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Types of Mergers Investment Bankers Should Know

Fundamentally, there really is no difference between a merger and an acquisition to investment bankers. Both terms refer to a situation in which two companies combine and become one company.

Typically, a transaction is referred to as a merger if it's a combination of equals — that is, if both firms are approximately the same size — and if both parties agree to the combination. A transaction is typically referred to as an acquisition when a larger entity buys a much smaller entity or when the decision to combine is not mutual (in which case, it's referred to as a takeover).

There are three basic kinds of mergers — horizontal, vertical, and conglomerate, referring to the business relationship between the two parties. Understanding the different kinds of mergers gives you insight into the motivations behind mergers.

Horizontal mergers

A horizontal merger is one in which a firm acquires another firm in its same industry and with similar or compatible product lines. Horizontal mergers often result in the combined firm having a more complete product line and often provide greater geographic coverage with the products. A horizontal merger may also allow the combined firm to realize economies of scale — cost per unit of output declines as output increases.

Firms such as ExxonMobil, ChevronTexaco (now called Chevron), and ConocoPhillips are all examples of firms created as the result of horizontal mergers in the petroleum industry. The merger of Daimler-Benz and Chrysler is an example of a horizontal merger in the automobile industry.

Horizontal mergers are the most scrutinized for potential antitrust violations by the U.S. Department of Justice, because the combination of former competitors can serve to restrict competition and raise prices to the consumer.

Vertical mergers

A vertical merger takes place when two companies combine that previously sold to or bought goods from each other. A manufacturer may merge with a supplier of parts or producer of raw materials, or it may merge with a retailer who sells the products of the firm.

The goal of a vertical merger is not necessarily to grow or increase revenue, but to cut costs and realize a higher profit margin. Another reason for a vertical merger is to ensure that you have access to needed supplies in the production process.

One of the largest and most infamous vertical mergers (infamous because it was disastrous for Time Warner shareholders) took place when Internet provider America Online (AOL) merged with publisher Time Warner. This was considered a vertical merger because Time Warner produced content and AOL distributed content through its Internet service. Another example of a vertical merger involves the recent trend of both Coca-Cola and PepsiCo acquiring their bottling companies.

Conglomerate mergers

A conglomerate merger occurs when two companies with completely unrelated businesses combine. The primary motivation for a conglomerate merger is to diversify the firm and decrease risk.

The idea is that when one part of the business is performing poorly, a completely unrelated business may be thriving. If the profits of the separate businesses are not highly correlated — that is, their sales don't tend to move together — then the earnings stream of the combined business will be more stable.

There are many examples of very profitable conglomerate firms, with General Electric perhaps being the poster child for a successful conglomerate because GE produces everything from refrigerators to jet engines. An example of a conglomerate merger was the combination of ABC and the Walt Disney Company.

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