Corporate Governance: Law,
Economics & Politics
The Determinants of Mergers
1
Empirical Regularities
1) Mergers come in waves
USA: Late 1890s, 1920s, 1960s, 1980s, 1990s
2) Merger waves are correlated with increases in
share prices and price/earnings ratios
2
Mergers and Average P/E ratio
45
40
35
30
25
20
15
10
5
0
1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Year
Average P/E
Mergers/Population
3
4
5
• Takeovers in the 1980s were characterized by
heavy use of leverage.
– Firms purchased other firms in leveraged takeovers
by borrowing rather than by issuing new stock or
using solely cash on hand.
– Other firms restructured themselves, borrowing to
repurchase their own shares.
– Finally, some firms were taken private in leveraged
buyouts (LBOs). In an LBO, an investor group, often
allied with incumbent management, borrows money to
repurchase all of a company's publicly owned shares
and takes the company private. Kohlberg, Kravis and
Roberts was one of the earliest and most prominent
LBO investors.
6
7
• Almost half of all major U.S. companies
received "hostile" takeover bids in the
1980s, where hostility is defined as bids
pursued without the acquiescence of
target management (Mitchell and
Mulherin, 1996).
• Even those firms that were not actually
taken over often decided to restructure in
response to hostile pressure, particularly
when corporate raiders had purchased
large blocks of shares.
8
9
Why Did Corporate Governance and Mergers in
the 1990s Look So Different?
The Rise of Incentive-based Compensation
• Hall and Liebman (1998) find a remarkable increase in equity-based
compensation for U.S. CEOs.
– From 1980 to 1994, the average annual CEO option grant (valued at
issuance) increased almost seven-fold. As a result, equity-based
compensation made up almost 50 percent of total CEO compensation in
1994, compared to less than 20 percent in 1980. The effect of the
increase in equity-based compensation has been to increase CEO paytoperformance sensitivities by a factor of ten times from 1980 to 1998
(Hall and Liebman, 2000)
• Holderness et al. compare equity ownership by officers and directors
in 1935 and 1995 and find that equity ownership was substantially
greater in 1995 than in 1935.
– The results in Hall and Liebman (1998, 2000) combined with those in
Holderness, Kroszner and Sheehan (1999) suggest that managerial
equity ownership is very high today relative to most of the last century.
10
Forcing a Recognition of the Cost of Capital
• The second distinguishing characteristic of leveraged
buyouts was to incur enough leverage to force
management to view capital as costly, because LBOs
have to earn a return on capital sufficient to repay the
interest and principal on the debt.
– Corporations (and consulting firms) now try increasingly to
create a parallel effect through new performance measurement
and compensation programs. For example, Stern Stewart
markets Economic Value Added (EVA) and the Boston
Consulting Group markets Total Business Return (TBR). These
programs compare a measure of return on capital, usually the
after-tax profit earned by a company or division, to a measure of
the cost of capital, like the after-tax profit required by the capital
invested
11
Monitoring
• The third distinguishing characteristic of LBOs is
closer monitoring by shareholders and the
board.
• There are several reasons it is likely that
shareholders monitor management more closely
in the 1990s than in the 1980s.
– The shareholdings of professional, institutional
investors increased substantially. From 1980 to 1996,
large institutional investors nearly doubled the share
of the stock market they owned from under 30 percent
to over 50 percent (Gompers and Metrick, 2001). This
change means that professional investors-who have
strong incentives to generate greater stock returnsmonitor an increasingly large fraction of U.S.
corporations.
12
– In addition, in 1992, the Securities and Exchange Commission
(SEC) substantially reduced the costs to shareholders o f
mounting proxy contests that challenged management teams.
Under the old rules, a shareholder had to file a detailed proxy
statement with the SEC before talking to more than ten other
shareholders. Under the new rules, shareholders can essentially
communicate at any time in any way as long as they send a
copy of the substance of the communication to the SEC. The
rule change has lowered the cost of coordinating shareholder
actions and of blocking management proposals. Not surprisingly,
the Business Roundtable-a group o f 200 CEOs of the very
largest U.S. companies-and other management organizations
were extremely hostile to this rule change when it was proposed.
