The Determinants of MergersBurcin YurtogluUniversity of Vienna Department of Economics

Empirical RegularitiesMergers come in waves USA: Late 1890s, 1920s, 1960s, 1980s, 1990s

Merger waves are correlated with increases in share prices and price/earnings ratios

Diagramm1

43

26

69

303

1208

340

423

379

142

79

226

128

87

50

49

142

103

82

85

39

71

117

195

71

171

206

487

309

311

368

554

856

870

1058

1245

799

464

203

120

101

130

126

124

110

87

140

111

118

213

324

333

419

404

223

126

219

235

288

295

387

683

673

585

589

835

844

954

853

861

854

1008

995

1496

4462

6107

5152

4608

4801

4040

2861

2297

2276

2224

2106

2128

1889

2395

2533

2543

2543

3001

3336

2032

2258

2366

2074

1877

2574

2663

2997

3510

5848

7800

7809

combined data:1895-1920: Nelson (1959)1921-67: FTC1968-83: MA1984-98: GMYZ

Mergers

Figure 8.1Numbers of Mergers

Chart3

4317.1293481572

2616.9573368836

6917.9699722309

30319.4816406839

120821.5381678475

34018.571103806

42322.73651647

37921.9569024678

14217.6365457354

7916.290311499

22619.3125164483

12818.718517101

8713.4092491649

5013.1384143216

4914.8579527304

14213.5498274068

10314.2479052212

8213.7341019615

8511.9469319117

3911.0542518545

7111.4978513694

11711.9986916811

1958.7828469866

716.4410599389

1716.5428237663

2065.3113808461

4875.4066889781

3097.5230652322

3117.8627375829

3688.3718872698

55410.1025217012

85611.7261181982

87015.856800707

105821.7894221765

124527.6008331357

79921.4788426397

46414.6659329281

2038.0703441006

12011.097248433

10112.1964402102

13013.1210346448

12619.258219785

12418.4564520626

11013.9288362725

8715.5660029017

14014.6857117454

11112.2131400924

1189.2383636942

21311.0420847806

32411.342426436

33313.2706302746

41914.0460187135

40411.1728619855

22310.6545457014

1269.9017722617

21911.1825805323

23512.0081853818

28812.4554494991

29512.0025251019

38713.6644005293

68317.5243151484

67318.2586972739

58515.6139753114

58915.1427334654

83518.3669629217

84417.4169250809

95420.4566437038

85318.8235121608

86120.2592394909

85422.5534236629

100823.262154452

99521.3017639497

149621.606171101

446221.4860862636

610719.4274846418

515215.1841516734

460816.8672876013

480117.7687667275

404016.1479152853

286110.9262117887

229710.2362398756

227611.5434639395

222410.4315126312

21069.3791396495

21288.9272334824

18898.8330489903

23958.4632109552

25337.3467455585

25439.6420818166

25439.4295562305

300110.691307551

333613.3877091945

203216.0148687703

225814.4399157717

236616.6136281698

207416.4566305781

187717.9201414191

257419.6358563509

266320.7497684949

299720.4797456567

351022.7207007485

584825.9439560601

780030.9558873084

780936.0077469744

961442.0693621636

1095241.7025081885

842332.0651717447

660023.4441410187

Mergers

Average P/E

Year

Mergers

P/E ratio

Mergers and P/E Ratios

Chart1

17.12934815720.6189620254

16.95733688360.3673570379

17.96997223090.9572627944

19.48164068394.1288979249

21.538167847516.1735414572

18.5711038064.4740035131

22.736516475.4515687785

21.95690246784.7859510541

17.63654573541.757689396

16.2903114990.9589048811

19.31251644832.6910072159

18.7185171011.4956557277

13.40924916490.9979472111

13.13841432160.5632106648

14.85795273040.5421883625

13.54982740681.5439437263

14.24790522121.1034205437

13.73410196150.8657100444

11.94693191170.8845526062

11.05425185450.4001329344

11.49785136940.7183221936

11.99869168111.1674866348

8.78284698661.919496891

6.44105993890.6895684187

6.54282376631.6389234309

5.31138084611.948716148

5.40668897814.5337303205

7.52306523222.831653732

7.86273758292.8061006469

8.37188726983.2700532997

10.10252170124.8493195617

11.72611819827.3825382961

15.8568007077.3944556202

21.78942217658.8637806152

27.600833135710.2834254112

21.47884263976.5078369996

14.66593292813.7520881503

8.07034410061.6298165414

11.0972484330.9566073957

12.19644021020.7994760756

13.12103464481.0218345609

19.2582197850.9835176185

18.45645206260.961232799

13.92883627250.8468676644

15.56600290170.6652401064

14.68571174541.0632701

12.21314009240.8310119899

9.23836369420.87101008

11.04208478061.5504700268

11.3424264362.3262407306

13.27063027462.3586357005

14.04601871352.9283062297

11.17286198552.7864196637

10.65454570141.5181248035

9.90177226170.8468052431

11.18258053231.4532437728

12.00818538181.5290050302

12.45544949911.8379995376

12.00252510191.8473354935

13.66440052932.378803701

17.52431514844.1223003339

18.25869727393.9897664684

15.61397531143.4075239247

15.14273346543.371951973

18.36696292174.6996277129

17.41692508094.6714744626

20.45664370385.1935040827

18.82351216084.5727948193

20.25923949094.5497299754

22.55342366294.4504897915

23.2621544525.1877735212

21.30176394975.0620675621

21.6061711017.5284834333

21.486086263622.2315227248

19.427484641830.131688554

15.184151673425.1253340616

16.867287601322.1900124603

17.768766727522.873232458

16.147915285319.0647879633

10.926211788713.3782861204

10.236239875610.6355891018

11.543463939510.4386906528

10.431512631210.0981203112

9.37913964959.4615543531

8.92723348249.4554661054

8.83304899038.2950563396

8.463210955210.4145830253

7.346745558510.9092631833

9.642081816610.8532818617

9.429556230510.75955794

10.69130755112.5846032558

13.387709194513.8623977839

16.01486877038.3688901336

14.43991577179.2155369284

16.61362816989.5657025495

16.45663057818.2968963303

17.92014141917.4288091324

19.635856350910.0779139423

20.749768494910.3169465148

20.479745656711.4987514896

22.720700748513.3418477889

25.943956060122.026199426

30.955887308429.0992658031

36.007746974428.867801925

42.069362163635.2232145003

41.702508188539.7716543439

32.065171744730.4079422383

23.444141018722.9056059631

Average P/E

Mergers/Population

Year

Mergers and Average P/E ratio

Sheet1

YearNelsonFTCM&AsGMYZ (SDC)GMYZ (SDC Broad)MergersAverage P/EpopMergers/Population

