Economics of Mergers and Acquisitions - Essay Example

The number of mergers of companies of different sizes and performing in variable industries, acquisitions and alliances created in the last decades has exceeded the number for the years before which in the 1960s, for example, were mainly unions between conglomerates. According to statistics from the web resource Mergerstat.com, the amount of mergers only until 2002 has reached 4,363 worth over $291,7 billions1 and the majority of the deals was done within Internet, Healthcare, Telecommunications, Banking and Semiconductors industries. This type of vertical integration and diversification of production achieved usually leads to only humble profits and no dramatic increases in value of the companies going into the merger, with several exceptional cases of extremely successful mergers. Study in 1999 revealed that up to 75% to 83% of the mergers failed meaning lower productivity on post-merger process for both companies, decrease of shareholders value and accelerating absenteeism. The main reasons for the failures are the improper resources allocated and as a result insufficient company strengths, weaknesses, opportunities and threats analysis; poor merger management, due diligence of the company prior to merger, irrational optimistic expectations of the synergy effect; badly planned post-merger strategy and vision development due to slow post-merger companies integration, contradicting corporate cultures, absenteeism of risk management within strategy development and others. As can be observed from the information above, the results are not always rewarding no matter what is the initial reason for the merger or acquisition. The analysts have drawn three acquisition categories2, with first being the plan and prosper acquisition aiming at connecting a company with high goodwill and one with low disparity operating in similar markets and the first with superb skills and expertise taking over the second one. The second type of the merger is the stand and hold acquisition which is often seen as conglomerate and mergers a company with high good will with one with high disparity due to decreased market share and profits by the first and wish to remain the biggest player on the market. The low goodwill and low disparity merge and grow acquisition is the most known strategy to gain market share subject to be done very rapidly in order to succeed. The fourth strategy is to unite low goodwill and high disparity companies and is the least desirable strategy as both companies lack efficient knowledge and skills to share with the other and thus increase the benefits. Each of these strategies has economic grounds for trying to accomplish it. Entrepreneur organizes a firm when he is able to achieve long term contracts and thus agree with suppliers and sometimes stable customers on long term which will further on allow him to plan his actions. The main target of the entrepreneur is to maximize his profits and this is the sole purpose of the firm operation. Each firm has its’ own competitive advantages over others producing the same or substitute products and the producer satisfying the best level of customers utility maximization function enjoys the highest sales. But this customer may not be the one enjoying the highest profits. The profit is the difference between the sales and the costs of producing the goods and thus having high margins by selling products at much higher prices over the cost of the production can lead to lower satisfying customer utility maximization and lower sales which will lead to overall entrepreneurs lower total profits. On the other hand, an entrepreneur which operates on lower profit margin from each good will thus attract more clients and will generate higher sales and thus higher overall profits, given that the production costs for the both entrepreneurs are the same. That is why the product price is dictated usually by the market in case of oligopoly market structure, which is commonly the case in present economic developments, and the only way for the entrepreneur to increase his profits is to cut down his production costs and in the future prices to win the price competitive advantage. The output of the firm, or the size of the firm, is dependant on the rising production costs and is set at the level when the marginal cost of transacting another unit equals the cost of this transaction. Another restriction lies in the production function of the company where up to some point in the production, the marginal cost of producing extra item is less then the average cost of producing one item. But after the break point, as the average cost is the sum of fixed costs plus the variable costs, the expenses to produce extra unit require additional fixed costs inflow which will make the marginal production cost of this extra unit higher than the average cost. This limit can be overcome when there are several factories and then the size of the company is limited only by its’ competitive market share and the diminishing returns to management when after some marginal cost of increasing company operation by one unit due to increased management, administration expenses are higher than the benefit or the revenue received from selling it. The firms with wide spatial distribution, very heavy inside transaction costs and firms operating in highly volatile markets are the