Diversifications Effect on Firm Value: Mergers and Acquisitions - Research Proposal Example

Mergers and Acquisitions Mergers and Acquisitions (M&A, referred to as 'mergers' in this text) is a process where one company integrates with anotherunder a single management. When the two are individually large companies the term merger is used as compared with the situation where a small company integrates with a larger company; this is referred to as an acquisition. This report is brief for management on some of the important issues relating to this process such as Synergy to be derived from a merger; Legislation and Laws governing mergers; and Defence against hostile merger attempts. 1.0 Synergies 1.1 Drivers of Mergers Mergers are a business strategy that brings together two companies to exploit their individual strengths to address the larger issue of creating value for the stakeholders. The different rationales that drive M&A actions are: 1. Growth: In a bid to expand operations, the company is faced with the choice between internal (organic) growth and growth by acquiring another business. Internal growth can be a slow and uncertain process while acquisition is a much more rapid path to growth, though it also brings its own uncertainties. Growth may be lateral (increase in market size or share) or vertical (backward or forward integration) within the same industry or diversification into a new line of business. 2. Synergy: The word refers to the result of two factors combining to produce a result that is greater than the sum of the two, operating independently, would produce. In the corporate backdrop it translates to the combination of two entities to produce larger profitability than the total of the two separately. Mergers, on the basis of a diversification strategy have also taken place and have not been successful in most instances (Gaughan, 1996). Only where the merger did not involve a movement to a very different type of business some success has been achieved (Berger & Ofek, 1995). 1.2 Synergy and its Creation Theory suggests that synergy is an essential ingredient for value creation to occur as a result of mergers. Synergy realisation depends on the similarities and the complementarities of the two merging businesses, the extent of interaction and coordination during the organisational integration process, and the lack of employee resistance to the combined entity (Larsson & Finkelstein, 1999). On the other hand it is argued (Harrison et al, 1991) that a similarity among resources within the acquiring and the target firm is not essential and that uniquely viable synergy might be created even where differences exist between the resources of the two companies. The types of synergies that may be perceived in a merger are operational and financial synergies. Operational synergy may include economies of scale and economies of scope and is perhaps the soundest basis for a merger. Financial synergy is much harder to define and thus a more obscure foundation for a merger or an acquisition. Synergy may be perceived as covering additional areas, including the effect of replacing an inefficient or ineffective management with a more capable one from the acquiring company (Asquith, 1983). The increase in scale of operations allows the reduction of expenses and overheads, an example of this is the size and manning of the marketing and distribution channels. The same resources may be mobilised to deliver larger returns and therefore reduce costs and effort. Mergers to build market power do not pay. Studies by Ravenscraft and Scherer (1987) and Ravenscraft (1991), reveal that efforts to enhance market position through mergers yield no better performance, and sometimes worse. Studies by Stillman (1983) and Eckbo (1983) find that share price movements of competitive rivals of the buyer do not conform to increases in market power by buyers. It suggests that the sources of gains from merger do not derive from a combination of firms that bases itself on reducing competition. Mergers are also related to the change of scope, economy of scope is the ability of a firm to use one set of inputs to provide a broader range of products and services. Mergers among companies with similar production and marketing organisations are more likely to face resistance from the employees than a merger that focus on realising complementary benefits. 1.3 Synergy Realisation In the global marketplace that emerged with the blurring of international boundaries a number of mergers and acquisitions have taken place across countries. However, statistics show that the failure rate of most mergers and acquisitions lies somewhere between 40-80%. If one were to define 'failure' as failure to increase shareholder value then statistics show these to be at the higher end of the scale at 83% (Cnnfn.com 1999). How does one measure the success or lack thereof Referring to past studies of merger activity using share values as the measure of performance, Michael Porter has stated that ' no self-respecting executive would judge a corporate strategy this way' (in Brouthers et al. 1998). Different studies have consistently shown that acquiring firms do not benefit from mergers and that around 50 per cent of all mergers failed to produce the synergistic benefits that were expected of them (Balmer & Binnie, 