1895434317.12934815720.6466560855694711440.61896202540.6355734749

1896262616.9573368836707758320.3673570379

1897696917.9699722309720805200.9572627944

189830330319.4816406839733852004.1288979249

18991208120821.53816784757468988816.1735414572

190034034018.571103806759945764.4740035131

190142342322.73651647775923445.4515687785

190237937921.9569024678791901124.7859510541

190314214217.6365457354807878801.757689396

1904797916.290311499823856480.9589048811

190522622619.3125164483839834242.6910072159

190612812818.718517101855811921.4956557277

1907878713.4092491649871789600.9979472111

1908505013.1384143216887767280.5632106648

1909494914.8579527304903744960.5421883625

191014214213.5498274068919722641.5439437263

191110310314.2479052212933460961.1034205437

1912828213.7341019615947199360.8657100444

1913858511.9469319117960937760.8845526062

1914393911.0542518545974676080.4001329344

1915717111.4978513694988414400.7183221936

191611711711.99869168111002152801.1674866348

19171951958.78284698661015891201.919496891

191871716.44105993891029629520.6895684187

19191714381716.54282376631043367841.6389234309

19202067062065.31138084611057106241.948716148

19214874875.40668897811074170644.5337303205

19223093097.52306523221091235122.831653732

19233113117.86273758291108299522.8061006469

19243683688.37188726981125363923.2700532997

192555455410.10252170121142428324.8493195617

192685685611.72611819821159492807.3825382961

192787087015.8568007071176557207.3944556202

19281058105821.78942217651193621608.8637806152

19291245124527.600833135712106860810.2834254112

193079979921.47884263971227750486.5078369996

193146446414.66593292811236644723.7520881503

19322032038.07034410061245538961.6298165414

193312012011.0972484331254433120.9566073957

193410110112.19644021021263327360.7994760756

193513013013.12103464481272221601.0218345609

193612612619.2582197851281115840.9835176185

193712412418.45645206261290010080.961232799

193811011013.92883627251298904240.8468676644

1939878715.56600290171307798480.6652401064

194014014014.68571174541316692721.0632701

194111111112.21314009241335720800.8310119899

19421181189.23836369421354748960.87101008

194321321311.04208478061373776961.5504700268

194432432411.3424264361392805122.3262407306

194533333313.27063027461411833122.3586357005

194641941914.04601871351430861282.9283062297

194740440411.17286198551449889282.7864196637

194822322310.65454570141468917441.5181248035

19491261269.90177226171487945440.8468052431

195021921911.18258053231506973601.4532437728

195123523512.00818538181536947201.5290050302

195228828812.45544949911566920961.8379995376

195329529512.00252510191596894561.8473354935

195438738713.66440052931626868162.378803701

195568368317.52431514841656841924.1223003339

195667367318.25869727391686815523.9897664684

195758558515.61397531141716789123.4075239247

195858958915.14273346541746762723.371951973

195983583518.36696292171776736484.6996277129

196084484417.41692508091806710084.6714744626

196195495420.45664370381836910085.1935040827

196285385318.82351216081865380004.5727948193

19638611,36186120.25923949091892420004.5497299754

19648541,95085422.55342366291918889924.4504897915

196510082,125100823.2621544521943030085.1877735212

19669952,37799521.30176394971965600005.0620675621

196714962,975149621.6061711011987120007.5284834333

19684,4624,46221.486086263620070600022.2315227248

19696,1076,10719.427484641820267699230.131688554

19705,1525,15215.184151673420505200025.1253340616

19714,6084,60816.867287601320766099222.1900124603

