Eat or Be Eaten Analyzed: How the Distribution of Firm Size Triggers Merger Waves
Corporations Advanced Topic: Mergers & Acquisitions
Spring 2012 – Prof. Palmiter
Jordan Benton
When an industry is faced with a significant regulatory change or other landscape altering
event, management faces a significant challenge in preserving or improving their firm’s position
in the market. Such conditions are ripe for aggressive acquisitions to either protect a firm from
being acquired itself or to improve its attractiveness to potential suitors. Gary Gorton, Matthias
Kahl, and Richard Rosen set out to determine whether managerial motivations during such an
industry wide regime shift lead to profitable mergers depending on firm size in their paper Eat or
Be Eaten: A Theory of Mergers and Firm Size (2009). By applying a game theory turn by turn
game scenario, the authors seek to measure whether the potential utility payoffs to acquirers’
managers and target’s shareholders lead to defensive or positioning acquisitions that will be in
the best interest of either firm. Their models show that the potential for profitable mergers
hinges on the distribution of firm sizes within an industry.
The causes of two phenomena in the mergers and acquisition field have yet to be
explained in the context of each other. First, the stock price of acquiring firms typically takes a
hit upon the announcement of a merger. Second, industries facing a recent regime change often
experience a wave of mergers. The authors start by acknowledging the short comings of two
dominant theories in the study of mergers and acquisitions, neoclassical merger theory and
managerial self-interest theories. Neoclassical theory states that mergers are an efficient
response to regime shifts by value-maximizing managers, but this fails to explain why acquiring
firms so often end up with negative returns on their acquisitions. Managerial self-interest
theories focus on the empire building tendencies of established management, but this does not
explain the jump in the frequency of mergers during a regime change in a given industry. Gorton
et. al. seek to bridge the gap between these theories by positing that the distribution of firm size
in an industry creates an incentive to acquire or be acquired during a regime change to both
protect management and maximize value.
I.
Modeling the Game
In order to create a workable model a few assumptions were necessary. First, managers
derive utility from running a firm, termed “private benefits,” that I separate from any ownership
interest they may have. This assumption is no significant leap. The desire for management to
protect their employment and continued control over a company is well documented and widely
accepted. This very fact has created a line of precedent forcing courts to take discretion out of
the hands of management to ensure that they are not abusing their control in order to perpetuate
employment and control or engage in empire building.
The second assumption is that a regime change in an industry creates the potential for
synergies and therefore profitable mergers. A regime shift can be triggered by many things.
Frequently they take the form of a substantial change in the regulation of an industry or the
incorporation of a new technology into an industry. The occurrence of such an event makes it
more likely that firms may find potential synergies and profitable combinations with a focus on
acquiring larger targets to maximize the benefits of economies of scale.
Finally, the model requires the assumption that an acquirer must be larger than its target.
While smaller companies can finance the takeover of larger companies by taking on debt or
diluting shareholder ownership in the resulting company, such deals are rarities. The difficulty
of finding financing for such an acquisition can be prohibitive.
With these assumptions in place, the authors set up three turn-by-turn games in which
each firm in an industry must either engage in a defensive or position merger or wait and react to
the actions of other firms. Defensive merger are those in which a firm acquires another in order
to preempt being acquired by a larger firm in the industry. Under the third assumption of the
model, any firm that merges is no longer a target for firms that are smaller than the resulting
entity. Position mergers are deals struck in order to make a firm more appealing to potential
suitors. Firms engaging in position deals are hoping to secure a premium for their shareholders
by becoming more attractive to larger, possible acquirers.
II.
Game One
The first game presents the scenario of three slightly different sized firms (Firm 1 > Firm
2 > Firm 3) which are each given two turns. A firm’s decision whether to merge with a smaller
firm is made by the management which is not utility maximizing for the firm, but for themselves.
