middle East on the Oil markets. Previously, I completed an internship within the Equity Research and Strategy Team at UniCredit CAIB in London, working again on the emerging markets, this time on the EMEA region.
I thought that it would have been interesting to study whether M&A deals in this industry create increase operating performance, and which are the main drivers. Initially, I intended to focus on those deals where the acquiror (or its ultimate parent) comes from one of the so-called emerging markets. However, it was impossible to have a statistically significant sample to analyse, because many information was missing (e.g. financial data such as EBITDA, Total assets, or other precious information such as the attitude of the deal, the method of payment, etc.). As I could not have access to databases other than ThomsonOne Banker and DataStream, I decided to enlarge the scope of the analysis to the whole Oil & Gas industry, in order to be able to analyse the profitability of mergers and acquisitions completed by such companies. I think that this study is interesting also because focused research on this industry is lacking. There is in fact almost no research on post-deal operating performance of companies in the Oil & Gas industry.
Furthermore, personally, I found it useful not only for the knowledge it gave me about value creation of mergers and acquisitions, but also because it gave me the opportunity to use a statistical software aimed at data analysis, Stata, which has been crucial in the analysis which has been carried out.
An introduction to M&A
After the last wave of mergers and acquisitions at the beginning of the new century, the number and the value of deals has decrease substantially due to the crisis which is still affecting the global economy. Chart 3  shows the trend of the overall value of mergers and acquisitions deals starting from 1990, until 2008 in the mid of the crisis. We can observe here the last two waves, which characterised respectively the last years of the 90’s and the first years of the new millennium. The last wave ended in2008, when the global value of M&A deal sunk from 4,7 trillions of US$ in the previous year to almost half at 2,7 trillions of US$. Another interesting information available in this chart is the relative value of cross-border deals, which represent an always more important stake in the corporate market pointing out the growing importance of the global economy in the last twenty years.
An always more important role in this phenomenon is played by emerging economies, as Chari et al. (2004) points out, not only as a target for growth, but also as a source for it.
Chart 4  shows the values in 2009 by target macro industry. We can see that the Energy and Power macro industry is amongst the first three, both for value of target and number of deals (Chart 5  ). This proves the interest of this paper also in a view of prominence of the industry it is going to analyse. However, the global value is still lowering comparing to the previous years, below 2$trillions, the historical minimum in the last 5 years, thus continuing the downwards trend in 2009.
In the first months of 2010, however, there seems to be a recovering of M&A activity, with more than 12,000 deals announced, and with the Energy and Power industry leading the way with an announced value of more than 150 billions of US$.
Chart 6  shows the geographical repartition (by target) of M&A deals in 2009. In 2009 most of the activity, as historically verified, has taken place in the Americas (mainly, the US,) and in Europe. However, the importance of other regions, such as South America and Asia Pacific, is continuously growing.
Academic research and empirical evidence show how mergers and acquisitions come in waves, as pointed out by Andrade et al. (2001), each wave being closely correlated to macroeconomic reasons.
An interesting study on merger waves has been developed by Lipton in 2006 ( “Merger waves in the 19th, 20th and 21st centuries”, The Davies Lectures, Osgoode Hall Law School, York University), explaining how each wave originated and the causes of its end. The first wave took place in the period between 1983 and 1904, and had a great importance as it radically modified the economic landscape in the United States, characterised by intense technological innovation and economic development. This first wave has been of a particular importance for the Oil & Gas industry, as it was characterised by the surge of Standard Oil as a enormous actor in the market, so dominating that in 1911 it was declared a trust and split by the Supreme Court of the United States. From its ashes, they were born some of the major oil companies which still exist today as major players, such as Exxon (formerly, Esso) and Mobil, today forming the Exxon-Mobil group, Chevron and others which are today part of British Petroleum. It has been, in fact, the new antitrust regulation one of the causes of the end of this wave (namely, the Sherman Act of 1904), together with the stock market crash of the early years of the new century and the associated recession.
The second wave came at the end of WWI, and lasted until 1929, the year of the “Great Depression”. In this period, antitrust regulations were suspended in order to speed economic reconstruction, and a new wave of technological progress took place. Two main characteristics of this wave were the US stock market, and the trend towards vertical integration. The DJ Industrial index grew 500% in only five years. Then, after the Black Thursday in 1929, the mergers and acquisitions activity did not knew a new wave until the post-WWII.