– Shareholder activism has increased in the United States since
the late 1980s. Some of the more prominent activists included
CALPERS, the Council of Institutional Investors, the LENS Fund,
and Michael Price's Mutual Shares. Changes in the proxy rules
have made this possible. The evidence on the impact of
shareholder activism, however, is mixed.
13
• There also is evidence that boards of public companies
have changed in the 1990s and become more active
monitors than in the past.
– Like top management, directors receive an increasing amount of
equity-based compensation. Perry (1999) estimates that the
fraction of compensation for directors that is incentive-based
increased from 25 percent in 1992 to 39 percent in 1995. Russell
Reynolds Associates (1998) report that the use of incentivebased compensation for directors also increased from 1995 to
1997.
– Boards of public companies have become somewhat smaller
over time (Hermalin and Weisbach, 2000; Wu, 2000). This is
interesting because boards of leveraged buyout firms are smaller
than otherwise similar firms (Gertner and Kaplan, 1996); and
smaller boards are associated with higher valuations (Yermack,
1996).
14
Types of Mergers
• Horizontal
– involve two firms operating in the same kind of
business activity, e.g. Daimler-Chrysler
• Vertical
– occur between firms in different stages of production
operation
• Conglomerate
– occur between firms engaged in unrelated types of
business activity
– product-extension: broadens the product lines of firms
– geographic market-extension: between firms whose
operations have been conducted in non-overlapping
geographic areas
15
• The theory of takeovers argues that two market
failures can be corrected by the proper
functioning of a third market „the market for
corporate control“.
– Competition in product and input markets may fail,
– Within companies free from strong external market
pressure, the "separation of ownership and control"
identified by Berle and Means (1932) allows
managers to pursue investment and cost-padding
strategies that fail to maximize the profits of absentee
owners-the shareholders.
• In both cases, a well-functioning market for
corporate control may come to rescue.
16
• Viewing the theory's applicability from a broad historical
perspective raises awkward questions:
– The "separation of ownership and control," though increasing
over time, was found by Berle and Means to be widespread
among large U.S. corporations during the 1920s. If managerial
deviations from profit maximization were already commonplace
then, how can one explain the strong performance of the U.S.
industrial economy during the 1950s and 1960s, before
efficiency-restoring tender offer takeovers came into vogue?
– Also, the tender offer takeover phenomenon is both new and
almost uniquely Anglo-American. If takeovers are necessary for
efficiency, how have nations such as Japan, West Germany,
Switzerland, and France continued to perform strongly, even
though hostile takeovers are practically nonexistent there, and
stock ownership is often separated from managerial control, as
in America and Great Britain? The questions are rhetorical, for
no satisfactory answer has been forthcoming.
17
Hypothesis about Mergers
There are a big number of hypothesis as to why
mergers occur, these can be grouped into two
broad categories:
1) Neoclassical theories
that assume that managers maximize profits or
shareholder wealth and thus that mergers
increase either market power or efficiency
2) Non-neoclassical or behavioral theories
that posit some other motivation for mergers
and/or other consequences.
18
1) Neoclassical Theories
a) Market Power Increases
b) Efficiency Increases
2) Non-neoclassical or Behavioral
a)
b)
c)
d)
e)
f)
g)
h)
Speculative Motives
The Adaptive Firm Hypothesis
The Market for Corporate Control
The Economic Disturbance Hypothesis
Financial Efficiencies
The Capital Redeployment Hypothesis
The Life-Cycle-Growth-Maximization Hypothesis
The Winner’s Curse- Hubris Hypothesis
19
(1a) Market Power Increases
Horizontal Mergers
–
–
fewer firms in an industry have greater incentives to
cooperate and raise the price
In a symmetric Cournot equilibrium, with
homogeneous product and all firms having the
same, constant unit cost c
L
–
–
pc H

p

H :Herfindahl index
 :price elasticity of demand for the industry
20
• Since a horizontal merger increases industry
concentration, it increases H, it must also increase the
industry price-cost margin and profits.
• Salant, Switzer and Reynolds (1983)
– However, Salant et al. (1983) show that mergers in such a
setting are not privately profitable. When all firms have identical
costs, they all must have the same size.
