Motivations behind Mergers

Synergy

Synergy is the concept that the combined performance and value of two companies will be greater than the sum of the separate parts. Synergies created through mergers will either increase revenues or reduce costs through economies of scale in various business functions.

Growth

Companies that are looking to grow their revenue will turn to mergers as an alternative. Growth through mergers is common for companies in a mature industry. The rationale is that it is riskier to enter a foreign market than to merge with an existing company that understands this market.

Increasing Market Power

A company that merges horizontally to increase market power can influence the market price. Vertical mergers also increase a company’s market power by locking in crucial suppliers.

Acquiring Unique Capabilities and Resources

Many companies cannot internally create capabilities crucial to future success without incurring high costs. Thus, mergers offer a better way for them to make up for the lack of resources and capabilities.

Diversification

Diversification is a major reason why companies merge. In the case of conglomerate mergers, the companies are tied as a portfolio of investment and can reduce the variability of the conglomerate.

Bootstrapping Earnings

The bootstrapping effect occurs when the shares of the acquirer trade at a higher P/E ratio than those of the target, and the acquirer’s P/E ratio remains unchanged after the merger. In an efficient market, the post-merger P/E should adjust to the weighted average of the two companies’ contributions to the merged companies’ earnings.

Manager’s Personal Incentives

Numerous managerial-related theories for mergers based on agency problems have been developed over the years. Managerialism theories suggest that many corporate executives engage in mergers to expand their control and power at the company’s expense.

Tax Considerations

An acquirer can buy a target with losses to reduce the tax liability of the acquiring company.

Unlocking Hidden Value

An acquiring company may acquire a target that has been underperforming with the hopes that it can acquire the company cheaply and unlock hidden value by reorganization, better management, or synergy. If the performance has been worse over the years, the acquirer may even believe it can buy the company for breakup value.

Cross-Border Motivations 

Several factors are likely to make multinational companies seek to merge with companies in different countries. Some of them include:

1. Exploiting market imperfections: By engaging in cross-border transactions, companies can fully exploit markets.
2. Overcoming adverse government policy: A good way to overcome disadvantageous government policies is through cross-border mergers.
3. Technology transfer: Companies with new and superior technology may acquire firms in different countries to open new markets. A company in a foreign country with new technology can also become an attractive target.
4. Product differentiation: Foreign companies often acquire target companies due to their highly differentiated products or intangible products that could benefit the acquirer.
5. Following clients: To better serve and support domestic clients, companies will engage in cross-border mergers to follow them. 

Question

Which one of the following is most likely the reason why companies merge?

1. High cost of capital.
2. Company law in their jurisdiction makes it mandatory.
3. To increase their market power.

Solution

The correct answer is C:

Many companies will merge to increase their market presence and power to influence prices.

A is incorrect: High cost of capital is not a reason for companies to merge.

B is incorrect: There is no empirical evidence that mergers are mandatory in different jurisdictions.

Reading 18: Mergers and Acquisitions

LOS 18 (b) Explain common motivations behind M&A activity.