The third wave came in 1955 and lasted for almost 15 years, until 1969. It has been called the “Conglomerate” wave, and was characterised by strong economic growth, free trade and technological development, as well as the surge of financial engineering, which brought to innovations such as risk diversification  . This wave, as well, has a particular importance concerning the Oil & Gas industry, as it saw the establishment of the Organisation of Petroleum Exporting Countries (OPEC) in 1961. The energy crisis which originated in these years, furthermore, was one of the causes of its end.
The fourth wave lasted for about five years, from 1984 to 1989, and was driven by economic expansion, a process of deregulation which will have an enormous influence on the economy for the following years till today, and technological innovation, especially in IT and computers, which allowed strong financial innovations as well. Following stronger regulation, the reform of the financial sector and events such as the Gulf War, the fourth wave came to an end.
The fifth wave (shown, as the following one, in Chart1) is also called the wave of “Mega-Deals”. As Black et al. (2000) point out, its main driver has been globalisation, and the increasing importance of some emerging markets such as the BRIC countries (Brazil, Russia, India and China), especially in the Asia-Pacific region. Exxon and Mobil merged in 1999 for about 77 billions of US$, giving birth to a preeminent player in the Oil & Gas industry. This wave stopped when the .com bubble burst and global economic downturn.
The sixth wave, as we can see from Chart1, started in 2003 and lasted only four years, marking the increasingly faster pace of merger and acquisitions waves in the last decades. It lasted until 2007, when the current crisis begun, with the subprime mortgage crisis. The main supporting factors were globalisation and the development of financial players such as private equities and hedge funds. Another characteristic of this period, which directly affects the research of this paper, has been the surge in commodity prices: from 2000 2007, oil prices increased of almost 400%.
Motivations for Mergers and Acquisitions
Mergers and acquisitions are considered a standard way of corporate growth. Some argue that most publicy traded companies could not meet their growth targets without external growth  . Generally, M%A deals are interesting because the bring to a faster creation of value, compared to internal growth.
The main motivations for mergers and acquisitions come from strategic needs and objectives. Such motivations usually concern the entry in new markets, or the need for access to technological innovation regarding the final product or the production process. They could also lead to a re-focalisation on the core business, or to vertical integration.
Economic motivations concern, generally, the pursuit of synergies and the increase of market share. Generally, cost synergies come with a reduction of employees and a reorganisation. Economies of scale are a main driver for mergers and acquisitions as well as economies of scope.
Main financial motivations include the possibility, for the merged company, to obtain a higher rating and thus to be able to lower its cost of capital. Some researchers (Duchin et al., 2008) argue that, behind many mergers and acquisitions, the might be an agency costs, suggesting a link between M&A and agency theory.
Fiscal motivations, instead, are related to fiscal benefits which an operation of M&A could give. These could originate for instance from a higher gearing and the exploitation of the tax deductibility of interest payments on debt.
Other motivations may include the possibility of influencing the regulator, if a critical size is reached, or gaining substantial influence on prices or on technology.
In the section dedicated to the literature review, this paper will analyse broad research showing that generally, M&A deals do create value only for the shareholders of the target company. In fact, once the merger or the acquisition is completed, it often happens that the merged company incurs in some issues such as integration problems, or adversity from employees.
An introduction to the Oil & Gas Industry
In this section, the paper will give a non-exhaustive introduction to the Oil & Gas industry, in order to provide the reader with a general idea of the main dynamics and actors involved.
Oil prices have been quite volatile in the last few years, picking in the summer of 2008 around 140 dollars per barrel and then bouncing back to a level of 30 dollars per barrel in only six months. Chart 7  shows the WTI oil price (i.e., the commonly reference for oil price in the U.S.) from the ‘80s to May 2010. We can see how the rise from 2002/2003 to 2007/2008 corresponds to the sixth (and last) merger wave, described in chapter 1.1.1. The other commonly referred-to benchmark price is the Brent, also known as London Brent.
As pointed out by Ownby et al. (2006), there are different actors in the Oil & Gas industry. In fact, generally the main actors are big companies, national (National Oil Companies – NOC’s) and typically owned by governments associated to the Organisation of Petroleum Exporting Countries (OPEC) or investor-owned (International Oil Companies – IOC’s). As shown by Chart 8  , OPEC countries have almost 80% of world proven oil reserves, even if they produce less than 40% of global production and have less than 10% of overall refining capacity.
The market of crude oil and natural gas is affected by a multitude of factors, such as supply and demand, geopolitical scenarios, refining capacity, and seasonality. Generally, the market of both production and refining is concentrated, opposite to the range of consumers, which represent a wide variety, related to the multiple uses and characteristics of the refined products.
In this sector, where the economies of scale are important, mergers and acquisitions take a big role, as described by Weston (2002), in analysing the case of the Exxon-Mobil merger.