– The above equation must hold before and after the merger.
Since the immediate effect of the merger is to make the merged
firm twice as big as ist competitors, it needs to shrink following
the merger to return to the new size of ist rivals.
– The loss of profits to the merging firms from having to shrink to
rejoin the symmetric Cournot equilibrium more than offsets the
gain in profits from the increase in price cost margin caused by
the increase in H.
21
• Vertical mergers
– by increasing the barriers to entry at one or more links in
the vertical production chain
– Example: a firm which wished to enter into aluminum
refining in the USA prior to the Second World War would
have found that all known bauxite deposits were owned
by ist main competitor ALCOA. ALCOA could easily
foreclose the bauxite market to the entrant and thus
created an entry barrier.
• Conglomerate mergers
– multimarket contact (Scott, 1982, 1993)
– An increase in concentration leads to a greater increase
in profits in a market in which the sellers also face one
another in other markets than when such multimarket
contact is not present. This motive may also be the
cause of purposeful diversification mergers.
22
(1b) Efficiency Increases
• Horizontal Mergers
AC
A
B
C
D
E
Output
23
• In such an industry, one would expect the merging firms
to be smaller than non-merging firms, because the
expected cost reductions are greter for pairs of small
firms.
• Empirical Evidence:
– In Belgium, Germany, USA, and UK merging firms were
significantly larger than non-merging firms
– In France, the Netherlands, and Sweden merging pairs were in
significantly different in size from randomly selected nonmerging
companies.
24
• Vertical mergers
• Can increase the efficiency of the merging firms by eliminating steps
in the production process, which reduces the transaction costs from
bargaining due to asset specificity
• Asset Specificity refers to the relative lack of transferability of assets
intended for use in a given transaction to other uses. Highly specific
assets represent sunk costs that have relatively little value beyond
their use in the context of a specific transaction. Williamson has
suggested six main types of asset specificity:
– Site, physical asset, human asset, brand names, dedicated assets,
temporal specificity
• High asset specificity requires strong contracts or internalization to
combat the threat of opportunism.
• Small subcontractors locating and investing next to only customer
who could potentially turn to alternative suppliers (site- and physical
asset specificity).
25
General Motors and Fisher Body 1919-1926
After a 10 year contractual agreement was signed in 1919, GM's
demand for closed-body cars increased to extent that it became
unhappy with the contractual price provisions and "urged Fisher to
locate its body plants adjacent to GM assembly plants, thereby to
realize transportation and inventory economies." [Williamson, AJS,
p.561]
Finally, Fisher Body was merged into GM in 1926 after Fisher had
resisted GM's locational demands.
As Coase recalls:
"I was told [by GM officials] that the main reason for the acquisition was
to make sure that the body plants were located next to General
Motors assembly plants." [Coase, "The Nature of the Firm: Origin",
in: Williamson & Winter, eds., The Nature of the Firm. 1993, p.43.]
26
• Conglomerate Mergers
– Economies of scope (ESC) arise when the production of two
different products by the same firm leads to lower production
costs for one or both products.
– Example: warehousing and delivery of products
– Formally, ESC is said to exist if the cost function is subadditive
C(x1, x2) < C(x1,0) + C(0, x2)
27
(2a) Speculative Motives
• Studies of early merger waves often mention “promoters’
profits as a cause for mergers. During these waves men
like J.P. Morgan often approached corporate managers
and suggested a possible merger. They earned large
fees for their advice and for other services they rendered
to facilitate and finance the deals.
• Underwriters of the securities floated in the great merger
that created the United States Steel Corp. In 1901,
earned fees of $575.5 million – over $1 billion in today‘s
dollars (The Economist, April 27, 1991, p. 11).