1999). This study identifies some of the reasons for this high failure rate to be attributable to the neglect of corporate identity and corporate communication issues. Short-term financial and legal issues are given undue attention to the detriment of long-term identity and communication issues and failure to secure the goodwill of a wide range of stakeholder groups common to both companies. This leads one to question why so many international mergers and acquisitions fail. It is now acknowledged that failure does not have its roots simply in financial, monetary and legal issues but in lack of intercultural synergy. Research suggests that up to 65% of failed mergers and acquisitions are due to 'people issues', i.e. intercultural differences causing communication breakdowns that result in poor productivity (Morosini, 1998). Morosini (ibid) argues that these failures can be due to the executives concentrating on the financial strategic aspects of the deal at the expense of cultural, organizational and execution aspects and when intercultural differences are ignored during the evaluation and negotiation stages of a merger, integration inevitably fails.Managements must understand the need to embrace cultural differences and indeed use them for delivering positive synergy. 1.4 Conclusion We see that distinctions between related and unrelated mergers may not be a useful way to develop an understanding of the possible synergies that may be created on merger and the possible performance of the merged firm. Issues of mergers, therefore, need to be addressed from economics, finance, strategy, organisational theory and human resource management perspectives. A model that integrates all these facets of management allows the understanding of synergies involved in a framework that looks beyond finding similarities or dissimilarities among the merging firms. The leaders and managers of companies must have a clear understanding that the synergies that may created go far beyond operational and financial issues. Intercultural integration and execution are primary to realising synergy. These issues should not be seen as reactive, damage limitation exercises but as a positive, proactive means of creating cohesion, maximising efficiency and building a competitive advantage. 2.0 Regulations and Legal Issues 2.1 Background Mergers can have positive (synergy) and negative (creation of monopolies) effects on economic welfare. Most research, and legislation, bases itself on achieving a balance between the positive and negative impacts of mergers - the positive impact being limited to the creation of wealth for the individual companies and their shareholders; and the negative impact to creation of monopolies (Singh, 1993). Mergers and Acquisitions help the process of channelling corporate assets towards their best possible use by reallocating control over companies (Rossi & Volpin, 2004). However, "frictions" can prevent the efficient transfer of control; such frictions may be transaction costs, information asymmetries, and agency conflicts (ibid). Regulations and laws governing mergers find their roots in the regulatory environment with regard to accounting practices, capital markets, company law, antitrust legislation and financial statutes. 2.2 Impact of Accounting Standards Better accounting standards imply greater disclosure and therefore easier identification of potential targets for merger or acquisition. Similarly, better investor protection eases the finding of a reasonable middle ground, whereas, when shareholder protection is relatively less effective, the private benefits of control are high and the market for corporate control is relatively less effective - because incumbents will try to entrench themselves via ownership concentration and takeover deterrence measures (Bebchuck, 1999). Rossi and Volpin (ibid) demonstrate that merger and acquisition activity is higher in developed markets which have better accounting standards and stronger shareholder protection. 2.3 Common Law vs. Civil Law Country-level differences in legal systems with respect to investor protection laws are associated with systemic variations in financial markets. The broadest distinction is between countries based on English common law and which generally have stronger laws and enforcement, versus those based on Roman civil law and which generally have weaker laws and enforcement (La Porta et al., 1998). American style firms with separation of ownership and management are more likely to be found in common law countries, and to pose the kinds of problems described by Berle and Means (1932) and Jensen and Meckling (1976). By contrast, companies in civil law countries are more likely to be owned and controlled by families (or the State) due to weak protection afforded to outside investors, and are therefore less likely to have problems (Ball, Kothari and Robin, 2000; La Porta et al., 1999 and 2000). 