Mergers and acquisitions (II)
This feature is a continuation of an earlier publication on various financial theories propounded to explain factors underlying mergers and acquisitions. Discussions in the previous write-up ended on theoretical perspectives of mergers and acquisitions.
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Synergy
Some theoretical discussions on mergers and acquisitions evaluate the extent to which firms achieve synergy through merger activities. Firms may, or may not achieve synergy through mergers.
Generally, the value of the merged companies tends to be higher than the value of the individual companies combined by the mergers. In mathematical terms, the occurrence of a synergy is presented as follows:
VAB > VA + VB (14)
Where:
VAB = Value of the merged companies
VA = Value of Company A
VB = Value of company B
The 1960s were characterised by dramatic conglomerate mergers. As a result, earlier literature on mergers and acquisitions was formulated in direct response to the historic conglomerate mergers witnessed in those years (1960s).
Measurement of the social benefits derived from conglomerate mergers during the literature formulation period was difficult. As a result, most of the seminal writings on the concept assumed synergy did not exist. The following equation explains better.
VAB = VA + VB (15)
Empirical studies by Myers (1968), Schall (1972), and Mossin (1973) affirm the conservation of value through mergers. The merger activities result in the combination of incomes of firms, and this increases the overall value of the firm.
The studies of these seminal theorists were formulated around the propositions of Modigliani and Miller (1958) on the cost of capital, corporate finance, and investment theory.
Nielsen’s (1974) work assesses the effectiveness of Myers’ (1968), Schall’s (1972), and Mossin’s (1973) assertions. Nielsen (1974) noted the findings of these seminal thinkers are based on the use of a partial equilibrium approach.
This approach assumes prices and other parameters are held constant. The research findings are also based on the assumptions that capital markets are characterised by completeness and perfection, and that the “equilibrium allocation of income (hence also the marginal utilities of all investors) is invariant with respect to a change in the number of trading instruments due to merger” (Copeland and Weston, 1983, p. 565).
The outcome of the foregoing studies is in tandem with the value additivity principle. This principle is in turn, consistent with the Modigliani’s and Miller’s (1958) assumptions.
Therefore, “at the theoretical level,” Copeland and Weston (1983) assert, “the conditions under which value is conserved (even assuming the absence of synergy) are more restrictive than generally acknowledged” (p. 565).
An emerging theme from these studies is the value additivity principle is equally relevant for analysis pertaining to mergers and acquisitions. The ability to add real value to firms has been identified as a major motivating factor for bid offers and takeovers by acquiring firms. Weston and Copeland (1992) aptly categorise synergy into two: operating synergy and financial synergy. Each of these forms is explained below.
Operating synergy
An operating synergy may occur when firms engage in a vertical or horizontal merger. A vertical merger involves the combination of firms at various stages in the lives of firms in a given industry.
Some researchers such as Arrow (1975), Copeland and Weston (1983), Klein, Crawford, and Alchian (1978), Weston and Copeland (1992) and Williamson (1971) opine a vertical integration allows firms to efficiently co-ordinate their activities at various levels.
Through vertical integration, firms are able to avoid communication costs, eliminate all forms of bargaining and opportunistic behaviours that impact adversely on the maximisation of shareowners’ wealth.
Horizontal integrations relate to the combination of economic resources of firms in the same industry. Horizontal mergers permit firms to have economies of scale.
Through horizontal mergers, firms are able to ensure effective utilisation of capacities as the economic lapse(s) in individual firms is or are identified and improved after the merger. The short run economies of scale that are achieved through the external integration of firms may be difficult to achieve if the firm decides to integrate its activities through internal investments.
Financial synergy
The proponents of the concept of financial synergy argue the combination of firms is likely to reduce the prevailing present value of bankruptcy costs. This is feasible, especially when the stream of cash flows for the combining firms has no perfect relationship. Higgins and Schall (1975) observe the impact of the decrease in bankruptcy costs is more beneficial to debt holders than to shareowners.
However, Galai and Masulis (1976) note the impact of bankruptcy cost on shareholders could be balanced if the acquiring firm increases its financial leverage after the merger: all interest payments on debt may be deductible before taxes are paid. This leads to higher tax savings.
Using the option pricing theory as the fundamental model, Stapleton (1982) argues there is no relationship between higher debt and bankruptcy costs. That is, bankruptcy costs do not necessarily have to exist before the debt capacity of the firm is increased.
Market power
Most firms desire to gain control of the market and industry in which they operate. One of the identified ways in which a firm can gain control is by merging with another firm. Thus, through mergers, firms are able to increase their share of the market in which they operate.
The pertinent question arising from this approach is whether it results in economies of scale or synergy.
Economies of scale occur when the intended objective is to witness an expansion in the firm’s activities. A merger may result in an increase in the firm’s share of the market when the intended objective is to increase in size, compared with other firms in the industry. The imminent question that begs for an answer here is whether a mere increase in size would translate into social benefits or economic gains for the firm.
The issue of expansion and increase in market share through mergers has led to the emergence of two schools-of-thought. One school believes vertical integration and economies of scale could be achieved internally. Therefore, there is no need for a merger.
The other school argues it is relatively easier and faster for the firm to expand its operations through external acquisition than through internal development.
However, the eventual cost of the acquired company may erode any economic benefits likely to be derived from the merger. In most cases, the firms’ desire to increase their market share through merger is dramatically opposed due to the fear of an undue concentration in their industries.
The United States Public Policy states that undue concentration may occur when “four or fewer [companies constitute] 40 per cent or more of the sales in a given market or line of business” (p. 567).
The dominance of the market by four or fewer companies means there may be interdependence, which could lead eventually, to the creation of a monopolistic power by the dominant firms in the market; the prices and profits of these businesses would be characterised by elements of monopoly.
When the determination of economies of scale is impossible, it could be assumed the undue concentrations would result in monopoly returns. Usually, the firms’ efficiencies are compared with the increased concentration when it is possible to establish the economies of scale from the merger.
The body responsible for the issuance of guidelines on mergers and acquisitions in the United States is the Department of Justice. In June 1982, the Department of Justice issued new merger and acquisition guidelines.
These guidelines superceded those announced earlier in May 1968. In Ghana, the Securities and Exchange Commission (SEC) has drafted Regulations (Securities and Exchange Commission Regulations 2003 (LI 1728)) on takeovers and mergers.
These Regulations apply to all public companies engaged in acquisitions and mergers in Ghana. This is pursuant to the Securities Industry Law, 1993 (PNDCL 333), as amended by the Securities Industry (Amendment) Act 2000 (Act 590). The SEC Regulations supercede the current Rules implemented by the Ghana Stock Exchange (GSE) on takeovers and mergers.
Other legislations that guide the activities of mergers and acquisitions in Ghana include the Central Securities Depository Act 2007 (Act 733) and the Companies Act 1963 (Act 179). Some industries and sectors of the Ghanaian economy have specific legislations on mergers and acquisitions. These include the Banking Act (Act 673) as amended by the Banking Act 2007 (Act 738); and the Insurance Act 2006 (Act 724).
