INTERNATIONAL CORPORATE FINANCE The subject matter of this paper is to discuss the costs and benefits of cross-border takeover merger and acquisition (M&A).
INTERNATIONAL CORPORATE FINANCE
MERGER & ACQUISITION
Introduction
The subject matter of this paper is to discuss the costs and benefits of cross-border takeover merger and acquisition (M&A). But first some definitions.
An acquisition is where the acquirer subsumes the target company, thus becoming one legal entity. On the other hand, a merger, extinguishes the identity of both participants, creating a new company. Cross-border M&A is the international dimension of this.
The main theory of merger and acquisition is synergy, that is, one and one makes three. Through synergy, managers create greater value with the integration of two companies, rather than that of their individual parts.
Costs and Benefits
Costs
In a study conducted by Francis Breedon and Francesca Fornasari, 2000, (FX impact of cross-border merger ) they found that the value of the target firm appreciated by 1%, while there was a relative deterioration of the acquirer's value. More specifically, the report found that, in the period immediately after the deal is announced, there is generally a strong upward movement in the target corporation's domestic value (relative to the acquirer's currency). Fifty days after the announcement, the target value is then, on average, 1% stronger. However, the study found that this currency impact tends to peak at approximately 5%. (Lien, K (2005) 'Mergers And Acquisitions - Another Tool For Traders', 12th October, www.investopedia.com/university/mergers )
Although there are many factors that may be impacting value at the time, the announcement of a large M&A deal can have a meaningful impact on the pair's price action.
For example, in Figure 1, the announcement by Procter & Gamble of a 77% acquisition of Wella AG for US$4.5 billion, saw the EUR/USD jump over 100 pips, followed by a 200 pips' rise the following week.
Another example of a large cross-border transaction having an impact on the currency market is Great West Life's acquisition of Canadian Life for US$4.7 billion. In Figure 2, the USD/CAD dropped approximately 50 pips on the day of the announcement, and was more than 250 pips lower the following week, falling by 600 pips after three weeks.
What can be said is that, the preceding examples all serve to illustrate the interconnectedness of the markets, as cross-border M&A activity impact on the currencies involved. Thus, FX traders can use this information to identify trading opportunities that others might miss.
The questions raised by this phenomenon are whether cross-border M&A transactions have a significant impact on value, and if this value effect differs systematically from the effects of purely domestic transactions.
To a large extent, the international orientation of corporations is based on a belief that gains accrue through economies of scale and scope, cost reduction, increased market power, and reduced earnings volatility. While in perfectly competitive capital markets, the announcement of an international merger should not yield returns to shareholders that differ from national transactions; the existence of different valuations of domestic and cross-border mergers may indicate the presence of market imperfections and/or a segmentation of the capital markets. 9 Fatemi and Furtado (1988))
In looking at the wealth effects of merger activities in one of the most internationally-oriented European economies, a sample of 114 acquisitions by Swiss firms between 1990 and 2001 was taken. (Switzerland is one of the world's major financial centres, hosting two of the 10 largest banks and managing about one-third of the volume of private assets globally held.)
It was found that, first, returns to target firm shareholders are on average significantly positive. Secondly, the returns to the acquiring firms' shareholders tend to be negative or close to zero.
Lowinsky states that, that view has been supported by Danbolt (1995) and McCann (2001), who concluded that the degree of capital market integration may have an impact on the emergence of abnormal returns to acquiring firms' shareholders, which differ from purely national merger activities.
Lowinsky also contrasts these results with the findings of Goergen and Renneboog (2002) who found significant positive bidder announcement returns for a sample of European domestic and cross-border acquisitions.
Wealth effects of acquisition announcements. The results provide evidence that acquirers achieve significant positive abnormal returns for a short time period around the announcement date, but invariably these returns are not sustainable.
Value effects of cross-border acquisitions. The empirical evidence states that there is a significant positive CARs for cross-border acquisitions for all event periods near the announcement date, which rise to 1.36%, but eventually that positive CAR diminishes. (Lowinsky, F (2004), The Effect of Cross-border merger on shareholder wealth-evidence from Switzerland, Review of Quantitative Finance and Accounting, 22:315-330)
Benefits
Strategic motives
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Wealth effects of acquisition announcements. The results provide evidence that acquirers achieve significant positive abnormal returns for a short time period around the announcement date, but invariably these returns are not sustainable.
