Global competitive forces
The 20th century has seen the focus on a combined and unified effort to compete against the global competitive forces unlike the past decades. Organizations recognized the significance of diversity and value of uniqueness. Companies merged together under one brand name in order to create “synergy” and capitalize on each other's strengths, capital-asset bases and growth opportunities (Trautwein, 1990). The analysis of both Horizontal and Vertical mergers is done in order to find significant similarities and differences between the two types of mergers and acquisitions. The research paper analyzes that Mergers and Acquisitions (M&A's) are most suited for situations where alliances and partnerships do not go far enough in providing companies with access to the needed resources and capabilities. Ownership ties are more permanent than partnership ties, allowing the operations of the merged/acquired firms to be tightly integrated creating more in-house control and autonomy.
Merger occurs when the companies involved integrate to become one company while typically in an acquisition a bigger company acquires (eats up) a smaller company or a business operation into its own system and setup. Mergers are driven by complex pattern of motives and no single approach can render a full account. However knowing that the world is a complex place and cannot be the end of scientific endeavor, therefore various attempts are made in order to correlate merger theories according to their plausibility and consistency with the evidence. There are two possible ways of getting evidence on motives, direct investigation and indirect inference from the merger outcomes. Direct investigation may produce unreliable results while inferences may be unwarranted. To offset these shortcomings both kinds of evidence are used for analysis (Trautwein, 1990).
Merging with or acquiring another company, companies can dramatically strengthen the market position and open new opportunities for a higher competitive advantage. The procedures include full as well partial merger/acquisition of specialized units and functions. Combining operations can fill resource gaps, allowing the new company to do things, which companies as single units could not. Mergers prompt companies to have more attractive packages for their products and services. They can increase the competitive ability of a firm to withstand and outsmart competitors. Mergers help companies to achieve a greater geographical coverage and financial resources. Greater finances generated can further be invested into the projects of research and development in order to create more technological advances, increase capacity and reduce costs.
The race for global market leadership is prompting numerous companies in participating into the merger activity by creating greater market presence in countries where they also indirectly compete. Efficient leadership through synergy are created where M&As promote positive change by creating and sharing vision (Kavanagh and Ashkanay, 2006). The recent motive to expand the magnitude of M&As across international borders is done with the creation and development of cross-border mergers. Mergers help companies to secure their future by filling the gaps in resources and technology and design a more specialized and cost effective line of products/services. These benefits can be quite substantial and explain why companies resort to M&As.
M&A are based on three basic rationales - economic, commercial and financial. Economic rational provides economies of scale, strategic benefits, complementary resources, utilization of surplus funds and probes to achieve management effectiveness. The commercial rationale looks at the market share figures, growth objectives, synergies and diversification. While the financial rationale looks at increasing earnings per share, purchase of undervalued assets, break-up possibilities and tax considerations.
The three rationales lead companies to merge/acquire the other company in four different types of mergers i.e. Horizontal, Vertical, Concentric and Conglomerate. This research article is pre-dominantly an in-depth study on Horizontal and Vertical Mergers and Acquisitions. They are the two basic forms of mergers that were used in the early waves of mergers of M&As and became a benchmark for other companies on the success of these two types of mergers. This paper is a study on the motives for mergers historically and also studying the merger waves in attempt to get a deeper understanding of the conditions prevalent in times of a particular kind of merger wave. Furthermore, using real world examples what efficiencies were achieved from the M&A activity of both types will be discussed. The aim of the paper is to find out similarities and differences of the motives for horizontal and vertical M&A, analyze them and figure out which type of merger has been more successful and useful historically. The motivation for selecting the horizontal and vertical mergers is because these two types of mergers are the most popular as the most widely used form of mergers. Horizontal M&As have historically evolved for the intrinsic motive of diversification and to achieve the market power motive that is now being strictly regulated by the anti-trust policies and regulations. Horizontal M&As have also developed to enter new businesses for economies of scale, expand along the product lines and manage critical interdependencies. However, the vertical M&As have historically evolved for the prime motive to manage critical interdependencies and achieve economies of scale by utilizing from the distributional capabilities of the firm (Barney, 1990).
The figures by Thomson Financial Securities Data give figures on how many mergers took place during 1800s, 1900s and 2000's. The data indicates that the total number of U.S and U.K deals amounted respectively to 11,9035 and 11,6925 over the 1990s. Recent trend of cross-border mergers started to surge in 1993 accounting for US$20 trillion which is five times more than the combined total of M&As for 1983-89. Since 2001, M&A activity has been on a constant rise till its sudden decline in 2003 due to the global recession factor which indicates that a new merger wave is in the making (Martynova, 2005).
Horizontal Merger/acquisition occurs when companies from the same sector or the same level join together for a market/industry. For example if Hagen-Daaz were to merge with movenpick ice-cream or the merger of General Motors (GM) and Ford. The real world example of a horizontal merger is the well-known merger of Daimler (Benz) and Chrysler where the two automobile companies from the same industry merged to work together as one amalgamated company. The amalgamation of Daimler-Benz and Chrysler (1999) was a $37 billion agreement and the largest trans-Atlantic merger ever with the market capitalization reaching $100 billion However, the post-merger market capitalization rate fell down to $44 billion in nearly three years and eventually the largest merger failed which had started as a big success (Weber and Camerer, 2003). This example of a horizontal merger has worked as a benchmark for achieving healthy short-term post merger results. However, the long-term profitability could not be attained due to the challenging nature of the deal and it's the maintenance of the management and human resource issues after the merger.
Antitrust concerns are more for the horizontal type of mergers than the vertical mergers. Hard antitrust law enforcement in the 1960s encouraged more firms to participate into diversification programs rather than investing into same industry. The Federal Trade Commission (FTC), an agency of the United States government can use the rule of law to prevent mergers if they feel they violate antitrust laws. FTC incorporates the provisions of the Clayton Act which is a key antitrust weapon which can stop any antitrust violations during M&A activity.
