Investment Banking: Why Do Companies Merge?
Firms have many motivations for seeking to combine with other firms and investment bankers should be aware of these motivations. Some reasons are very sound and seek to maximize the value of the entity for its owners, while others are less so.
Synergy is defined as 1 + 1 = 3, but how are synergies realized? If a bank acquires another bank, the combined entity can eliminate duplicate branches in the same local markets. In this manner, it maintains the same customers and has a lower cost structure. The same logic exists for mergers in which the combined firm has a much more complete product line.
Growing organically is tough and takes patience. It’s often quicker and more of a sure thing to buy growth via an acquisition than to patiently grow a business the good old-fashioned way. A company may not know how successful it will be in organically growing a business, but it knows exactly what it’s buying in an acquisition — or at least it thinks it does.
Achieving organic growth is particularly challenging in industries that are in very mature stages and merging may represent the only viable option to achieve rapid growth.
For increased market power
Mergers can result in increased market power. In particular, in a horizontal merger, there is less competition following the merger, so the combined firm will likely have more pricing power. In fact, many horizontal mergers are closely scrutinized for antitrust violations for precisely this reason— because they can dampen competition.
On the other hand, in vertical mergers, the result is less supply-chain uncertainty and a likely increase in product quality because the firm has more control over its supplies.
To gain access to foreign markets
Crossing borders can be very difficult for many businesses, and one of the easiest ways for a company to quickly and effectively access foreign markets is to merge with a firm from a different country. Crossing borders can be very difficult for a variety of reasons, most notably regulatory and cultural concerns, but merging with an existing firm can skirt many of those issues.
The creation of Latam Airlines Group — the result of a 2012 merger between Brazil’s TAM Airlines and Chile’s LAN Airlines — is an example of two firms merging to access markets beyond their home countries.
Because of the management’s own interests
One of the dirty little secrets of merger activity is that some mergers are realized because it’s in the best interests of the management — and not necessarily in the best interests of the shareholders. The fact is, bigger organizations pay their CEOs more than smaller organizations’ leaders are paid. And it isn’t just CEO pay, but the pay of the entire executive team.
The primary motivation for conglomerate mergers is diversification and reduction of risk. If a cyclical firm (one that tends to see its profits rise and fall with the business cycle) acquires a counter-cyclical firm (one that tends to see its profits rise when the broad economy falters), for instance, the profit stream of the combined firms should be more stable.
Diversification may be a good motivation for the management of a company but it isn’t necessarily a good motive from the standpoint of the owners of the firm, those pesky shareholders. A conglomerate merger actually reduces the investor’s ability to make choices among firms.
For tax considerations
Some mergers take place because it simply makes good sense from a tax perspective. Specifically, if a firm has accumulated large tax losses, it may make an attractive acquisition target by a firm with a large tax bill. The combined firm will have a lower tax bill than the two separate firms.
In addition, a firm that is able to increase its depreciation charges following an acquisition will save in taxes. These tax savings should result in an increase in firm value.
Rarely will a merger take place solely for the purpose of realizing tax savings, but it is a contributing factor.
For greater control
Many companies are acquired because the acquirer believes that there is hidden value in the assets of the acquired firm that can be unlocked if it gains control. In other words, the company is mismanaged and the new management team can turn the enterprise around.
If a company truly is being mismanaged, the value of the assets is not being maximized. If those assets can be acquired at a depressed price that reflects the current use of the assets, and the acquirer can make more effective use of those assets, then the hidden value of the assets can be realized through a change in control.
You often hear about a firm being acquired for less than breakup value. What that essentially means is that the value of the assets if the company is broken up and sold is greater than the market value of the firm as an ongoing entity. This kind of apparent undervaluation by the market is completely rational if the current management is squandering the use of the company’s assets.
To capitalize on untapped borrowing capacity
A source of hidden value is unused borrowing capacity. A firm may be an attractive takeover candidate if it has little or no debt on its balance sheet. An acquiring firm could acquire the assets of the firm and utilize the previously untapped borrowing capacity to acquire much needed capital and expand even further.
If the firm can make more on the borrowed funds than those funds cost, it will realize an increase in value and add to the combined firm’s return on equity, making both the shareholders and the management happy.