Corporate Expansion: Mergers, Acquisitions, and Defensive Tactics

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Corporate Expansion: Mergers, Acquisitions, and Defensive Tactics

Business Essentials · Chapter 4: Business Ownership, Growth, and EntrepreneurshipSection 4.2 · lesson 20 of 10514 min · free with a free account

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In this lesson

Why firms combine, why many combinations disappoint, and how targets resist.

  • Distinguish mergers from acquisitions and their types
  • Explain the motives, and why many deals fail to deliver
  • Describe integration and due diligence
  • Describe a target's defenses and regulatory review

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Business Ownership, Growth, and Entrepreneurship

Corporate Expansion: Mergers, Acquisitions, and Defensive Tactics

A business can grow in two ways. It can expand its own operations, or it can combine with another business. This section is about the second route, mergers and acquisitions. We'll separate the terms, and classify combinations by how the two firms relate. We'll look honestly at why firms combine, including motives that are rarely announced. And we'll face an uncomfortable fact. A substantial share of combinations fail to deliver what was promised. We'll see where the value leaks away, and how careful investigation can catch the problem early. Finally, we'll look at hostile bids, the defenses targets use, and the regulators who review the deals. Watch for one recurring theme. The hard part usually starts after the deal is signed.

Mergers And Acquisitions

Different in Form, Close in Substance

Start with the vocabulary. A merger is a combination in which two firms join to form a single organization. Ordinarily, one survives, and the other ceases to exist as a separate entity. An acquisition is a transaction in which one firm buys another. It can buy the shares, which gives it ownership and control of the whole firm. Or it can buy the assets. The firm making the purchase is the acquirer. The firm being acquired or merged is the target. In form, the difference is clear. A merger is described as two firms combining on agreed terms. An acquisition has a buyer and a target. In substance, the difference is often smaller than the terminology suggests. Many deals described as mergers of equals are really acquisitions, with one side dominating management and direction. The choice of word may simply reflect a wish to soothe the target's employees and shareholders. So we'll treat the two together, under the abbreviation M and A.

Table 4.2.1

Three Types of Combination

Combinations are classified by the relationship between the firms. A horizontal combination joins two competitors in the same market, like two regional grocery chains. The claimed benefit is scale, with fewer duplicated costs, a larger market share, and one less rival. But integration is substantial. Duplicated systems, staff, and locations must be combined or cut, and cultures collide. And regulators look hardest at this type, asking whether the deal lessens competition. A vertical combination joins firms at different stages of the same supply chain. A bakery buying a flour mill combines with a supplier. A furniture maker buying a retail chain combines with a customer. The claimed benefit is control of supply or distribution, and capturing margin that used to go to another firm. The difficulty is different in kind. The acquirer must learn to run an unfamiliar stage of the chain. Regulators worry that rivals may be denied supply or access. A conglomerate combination joins unrelated businesses, like a software firm buying a restaurant group. The claimed benefit is diversification, since unrelated earnings may not fall together, plus financial advantages like moving capital among units. Operational integration is low, but management complexity is high. The acquirer may not understand what it bought. So no type is uniformly easier. Always ask which benefit is claimed, and which difficulty is likely.

The Motives

Why Firms Combine

Firms combine for several reasons, and they're seldom exclusive. Scale economies come from spreading fixed costs over more output. Market share and pricing power come from removing a competitor and easing price pressure. That's legitimate to state, but it draws regulators' attention. Capability or technology may be faster to buy than to build. Geographic reach means buying your way into a new region. Vertical control secures supply or distribution. Tax and financial motives include using one firm's losses, or another's cash, within legal limits. And then there are managerial motives, like growth for its own sake. Managers' pay, status, and security often rise with the size of the firm they run. So they may favor acquisitions that enlarge it, even when the deal adds little value for the owners. That's the agency problem from the previous section, applied to deal-making. Listing it isn't an accusation against any particular manager. It's an honest account of why some combinations get proposed.

