Operating Synergy

Operating synergy consists of economies of scale, economies of scope, and the acquisition of complementary technical assets and skills, which can be important determinants of shareholder wealth creation. Gains in efficiency can come from these factors and from improved managerial operating practices.

Economies of scale often refer to the reduction in average total costs for a firm producing a single product for a given scale of plant due to the decline in average fixed costs as production volume increases. Scale is defined by such fixed costs as depreciation of equipment and amortization of capitalized software, normal maintenance spending, and obligations such as interest expense, lease payments, long-term union, customer, and vendor contracts, and taxes. These costs are fixed since they cannot be altered in the short run. Variable costs are those that change with output levels. Consequently, for a given scale or amount of fixed expenses, the dollar value of fixed expenses per unit of output and per dollar of revenue decreases as output and sales increase.

To illustrate the potential profit improvement from economies of scale, consider the merger of Firm B into Firm A. Firm A has a plant producing at only one-half of its capacity, enabling Firm A to shut down Firm B’s plant that is producing the same product and move the production to its own underutilized facility. Consequently, Firm A’s profit margin improves from 6.25% before the merger to 14.58% after the merger. Why? Because the additional output transferred from Firm B is mostly profit as it adds nothing to Firm A’s fixed costs (Table 1.2).³

Table 1.2

Economies of Scale

Period 1: Firm A (premerger)	Period 2: Firm A (postmerger)
Assumptions: • Price = $4 per unit of output sold • Variable costs = $2.75 per unit of output • Fixed costs = $1,000,000 • Firm A is producing 1,000,000 units of output per year • Firm A is producing at 50% of plant capacity	Assumptions: • Firm A acquires Firm B, which is producing 500,000 units of the same product per year • Firm A closes Firm B’s plant and transfers production to Firm A’s plant • Price = $4 per unit of output sold • Variable costs = $2.75 per unit of output • Fixed costs = $1,000,000
$\begin{array}{l}\mathrm{Profit}=\mathrm{price}\times \mathrm{quantity}–\mathrm{variable}\mathrm{costs}–\mathrm{fixed}\mathrm{costs}\\ =\mathrm{\$}4\times 1,000,000–\mathrm{\$}2.75\times 1,000,000\\ -\mathrm{\$}1,000,000=\mathrm{\$}250,000\end{array}$	$\begin{array}{l}\mathrm{Profit}=\mathrm{price}\times \mathrm{quantity}–\mathrm{variable}\mathrm{costs}–\mathrm{fixed}\mathrm{costs}\\ =\mathrm{\$}4\times 1,500,000–\mathrm{\$}2.75\times 1,500,000–\mathrm{\$}1,000,000\\ –\mathrm{\$}6,000,000–\mathrm{\$}4,125,000–\mathrm{\$}1,000,000=\mathrm{\$}875,000\end{array}$
$\begin{array}{l}\mathrm{Profit}\mathrm{margin}\left(\%\right)=\mathrm{\$}250,000/\mathrm{\$}4,000,000=6.25\\ \mathrm{Fixed}\mathrm{costs}\mathrm{per}\mathrm{unit}=\mathrm{\$}1,000,000/\mathrm{\$}1,000,000=\mathrm{\$}1.00\end{array}$	$\begin{array}{c}\mathrm{Profit}\mathrm{margin}\left(\%\right)=\mathrm{\$}875,000/\mathrm{\$}6,000,000=14.58\\ \mathrm{Fixed}\mathrm{cost}\mathrm{per}\mathrm{unit}=\mathrm{\$}1,000,000/1,500,000=\mathrm{\$}.67\end{array}$

Notes: Contribution to profit of additional 500,000 units = $4 × 500,000 − $2.75 × 500,000 = $625,000.

Margin per unit sold @ fixed cost per unit of $1.00 = $4.00 − $2.75 − $1.00 = $0.25.

Margin per unit sold @ fixed cost per unit of $0.67 = $4.00 − $2.75 − $0.67 = $0.58.

