20.5The Disadvantages of Mergers and Acquisitions

The preceding section described a number of benefits associated with mergers and

acquisitions, but there can also be offsetting disadvantages. The prevailing view of

mergers has changed substantially over time. Investors and analysts have become more

skeptical about potential gains from M&Aand more aware of the potential downside

of combining two firms. This change in the prevailing view is especially true for the

pure conglomerate acquisitions. In the 1960s, conglomerate acquisitions were in fashion

and acquiring firms were rewarded with rising stock prices. The kind of logic illus-

trated in Example 20.1 was generally accepted by the market. However, for the reasons

discussed below, diversifying takeovers have been viewed much more negatively since

the 1980s.

¹¹See Grossman and Hart (1986) for further discussion along these lines.

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Conglomerates Can Misallocate Capital

Combining two firms can destroy value if the managers of the combined firm use the

added flexibility to transfer resources between the two firms to subsidize money-losing

lines of businesses that would otherwise be shut down. Subsidization of this sort is

likely to occur if the firm’s top management is reluctant to cut jobs or has other rea-

sons to keep a losing business in operation. For example, the CEO may not want to

admit that a past decision was a mistake. Hence, the information asymmetries and

incentive problems that can lead financial markets to allocate capital inefficiently also

create even greater problems when managers allocate capital internally. Robert D.

Kennedy, chairman of Union Carbide, a company that was involved in a number of

conglomerate acquisitions, summarized this point as follows:

All that stuff about balancing the cash generators and the cash users sounded great on paper.

But it never worked. When corporate management gets into the business of allocating

resources between businesses crying for cash, it makes mistakes.¹²

Mergers Can Reduce the Information Contained in Stock Prices

When two firms combine, there is generally one less publicly traded stock. This can

create a cost if stock prices convey information that helps managers to allocate

resources. For example, McDonald’s may have interpreted the rise in its stock price in

the early 1990s to improving opportunities in the growing economies of Southeast Asia.

This “stock market opinion” might have led McDonald’s to expand its efforts in that

part of the world. However, if McDonald’s were instead part of a large conglomerate,

its executives would not have been able to observe market prices and would have had

to make their investment decisions based on more subjective information.

As Chapter 18 noted, the information from stock prices also is useful for com-

pensating and evaluating management. We observed that it is much easier to tie the

compensation of Compaq’s CEO to his performance than it is to tie pay to performance

for the head of IBM’s PC division because there is no observable stock price for IBM’s

PC division. In addition to providing motivation, Compaq’s stock price provides a sig-

nal to shareholders of their CEO’s effectiveness. In contrast, IBM’s stock price con-

tains much less information about the success of any of its individual divisions.

ASummary of the Gains and Costs of Diversification

The past two sections have covered the advantages and disadvantages of purely diver-

sifying takeovers. These are summarized in the following result:

Result 20.4

The advantages of diversification can be described as follows:

•	Diversification enhances the flexibility of the organization.
•	The internal capital market avoids some of the information problems inherent in an external capital market.
•	Diversification reduces the probability of bankruptcy for any given level of debt andincreases the firm’s debt capacity.
•	Competitors find it more difficult to uncover proprietary information from diversified firms.

¹²“Learning Business Week,Nov. 7, 1988.

to Live with Leverage,”

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•	Diversification is advantageous if it allows the firm to utilize its organization more effectively.

The disadvantages of diversification can be described as follows:

•	Diversification can eliminate a valuable source of information which may, amongother things, make it difficult to compensate the division heads of large diversifiedfirms efficiently.
•	Managers may find it difficult to cut back optimally on losing divisions when theycan subsidize the losers out of the profits from their winners.

20.6	Empirical Evidence on TakeoverGains forNon-LBO Takeovers

Anumber of academics and policymakers have asked whether, on average, mergers

create value. In other words, are the various financial and operating synergies discussed

in this chapter real, or are purported synergies merely a convenient rationale offered

by managers attempting to expand their empires? This section reviews a number of

studies that attempt to measure the value created by mergers.

Three types of studies have sought to determine the extent to which non-LBO

takeovers are value enhancing. The first type analyzes stock returns around the time of

the announcements of tender offers and merger offers, and it attributes the gains and

losses in stock prices to expected gains associated with combining the firms, improv-

ing management, or identifying undervalued assets. The second type of study looks

more specifically at whether diversified firms are either more or less valuable than non-

diversified firms. The third type of study examines accounting data to determine the

change, if any, in the profitability of the target firm’s business after it has been absorbed

by the bidder.

Stock Returns around the Time of Takeover Announcements

Stock market studies look at the returns of both bidding firms and target firms. The

sum of the two returns determines whether mergers create value.