Value effects of cross-border acquisitions. The empirical evidence states that there is a significant positive CARs for cross-border acquisitions for all event periods near the announcement date, which rise to 1.36%, but eventually that positive CAR diminishes. (Lowinsky, F (2004), The Effect of Cross-border merger on shareholder wealth-evidence from Switzerland, Review of Quantitative Finance and Accounting, 22:315-330)
Benefits
Strategic motives
Strategic motives involve acquisitions that improve the firm's strategy. For example, mergers intended to create synergy, capitalise on a firm's core competence, and the resultant increased market power provides the acquiring firm with complementary resources/products/strengths, or the ability to take advantage of a 'parenting advantage'. For instance, Ford's acquisition of Volvo could be called strategic, because that acquisition filled a gap in its product line both in terms of price, image and geography, which, except for sport utility vehicles, had the greatest potential for profit.
Synergy
Merging to create synergy is probably the most frequent justification for an acquirer to pay a premium for a target firm. Synergy is the concept whereby the merger of two firms increases overall value, because usually, the existing firms are operating below optimum. Generally, mergers will benefit shareholders when a company's post-merger share price increases by the value of the potential synergy.
Synergy: The Premium for Potential Success
Buyers need to pay a premium if they hope to acquire a company, despite their pre-merger valuation. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. Hence:
In other words, the success of a merger is measured by whether the value of the buyer is increased. However, unless the company was undervalued, where a profit can be easily realised, the practical constraints of mergers, often prevent the expected benefits from being fully achieved.
Merger Objective and Firm Benefits
Economies of scale - mergers translate into improved purchasing power - when placing larger orders, companies have a greater ability to negotiate price with their suppliers, and also benefit from the reduced transaction costs when operating in the stock market.
Given this, a profit-maximising company should be able to lower its price and thus lead to an increase in both sales and profits. For example, when Mercedes acquired Chrysler, it was announced that the merger would lead to $1.3 billion of cost savings in the first year mainly through combined purchasing. But evidence from 1951 to 1968 suggested that very rarely did M&A achieve synergy. (Cooke, T.E (1986) Mergers and Acquisitions, Basil Blackwell Ltd, UK, p. 27)
Acquiring new technology or assets - another reason for M&A is to gain complementary products, resources or strengths in order to remain or become more competitive. For example, the record company EMI, planned in the 1970s to diversify, based on their development of the CT scanner. But their lack of experience and resources in the United States, meant that they had only temporary success. Eventually, the market was lost as other firms with greater strength in the US market, copied their technology. The argument is that, had EMI acquired an established and reputable medical firm in the US, they may not have been as vulnerable to competitors.
Improved market reach and industry visibility - companies merge to reach new markets and grow revenues and earnings through new sales opportunities. A merger can also improve a company's standing in the investment community. They are also able to achieve a dominant market position and can better defend these positions.
Further, the term 'market power' connotes the ability to control price. Any merger that increases a firm's market power must, therefore, increase its ability to control the price of its products. If the firm faces a downward sloping demand schedule, and it takes advantage of its increase in market power by raising price, both its output and sales will fall. (If it is maximising profits, as it will then be operating in the elastic portion of its demand schedule ) But, the normal prediction is that, if that power is used to increase price, sales will fall.
Diversification - some commentators observe that company diversification is of no value to shareholders as they can do so more cheaply on their own accounts. But, others hypothesize that international risk diversification could be a motive for cross-border mergers. However, if international capital markets are perfectly integrated and efficient, with rational investors, then no diversification gains can be generated from international merger activity. But, according to some empirical work, diversifying mergers reduce shareholder wealth. (Hopkins, H.D, (1999) Cross-border Merger and Acquisitions: A Global and regional perspective, Journal of International Management, Vol.5, Issue 3, pp. 207-239)
General Principles
So, mergers that increase the efficiency of the merging firms should increase both their profits and their sales. Mergers that increase market power should increase profits and reduce sales. A merger which reduces efficiency is likely to reduce both profitability and sales. (Gugler, K, Mueller, D.C (2003) The effects of Mergers: an international comparison, International Journal of Industrial Organisation, Vol.21, Issue 5, pp. 625-653) Managers have been heard to comment that cost reductions are the major benefits that are most likely to be achieved, whereas, the achievement of synergy is highly uncertain.
For instance, the acquisition of Miller Beer by Philip Morris, where Philip Morris applied their strengths in marketing cigarettes to the brewing industry, which had previously emphasised production. In the process, they were able to improve Miller's market position from number seven to number two.
