The benefits of M&A activity

 

Mergers and acquisitions became popular in the late 19^th century when smaller US companies merged together to improve market share and keep prices high. Since then M&A activity has spread as globalisation took place. There are different types of mergers that usually fall into three categories;

Horizontal merger – Mergers of companies within the same business activity eg. Pfizer/Pharmacia

Vertical merger – Mergers of firms at different stages, so a firm may buy it’s supplier/customer eg. eBay/PayPal

Conglomerate merger – Mergers in unrelated business areas eg. P&G/Gilette

Mergers can sometimes take months and months of negotiations between Board’s, the target and the acquirer‘s Board of Directors must approve the deal and then put a vote to the target’s shareholders. Friendly takeovers are those were the two Boards agree on a merger and so very rarely would shareholders vote against the decision. Hostile takeovers are when the acquirer will purchase a large proportion of the target’s share s so that they can get enough votes to then replace the target’s Board of Directors and CEO.

There’s also the idea of the “golden parachute”, when the target offers an extremely beneficial severance package to the target’s senior management should they be let go through the merger. Evidence suggest that this actually creates value in that the merger goes through much easier without having to fight the target’s management when they become one company. I believe this isn’t a particularly ethical way of conducting business as you are effectively bribing the company. Furthermore, these lucrative severances are only benefitting those at the top; there will be many beneath who will come off worse because of senior management’s greed.

Mergers have been slowly declining since the financial crisis, recession fears reduce corporate activity and I would expect companies have enough problems keeping their own business afloat without thinking about buying more. It is also much harder to get the credit required for large acquisitions and the fall in share prices makes it harder to justify using these “undervalued” shares as a method of payment.

Yahoo Finance

Institute of Mergers, Acquisitions and Alliances

Looking at the two charts here you can see that there is a very strong correlation between the value of mergers involving and the FTSE 100, a similar comparison could be made with markets across the world. Now that markets are on the rise again we could potentially see mergers begin to increase again and certainly the value will continue to rise.

So how do firms actually finance mergers, well one of the options is to use cash. This is the simplest way and is thought to give a greater chance of success. It also allows the acquirer’s shareholders to retain the same amount of control over the company which should keep them happy. Cash does have its downsides and it could lead to the acquirer possibly having cash flow problems if it uses the majority of its reserves and a negative for the target’s shareholders is that they may then be liable for capital gains tax.

Another popular option is to acquire a target buy providing shares to the target’s shareholders, therefore postponing capital gains tax for them and also maintaining their interest in the merged company. For the acquirer this has the advantage of there being no initial outflow of cash. On the other hand it may not meet the approval of current shareholders as their shares will now be diluted due to the change in capital structure.

Mergers are a lot of hard work and can be risky so why do companies do it? Well one reason is to increase their market power in a particular industry; benefits can also come in the form of “synergies” between the two different firms. Naturally average costs decline with a larger size and there can be an automatic increase in capacity utilization. Something all firms have to look at prior to a merger decision is whether a supplier is still producing products cheaper than a merger could produce, so must choose between internal or external production to enhance profitability.

Not all merger decisions are based purely on what makes business sense. There are also good reasons why senior managers would like to push through a merger. Being at the top of a larger company will increase a manager’s status and power and will no doubt come with a hefty pay rise. There’s also the excitement of being involved with the merger itself which can bring a great feeling of importance and emphasis a manager’s position within an organisation.

Many companies will be worried about survival and so overtaking smaller firms in a bid to increase size so that they cannot be taken over is a popular tactic.

What’s in it for shareholders?



In 1983 Jensen and Ruback conducted a survey based on US studies to gain an understanding on the average effect on share price when mergers and acquisitions take place. Interestingly the target company does very well out of a successful merger whereas there is little or no impact on the acquiring company. Looking at unsuccessful mergers, if it is a takeover then the acquiring company feels the least effect and the other way round if it is a merger. However, the share price isn’t substantially affected for either party.




It’s not just after a merger that changes in share price can happen, even talk of mergers can have a substantial impact on share price. Take for example, the news that Stryker may make a bid for Smith & Nephew, the news broke on the 24^th December and within a day the price went up 7.7%, peaking as high as 10% in the morning. However, looking at Stryker’s share price there was little movement at all, less than 1%. This supports the theory that mergers and acquisitions are seen as better news for the target’s shareholders than the acquirer.

I believe that there is so much competition in every industry that mergers and acquisitions will always be a popular option for companies. Like I mentioned earlier, in many cases it is to grow so that the company is not taken over itself. Over coming years as the markets continue to rise, so will M&A activity and particulary on a global scale as companies try to extend their reach across the world.