19724,8014,80117.768766727520989600022.873232458

19734,0404,04016.147915285321190899219.0647879633

19742,8612,86110.926211788721385400013.3782861204

19752,2972,29710.236239875621597299210.6355891018

19762,2762,27611.543463939521803500810.4386906528

19772,2242,22410.431512631222023900810.0981203112

19782,1062,1069.37913964952225849929.4615543531

19792,1282,1288.92723348242250550089.4554661054

19801,8891,8898.83304899032277260008.2950563396

19812,3957438592,3958.463210955222996600010.4145830253

19822,5331,1201,4662,5337.346745558523218800010.9092631833

19832,5431,4012,3242,5439.642081816623430700810.8532818617

19842,5431,4362,5322,5439.429556230523634800010.75955794

19853,0014001,6993,00110.69130755123846600012.5846032558

19863,3365102,6063,33613.387709194524065100813.8623977839

19872,0325042,8072,03216.01486877032428040008.3688901336

19882,2586033,1332,25814.43991577172450209929.2155369284

19892,3668054,1912,36616.61362816982473420009.5657025495

19902,0747244,3862,07416.45663057812499729928.2968963303

19911,8779154,3291,87717.92014141912526649927.4288091324

19922,5741,2204,7602,57419.635856350925541000010.0779139423

19932,6631,3755,3012,66320.749768494925811900810.3169465148

19942,9971,5676,5042,99720.479745656726063699211.4987514896

19953,5101,8477,8253,51022.720700748526308200013.3418477889

19965,8481,8928,7475,84825.943956060126550200022.026199426

19977,8002,1729,6437,80030.955887308426804800029.0992658031

19987,8092,21710,5387,80936.007746974427050899228.867801925

19999,6149,61442.069362163627294499235.2232145003

200010,95210,95241.702508188527537200039.7716543439

20018,4238,42332.065171744727700000030.4079422383

20023,0986,60023.444141018728813907022.9056059631

Sheet2

Sheet3

Types of MergersHorizontalinvolve two firms operating in the same kind of business activity, e.g. Daimler-ChryslerVerticaloccur between firms in different stages of production operationConglomerateoccur between firms engaged in unrelated types of business activityproduct-extension: broadens the product lines of firmsgeographic market-extension: between firms whose operations have been conducted in non-overlapping geographic areas

Hypothesis about Mergers There are a big number of hypothesis as to why mergers occur, these can be grouped into two broad categories:

Neoclassical theories that assume that managers maximize profits or shareholder wealth and thus that mergers increase either market power or efficiencyNon-neoclassical or behavioral theories that posit some other motivation for mergers and/or other consequences.

Neoclassical TheoriesMarket Power IncreasesEfficiency IncreasesNon-neoclassical or BehavioralSpeculative MotivesThe Adaptive Firm HypothesisThe Market for Corporate ControlThe Economic Disturbance HypothesisFinancial EfficienciesThe Capital Redeployment HypothesisThe Life-Cycle-Growth-Maximization HypothesisThe Winners Curse- Hubris Hypothesis

(1a) Market Power IncreasesHorizontal Mergersfewer firms in an industry have greater incentives to cooperate and raise the priceIn a symmetric Cournot equilibrium, with homogeneous product and all firms having the same, constant unit cost c

H :Herfindahl index :price elasticity of demand for the industry

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.

Vertical mergersby increasing the barriers to entry at one or more links in the vertical production chainExample: 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 mergersmultimarket 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.