ones likely to be most negatively affected by this. Due to increased technology available for the production and numerous innovations, the optimal levels of output for the companies have increased and companies manage to decrease their production costs by using economies of scale. When a company invests in a highly productive plant, or several companies unite for supplier usage and other services, the marginal cost of producing extra unit for them becomes lower than the average total costs comparing to lower levels of production. But the company cannot operate at its’ optimal production level and thus maximize its’ profits as existing profits within the industry prompt other entrepreneurs to enter and they start competing and all the entrepreneurs operating at lower than their optimal level and selling goods at lower prices that could be achievable in case of monopoly market structure. The entrance of new entrepreneurs remains until the economic profit of operating within the industry is zero. The only way to avoid competition and thus become the market leader and dictate prices to the market is to create a monopoly or simply gain the largest market share by uniting several companies and then enjoying higher returns from using economies of scale in production and retailing, managing and operating at optimal production level as they state the prices and do not have to compete. This is the economic implication behind the mergers and acquisitions. Entrepreneurs tend to form teams not only from technological production gains, but from increased team work where people tend to perform better in teams where they are sharing skills and knowledge and each is using his best skill, rather than they would do alone. The teams are formed up to the point where the cost of adding another team worker in terms of increasing work efficiency monitoring is greater than the benefit received from product output from this employee. That is why the majority of the industry in the developed countries have oligopoly market structure where several companies are market players and are able to operate profitably in the long term. The firm is aimed at maximizing its’ overall profits in order to increase shareholders’ wealth by paying them out higher dividends in the present, and having enough funds for innovations and investing into high yielding projects in the future and thus generating profitable cash flows for the shareholders later on. Due to the fact that the owner of the company may not possess the skills and experience necessary for successfully running the company in the long term and that he will not always maximize profits but rather maximize his own utility, it is the common practice that the proficient in this sphere manager is hired whose main task is to maximize shareholder’s wealth. The problem arises with principle agent problem where the principle, or the firm owner, cannot trace and evaluate objectively the business actions of the agent, or the hired manager to run the business, and due to this asymmetric information available to the principle, the moral hazard problem or the temptation to overuse company resources and use them not to shareholders’, but to personal interests arises. As the wage of the manager is often tied to the company performance, they will be more likely to maximize company sales, or personal utility function as prestige, security and so on subject to minimal required by investors profit constraint in order for the manager to keep his job. According to Baumol theory, the manager will tend to promote share market increase which can sometimes mean operating at lower than marginal cost of production and thus will lead to lower profit margins and can be followed by lower profits though the increasing sales. Williamson suggested that firms emerged due to “asset specificity” where the value of the asset is much lower in its’ second best use comparing to its’ value within production of this very good. This brings agents to bargaining at positions above their optimal and the length of negotiating together with increase resource, for example, price lead to overall increase product price over the one accepted by the market. The solution is the removal of one of the agents by merger or acquisition or by developing high prestige name of the company which increases the benefit of working from it over the cost of receiving lower than the market wage. Another implication of Baulmol “cost diseases” theory3 is that the size of the firm is constrained by the hierarchical bureaucracy costs and increasing monitoring and controlling for workers efforts in order to provide appropriate rewarding. The productivity growth in the company can occur due to increased technology, higher labor skills, more capital accumulated for each worker, better management and using economies of scale when the production volumes increase. The company can thus increase its’ outputs by achieving one of these factors and Baulmol argued that the industry or one sector will experience ever increasing production costs from the administration and management sector due to its’ decreasing productivity or lower consumption of output. Another benefit of working for a large company for an entrepreneur rather than running own business, is risk sharing with other workers where the overall success is distributed among the team as well as the failures are offset by many