However, in a recent book by Mark Sirower (Sirower , M (1997) The Synergy Trap: How Companies Lose the Acquisition Game, p. 14), the author argues that synergy rarely justifies the premium paid. Sirower observes, 'Many acquisition premiums require performance improvements that are virtually impossible to realize even for the best managers in the best of industry conditions'. He further argues that the net present value of an acquisition can be modelled as:
NPV = Synergy - Premium
And that firms that don't realise this and don't realise that synergy almost never justify the premium paid. He cites as a typical example, the acquisition of WordPerfect for $1.4 billion by Novell.
However, Professor Williamson postulated that only a small gain in efficiency is necessary to offset a relatively large gain in market power, and so M&A are usually beneficial. This was called the partial-equilibrium welfare model:
Here AC1 is the cost of two firms, AC2 is the post-merger cost. Before merger, price is P1, output is Q1. With merger, costs decrease to AC2 and the price rises to A1, so that the merger is deemed beneficial. (Cooke, T.E (1986) Merger and Acquisition, Blackwell Ltd, UK )
Market motives
The most important market motive of a cross-border acquisition is to use it as a method to swiftly enter new markets in new countries, or enter mature markets without making it additionally concentrated. Firms from other countries may see acquisition of the formerly regulated or state-owned corporation as the fastest way to gain a strong position in the new market.
Economic motives
A final reason might be due to macroeconomic differences between countries. (Gonzalez et al. (1998)) That is, one country might have a higher growth rate and more opportunity than some other country. Thus, it would seem reasonable to expect the slower growth country to be more often home to acquirers whereas the faster growth country is likely to more often be home to target firms.
Pitfalls
Those who support mergers will argue that the merger will cut costs or boost revenues by more than enough to justify the price premium. Historical trends show that, roughly two-thirds of big mergers will lose value on the stock market. Motivations behind mergers can be flawed and efficiencies from economies of scale may prove elusive.
To determine whether a merger has increased profits or not, one must predict what the profits of the two merging firms would have been in the absence of the merger. The evidence seems to suggest that mergers have become associated with lowered productivity and hence a greater loss or neutral effect on profitability. According to the Department of Trade and Industry, merger failure rate was about 50 per cent. (Cartwright S, Cooper, C.L (1992) Mergers & Acquisitions: The Human Factor, Butterworth, UK, p. 22)
Longer-term studies
Bjorvatn, (2004) analysed studies performed by other academics and found an average stock loss of -5.5 per cent. Agrawal et al. (1992) found a decline of -10 per cent by using a five-year post-event window for acquisitions made between 1955 and 1987 and -19 per cent for those made between 1980 and 1987.
In contrast, Bradley and Jarrel (1988) used the same sample as Magenheim and Mueller (1988) but did not find negative returns. Loder and Martin (1992) found negative returns after three years but not after five years. A recent article from the New York Times (May 23, 1999) reviewed Ford's investment in Mazda and concluded that it had taken 20 years for the companies to start to reap benefits from their relationship.
Performance of related and cross-border acquisitions
A number of studies have looked at the performance of related acquisitions, that is, acquisitions where there is a common link in market, product or technology to the already established business of the acquirer.
Some studies have presented results indicating that relatedness between the acquiring and the acquired firm improves post-merger performance. For example, Singh and Montgomery (1987) examined a sample from the 1970s and found that, based on total dollar gains, related acquisitions performed better, although admitting that other studies suggested that relatedness is not an advantage.
Though there is a mix of studies on both sides of this question the weight of the evidence seems to support the value of relatedness.
Integration Problem
Some surveys found that one-third of all acquisition failures were because of integration problems.
One study suggests that cultural fit has a major effect on post-merger performance and that companies that allow multiculturalism perform better than less permissive firms. (Hopkins, H.D, (1999) Cross-border Merger and Acquisitions: A Global and regional perspective, Journal of International Management, Vol.5, Issue 3, p. 207-239)
The chances for success are further hampered if the corporate cultures of the companies are very different. When a company is acquired, the decision is typically based on product or market synergies, but cultural differences are often ignored.
The FT stated that Europe is in a grip of cross-border mergers, most recently being the acquisition of two-thirds of Messer Griesheim by Air Liquide. It went on to say that the leading cause of merger failure is corporate cultural differences, such as concerns over whether the right people were picked - 'a them vs us culture' and 'we are the best' mentality. (Financial Times, A Good Merger is all in the Mind, 15th March, 2006)
More insight into the failure of mergers is found in a study that concludes that companies often focus too intently on cutting costs following mergers, while revenues and, ultimately, profits suffer as it prompts nervous customers to flee. This loss of revenue momentum is one reason so many mergers fail to create value for shareholders. (Acclaimed study from the global consultancy McKinsey)
The success or failure of a deal also depends on the time horizon over which evaluation is done. Normally, in the short term, stock reactions to merger announcements tend to raise the target's stock price, while the stock of the acquirer stays about the same. This is normally attributable to the expectation that there will be a bid that is successful and involves a premium above the current market price of the stock. Acquirer prices stay the same, in general, as the market reacts conservatively, depending on the specifics of the deal.