Economies of scale also affect variable costs such as a reduction in purchased material prices due to an increase in bulk purchases and lower production line setup costs resulting from longer production runs. When one company buys another, the combined firms may be able to negotiate lower purchase prices from suppliers because of their increased leverage. Suppliers often are willing to cut prices, because they also realize economies of scale as their plant utilization increases if they are able to sell larger quantities. Setup costs refer to the expense associated with setting up a production assembly line. These include personnel costs in changing from producing one product to another, any materials consumed in this process, and the time lost while the production line is down. For example, assume a supplier’s initial setup costs are $3000 per production run to produce an order of 2500 units of a product. Setup costs per unit produced are $1.20. If the order is doubled to 5000 units, setup costs per unit are cut in half to $0.60 per unit. Suppliers may be willing to pass some of these savings on to customers to get a larger order.

Economies of scope refers to the reduction in average total costs for a firm producing two or more products, because it is cheaper to produce these products in a single firm than in separate firms. Economies of scope may reflect both declining average fixed and variable costs. Common examples of overhead- and sales-related economies of scope include having a single department (e.g., accounting and human resources) support multiple product lines and a sales force selling multiple related products rather than a single product. Savings in distribution costs can be achieved by transporting a number of products to a single location rather than a single product. In 2012, following its emergence from bankruptcy, Hostess Baking achieved significant reductions in distribution costs when its unions allowed the firm to transport both bread and other baked goods to customers in the same truck rather than in separate trucks as had been the case. Economies of scope also include the cost savings realized by using a specific set of skills or an asset currently employed in producing a specific product to produce multiple products. Procter & Gamble, the consumer products giant, uses its highly regarded consumer marketing skills to sell a full range of personal care as well as pharmaceutical products. Honda employs its proprietary knowledge of internal combustion engines (an intangible asset) to enhance the manufacture of engines used in cars, motorcycles, lawn mowers, and snow blowers.

Complementary technical assets and skills are those possessed by one firm that could be used by another to fill gaps in its technical capabilities. Gaining access to this know-how can be a significant motivation for one firm to acquire another. For example, merger activity is likely to occur between firms pursuing related research and development activities, with certain technologies owned by one firm appearing to be very attractive to the other. Both firms gain potentially from an increased rate of innovation after the merger, because they have access to each other’s technical skills and patent portfolios. When Pharmacia & Upjohn combined with Monsanto to form Pharmacia, the merger gave Pharmacia & Upjohn access to Monsanto’s Cox-2 inhibitors and Monsanto access to the other’s expertise in genomics. The merger allowed for expanded in-house clinical R&D, resulting in an increase in the average size of R&D projects and a reduction in the time required getting products to market.

Financial Synergy

Financial synergy refers to the reduction in the acquirer’s cost of capital due to a merger or acquisition. This could occur if the merged firms have cash flows that are relatively uncorrelated, realize cost savings from lower securities’ issuance and transactions costs, or experience a better matching of investment opportunities with internally generated funds. The conventional view holds that corporations moving into different product lines whose cash flows are uncorrelated reduce only risk specific to the firm such as product obsolescence (i.e., business specific or nonsystematic risk) and not risk associated with factors impacting all firms (i.e., systematic risk) such as a recession, inflation, or increasing interest rates.

Recent research suggests that M&As resulting in firms whose individual business unit cash flows are uncorrelated can indeed lead to a reduction in systematic risk. Such firms may be better able to withstand the loss of customers, suppliers, employees, or the impact of financial distress than single product firms. Sometimes referred to as coinsurance, the imperfect correlation of business unit cash flows allows resources to be transferred from cash-rich units to cash-poor units as needed. In contrast, the loss of key customers or employees in a single product firm could be devastating. Consequently, multi-product line firms with less correlated business unit cash flows can have less systematic risk than firms whose business unit cash flows are correlated.

Target firms, unable to finance their investment opportunities, are said to be financially constrained, and they may view access to additional financing provided by an acquirer’s unused borrowing capacity⁴ or excess cash balance as a form of financial synergy. That is, financially constrained firms often increase their investment levels following acquisition by a firm not subject to financial constraints.⁵

There is evidence that diversification may be to some extent cyclical. Firms have incentives to engage in diversification whenever access to credit markets becomes more difficult. As credit availability tightens, so goes the reasoning, highly focused firms cannot take advantage of attractive investment opportunities if they lack internal financial resources. More diversified firms can more easily redeploy resources from other lines of business. When it becomes easier to borrow, firms are more inclined to narrow their focus by reducing the number of different lines of business.⁶

A Legal Perspective

A merger is a combination of two or more firms, often comparable in size, in which all but one ceases to exist legally. A statutory or direct merger is one in which the acquiring or surviving company assumes automatically the assets and liabilities of the target in accordance with the statutes of the state in which the combined companies will be incorporated. A subsidiary merger involves the target becoming a subsidiary of the parent. To the public, the target firm may be operated under its brand name, but it will be owned and controlled by the acquirer. A statutory consolidation—which involves two or more companies joining to form a new company—is technically not a merger. All legal entities that are consolidated are dissolved during the formation of the new company, which usually has a new name. Shareholders in the firms typically exchange their shares for shares in the new company.