In the next chapter, the paper will go through some previous literature, analysing, with different methodologies and focusing on different characteristics of deals, acquirors and targets, the positive effect on value for shareholders and on profitability of mergers and acquisitions.
Extensive research exists on the subject of value creation of M&A deals. However, there is not a real convergence of opinions about whether mergers and acquisitions create value or not and conclusions are inconsistent, often biased by the methodology used or by the characteristics of the deals on which they focus more. Generally, it is recognised however that, if they do, it is for the shareholders of the target company.
Jensen et al. (1983), in their analysis of the corporate control market, indicate that “corporate takeovers generate positive gains […] and that bidding firm shareholders generally do not lose”. Jensen indicates that the weighted average abnormal returns for targets in case of unsuccessful takeovers are approximately equals to those of targets in case of successful takeovers in the short term  . His conclusion is that, in case of successful takeovers, targets earn significant abnormal positive returns. Interestingly enough, those targets of unsuccessful operations which receives another offer in the medium term earn even higher returns. This result is similar to the findings of Jarrell, Brickley and Netter (1988).
Characteristics of the target and of the acquiror
Many studies focus on the characteristics of the target firm. Dietrich et al. (1984) applies logit analysis to a sample of firm to determine the probabilities that they become targets of mergers, taking into account differences between industries. The variables they identify as increasing the possibility of a firm becoming a target are, generally, low asset turnover, low debt/assets ratio and low payout ratio. Brar et al. (2009) start from the research developed by Palepu (1986), based on his acquisition likely model, by adding technical measures “measures of a technical nature, e.g. momentum, trading volume as well as a measure of market sentiment”  . The identified likely target here are small sized, undervalued firms.
Concerning the characteristics of acquiring firms, Huyghebaert et al. (2009) identified in size and in intangible capital two variables characterizing bidding companies. On the other hand, “neither the firm’s cash position nor its cash-generating abilities influence its choice”  . They also suggest that recent deregulation has no impact, and that a negative impact is given by high ownership concentration.
Chari, Ouimet and Tesar (2004) examine cross-border mergers and acquisitions directed specifically to emerging markets, where the acquirer comes from a developed market. They study the market reaction to announcement on a sample of firms from 1988 to 2002. They find that monthly returns for acquirers increase by 1.65% to 3.05%, and that monthly returns for target firms increase by 5.05% to 6.68%. This research shows then different results from previous studies, in indicating that, when the bidder comes from a developed market and the target comes from an emerging market, both the shareholders of the acquiror and those of the target firm gain, when the stock price reaction is analysed. They indicate that one of the main sources of value for the combined company are synergies created by the operation. They also suggest that if the target comes from an emerging market it is likely to have an higher cost of capital, so the operation would allow to the company access to cheaper capital. Concerning the acquiring company, they indicate as crucial its bargaining power and information asymmetry, which may play a favourable role in the negotiation, and the acquisition of majority control in the target company.
Chari, Chen and Dominguez (2009), examine on the other hand the opposite phenomenon, i.e. mergers and acquisitions in which the target company is based in the U.S., and the acquiror company comes from an emerging market. Their sample for this study includes all mergers and acquisitions in the period between 1980 and 2007, and concerning no less than 5% ownership. They first observe how this kind of operations contradicts the neoclassical theory, which states that capital should flow from capital-scarce to capital-abundant countries. Their methodology consists in a difference-in-differences approach. In order to create an appropriate control group of peer companies, they applied a propensity score matching. One first finding is that, generally, emerging market bidders target companies which are bigger in size. Then, following the acquisition, profitability rises, thanks to a cut of sales and number of employees, thus suggesting that such operations are typically accompanied by considerable restructuring of the acquired firm.
Andrade et al. (2001) suggest that M&A activity is influenced by specific industry factors, such as technological innovations, supply shocks and deregulation, as they showed Mitchell and Mulherin (1996). They argue that, for the combined merging companies analysed in their sample in the 1973-1998 period, the response of the stock market is positive, thus suggesting a creation of value for shareholders. They also specify that those who gain more are the shareholders of the target company, even if results found for shareholders of acquiring firms are not so clear, consistently with Jensen et al. (1983) and Jarrell et al. (1998). They also take into consideration long-term operating performance, finding a 1% statistically significant improvement.