Vertical merger is one in which a firm or company combines or merges with its supplier or distributor. The major objective of a vertical merger is to gain more control over the manufacturing or selling processes of the business. Uncertainty and ambiguities can also be minimized regarding the quality of products/services and the quantity of supplies. Monopolistic practices can be hedged by taking advantage from economies of scale and scope and reducing transaction costs, taxes and other expenses. Vertical merger can be useful and profitable because it has the ability to lower cost of production and distribution and by using the resources well. Vertical merger is seen as anticompetitive as it often can take the business away from its competitors by integrating with the backward or the forward supplier/distributor.
Vertical mergers can best be understood from examining real world examples. The merger of America Online with CompuServe (1998) is a well known example of vertical mergers. This merger took place with an intrinsic motive to leverage time constraints and improve the service quality and value addition for the end-users. Another popular example of a vertical merger is the merger of Apple Computers (a computer manufacturer) with Intel (a manufacturer for processors) in 2006 with the motive to provide end-users with a user-friendly, high quality and economical solution.
Economic Performance and Efficiency
The rationale behind M&As is economic gain; value of a merged company (VAB ) is expected to be higher than the sum of the value of separate companies ( VA, VB ):
VAB > (VA + VB)
This motive is strongly related to the neoclassical theory of firm whereby firm behavior is derived from assumption that a firm maximizes its profits. However, maximizing profit or shareholder value is too broad a motive for M&As. It does not reveal how the process is expected to lead up to profit or value improvement. The following discussion will emphasize in detail the factors that contribute to the increased profit value.
The term synergy is often used as a synonym for cost advantages. According to this motive, mergers are undertaken in order to achieve cost savings. Potential cost advantages include both fixed and variable costs. By eliminating intersecting costs such as administration and IT expenditure, financial performance can be improved. Due to the nature of fixed costs, cost reduction potential is not restricted only to vertical and horizontal mergers but also includes other types of mergers (Dranove and Ludwick, 1999).
Vertical integration has some unique sources of cost reduction. For instance, cost advantages can be achieved by avoiding costs of communication and bargaining. Moreover, if production processes require tightly integrated production chain, lower production costs may be achieved by vertical integration. The bigger size can be a source for cost reductions for less than minimum efficient size firms. In this case, with help of bigger size average unit costs reduces hence a merged company enjoys economies of scale. However in multiple-product case, the relation between scale economies and benefits of mergers is more complex. Due to the diseconomies of scope, there may still exist overall diseconomies of scale even if there are product specific economies of scale.
Motives for Horizontal and Vertical M&A
This section will simultaneously discuss the similarities and differences for the motives of horizontal and vertical M&As. Motives will be analyzed with their respective importance and weight to the categories of merger motives.
The commercial rationale for merger motives is to attain diversification, synergies, and growth objectives by new business and interdependencies.
Achieving diversification is a very important motive as an outcome of the M&A activity. It is a technique used to diversify risk and allows growth incentives of the business to expand to other industries as well rather than limiting to the same market. Portfolio diversification is the term that is used for diversification into different investment options/fields for example investment into cash, bonds, stocks, shares and capital etc. Diversification is horizontal as well as vertical in nature. Horizontal diversification allows firms to invest into the same industry/sector while vertical diversification can have the upstream and downstream linkages with the supplier and distributors. Diversification allows company to minimize uncertainty and risk against loss. However, diversification does not reduce the systematic risk or β factor to zero. There are other risks like the recent global recession or any unknown calamity that cannot be diversified no matter how much the company tries to diversify.
Gaudie and Meeks (1982) suggests that diversification is the most important component in helping companies to achieve their long-term financial goals and objectives by achieving high levels specialization. Diversification encourages investing into risk-free investment options where the systematic risk factor or β has risk and level of volatility closest to zero. The risk free factors too have minimal level of un-diversifiable risk and cannot deal with all forms of uncertainty. Diversification confronts the economic, institutional and behavioral challenges like inflation, economic recession and low capital productivity. Diversification allows quick and cost effective solution for dealing with all long-term financial challenges during the M&As activity (Salter and Wienhold, 1982).
In the decision to pursue diversification, choice must be made weather to diversify into related business, unrelated business or a mix of both. The related diversification exploits the value chain by using the concept of synergy to improve performance outcomes and build shareholders value. Businesses operating in the unrelated diversification have dissimilar value chains with little potential to transfer skills and technology from one business to another.
The Celler-Kefauver act passed in 1950s became a major cause for diversification by investing and merging with different lines of businesses. It is analyzed that there is no particular significance given to large mergers and both large and small mergers are treated equally yet the waves of 1960s and 1970s have seen a greater fraction of diversification for the larger firms. Matsusaka (1996) notes that diversification is a very useful tool in hedging against antitrust concerns. The impact of tough antitrust laws in the 1960s caused firms to engage more into diversification programs discouraging the companies to enhance their magnitude for growth within the same industrial sector. Instead, the antitrust policy encouraged companies to involve into diversification by reaching out to other industries with diverse portfolios, minimizing the risk of loss and environment of uncertainty. The antitrust hypothesis suggests that diversification occurred more in 1960s during the tough antitrust policy standards whereas during the 1980s when the laws were relaxed companies managed to merge horizontally taking them away from diversification and focusing more on their key businesses.
The research study by Matsusaka (1996) expands its focus from the U.S to U.K, Germany, France and Canada in the 1960s and has found non-stringent antitrust policy regulations yet there was an increase in the ratio of diversification. The data used comprises of 549 mergers in the year 1968 where bidder and target belongs to the area of manufacturing or mining. Diversification is calculated in SIC (Supplementary Information Code) formats. Information for the vertical mergers is collected from the census bureau metrics for U.S in the year 1972. The classification was done for 52 listed manufacturing companies. Data has been gathered from Moody Industrial Manual a year before mergers took place and the relationship between the retail and the manufacturing must suggest with the help of SIC codes where 1968 SIC Codes were converted into 1972 SIC Codes for analysis purposes. Logit regression analysis is done using the data of 549 mergers by NYSE firms in 1968 where it is found that bidders were more likely to enter new industries when they operated for small mergers as well as large mergers. The research concludes that the strict antitrust policies have a significant impact on diversification but is not the only cause for increase in diversified companies. Historical evidences suggest how diversifications still took place in conditions of weak regulatory environment. It cannot however be denied that stringent anti-trust policies contribute positively to diversify both large and small company mergers.