An Economic Perspective

Business combinations may also be defined depending on whether the merging firms are in the same (horizontal) or different industries (conglomerate) and on their positions in the corporate value chain (vertical). Fig. 1.1 illustrates the different stages of the value chain. A simple value chain in the basic steel industry may distinguish between raw materials, such as coal or iron ore; steel making, such as “hot metal” and rolling operations; and metals distribution. Similarly, a value chain in the oil and gas industry would separate exploration activities from production, refining, and marketing. An Internet value chain might distinguish between infrastructure providers such as Cisco, content providers such as Dow Jones, and portals such as Google. In a vertical merger, companies that do not own operations in each major segment of the value chain “backward integrate” by acquiring a supplier or “forward integrate” by buying a distributor. When paper manufacturer Boise Cascade acquired Office Max, an office products distributor, the $1.1 billion transaction represented forward integration. PepsiCo backward integrated through a $7.8 billion purchase of its two largest bottlers to realize $400 million in annual cost savings.

Investment Banks

Investment banks provide advice and deal opportunities; screen potential buyers and sellers; make initial contact with a seller or buyer; as well as provide negotiation support, valuation, and deal structuring guidance. The “universal or top-tier banks” (e.g., Goldman Sachs) also maintain broker-dealer operations, serving wholesale and retail clients in brokerage and advisory roles, to support financing mega-transactions.

Investment bankers derive significant income from so-called fairness opinion letters—signed third-party assertions that certify the appropriateness of the price of a proposed deal involving a tender offer, merger, asset sale, or LBO. They often are developed as legal protection for members of the boards of directors against possible shareholder challenges of their decisions.⁵⁵ Researchers have found that fairness opinion letters reduce the risk of lawsuits associated with M&A transactions and the size of the premium paid for targets if they result in acquirers’ performing more rigorous due diligence and deal negotiation.⁵⁶

In selecting an investment bank, acquirers and target firms focus far more on a bank’s track record in generating high financial returns for their clients than on its size or market share. Smaller advisors may generate higher returns for their clients than the mega-investment banks because of proprietary industry knowledge and relationships. About one-fourth of merging firms tend to hire so-called boutique or specialty investment banks for their skill and expertise as their advisors, especially in deals requiring specialized industry knowledge. However, size and market share do matter in certain situations. Contrary to earlier studies that report a negative or weak relationship between bidder financial advisor size and bidder returns,⁵⁷ bidders using top-tier investment banks as advisors report on average a 1% improvement in returns in deals involving public targets. Top-tier investment banks are better able to assist in funding large transactions, which typically involve public companies, because of their current relationships with lenders and broker networks.

About 50% of deals are advised by top-tier investment banks. Such banks seem to be more helpful in improving both short and long term financial performance for acquirers who have limited access to funds than for those that have few financial constraints. Perhaps high financing costs force constrained firms to be more careful in making acquisitions and are more inclined to hire top-tier advisors to identify more readily achievable synergies.⁵⁸

Longstanding investment banking relationships do matter. However, their importance varies with the experience of the acquirer and target firm. Targets, having such relationships with investment banks, are more likely to hire M&A advisors⁵⁹ and to benefit by receiving higher purchase price premiums. Frequent acquirers are more likely to use the same investment advisor if they have had good prior outcomes. Otherwise they are very willing to switch to a new investment advisor. Investment banking relationships are significant for inexperienced acquirers which are more likely to hire financial advisors with whom they have had a longstanding underwriting relationship for new equity issues.⁶⁰

Firms that are in the mature stage of their corporate life cycle (net cash generators with limited investment opportunities) are more inclined to use investment bankers than firms in their growth phase (net cash users with many investment opportunities). Mature firms hiring investment bankers often show higher returns than those that do not, suggesting that financial advisors add value perhaps by helping such firms identify and value appropriate investment opportunities. Firms in their growth phase are less likely to use financial advisors due to the many investment opportunities that exist for such firms, but those not using advisors tend to earn lower returns than those that do.⁶¹

In recent years, active acquirers are relying more on their internal staffs to perform what has traditionally been done by outside investment bankers. According to Dealogic, 27% of public company deals valued at more than $1 billion in 2016 did not use investment advisors. This compares to 13% in 2014. The trend is driven by a desire to control costs, keep deals confidential, and move quickly when needed.