• Michael Milken
28
Fee Revenue from underwriting and M&A
transactions in 1998 (Saunders and Srinivasan, 2001 )
Fee Revenue from
Underwriting (equity &
debt) (1)
Fee Revenue
from Merger
Advice (2)
(2) / (1)
Morgan Stanley
1253.8
302.9
19.50%
Goldman Sachs
1087.8
531.2
32.80%
Merrill Lynch
1496.9
321.3
17.70%
386
287.4
42.70%
DLJ
491.8
200
28.90%
Citibank
913.2
189.1
17.20%
Lehman
516.3
199.2
27.80%
J.P. Morgan
358.9
70.9
16.50%
Bankers Trust
252.2
56.9
18.40%
NationsBank Montgomery
132.7
26.2
16.50%
Average
688.9
218.5
23.80%
Total
6889.6
2185.1
31.72%
Investment Bank
Credit Suisse First Boston
29
(2b) The Adaptive (Failing Firm) Hypothesis
• Donald Dewey (1961):
– mergers as a civilized alternative to bankruptcy
• John McGowan (1965):
– An adaptive theory to account for why small firms are typically
the targets in mergers and why the much more competitive US
and UK economies had more mergers than the less competitive
ones.
• Two implications:
– Mergers should follow a counter-cyclical pattern. Why don’t we
see merger waves during recessions?
– Profit rates of acquirers should be higher than targets
• Empirical Evidence
– Most studies of mergers in the USA have found that acquired
firms have the same average profit rates as similar non-acquired
companies
– During the conglomerate merger wave acquiring companies had
below average profit rates and also profit rates lower than the
firms they acquired.
30
Characteristics of Acquiring and Target
Companies, 1980-1998
Gugler, Mueller, Yurtoglu, and Zulehner (2003)
Profit rate
Number
of Mergers
Acquirer
Target
1,967
0.029
0.019
United Kingdom
379
0.066
0.039
Continental Europe
172
0.035
0.033
Japan
16
0.011
0.030
Australia/N.Zealand/Canada
172
0.024
0.027
Rest of the World
47
0.052
0.013
2,753
0.034
0.023
United States of America
All mergers
31
(2c) The Market for Corporate Control
• Mt: market value of the firm in year t
• Kt: the value of the assets of the firm in year t
• If Mt > Kt: the assets bundled together as a firm are
worth more than their sum as measured by Kt.
• Marris (1963, 1964) called Mt / Kt the valuation ratio, Vt
• Tobin (1969) measured Kt as the replacement cost of
the firm’s asset and called qt = Mt / Kt.
• Manne (1965):
• Buyers in the market for corporate control would step in
whenever Vt falls short of its maximum value, and thus
that this process ensures that corporate assets are
managed by the most competent managers and those
intend shareholder wealth maximization.
32
• Smiley (1976):
– Actual market values of acquired companies are
compared to a projected value (control group).
– The market values of takeover targets began to fall
below their predicted values on average 10 years
before the takeover, and that the cumulative decline
was 50% of predicted values.
• Other Studies
– have found the shares of acquiring firms to be
underperforming prior to their takeover (Mandelker,
1974; Langetieg, 1978; Asquith, 1983; Malatesta,
1983)
– Exception Dodd and Ruback (1977)
33
(2d) The Economic Disturbance
Hypothesis
• Gort (1969)
– a group of non-holders suddenly raises its
expectations about firm B’s future profits. If these
non-holders are managers of another firm, the
transaction takes the form of a merger.
– Mergers under this hypothesis are more likely to
happen in periods in which stock market experiences
rapid changes in value.
– Consistent with the wave pattern
– But also consistent with merger waves during sudden
drops in stock market values (even more intense
merger activity!)
34
(2e) Financial Efficiencies
Savings on Borrowing Costs
Riskpooling
35
(2f) The Capital Redeployment
Hypothesis
• Weston (1970)
– Similar to financial efficiencies argument, but
goes beyond it by positing ongoing potential
gains from a central management team’s
ability to monitor the investment opportunities
of each division and shift capital across them.
36
(2g) The Life-Cycle Growth
Maximization Hypothesis
• Mueller (1969)
– Mergers are the quickest way to grow and
diversify and thus an attractive way for
managers with limited time horizons to
achieve growth.
