Corporate mergers and acquisitions: one more wave to consider
Jeffrey P. Katz
The latest wave of M&A is tranforming whole undustries, rocking competition, crippling future inovation, and increasing stockholder vulnerability.
American business is experiencing yet another round of corporate growth via mergers and acquisitions (M&A), the fifth such wave in just over 100 years. Mergers and acquisitions are the primary means of rapid external growth. Although they differ legally from each other, they both allow firms to expand almost instantly, causing concern for why such growth occurs in waves.
In discussing corporate growth and its causes, consequences, and implications, we shall examine M&A using Porter’s (1987) framework of corporate diversification. The focus is on the roles portfolio management, restructuring, skill transfer, and activity sharing play on motivating company managers to expand the firm through M&A. Because the wave of the 1990s is still in progress, we pay particular attention to its effects on corporate performance, as well as to potential stockholder vulnerability, and identify the factors that will increase chances for success in the current M&A environment.
Worth pursuing? We say yes. Stockholders, managers, and board members need all the tools at their disposal when an M&A potentially affects their investment or workplace.
How prevalent is M&A activity? Extensive maneuvering occurred in the 1890s, 1920s, 1960s, and 1980s. Most recently, M&A value in the mid-1990s has approached the $340 billion record year of 1989. Mega-deals such as the Viacom-Blockbuster Entertainment Lockheed-Martin Marietta, and Hoechst-Marion Merrell Dow mergers, and acquisitions such as IBM’s purchase of Lotus, show that M&A is transforming industries, not only locally but in the global marketplace as well. The Ciba-Sandoz merger of Swiss drug firms is a recent example. To provide an even clearer picture, in health care alone (shown in Figure 1), M&A activity totaled more than $55 billion between 1993 and 1995.
Recent Mergers and Acquisitions In The Drug Industry
August 1995 Upjohn Co. and Sweden’s Pharmacia AB
agreed to a $13 billion merger.
May 1995 Hoechst AG, the German chemical and health
care company, bought U..S. drugmaker Marion
Merrell Dow Inc.–$7.1 billion.
January 1995 British drugmaker Glaxo PLC bought competitor
Wellcome PLC–$14.24 billion.
August 1994 American Home Products Corp. bought
American Cyanamid Co.–$9.7 billion.
May 1994 Swiss company Roche Holding Ltd. bought
U.S. firm Syntex Corp.–$5.3 trillion.
July 1993 Merck & Co. bought Medco Containment
Services Inc.–$6.6 trillion.
“Debtism” was another consequence of restructuring. By 1989, non-financial U.S. companies had almost doubled their debt to a total of $1.8 trillion while reducing their capital by $800 billion. When debt-laden firms had difficulty paying interest, money for new deals dried up and the junk bond market collapsed. This resulted in highly leveraged firms having to cut back real investment to service their debt. This became a big problem for firms facing growth prospects in uncertain economies. In stable economic conditions, debt might be a better way of financing M&A because it tends to discourage financial waste in firms with large cash flows but low or negative growth prospects. Debt, therefore, tends to mitigate the ineffective M&A because when the discretionary cash available to managers for spending lavishly is smaller, managers are more motivated to be efficient.
If conglomeration was a result of management problems in the 1960s and 1970s, many believed restructuring was the route to correcting those problems in the 1980s. Widely diversified businesses were considered appropriate for stocks and bonds but not for corporations that had to coordinate such businesses at high cost. The fact is, no single senior manager had enough expertise and experience to cope with all the diversified businesses that emerged.
Transfer Of Skills And Sharing Activities–The 1990s
Logically, M&A activity that results in skill transfer and shared activities should add value to the firm. Such activity should contribute to the firm’s competitive advantage through economies of scale and scope in tangible and intangible areas. However, empirical testing of the “relatedness hypothesis” has not consistently shown significant differences in returns to shareholders or bidders for related and unrelated diversification. Relatedness of business units under the corporate umbrella is not a guarantee for increased profit growth.
One explanation might be that relatedness is sometimes illusory. That is, synergies are only imagined. Other explanations are that the value added may go to the shareholders of the acquired firm only, or more likely that synergies are not exploited successfully after a deal is consummated. Price premiums and implementation failures are two mechanisms that explain the latter.
Price premiums occur when bidders pay a price that exceeds or equals the value added by acquiring a target firm. In these cases, only the target firm profits from the M&A. There are two conditions in which bidders may potentially realize above-normal returns when paying a premium. First, the target must be worth more to them than to any other bidder, and no other bidder is aware of its true value. Second, the bidder must be able to implement the potential for competitive advantage quickly. In the absence of these conditions, a firm could be lucky and simply get a bargain. Even though this seems to be the motive of many managers, the latter is unlikely to occur with any regularity.