Lawyers

Lawyers help structure the deal, evaluate risk, negotiate the tax and financial terms, arrange financing, and coordinate the sequence of events to complete the transaction. Specific tasks include drafting the purchase agreement and other transaction-related documents, providing opinion of counsel letters to the lender, performing due diligence activities, and defending against lawsuits. Moreover, the choice of legal counsel in deal making often is critical as top legal advisors may be better able to handle the complexity and strategy that accompany M&A related lawsuits. They often can negotiate cheaper and faster deals and protect low premium deals from serious legal challenges. Moreover, top attorneys are more effective in multi-jurisdictional litigation cases.⁶²

Accountants

Accountants provide advice on financial structure, perform financial due diligence, and help create the optimal tax structure for a deal. Income tax, capital gains, sales tax, and sometimes gift and estate taxes are all at play in negotiating a merger or acquisition. In addition to tax considerations, accountants prepare financial statements and perform audits. Many agreements require that the books and records of the acquired entity be prepared in accordance with Generally Accepted Accounting Principles (GAAP).

Proxy Solicitors

Proxy contests are attempts to change the management control or policies of a company by gaining the right to cast votes on behalf of other shareholders. In contests for the control of the board of directors of a target company, it can be difficult to compile mailing lists of stockholders’ addresses. The acquiring firm or dissatisfied shareholders hire a proxy solicitor to obtain this information. Furthermore, proxy solicitors have the systems in place to keep track accurately of thousands of votes cast. The target’s management may also hire proxy solicitors to design strategies for educating shareholders and communicating why they should support the board.

Public Relations Firms

Such firms often are hired to ensure that a consistent message is communicated during a takeover attempt or in defending against takeovers. In initiating a hostile takeover attempt, the message to target shareholders must be that the acquirer’s plans for the company will increase shareholder value more than the plans of current management. Often, the target’s management will hire a private investigator to develop detailed financial data on the company and do background checks on key personnel, later using that information in the public relations campaign to discredit publicly the management of the acquiring firm.

Commercial Banks

Traditionally, commercial banks have accepted checking, savings, and money market accounts and would lend these funds to borrowers. This model has evolved into one in which banks sell many of the loans they originate to others for whom buying, selling, and collecting loan repayments is their primary business. Commercial banks also derive an increasing share of their profits from fees charged for various types of services offered to depositors and fees charged for underwriting and other investment banking services. The Dodd-Frank bill, passed in 2010, is intended to limit the riskiness of bank lending and to severely restrict the types of investments that can be made. See Chapter 2 for a more detailed discussion of Dodd-Frank.

Hedge, Private Equity, and Venture Capital Funds

These funds assume higher levels of risk than other types of institutional investors and usually are limited partnerships in which the general partner has made a substantial personal investment. They are distinguished by their investment strategies, lockup periods (i.e., the length of time investors are required to commit funds), and the liquidity of their portfolios. Hedge fund investment strategies include trading a variety of financial instruments—debt, equity, options, futures, and foreign currencies—as well as higher risk strategies, such as corporate restructurings (e.g., LBOs) and credit derivatives (e.g., credit default swaps). Because of their shorter lockup periods, hedge funds focus on investments that can be readily converted into cash. In contrast, private equity funds often make highly illiquid investments in private companies and hold such investments for 5 years or more; they attempt to control risk by being actively involved in managing the firm in which they have invested. Venture capitalists are a significant source of funds for financing both start-ups and acquisitions.

Sovereign Wealth Funds

Sovereign wealth funds are government-backed or -sponsored investors whose primary function is to invest accumulated foreign currency reserves. Countries with huge quantities of US dollars would, through such funds, often reinvest the money in US Treasury securities. These funds are increasingly taking equity positions in foreign firms, often making high-profile investments in public companies.

