The Determinants of Mergers

Burcin Yurtoglu
University of Vienna
Department of Economics

Empirical Regularities
1) Mergers come in waves
USA: Late 1890s, 1920s, 1960s, 1980s, 1990s

2) Merger waves are correlated with increases in

share prices and price/earnings ratios

Mergers and Average P/E ratio

45
40
35
30
25
20
15
10
5
0
1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Year
Average P/E

Mergers/Population

Types of Mergers
Horizontal
involve two firms operating in the same kind of
business activity, e.g. Daimler-Chrysler

Vertical
occur between firms in different stages of production
operation

Conglomerate
occur between firms engaged in unrelated types of
business activity
product-extension: broadens the product lines of firms
geographic market-extension: between firms whose
operations have been conducted in non-overlapping
geographic areas
4

Hypothesis about Mergers

There are a big number of hypothesis as to why
mergers occur, these can be grouped into two
broad categories:
1) Neoclassical theories
that assume that managers maximize profits or
shareholder wealth and thus that mergers
increase either market power or efficiency
2) Non-neoclassical or behavioral theories
that posit some other motivation for mergers
and/or other consequences.

1) Neoclassical Theories
a) Market Power Increases
b) Efficiency Increases

2) Non-neoclassical or Behavioral
a)
b)
c)
d)
e)
f)
g)
h)

Speculative Motives
The Adaptive Firm Hypothesis
The Market for Corporate Control
The Economic Disturbance Hypothesis
Financial Efficiencies
The Capital Redeployment Hypothesis
The Life-Cycle-Growth-Maximization Hypothesis
The Winners Curse- Hubris Hypothesis
6

(1a) Market Power Increases

Horizontal Mergers

fewer firms in an industry have greater incentives to

cooperate and raise the price
In a symmetric Cournot equilibrium, with
homogeneous product and all firms having the
same, constant unit cost c
L

pc H

H :Herfindahl index
:price elasticity of demand for the industry
7

 Since a horizontal merger increases industry

concentration, it increases H, it must also increase the
industry price-cost margin and profits.
Salant, Switzer and Reynolds (1983)
However, Salant et al. (1983) show that mergers in such a
setting are not privately profitable. When all firms have identical
costs, they all must have the same size.
The above equation must hold before and after the merger.
Since the immediate effect of the merger is to make the merged
firm twice as big as ist competitors, it needs to shrink following
the merger to return to the new size of ist rivals.
The loss of profits to the merging firms from having to shrink to
rejoin the symmetric Cournot equilibrium more than offsets the
gain in profits from the increase in price cost margin caused by
the increase in H.
8

 Vertical mergers
by increasing the barriers to entry at one or more links in
the vertical production chain
Example: a firm which wished to enter into aluminum
refining in the USA prior to the Second World War would
have found that all known bauxite deposits were owned
by ist main competitor ALCOA. ALCOA could easily
foreclose the bauxite market to the entrant and thus
created an entry barrier.

Conglomerate mergers
multimarket contact (Scott, 1982, 1993)
An increase in concentration leads to a greater increase
in profits in a market in which the sellers also face one
another in other markets than when such multimarket
contact is not present. This motive may also be the
cause of purposeful diversification mergers.
9

(1b) Efficiency Increases

Horizontal Mergers
AC
A
B

C
D
E
Output
10

 In such an industry, one would expect the merging firms

to be smaller than non-merging firms, because the
expected cost reductions are greter for pairs of small
firms.
Empirical Evidence:
In Belgium, Germany, USA, and UK merging firms were
significantly larger than non-merging firms
In France, the Netherlands, and Sweden merging pairs were in
significantly different in size from randomly selected nonmerging
companies.

11

 Vertical mergers

Can increase the efficiency of the merging firms by eliminating steps

in the production process, which reduces the transaction costs from
bargaining due to asset specificity

Asset Specificity refers to the relative lack of transferability of assets

intended for use in a given transaction to other uses. Highly specific
assets represent sunk costs that have relatively little value beyond
their use in the context of a specific transaction. Williamson has
suggested six main types of asset specificity:
Site, physical asset, human asset, brand names, dedicated assets,
temporal specificity

High asset specificity requires strong contracts or internalization to

combat the threat of opportunism.
Small subcontractors locating and investing next to only customer
who could potentially turn to alternative suppliers (site- and physical
asset specificity).
12

