Merger Waves and Merger Profitability

1. Merger Waves

Look back at Figure 31.1, which shows the number of mergers in the United States for each year since 1985. Notice that mergers come in waves. There was an upsurge in merger activ­ity from 1967 to 1969 and then again in the late 1980s and 1990s. Another merger boom got under way in 2003, petered out with the onset of the credit crisis, and resumed in 2013. These were generally periods of rising stock prices

We don’t really understand why merger activity is so volatile and why it seems to be asso­ciated with booming stockmarkets. If mergers are prompted by economic motives, at least one of these motives must be “here today and gone tomorrow,” and it must somehow be associ­ated with high stock prices. But none of the economic motives that we review in this chapter has anything to do with the general level of the stock market. None burst on the scene in the 1960s, departed in 1970, and reappeared for most of the 1980s and again in the mid-1990s and early 2000s. Some mergers may result from mistakes in valuation on the part of the stock market. In other words, the buyer may believe that investors have underestimated the value of the seller or may hope that they will overestimate the value of the combined firm. But we see (with hindsight) that mistakes are made in bear markets as well as bull markets. Why don’t we see just as many firms hunting for bargain acquisitions when the stock market is low? It is possible that “suckers are born every minute,” but it is difficult to believe that they can be harvested only in bull markets.

Merger activity in each wave tends to be concentrated in a relatively small number of industries and is often prompted by deregulation. For example, deregulation of telecoms and banking in the 1990s led to a spate of mergers in both industries.^[1] Changes in technology or the pattern of demand can also prompt a spate of mergers. For example, the reduction in defense expenditures following the end of the cold war led to a wave of consolidations among defense companies.

2. Merger Announcements and the Stock Price

Look back at Figure 13.3, which shows the performance of the stocks of U.S. target firms around the time of the merger announcement. On average, the announcement was associated with an abnormal return of 17.3% for the target shareholders. This is the premium that inves­tors expected the acquirer would need to pay to consummate the merger. Of course, this is an average figure; selling shareholders sometimes obtained much higher returns. When Hewlett- Packard won its takeover battle to buy data-storage company 3Par, it paid a premium of 230% for 3Par’s stock.

Selling shareholders clearly do well from mergers. But what about shareholders of the acquiring firm? A similar picture to Figure 13.3 would show that they have roughly broken even in the weeks surrounding the bid. Perhaps the acquirers’ shareholders were unduly pes­simistic about the merger, but there is no sign that they became more enthusiastic later.

Since the selling shareholders gain and the buyers roughly break-even, it looks as if on average the merging firms are worth more together than apart. For example, Andrade, Mitch­ell, and Stafford found that between 1973 and 1998, the overall value of merging U.S. firms, buyer and seller combined, increased by 1.8%. However, the gains are at best fairly small and accrue to the seller rather than the buyer.^[2]

3. Merger Profitability

Studies of the stock price reaction to merger announcements may show how investors expect mergers to work out. But can we say whether mergers do subsequently enhance profitability? The problem here is that we don’t know how companies would have fared if they had not merged. Ravenscroft and Scherer, who looked at mergers during the 1960s and early 1970s, argued that productivity declined in the years following a merger.^[3] But studies of later merger activity suggest that mergers do seem to improve real productivity. For example, Paul Healy, Krishna Palepu, and Richard Ruback examined 50 large mergers between 1979 and 1983 and found an average increase of 2.4 percentage points in the companies’ pretax returns.^[4] They argue that this gain came from generating a higher level of sales from the same assets. There was no evidence that the companies were mortgaging their long-term future by cutting back on long-term investments; expenditures on capital equipment and research and development tracked industry averages.^[5]

4. Do Mergers Generate Net Benefits?

There are undoubtedly good acquisitions and bad acquisitions. But if, on average, mergers appear to break even for the buyer, why do we observe so much merger activity? Some believe that the explanation lies in behavioral traits. The managers of acquiring firms may be driven by hubris or overconfidence in their ability to run the target firm better than its existing man­agement, so the acquirers pay too much. There is some evidence to support this view. For example, one study documents large losses to more aggressive acquirers in the merger wave of 1998-2001.^[6] Another study of closely fought takeover contests found that winners’ stock returns were 24% less than the losers’ over the three years post-merger.^[7] Warren Buffet summarizes the situation as follows:

Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do won­ders for the profitability of Company T[arget]. . . . We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses—even after their corporate backyards are knee-deep in unresponsive toads.^[8]

Why do so many firms make acquisitions that appear to destroy value? We have suggested that overconfidence may be an explanation, but we should also not dismiss more charitable explanations. For example, McCardle and Viswanathan have pointed out that firms can enter or expand in a product market either by building a new plant or by buying an existing busi­ness. If the market is shrinking, it makes more sense for the firm to expand by acquisition. Hence, when it announces the acquisition, firm value may drop simply because investors conclude that the product market is no longer growing. The acquisition in this case does not destroy value; it just signals the stagnant state of the market.^[9]

We have discussed the impact of mergers on the companies directly involved, but the most important effects may be felt by the managers of other companies. Since poorly performing firms are more likely to be targets, the threat of takeover may spur the whole of corporate America to try harder. Unfortunately, we don’t know whether, on balance, the threat of merger makes for active days or sleepless nights.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.