Angel Investors

Angel investors are wealthy individuals banding together in “investment clubs” or networks to identify deals, pool money, and share expertise. Some angel groups imitate professional investment funds, some affiliate with universities, while others engage in for-profit philanthropy. The angel investor market tends to be largely informal and less professional than the venture capital market. Their appeal is that they fund early stage startups (often without revenue) and serve as mentors and sometimes as outside directors for entrepreneurs. Angel investors boost growth, operating performance, and the long-term survival of the firms they finance. In countries less friendly to entrepreneurs, angels tend to finance more established revenue generating firms.⁶⁶

Mutual Funds and Pension Funds

While regulations restrict their ability to discipline corporate management, institutional investors with huge portfolios can be very effective in demanding governance changes.⁶⁹ Corporate governance is the system of rules, processes, and practices that direct and control a firm. These institutions may challenge management on such hot-button issues as antitakeover defenses, CEO severance benefits, and employee stock option accounting. Voting against management, though, can be problematic, since some mutual funds manage retirement plans and, increasingly, provide a host of outsourcing services—from payroll to health benefits—for their business clients. Mutual funds may own stock, on behalf of their clients, in these same firms.

Pressure from institutional activists may account for the general decline in the number of executives serving as both board chairman and CEO of companies. Sometimes, CEOs choose to negotiate with activists rather than face a showdown at an annual shareholders meeting. Activists also are finding that they may avoid the expense of a proxy fight simply by threatening to vote in certain ways on supporting a CEO or a management proposal. This may mean a “no” vote, although in some instances the only option is to vote in the affirmative or abstain. Abstaining is a way to indicate dissatisfaction with a CEO or a firm’s policy without jeopardizing future underwriting or M&A business for the institution.

Hedge Funds and Private Equity Firms

Hedge funds and private equity firms have had more success as activist investors than other institutional investors. They are successful about two-thirds of the time in their efforts to change a firm’s strategic, operational, or financial strategies, often generating attractive financial returns for shareholders.⁷⁰ They seldom seek control (with ownership stakes averaging about 9%) and are most often non-confrontational. Their success as activists can be attributed to their managers, who direct large pools of relatively unregulated capital and who are highly motivated by financial gain. Because hedge funds are not subject to the same regulations governing mutual funds and pension funds, they can hold concentrated positions in a small number of firms. Moreover, they are not limited by the same conflicts of interests that afflict mutual funds and pension funds. Hedge funds tend to have the greatest impact on shareholder returns when they prod management to sell a company, but their impact dissipates quickly if the sale of the company is unsuccessful. Firms once targeted by activists are more likely to be acquired.

Returns High for Target Shareholders

Average abnormal returns to target shareholders during the 2000s averaged 25.1% as compared to 18.5% during the 1990s.⁸⁰ This upward trend may reflect bidders’ willingness to offer higher premiums in friendly takeovers to preempt other bidders, the increasing sophistication of takeover defenses, federal and state laws requiring bidders to notify target shareholders of their intentions before completing the deal, and the decline in the number of publicly listed firms during the last two decades.⁸¹ While relatively infrequent, returns from hostile tender offers generally exceed those from friendly mergers, which are characterized by less contentious negotiated settlements and the absence of competing bids.

Sometimes returns to target shareholders on the announcement date can be negative. Why? Because investors are sensitive to the size of the actual offer price relative to the expected offer price.⁸² When the announced offer price is below expectations, investors express their disappointment by selling their shares. Selling pressure can be particularly intense when the run-up in share prices prior to the bid is fueled largely by speculators hoping to profit from a sizable jump in the stock. When it becomes clear that their expectations will not be realized, speculators try to lock in any profits they have by selling their shares.

Rival firms in the same industry as the target firm also show significant abnormal financial returns around the announcement date that the target is to be acquired. This reflects investor anticipation that such firms are likely to become targets themselves as the industry undergoes consolidation. Those firms that are covered by the largest number of security analysts tend to show the highest abnormal returns, as analysts fuel such speculation.⁸³

Returns to Acquirer Shareholders are Positive on Average

Recent research involving large samples of tens of thousands of public and private firms over lengthy time periods including US, foreign, and cross-border deals document that returns to acquirer shareholders are generally positive around the deal announcement date.⁸⁴ Before 2009, event studies showed on average negative abnormal financial acquirer returns of about 1% in cash and stock deals involving large public firms. After 2009, M&As showed average positive and statistically significant abnormal returns of about 1% for acquirers while stock deals no longer destroy value.⁸⁵ Why? The Dodd-Frank reform act that passed in 2010, although aimed primarily at financial institutions, has improved monitoring and governance systems for all US listed firms. This has been achieved through new mandatory disclosure rules, refining executive compensation, granting more powers to shareholders, and strengthening executive/director accountability.