Though these short-term studies have come to dominate merger and acquisition research, the question remains whether this is best way to judge the effects of mergers and acquisitions from a strategic perspective. Researchers who have judged mergers and acquisitions on a long-term basis have reported a more mixed outcome.
Conclusion
Acquisitions do not appear to result in an increase in value nor do they lead to strong financial performance. More specifically, research shows that the value of the acquiring firm does not benefit from an acquisition. However, there is some evidence that related acquisitions and cross-border acquisitions do add value.
Broadly speaking, mergers and acquisitions often seem to fail. But this depends on how failure is defined. In the extreme case, if failure is assessed as the sale or liquidation of the business, then the rate of failure is relatively low. On the other hand, if failure is the lack of attainment of management's financial objectives, then the rate of failure is high.
Based on his experience, Joseph Miller, (Senior Vice-President and Chief Technology Officer of DuPont) offered the following explanation for failure of some deals:
'In the case of [failure], it was an acquisition that was driven by the corporation and not supported by the business [strategic business unit] ... and in the case of one that worked, there was total alignment and support from the corporation and from the business.' (Avi Aden, Vice-Chair of Vishay Intertechnology, a Pennsylvania-based high-tech enterprise, 'We will not buy a company that we cannot improve... . Our goal is to look at a company that's either in trouble or not doing as well as we think it can do and then take decisive steps very quickly to improve it.')
Anthony Ruys states that mergers and acquisitions are not only good for some businesses, but possibly essential, if they are focused and support the core business. He says: 'Of course we make acquisitions when they are strategic. A strategic acquisition can be one that gives you real leadership in one or more countries simultaneously. If you already have a healthy export position in a market, and you get the chance of buying the number one in that market, and that number one has a brand that is also healthy in its own right, that's a smart acquisition.' (Anthony Ruys, in an interview with Hans Smits, on the acquisition of Murphy's, now an important part of the Heineken 'family'.)
Therefore, the success of mergers depends on how realistic the dealmakers are when negotiating and how well they can integrate two companies, while maintaining day-to-day operations. (www.investopedia.com/university/mergers)
References
Bjorvatn, K (2004) Economic Integration and the Profitability of Cross-border mergers and acquisitions, European Economic Review, Vol. 48, Issue 6, pp. 1211-1226
Breedon, F and Fornasari, F (2000), FX impact of cross-border M&A, BIS Paper 2
Cartwright S and Cooper, C.L (1992) Mergers & Acquisitions: The Human Factor, Butterworth, UK, p. 22
Cooke, T.E (1986) Merger and Acquisition, Blackwell Ltd, UK
Chaganti, R and Kotabe, M (1999) Cross-border M&A; Global Strategy; International Management, Journal of International Management, Vol. 5, Issue 3, pp. 207-239
Fatemi, A and Furtado, E (1988) An Empirical Investigation of the Wealth Effects of Foreign Acquisitions, Recent Developments in International Banking and Finance, Lexington Books, US
Financial Times, A Good Merger is all in the Mind, 15th March 2006
Gugler, K; Mueller, D.C; Yurtoglu, B.B and Zulehner, C (2003) The effects of mergers: an international comparison, International Journal of Industrial Organisation, Vol. 21, Issue 5, pp. 625-653
Hopkins, H.D (1999) Cross-border Merger and Acquisitions: A Global and regional perspective, Journal of International Management, Vol.5, Issue 3, pp. 207-239
Lien, K (2005) Mergers and Acquisitions - Another Tool For Traders, 12th October Lowinsky, F (2004), The Effect of Cross-border merger on shareholder wealth-evidence from Switzerland, Review of Quantitative Finance and Accounting, 22:315-330
Singh, H and Montgomery, C.A (1987) Corporate acquisitions and economic performance, Strategic Management Journal, 8 (4): pp. 377-386
Sirower, M (1997) The Synergy Trap: How Companies Lose the Acquisition Game, The Free Press, NY
Vasconcellos, G.M and Kish, R.J (1998) Cross-border mergers and acquisitions: the European-US experience, Journal of Multinational Financial Management, 8, pp. 431-450
www.investopedia.com/university/mergers