Returns of Target Firms.Stock market evidence strongly indicates that target share-

holders gain from a successful takeover. This is not surprising given that target share-

holders require a premium as an inducement to sell their shares to the acquiring firm.

Jensen and Ruback (1983) reported that, on average, target shares increase in price from

about 16 to 30 percent around the date of the announcement of a tender offer. Evidence

by Jarrell, Brickley, and Netter (1988) found that these returns increased substantially

during the 1980s to an average of about 53 percent. Jensen and Ruback (1983) reported

that the average return to target firms in negotiated merger offers is only about 10 percent.

Returns of BidderFirms.Returns to bidders around tender offer announcements are

sometimes positive and sometimes negative, and the average returns vary considerably

over time. Jarrell and Poulsen (1989) reported that the announcement return to bidders

in tender offers dropped from a statistically significant 5 percent gain in the 1960s to

an insignificant 1 percent loss in the 1980s. This finding can be attributed in part to

regulations that are disadvantageous to the bidder and perhaps to increased competition

among bidders for specific targets. One also can interpret this finding as an indication

that either the number of bad takeovers has been increasing or bidders have been pay-

ing too much in recent years.

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Summary of Bidderand Target Returns.Adding the bidder and target returns

implies that, on average, there is a net gain to shareholders around the time of the

merger announcement. Bradley, Desai, and Kim (1988) found that successful tender

offers increased the combined values of the merging firms an average of 7.4 percent

or $117 million (stated in 1984 dollars), which suggests that mergers are, on average,

value enhancing.

Result 20.5 summarizes how stock prices react at the time of takeover announce-

ments.

Result 20.5

Stock price reactions to takeover bids can be described as follows:

•	The stock prices of target firms almost always react favorably to merger and tenderoffer bids.
•	The bidder’s stock price sometimes goes up and sometimes goes down, dependingon the circumstances.
•	The combined market values of the shares of the target and bidder go up, onaverage, around the time of the announced bids.

Interpreting the Stock Return Evidence.As Chapter 19 discussed, the stock price

reaction on the announcement of a corporate decision cannot be attributed solely to

how the decision affects the firm’s profitability. The stock returns of the bidder at the

time of the announcement of the bid may tell us more about how the market is reassess-

ing the bidder’s business than it does about the value of the acquisition. Indeed, stock

prices may react favorably to the announcement of an acquisition, even when investors

believe the acquisition harms shareholders.

For example, a tender offer, especially one for cash, may indicate that the bidding

firm has been highly profitable in the past, given that it had accumulated the financial

ability to make the offer. Hence, the bidding firm’s stock price may increase even if

the market views the acquisition as a negative NPVproject. Indeed, stock prices react

very favorably to a firm purchasing its own stock because of the information this deci-

sion conveys, even though a share repurchase is a zero NPVinvestment. Given that

thestock price reaction around the time of the announcement of an offer for another

firm’s stock is generally much weaker, one might conclude that the market, on average,

views these acquisitions as negative NPVinvestments.

Stock Returns and the Means of Payment.The way in which a bidder pays for the

target can have a major effect on how the bidder’s stock reacts to the announced bid.

Franks, Harris, and Mayer (1988) and Travlos (1987) demonstrated that average bid-

der returns differ significantly, depending on whether the bidder offers cash or shares

of its own stock in exchange for the target’s shares. For example, Travlos found that

in U.S. acquisitions financed by an exchange of stock, the bidding firm’s stock prices

fell 1.47 percent, on average, on the two days around the offer’s announcement. Franks,

Harris, and Mayer found a similar negative return for equity-financed bidders in both

the United States and the United Kingdom. Both studies found that the market price of

the bidder reacted favorably to announcements of cash acquisitions, but the returns, on

average, were quite small. The returns on the two days around the announcement of a

cash offer, as reported by Travlos, were only marginally different from zero (0.24 per-

cent) and the monthly returns around the announcements of cash offers reported in

Franks, Harris, and Mayer were 2.0 percent in the United States and 0.7 percent in the

United Kingdom.

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Chapter 19 provides two explanations for why bidders who make cash offers expe-

rience higher returns. Bidders offer stock when they believe their own stock is over-

valued, but offer cash when they believe their own stock is undervalued. In addition,

a cash offer may signal that the bidder is able to obtain the financial backing of a bank

or other financial institution. Astock offer may then signal that the banks refused to

provide the bidder with financial backing, reflecting badly on the bidder’s financial

strength.

Result 20.6

The bidder’s stock price reacts more favorably, on average, when the bidder makes a cashoffer rather than an offer to exchange stock. This may reflect the relatively negative infor-mation about the bidder’s existing business signaled by the offer to exchange stock.