Earlier studies largely ignored deals involving private acquirers, private targets, or both, which comprise at least four-fifths or more of total deals. Studies including private targets and acquirers display average acquirer shareholder positive abnormal returns of about 1%–1.5%. The earlier studies also fail to explain why tens of thousands of M&As are reported annually worldwide and why the number and size of M&As continues to grow, implying inexplicably that managers do not learn from past failures.

Pre-2009 studies may also understate average acquirer returns because they are based on relatively small samples of mostly large public firms, employ problematic methodologies, fail to capture the preannouncement rise in acquirer share prices,⁸⁶ and fail to adjust for distortions of a few large transactions. Nor do they properly account for premerger pay for performance programs even though bidders with high pay for performance plans tend to pay lower premiums and realize higher announcement date financial returns than firms that do not have such plans.⁸⁷ Furthermore, commonly used sampling methods bias sample selection toward larger publicly traded firms making such samples unrepresentative of the general populations of firms involved in M&As.⁸⁸ Moreover, studies focusing on publicly traded firms are likely to suffer from increasingly small sample bias as the number of such firms continues to drop, having fallen by more than 50% over the last several decades.

A more significant shortcoming of measuring the success or failure of deals using announcement date returns is that such deals often are not viewed in the context of a larger business strategy.⁸⁹ Business strategies tend to drive M&A outcomes and consolidated financial returns⁹⁰ and announcement date returns vary widely often reflecting the differing motives for mergers.⁹¹ Event studies assume that investors at the time of the deal’s announcement can accurately assess potential synergy, even though investors lack access to the necessary information to make an informed decision. If event return studies understate synergy they tend to understate actual financial returns to the acquirer including the effects of the target firm. What follows are illustrations of how corporate wide strategies can generate highly attractive financial returns to acquirers even though individual M&A’s can be viewed as destroying shareholder value when viewed in isolation.

Google was widely criticized as having overpaid in 2006 when it acquired YouTube for $1.65 billion. Google’s business strategy was to increase usage of its search engine and websites to attract advertising revenue. Today, YouTube is widely recognized as the most active site featuring videos on the internet and has attracted substantial additional web activity for its parent. Viewed independently from the Google business strategy, YouTube may not exhibit attractive financial returns, but as part of a larger strategy, it appears to have been wildly successful. Moreover, event studies do not take into account the potential beneficial impact of defensive acquisitions.⁹² Facebook’s eye-popping $21.8 billion acquisition in 2014 of WhatsApp with its meager $20 million in annual revenue was in part justified because it kept this rapidly growing mobile messaging business out of the hands of Google. Amazon.com‘s $13.7 billion buyout of grocer Whole Foods in 2017 may show negative returns if viewed as separate from Amazon’s corporate strategy but can exhibit very positive financial returns if viewed in the context of creating more brand loyalty. It does not matter where Amazon.com makes money throughout its diverse array of businesses but only that it does make enough to satisfy investors.

Disney was severely criticized as overpaying when it acquired Pixar for $7.3 billion in 2006, Marvel Entertainment in 2009 for $4 billion, and Lucasfilm for $4 billion in 2012. Disney’s business strategy has been to nurture strong brands and grow creative content. The acquisition of the highly successful film animation studio Pixar reinvigorated Disney’s animation and production studio business and prevented Pixar from being acquired by a rival. Marvel Entertainment provided the firm with such iconic brands as Iron Man, Spider-Man, the X-Men, Captain America, the Fantastic Four, and Thor. Lucasfilm added the Star Wars franchise to Disney’s growing film library. When combined with Disney’s creative skills and global distribution, these brands have helped push Disney earnings to record levels.