(1b) Efficiency IncreasesHorizontal Mergers

ACOutputABCDE

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 firmsIn France, the Netherlands, and Sweden merging pairs were in significantly different in size from randomly selected nonmerging companies.

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).

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.]

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)

(2a) Speculative MotivesStudies 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 todays dollars (The Economist, April 27, 1991, p. 11).Michael Milken

Fee Revenue from underwriting and M&A transactions in 1998 (Saunders and Srinivasan, 2001 )

(2b) The Adaptive (Failing Firm) HypothesisDonald Dewey (1961):mergers as a civilized alternative to bankruptcyJohn 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 dont we see merger waves during recessions?Profit rates of acquirers should be higher than targetsEmpirical EvidenceMost studies of mergers in the USA have found that acquired firms have the same average profit rates as similar non-acquired companiesDuring the conglomerate merger wave acquiring companies had below average profit rates and also profit rates lower than the firms they acquired.

Characteristics of Acquiring and Target Companies, 1980-1998Gugler, Mueller, Yurtoglu, and Zulehner (2003)

Profit rateNumberof MergersAcquirerTargetUnited States of America1,9670.0290.019United Kingdom3790.0660.039Continental Europe1720.0350.033Japan160.0110.030Australia/N.Zealand/Canada1720.0240.027Rest of the World470.0520.013

All mergers2,7530.0340.023

(2c) The Market for Corporate Control Mt: market value of the firm in year tKt: the value of the assets of the firm in year tIf 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 firms 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.

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 Studieshave 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)

(2d) The Economic Disturbance HypothesisGort (1969)a group of non-holders suddenly raises its expectations about firm Bs 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 patternBut also consistent with merger waves during sudden drops in stock market values (even more intense merger activity!)

(2e) Financial EfficienciesSavings on Borrowing Costs

Riskpooling

(2f) The Capital Redeployment HypothesisWeston (1970)Similar to financial efficiencies argument, but goes beyond it by positing ongoing potential gains from a central management teams ability to monitor the investment opportunities of each division and shift capital across them.

(2g) The Life-Cycle Growth Maximization HypothesisMueller (1969)Mergers are the quickest way to grow and diversify and thus an attractive way for managers with limited time horizons to achieve growth.Predictionsdiversification mergers by mature firms

Direct Evidence by Harford (1999):Cash rich firms are more likely to acquireTheir acquisitions are more likely to be diversifyingThe abnormal price reaction is negative and lower for bidders who are cash richOperating performance deteriorates after mergers by cash rich companies

(2h) The Winners Curse Hubris hypothesisThere are a number of biddersThe bidder with the highest valuation acquires the targetWith rational expectations, the expected true value of the target should be at the mean of the distributionThe winner will bid too much!Why bid then?Roll (1986):Because managers of acquiring firms suffer from hubris, excessive pride and arrogance.

Testing Competing Hypotheses about the Determinants of MergersThree categories of hypothesesSynergye.g., a horizontal merger that increases the market power of the two merging companiesThe ynergistic gains arise from specific characteristics of the two merging firms.It is reasonable to assume that both firms share these gains, since each firms 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.

Market for Corporate ControlAll 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 targets share price rises by enough to reflect all of the gains from replacing ist management, the bidders shareholders will experience no gain from the merger.Targets shareholders receive positive welath increasesBidders gains averge zero and are unrelated to the gains to the targets.

Managerial DiscretionThere are no net gains from the mergersEach dollar paid to the target shareholders represents a dollar loss to the acquirers shareholders.Thus, the gains to the targets and bidders 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.

Tests: Mueller and Sirower (2002)G: Gain to the bidder in dollars over a 24-month period beginning with the month of the mergerP: Premium paid to the targets shareholders in dollarsVT: Market value of the target firm

The predicted coefficients

Relationship between gains to acquirers and premia paid to targets

efN / R2efN / R2ContestedUncontested0.03-0.2144 / -0.0230.26-2.23124 / 0.053(0.06)(0.19)(0.97)(2.81)Multiple BiddersSingle Bidder0.48-1.9445 / 0.0510.09-1.34123 / 0.015(1.13)(1.84)(0.32)(1.68)Related (3 Digit)Unrelated (3 Digit)0.20-0.6895 / -0.0000.13-2.5473 / 0.052(0.79)(1.00)(0.31)(2.23)Cash OnlyNoncash (mixed)0.49-1.4690 / 0.0230.05-2.4878 / 0.057(1.42)(1.75)(0.16)(2.38)

The mean gain to the bidders is -$50The variance around this mean is $ 3,579,664 millionAre you willing to play in a game in whichthe expected winnings are -$50you might lose as much as $10, 000,000You 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 themManagerial discretion? They are not gambling with other peoples money!