Mergers and acquisitions offer in current business climate.
The literature review is focused around concept of mergers and acquisitions and difference between mergers and acquisition, it describes the reason why a company goes for merger and acquisition.
1.1 Definition; Mergers and Acquisitions:
Occurs when buyer acquires all or part of the assets or business of a selling entity, if buyer is doing despite active resistance of other party it is hostile takeover.
Occurs when two companies combine into one entity, vast majority of all business combinations are handled as an acquisition, where one entity clearly takes over the operation of other (Steven, 2009), (Garside P, 1994), M&A are very much renowned in market due to opportunities attached to them.
Mergers and acquisitions have existed for a long time in business but there is no hard proof M&A is successful in improving the company's performance, there are success and failure examples that give different insight on improving companies performance (Scott Moeller and Chris Brady, 2007). There have been dramatic failures like AOL/Time Warner who lost 93% of its value during integration period as internet service provider merged with publishing company in an effort to combine content with delivery. Before merger it was predicted to combine Time Warner's vast collection of movies, music and TV shows with AOL's internet connection would create synergies that would make new company an ultra marketing machine. But after the merger only significant change that occurred was AOL Time Warner's biggest advertiser that means apart from the self advertisement the synergies that were promised did not came through. (By Jerry Knight Monday, April 1, 2002, AOL Time Warner Merger Adds Up To Less Than the Sum of Its Parts)
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Mergers can be described by legal or economic perspective. (Donald M. DePamphillis, Mergers and Acquisitions, and other restructuring Activities, fourth edition, 2008)
1.2 Acquisition and Divestiture:
Acquisition occurs when one company takes controlling ownership interest in another firm, a legal subsidiary of another firm or selected assets of another firm such as production facility. An acquisition can involve the purchasing of another firm's assets or stock, while the acquired firm continues to exist as a legally owned subsidiary of the acquirer. On the opposite a divestiture is the sale of all or substantially all of a company or product line to another party for cash or securities. A firm that attempts to acquire or merge with another company is called an acquiring company or acquirer. The target company or the target is the firm that is being solicited by the acquiring company.
1.3 Legal Perspective for Mergers:
This perspective refers to the legal structure to accomplish the transaction. Such structures may take different forms depending upon nature of the transaction. A merger is combination of two or more firms in which all but one legally cease to exist, and the combined organization continues to work under the original name of the surviving firm. In a usual merger, shareholders of the target firm would exchange their shares for those of the acquiring firm, after a shareholder vote approving the merger. Minority shareholders, those not voting in favor of the merger, are required to accept the merger and exchange their shares for those of the acquirer. Mergers requiring a shareholder vote are sometimes called long form mergers. If the parent firm is the primary shareholder in the subsidiary, the merger does not require approval of the parent's shareholder in the subsidiary such a merger is called a Short form merger. The principal requirement is that parent's ownership exceeds the minimum threshold. Example a country allows a parent corporation to merge without a shareholder vote with a subsidiary if the parent owns at least 90 % of the outstanding voting shares. A statutory merger is one in which the acquiring company assumes the assets and liabilities of the target in accordance with the country laws in which combined companies will be incorporated. A subsidiary merger of two companies occurs when the target becomes a subsidiary of the parent.
Although the term merger and consolidation often are used interchangeably, a statutory consolidation, which involves two or more companies joining to form a new company, is technically not a merger. All legal entities that are consolidated are dissolved during formation of the new company, which usually has a new name. In a merger either the acquirer or the target survives. The 1999 combination of Daimler-Benz and Chrysler to form DaimlerChrysler is an example of a consolidation. The new corporate entity created as a result of consolidation or the surviving entity following a merger usually assumes ownership of the assets and liabilities of the merged or consolidated organizations. Stockholders in merged companies typically exchange their shares for shares in the new company.
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A merger of equals is a merger framework usually applied whenever the merger participants are comparable in size, competitive position, profitability, and market capitalization. Under such condition it is not clear if either party is ceding control to the other and which one is providing the superior synergy. Consequently, target firm shareholders rarely receive any significant premium for their share. It is common for the new firm to be managed by former CEO's of merged firm. In 1998 formation of Citibank and Travelers is an example of merger of equals.