The Evidence

Many Combinations Disappoint

Do combinations deliver? Many studies over several decades have examined that question, and the broad pattern is clear. A substantial proportion of combinations don't deliver the value claimed for them. The target's shareholders frequently gain, because the acquirer pays a premium over the market price. The acquirer's shareholders frequently fare worse. On average, they gain little, or lose. Findings vary by study, by period, and by how success is measured. And some combinations plainly succeed. So the pattern is a large fraction of disappointments, not universal failure. Three reasons are commonly given. Overpayment means paying more than the target is worth to the acquirer. Competitive bidding, and the wish to win, push the price up. Overestimated synergies come next. A synergy is a benefit that exists only because the firms are combined, like savings from cutting duplicated functions. When those savings or added revenues prove smaller than forecast, the price no longer makes sense. And integration failure means the firms simply can't be combined effectively after closing.

Integration

Where the Value Is Lost

Integration is the process of combining the two organizations after the deal closes. It's where much of the value is lost. Four areas must be combined. Systems, like accounting and information technology, are often incompatible, and expensive to merge. Processes, like how orders are fulfilled and decisions approved, differ and must be reconciled. People are the most sensitive area. The target's employees fear for their jobs, and the best of them can find work elsewhere. Key customers and suppliers may leave with them. And culture, the shared assumptions about how work gets done, is the area most often cited as a cause of failure. Picture a firm used to rapid, informal decisions, meeting a firm used to layers of approval. Each will experience the other's methods as obstacles. And none of that is visible in the financial analysis that justified the deal.

Figure 4.2.1

From Value Claimed to Value Delivered

Here's how the value drains away in an illustrative combination. The figures are index points, not data. The deal case claims a hundred points of value. Three losses follow. Two of them together take thirty-five points. The largest single loss, at thirty points, is the cost and delay of integration. What's left is thirty-five points of value actually delivered. That's about a third of what was promised. Now notice the timing. Every one of these losses arrives after the deal is announced and priced. The price is already paid, so the acquirer's owners bear the shortfall. That's why integration must be planned with the same care as the price.

Due Diligence

Verify What You Are Buying

The defense against paying for problems you can't see is due diligence. It's the investigation an acquirer carries out into a target before completing the deal. The aim is to verify what it's buying, and to find problems that affect the price, or the decision itself. It falls into five categories. Financial due diligence tests the accounts, earnings, cash flow, and debts, and asks whether the figures can be relied on. Chapter twenty develops the accounting. Legal due diligence examines contracts, litigation, intellectual property, licenses, and regulatory compliance. Operational due diligence looks at the systems, facilities, suppliers, and processes through which the target actually works. Commercial due diligence tests the market, the customers, and the competition, to see whether projected sales are credible. And cultural due diligence examines how the target is led, how decisions are made, and how its people are likely to respond. That last one is the most often skipped, because it's hard to quantify. Yet it bears directly on the cause of failure cited most often.

Hostile Approaches

Going Around the Board, and Five Defenses

An approach is friendly when the target's board agrees, and hostile when it doesn't. In a hostile approach, an acquirer that can't win the board may go straight to the shareholders. One method is a tender offer, a public offer to buy shares at a stated price, usually above market. Federal securities rules, administered by the S E C, apply. The other is a proxy contest, an attempt to win shareholders' votes to replace the directors with ones who'll accept the deal. A target that wants to resist has defensive measures. Here are five, described by how they work. A staggered board elects only a fraction of its directors each year, so even a winning acquirer can't replace the whole board at once. A supermajority provision requires a large majority, more than half, to approve a merger. A bare majority isn't enough. A shareholder rights plan lets existing shareholders, other than the acquirer, buy extra shares at a discount if anyone passes a set stake without approval. That makes an unapproved acquisition dramatically more expensive. Finding a white knight means inviting a friendlier buyer to make a competing offer. And restructuring means changing the balance sheet, by selling the assets the acquirer wants or taking on debt, so the target looks less attractive.

The Debate

Protecting Shareholders, or Entrenching Managers?