2.3 Historical Perspective During the first half of the 20th century mergers and acquisitions were usually made by the bidder approaching the directors and agreeing to purchase their shares (Hannah, 1974a). A price was negotiated and paid. Management urged the minority shareholders to agree to accept the decision. The same terms were offered to outside shareholders as the directors. "In practice the shareholders would recognize the superiority of the directors' information and tend to take their advice on the true value of the company in relation to the bid price" (Hannah 1974b, p. 70-71). The emergence of corporate control in the US is associated with the rise in institutional shareholding (Jarrell et al, 1988; Chandler, 1992). But in the UK the market for corporate control predated the accumulation of most institutional shareholdings. This is due to the fact that the tighter financial disclosures required under the Companies Act provided the basis on which corporate predators could make reasonably accurate estimates of asset values and earnings, and thus launch bids without the co-operation of the target (Hannah, 1974a). During the 1940's and 1950's there were important changes in the UK capital markets. Firstly, minority investor protection was strengthened. Disclosure was improved and anti-director provisions were introduced. Secondly, there was a sharp increase in institutional ownership. Thirdly, and most significantly, a market in corporate control emerged (Roberts, 1992). In 1959 the City produced the City Code on Take-overs and Mergers and created the Panel on Take-overs and Mergers. This in due course established the principles of equal treatment of all shareholders, the requirement of acquiring firms to disclose their shareholdings and reveal their intentions, and the obligation to make offers for all shares at highest prices once 30% of the target firm's shares had been acquired. The Takeover Panel was established in 1968. Its first rules included mandatory bid and equal price requirements. These rules had the effect of both preventing discriminatory price offers and the build up of large share blocks. By the beginning of the 1970's the key features of current UK corporate ownership and control were in place: substantial institutional shareholdings, a hostile takeover market and extensive minority investor protection. 2.4 Present Regulations and UK Merger Reform In the United Kingdom, merger and takeovers activities are broadly controlled by two types of regulation - the anti-trust and self-regulatory controls. Because managers of firms may not necessarily act in the best interest of all investors, the protection of investor rights, particularly outside (minority) investors, is important in creating economic incentives for the development of financial markets (Hart, 1995). Some of the documented features of stronger investor protection include the one-share one-vote rule, the solicitation of proxies by mail (making it easier to mount challenges to directors), cumulative voting or proportional representation of minorities on boards of directors, mechanisms to legally safeguard minority investors, pre-emptive rights to new share issues (to maintain proportional holdings), and the ability to call an extraordinary shareholders' meeting. The Enterprise Bill brought in major reforms in the framework for merger control in the UK, but substantive policy has remained largely unchanged. At present, the test by which mergers are appraised is formally the 'public interest'; in practice a 'competition' test is paramount in virtually all cases. This is consistent with the view that the best that merger control can do for the public interest is to safeguard competitive conditions. The new test determines whether a merger has resulted, or may be expected to result, in a substantial lessening of competition in the market. The main institutional reform in the UK is that Ministers are no longer part of the process (except where exceptional public interest such as national security is involved). At present the Office of Fair Trade's (OFT) role is to advise the Secretary of State for Trade and Industry whether to refer a merger for full investigation to the Competition Commission (CC). Where the CC finds that a merger is against the public interest it determines remedies. The new framework includes rights of appeal against OFT and CC merger decisions to the Competition Appeal Tribunal. As part of the process of transparency the OFT and the CC have issued guidelines that govern the examination of mergers. Wier (1992) examines the extent to which specific elements of the public interest appear to influence the Monopolies and Mergers Commission in dealing with referred merger bids and finds that relatively few public interest issues such as competition, price and balance of payments had a significant impact on the Commission's decisions. 3.0 Defence Strategies Our strategy considerations for blocking the takeover bid must keep the following three principles in view: 1. Protecting and enhancing corporate value and the interests of shareholders as a whole is the paramount concern. 2. Details of all proposed defence measures must be disclosed, in advance, and a reasonable consensus obtained from shareholders at all times. 