1.4 An Economic Perspective for Mergers:
Mergers can be classified as Horizontal, vertical and conglomerate. How we can classify a merger depends upon the merging firms exist in same or different industries and also on their position in the corporate value chain (porter, 1985) (competitive advantage, the free Press, New York, 1985). Horizontal and conglomerate mergers can be best described in context of whether the merging firms exist in different or same industries. A Horizontal merger occurs when two firms within the same industry merge. Example of a horizontal acquisitions include Procter and Gamble and Gillette (2006) in household industry, Oracle and PeopleSoft merged (2004) in business application software industry, Exxon and Mobil in Oil industry (1999), SBC communications and Ameritech in telecommunication industry (1998) and National Bank and BankAmerica in commercial banking industry (1998). Conglomerate mergers are the ones in which acquiring company purchases firms in largely unrelated industries. An example would be U.S Steel's acquisition of Marathon Oil to form USX in the mid-1980s.
Vertical mergers can be better described operationally in the context of corporate value chain. Vertical mergers are those in which two merging firms participate at different stages of the production or in the value chain. Example in a value chain of steel industry may distinguish between the raw materials, such as coal or iron ore; steel making, steel making and metal distribution. Similarly a value chain in an oil industry would separate exploration activities from production, refining and marketing. An internet value chain might distinguish between infrastructure providers, such as Cisco, content providers, such as Dow Jones and portals such as Yahoo and Google. In context of Value Chain, a vertical merger is one which companies that do not own their own operations in each major segment of the value chain chose to “backward integrate” by acquiring one or more supplier or to “forward integrate” by acquiring one or more distributor. An Example of forward integration; in which paper manufacturer Boise Cascade's acquisition of office products distributor Office Max, for $1.1 billion in 2003. An example of backward integration in the technology industry is America Online's purchase of media and content giant Time Warner in 2000. According to Gugler, Muller, Yurtoglu, and Zulehner (2003), horizontal, conglomerate, and vertical mergers accounted for 42, 54, and 4% of the 45,000 transactions analyzed by them between the periods of 1981 to 1998.
1.5 Common Motivations for Mergers and Acquisitions
There are different motives behind Mergers and Acquisitions, Donal M. Depamphilis (2008) came up with prominent theories about these motivation factors:
Synergy can be simply defined by considering if two businesses were to be combined together they can create greater shareholder value than if they were to be operated separately. Synergy has two basic types that are operating and financial.
Operating Synergy (Economies of Scale and Scope)
Operating synergy is made up of economies of scale and economies of scope. Gains in efficiency can come from either factor plus effective management practices. Studies suggest that such synergies are important determinants of shareholders wealth creation (Houston, James, and M.Ryngaert, Where do merger Gains come from, journal of Financial Economics, 2001; DeLong, Does Long term performance of Mergers Match Market Expectations?, Financial Management, 2003.
Economies of scale refer to the spreading of fixed costs over increasing level of production gained by merging with another firm.
Economies of Scope refer to using a specific set of skills or an asset currently used in producing a specific product or service to produce related products or services. They are most often found when it is much cheaper to combine two or more product lines in one firm than to produce them in separate firms. Example Honda uses its engines to develop motorcycles, lawn mowers and snowblowers as well as automobiles.
Financial Synergy (Lowering the Cost of Capital)
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Financial synergy refers to the impact of mergers and acquisitions on the cost of capital (the minimum return required by investors and lenders) of the acquiring firm or the newly formed firm resulting from merger or acquisition. Cost of capital can be reduced if the merged firms have uncorrelated cash flows (co-insurance). Combining a firm with excess cash flows to a firm whose internally generated cash flow is insufficient to fund its investment opportunities may result in lower cost of borrowing.
Diversification refers to a strategy of buying firms outside of the current business line of company. There are two justifications identified for diversification. First one relates to the creation of financial synergy that would result in reduced cost of capital. The second argument for diversification is shifting from their core product line or markets into product line or markets that have a higher growth opportunity. Such diversification can be related or unrelated to the firm's current products or markets.
The product-market matrix shown in graph identifies a firm's primary diversification options. In case a firm is facing a slow growth in its current markets, it can sell its products in new markets which can accelerate the growth but these markets are not well known hence more risky. Example pharmaceutical giant Johnson and Johnson's announced unsuccessful takeover attempt of Guidant Corporation in late 2004 reflected its attempt to give its medical devices business an opportunity into fast growing market for implantable devices, a market that it doesn't exist currently. Similarly a firm a firm can attempt to achieve greater growth by developing or acquiring new products which are unfamiliar to them and sell them into markets which they are already familiar with, hence less risky. Example J.C.Penney's went for acquisition of Eckerd Drugstore chain. These strategies are related diversification with low risk compared to high risk strategies of unrelated diversification when developing new products for new markets. Investors often perceive companies diversified in unrelated areas as riskier, given the reason they are difficult for management to understand and management often fails to fully fund the most attractive opportunity (Morck, Randall, Andrei Shleifer, and Vishny, Do Managerial Objectives Drive Bad Acquisitions, Journal of finance, 1990), while (Megginson, Morgan and Nail, 2003) claim most successful mergers are those that focus on deals that would promote acquirers core business.
