Motives
for Acquisitions
Not
all firms that make acquisitions have acquisition strategies, and not all firms
that have acquisition strategies stick with them. In this section, we consider
a number of different motives for acquisitions and suggest that a coherent
acquisition strategy has to be based on one or another of these motives.
Acquire
undervalued firms
Firms that are undervalued by financial markets can be
targeted for acquisition by those who recognize this mispricing. The acquirer
can then gain the difference between the value and the purchase price as
surplus. For this strategy to work, however, three basic components need to
come together.
1.
A
capacity to find firms that trade at less than their true value: This capacity would require either
access to better information than is available to other investors in the
market, or better analytical tools than those used by other market
participants.
2.
Access
to the funds that will be needed to complete the acquisition: Knowing a firm is undervalued does not
necessarily imply having capital easily available to carry out the acquisition.
Access to capital depends upon the size of the acquirer Ð large firms will have
more access to capital markets and internal funds than smaller firms or
individuals Ð and upon the acquirerÕs track record Ð a history of success at
identifying and acquiring under valued firms will make subsequent acquisitions
easier.
3.
Skill in
execution: If the
acquirer, in the process of the acquisition, drives the stock price up to and
beyond the estimated value, there will be no value gain from the acquisition.
To illustrate, assume that the estimated value for a firm is $100 million and
that the current market price is $75 million. In acquiring this firm, the
acquirer will have to pay a premium. If that premium exceeds 33% of the market
price, the price exceeds the estimated value, and the acquisition will not
create any value for the acquirer.
While
the strategy of buying under valued firms has a great deal of intuitive appeal,
it is daunting, especially when acquiring publicly traded firms in reasonably
efficient markets, where the premiums paid on market prices can very quickly
eliminate the valuation surplus. The odds are better in less efficient markets
or when acquiring private businesses.
Diversify
to reduce risk
We made a strong argument in Chapter 6
that diversification reduces an investorÕs exposure to firm-specific risk. In
fact, the risk and return models that we have used in this book have been built
on the presumption that the firm-specific risk will be diversified away and
hence will not be rewarded. By buying firms in other businesses and diversifying,
acquiring firmsÕ managers believe, they can reduce earnings volatility and risk
and increase potential value.
Although diversification has benefits, it
is an open question whether it can be accomplished more efficiently by
investors diversifying across traded stocks, or by firms diversifying by
acquiring other firms. If we compare the transactions costs associated with
investor diversification with the costs and the premiums paid by firms doing
the same, investors in most publicly traded firms can diversify far more
cheaply than firms can.
There are two exceptions to this view. The first is in the
case of a private firm, where the owner may have all or most of his or her
wealth invested in the firm. Here, the argument for diversification becomes
stronger, since the owner alone is exposed to all risk. This risk exposure may
explain why many family-owned businesses in Asia, for instance, diversified
into multiple businesses and became conglomerates. The second, albeit weaker
case, is the closely held firm, whose incumbent managers may have the bulk of
their wealth invested in the firm. By diversifying through acquisitions, they
reduce their exposure to total risk, though other investors (who presumably are
more diversified) may not share their enthusiasm.
Create
Operating or Financial Synergy
The third reason to explain the
significant premiums paid in most acquisitions is synergy. Synergy is the potential additional
value from combining two firms. It is probably the most widely used and misused
rationale for mergers and acquisitions.
Sources
of Operating Synergy
Operating synergies are those synergies
that allow firms to increase their operating income, increase growth or both.
We would categorize operating synergies into four types.
1.
Economies
of scale that may arise
from the merger, allowing the combined firm to become more cost-efficient and
profitable.
2.
Greater
pricing power from
reduced competition and higher market share, which should result in higher
margins and operating income.
3.
Combination
of different functional strengths,
as would be the case when a firm with strong marketing skills acquires a firm
with a good product line.
4.
Higher
growth in new or existing markets,
arising from the combination of the two firms. This would be case when a US
consumer products firm acquires an emerging market firm, with an established
distribution network and brand name recognition, and uses these strengths to
increase sales of its products.
Operating
synergies can affect margins and growth, and through these the value of the
firms involved in the merger or acquisition.
Sources
of Financial Synergy
With
financial synergies, the payoff can take the form of either higher cash flows
or a lower cost of capital (discount rate). Included are the following.
á
A
combination of a firm with excess cash, or cash slack, (and limited project opportunities) and
a firm with high-return projects (and limited cash) can yield a payoff in terms
of higher value for the combined firm. The increase in value comes from the
projects that were taken with the excess cash that otherwise would not have
been taken. This synergy is likely to show up most often when large firms
acquire smaller firms, or when publicly traded firms acquire private
businesses.
á
Debt
capacity can increase,
because when two firms combine, their earnings and cash flows may become more
stable and predictable. This, in turn, allows them to borrow more than they
could have as individual entities, which creates a tax benefit for the combined
firm. This tax benefit can take the form of either higher cash flows or a lower
cost of capital for the combined firm.
á
Tax
benefits can arise
either from the acquisition taking advantage of tax laws or from the use of net
operating losses to shelter income. Thus, a profitable firm that acquires a
money-losing firm may be able to use the net operating losses of the latter to
reduce its tax burden. Alternatively, a firm that is able to increase its
depreciation charges after an acquisition will save in taxes and increase its
value.
Clearly,
there is potential for synergy in many mergers. The more important issues are
whether that synergy can be valued and, if so, how to value it.
Empirical
Evidence on Synergy
Synergy
is a stated motive in many mergers and acquisitions. Bhide (1993) examined the
motives behind 77 acquisitions in 1985 and 1986 and reported that operating
synergy was the primary motive in one-third of these takeovers. A number of
studies examine whether synergy exists and, if it does, how much it is worth.