– Predictions
• diversification mergers by mature firms
37
• Direct Evidence by Harford (1999):
– Cash rich firms are more likely to acquire
– Their acquisitions are more likely to be
diversifying
– The abnormal price reaction is negative and
lower for bidders who are cash rich
– Operating performance deteriorates after
mergers by cash rich companies
38
(2h) The Winner’s Curse –Hubris
hypothesis
• There are a number of bidders
• The bidder with the highest valuation acquires
the target
• With rational expectations, the expected true
value of the target should be at the mean of the
distribution
• The winner will bid too much!
• Why bid then?
• Roll (1986):
• Because managers of acquiring firms suffer from
hubris, excessive pride and arrogance.
39
Testing Competing Hypotheses about
the Determinants of Mergers
Three categories of hypotheses
1) Synergy
•
•
•
•
e.g., a horizontal merger that increases the market
power of the two merging companies
The ynergistic gains arise from specific
characteristics of the two merging firms.
It is reasonable to assume that both firms share
these gains, since each firm‘s participation in the
merger is required for there be any gains at all.
A weaker assumption would be simply that the
shareholders of both firms benefit from the merger.
40
2) Market for Corporate Control
•
•
•
•
All of the gains from the merger are tied to the
target firm. In principle, any other firm could buy the
target and replace its managers and obtain the
wealth increase from its action.
If the bidding for the target continues until the
target‘s share price rises by enough to reflect all of
the gains from replacing ist management, the
bidder‘s shareholders will experience no gain from
the merger.
Target‘s shareholders receive positive welath
increases
Bidders‘ gains average zero and are unrelated to
the gains to the targets.
41
2) Managerial Discretion
•
•
•
•
•
There are no net gains from the mergers
Each dollar paid to the target shareholders represents a dollar loss
to the acquirers‘ shareholders.
Thus, the gains to the target‘s and bidder‘s shareholders should be
inversely related.
It is not possible to distinguish a merger motivated by pure hubris
from one stemming from managerial empirebuilding. In both
cases, the targets‘ gains are bidders‘ losses. It is also possible,
however, that managerial hubris may arise with mergers that do
generate positive net wealth gains. Out of overoptimism the
bidder pays too much for the target.
In such a mixed case, we would expect a net positive gain from
the merger, but a loss to the bidder. Moreover, the bigger the gain
to the target, the more likely it is that the bidder overbid, and the
bigger ist expected loss.
42
Tests: Mueller and Sirower (2002)
G: Gain to the bidder in dollars over a 24-month period beginning with
the month of the merger
P: Premium paid to the target‘s shareholders in dollars
VT: Market value of the target firm
G
P
 e f

VT
VT
43
The predicted coefficients
Hypothesis
Synergy
(SH)
Market for Corporate
Control
(MCCH)
Managerial discretion
(MDH)
Prediction without
Hubris Hypothesis
Prediction with
Hubris Hypothesis
e=0, f=1
e<>0, f<1
e=0, f=0
e<>0, f<0
e=0, f=-1
e=0, f=-1
44
Relationship between gains to acquirers and premia paid to targets
e
f
N / R2
e
Contested
0.03
-0.21
(0.06)
(0.19)
-1.94
(1.13)
(1.84)
44 / -0.023
0.26
-2.23
(0.97)
(2.81)
-0.68
(0.79)
(1.00)
45 / 0.051
0.09
-1.34
(0.32)
(1.68)
-1.46
(1.42)
(1.75)
123 / 0.015
Unrelated (3 Digit)
95 / -0.000
0.13
-2.54
(0.31)
(2.23)
Cash Only
0.49
124 / 0.053
Single Bidder
Related (3 Digit)
0.20
N / R2
Uncontested
Multiple Bidders
0.48
f
73 / 0.052
Noncash (mixed)
90 / 0.023
0.05
-2.48
(0.16)
(2.38)
78 / 0.057
45
• The mean gain to the bidders is -$50
• The variance around this mean is $ 3,579,664 million
• Are you willing to play in a game in which
– the expected winnings are -$50
– you might lose as much as $10, 000,000
– You might also win as much as $13,000,000
• These are summary statistics from the above sample,
except that they are measured in millions.
• Why do managers of these firms undertake such
gambles?
– Hubris? Averages do not apply them
– Managerial discretion? They are gambling with other peoples
money!
46