Advanced Corporate Finance
Merger and acquisition happens when two or more companies are combined together to accomplish certain strategic or business objectives. These transactions, their success or failure, have great implications not only to the companies themselves but also to so many others; such as shareholders, employees, managers, lenders, competitors and economies. The value of merger and acquisitions in US rose from $200 billions in 1992 to more than $1.70 trillions in at the end of 90s.In Europe value of M&A deals has peaked to almost $1.5 trillions at the height of merger boom in 1999. Although with the market crash of 2001-2002, acquirers of many of these deals suffered huge losses. (Sudarsanam, 2003)
Mergers are often categorised as vertical, horizontal, or conglomerate. According to Brealey (2001), most of mergers around the turn of the century such as British Petroleum's acquisition of Amoco were horizontal. According to Arnold (2005), sensible motives for mergers fall into four groups of synergy, bargain buying, managerial motives and third party motives. The idea underlying synergy is that whether there is an economic gain from the merger or not. For instance if the combined firm would be worth PV AB and that the separate firms are worth PVA and PVB then
There is an economic justification for merger if only this gain is positive. The costs of acquiring firm also have to be taken into account.
The attempt to increase market power is another motivator for mergers in which firm try to use some control over the price of the product. For example, General Electric attempt to merge with Honeywell in 2001 was blocked by the European Commission in suspicion of putting other competitors at a disadvantage. Economies of scales, internalisation of transactions, entry to new markets, tax advantage and risk diversification are among other contributors to synergy. There are different methods of financing mergers. According to Arnold (2005) cash in the most attractive option, followed by shares and finally by loan stocks, debentures and preference shares.
Theoretically, mergers and acquisitions should create value for both shareholders of the bidding firm and target company. As a result, there has been a considerable amount of empirical studies into mergers and acquisitions and their effects on acquirers and target companies. Arnold (2005) believes that there is overwhelming evidence that target shareholders gain from mergers because acquirers usually have to pay a high premium to persuade target shareholders. Brealey (2001) stated two reasons for why sellers earn higher returns .First, in many mergers the buyer is so much larger than seller .As a result sellers shareholder receive a bigger return of value created in the merger. The second reason is the competition among potential bidders, leading to highest attainable price to sellers. Agrawal and Jaffe (2000) found strong evidence that acquiring firms give their shareholders poorer return comparing to firms that are not acquired. On the other hand, it is not all dark and pessimistic for acquiring firms. There is a great deal of empirical evidence in relation to acquirers, which their key findings are listed below.
Powel and Stark (2005) found that operating performance improved for acquirers compared to the industry average and other non-participating peers. Switzer and Linn (2001) found evidence of significant increase in US target and acquirer firms' combined operating cash flow.
Rau and Vermaelen (1998) found that in America ‘value acquirers', acquirers with a high book-to-market equity ratio, enjoyed positive long-run returns, whereas ‘glamour' acquirers, those with a low book-to-market equity ratio, suffered negative long-run returns. They concluded that managers of glamorous companies often misjudge their abilities to manage an acquisition in contrast to smaller firms that are more cautious in assessing prospective targets, which tend to assist them in making better choices. In addition, Sudarsanam and Mahate (2003) established that glamour acquirers in UK critically underperformed value acquirers in terms of returns in the three-year post-acquisition period.
By reviewing about 80 acquisitions in US,UK and Europe, Aw and Chatterjee (2004) suggest that cross-border deals decrease overall value of firms .In contrast Moeller and Schlingemann (2005) found that acquirers of domestic target companies experienced better post-takeover performance and bigger financial gains than acquirers of cross-border targets.
PwC (2006) found those serial acquirers' share price performance rises up to a point, after which it starts to turn negative, suggesting that too many acquisitions are difficult to handle efficiently. Moreover KPMG (2007) found that whilst acquirers that had one or two deals in the two years before the acquisition, performed best, those with 10 or more acquisitions performed worst in terms of normalized stock returns as well as EBITDA margins.
The form of financing in mergers and acquisitions is a key in creating value for shareholders of acquirer companies. Stock financed mergers are linked to considerably negative returns, whereas cash deals raise shareholder value or are value neutral. Loughran and Vijh (1997) stated negative returns five years after the acquisitions for companies that financed them with stock. For firms with cash finances, returns were zero or slightly positive. Nonetheless, Harford (1999) found that acquisitions financed with excess cash are not successful .the higher the acquirer's cash reserves, the lower the returns of post-deal announcement. A cash stockpile insulates managers from the external market's observant eye, in so doing allowing them to make economically unreasonable investment decisions. This clarifies the poor stock returns and weak operating performance.
Healy, Palepu and Ruback (1997) stated that deals with high managerial stakes pays off. Their study linked returns to buyers' shareholders with larger equity stakes of managers in the firm. In addition, Cosh, Guest and Hughes (2006) study found that leveraged buyouts in which the interests of managers are aligned with those of shareholders create value for buyers. In their research, they stated that managers' ownership had a strong constructive impact on long-term returns.
KPMG (2007) found out that deals enjoyed considerably higher returns when the firms had low Price/Earnings ratios. According to KPMG Acquirers with low P/E ratios are less expected to make risky deals, perhaps because their stock is not overvalued by the market.
Even though horizontal mergers are frequently undertaken to increase market power in setting prices, Shahrur (2005) found out that most companies are not successful in achieving so. In addition, Fee and Thomas (2004) found that these mergers did not disadvantage customers or suppliers, so horizontal mergers do not show to notably increase market power.
Moeller, Schlingemann and Stulz (2004) found that acquisitions pay off for small acquirers. Their study shows that returns post-announcement were higher for shareholders of small acquirers, no matter what the finance method and the target's ownership were. Furthermore, Mitchell and Stafford (2000) found significant positive three-year returns just for the smallest acquirers. KPMG (2007) stated that deals by small acquirers earned an average return of more than 6 percent, whilst large acquirers' average return was -3.5 percent. Second year returns had increased to more than 15 percent for small acquirers, whereas large acquirers return had dropped to -7 percent.
According to Fuller, Netter and Stegemoller (2002) returns to shareholders of shareholders of more than 500 American firms, which made several acquisitions in 90s, were considerably negative when buying public targets. Yet when the target was a private company, returns were notably positive. Conn et al. (2005) found comparable results in Investigating 4,000 domestic and cross-border acquisitions in UK. The authors argue that this evidence is because of better information sharing in bids for private companies.
Based upon a sample of 1,974 mergers and acquisitions, Bouwman, Fuller and Nain (2003) found that deals announced during bullish periods pay considerably positive but there was no important change throughout bearish periods. Acquisitions during bullish markets underperformed those initiated during bearish markets in terms of returns, in addition return on assets and return on operating income, in spite of the nature of the bud and the financing method.
The Boston Consulting Group (2003) found out that of more than 270 mergers and acquisitions in the US, deals carried out during economic slumps generated significantly higher value for shareholders, on average 14 percent, than those during economic growth.
In conclusion, due to great implications of mergers and acquisitions on many stakeholders, including firms, shareholders, employers and economies, there has been a considerable amount of empirical studies into their effects on acquirers and target companies. A wealth of studies suggests that target shareholders gain from mergers because acquirers usually have to pay a high premium to persuade target shareholders. However, not all deals enjoy the same gains for acquirers. Success does not lie in an acquirer's size, glamour status or previous acquisition experience. On the contrary, small acquirers with low stock market valuations and small or even no experience in deal making often perform better. These studies agree on the importance of financing deals with cash rather than stock and that deals made during economic downturns pay off. Academic studies find that cross-border deals are difficult, although some of these deals can flourish in some conditions.
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