1. Why Companies Merge or Acquire: A Historical Perspective
Companies grow in two main ways: either organically or by merging with or acquiring other companies. Although the number and volume of M&As broke records in the first decade of the 21st century, these transactions are not a recent phenomenon. We begin our journey by identifying the periods that were characterized by a high level of M&A activity and then summarize the major reasons companies make acquisitions.
1.1. Mergers and Acquisitions Waves
M&As come in “waves.” Martynova and Renneboog (2008) reviewed a century of transactions and identified six major waves of M&As: 1890–1903, 1910–1929, 1950–1973, 1981–1989, 1993–2001, and 2003–2007. Their research shows that the end of a wave typically coincides with a crisis or a recession—for example, the most recent wave ended with the subprime debt crisis in 2007. What triggers the start of a wave varies across time, but three factors have clearly driven M&A activity since the end of the 19th century: industrial and technological shocks, regulatory changes, and credit availability.
The 1890s and early 1900s witnessed what is considered the first wave of M&As. Companies in the United States tried to build monopolies in their respective industries by forming trusts—in essence, an extreme form of horizontal integration. Examples include the creation of Standard Oil Company of New Jersey in 1899, United States Steel Corporation in 1901, and International Harvester Corporation in 1902. After the government enacted laws prohibiting anticompetitive behavior, acquisition-oriented companies turned their attention to vertical integration as a means of growth. Vertical integration is perhaps best illustrated by the oil and gas industry; companies that began as pure oil exploration businesses eventually moved into refining, transportation, and, ultimately, retailing of oil and gas products.
Most of the M&As that took place during the second wave in the 1920s involved small U.S. companies that were left outside the monopolies created during the previous wave. Those companies merged with or acquired one another to gain economies of scale and to be able to compete with the dominant player in their industry. The 1929 crisis and the depression that followed put an end to this second wave of M&As. Because of World War II, M&A activity remained low until the 1950s.
The 1950s, 1960s, and early 1970s witnessed a third wave of M&As, during which companies tried to diversify their revenue streams and, in doing so, reduce their perceived riskiness. This trend led to the creation of conglomerates and holding companies composed of many unrelated businesses. General Electric Company is a typical example of this trend. However, today’s capital markets no longer place a premium on highly diversified companies. In fact, the share prices of most highly diversified companies are subject to a conglomerate discount because equity markets struggle to see the benefits of these complex enterprises.1 In essence, equity markets now prefer “pure plays”—that is, companies that operate in a single industry—to highly diversified companies, in large part because understanding and valuing pure plays is easier than conglomerates. This third wave of M&As peaked in 1968 and collapsed with the oil crisis in 1973.
The late 1970s and early 1980s were characterized by relatively high inflation rates and, consequently, high borrowing costs. To remain profitable, many companies sought ways to reduce both operating and financing costs. Reaching a critical size was often viewed as the way to survive the industry “shake-outs” that inevitably characterize such economic periods, giving rise to the fourth wave of M&As. Many companies merged with or acquire one another to take advantage of the economies of scale associated with larger-volume producers. Moreover, some companies saw M&As as a means to reduce their riskiness and lower their financing costs, which reached as high as 25 to 30 percent in some instances in the late 1970s and early 1980s.
The 1980s were also marked by deregulation and the creation and development of new instruments and markets. One such example is the “junk” bond market, or the market for bonds issued by companies with poor credit quality.2 The availability of credit to finance highly risky companies and transactions fuelled an increase in leveraged buyouts (LBOs) and leveraged recapitalizations.3 Some companies that had bought unrelated businesses during the previous wave took advantage of the booming M&A market to sell their poorly performing divisions and refocus on their core business. The stock market crash of 1987 and the collapse of several highly leveraged companies put an end to this fourth wave of M&As.
The 1990s saw new justifications for acquisitions emerge, paving the way for a fifth wave of M&As. Some companies made acquisitions to gain access to knowledge-based assets, particularly in the late 1990s, when the “first mover” advantage became highly prized. The 1990s also witnessed an increase in the number and volume of cross-border acquisitions. With the evolution of the global economy, many companies saw M&As as the quickest and least expensive means of acquiring a presence in a foreign country and preserving their place in the global economy. This latter trend was largely driven by the formation of multination trade zones such as the European Union (E.U.), Mercosur, and the North Atlantic Free Trade Agreement (NAFTA).