If synergy is perceived to exist in a takeover, the value of the combined firm
should be greater than the sum of the values of the bidding and target firms,
operating independently.
V(AB)
> V(A) + V(B)
where
V(AB)
= Value of a firm created by combining A and B (Synergy)
V(A)
= Value of firm A, operating independently
V(B)
= Value of firm B, operating independently
Studies
of stock returns around merger announcements generally conclude that the value
of the combined firm does increase in most takeovers and that the increase is
significant. Bradley, Desai, and Kim (1988) examined a sample of 236
inter-firms tender offers between 1963 and 1984 and reported that the combined
value of the target and bidder firms increased 7.48% ($117 million in 1984
dollars), on average, on the announcement of the merger. This result has to be
interpreted with caution, however, since the increase in the value of the
combined firm after a merger is also consistent with a number of other
hypotheses explaining acquisitions, including under valuation and a change in
corporate control. It is thus a weak test of the synergy hypothesis.
The
existence of synergy generally implies that the combined firm will become more
profitable or grow at a faster rate after the merger than will the firms
operating separately. A stronger test of synergy is to evaluate whether merged
firms improve their performance (profitability and growth) relative to their
competitors, after
takeovers. On this test, as we show later in this chapter, many mergers fail.
Take
over poorly managed firms and change management
Some firms are not managed optimally and
others often believe they can run them better than the current managers.
Acquiring poorly managed firms and removing incumbent management, or at least
changing existing management policy or practices, should make these firms more
valuable, allowing the acquirer to claim the increase in value. This value
increase is often termed the value of control.
Prerequisites
for Success
While this corporate control story can be
used to justify large premiums over the market price, the potential for its
success rests on the following.
1.
The poor
performance of the firm being acquired should be attributable to the incumbent
management of the firm, rather than to market or industry factors that are not
under management control.
2.
The
acquisition has to be followed by a change in management practices, and the
change has to increase value. As noted in the last chapter, actions that
enhance value increase cash flows from existing assets, increase expected growth
rates, increase the length of the growth period, or reduce the cost of capital.
3.
The market
price of the acquisition should reflect the status quo, i.e, the current
management of the firm and their poor business practices. If the market price
already has the control premium built into it, there is little potential for
the acquirer to earn the premium.
In
the last two decades, corporate control has been increasingly cited as a reason
for hostile acquisitions.
Empirical
Evidence on the Value of Control
The strongest support for the existence
of a market for corporate control lies in the types of firms that are typically
acquired in hostile takeovers. Research indicates that the typical target firm
in a hostile takeover has the following characteristics.
(1)
It has under performed other stocks in its industry and the overall market, in
terms of returns to its stockholders in the years preceding the takeover.
(2)
It has been less profitable than firms in its industry in the years preceding
the takeover.
(3)
It has a much lower stock holding by insiders than do firms in its peer groups.
In
a comparison of target firms in hostile and friendly takeovers, Bhide
illustrates their differences. His findings are summarized in Figure 25.3.
As you
can see, target firms in hostile takeovers have earned a 2.2% lower return on
equity, on average, than other firms in their industry; they have earned
returns for their stockholders which are 4% lower than the market; and only
6.5% of their stock were held by insiders.
There
is also evidence that firms make significant changes in the way they operate
after hostile takeovers. In his study, Bhide examined the consequences of
hostile takeovers and noted the following changes.
1.
Many of
the hostile takeovers were followed by an increase in debt, which resulted in a
downgrading of the debt. The debt was quickly reduced with proceeds from the
sale of assets, however.
2.
There
was no significant change in the amount of capital investment in these firms.
3.
Almost
60% of the takeovers were followed by significant divestitures, in which half
or more of the firm was divested. The overwhelming majority of the divestitures
were units in business areas unrelated to the company's core business (i.e.,
they constituted reversal of corporate diversification done in earlier time
periods).
4.
There
were significant management changes in 17 of the 19 hostile takeovers, with the
replacement of the entire corporate management team in seven of the takeovers.
Thus, contrary to popular view[1], most hostile takeovers are not followed
by the acquirer stripping the assets of the target firm and leading it to ruin.
Instead, target firms refocus on their core businesses and often improve their
operating performance.
Cater
to Managerial Self Interest
In most acquisitions, it is the managers
of the acquiring firm who decide whether to carry out the acquisition and how
much to pay for it, rather than the stockholders of the firm. Given these
circumstances, the motive for some acquisitions may not be stockholder wealth
maximization, but managerial self-interest, manifested in any of the following
motives for acquisitions.
á
Empire
building: Some top
managers interestsÕ seem to lie in making their firms the largest and most
dominant firms in their industry or even in the entire market. This objective,
rather than diversification, may explain the acquisition strategies of firms
like Gulf and Western and ITT[2] in the 1960s and 1970s. Note that both
firms had strong-willed CEOs, Charles Bludhorn in the case of Gulf and Western,
and Harold Geneen, in the case of the ITT, during their acquisitive periods.
á
Managerial
Ego: It is clear that
some acquisitions, especially when there are multiple bidders for the same
firm, become tests of machismo[3] for the managers involved. Neither side
wants to lose the battle, even though winning might cost their stockholders
billions of dollars.
á
Compensation
and side-benefits: In
some cases, mergers and acquisitions can result in the rewriting of management
compensation contracts. If the potential private gains to the managers from the
transaction are large, it might blind them to the costs created for their own
stockholders.
In
a paper titled ÒThe Hubris HypothesisÓ, Roll (1981) suggests that we might be
under estimating how much of the acquisition process and the prices paid can be
explained by managerial pride and ego.