Do these defenses protect shareholders, or entrench managers? Here are both cases at full strength. The protective case says defenses give the board time and bargaining power. With them, the board can push for a higher price, look for better alternatives, and resist coercive offers that pressure shareholders to sell cheaply. And the board is better informed about the firm's value than scattered shareholders are. The entrenchment case says boards may use the same tools to protect their own positions. Defenses can discourage offers that would have benefited shareholders. And the threat of a takeover is part of the discipline that keeps managers accountable. The empirical question is what these measures do to the prices shareholders receive, and to firm performance. The evidence is mixed. The normative question is who should have the last word on selling a firm, the board or the shareholders. Corporate law is largely state law, and each state's courts have developed their own standards for reviewing defenses.

Review And Reversal

Regulators, Divestitures, and Spin-Offs

Combinations also face competition review. Section seven of the Clayton Act prohibits acquisitions whose effect may be to substantially lessen competition, or to create a monopoly. The Hart-Scott-Rodino Antitrust Improvements Act of nineteen seventy-six adds a notification step. Parties to deals above a size threshold, adjusted from time to time, must notify the Federal Trade Commission and the Justice Department's Antitrust Division. Then they wait while the agencies review. The agencies can clear the deal, require changes like selling certain businesses, or challenge it in court. Foreign buyers may also face national security review, by the Committee on Foreign Investment in the United States. And firms in regulated industries, like banking, need approval from their sector regulators. In practice, counsel is required. Combinations can also be reversed. A divestiture is the sale or disposal of a business unit or subsidiary. It may follow a failed integration, or a business that no longer fits the strategy. Regulators may even require it as a condition of approval. A spin-off is a divestiture in which the parent distributes the unit's shares to its own shareholders, creating a separate company. And the sheer prevalence of divestitures is itself evidence that many combinations don't deliver what they promised.

Case Vignette

The Diligence That Was Skipped

Let's close with a composite case. Petra is a corporate development manager at a logistics company. It agrees to buy a smaller firm that makes route-planning software. The deal case rests on two things. Savings from combining back-office functions, and adding the software to the acquirer's own service. The team completes financial, legal, and commercial due diligence. The accounts are sound, and the customer list is good. No one examines how the target's engineers work, or how its leaders make decisions. After closing, the acquirer applies its own approval process to a development team, one that had worked with almost no formal sign-off. Within a year, several of the most senior engineers have left, the new release is delayed, and a large customer cuts its orders. The cost savings arrive. But the software, the main reason for the purchase, delivers far less than promised. The skipped category was cultural due diligence, along with the operational check on how the team actually worked. At the time, deeper inquiry meant cost and delay, and culture is hard to measure. On review, Petra sees it plainly. The firm paid for the software and for the people who could build it. Whether those people would stay was the question the whole value depended on.

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FAQ

Questions students ask us

About Corporate Expansion: Mergers, Acquisitions, and Defensive Tactics

What is the difference between a merger and an acquisition?
In a merger, two firms combine into a single organization, usually with one surviving and the other ceasing to exist separately; in an acquisition, one firm buys another's shares or assets. In substance, the difference is often small. Many deals described as mergers of equals are really acquisitions, with one side dominating management, and the word merger may be chosen to reassure the target's employees and shareholders.
What are horizontal, vertical, and conglomerate mergers?
A horizontal merger joins competitors in the same market, a vertical merger joins firms at different stages of the same supply chain, and a conglomerate merger joins unrelated businesses. Horizontal deals promise scale but draw the most antitrust scrutiny. Vertical deals promise control of supply or distribution but require running an unfamiliar stage. Conglomerates promise diversification but bring management complexity, since the acquirer may not understand what it bought.
Why do many mergers and acquisitions fail to create value?
Many combinations disappoint because of overpayment, overestimated synergies, and integration failure. Competitive bidding pushes prices above what the target is worth to the buyer, forecast savings or revenues prove smaller than expected, and systems, processes, people, and culture prove hard to combine. Studies generally find that target shareholders often gain from the premium, while acquirer shareholders on average gain little or lose, though results vary by study and period.
What is a poison pill in a hostile takeover?
A poison pill, formally a shareholder rights plan, lets existing shareholders other than the acquirer buy extra shares at a discount if anyone passes a set ownership stake without board approval. That makes an unapproved takeover far more expensive. Other defenses include a staggered board, supermajority voting provisions, a white knight, and restructuring. Supporters say defenses give boards bargaining power, while critics say they can entrench managers.

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