Competitive bidding almost always increases premiums to a level that makes it impossible to create value for the bidder’s shareholders and earn back at least the cost of capital used. A study of cross-border M&A (Warner, Templeman, and Horn 1995) among large companies found that nearly 40 percent ended up in total failure. In addition, it was found that foreign acquirers generally paid more than national firms, presumably because of poor information. Managerial over-commitment in the acquisition process, regardless of the benefits to the acquiring firm, is a common phenomenon. Escalation of commitment is highly likely especially if (a) the manager is personally responsible for the acquisition decision, (b) there is excessive competitive bidding (beating an arch rival), or (c) the decision to acquire is already public knowledge (face saving). In most cases, unfortunately, negative information about the target will often be ignored in the face of the acquirer’s strong commitment.
The management inefficiency explanation is closely related to over-commitment and seems to hold true in most cases: The bigger the CEO’s ego, the higher the premium. As Porter remarks, “It’s the big play, the dramatic gesture; with the stroke of a pen you can add billions to size, get a front-page story, and create excitement in the markets.” Considering the excessive premiums that result, hubris may indeed include a “winner’s curse.”
Failure of implementation synergies creates a trade-off between the benefits of related diversification and the costs of managing interdependence among businesses. In these cases, synergies are neither automatically realized nor free. Their implementation is an active and costly process. A barrier to implementation that plays a major role in M&A is the clash of incompatible cultures. This incompatibility may lead to a reduction in the status of the acquired firm’s executives, making them feel like defeated enemies. Yet it is precisely their cooperation and commitment that is necessary to create value after M&A is completed.
Cultural compatibility is especially important in cross-border M&A. National cultural dimensions of uncertainty avoidance and individualism imply that significant change in both firms may cause severe resistance to M&A in countries where people strongly avoid risk or set a high value on autonomy. These factors must be considered by stockholders and managers in the 1990s before offers are tendered.
The necessity and the costs of post-acquisition change are highest for sharing activities and transferring skills, medium for restructuring, and lowest for portfolio management. Relative bargaining power is a crucial determinant in the distribution of value between the shareholders of target firms and bidders. Companies must take precautions to avoid over-commitment in bidding as well as in other non-value-seeking behavior. This is especially important in the 1990s as CEOs use equity rather than debt to complete M&A. Overall, the potential for value creation is exceptionally high. At the same time, implementation of underlying strategies is exceptionally difficult and costly. How much of the value-adding potential will be realized will differ from case to case. Company owners must become highly skilled at understanding the nature of the strategic relatedness between themselves and potential targets.
Highlighting the approaches of portfolio management, restructuring, and skill transfer/activity sharing, the causes and consequences of M&A activity from 1960 through the 1990s can be examined further through a brief case history of one firm’s M&A activity over this period, profiled in Figure 3. And there are many similar patterns of M&A over the past 30 years. The most destructive is the likelihood of impairing future technological innovation. Given the concern for maintaining global competitive advantage, the future of industries depends on how the current M&A wave is handled. Stockholders need to be forceful in ensuring that managers are motivated to maximize the value of the firm and are not shortchanging the shareholder through M&A premiums or by sacrificing innovation. The implications for company owners and managers can be dangerous, leading to declining corporate innovation and greater stockholder vulnerability.
Figure 3 A Case Study Of Corporate Growth: Figgee International
After an impressive career in management consulting at Booz Allen and Hamilton specializing in profit enhancement and cost containment, Harry E. Figgee, Jr., began his own company in 1963 with the leveraged buyout of the Automatic Sprinkler Corporation of America. The company had not been profitable for more than five years. Nevertheless, through aggressive cost cutting and applying the management tools he had learned over the years, Figgee was able to increase revenues and turn a profit the first year of ownership. This was the birth of a conglomerate firm that spanned the 1960s-1990s M&A waves using three phases of growth portfolio building, restructuring, and skill focus.
Phase One–Portfolio Building
Phase one involved lowering the leverage of Figgee International since early acquisitions were achieved using short-term debt. In 1965 the firm went public. The equity capital provided a “war chest” of funds with which to finance other acquisitions. Most subsequent purchases involved acquiring poorly performing firms in a number of loosely related industries. Because the intent was to improve operations by bringing new, more effective management to the acquired firms, the “inefficient management theory” motivated acquisitions. Acquisitions during the 1965-1969 period included firms in consumer businesses (primarily recreation, including Rawlings Sporting Goods and Fred Perry Sportswear), electrical and electronics, industrial machinery, and construction equipment. During this five-year period, 36 companies were added to Figgee International’s portfolio.
