REVIEW2.1IntroductionThischapter provides a review of the related theoretical and empirical literatureon mergers and acquisitions. The theoretical part consists mainly of providingsome theories of M&As and reasons forundertaking M&As. The empirical part reviews some recent researches andconclusions on the subject.
2.2Definition and types of mergers ArthurR.Wayes (1963) defined merger ,also known amalgamation, as being the process bywhich two or more companies come together under a single control. On the otherhand he defined acquisition as the actof acquiring effective control over management and assets of another companywithout the need for combinating the companies under a common control.
Horizontal,vertical and conglomerate are the three main types of M&As.1. HorizontalMergers HorizontalM&As combine two similar organizations in the same industry.
HorizontalM&As are normally motivated by a desire for greater market power, forexample Nissan has acquired a 34% stake in Mitsubishi. The acquisition will enableNissan to get a better access to Mitsubishi’s extensive Asian market and reducepotential duplication costs of Nissan attempting to set up dealerships acrossthe area. Horizontal M’s are highly regulated by competition authoritiesso companies cannot create a monopolistic scenario, for example, the UScompetition authorities prohibited the merger of AT&T and T-Mobile as itwould have created the largest US mobile operator and taken a huge marketshare. One recent example of a vertical M&A took place between AOL and TimeWarner. Through this business transaction Time Warner supplied information toconsumers via CNN and Time magazine whilst AOL shared such information throughtheir internet business.2.
VerticalMergersAvertical M&A takes place between two companies that has a buyer seller typerelationship and combine under a single ownership. For instance, a manufacturermight decide to merge with a supplier as an example. These companies aregenerally at different stages of production. The main goal of vertical mergeris to improve efficiency or reduce costs.3. ConglomerateMergersA conglomerate M&A appears when two ormore companies in different markets join to form a single company.
Thesecompanies are generally not competitors for example the merger between Proctor& Gamble, a consumer goods company and Gillette, a man’s personal carecompany in 2005. The conglomerate M can be seen as a diversificationstrategy allowing the companies to exploit new markets.These3 different types of mergers can take place in different ways that is mergersby absorption, amalgamation, takeover, exchangereconstruction and group holding. Merger by absorption involves theacquisitions of an existing company by another company. It is a situationwhereby a bigger company purchases the assets of a smaller company, as distinctfrom acquiring its share capital. The second way is by amalgamation. It occurswhen a new company is formed to takeover an existing company as the existingshareholder receive share in the company, the old company is thereforeliquidated.
Takeover is another way ofmerger by the purchase of controlling interest in one company by anothercompany. It does not involve purchase of assets of the target company but mereacquisitions of shares of such company. ExchangeReconstruction occurs when a new company emerged to takeover an existingcompany, the implication here is that due to financial, the structure and bookvalue of its assets and liabilities. This is normally carried out to facilitatebetter trading of operation. Groupholding is another situation of merger whereby new company may be formed toacquire majority of equity or shareholding of various companies and the willthen become the subsidiary of new holding company.2.
3Theories on mergersThemost popular theories on M are the neoclassical theory, agency theory,behavioral theory and signalling theory. 2.3.1Neoclassical theoryIn the concept ofmerger and acquisitions, neoclassicaltheory defines the M activity based upon the view of value maximization.A M deal should generate economic gains to both companies or at leastgenerate non-negative returns to add value for shareholders (Baradwaj 1992). In other words, M transactionsshould help companies create synergy. Synergy is achieved when the value of apost-merger company is greater than the combined value of each individualcompany before M transaction. Gaughan (2011) divided synergyinto 2 types namely are operating and financial synergy.
Operating synergy can be achieved through revenue enhancement or cost-reduction.Revenue enhancement refers to new opportunities that both companies may havewhen they are combined. For instance, by engaging into M transactions,companies are able to get benefits from reduced competition and higher marketshare. As a result, companies will have greater pricing power and earn greatermargins and operating income. Operating synergy can come from Mtransactions between two companies with two functional strengths such as goodproduct line and good marketing skills. Cost reduction canbe achieved through economies of scope, economies of scale, or reductions inassets.
Economies of scale refer to the reduction in cost per unit byproduction of larger size or scale of products. In addition, cost reduction canbe achieved through specialization of labour and management, efficient use ofcapital equipment, but this might not be possible if companies produce at lowoutput levels. This theory assumes assume that managers maximize profits orshareholder wealth and thus that mergers increase either market power orefficiency. It is also based on the assumption of a rational economic man withtotal information. 2.