General Motors and Fisher Body 1919-1926

After a 10 year contractual agreement was signed in 1919, GM's
demand for closed-body cars increased to extent that it became
unhappy with the contractual price provisions and "urged Fisher to
locate its body plants adjacent to GM assembly plants, thereby to
realize transportation and inventory economies." [Williamson, AJS,
p.561]
Finally, Fisher Body was merged into GM in 1926 after Fisher had
resisted GM's locational demands.
As Coase recalls:
"I was told [by GM officials] that the main reason for the acquisition was
to make sure that the body plants were located next to General
Motors assembly plants." [Coase, "The Nature of the Firm: Origin", in:
Williamson & Winter, eds., The Nature of the Firm. 1993, p.43.]
13

 Conglomerate Mergers
Economies of scope (ESC) arise when the production of two
different products by the same firm leads to lower production
costs for one or both products.
Example: warehousing and delivery of products
Formally, ESC is said to exist if the cost function is subadditive
C(x1, x2) < C(x1,0) + C(0, x2)

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(2a) Speculative Motives

Studies of early merger waves often mention promoters
profits as a cause for mergers. During these waves men
like J.P. Morgan often approached corporate managers
and suggested a possible merger. They earned large
fees for their advice and for other services they rendered
to facilitate and finance the deals.
Underwriters of the securities floated in the great merger
that created the United States Steel Corp. In 1901,
earned fees of $575.5 million over $1 billion in todays
dollars (The Economist, April 27, 1991, p. 11).
Michael Milken

15

Fee Revenue from underwriting and M&A

transactions in 1998 (Saunders and Srinivasan, 2001 )
Fee Revenue from
Underwriting (equity &
debt) (1)

Fee Revenue
from Merger
Advice (2)

(2) / (1)

Morgan Stanley

1253.8

302.9

19.50%

Goldman Sachs

1087.8

531.2

32.80%

Merrill Lynch

1496.9

321.3

17.70%

386

287.4

42.70%

DLJ

491.8

200

28.90%

Citibank

913.2

189.1

17.20%

Lehman

516.3

199.2

27.80%

J.P. Morgan

358.9

70.9

16.50%

Bankers Trust

252.2

56.9

18.40%

NationsBank Montgomery

132.7

26.2

16.50%

Average

688.9

218.5

23.80%

Total

6889.6

2185.1

31.72%

Investment Bank

Credit Suisse First Boston

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(2b) The Adaptive (Failing Firm) Hypothesis

Donald Dewey (1961):
mergers as a civilized alternative to bankruptcy

John McGowan (1965):

An adaptive theory to account for why small firms are typically
the targets in mergers and why the much more competitive US
and UK economies had more mergers than the less competitive
ones.

Two implications:
Mergers should follow a counter-cyclical pattern. Why dont we
see merger waves during recessions?
Profit rates of acquirers should be higher than targets

Empirical Evidence
Most studies of mergers in the USA have found that acquired
firms have the same average profit rates as similar non-acquired
companies
During the conglomerate merger wave acquiring companies had
below average profit rates and also profit rates lower than the
firms they acquired.

17

Characteristics of Acquiring and Target

Companies, 1980-1998
Gugler, Mueller, Yurtoglu, and Zulehner (2003)
Profit rate
Number
of Mergers

Acquirer

Target

1,967

0.029

0.019

United Kingdom

379

0.066

0.039

Continental Europe

172

0.035

0.033

Japan

16

0.011

0.030

Australia/N.Zealand/Canada

172

0.024

0.027

Rest of the World

47

0.052

0.013

2,753

0.034

0.023

United States of America

All mergers

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(2c) The Market for Corporate Control

Mt: market value of the firm in year t
Kt: the value of the assets of the firm in year t
If Mt > Kt: the assets bundled together as a firm are
worth more than their sum as measured by K t.
Marris (1963, 1964) called Mt / Kt the valuation ratio, Vt
Tobin (1969) measured Kt as the replacement cost of the
firms asset and called qt = Mt / Kt.
Manne (1965):
Buyers in the market for corporate control would step in
whenever Vt falls short of its maximum value, and thus
that this process ensures that corporate assets are
managed by the most competent managers and those
intend shareholder wealth maximization.

19

 Smiley (1976):
Actual market values of acquired companies are
compared to a projected value (control group).
The market values of takeover targets began to fall
below their predicted values on average 10 years
before the takeover, and that the cumulative decline
was 50% of predicted values.

Other Studies
have found the shares of acquiring firms to be
underperforming prior to their takeover (Mandelker,
1974; Langetieg, 1978; Asquith, 1983; Malatesta,
1983)
Exception Dodd and Ruback (1977)
20

(2d) The Economic Disturbance

Hypothesis
Gort (1969)
a group of non-holders suddenly raises its
expectations about firm Bs future profits. If these
non-holders are managers of another firm, the
transaction takes the form of a merger.
Mergers under this hypothesis are more likely to
happen in periods in which stock market experiences
rapid changes in value.
Consistent with the wave pattern
But also consistent with merger waves during sudden
drops in stock market values (even more intense
merger activity!)
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(2e) Financial Efficiencies

Savings on Borrowing Costs

Riskpooling

22

(2f) The Capital Redeployment

Hypothesis
Weston (1970)
Similar to financial efficiencies argument, but
goes beyond it by positing ongoing potential
gains from a central management teams
ability to monitor the investment opportunities
of each division and shift capital across them.

