Synergy, Managerialism or Hubris - Essay Example

Mergers & Acquisitions Introduction In the business world, separate companies get togetherto formlarger ones by way of mergers & acquisitions. Hundreds of millions, or even billions, of dollars deals are made as a result of different companies joining together and thus also create headlines in the business world. Most companies carry it out to improve their business fortunes. The terms mergers & acquisitions are generally used together or sometimes even interchangeably but there is a sight difference in the two terms. Acquisition takes place when one company becomes the owner of another company in a way that the company sold ceases to exist and the buyer company continues to trade its stock. Merger usually takes place when two companies join together as one company and both companies cease to exist as separate entities and a new entity is formed as a result. The example of DaimlerChrysler is most suitable here because this new business concern was formed by the merger of Daimler-Benz and Chrysler. It is also believed that mergers take place among or between equals. Practically however, the two or more companies are not always on equal grounds. Some times the companies undergoing a deal call the association as merger while in actuality it is an acquisition. The deal is a merger or an acquisition also depends on the circumstances. Friendly or hostile nature of the deal also becomes important. Irrespective of its nature the business deals of this kind greatly affect the board of directors, employees and shareholders. Apart from the distinction of mergers there also exist different forms of mergers. For example horizontal merger is one when companies sharing sharethe same product lines and markets join hands. When supplier and company merge it is termed vertical merger. Conglomeration happens when companies having different businesses come together. Reasons There re different reason given for the mergers and acquisition among companies but three hypotheses are very well known practically as well as theoretically. The synergy hypothesis, hubris hypothesis and managerialism hypothesis have been studied and different observations made regarding them. "The synergy hypothesis proposes that acquisitions take place when the value of the combined firm is greater than the sum of the values of the individual firms. Managers are assumed to be motivated by shareholders' interests to create economic value, and to have the ability to judge accurately the value potential of the combined firm. Other explanations do not assume value-maximizing behavior on the part of managers. The managerialism hypothesis suggests that managers embark on acquisitions to maximize their own utility at the expense of the shareholders of the firm. The hubris hypothesis suggests that bidding firm managers make mistakes in evaluating target firms, but undertake acquisitions presuming that their valuations are correct" (Pettit, Seth & Song, 2000). Synergy Hypothesis Two companies joined together may create the effect of three not two is the reason why most companies choose the path of mergers & acquisitions. The synergy is considered one of the main reasons. By mergers and acquisitions the companies seek to create more value for the shareholders. Synergy gets many benefits for the engaging companies. Most important benefits come in the form of revenue augmentation and cost savings. Due to staff reductions the company gets to save a lot. Especially, when one of the two CEO leaves the company with other employees they also forgo their expensive compensation packages causing huge reduction in costs. Economies of scales can be achieved by two companies together than separately. Relationship with suppliers also improves when stronger and larger groups negotiate. When placing orders for the company management can have a stronger position and as result could get better bargain. Some companies achieve an edge in a particular area by acquiring or merging another company. For example a small company having an edge in IT or any other scope of technology can give the parent company a competitive advantage. Also companies can extend their market reach with the help of another company. Marketing, distribution and sales of a company can increase considerably with help of mergers & acquisitions and as a result revenues and earnings can grow. The benefits mentioned above do not come so easily for companies. So the concept of synergy is hard to achieve in reality. In fact sometimes opposite could happen and two companies together are unable to even create half of their value. Companies that get together for the reason of synergy try to create the perception of enhanced value but if they fail to do so the market price of the shares go down. Hubris Hypothesis Sometimes it happens that managers are unable to make the right evaluation of the firms they seek to acquire because of which error occurs. This is the premise of hubris hypothesis. It is assumed that a random variable having the mean as current market price is taken as the value of the target. Generally, managers commit errors as a result of overvaluation or undervaluation. The error observed in such a situation is normally in the same direction, as the left tail of the distribution of valuations is shortened by the current market price. In such takeover bids synergies do not occur and the acquirers generally transfer the total or excess premium to the target firm. In case of synergies the underlying assumption of the mergers by individual managers is surely rational profit maximization while in hubris hypothesis scenario individual managers exhibit irrational behavior as they make bids above the market price. If rational behavior persisted managers would not bid so irrationally. In certain circumstances while taking a moderate view of the hubris hypothesis it is possible that managers would make mistake in the market valuation but synergies also occur in the process but in these cases also overpayment to acquirers may result. It might happen that the value of the combined entity surpasses the pre-acquisition value of the combining firms on average but still due to erroneous valuation overpayment could result in a loss to shareholders of the purchasing firm. Different experts have also studied the empirical evidence on different takeovers to make a conclusion regarding their consistency or inconsistency with the different versions of the hubris hypothesis. The study of a sample of U.K. takeovers shows that hubris has been the reason behind most of domestic takeovers. Hubris hypothesis was not only found relevant to domestic takeovers but it was also to cross-border takeovers. Also in cases of cross-border takeovers bidders make the mistake of overvaluations. In fact in the context of cross-border takeovers the chances of making mistakes increase due to greater information