and not suffered by one. This removes uncertainty for person and tends him to work for big companies. By acquiring or merging with a company offering similar products or services, the company is implementing horizontal integration and thus expands at one level, contrary to vertical integration when the company grows to upper or lower activities, purchasing a company from the same value added chain. The benefits of horizontal integration are in the ability to use economies of scale and economize on costs of selling similar products which can be implemented by expanding within one geographic region, the “synergies” effect known as “2 + 2 = 5” and is sometimes referred to as advantage of economies of scope when several companies share the same resources, such as benefit from sharing advertisement suppliers, media resources when the companies operate within different industries. It is expected that due to decreased costs when the companies producing the similar products are united, and taking only their strengths while trying to eliminate their weaknesses will lead in the future to higher value of the sum of these two companies than this sum before the merger. The bigger is the company within one segment, the stronger is its’ market share and position over its’ suppliers and other down vertical line segments. Sometimes the company can also achieve reduction of operation costs of the plants in their subsidiaries in the foreign market and the benefit from foreign trade will thus multiply. The horizontal merger will be successful The drawback of increasing the market share through merger or acquisition is the constraint placed on such activities by antimonopoly committees which aim at preventing monopolistic power within one industry which leads to higher than optimal prices, losses by consumers and the government as the tax payments would be lower. Another pitfall is the inability to precisely estimate the synergy affect of cooperation of several products which will not capture the desired market for the company. Some scholars, Baumol4 being one of them, and empirical works prove that the company at its’ growth stage will target not profit maximization, but sales maximization constrained by target profit desired by the company with other scholars stressing that the company maximizes profits which are subject to revenues constraint to be removed only with higher market share. Baumol reasons company’s striving for sales maximization as the firm wishing long term growth will heavily invest in capturing higher markets or introducing new products and thus will require more funds where capital markets provide cheaper funds at more favorable terms to larger firms and make the company provide to investors minimum determined by capital markets returns; the benefit of reducing costs on marketing and advertisements campaigns; dependence of management compensation on sales rather than profit maximization and not satisfactory level within workers in a stable not growing firm. Thus the company will target achieving greater sales by any means. The graph below5 presents the points usually chosen by managers or the interaction of advertising outlays to output. As can be seen, or the target profit of £20, the manager can choose either points W or Y, but the revenue maximizing manager, which is usually the case within oligopolies in the economy, will prefer point Y though the profits will be lower due to higher advertisement fees. The recent merger proposed by Boots and Alliance Unichem on creating Alliance Boots is targeted at creating a group with total sales volume over £13 billions a year which will combine the positive aspects of both companies and will create the widest pharmacy business in Europe. The company is aiming at significantly reducing costs by at least £100 annualy within purchasing, logistics, retailing, corporate management segments. The aim is to increase company prevalence geographically and be able to provide products at lower costs and thus generate higher market share and higher profits with the majority of them to come from retail segment of the business, while the turnover is mainly made up from the wholesale part. Some scholars believe that the company is trying to avoid the failure of the recent years when they have lost enormous market share to more price competitive retail and supermarket chains which is not purely the fault of the company. It is believed that the price paid by Boots is rational and both shareholders of two companies will benefit. The problem of increased market share and strength can come from anti monopoly sues which can make the deal not come true. References: 1) Baumol, W. Business Behavior, Value and Growth, New York, McMillan, 1959. 2) Baumol, William J., 1967. ”Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis.” AmericanEconomic Review 57 (2), 415–426. 3) Hawkings, C. J., The Revenue Maximization Oligopoly Model: Comment, The American Economic Review, Volume 60 (3), 1970, pp. 429-432. 4) Lynch, J., Lind, B. Escaping Merger and Acquisition Madness, Strategy and Leadership, Volume 30 (2), 2002, pp. 5-12. 5) Nguyen, H., Kleiner, B. The Effective Management of Mergers, Leadership & Organization Development Journal, Volume 24 (8), 2003, pp. 447-454. 6) The Profit Maximization Assumption, H. T. Koplin, Oxford Economic Papers, New Series, Volume 15, No. 2, July, 1963, pp. 130-139. Read More