1.5.3 Strategic Realignment
Strategic realignment suggests that firms may consider M&A's as opportunity to adjust to changes occurring in their external environment. Two areas that are most important are regulatory environment and technological innovations.
M&A activity in recent years has been focused on industries that are subject to significant deregulation. Such industries include financial services, health care, utilities, media, telecommunications, and defense. There is significant evidence that takeover activity is higher in deregulated industry compared to the regulated industry.(Jensen, the modern industrial revolution, exit, and failure of internal control systems, 1993) (Mulherin, J. Harold, and Audra l.Boone, Comparing Acquisitions and Divestitures, 2000). Deregulation brings competition among competitors.
Technological advancement creates new products and industries. Innovation has resulted in companies as Kodak to focus from their analog based technology to shift towards digital technology. M&A is often used to rapidly exploring new products and industries made possible because of emergence of new technology. Large firms often fail to focus on innovation compared to small more nimble and niche players can display. Companies tend to acquire or merge these small technological firms in order to get short and sometimes cheaper way to get new technology. Example eBay acquired Skype technologies, internet phone provider, to help their customers make faster deals because some products need detailed information like real estate. That would prevent their competitors from getting that technology and gave them competitive advantage.
1.5.4 Hubris/Ego and the “Winners Curse”
As a result of hubris, managers tend to believe in their own valuation instead of depending upon market's valuation. Thus that leads to the acquiring company overpaying for the target just because of over optimism in evaluating synergies. Competition among the bidders to acquire the target is likely to end in overpaying by the winner because of hubris, even if significant synergies are present to the acquirer (Roll, Richard, The Hubris Hypothesis of corporate takeover, Journal of business, 1986). Senior managers tend to be very competitive and sometimes become self-important. The competitive nature brings the desire not to lose and that can result in a biding war that can drive acquiring price of an acquisition well in the excess of the actual economic value (cash generating capability) of that company.
Hubris or ego-driven decision making is a factor contributing to the “winners curse”. In auction environment it is likely to be many bidders that leads to a biding war and acquirer is likely to end up getting the target firm at a price that is excess of the expected value. This is often linked to difficulty faced by opponents to estimate the actual value of the target and competitive nature of the process. The winning bidder is left cursed in paying more than the company is actual worth and ultimately left felling remorse for doing so.
1.5.5 Buying Undervalued Assets (The Q-Ratio)
The Q-ratio is the ratio of the market value of the acquiring firm's stock to the replacement cost of its assets. Firms interested in expansion have a choice of investing in new plant and equipment or they have option of obtaining assets by acquiring a company whose market value is less than the replacement costs of its assets (Q-ratio < 1). This theory was very much behind the reason for M&A's in late 1970's when high inflation and interest rates depressed stock prices well below the book value of many firms. High inflation also resulted in higher replacement costs for assets than the book value of assets. Recently gasoline refiner Valero Energy Corp acquired Premcor Inc in an $8 Billion transaction that resulted in the largest refiner in North America, the estimated cost of building a new refinery with capacity equivalent to Premcor would have cost them more than 40% of the total acquisition price (Zellner, Wendy, “This big oil deal Shouldn't Hurt a bit”, Business Week, 2005)
1.5.6 Mismanagement (Agency Problems)
Agency problems arise when there is a difference between the interests of incumbent managers (those currently managing the firm) and the firm's shareholders. This situation arises when management owns a small fraction of the outstanding shares of the firm. These managers may be more interested in focusing on maintaining job security and a lavish lifestyle other than focusing on maximizing the shareholder value. When the shares of a company are extensively held, the cost of mismanagement is spread over a large number of shareholders. Each shareholder bares a small amount of the cost; this allows mismanagement to be tolerated for a long period of time. Mismanagement results in mergers taking place to correct situation where there is a separation between what the managers want and what the owners want. Low stock prices put pressure on managers to take actions to raise the share price or become the target of acquirer, who perceive the stock price to be undervalued (Fama and M.C.Jensen, Separation of Ownership and control, Journal of Law and Economics, 1983).