Hoskisson et al (1993) has analyzed construct validity used as a categorical measure objective for using the diversification strategy. Construct validity refers to a scale that measures psychological traits like intelligence and personality of a person. The data has been analyzed as SIC codes and the multi trait-multi method approach suggesting five elements critical to construct validity like content validity, reliability, discriminant validity, convergent validity and criterion validity. SIC codes have been analyzed using compustat segment tapes. The results of the study suggest that diversification can be best measured by using categorical measure that indentifies the strategic intent of the top officers. The entropy measure gives the information about the related and unrelated diversification used at the corporate level. For the year 1988, a random sample of 200 firms was selected from the publically traded companies listed in NYSE and AMEX stock exchanges. The research concludes that reliability and validity are the two most crucial components for an efficient diversification strategy.
Downie in 1958 suggests that a typical firm operates in one industry and one line of business. However in 1972, it is concluded that diversification has a major role to play in transforming the industrial structure of a country. The research study by Gaudie and Meeks in 1982 has researched the significance and nature of diversified mergers for the population of the U.K listed companies during the period of 1949-1973. The companies selected in the research study are mainly service industries from the areas of manufacturing, distribution and other services. The methodology of the research study is based on listing quarterly results into a table for 22 industries involved in the M&A activity. In total, 1,481 mergers have been analyzed and inserted into the table. The sum of rows refers to the originally classified listed company acquired by members of population while the column sums specifies the number of listed companies of the particular industry. Input of data has been done in forms of 25 annual matrices with 22 rows and 22 columns. The table forms a diagonal matrix in which all companies operate in a horizontal merger setting and are diversified. The share in case of the diversified merger in a horizontal setting is larger than other types of mergers. Diversified companies have seen a substantial increase from 9.3 percent during 1947-1953 to 46.6 percent during 1969-1973. Analyzing the statistical table, it can be clearly seen that the diversification peak contributing maximum value of 70% is for the horizontal mergers are in the year 1972. Conclusions of the study are drawn and one third of the population under observation during 1969-1973 was found to be diversified. The mergers have seen an increasing trend during the time period of 1949-1953 in comparison with 1969-1973. The clear direction of the diversification activity however could not be found but few clear patterns and the increasing or decreasing trends could be seen for Pharmaceutical industries and Petroleum industries giving useful insights to the nature of industries involved in M&As for the motive of diversification.
Diversification discount or diversification premium can be an outcome of M&A activity. Diversification discount is like an artifact or a work of art of segment data while premium is the excess value for diversification. The concept of diversification discount is of pivotal importance for the study of diversification. It is observed that dividend discount typically drops or can also turn into premium. This method explains the importance of diversification and its effects on a firm's value. Reeb (2002) notes that the excess value is negatively correlated to the diversification discount and its effects on leverage. Kedia and Camba (2002) analyzes that excess value correlates with diversification discount even when controlled leverage is used. Guo and Rong (2004) also finds negative correlations of diversification discount to leverage while the leverage control exists. The effects on the firm's value are separated from the effects of diversification on firm's valuation. Diversification is a concept which minimizes risk against uncertainty and takes into account the antitrust considerations. Diversification has been seen more for the horizontal mergers than the vertical mergers as analyzed and discussed in detail by Gaudie and Meeks in 1982. Antitrust concerns are also more tough and stringent for the horizontal mergers in comparison to the vertical mergers. Major motives for diversification as discussed in earlier researches are reduction of managerial and employment risk and desire for increased compensation due to its positive correlation between diversification, managerial compensation and company size. Diversification can enhance the strategic competitiveness of a company and improve the post-merger average returns.
The importance for diversification cannot be denied as it has improved the overall post-merger competitiveness for both types of horizontal and vertical mergers. However a more pre-dominant role of diversification has been seen for the horizontal mergers that the vertical mergers. Gaudie and Meeks (1982) have shown in their research study that greater market share is realized for horizontal mergers in a diversified setting than the vertical mergers. In addition the anti-trust policies have played a very influential role regulating horizontal and vertical mergers but it cannot be purely said that only stringent anti-trust policies are responsible of the creation of the concept for having diversified mergers. However without the antitrust policies, there would have been an environment of weak regulations and companies would have remained to merge for the power and the monopoly motive.
Mergers are a way managers enter new businesses by promoting visibility with investors, bankers or governments in order to reap benefit later. Firms are highly motivated to move beyond their current markets and production and utilize acquiring company's expertise in marketing, production or other areas within an acquired company. M&As can also gain complementary financial features such as those that balance earnings cyclicality. They can divest the poor performing elements of the otherwise undervalued acquired company in portfolio management style and can also sell stock at a profit by pressurizing the acquired firm for improved earnings (Hennart, 1988). Financial synergy is the reduction in cost of capital as a diversification technique. The opportunity for creating new businesses is seen much more for the vertical M&As since they merge with related as well as unrelated forms of businesses (Trautwein, 1990). For example the merger in 2001, two companies formed a blockbuster merger worth around $166 billion. AOL, the smaller of the two companies, had in fact, acquired Time Warner. The two formed “AOL Time Warner” at the time, under a completely new identity.
Mergers are a way managers deal with critical and ongoing interdependencies with others in the firm's environment. M&As either aim to accelerate growth or reduce risks and costs in a particular industry in which the acquiring company has strength e.g. executive wisdom (Barney, 1990). Interdependencies can be used to mutually improve and reduce risks in the supply of the specific goods and/or services to the acquiring company. Interdependencies are found more for the vertical mergers where M&As are more common for the related supplier/distributor businesses. For example very large pulp and paper production facilities close to each other in huge forests in Scandinavia or Canada vertically merge to produce liquid pulp from wood and directly transformed into paper (Avenel, 2008). Interdependencies are created in an horizontal setting when Standard Chartered Bank merged with Grindlays Bank to create new opportunities for them and combining the knowledge and experience of both institutions creating a new standard of banking excellence. Customers benefited through a larger network of branch and office locations and a wider range of products and services. ANZ Bank, a well known Australian bank wanted to penetrate Pakistani market in order to expand business across the border so it acquired Grindlays Bank in the year 1989. Later Standard Chartered Bank acquired ANZ Grindlays after buying 100% of the bank shares and opened 20 branches across Pakistan. The mega merger of Standard Chartered and Grindlays happened in the year 2000 and now the bank operates under the brand name of “Standard Chartered” as shown in figure 1.