irregularity between foreign bidders and domestic targets. Managerial Hypothesis Sometimes managers diversify their firms for the purpose of capturing private benefits. " A merger may often have more to do with glory-seeking than business strategy. The executive ego, which is boosted by buying the competition, is a major force in M&A, especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives get a big bonus for merger deals, no matter what happens to the share price later" ('Mergers and Acquisitions: Doing The Deal') In case of hubris hypothesis managers unintentionally overpay for target firms while the managerialism hypothesis states that that managers on purpose overpay in takeovers. In these cases managers sacrifice the well-being of their firm's shareholders and go for acquisitions for their own efficacy. One reason given for this change is manager's own compensation. Mangers' compensation is more related to the amount of assets and higher rates of growth in assets rather than profits. Managers may also engage in this activity in order to reduce the risks related with human capital. Managerialism has been witnessed in takeovers that reflected negative gains. The theory of managerialism seems more effective in case of cross-border acquisitions rather than domestic acquisitions. There are usually low correlations between earnings in different countries and so the case for cross-border acquisitions becomes strong. Especially if the corporate governance is not good, managers may make discretionary decisions and overpay for the acquisitions. Valuations When an acquiring company targets another company and two or more companies merge the value of resultant firm becomes a cumbersome process. A significant premium is paid on the stock market value of the target company by the acquiring company. This holds true whether the reason is synergy, hubris or managerialism. So, irrespective of the pre-merger valuation of the target firm most acquirers or buyers have to pay a premium to the sellers without which they would not agree for a merger or sale. Investors and shareholders generally look for different clues to see if the deal is worthwhile. For example if abnormal premiums are paid then investors become doubtful of the deal particularly if extraordinary synergies do not result. Shareholder value or investor interests also depend on the kind of transactions that is cash transaction, stock-for-stock transaction or a combination of both. In case of cash transaction risks are low while in stock transaction the chances of deal going haywire are high. Regulatory Framework in UK The creation of the Office of Fair Trading (OFT) by the Fair Trading Act 1973 can be considered a major development in the UK regulatory framework with regard to mergers & acquisition. The reform of United Kingdom competition law then occurred in the form of the major provisions of the Competition Act 1998 (CA98) in 2000. "Britain introduced a public, effects-based, administrative, and informal system for reviewing and controlling mergers back in the 1960s and revised its structure in 1973. This highly discretionary system does not require companies to register pending or completed mergers and acquisitions. The government ministers and civil servants who administer merger policy consider the effects of each merger on the share of supply of the respective good or service within the United Kingdom. The "share of supply" differs from a "market share" test because share of supply depends upon the government's description of the good or service under consideration, not an economist's or firm's conventional definition of a market" (Kryda, 2002). Company law primarily gives provisions for other issues related to the mergers & acquisition of companies. Issue like investment advertisements are dealt with the laws in the Financial Services and Markets Act, 2000. Also, City Code on Takeovers and Mergers (Takeover Code'), EU (European Union) Takeover Directives and the Stock Exchange's Yellow Book rules and regulations are used when mergers or takeover involve offers to the public. Some changes have also been brought by the EU recommendations in the UK law. EU Directive sought to remove barriers to takeovers by providing a framework of common laws for takeovers in the EU and thus creating a new legal framework for cross-border mergers. All Member-states were supposed to implement the directive in their national laws by no later than May 20, 2006. So, UK had to implement the directive in its laws by making amendments to the Takeover Code. The implementation is seen as way to support UK companies looking for cross-border mergers with companies from other Member States. For the purpose of taxation different regulatory frameworks like the Income and Corporation taxes Acts of 1970 and 1988, the Taxation of Chargeable Gains Act of 1992, the Capital Allowances Act of 2001, Annual Finance Acts subsequent to the above consolidating acts, Value Added Tax Act of 1994 and subsequent Finance Acts, and the Stamp Act of 1981 exist in UK which are of importance for companies going for mergers. There also exist certain restrictions to takeover of certain businesses in UK. The Fair Trading Act, the Industry Act, and licensing provisions provide certain restrictions for industries such as banking, insurance and broadcasting for the purpose of stopping cartels and other damaging anti-competitive behavior. The changes brought about by the EU in UK laws facilitate the process for mergers within EU and investors welcome these moves. Apart from these facilitations laws in UK are not however considered relaxed. Companies have to fulfill different legal obligations for a merger to take place. Legal framework in UK after EU recommendations and changes includes legal obligations as well as facilities for firms. Conclusions Some mergers fail while some succeed. Some companies succeed in achieving synergies, advantages, and greater efficiency due to strong management. While in some cases managers spend too much of their time on power struggle and deal management resulting in failures. Whatever the case, mergers and acquisition have become important in today's global business environment. References: Pettit, R, Seth, A, & Song, K. (2000). Synergy, Managerialism or Hubris an Empirical Examination of Motives for Foreign Acquisitions of U.S. Firms. Journal of International Business Studies. Vol: 31. Issue: 3. Kryda, G. (2002). The Competition Criterion in British Merger Control Policy. Policy Studies Journal. Vol: 30. Issue: 2. Murali, D. (October, 2006). UK laws that Indian acquirers need to know about. The Hindu Business Line. Retrieved on January 07, 2007 from: http://www.thehindubusinessline.com/2006/10/19/stories/2006101900480900.htm 'Mergers and Acquisitions: Doing the Deal'. Retrieved on January 07, 2007 from: http://www.investopedia.com/university/mergers/mergers3.asp Read More