This is illustrated in the equation uA = w + α(s – π). Here, uA is the managements’ utility, w is
the expected value of private benefits management will receive (e.g. continued employment), α
represents management’s percentage ownership in the company, s is the expected increase in the
value of the acquiring firm due to the acquisition, and π is the target firm’s stand-alone value as
determined by the purchase price. If uA is greater than zero, then management will engage in the
merger. Since any potential merger under the model must be sanction by the acquiring
management and target’s shareholders, these parties must negotiate that amount of premium paid
by the acquirer over target’s current value. It is important to note that if target’s management
was able to decide whether to accept an offer of merger, then there would be no incentive for
defensive mergers as they would almost always be denied. The flipside to this is that acquirer’s
shareholders do not control merger decisions, since otherwise there would never be unprofitable
mergers which shareholders have no reason to approve. These tensions go more towards the role
of corporate governance in mergers and acquisitions, but are illustrated here in the utility
equation that supposedly controls management’s merger decisions.
Under this model, the premium an acquirer’s management is willing to pay to target
shareholders is limited by the effect of the merger on management’s private benefits. The take
away here being that acquiring firms will pay a premium for targets even if the deal provides no
positive synergies if the private benefits for management are high enough. This gives target
shareholders the potential to extract a larger premium from the acquirer than the deal is really
worth. The loser in this situation is the acquirer’s shareholders. They are bound by the actions
of management and likely must wait until the next annual meeting before they can hold such
officers accountable. However, the authors found that the exact split of the premium between
management and target shareholders did not affect their results as long as management took
some portion.
In this game, Firm 1 does not immediately need to engage in a defensive merger as it is
the largest firm and similarly does not need to engage in a position merger as there are again no
potential acquirers due to the third assumption. The only remaining issue is whether Firm 1
deems it necessary to preemptively merge with Firm 2 in anticipation of a merger between Firm
2 and Firm 3 which would leave Firm 1 vulnerable. Firm 2 is incentivized to engage in a
defensive merger with Firm 3 from the beginning to protect itself. Finally, Firm 3 is at the mercy
of the other firms as they are too small to acquire either other firm.
The equilibrium of this game was found to turn on the size of the private benefits
management received. If private benefits were minimal, then Firm 1 acquires Firm 2, but if the
private benefits are substantial enough, they would overcome the negative effect of a defensive
merger and Firm 2 would acquire Firm 3 first. Also contributing to this result is management’s
ownership percentage; the greater management’s shareholdings, the less likely Firm 2 is to
acquire Firm 3. This is because management would suffer more of the negative consequences of
such a defensive merger offsetting the private benefits they retained for themselves.
III.
Game Two
Game two expands on the first by including five firms to demonstrate the potential
triggers of a merger wave. Only one firm (Firm 1), the largest, has the potential for a profitable
acquisition, but all other firms are incentivized to engage in defensive mergers. The sizes of the
firms are such that the merger of any two firms will result in an entity larger than Firm 1.
Finally, in this game, firms may only engage in one merger each.
Again, as in game one, the driving variable determining whether firms engage in
defensive mergers is the amount of private benefits held by management in each firm. If private
benefits are low, then the only merger that will occur is between Firm 1 and Firm 2 as it is the
only potentially profitable merger based on gains from synergies. No defensive mergers will
occur because private benefits are not enough to offset the loss management will take on their
shareholdings. However, if private benefits are high, then a wave of defensive mergers will
occur. Firms 2 through 4 each have an incentive to engage in a defensive merger to avoid being
acquired because they know that Firm 1 is looking to take advantage of its unique ability to
profit from a merger. Thus whichever firm has the first turn will merge with Firm 5 since it is
the smallest and therefore presents the smallest loss potential among available targets. This will
still leave another firm with a defensive merger opportunity which it will seize as it still has an
incentive to not be acquired by Firm 1.
This progression shows how firms respond to a regime change when one firm in the
industry is known to have the potential to benefit from the synergies of a merger. Each
remaining firm that is able will merge with a smaller firm so that its management may insulate
itself from the potential for acquisition and the loss of their private benefits. The result is a
merger wave.
IV.