M&As may also create as a desire to achieve sufficient size to have efficient access to Capital Markets or inexpensive advertising. Capital markets are platform where debt and equity securities are traded such as stocks and bonds. Marketing experiences contribute a lot to tap on the opportunities of the firms involved in M&As. Synergy minimizes the costs and increases the production capacity. Therefore M&As also aims at reaching capital markets more efficiently and with relatively lower costs. “Financial synergies can be achieved by increasing the company's size that seems to exist in the Capital Markets” (Scherer and Fredric, 1987). By correlating industrial organization theory and research on capital markets, empirical evidence suggests that merger motives of firms are influenced by their exiting concentration in the industry. Analyzing wealth effects on target, acquiring and rival firms for 330 transactions in the machinery industry between 1997 and 2007, Geiger (2009) discovered that mergers in concentrated industries are primarily motivated to achieve productive efficiency gains. The positive impact of synergies and productive efficiency gains are reflected in positive capital market evaluations for target and acquiring companies due to prior merger announcements creating profit gains for the horizontal mergers.
Economic and Financial Rationale
Economic rationale refers to the economic logic that occurs during a M&A activity. Companies participating in the mergers pre-plan to determine objectives and goals that lead to accomplish positive benefits from post-merger economic rationale such as economies of scale, strategic benefits, complimentary resources, utilization of the surplus funds and industry effectiveness.
Howard and Bondt (1992) gauges the impact of economic factors as driving force behind mergers. Many economists voice against the regulatory bodies like FTC, SEC and IRS (U.S department for justice) for imposing laws and policies limiting the number of mergers and acquisitions. During analysis it was found that mergers are motivated by diverse motives as separate laws have been made in order to regulate them. Managers of the bidding firms are regulated for the motive of “synergy”, desire to limit new entrants into the market, benefit from corporate tax savings. Economists have concerns over damaging the quality and benefits from merger deals due to extensive existing and new regulations on mergers. It is of greater concern that over regulations can directly affect the efficiency gains by majority of large mergers. Efficiency gains are believed to be a significant part for achieving corporate control. The empirical analysis uses the data from the Center of Security Prices at the University of Chicago (CRSP). The efficiency gains are measured using the sample of all companies delisted from the New York stock exchange for the purpose of mergers from the timeline of 1926-1988. The findings suggest that few mergers were mismanaged and there was underutilization of resources in conditions of no regulations in past. It is concluded that it will be a mistake to condemn the takeover regulations however the real challenge for the policy makers is to develop a proper framework that promotes economic efficiency and maintains balance in equity for the shareholders. The research also suggests the motives that have the ability to increase wealth transfers. The first motive is the under-valuation in the financial markets where shareholders gain is higher than the bidder's gain. The second motive is the bidder management's self interest where managers have a tendency to be overconfident and they feel target firm will eventually end up being profitable. The third motive, why regulations are useful is creating breach of trust when merger comes as a surprise for the shareholders and the employee turnover increases due to pressure of the new merger challenges. The fourth motive why regulatory bodies control mergers is for the motive to gain more monopoly power. This motive is seen more for the horizontal mergers but now they are under stringent review of anti-trust laws. Lastly, mergers are regulated with the motivation to gain benefits from the corporate tax savings. The bidders may also be willing to pay an extra tax premium as an opportunity to enhance the value of the depreciated assets. Research further analyzes that taxation gains are stepped up from the previous carryover losses.
>Economies of Scale
Economies of scale refer to increase in the efficiency of production as the number of goods being produced increases. The average cost per unit decreases as the fixed cost is shared by an increased number of production units. This motive for mergers and acquisition can be achieved by utilizing the acquiring company's expertise in marketing, production or other areas within the acquired company (Barney, 1990).
Economies of scale can also be enhanced through capacity expansion by utilizing the acquired company's personnel skills or technology in other operations of the acquiring company. Economics literature has traditionally seen horizontal acquisitions as an opportunity to achieve cost savings through the exploitation of economies of scale and scope (Capron, 1999) Economies of scale and scope are particularly useful in predicting the performance for horizontal acquisitions. Horizontal mergers are more likely to exist with overlapping businesses than with unrelated acquisitions (Flanagan and O'Shaughnessy, 1998). However, they are prevalent in both horizontal and vertical M&A. They result in lower average cost of production s due to higher level of operations.
Economies of scale are referred to as operating efficiencies. Stewart et al (1984) discusses how economies of scale can positively contribute to the post merger success. He suggests that the total cost tends to minimize with the effect of economies of scale than for separate and independently operating units. Greater economies of scales have been realized for larger companies using the advertising and marketing tools. Transfer of brand image, loyalty and access to different business channels are more significant and cost effective for the large companies involved in mergers and acquisitions. R&D is likely to be of most important motive for a merger involving two firms in R&D intensive industries. Economies in advertising and R&D are sufficient to motivate a merger occurring between firms in advertising and R&D intensive industries. The results suggest that firms are inclined more to merge in a concentrated industry. Firms where market power is concentrated may be in better position to exploit economies of scale.
An example of an horizontal M&A is when Daimler-Benz merged with Chrysler to create a broader product line, economies of scale and a stronger global presence in the world's motor vehicle industry, enhancing the company's combined capability to compete with Ford, Toyota, and General Motors (1998) Economies of scale were created in a vertical M&As setting when America Online acquired CompuServe by utilizing CompuServe's technological skills to give it stronger appeal to customers wanting Internet access (1997).
Complementary Resources, Patents, or Factors of Production
Mergers can be an outcome of a desire to prevail over gaps and lacks in one's own company. Complimentary resources, patents and factors of production can be acquired in order to fill these gaps after the merger. This activity does not only involve tangible (physical) but also patenting for the in-tangible (non-physical) goods and services.