Smaller Acquirers Tend to Realize Higher M&A Returns

Managers at large firms tend to overpay more than those at smaller firms, since large firm executives may have been involved in more deals and be subject to hubris. In addition, incentive systems at larger firms may be skewed toward rewarding growth rather than ongoing performance thereby encouraging senior manages to focus on large acquisitions, which often are difficult to integrate. Finally, managers of large firms may pursue larger, more risky investments (such as unrelated acquisitions) in an attempt to support the firm’s overvalued share price. In contrast, CEOs of small firms tend to own a larger percentage of the firm’s outstanding shares than those of larger firms. On average CEOs of small firms own 7.4% of their firm’s stock, while those of larger firms own on average 4.5%. Consequently, small company CEOs may be more risk averse in negotiating M&As. Regardless of the reason, research shows that large public acquirers tend to destroy shareholder wealth, while small acquirers create wealth.⁹⁴

Large size can have benefits for M&As in countries characterized by weak corporate governance, (i.e., countries in which the laws and courts fail to protect shareholders’ rights). Realizing positive abnormal financial returns averaging 1.3% around the deal announcement date, large acquirers in such countries often are better able to insulate themselves from corrupt governments due to their sheer size, prestige, influence, and political connections. Reflecting their excellent political connections in weak governance environments, large acquirers often take less time to complete deals than in countries with more rigorous governance practices enabling a more rapid realization of anticipated synergies.⁹⁵

Acquirer Returns Often Positive for Privately Owned or Subsidiary Targets

US acquirers of private firms or subsidiaries of publicly traded firms often realize positive abnormal returns of 1.5%–2.6% around the announcement date.⁹⁶ Acquirers pay less for private firms or subsidiaries of public companies due to the limited availability of information and the limited number of bidders for such firms. That is, the market for private firms is illiquid. Since these targets may be acquired at a discount from their true value, acquirers can realize a larger share of the combined value of the acquirer and target firms.

Relatively Small Deals May Generate Higher Returns

Acquirer announcement date financial returns tend to be three times larger for acquisitions involving small targets than for those involving large targets.⁹⁷ High-tech firms realize attractive returns by acquiring small, but related, target firms to fill gaps in their product offerings.⁹⁸ Larger deals tend to be riskier for acquirers⁹⁹ and experience consistently lower postmerger performance, possibly reflecting the challenges of integrating large target firms and realizing projected synergies. There are exceptions: firms making large acquisitions show less negative or more positive returns in slower growing than in faster growing sectors.¹⁰⁰ In slow growth industries, integration may be less disruptive than in faster growing industries, which may experience a slower pace of new product introductions and upgrade efforts. Furthermore, small firms are less likely than larger firms to receive overpriced stock offers since they often are less attractive to larger firms, which are more prone to use overvalued stock.¹⁰¹ Why? Because small deals often do not provide the incremental revenue and profit to jumpstart growth for the larger firms. Therefore, purchases of smaller firms at reasonable prices provide a greater likelihood of realizing attractive financial returns.

Form of Payment Impacts Acquirer Returns

Pre-2009, empirical studies frequently concluded that announcement date returns to acquirer shareholders were negative when the acquirer and target are publicly traded and the form of payment consists mostly of stock. Why? Publicly traded acquirers tend to issue stock opportunistically when they believe their shares are overvalued, because they can issue fewer new shares resulting in less earnings dilution. Investors treat such decisions as signals that the stock is overvalued and sell their shares when the new equity issue is announced, causing the firm’s share price to decline. Moreover, acquirers using overvalued stock tend to overpay for target firms making it difficult to recover the premium paid by realizing synergy.¹⁰² The combination of these factors, so the argument goes, made most stock deals unattractive for acquirer shareholders. While acquirer firms may be able to convince target firm shareholders to accept overvalued shares, there appears to be little evidence according to one recent study that they can do so frequently.¹⁰³

While the value of acquirer shares can be ambiguous (i.e., over or undervalued) to investors, the value of cash is not. Acquirers using cash to purchase the target firm are less inclined to overpay as it can be more obvious to investors. Such acquirers often exhibit better long-term share price performance than do those using stock.¹⁰⁴ Investors interpret the use of cash as a signal that the acquirer’s stock is undervalued and bid up the acquirer’s share price.