Black, Carnes and Jandik (2000) analysed the long term performance of mergers and acquisitions, focusing on cross-border deals. They based their research on the models already proposed by Lyon et al. (1999) and Ali and Hwang (2000). Their sample consists in U.S. bidders and foreign targets in 17 countries from 1985 to 1995. They also examine country-specific factors related to the value relevance of accounting data. They also consider main reasons for cross-border acquisitions, such as entry into new markets, risk reduction and economies of scale. In their analysis, they find a negative medium and long-term return for acquiring companies. Amongst the possible explanations, they say that, even if the methodology suggested by Lyon et al. (1999) is specifically aimed at avoiding results which are due to chance or biased methodology, this might in fact have occurred. Also, they recall that, as successful bidders generally are outperforming the market when the bid is made, a simple mean reversion of stock prices would result in negative abnormal returns. However, this explanation is dismissed, and their findings confirmed on the basis of the methodology adopted. They also analyse the hypothesis that U.S. bidders may find it harder to price companies whose country’s account standards are different, or in whose country accounting information is less relevant. Their conclusion concerning this point, however, is that there is in fact an inverse relationship between the value relevance of accounting information and negative abnormal returns.
Martinova, Oosting and Renneboog (2006) analysed the long-term profitability of mergers and acquisitions in Continental Europe and UK. Their analysis is based on four different measures of operating performance: EBITDA/Total assets, EBITDA/Sales, EBITDA – changes in Working Capital/Total assets and EBITDA – changes in Working Capital/Total assets. Even if both companies for each deal outperformed the peers in the same industry before the deal, the raw profitability of the combined firm decreased once the operation was completed. However, this difference in profitability is statistically insignificant if it is adjusted for the median performance of the peers of both the acquiror and the target. They selected the peers companies in order to adjust the performance for industry, size and pre-event performance. They found statistically significant influence only on hostile takeovers, less performing than friendly deals, and tender offers, less performing than negotiated deals. A peculiarity of their research is that they observed that excessively cash-rich acquiror companies might have cash flow issues and thus might be more likely to make wrong choices in their target companies, as their performance is weaker after the acquisition. This would be confirmed by the free cash flow theory of Jensen (1986). Research conducted by Moeller and Schlingemann (2004) and Harford (1999) further confirm this assumption. Furthermore, they observed a positive correlation between the size of the target and the performance of the combined company.
Previous literature has analysed different factors influencing the value creation, or the operating profitability, of mergers and acquisitions. However, results have been discordant.
The main hypothesis of this research is that mergers and acquisitions in the Oil & Gas sector create a significant decrease in operating performance after the operation, compared to operating performance prior to the deal. This is based on the results of previous research finding that profitability decreases, and that this decrease becomes insignificant only if adjusted for the performance of peers in the same industry  .
Sample selection and description
Our initial selection of data includes all mergers and acquisitions between 1980 and 2008, where the acquiror’s ultimate parent is a company in the Oil & Gas Mid Industry and both companies are public. We used as a reference date the effective date, as we do not analyse the reaction of the stock market, but operational profitability of the combined company. We only considered the successful deals, in which the acquiror owned at least 50% of the target’s shares at the end of the deal. This initial sample included 1010 deals. All the data in this first step were collected from the database ThomsonONE Banker. We then filtered down in order to exclude those deals developed in multiple steps, and those deals in which the target was re-sold within three years. Also, we eliminated from the sample those deals in which the acquiror had completed another M&A operation less than three years prior or less than three years after each deal itself. After this selection, the amount of deals was 199. We then used the database of DataStream to collect all the financial data about EBITDA and Total assets for both the acquiror company and the target company, for a period which goes from 3 years prior to the acquisition, to 3 years after the acquisition. Once downloaded the data, the deals for which relevant information was available were 55. Any deal for which there was information available at least for the year prior and the year following has been kept into the sample.
In more than 50% of these deals the acquiror company was located in Canada, more than 35% in the United States, 5% in the United Kingdom. Similarly, 60% of the target companies were located in Canada, almost 20% in the United States and 2% in the United Kingdom as well as in Norway and in Australia. It is important to say here that this is due to the filter done on multiple deals, as in the original sample U.S.-based companies represented by far the majority of both acquiror companies and target companies. Domestic deals represent 85% of the sample, while 15% are cross-border deals; concerning the final sample, none of them involved a target company based in an emerging market. With regard to the mid industry (Oil & Gas), 92% of the deals were focused. In the initial sample, diversification was directed towards industries such as Power, Metals and Mining, Building/Construction & Engineering, Pipelines, Other Industrials, Automobiles and Components. In the final sample, other sectors include Power, Automobiles & Components, IT Consulting & Services, and Telecommunications. Chart 9  shows the classification given by ThomsonONE Banker concerning the deal attitude: the great
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