Goodwill is an important in-tangible value addition for the parent company after the merger/acquisition. The value of a firm also increases with a successful merger for factors of production and technology. A real life example of a vertical merger is Apple (which manufacture computers) with Intel (which manufactures processors that go in the Apple Computers) improving the goodwill and the service quality in the eyes of the target market (2005).
According to the market power motive companies merge in order to achieve more market power. If the merger or acquisition is large enough, the firm obtains a monopoly like position in terms of the above-normal profit. Moreover, if large economies of scale exist, a big company may set its price above marginal costs but below the level that would induce entry into the industry. Thereby in some cases, large mergers cause an entry barrier for potential competitors. Market power motives often intertwine with scale-based motives of a horizontal acquisition while capacity divestiture through acquisition may also simultaneously serve as a market power objective for horizontal M&As. Capacity divestiture refers to the selloff, spin off and liquidation of the capacity or size of the company unit. For example, high share enables the firm to reduce its per-unit cost of differentiation and R&D, thereby enhancing customer loyalty (Porter, 1985). In vertical M&As, the integrated firm leaves the intermediate market and the nonintegrated upstream firms enjoys more market power and raise the intermediate price that they charge to independent downstream firms (Avenel, 2008). Vertical integration changes downstream producers pricing incentive and the ability to raise input prices for its competitors and also changes the incentive to choose its own suppliers (Chen, 2001).
M&As can also solve the problem of under-utilized market power through combined synergies of marketing, production and capacity can be improved through economies of scale and scope. Market power in a nutshell is the extent to which a firm can influence its price with the forces of demand and supply. When firms have highly specialized and differentiated products, market power is another name of market monopoly. Under - utilized market power is when the resources of machine capacity, labor and infrastructure are underutilized. When the prices and costs are too high, resources are expected to be underutilized. Under-utilized potential gap can be filled by acquiring a better or complimentary technology of the acquired firm. Utilization of the market power is also successful when the top management of the target firm is waived eventually within the first five years or the merger/acquisition. Senior managers of the parent company might like to retain the top management of the target company for fully utilizing the past experiences of the top managers for a merger/acquisition. Under-utilized market power is seen in related as well as unrelated mergers. In both cases, the under-utilized power can be synergized and used as a market power tool for both firms involved in M&As.
Power motive has been seen quite common in case of the horizontal mergers. It is considered a good sign at different supply chain levels of the vertical merger. Regulatory bodies keep a closer eye on the horizontal merger to keep them from synergizing monopoly with the intension to gain more power and control.
Market Share/ Market Position
Mergers and acquisitions help managers in expanding the current product lines and markets by attaining improved competitiveness inherent in holding a sizable market share or important market position. Risks and costs can be substantially reduced by diversifying products and services delivered to the customers within an industry. Mergers and Acquisitions (M&As) are used to penetrate the markets by utilizing the acquired company's marketing capabilities. Distributional capacities can be acquired to absorb expanded output improving economies of scale (Salter and Weinhold, 1982) Mergers and acquisitions can also broaden the customer base for existing goods and services of the acquiring company. They can be targeted to expand capacity at less cost than assembling new facilities, equipment and/or physical assets. It is observed that firms with large market shares, low capital/asset ratios, and operations in urban areas are relatively likely to be acquired but not firms with low profits or low growth (Hannan and Rhaodes, 1987).
Gupta and Gerchak (2002) have analyzed how the merger activity has increased sharply since 1900s. The aim of their study was to capture important parameters from the production side for value enhancement of the shareholders gains from market shares. M&A activity has significantly increased since the early 1990s. The worldwide dollar value of M&A in 1998 was 50% higher than in 1997 and twice as much as in 1996. Furthermore, there were approximately 26,200 mergers worldwide in 1998 worth nearly 2.4 trillion dollars. The DCF (Discount cash flow) method is performed by using the spreadsheets involving tax consideration, laws of demand and growth figures. Financial ratios are used such as PE (Price earnings) ratio and market to book earnings ratios to account for analyzing the effect of operational synergies on shareholders market position and gains. Operational synergy model is used to differentiate the bidder's assets and demand patterns. It is analyzed that a bidder should be willing to pay for the extra premium arising from the operational synergies. Numerical analysis of bivariate normal distribution method is used to derive meaningful results. It is seen that the demands is affected by using correlated demands for the target company. The demand and supply model can further be explained with the help of an example of positive and negative dependence of demand. Suppose a manufacturer of carbonated soft drinks (bidder) wishes to acquire a company manufacturing frozen fruit juice (target). It can be safely said that their demands are positively dependent. Demand is positively affected by factors like the intensity and length of the summer season. However if the same carbonated soft drink manufacturer wishes to acquire another carbonated soft drink manufacturer with a competing brand name, then the bidder and target are likely to have negatively correlated demands. Therefore, higher the demand for the competing soft drink brand, the lower might be its value to the bidder. The research analyzes that bidder can make long-term use of target firm's capacity and operational synergies but these must be followed by rational cost-cutting and complementary skills of target and the bidder.
Horizontal mergers are motivated by a desire to acquire competitive advantage through a greater market share and reduced cost. This trend is much more pronounced in developed countries with mega examples of banks M&As like Standard Chartered with ANZ Grindlays and Chase Manhattan with Chemicals Bank. An example of Vertical M&A with respect to market share is when General Motors acquired Michelin tyres and substantially improved their market share figures.
The background of managerial motives can be found from the principle-agent theory. Corporate managers act as agents on behalf of owners of company (principal). Agency problems arise when ownership and management of firm are separated. These problems exist because owners and managers have different interests and because perfect contracts between owners and managers cannot be written. M&As provide much faster means to grow than internal expansion does. Empire building theory refers to when managers yearn to improvise their own value and utility than the shareholders value. This motive does not work on the growth maximization of the business however power motive becomes more important than profit motive.
The broad managerial motives for M&As are to accelerate growth and reduce risk of uncertainty, promote visibility for investor and other institutional bodies involved in the M&A activity. Gain financial strengths and attain substantial market share, gain financial features, utilize marketing and production skills, create economies of scale, enter new markets, divest poor performing businesses and improve managerial efficiencies etc (Barney, 1990).