3. All actions in defence against the hostile takeover test positive against the parameters of "necessity and reasonableness". Stock repurchases may serve as a defence against takeovers. Since the cost is inversely related to the value of the firm a repurchase signals that the value of the stock is high, blocking a takeover. However, the cost of blocking a takeover by share repurchase is very high and of marginal benefit. Merger transactions deliver a premium return to target firm shareholders (Jenson and Ruback, 1983). The predator will offer our stockholders a premium for their shares and therefore our defence will be viewed by them as a barrier to increasing their wealth. It is imperative that we demonstrate that our defence against this takeover bid is not motivated by the need to defend our personal positions and benefits (Byrd and Stammerjohan, 1997), but is warranted by our commitment to promote their interests by raising takeover premiums, (DeAngelo & Rice, 1983) improve management and protect our company's long term strategy. 3.1 Pre-Bid Strategies Since the takeover bid has not been formalized through an offer as yet, we may consider 'pre-bid' (or preventive) measures, which are: 3.1.1 Poison Pill This line of defence implies that we offer our stockholders preferred stock in the merged company as a mandatory consequence of a successful takeover - at a highly attractive rate of exchange. This will dilute the stock of the merged company so much that the attacking firm loses money on its investment. The Poison pill can take two forms: Poison pill with flip-over rights: this distributes rights rather than shares of preferred stock, issuing them to existing stockholders who can then buy preferred stock at a deeply discounted price. Using such rights is advantageous to our defence because of the negative impact preferred shares have on a balance sheet. However, this has a major drawback in that they are not exercisable unless the bidder acquires 100 percent stock of our company. Flip-in poison pills: With flip-in options, stockholders are given the right to acquire additional shares in our company at a substantially lower price than the current offering. This option is to be preferred if the bidder is not intent on buying the entire outstanding stock of our company. A 'Poison Pill' offer must include a triggering event that begins the issuing of the rights to the stockholders commonly the purchase of, or a tender offer for, a specified percent of the stock outstanding. Poison pills have the effect of rebuffing takeover attempts or forcing up the final price of a takeover. However, shareholders have to be prepared for a temporary fall in stock prices on the announcement of a poison pill initiative (Maltesa & Walkling, 1988). 3.1.2 Corporate Charter Amendments Some companies have adopted a defence which staggers the elections of members to the board of directors so that a well-established board will be able to fend off an attacker's advances. This prevents a corporate aggressor from installing a completely new board of sympathetic directors to facilitate the strategic transition in the aftermath of the takeover. This strategy has not proved very effective in the past and is not recommended. 3.1.3 Golden Parachutes This consists of entering into agreements with our senior executives providing for special and very lucrative compensation packages, in cash, if the takeover bid is successful. This will demonstrate that we are not blocking this takeover due to personal concerns over-arching the concern for increase of shareholder wealth (Walkling and Long, 1984). The high cost that the acquiring company shall have to pay following a takeover will also act as a deterrent to their attempts. Defensive measures which are clearly detrimental to the interests of shareholder as a whole cannot be adopted. Examples: Green mail (Acquisition with the intent to sell back the shares at a higher price) Scorched earth intent acquisitions (intent to cannibalize assets) 3.2 Post Bid Alternatives Once an offer is received, we shall have recourse to the following alternatives (or a combination thereof). 3.2.1 Litigation Taking recourse to the courts of law can help us stall the hostile attack and perhaps completely thwart it. The first step would be to obtain a legal injunction and restraining order against the predator company that bars them from acquiring additional stock of our company until such time as they can prove legally that the justification for the injunction is unfounded. Litigation may be under antitrust legislations, under which we may argue that if the takeover is completed, the resulting combination will de facto violate antitrust laws. Otherwise we can allege inadequate disclosure or fraud. While they are preparing their rebuttal it allows us time to prepare and implement strategy to thwart their attempt or to get more attractive offers from other bidders. 3.2.2 Standstill Agreement We can enter into an agreement with them where they agree not to acquire any more stock of our company for a specified period of time in exchange for a fee that we agree to pay. Such an agreement should include a clause that allows us the right of first refusal in the event that they decide to sell the stock acquired by them. This provision should also give us the right to keep the shares from being sold to another pursuer. 