3.3 Agency theoryIn contrast to neoclassical theories with the aim ofmaximizing the shareholder wealth, agency theory states that managers will actin the ways that maximize their own interests. Therefore, thisleads to the problem that the managers who are working as agents for the shareholdersmay have some conflicting interests. This is because some managers are interestedin the actions that provide them with extra power and prestige such as growth,size and diversification, whereas the shareholders are more likely to beinterested in the profitability of their firm as well as the increase in theirstock prices. Therefore, theacquirers’ management will purposely overpay for takeovers to maximize theirown wealth and corporate growth rather than maximizing shareholders’ wealth (Seth 2000) 2.3.4 Behavioural theoryThe behavioural theory or its hypothesis is morefocused on correlation between merger activity and stock market valuation. Asper behavioural theory, merges and acquisitions occur because of overvaluedmarkets and managerial timing.
The behavioural hypothesis assumes that mergerwaves are the result of overvalued markets and managerial timing (Eckbo, 2010).Here, managerial timing refers to time horizon in which decision regardingmerger and takeover by management takes place. Kropf andViswanathan (2004) have stated that such overpriced stocks of bidders are acceptedby target management in the span of short time span making assumption ofsynergies. Such overvaluation and timing lead to merger activities.
2.3.4 Signalling theoryThe signalling theory occurs because of marketimperfection and means that managers have access to better information than theremaining shareholders and may act from it. The signals that management sendsout can illustrate the future direction of the firm and which results thecompany faces. The market is in need of information and reacts not only on whatthe management communicates but also on how it performs. Managers can management sends signal to the market of any potentialM transactions which can influence expectations of the investors.
Ifthere is a strong confidence in the management and the information about thetransaction is explicit, it should be reflected in the reaction of theinvestors. If the signals are interpreted by the market as the management hasan optimistic belief in the future, this should cause the stock price rise.This is also true for the reverse, when there is pessimistic belief in thefuture the opposite reaction is expected.2.4 Merger Motives 2.3Empirical Evidence In the past decadenumber of studies had been conducted on the topic of merger and acquisition, andtheir effects on profitability, leverage and on share prices.
(ARSHAD, 2012) consideredM as a strategy to gain profitability, avoid insolvency, maximizingreturn on assets and improving asset quality.The empirical studies looking at post-mergerprofitability have mainly used data concerning stock market returns andaccounting ratios to assess the effects of M on firms’ performance. Infact, Bruner (2004) identified four research approaches namely event studies,accounting studies, survey or clinical studies.
Clinical studies are used dueto a smaller number of observations and an inductive research is conducted withthe objectives of revealing new patterns and behaviours to managers. Researchershad done many studies on M&As and these studies came with differentresults. For instance, Kemal (2011) found that the effects of M&Asactivities on acquiring firms caused a worsening of financial ratios especiallyliquidity ratios, along with a decline in share prices. Chatterjee (2011) alsonoted a reduction in share prices which could be the result of direct andindirect acquisition costs.
Pandit and Srivastava (2016) studied the effects ofmergers by interviewing ten managers of merged companies and by analysingsecondary data of financial ratios. Oleyede and Adedamola (2012) used ratio analysis withpaired sample test to find the effects on firms’ performance. They concludedthat there was a significant effect in ROA and secondly there was a significantimpact on profitability in conglomerate sector as compare to a very smallimpact in manufacturing sector. Pervan (2015) studied the impact of M on company’sperformance.
The research targeted only companies which continue to operateindependently after the takeover. He used a sample of 116 companies acquiredbetween 2008 and 2011.Three different measures of profitability namely returnon assets (ROA), return on equity (ROE) and profit margin (PM) were used. Theresult showed that there was no significant difference between pre-merger andpost-merger, the costsof the acquired companies weren’t lower after companies engaged in M andthe majority of acquisition were carried out by domestic firms. Kurui (2014)undertook a study on the relationship between M on the financialperformance of listed firms at the NSE using descriptive design. The populationconsisted of 10 firms which participated in the M between 2000 and 2013.This study looks at share price reaction and not financial performance asmeasured by ROA during the pre and post-merger period.
The study revealed founda positive relationship in the post-merger period. Harford,Klasa and Walcott (2009) made a suggestionthat acquiring firms use M as a vehicle to move their leverage ratiostowards target levels. They hypothesize that, when managers of acquiring firmsmake decisions on the method of payment for the M, they incorporate howthe M transaction changes the firm’s target leverage. They argue that, iffor example, an underleveraged bidder aims to move its leverage ratio towardstarget levels, it would finance the M&A with debt, rather than with equity.Consistent with their prediction, they find a significantly positiveassociation between the merger-induced changes to the acquirer’s actual andtarget leverage ratios. They interpret this finding to imply that when managersof bidding firms make decisions on how to finance large M, theyincorporate more than two-thirds of the change in the merged firm’s targetleverage.Pazarskis et al.