The advantages reaping through the M&As are numerous however; all mergers involved in the M&A activity have not been completely successful in achieving the motives they were determined to achieve. Trautwein (1990), classifies merger motives into seven expansive categories. First is the efficiency theory that target to create synergies in three different forms i.e. Financial Synergies, Operational Synergies and Managerial Synergies. Financial synergies are an outcome of low cost of capital and other resources. Systematic risk can be hedged by diversification of portfolio. Monopoly theory influences others in a powerful way in which firms can cross subsidize products. Phillip Morris cross-subsidized products after merging with miller (1970). Competition can also be limited by integrated processes of purchasing etc. New entrants can be discouraged to enter new markets thus creating monopoly and limiting competition. Theory in which managers yearn to improvise their own value and utility than the shareholders value refer to the empire building theory. This motive does not work on the growth maximization of the business however power motive becomes more important than profit motive. The empire building motive covers a broader range than the monopoly theory and has gained immense popularity over the years. Process theory suggests that people have limited information processing capability therefore it has to rely on machines and other tools for information processing. Political power motive helps develop the process strategies for running the show. Less emphasis is given to the process theory than the empire building theory. Raider theory deals with bidder involved in wealth transfers through greenmails or excessive compensations. Disturbance theory has been given by Gort (1969) where merger waves occur because of economic disturbances. The efficiency theories do not give credible results however highest significance has been shown for the empire-building theory.
Managers also compete for the right to manage the resources of the company in order to achieve greater market control. Hence, poorly performing firms are threatened to become a successful merger/acquisition. The acquirer firms assume that economics gains can be achieved by replacing inefficient incumbent managers with more efficient persons.
Mergers occur in waves making cyclic patterns in the periods of aggressive merger activity. Mergers have been a topic of considerable interest in the U.S for over a century and major research and development has also been made in that field. However the magnitude of analysis of this research paper is of the international context. In this section, the merger motives and the merger waves will be correlated and interlinked to horizontal and vertical type of mergers to form conclusion with the help of real world examples. Economic conditions will be discussed under which the merger waves were formed. Economic, financial and global forces of demand and supply have contributed to the causes for merger waves and solutions to solve the economic, financial and the global issues are the reasons behind the motives for the M&A activity.
The pivotal question is what causes the merger waves? Aggregate waves are usually due to market timing or a combination of industry shocks that create changes in the environment. The mergers shocks can be economic, regulatory, technological or due to global forces of demand and supply. Liquidity, also known as marketability is a characteristic of an asset which can be quickly converted into cash. More liquidity is required during the M&A periods due to quick need of cash for improving technology and deal with post-merger uncertainties. Investors with liquid assets can take out their money easily from the investments. Examples of liquidity are cash, blue chip assets and money market securities.
The industry level M&As occur in clusters where industrial groups are formed in same industry types such as automobile industry, electronic industry, services industry and banking industry etc. A merger waves historically trigger M&As using industrial clusters and groups (Boone and Harold, 2000). Broadly, there are two merger theories i.e. the neoclassical theory and the behavioral theory. The neoclassical explanations of merger waves are based on economic disturbances that lead to industry reorganizations like M&As (Gort, 1969). Economic disturbances can change the individual expectations and the level of uncertainty. Technological advances can also trigger a merger wave to start. Maksimovic and Phillips (2001) used improvements at the plant level to support the argument of the affect of technological advances being a cause of merger wave. His analysis suggested that the less productive firms tend to sell their divisions in conditions of industry expansion while the efficient firms based on new technological advances experienced an increase in demand. The Behavioral empirical research suggests that merger waves are also influenced by the liquidity in the market and strongly correlate with the Stock price valuations. High valuations from enough firms are required to generate a merger wave. In financial terms, merger waves are expected to be created when there are abnormally high stock returns or market to book ratios and when the dispersion in those returns/ratios is large. Stock deals are used more for industries with greater technological advances so therefore high stock markets can also trigger a new merger wave. The aim of conducting this research study is to study how historically the motives for mergers of each type have changed. Five merger waves have been identified by the merger specialists and researchers from the history of the United States. The first merger wave in the U.S started in late 18,90s triggered by an economic depression by creation of new state legislations and industrial shocks on NYSE (New York Stock Exchange) and ended in 1889-1904. The horizontal type of mergers became most popular during the first wave. The second wave from 1916-1929 brought the culture of vertical integrations while the third wave from 1965-1989 were merger waves for diversified conglomerate mergers. The fourth merger wave form 1992-1998 were a mix of concentric mergers, hostile takeovers and the recent and ongoing wave in 2000s is that of cross border mergers. The waves during the 19th century in the U.S is referred to as the “Great Merger Movement” which 1800 firms disappeared into consolidations/mergers and 1900 firms got acquired contributing to 20% of GDP during the first merger wave (Martynova, 2005). The first wave carried immense economic growth contributed by major positive changes in the production technology and economic infrastructure such as the advent of electricity and the development of the rail road systems.
The motive for mergers in the first wave was for higher economies of scale and mainly power motive which in later waves was replaced by the profit motive (Viswanathan, 2006) The horizontal mergers are created for the motive to gain higher “market share” since with the related Mergers and Acquisitions activity, buyers will be absorbing a major competitor in itself and thus increasing market power. This leads the horizontal mergers to be created for the motive of more integrated “market power”.
The second merger wave comprised primarily of the vertical mergers with the upstream and downstream suppliers/distributers again for the motive of gaining higher “economies of scale” and “economies of scope”. Vertical integration is also done for the motive of creating “synergy” from the new alliances through mergers by using skills of respective unique selling proposition (USP) and specialized skills and technologies. Vertical Mergers also occur for the motive and desire of “cross selling”. Cross selling is done when a manufacturer mergers with the supplier or the distributor and thus can sell complimentary products and services. Vertical integrations are done with the motive of “profitability” as well as use of different skills sets but work towards one finished product (Higgins, 2009). By reducing reliance on supplier and distributors, greater profits are expected to be realized. Motivation of a backward vertical merger is to attain cheaper supplies from the supplier/distributor.