3.2.3 Capital Structure Changes We can restructure our capital to defend against a hostile takeover. Four principal options are available: recapitalisation, assuming additional debt, approving the sale of additional stock, or buying back outstanding shares. Recapitalizing may entail paying our shareholders a super dividend, primarily financed through the assumption of additional debt. 3.3 Follow-up Considerations In case the takeover bid is successful we need to consider whether a 'cash offer' or a 'share exchange is better, especially to protect the interest of our shareholders. Companies usually issue shares at the high point in the cycle of the company's fortunes, or in the stock market. Thus, the announcement of the payment with shares could be taken as a signal that they believe their shares are overpriced. Therefore, management should opt for payment in cash. The pursuer company's shares will trade higher due to the announcement of the merger and are likely to fall subsequently as bidding company shareholders have second thoughts (e.g. see Caves, 1989, Schipper & Thompson, 1983). References: Asquith, P. (1983): Merger Bids, Uncertainty and Stockholder Returns, Journal of Financial Economics, 11(1-4), 51-83. Ball, R., Kothari, S. and Robin, A. (2000): The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics 29, 1-51 Balmer, J.M.T. andDinnie, K.(1999): Corporate identity and corporate communications: the antidote to merger madness, Corporate Communications: An International Journal, 4(4), 182-192. Berger, P.G., and Ofek, E. (1995): "Diversification's Effect on Firm Value," Journal of Financial Economics, 37, 39-65. Berle, A. and G. Means. 1932. The modern corporation and private property (Macmillan, New York). Brouthers, K.D; van Hastenburg, P. and van den Ven, J. (1998): If most mergers fail why are they so popular Long Range Planning, 31(3), 347-353 Byrd, J. W., and Stammerjohan, w.w. (1997): Success and failure in the market for corporate control: Evidence from the petroleum industry. Financial Review 32/4, 635-659. Caves, R. (1989): "Mergers, Takeovers, and Economic Efficiency," International Journal of Industrial Organization, 7, 151-174. Chandler, Alfred D., 1990. Scale & Scope: The Dynamics of Industrial Capitalism. Harvard University Press, Cambridge: MA. DeAngelo, H. and Rice, E. (1983): Anti-takeover charter amendments and stockholder wealth. Journal of Financial Economics 11(1-4), 329-360. Eckbo, E., (1983): "Horizontal mergers, collusion, and stockholder wealth," Journal of Financial Economics, 11. Gaughan, P.A. (1996): Mergers, Acquisitions and Corporate Restructuring, John Wiley and Sons, NY. Hannah, L. (1974a): Mergers in British manufacturing industry 1880-1918. Oxford Economic Papers 26, 1-20. Hannah, L. (1974b): Takeover bids in Britain before 1950: An exercise in business 'Pre-history'. Business History 16, 65-77. Harrison, J.S.; Hitt, M.A.; Hoskisson, R.E.; and Duane, R. (1991): Synergies and Post-Acquisition Performance: Differences versus Similarities in Resource Allocations, Journal of Management, 17(1), 173-190 Hart, O. (1995): Firms, contracts, and financial structure, Oxford University Press, London. Jarrell, G.A.; Brickley, J.A; and Netter, J.M. (1988): The Market for Corporate Control: The Empirical Evidence since 1980, The Journal of Economic Perspectives, 2(1) 49-68. Jensen, M. and Ruback, R. (1983): "The Market for Corporate Control: The Scientific Evidence," Journal of Financial Economics, 11, 5-50. Jensen, M.C. and Meckling, W.H. (1976): Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3 (October), 305-360. La Porta, R. F.; Lopez-de-Silanes; Shleifer, A.; and Vishny, R. (1998): Law and finance. Journal of Political Economy 106 (December), 1113-1155. La Porta, R. F.; Lopez-de-Silanes; Shleifer, A. (1999): Corporate ownership around the world. Journal of Finance 54 (April), 471-517. La Porta, R. F.; Lopez-de-Silanes; Shleifer, A.; and Vishny, R. (2000): Agency problems and dividend policies around the world. Journal of Finance 55 (February), 1-33. Larsson, R. and Finkelstein, S. (1999): Integrating Strategic, Organizational, and Human Resource Perspectives on Mergers and Acquisitions: A Case Survey of Synergy Realization, Organization Science, 10(1) 1-26 Malatesta, P. and Walkling, R. A. (1988): Poison pill securities: Stockholder wealth, profitability and ownership structure. Journal of Financial Economics: 347-376. Morosini, P. (1998): Managing Cultural Differences: Effective Strategy and Execution across Cultures in Global Corporate Alliances, Elsevier Science, US. Ravenscraft, D. (1991):"Gains and Losses from Mergers: The Evidence," Managerial Finance, 17, 8-13. Ravenscraft, D. and Scherer, F.M. (1987): "Life after Takeovers," Journal of Industrial Economics, 36, 147-156. Roberts, R. (1992): Regulatory responses to the rise of the market for corporate control in Britain in the 1950s. Business History 34, 183-200. Rossi, S. and Volpin (2004): Cross-Country Determinants of Mergers and Acquisitions, Journal of Financial Economics, 74, 277-304. Schipper, K. and Thompson, R. (1983): The Impact of Merger-Related Regulations on the Shareholders of Acquiring Firms, Journal of Accounting Research, Vol. 21(1) 184-221. Singh, A. (1993): in Industrial Economic Regulation, Sugden, R. (ed.) Routledge, UK Stillman, R. (1983): Examining antitrust policy toward horizontal mergers, Journal of Financial Economics, 11, 225-240. Walkling, R. A. and Long, M. S. (1984): Agency theory, managerial welfare, and takeover bid resistance. Rand Journal of Economics, 15(1) 54-69. Weir, C. (1992): Monopolies and Mergers Commission, merger reports and the public interest: a probit analysis, Applied Economics, Volume 24(1), p 27 - 34. . Read More