Cross-border Mergers and Acquisitions

Theory and Empirical Evidence

O. Morresi, A. Pezzi

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137357625
• Topic: Business
• Subtopic: International Business
• Index: Business

Since their explosion in the mid-1990s, mergers and acquisitions (M&As) have turned into a global phenomenon with growing prevalence. A large number of theoretical and empirical studies focus on cross-border deals from several perspectives, such as motives, strategic issues, and performance. Most books treat these studies as specific characteristics of M&As, paying little attention to the distinctive elements that differentiate them from domestic operations. In short, there is now a real need for a fresh review and categorization of cross-border deals.Cross-Border Mergers and Acquisitions is the first book to provide readers with a complete guide to understanding the main concepts, theories, and results driving cross-border M&As. Morresi and Pezzi present an original framework that ties together the growing body of theoretical and empirical studies on the topic. This work describes the relevance of the phenomenon in terms of its economical, geographical, and historical impact, and analyzes the market- and accounting-based performance of cross-border deals.

CHAPTER 1

The M&A Phenomenon

Mergers and acquisitions (M&As) can conventionally be defined as the purchase of entire companies or their specific assets by another company. M&A transactions therefore imply that existing assets are combined in a new shape. In a frictionless world, asset recombination occurs whenever corporate assets are not used in the best possible way. The new asset combination should therefore be more productive than the old one. This means that corporate assets should be channeled toward those combinations that assure their highest productivity. Put differently, the combination of two or more assets should be more valuable than the sum of its parts. M&As have their theoretical foundation in three well-recognized theories: neoclassical theory, redistribution theory, and behavioral theory.

According to the neoclassical theory of M&As, the only condition that may trigger a recombination of assets is when the value of the new combination is expected to be greater than the sum of the values of the independent, pre-M&A entities. M&As should therefore be positive net present value (NPV) investments. Where do value gains come from? Neoclassical theory claims that the new combination may be worth more than the old one as a result of synergy gains, that is, the new asset interaction may generate higher cash flows and/or may be less risky than the previous one because of the better use of existing assets. M&As therefore help reallocate control over a firm’s resources provided their best possible use has not already been reached. If all corporate assets were exploited in the best way, at any time, M&A transactions would not be required. This implies that we need external (i.e., economic, technological, and regulatory) shocks that make existing asset combinations no longer optimal. Consequently, according to the neoclassical explanation, the factor that triggers M&A transactions is represented by the occurrence of change forces that lead to a transformation in industry structure so as to create room for improving the value of existing assets (Gort, 1969; Mitchell and Mulherin, 1996). Weston et al. (2004) and Ahern and Weston (2007) summarize the powerful change forces that have characterized M&A activity in the last decades.

Redistribution theory also assumes that M&As are beneficial for shareholders of the acquiring and/or target firm. However, unlike the neoclassical explanation, it argues that value gains that accrue to shareholders do not come from actual synergies but rather from wealth transfers that occur at the expense of one of the firms’ stakeholders such as government, consumers, bondholders, employees, and pension funds.

Finally, some scholars argue that M&As are not moved by the desire to acquire potential synergies that arise from external shocks but rather by behavior-related reasons such as managerial hubris, stock market misvaluations, and empire building. Therefore, these three behavioral approaches do not link M&A activity to economic drivers.

Overall, neoclassical, redistribution, and behavioral theories help explain the merger movements of the twentieth and twenty-first centuries.

1.1 Historical Trends and Merger Waves

One of the most observed and studied empirical regularities in the M&A market is that mergers tend to occur in waves and, within a wave, they strongly cluster by industry. This evidence is not unexpected: we have already stated that according to the neoclassical theory, M&As are a response to economic, technological, and regulatory shocks. These external forces trigger changes in industry structure, thereby causing M&As to occur clustered by time and sector. Likewise, according to the misvaluation theory, M&As are a response to bull markets and increased dispersion of valuations within industry. We should not therefore be surprised to find that M&As are clustered during specific time periods and within specific industries.

1.1.1 The First Wave (1895–1904)

The first merger movement is known as the wave of horizontal mergers, which promoted concentration within many industries. The wave affected a large number of mining and manufacturing industries such as primary metals, food products, petroleum products, chemicals, transportation equipment, fabricated metal products, machinery, and bituminous coal. This period was characterized by the creation of a few large monopolies and some of today’s industrial giants such as US Steel, DuPont, Standard Oil,¹ General Electric, Eastman Kodak, and RJ Reynolds Tobacco Company. Monopoly power arose mainly due to lax enforcement of federal antitrust laws such as the Sherman Act of 1890. Moreover, corporation laws in some states were gradually relaxed. This further enabled firms to collect capital, hold shares in other firms, and expand their lines of business operations. Greater access to capital fed the financing of acquisitions. This merger wave was also fueled by major changes in economic infrastructure and production technologies such as the completion of the transcontinental railroad system, the advent of electricity, and a major increase in the use of coal. These changes transformed regional firms into national firms and enabled them to achieve economies of scale.

This first merger movement, which had been declining since 1901 as a result of unexpected failures of some early objectives and the concomitant recession, came to a definitive end when the Supreme Court, in the Northern Securities case of 1904, established that mergers could be attacked successfully by Section I of the Sherman Act. This decision was, among other things, a consequence of Roosevelt’s policy to make the antitrust environment more stringent.