The third merger waves comprised of the conglomerate mergers which were caused as the major motive for “risk reduction” or “diversification”. “Diversification” is used both for the horizontal as well as the vertical integration since in both cases it helps mergers to diversify portfolios in order to hedge diversifiable risk (Gaudie and Meeks, 1982) The third wave brought the concept of diversified companies with development of conglomerates while in UK, the emphasis till remained on the horizontal type of mergers. Diversification also encouraged the “managerial synergy theory” that decreases the earnings volatility (Marynova, 2005). Vertical mergers “manage critical interdependencies” by using interlocking and mutually synergetic qualities. In particular, managers with “Market for Corporate Control” motive, reduces the “employees risk” by replacing inefficient incumbent managers with more efficient employees and managers (Amihud and Lev, 1999). This motive also associates to “displacing the existing management” motive. Risk reduction in conglomerate mergers are also attributed to the risk reduction of the employment risk e.g risk of losing job and good reputation. Motive to gain “goodwill” is also very important for the conglomerate mergers. “Managerial” motives are also cause of conglomerate type of mergers and provide faster internal development and expansion. “Utilizing financial Strengths” is another motive for conglomerate mergers (Barney, 1990).
The fourth merger wave brought the concept of concentric mergers which occur with the motive of expanding current markets and increase the scope of “geographical proximity” by outreaching to dispersed target markets. Concentric mergers expand along the product lines (Barney, 1990). Conglomerate and concentric type of M&As have relatively close motives and desire for opportunistic expansion and growth.
The fifth merger wave brought out the concept for cross border mergers in the 2000s with the recent rise of globalization and multinational companies trend all across the globe. The cross border mergers however are relatively complicated in designs deals with different cultures, religions and norms. There is enormous growth in the globally integrated capital markets which aim to provide foreigners access to the local capital markets that include “reduction of trade barriers”, “removal of capital control” with regulations and harmonization of “tax laws” across the board.
Globally the merger waves are most important and the largest merger movement has been in the UK and US since 1890s. European countries have also been very active in the M&A activity. The prime motives then were the surge in the trend for globalization, liberalization, closer integration of financial world markets and creation of one European single market. However, other than UK and US, the rest of the world has also experienced an unprecedented growth in mergers and acquisitions since 1990 (Martynova, 2005). It is analyzed by Goyal (2006) that merger wealth effects have found to be significantly more during the period of 1980s and 1990s mainly attributed to the vertical mergers during that merger wave. The trickle down affect of mergers and acquisitions from the UK and US affected the developing countries and the transaction volume due to mergers tripled between 1990s and 2000. Mergers and acquisition activities tend to cluster by time, region as well as industry. There is no overlapping of industry types in time zones of 1970s, 1980s and 1990s. From 1990 onwards, the economic conditions that most triggered the merger shocks are deregulation, increasing globalization and stronger competition from reduction of subsidization. International analysts were confident that elimination obstacles from price movement and capital and good flows would assure sustained growth for developing countries. This confidence however has been shaken after the Mexican peso crisis in 1994, the East African financial crisis of 1997-98 and the Russian Brazilian crisis of 1998-99. The mergers and acquisitions M&As are very common in the developing countries as well but more for multinational companies/banks than the local companies. The global merger waves start from the developed countries like the U.S or U.K due to economic conditions like technological advances, globalization and deregulation. The trickle down affect of global merger waves fall on the developing countries but the motives for merging differs in different types of mergers, at different times and for different reasons.
Post Merger Analysis
Post- merger analysis is conducted to study the examples and factors that caused the success or the failure of a particular merger. This section also studies how diversification has positively contributed to the success of many mergers.
Capron in 1999, discusses the post M&A performance of horizontal mergers and conducted a detailed survey of acquiring firm managers. Samples comprised of 253 horizontal mergers and acquisitions that took place in American and European manufacturing industries from 1988 to 1992 and analyzed that from statistical analysis that 44% of the horizontal firms turned out to be diversified. His research further suggests that the diversification by a firm favors redeployment of resources across diverse business settings.
Post merger integration is a phase with a grave risk of failure if the planning and implementation is not appropriately done. Conditions that hedge the post merger failure are proper implementation of strategy that incorporates effective communication between the employees, employee ownership control and management's proactive style in an approach to satisfy the stakeholder's expectations. Open communication of leadership with the management can circumvent the possibility of M&A failures. Organizational cultures can positively or negatively affect the firm's performance. Employee retention is done when merged with the new company. It is seen that post merger ratio of employee turnover increases as the employees feel the pressure to fulfill unrealistic expectations from their leadership.
Horizontal acquisitions can increase post-merger market coverage through the geographic extension of the market and through product line extension. Overall, superior marketing capabilities can lead to increased customer value, which in tu can be translated into premium prices and/or increased volumes. Horizontal acquisitions can enhance innovation capability by using the superior innovation capability with the help of patents, technology and know-how used in order to improve organizational and marketing effectiveness for e.g, time to market and customer satisfaction. Innovation capability can be mint price increase in premium which can lead to higher revenues. It can thereby be concluded that post merger market-related performance in horizontal M&As have a much stronger impact on financial performance than cost savings.
In case of vertical post-merger, the integrated firm has more stake and interest in raising the price for upstream suppliers/distributers. The higher input prices can further raise the costs of its rivals downstream relaxing the competitive constraint on its downstream division leading to improved growth in the market power and enhanced downstream profits. “A vertically integrated firm is more likely to incur the costs of coordinating and the lost profits from not cheating because it will benefit in the long run for greater and higher profits for both upstream and downstream parties” (Higgins, 2009). The greater the benefit of the downstream division from raising the costs of its rivals, the more vertical merger will enhance incentives for an integrated firm to cooperate with coordinated pricing upstream.
The real world successful example of a company merging for the motive of diversification is a the two pharmaceutical companies Glaxo Wellcome and SmithKlien Beecham which merged as one company after the merger under the new name of GlaxoSmithKlien (GSK) (2000) for the prime motive of diversification (Delaney, 2003). Glaxo, headquartered in London pioneered in making baby food products and milk supplements but now GSK is more than a baby food company, it manufacturers vitamin supplements, life saving drugs, other medicines and compact machinery in the use of medical field. The operations of GSK also do not limit themselves in London but reaches to America, Canada and the rest of the world improvising the diversification motive.