In addition, some companies viewed M&As as an opportunity to consolidate industries characterized by excess market participants and, hence, low profitability. These “consolidators” recognized that not every participant could survive such economic conditions and fostered a mentality of “Acquire or be acquired.” Examples of industries affected by this global trend include the oil and gas industry (consider the mergers of British Petroleum [BP] and Amoco, and of Exxon and Mobil), the pharmaceutical industry (for example, the creations of Pharmacia, the result of the merger of Pharmacia & Upjohn with Monsanto, and of GlaxoSmithKline, the result of the merger of SmithKline Beecham and Glaxo Wellcome), and the automobile industry (think of the merger of Daimler and Chrysler, and the acquisition of Volvo by Ford). The burst of the dotcom bubble in 2000 and the recession that followed marked the end of this fifth wave of M&As.
M&A activity soon recovered, with a sixth wave starting in 2003. This wave saw the continuation of the two trends initiated in the 1990s: cross-border acquisitions and industry consolidations. But it was also reminiscent of the 1980s, in that leveraged transactions made a comeback. The low-interest environment coupled with the seemingly endless credit availability fuelled an increase in LBOs, many sponsored by private equity firms. Investors went in search of diversification benefits and higher yields. As they poured money into new asset classes such as private equity, large amounts of funds became available to take companies private and purchase divisions for sale. This sixth wave of M&As came to an abrupt end following the subprime debt crisis of 2007.
As of this writing, M&A activity is picking up, and some market participants are suggesting that a new wave of M&As could be underway. However, it is too early to tell.
1.2. Motivations for Mergers and Acquisitions
Companies make acquisitions for a long list of reasons. Some of these reasons are good, in that the motivation for the transaction is to maximize shareholder value. Unfortunately, other reasons are bad, or at least questionable.
Theoretically, companies should pursue an acquisition only if it creates value—that is, if the value of the acquirer and the target is greater if they operate as a single entity than as separate ones. Put another way, a merger or acquisition is justified if synergies are associated with the transaction. Synergies can take three forms: operating, financial, or managerial.
Operating synergies arise from the combination of the acquirer and target’s operations. A first type of operating synergies is revenue enhancement. It includes gaining pricing power in a particular market or being able to increase sales volume by accessing new markets—for example, by leveraging one company’s sales force or distribution network, or by selling one company’s products to the other company’s customers. A second type of operating synergies is cost reduction. As mentioned earlier, many companies view M&As as a way to reach a critical size and, consequently, be able to benefit from economies of scale with lower production costs. An acquisition might also generate cost savings in advertising, marketing, or research and development. Revenue enhancement and cost reduction are more likely in cases of horizontal integration and can also play a role in vertical integration.
Financial synergies come from lower financing costs. Big companies usually have access to a wider and cheaper pool of funds than small companies. One rationale for the third wave of M&As was that diversifying into unrelated businesses enabled companies to reduce risk and, therefore, increase their debt capacity and lower their before-tax cost of financing. The risk reduction benefit is compounded by the beneficial tax treatment of debt relative to equity. Thus, the more debt a company has in its capital structure, the lower its cost of financing, net of taxes.4 History has shown, however, that companies tend to overestimate the risk reduction and tax benefits associated with M&As. Although financial synergies are a source of value, particularly in the case of leveraged transactions such as LBOs, they should not be the only motivation for a merger or acquisition.
Managerial synergies arise when a high-performing management team replaces a poor-performing one. One advantage of acquisitions is that they give the acquirer the opportunity to remove incompetent managers, which could improve the target’s performance.
Unfortunately, not all M&As are motivated by the goal of creating shareholder value. Research has shown that some managers look after their own self-interest instead of shareholders’.5 They might use M&As to build empires and diversify their human capital, even if little or no value is associated with the merger or the acquisition.6 Managers also sometimes suffer from hubris; they are overconfident in their ability to negotiate a good deal for their shareholders and then run the combined entity.7 Thus, they tend to overpay for their acquisitions. Last, some managers go through an acquisition spree to deliver growth and earnings targets, even if the acquisitions are not strategically sound or have a negative effect on the company’s profitability and ability to create shareholder value.