During the technology, software, and Internet stock boom of the late 1990s and

first quarter of 2000 there were a number of mergers where acquirers in these indus-

tries used stock for acquisitions. There was a popular belief at the time that the stock

prices of these firms were overvalued and bidders often saw their stock prices drop

substantially on the announcement of a stock-financed acquisition.

Information Conveyed about the Target.Abidding firm does not only reveal infor-

mation about itself when bidding for another company. If the financial markets believe

that a bidder has special information about a target, then a bid also is likely to convey

information to the market about the value of the target as a stand-alone company. One

can obtain insights about the extent to which special information about a target is

revealed by examining stock price reactions when offers are terminated.

Share prices tend to decline subsequent to the failure of an initial bid, but the prices

generally stay considerably above the stock price for the target that existed before the

bid [see Bradley (1980), Dodd (1980), and Bradley, Desai and Kim (1983)]. This evi-

dence could indicate that the bidders have some special information because, if the

gains were all due to either improved management or synergies, the stock price theo-

retically should drop back to its original level after a failed bid.

Bradley, Desai, and Kim suggested a different interpretation. They pointed out that

the relatively small decline in share prices when initial bids fail may not occur because

the initial bid signaled that the firm was undervalued, but because most failed targets

do eventually get taken over. Indeed, a failed bid is often due to a better offer; there-

fore, the stock price may eventually exceed the price level attained after the initial

acquisition announcement. The authors found that one to five years after the first price-

raising bid, the average share prices of targets that were not subsequently acquired by

any firm returned to the level that existed before the initial offer. This would suggest

that the bidder generally had no special information and that undervalued assets were

not the motivation for the takeovers.

In the Bradley, Desai, and Kim sample, only 26 of 371 target firms (about 7 per-

cent) were not acquired once they were “put into play,” making it difficult to make

strong inferences about the motivation of the initial bidders—whether the bidders felt

they could actually improve the values of the firms or believed that the firms were

undervalued.

In the 1980s, there were substantially more takeover attempts that failed, and many

were not subsequently taken over, making it easier to examine some of the hypothe-

ses considered by Bradley, Desai, and Kim. Safieddine and Titman (1999) examined

573unsuccessful takeover attempts during the 1982–1991 period and found that, on

average, target stock prices declined 5.14 percent on the termination date. This decline

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is smaller than the average increase when the takeover offers were originally

announced, suggesting that either the takeover announcement conveyed information

about the target’s value or, alternatively, that the offer created value, even if the offer

subsequently failed.

In contrast to Bradley, Desai, and Kim’s earlier sample, fewer than half of the tar-

gets of failed takeover bids in the 1982–1991 period were subsequently taken over.

Moreover, more than two-thirds of the failed targets that stayed independent substan-

tially increased their leverage ratios. Many of them implemented restructuring strate-

gies that were similar to the strategies that would have been imposed on them by their

hostile suitor. In particular, there was a tendency of the leverage increasing failed tar-

gets to sell assets, reduce investment, reduce employment, and increase focus. These

firms subsequently performed quite well. This evidence suggests that value is often cre-

ated by takeover offers even when they fail and the firm is not subsequently taken over.

Perhaps, the threat of additional takeover attempts provides management with the incen-

tives to cut wasteful spending and investment and to take other steps that create value

for their shareholders.

Empirical Evidence on the Gains to Diversification

Whether there are gains associated with takeovers depends, in part, on whether diver-

sification helps or hurts firm values. Anumber of empirical studies have documented

that U.S. corporations increased their level of diversification from the early 1960s to

the mid-1970s, in many cases through acquisitions. Starting in the late 1970s, U.S. firms

decreased their level of diversification and continued to do so throughout the 1980s

and 1990s, as many of the earlier acquisitions were spun off or divested.¹³

Anumber of empirical studies have examined whether diversification increases or

decreases firm values. Lang and Stulz (1994) and Berger and Ofek (1995) found that

the market places lower values on more diversified firms. Comment and Jarrell (1995),

who examined changes in diversification during the 1980s, found that firms destroy

value when they diversify and create value when they sell off divisions and become

more focused. Servaes (1996) found that the market’s attitude toward diversification

depends on the time period studied. In contrast with the earlier findings of diversifica-

tion discounts in the 1980s, Servaes found no significant valuation penalty associated

with diversification in the 1970s. However, he did find significant diversification penal-

ties in the 1960s, as well as the 1980s. Finally, Denis, Denis, and Sarin (1997) found

that the tendency of firms to diversify is related to ownership structure. They found

that firms managed by individuals who own more of the company’s shares are less

diversified. This finding supports the idea that the diversification discount at least par-

tially reflects the tendency to diversify for managerial benefits when there are insuffi-

cient incentives to maximize share value.