Post-2009, acquirer returns, as noted previously, have improved significantly.¹⁰⁵ Cash deals often show positive returns and stock deals no longer destroy value. The magnitude of the decline in acquirer shares (and in turn investor wealth) in stock deals appears to be overstated. The majority of the decline in acquirer shares on the announcement date may be related more to merger arbitrage activity than to investors believing the shares are overvalued. About 60% of the sharp decline in acquirer shares on the announcement date may reflect short selling as arbitrageurs buy the target’s shares and short the acquirer’s.¹⁰⁶

The decline in acquirer share prices in stock-financed deals is more likely with transactions in which the acquirer is subject to high rather than low investor scrutiny.¹⁰⁷ Because deals can be highly complex and vary depending on terms and conditions, investors may not be paying sufficient attention to the extent of the acquirer’s stock overvaluation. When investor attention is low (as measured by acquirer share trading volume around the announcement date) acquirer share price reductions may not incorporate the full effects of overvaluation. However, the acquirer’s share price may continue to decline post acquisition as investors recognize the full extent of the overvaluation.

Why would target shareholders accept overvalued acquirer shares? They may agree to such payment terms because in share exchanges the requirement to pay capital gains taxes may be deferred until the target shareholders sell their shares, the takeover may be too big for the acquirer to finance with cash, and overvaluation may not be obvious. Moreover, target firm shareholders may believe the likely synergy resulting from the merger is substantial enough to offset the potential for the overvalued acquirer shares to decline over time¹⁰⁸ and the use of acquirer shares may reduce the leverage of the combined firms. The latter factor recognizes that the postmerger risk associated with acquirer shares reflects the combined leverage of both the target and acquiring firms. Overvalued acquirer shares may be justified if their issuance will result in a reduction in the leverage (i.e., a lower debt to total capital ratio) of the combined firms.¹⁰⁹ The resulting risk reduction may reduce or eliminate the overvaluation of the acquirer shares.

Institutional and legal differences (as well as the concentration of equity ownership) among countries offer contrary results making generalizations problematic. For example, on average publicly traded Chinese acquirers realize positive abnormal rates of return on announcement dates, and their excess returns tend to be substantially higher in non-cash deals.¹¹⁰ Why? In China, a 20% capital gains tax is levied immediately on a target’s shareholders when they are paid in cash. Consequently, target shareholders may be willing to accept a lower purchase price to benefit from tax deferral. Furthermore, equity-financed deals in the European Union often display higher acquirer returns than those using cash due to the existence of large block shareholders, whose active monitoring tends to improve the acquired firm’s performance.¹¹¹ Such shareholders are less common in the US.

Announcement-period gains to acquirer shareholders tend to dissipate within 3–5 years, even when the acquisition is successful, when stock is used to acquire a large public firm. These findings imply that shareholders, selling around the announcement dates, may realize the largest gains from either tender offers or mergers. A tendency for target firms to manage pre-merger earnings also may explain their underperformance in the years immediately following a takeover, even when acquirers use cash rather than equity. Targets may deliberately over-accrue revenue and under-accrue expenses during the year prior to takeovers in order to boost reported earnings used by the acquirer to value the target firm.¹¹² In cash transactions, the full cost of such earnings management is borne by acquirer shareholders who may see their shares decline in value as generally accepted accounting principles are accurately applied in future years, while target shareholders having received cash at closing are unhurt.¹¹³

Firm Specific Characteristics May Outweigh Deal Specific Factors

Acquirer characteristics can explain to a greater extent than deal specific factors (e.g., form and timing of payment) the variation in financial returns to acquiring firms.¹¹⁴ While a growing literature using increasingly larger and more diverse samples over the last three decades has identified a number of determinants of acquirer performance, the overall variation in acquirer returns remains largely unexplained. Not surprisingly, acquirers displaying superior managerial ability, particularly in highly uncertain environments, achieve higher abnormal financial returns.¹¹⁵ In addition, a firm’s organizational deal making skill and knowledge residing in an in-house corporate development team charged with screening deals, performing due diligence, and undertaking most of the analysis underlying acquisition decisions can boost returns. Another factor is the acquirer’s performance relative to the target’s. Acquirers experience higher positive announcement date returns when they have significant growth opportunities and acquire firms with lower growth opportunities.¹¹⁶ Such acquirers can divert the target’s resources that were supporting poor investment opportunities to supporting more attractive ones.

Other factors impacting acquirer financial returns could include a firm’s time-tested postmerger integration process, specific industry or proprietary knowledge, or accumulated experience. Successful acquirers tend to internalize the M&A process such that continuing success is not totally dependent on the leadership at the top and the deal structure employed.