1.5.7 Tax Considerations
There are two important issues in role of taxes as a motive for M&A's. First, tax benefits such as loss carry forwards and investment tax credits can be used to offset the combined firm's taxable income. Additional tax shelter is generated if the acquisition is recorded under the purchase method of accounting, which requires the book value of the acquired assets to be revalued to their current market value. The resulting depreciation of these normally high assets value also reduces the amount of future taxable income that would be generated by the combined companies. Second, the taxable nature of transaction frequently transaction normally plays a more important role in determining if the merger goes ahead than any tax benefits that accrue to the acquiring company. Tax free nature of transaction maybe viewed by the seller as a prerequisite for the deal to take place.
1.5.8 Market Power
Market power is a motive that firms merger to improve their monopoly power to set the product prices in market that cannot be set in a competitive market.
The misevaluation approach to takeovers has been overshadowed by presumption that markets are efficient. Efficiency implies that targets share price will reflect accurately its real economic value (cash generation potential). Evidence found over time shows assets values reflects their true economic value is substantial, the evidence that temporarily assets current value may not reflect the true underlying economic value is growing. The misevaluation hypothesis was stronger in the 1990's compared to the earlier periods (Dong, Ming, Hirshleifer, Richardson, and Teoh, “Does Investor Misevaluation Drive the Takeover Market, Journal of finance, 2006) the authors suggest acquirer may periodically profit by buying undervalued targets for cash at a price below the actual value or either using equity, it is still profitable to buy overvalued as long as the target is lee overvalued than the acquirer stock.
1.6 Historical Merger and Acquisition Waves
Mergers tend to occur during periods of sustained high rates of economic growth, low or declining interest rates and a rising stock market. Each merger wave differed in terms of specific development such as the emergence of a new technology, industry focus such as rail, oil, or financial services, degree of regulation and type of transaction such as horizontal, vertical, conglomerate, strategic or financial.
1.6.1 Theories why merger waves occur
There are two theories identified by author (depamphilis, 2008) as to why M&A's occur in waves. The first theory referred to as neoclassical hypothesis, argues that merger waves occur when firms in industries react to “shocks” in their operating environments (Brealey and Myers, Principles of Corporate Finance, 2003) (Mitchell and Mulherin, “The impact of industry socks on Takeover and restructuring activity, Journal of financial economics, 1996). Shocks could reflect such events as deregulation or the emergence of new technologies, distribution channel or substitute products. The size and length of the M&A wave depends hugely on number of industries impacted by and the extent to what level they are getting affected by the shock. Some shocks, such as the emergence of internet, are pervasive in impact, while others are more specific deregulation of financial services and utilities or rapidly escalating commodity prices. In the response to these shocks firms within industries mostly go for acquiring either all or parts of other firms.
The second theory referred as behavioral hypothesis is based on the misevaluation hypothesis and suggests that managers use overvalued stock to buy the assets of lower-valued firms. For M&A's to cluster in waves, this theory takes into consideration valuations of firms measured by their price-to-earnings or market-to-book ratios compared to other firms must increase at the same time. Mangers working in firms with overvalued stock prices move concurrently to acquire companies with lower valued stock prices (Rhodes-Kropf and Viswanathan, Market Valuation and Merger Waves, 2004), (Shleifer and Vishny, Stock Market Driven Acquisitions, Journal of financial economics, 2003). Looking at the influence of overvaluation, the method of payment would be stock according to this theory. Different studies confirm long term fluctuations in market valuations and the numbers of takeovers are correlated (Dong, Ming, David Hirshleifer, Scott Richardson and Teoh, Does Investor Misevaluation Drive the takeover market, Journal of Finance, 2006), (Ang and Cheng, Direct Evidence on the Market-Driven Acquisition Theory, 2006), (Andrade, New Evidence and perspectives on mergers, Journal of economic perspectives, 2001), however high valuation contributing to high takeover activity or M&A is less clear.