Game Three
The final game changes the scenario substantially by making Firm 1 dominant in the
industry. There are three other firms in the game that are more similarly sized to each other
(Firm 2 > Firm 3 > Firm 4), but no combination of these firms will be larger than Firm 1, so the
only firm with any incentive for a defensive merger is Firm 3 in order to thwart Firm 2. The
authors posit that when an industry has such a dominant firm, the remaining firms seek to be
more attractive acquisition targets rather than less attractive as in the previous scenarios. It is not
clear why this is the case according to the authors. One possible rationale is that no other firms
can compete with the dominant company and so seek to be bought out as opposed to being run
out of business. Another explanation may be that management in significantly smaller firms sees
more upside in maximizing a potential merger premium for their ownership interest rather than
perpetuating any private benefits. Either way, this scenario introduces the incentive for
positioning mergers where non-dominant firms seek to improve their attractiveness as
acquisition targets by becoming as large as possible. Size is seen as an attractive feature in a
potential target due to the second assumption and the benefits of maximizing economies of scale.
In contrast to the other games, the effect of the level of private benefits is flipped. Low
private benefits encourage position mergers and high private benefits serve as an impediment to
position mergers. Private benefits incentivize management to keeps their firms independent, but
if they are not substantial enough, the premium paid to shareholders in a merger becomes a
stronger incentive. To maximize such private benefits, management is better served to remain
idle and not subject themselves to a merger offer.
V.
Hypotheses
From their modeling, the authors present two hypotheses as to mergers resulting from a
regime shift in an industry. First, the profitability of acquisitions will increase in the ratio of the
size of the largest firm in the acquirer’s industry to the size of other firms in the industry, all else
equal. Thus, the more dominant that the largest firm in an industry is, the more potential there is
for position mergers that can maximize the ultimate premium paid for targets acquired by the
dominant firm. The second hypothesis is that following a regime shift, the quantity of mergers
will increase in proportion to the number of medium sized firms in an industry, all else equal.
Medium sized firms are those that feel the pressures of engaging in defensive and position
merger. Larger firms can sit back and wait for the dust to settle after a regime change, while
small firms are unable to secure the financing to acquire other companies and are too
insignificant in the market to generate acquisition interest in themselves. This leaves medium
sized firms to battle it out for acquisitions to insulate management or to promote the value of the
firm as an acquisition target.
To test these hypotheses, the authors analyzed data spanning the merger rich 1980s and
1990s. Regime shifts were identified by two methods. First, by looking for changes in
regulation or technology that may affect a regime change, and second, by identifying merger
waves which were generally assumed to be associated with a regime change. The first method
needed to be complimented as it would be relatively limited to only identifying regulated
industries. The second method appears to present some issues however. In trying to test for
whether the distribution of firm size during a regime change results in a merger wave, it seems
disingenuous to assume the presence of a regime change just because there is a merger wave.
The authors were effectively seeking examples of the desired result in order to prove their
hypothesis. Not surprisingly they concluded that their prediction of increased merger waves was
confirmed based on the merger waves they used as data points.
VI.
Analysis
Creating a workable game theory analysis requires controlling for a nearly infinite
number of variables that may influence a party’s decision or utility payoff. The result is often
either too theoretical to be useful beyond academics or overly dependent on myriad assumptions
ending in the same result. While Gorton and his cohorts attempt to paint their study as only
relying on three key assumptions, this belies the true number necessary for their model to work
in the game scenarios they have created.
The most significant assumption not disclosed by the authors is that private benefits be
uniform across an industry. This is plainly unreasonable. Management across different firms in
an industry will have varying levels of power, prestige, and compensation which results in
differing values of private benefits when analyzing the utility payoff to management of a
potential merger. Also, different managers may value these advantages differently. Some are
more enticed by the potential for empire building, the security of maintaining the same job, or
the prestige of manning the helm of a particular company. The authors’ prediction of merger
waves depends on private benefits being uniform across an industry or at least close enough that
all management faces a similar utility payoff. Without this similarity, some firms’ management
may be willing to engage in mergers to protect their benefits, but others will not, stymieing the
development of any potential merger wave.