Astudy by Morck, Shleifer, and Vishny (1990) provided evidence consistent with

the change in attitudes about diversification during the 1970s and 1980s.¹⁴Their study

related the stock returns of bidders around the announcement dates of acquisition bids

to characteristics of both the bidder and the target, measuring the extent to which the

firms were in related lines of business. They found that bidder stock returns for

13

See Comment and Jarrell (1995) and Servaes (1996).

¹⁴A

related study by Matsusaka (1993) found that the stock prices of conglomerates responded

positively in the 1960s when they announced acquisitions, but responded negatively to similar announce-

ments in the 1980s.

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diversifying acquisitions (that is, an acquisition of an unrelated firm) were lower in the

1980s, when they were negative, than they were in the 1970s. For nondiversifying

acquisitions, however, bidder stock returns increased somewhat in the 1980s. The dif-

ference in the announcement returns between diversifying and nondiversifying acqui-

sitions was only 1.31 percent in the 1970s, but it was 6.97 percent in the 1980s.

Accounting Studies

Because stock price reactions reflect the information conveyed by an offer, it is diffi-

cult to use stock returns to draw inferences about the operating synergies or the eco-

nomic efficiency generated by a merger. For this reason, some researchers have exam-

ined accounting data to draw inferences about the underlying economic impact of a

merger.

Evidence of Negative PostmergerPerformance.In their comprehensive study,

Ravenscraft and Scherer (1987) investigated more than 5,000 mergers occurring

between 1950 and 1975. Using accounting data for each of the different lines of busi-

ness in which the firms were involved, they calculated and compared the postmerger

performance of acquired firms with the performance of nonacquired control groups in

the same industry. On average, they found significant declines in the postmerger prof-

itability of the acquired portions of those firms.

The Wealth TransferInterpretation.The evidence in the Ravenscraft and Scherer

study is inconsistent with the view that mergers create value. However, the interpreta-

tion of these results has been the subject of much disagreement. First, the validity ofthe

results depends on the accuracy of the accounting numbers, which have been ques-

tioned by a number of authors. Second, the mergers may be creating value even if the

targets appear to be doing poorly after the takeover. This will be the case if enough

wealth is transferred from the acquired firm to the acquirer. For example, Texas Air

acquired Eastern Airlines in 1986 for $600 million. Subsequent to the Eastern bank-

ruptcy, some of Eastern’s creditors suggested that wealth was transferred from Eastern

to Texas Air. After only four months, Eastern sold a number of jumbo jets (at what

some considered to be favorable prices) to Continental (also owned by Texas Air) and

sold Eastern’s reservation system to the parent firm. Finally, the accounting perfor-

mance of acquired firms will appear to be unfavorable if the targets are generally firms

with poor prospects. Although these firms perform poorly subsequent to being taken

over, they might have performed even worse had they remained independent.

Tobin’s qand the Interpretation of Mediocre Accounting Performance.Hasbrouck

(1985) offered support for the view that targets frequently are firms in decline. Has-

brouck assessed each firm’s Tobin’sq,the ratio of the market value of the firm’s assets

to the replacement value of the assets, which can be viewed as a measure of manage-

rial performance. Well-managed firms have a high Tobin’s qvalue; poorly managed

firms have a low Tobin’s q. Hasbrouck found that target companies have relatively low

values of Tobin’s q; target shares are often selling at a value below their replacement

cost. In addition, several studies [see, for example, Asquith (1983)], have found that tar-

gets tend to experience lower returns than firms of comparable risk in the years before

the merger. Hence, relative to either their past stock prices or their replacement values,

target share prices are low at the time of the initial offer, indicating that investors were

somewhat pessimistic about the target’s prospects as a stand-alone entity. This suggests

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Strategy, Second Edition

712Part VIncentives, Information, and Corporate Control

that the subsequent mediocre postmerger accounting performance of firms may have

occurred even if the acquisition had not taken place.

Evidence of Positive PostmergerPerformance.Healy, Palepu, and Ruback (1992)

examined 50 large mergers between 1979 and 1983 and found improvements in both

sales and profits of the combined firms following the mergers. This evidence suggests

that the mergers of the early 1980s may have been quite different from those of the

1960s and 1970s examined by Ravenscraft and Scherer. As mentioned earlier, the moti-

vation for many of the mergers of the 1960s and 1970s was diversification, and there

can be efficiency losses associated with diversification. However, diversification was a

less important motivation for mergers in the 1980s, a decade in which many takeovers

were motivated by the potential gains from improving managerial incentives. The

Healy, Palepu, and Ruback evidence suggests that in many cases productivity did

improve as a result of the takeovers.

Amore comprehensive study by Andrade, Mitchell, and Stafford (2001) examined

approximately 2000 mergers during the 1973 to 1998 period. Their results suggest that

the combined target and acquirer operating margins improve by about 1 percent sub-

sequent to the merger.