(2006) examined the impact of mergerand acquisition transactions on the operating performance of 50 acquiring firmsthat were involved in domestic and international acquisitions in Greece. Theyconducted their study by examining some of the financial ratios of thecompanies over a time period of three years pre-acquisition and three yearsafter the acquisition. After comparing the means from the sum of each companyratio for the pre-acquisition years and post-acquisition years, the results ingeneral show a significant decrease in the profitability and solvency ratioswhereas there are insignificant changes in the liquidity ratios.
Similarly, Mantravadi and Reddy (2008) studied theeffect of mergers on the operating performance of acquirer firms involved indomestic mergers in India for a sample of 68 mergers between 1991 and 2003. Thestudy also undertook to examine whether the type of industry had any impact onthe operating performance of acquirer firms. They examined three-year pre- and three-yearpost-merger financial ratios. Their results revealed that all the mergers in thesample showed a decline in the operating financial performance after themergers, since there was a decline both in the profitability ratios and returnson net worth and invested capital. Therefore, the full sample showed a negativeimpact of mergers on the performance of acquirer firms in terms of profitabilityas well as returns on investment. Furthermore, they found that the type of industry hadan impact on the changes in operating performance of acquiring companies afterthe merger, since they found different results for merger samples in differentindustry sectors in terms of their impact on operating performance, althoughsome of the differences were not statistically significantIsmail, Abdou, and Magdy (2011) examined a sample ofnine Egyptian companies in the construction and technology sectors that wereinvolved in domestic merger and acquisition deals during the period 1996 to2003. The main reason for conducting their study was to check whether there wasany significant improvement in the operating performance following mergers andacquisitions and whether there was an impact from the industry sector on thecompanies’ operating performance.
In order to examine the operating performance of firmsthey compared pre- and post-merger performances of merged firms usingfinancial-based measures consisting of 26 ratios. The results from comparingthe operating performance ratios of the whole sample in the pre- andpost-merger periods didn’t show any significant difference in the average meanof profitability, efficiency, solvency and cash flow position. When the sector levelwas examined, the results showed that mergers and acquisitions in theconstruction sector have resulted in significant improvements in the firms’profitability whereas there were no significant changes in the efficiency,liquidity, solvency and cash flow position. In the technology sector, theresults didn’t show any significant improvements following mergers.
However,this study suffers from the very small sample size consisting of only 9companies. Recently, Rashid and Naeem (2017) examined the impactof mergers on financial performance of firms in Pakistan during 1995-2012. Theytook a sample of 25 merged and acquired firms that are listed on Pakistan StockExchange It was the first timethat empirical Bayesian method was used to analyse the impact of mergers oncorporate financial performance. The result of the regression analysisconducted revealed that that mergers do not have any significant impact on theprofitability, liquidity, and leverage position of the firms. However, theresult also show that mergers have a negative impact on the quick ratio ofcompanies.
Andreou, Louca, and Panayides (2012) analysed the valuationeffects of merger by taking a sample of 59 merger deals in the transportationindustry for the time period of 1980 to 2009. They concluded that mergersbenefit both target and bidder firm’s shareholders however the target firm’sshareholders enjoy most of the synergistic gains. They also found that verticalmergers create greater valuation effects than horizontal mergers. Arikan andStulz (2016) compared different theories behind M&As. Their findings wereconsistent with neoclassical theories showing that acquirer firms werebetter-off and were creating wealth through acquisitions of non-public firms.
Their findings were also consistent with agency theory because older firmsproved that older firms had negative stock reaction for public companies.Researchers also conducted event study test to findwhether M&As affect share prices. For instance, Carl B.
McGowan (2008)examined the effects of merger announcements on share prices using event studymethodology. He took 61 daily closing prices of 2 banks namely the ArabMalaysian Bank Berhad and the Hong Leong Bank Berhad. The results from eventstudy showed that merger announcements are treated as positive information bythe market. He concluded that there might be information leakage or that themarket could easily anticipate the completion of a merger. Similarly, Adnan and Hossain (2016)investigated the impact of M&A announcement on share prices. An event studymethodology together with a sample of 50 acquired companies were used.
Theresult showed that the CAAR value was increasing this is may be for the reasonthat leakage of information or the anticipation of merger.