During the late 1970s and early 1980s, Figgee focused attention on the internal operations of the business by trying to coordinate business units. It was believed that the firm had attained an adequate size and the intent was to develop the existing management team. Fully 99 percent of the company’s growth came from revenue increases of existing businesses. Corporate “service organizations” were added from existing departments, including a leasing corporation, property corporation, and a security firm. The company also began to focus on global competition as a potential source of competency. The corporate role became coordinator and surgeon.
Phase Three–Skill Focus
Beginning in the early 1990s, adverse economic conditions forced the firm into close examination of existing strategy. By 1996 only 10 of 35 businesses remained in the original portfolio. Total corporate revenues, once in the $1.3 billion range, sank as low as $400 million. Harry Figgee, Jr., became an observer as others redesigned the firm to focus on core competencies that included the original Automatic Sprinkler Corporation. Management continues to focus not only on operational efficiency but also on the technological core competency of the firm. The new corporate role is that of coach and architect. Whether the acquisition wave will begin all over again remains an open question.
Source: Adapted from Dowd, Atchinson, and Lindgren (1995)
Current growth by M&A might imply a trade-off between managerial commitment and innovation. Firms lose competitive strength if they focus too much on value-transferring activities (such as mergers and acquisitions) instead of value-creation activities (such as R&D). There are several reasons why commitment to innovation might decrease for acquiring firms.
First, acquisitions become a substitute for innovation as resource constraints force firms to focus on one approach to growth. Managerial risk aversion often leads to ineffective M&A priority. When this commitment to “buying” growth escalates over time, internal R&D competency is very likely to suffer, resulting in impaired long-term competitiveness. Thus, diversification may occur for the sake of growth rather than being the focus of long-term competitive advantage.
Second, when firms use debt to finance an acquisition, the result is to limit projects with high risk and high rewards as debt holders gain power. This means that in highly leveraged transactions, investment in R&D may be cut to service the high debt load resulting from the leveraged M&A. As managerial talent is released as a result of the acquisition process, less attention will be given to long-term bases of competitive advantage, such as R&D.
Third, greater firm size and increased attention to diversification means firms are more likely to rely on financial and formal behavioral control, whereas innovation would be fostered using strategic and informal behavioral controls. There is considerable likelihood that the huge firms created by the current M&A wave will suffer from organizational inflexibility or creeping bureaucracy–a certain limitation in the rapidly changing global marketplace.
Overall, corporate owners and managers must ensure that M&A does not harm innovation or flexibility. In this regard, alternatives to M&A growth are worth considering. “We learn for ourselves and see what we can create,” says Christopher B. Galvin, president of Motorola, Inc., a successful non-acquirer.
Many deals in the current M&A wave may be explained as “Merger Mania,” which entails non-value related motives rather than those of conscientious economic reasoning. When CEOs are allowed to use their company’s equity as “cheap currency” to pursue external growth, stockholders are especially vulnerable. Unless shareholders raise objections, stock value will be destroyed in the same way bond value was.
A study of firm size and relatedness of business units (Bergh 1995) noted that managers tend to sell large, related businesses whereas owners would rather sell small, unrelated business units. A possible explanation is that managers find it more difficult to coordinate and control a set of units with interdependent operations. Unrelated diversification helps managers minimize their potential for being fired by expanding the company in the way that promises the lowest level of associated risk. As one would expect, relatedness of business units sold is negatively associated with post-M&A performance, whereas unrelatedness is positively associated with post-M&A performance.
Finally, compensation arrangements and monitoring by boards of directors are important mechanisms to support value creation, as the M&A wave of the 1980s showed. Debt-financing and hostile takeovers often discipline managers. Unfortunately, an increasing number of “short-term owners,” without a clue about companies’ strategies, are unlikely to be interested in anything but short-term profits. It is these owners who pose the most serious threats to the M&A of the 1990s.
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Jeffrey P. Katz is an assistant professor of management and James B. Townsend is a professor of management, both at Kansas State University in Manhattan, Kansas. Astrid Simanek is a Ph.D. candidate in the Department of Industrial Management at Justus Liebig University in Giessen. Germany. The authors wish to thank the editor for providing many helpful suggestions that substantially improved the article. A previous version of this paper was presented at the 1996 Annual Meeting of the Southern Management Association.
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