23

(2g) The Life-Cycle Growth

Maximization Hypothesis
Mueller (1969)
Mergers are the quickest way to grow and
diversify and thus an attractive way for
managers with limited time horizons to
achieve growth.
Predictions
diversification mergers by mature firms

24

 Direct Evidence by Harford (1999):

Cash rich firms are more likely to acquire
Their acquisitions are more likely to be
diversifying
The abnormal price reaction is negative and
lower for bidders who are cash rich
Operating performance deteriorates after
mergers by cash rich companies

25

(2h) The Winners Curse Hubris

hypothesis
There are a number of bidders
The bidder with the highest valuation acquires
the target
With rational expectations, the expected true
value of the target should be at the mean of the
distribution
The winner will bid too much!
Why bid then?
Roll (1986):
Because managers of acquiring firms suffer from
hubris, excessive pride and arrogance.
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Testing Competing Hypotheses about

the Determinants of Mergers
Three categories of hypotheses
1) Synergy

e.g., a horizontal merger that increases the market

power of the two merging companies
The ynergistic gains arise from specific
characteristics of the two merging firms.
It is reasonable to assume that both firms share
these gains, since each firms participation in the
merger is required for there be any gains at all.
A weaker assumption would be simply that the
shareholders of both firms benefit from the merger.
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2) Market for Corporate Control

All of the gains from the merger are tied to the

target firm. In principle, any other firm could buy the
target and replace its managers and obtain the
wealth increase from its action.
If the bidding for the target continues until the
targets share price rises by enough to reflect all of
the gains from replacing ist management, the
bidders shareholders will experience no gain from
the merger.
Targets shareholders receive positive welath
increases
Bidders gains averge zero and are unrelated to the
gains to the targets.
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2) Managerial Discretion

There are no net gains from the mergers

Each dollar paid to the target shareholders represents a dollar loss
to the acquirers shareholders.
Thus, the gains to the targets and bidders shareholders should
be inversely related.
It is not possible to distinguish a merger motivated by pure hubris
from one stemming from managerial empirebuilding. In both
cases, the targets gains are bidders losses. It is also possible,
however, that managerial hubris may arise with mergers that do
generate positive net wealth gains. Out of overoptimism the
bidder pays too much for the target.
In such a mixed case, we would expect a net positive gain from
the merger, but a loss to the bidder. Moreover, the bigger the gain
to the target, the more likely it is that the bidder overbid, and the
bigger ist expected loss.
29

Tests: Mueller and Sirower (2002)

G: Gain to the bidder in dollars over a 24-month period beginning with
the month of the merger
P: Premium paid to the targets shareholders in dollars
VT: Market value of the target firm

G
P
e f

VT
VT

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The predicted coefficients

Hypothesis

Synergy
(SH)
Market for Corporate
Control
(MCCH)
Managerial discretion
(MDH)

Prediction without
Hubris Hypothesis

Prediction with
Hubris Hypothesis

e=0, f=1

e<>0, f<1

e=0, f=0

e<>0, f<0

e=0, f=-1

e=0, f=-1

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Relationship between gains to acquirers and premia paid to targets

e

N / R2

Contested
0.03

-0.21

(0.06)

(0.19)

-1.94

(1.13)

(1.84)

44 / -0.023

0.26

-2.23

(0.97)

(2.81)

-0.68

(0.79)

(1.00)

45 / 0.051

0.09

-1.34

(0.32)

(1.68)

-1.46

(1.42)

(1.75)

123 / 0.015

Unrelated (3 Digit)
95 / -0.000

0.13

-2.54

(0.31)

(2.23)

Cash Only
0.49

124 / 0.053

Single Bidder

Related (3 Digit)
0.20

N / R2

Uncontested

Multiple Bidders
0.48

73 / 0.052

Noncash (mixed)
90 / 0.023

0.05

-2.48

(0.16)

(2.38)

78 / 0.057

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 The mean gain to the bidders is -$50

The variance around this mean is $ 3,579,664 million
Are you willing to play in a game in which
the expected winnings are -$50
you might lose as much as $10, 000,000
You might also win as much as $13,000,000

These are summary statistics from the above sample,

except that they are measured in millions.
Why do managers of these firms undertake such
gambles?
Hubris? Averages do not apply them
Managerial discretion? They are not gambling with other peoples
money!
33