1.6.2 Trends in Recent M&A activity
The table illustrates US and global trends in M&A activity in recent years. M&A reached an historical peak in 2000 in terms of number of transactions and value of transactions given strength by economic growth and the internet bubble of the late 1990's. During 2000, the dollar value of total transactions in the United States accounted for almost one-half transactions of the global total. In 2001 due to terrorist attacks and decline in world stock markets resulted in decline of Dollar value and number of M&A transactions. The most recent merger wave in 2003 is a bit different than 1980's and 1990's waves in that mergers tend to be larger in size, horizontal, cross-border, and heavily concentrated in banking, telecommunications, health care, utilities, and in commodities such as oil, gas and metals. Ongoing deregulation in the banking, telecommunications and utilities industries has promoted M&A activity in these sectors. Commodities have gone for consolidation in natural resource industries as less costly and quick means of acquiring assets instead of developing new mines and exploring new locations for transferring raw materials. Increasing the interdependence of economies across globe has accelerated cross-border transactions to achieve high level of scale to compete with larger global competitors. Private equity participants accounting for one in five transactions globally, that never happened before in previous waves.
1.7 Mergers and Acquisitions pay off for shareholder
M&A pays of depend upon for whom and for what period of time. Around the announcement date of transaction, on average return for target shareholders are about 30%. In contrast, shareholders of acquiring firm generally shows return slightly negative to modestly positive around the announcement date. On longer analysis many M&A either underperform or destroy the shareholders value. Two approaches are used to measure shareholders value due to takeover. First approach, premerger return, involves examining abnormal stock return at time of announcement of takeover (successful and unsuccessful), as shown in table most of target shares go up abnormally because of announcement of merger and acquirer share face slight changes. Second approach post merger approach, measures the impact on shareholders value after the completion of transaction. Some findings show value is created for the shareholder by M&A, but other studies find 50-80% underperform in their industry or fail to earn their cost of capital.
1.8 Why Mergers and Acquisitions Fail to Meet Expectations
Overpaying, Slow integration and Poor business strategy
1.9 Merger Success factors
7 Steps to merger success (Leah Carlson, 7 Steps to merger success, 2009)
* Encourage senior management to involve HR benefits
* Create project management office to coordinate everything related to the transaction
* Conduct cultural assessment
* Careful access and plan for future staffing needs of newly formed organization
* Access and define future structure of hr
* Don't panic due to changes in organization
* Communicate clearly and early to your employees
Cultural fit helps drive merger success, Mark.E.Ruquet, 2008
Merger success starts with people, Sue, 2007
2.1 Strategies for Growth:
Strategy defined by Keith (2006) as in plan “consciously intended course action” , as a ploy in a competitive game example brand cannibalizing to stop entrance of competitors, as pattern, as position example carving a niche to avoid competition, as perspective looking into information judging opportunities and choice (Ashmore, 89)
Strategies for Growth: potential methods for growth. Growth challenge is to find opportunities for developing and deploying techniques, processes and competencies in ways that generate a more effective and beneficial match between the organizational products and services.
2.1.2 Types of growth:
Organic Growth: is growth from within organization with more control but slow in progress
Acquisition: Fast in action, an umbrella term taking friendly purchase of one company by another, an unfriendly purchase (a takeover), and a straightforward merger of the assets of two or more organizations where an organization develops its resources. It very high risk growth as any misjudgment would lead to heavy loss, maybe left with unwanted assets.
Strategic Alliance: agreement between two companies where they share resources to achieve strategy. It is much cheaper than overtaking another company. Can be very useful if used in scenario as globalization where one company lacks other company's expertise, both can combine to achieve mutual strategy.
These strategies could be used as alternative to go for M&A if there is high risk involved since all other strategies are less risky they can meet objectives of the organization.
3.1 Market Entry:
The development strategies have chosen depending upon the environment of the organization, to implementation, evaluation and control. Here the strategic management process decides what strategy to adapt. That leads to analysis of selection of strategies, than leads to implementation of strategies and thereafter evaluation and control. (Stephen, 1989)
Strategies that can be adopted:
1. Stability: remaining in similar kind of business with similar effort, pursuit of existing objects and slow improvement
2. Expansion: into new business areas with aim of increasing the number of sales, profits or market share at a greater level than the competitors
3. Retrenchment: Withdrawing from some parts or all of the business, with objective of reducing organization into smaller one easily manageable.
4. Combination: some combination of above strategies, at the same time or in a sequence.
International Market Entry Strategies: (Driscoll, 1997)
* Indirect exporting: When someone else takes product into international market
* Direct exporting: trade between countries
* Sales Subsidiary: Buyer gets more control
* Franchising: Let different places work under one company name and follow its rules regulations
* Licensing: example just let the name to used
* Contract manufacturing: get agreement to manufacture in other country
* Assembly: get stuff assembled by under main company name
* Local production: produce local
These strategies are used to enter the market depending upon the internal and external environment given at certain time. If company willing to expand; than it can go for M&A