1.1.2 The Second Wave (1922–1929)

The second merger movement was also fueled by an upturn in business that followed the post–World War I economic boom. The economic expansion provided better and cheaper access to the capital required to fund investments such as M&As. However, unlike the first wave, known as “merging for monopoly,” the second one was called “merging for oligopoly.” The huge number of horizontal mergers that characterized the first wave was replaced by a larger incidence of vertical mergers. In fact, the antitrust environment of the 1920s was stricter than the environment that had prevailed before the first merger wave. New regulations such as the Clayton Act of 1914 reinforced the Sherman Act so as to make the US government’s antimonopoly policy stronger. Consequently, fewer monopolies were created but more oligopolies came into play through vertical mergers. Moreover, this wave was the first large-scale attempt to form conglomerates.

In terms of the industries involved in the consolidation process, new sectors such as public utilities and banking were significant. A large portion of the 1920s M&As represented product extension mergers in industries such as food retailing, department stores, and motion picture theaters, and pure vertical mergers were more common in mining and metals industries.

The main innovations that triggered the second merger movement were developments in transportation, communication, and merchandising. For example, transportation by means of motor vehicles broke down small local markets by enabling sellers to extend their sales areas and making consumers more mobile. The development of home radios promoted national-brand advertising, which became a form of product differentiation. Mass distribution with low profit margins became a new method of merchandising. These developments induced an increase in the size of operations achieved by M&As.

The second merger wave ended with the stock market crash of 1929 and the following drop in business and investment confidence, which was one of the factors that played a main role in the development of the Great Depression.

1.1.3 The Third Wave (1965–1969)

During the 1960s, the antitrust hand was further intensified by the entry into force of the Celler-Kefauver Act of 1950, which amended the Clayton Act of 1914 and granted the federal government additional power to declare as illegal mergers that tended to increase industry concentration and obstruct competition. As a consequence, horizontal and vertical mergers began to decrease, thereby making conglomeration the main path toward growth. Conglomerates that were established in this period held a portfolio of firms operating in highly diversified industries without the prevalence of one business over the others.

While the previous waves were characterized by larger firms that acquired their smaller counterparts, in this wave most acquisitions were initiated by small and medium-sized firms that decided to diversify their business outside their traditional areas of interest. Conglomerate merger was supposed to be a strategy to protect firms from sales and profit instability, adverse growth developments and competitive shifts, technological obsolescence, and increased uncertainties associated with their industries.

The defensive character of conglomeration went together with other reasons. The growth of management science promoted this merger movement. Schools of management increasingly and rapidly expanded, thereby increasing the professionalization of business operations. The prevalent idea was that management science could be applied to any type of business. Another influencing factor was the so-called Earnings Per Share (EPS) game. When an acquiring firm with a high price/earnings (P/E) ratio merges with a firm with a lower P/E ratio, the EPS of the buyer will increase even if the merger does not create any synergy. The higher post-merger EPS may have induced managers to undertake mergers even if no value-increasing motive lay behind the transaction. The hostile public policy environment together with the stock market downturn in 1969 depressed the stock price of conglomerates and declared the end of the wave.

1.1.4 The Fourth Wave (1981–1989)

Many of the conglomerates assembled in the 1960s and 1970s experienced poor performance in the following years, leading to a dismantling process that involved more than 50 percent of cross-industry acquisitions in that period (Gaughan, 2007). This wave was therefore characterized, to a large extent, by firms that tried to focus on their core capabilities. This trend against diversification was performed, on one hand, through financial buyers that acquired segments of diversified firms and, on the other hand, by the so-called bustup acquisitions where either corporate or financial buyers looked for firms whose parts as separate entities were worth more than the whole. After the acquisition, the parts would be sold and the incomes of these sales would be used to slash the debt incurred to finance the deal. The concept of buying a public company and making it private, with substantial use of debt, while providing managers with large equity interest for strong incentives, improving operations, reducing debt, and harvesting the investment by listing the firm again within a three- to five-year holding period, was called leveraged buyout (LBO), a technique to back M&As that became very popular in the fourth wave. According to Jensen (1989) and Holmstrom and Kaplan (2001), LBOs and, more broadly, public-to-private transactions arose in the 1980s in response to the need to cope with the failure of internal governance mechanisms of US corporations. Among the biggest drawbacks of corporations was the propensity to subsidize poorly performing divisions by draining cash from successful ones, instead of giving cash flows back to investors. Corporate diversification was therefore repeatedly demonstrated to be a value-destroying strategy. This made many conglomerates that were assembled in the 1960s targets of takeovers as a result of their depressed stock market valuations compared to those of single-segment firms (the so-called diversification discount²). LBOs came into play as a successful governance mechanism aimed at minimizing the waste of resources that characterized the 1960s and the 1970s and making the firms more focused on core activities. The large-scale use of debt was spurred both by financial innovations, such as junk bonds, developed by investment banks and law firms that introduced many innovative and sophisticated products designed either to assist or to prevent takeovers, and by a succession of laws that contributed to deregulating financial institutions.

The so-called corporate raiders made their final appearance in the 1980s. A raider earned large profits from acquisition attempts without ever buying the target firm. A raider’s ability lay with selling target shares at a price that was higher than the purchase price, for example, through greenmail pa...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Figures
• List of Tables
• Preface
• Acknowledgments
• 1. The M&A Phenomenon
• 2. Cross-border M&As: Theory and Strategic Process
• 3. Cross-border M&As and Performance: Empirical Evidence
• 4. Cross-border M&As and Stock Market Performance: Evidence from Medium-Sized US and European Firms
• Index