The paper also ignores the role of regulatory authorities in evaluating and authorizing
mergers. National governments committed to free market or capitalistic systems must enforce
anti-trust law to prevent companies from exploiting too much control on markets. One means of
engaging in this enforcement is the regulation of mergers that result in entities with excessive
market share or have a negative effect on competition in general. Even if the incentives for
acquisition are well placed the ultimate decision on the feasibility of a merger is not necessarily
in the hands of management. This would present an issue especially in the third game as it
depicts a dominant firm growing via acquisitions as opposed to organically. Regulators would
be keen to measure the effect of such a transaction and may exert their authority to invalidate a
deal. Management would obviously be aware of this risk and would include it in their calculus
as to whether a potential merger is worth pursuing. Directors of medium sized firms may
discount the utility payoff from receiving a premium on ownership shares for this risk. Such a
discount could skew the equation offered by the authors and alter the balance between private
benefits and share value.
The sparse explanation of position mergers and the lack of any examples to illustrate their
value to firms present another short coming. While many start-up businesses seek to develop
themselves to a point where they are attractive enough to be sold off, this is not typically the case
for established businesses, especially those with management holding interests in both continued
employment and equity value growth. Those companies that do seek to be bought out likely do
not reach that determination due to a regime change in the industry, but rather for reasons very
specific to the firm itself. Majority owner/employees may want to cash-out and retire,
management may see the limited potential for the company going forward, or shareholders in a
private company may seek a liquidity event to allow them to realize their investment. Each of
these scenarios presents a reason for making a firm more attractive for acquisition, but none is
triggered by a change in technology or regulatory policy.
Position mergers make more sense, however, from the perspective of the dominant firm.
Why would a company in such a dominant position need to acquire smaller competitors? First,
so the firm may enjoy further economies of scale. Larger operations can decrease marginal costs
of production by spreading fixed costs over a larger output. Second, to acquire a new business
program. Smaller competitors may bring a new technology or present a different business model
that is attractive to the dominant firm. Starting a new program on its own carries many risks for
a business that can be avoided by purchasing an established program from a competitor. Finally,
a dominant firm may seek to expand its market share. This may run the risk of aforementioned
anti-trust regulation, but a firm below the threshold market share concerning regulators may
desire to grow up to that point. Still, acquiring a recently merged firm still may not be desirable.
Mergers often require the resulting entity to take on additional debt. Also, assimilation of one
company into the acquirer can be difficult, if this process has not been completed in the target, it
would be even more burdensome and costly.
Another criticism to the theory presented is that it ignores management’s other alternative
if preservation of private benefits is such a motivating factor. The creation of poison pills and
implementing staggered board elections can help entrench current management and dissuade or
repulse potential acquirers. Management may also take on additional debt to make a firm
unattractive to acquirers. Shareholders can be placated by using the new cash to pay dividends
or repurchase outstanding stock. These strategies demonstrate that there are other courses of
action than relying on firm size to protect a company from acquisitions during a regime change.
By avoiding discussing these alternatives, the authors fail to acknowledge the limits of their
analysis.
Finally, the most glaring issue with the author’s propositions is that their theory ignores
the value of potential synergies in mergers. Acquirers and targets do not act solely on the basis
of management’s selfish goals or premiums paid to targets’ shareholders. Although these can be
powerful factors in determining whether a merger occurs, management can engage in
acquisitions for the benefit of the business. The assumption that all mergers during a regime
change are effectuated for such selfish goals as perseverance of private benefits is cynical and
blind to the existence of deals founded on sound financial analysis. While many acquirers fail to
realize the projected synergies of deals, this does not prove such benefits do not exist.
VII.
Conclusion
Gorton, Kahl, and Rosen took on a daunting challenge in trying to model firms’ behavior
in merger rich regime changes. Their turn based games and utility deriving formula present a
novel approach to explaining why mergers often occur in waves. Unfortunately to create any
workable model, so many variables had to be stripped away to render the result only useful in an
academic sense. It succeeds in presenting a new theoretical approach to firm behavior in such a
scenario, but falls short of providing practical knowledge useful to management facing an
imminent regime change as the theory ignores market forces beyond management’s self-interest
and target shareholder’s desire for a premium upon sale.