Vertical post merger performance has shown positive results for most M&As over the last years. The largest famous example of vertical M&A with successful post merger results is that of Carnegie Steel Company merger with U.S Steel Corporation in 19,00s. Another example for recent and successful post merger stories is of Hyundai Motors which is a large car manufacturing company with approximately 2/3 of the Korean car market. The acquired firm was the largest supplier of electronic auto parts. Hyundai participates in the electronic auto parts market so the merger was both horizontal and vertical mergers. Second, new cars and new auto parts are developed jointly and their life cycle in the market goes together for about 6 to 8 years from the stage of development to the stage of sales and later services.
Efficiencies from a horizontal merger can arise from various sources like reducing costs of supplying the market which is passed on to the consumer in the form of lower prices that can ultimately benefit end consumers. Horizontal merger improves productive efficiencies that positively impacts profitability. Horizontal mergers and acquisitions have shown positive post merger cash flows in the environment of dynamic competition (Benchekroun, 2000) A merger can be only successful if the market shares attained after the merger are substantially significant.
Chen (2001) analyzes that vertical integration not only changes an upstream firms' pricing incentive but the same is true for downstream firms' pricing incentive and competitor's incentive when selecting input supplier. The researcher has developed an equilibrium theory according to which additional considerations have been accounted for resulting in measurement and comparison of competitive effects of vertical merger. The bottom-line of analysis has been that if a firm supplies inputs to downstream rivals, its competitive prices in downstream market can downwardly impact its profits in upstream market. When downstream firms merge with the more efficient upstream firm and the un-integrated downstream firm will select the integrated firm as its input supplier. In this situation the integrated firm will have a lower marginal cost in the downstream market and hence more incentive to lower its downstream price.
Since the merger changes the rivals' incentive in selecting input suppliers, a vertical merger can raise downstream rivals' cost. A vertical merger creates the opportunity for multimarket interdependence between competitors in the downstream market and will thus have a collusive effect. However, this collusive effect can be realized if and only if the vertical merger also has an efficiency effect due to lowered marginal cost of the integrated firm in producing the final product. A firm is believed to gain competitive advantage in a market place if it is able to cut down its own cost or become more competitive by being able to raise cost of a rival firm. In latter case the strategy can be considered as anticompetitive, however it is possible to achieve the same by opting for vertical integration that is if its own cost is sustainably lowered through the integration.
The research study has given important insights to the phenomenon of M&As and the significance of their motives. Various merger motives are discussed and analysis has been done on why mergers take place, what merger motives have been a cause of both types of mergers and which merger motives have been the cause of a surge in the trend for global M&As. Horizontal and vertical mergers were studied in particular and it can be safely concluded that both types are most commonly used and have shown post merger profits. Horizontal mergers however have proved more popular as well as profitable than vertical mergers also heavily used in the first merger wave as a benchmark merger type. The success of the horizontal merger depends on the relatedness of the merging firms. Empirical evidence indicates that mergers between firms of similar products or markets tend to be more successful. Horizontal mergers are most profitable than the vertical mergers can also be attributed to the fact that horizontal mergers create greater opportunities for market dominance.
Primarily it is seen that the desire for market power motivates merger behavior therefore restrictive policies and antitrust laws have been devised particularly for the horizontal mergers. It is considered the opposite for the vertical mergers that the greater market power at a supply chain level, better it is for the business and so vertical mergers are more likely to be easily approved by the regulatory authorities. Consumers in case of the vertical mergers can benefit from the increased efficiencies that can result from the supply chain integration often in forms of low prices and superior quality. Market share and profitability motive has probably been the most important cause for increase in the trend for M&As. The post-merger market share of the merged parties is based on the assumption that they are equivalent to the sum of their pre-merger market shares. Market shares motive are considered to be an indicator of a firm's ability to act independently of its competitors. If goods are horizontally differentiated, and if they are close substitutes, market power will certainly be a result of merger. Here, efficiency gains may be a result of economies of scale motive. Economies of scope, by the joint production of old and new goods after the merger, may also appear, and cause efficiency gains. Horizontal differentiation may enable the merger to eliminate goods that are much alike. A vertically integrated firm could also oblige an upstream firm to increase sales to the level that is optimal for the integrated structure. The elimination of these problems may therefore bring some efficiency benefits. It is seen that efficiency gains and economies of scale motive has shown positive cash flows for both Horizontal and Vertical mergers.
The most common benefit of vertical integration is that companies may create a more cost efficient organization. For example, such benefits may arise from technological economies, (the integration of technological processes, such as the integration of iron- and steelmaking). Another benefit could be the lowering of transaction costs, the main source of which are the costs involved in bringing buyers and sellers together. By aligning the incentives of firms operating at different levels of the supply chain, vertical mergers may also reduce the double-marginalization problem, which describes a situation where every firm in the supply chain wants to maximize its profits. Greater value is created by the vertical mergers in order to generate value while in imperfectly competitive markets. These are the times when firms need to invest in specialized assets making difficult market exchanges. Little support is available to prove the evidence for maximizing value for vertical mergers due to contracting problems due to information asymmetries and price uncertainty. However, informational asymmetries have shown evidence to increase the value of horizontal mergers. Economic conditions are studied under which merger waves are trigged however the conclusion suggests that economic conditions have given more boost to the horizontal mergers because of their least complicated designs and structure. In addition horizontal mergers have proved to be more profitable and successful yet more regulations keep a track of its motives since many horizontal mergers merged for the “power motive” or for the sake of monopoly. Vertical mergers are a very unique type of M&As and they are the second largest type of mergers to be used. Value addition is done at every level of the mergers and therefore post merger results for vertical mergers have frequently shown positive results however vertical integration is likely to reduce welfare at the margin if the dominant firm is substantially vertically integrated and if the output market share of the dominant firm is substantially larger than its input market share. The recent trend for the motives to merge is to expand the line of business across the borders with the help of Cross-border mergers. Diversification has played a pivotal role in hedging risks against uncertainty and loss more for the horizontal mergers and anti-trust policies have played their significant role in order to regulate the diversified mergers to have positive impact on the profitability of mergers.
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