EF4312 Mergers and Acquisitions Chapter 3 Alternative Perspectives on Mergers

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EF4312 Mergers and Acquisitions Chapter 3
Alternative Perspectives on Mergers
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Learning Objectives

• At the end of this chapter, you should be able to
  understand
• The different perspectives on M A, their focus
  and the major elements
• The rationale for merger decisions under each
  perspective
• The potential outcomes of merger decisions under
  each perspective
• Sources of value and risk in mergers and
• M A as a process rather than as a mere
  transaction

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Perspectives

• Comprehensive understanding of M A as a process
  requires approaching the subject from different
  perspectives
• Five perspectives are important to give a rounded
  view of M A
• Economic
• Corporate strategy
• Finance theory
• Managerial and
• Organizational

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Objectives for M As

• Long-run profit maximization is the objective of
  firms in pursuing their competitive strategies
• M A strategies of firms are guided by this
  objective
• The ability of a firm to compete depends on the
  market structure competitive, oligopolistic or
  monopolistic
• The economic perspective on mergers deals with
  how costs and market power form the basis of
  competition

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Horizontal Mergers

• Firms undertake mergers to alter the competitive
  structure of their industry in their favour
• Three types of economies achieved through mergers
  can lead to cost reduction
• Scale economy reduction in unit cost of a
  product by producing it on a larger scale in a
  single period
• Learning economy reduction in unit cost achieved
  through efficient learning about the production
  process by increasing cumulative production of a
  product over several time periods

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Horizontal Mergers

• Scope economy reduction in total cost of
  producing and selling several products by a
  multi-product firm compared to the aggregate cost
  when each product is produced and sold by an
  independent firm
• These economies may be achieved by mergers of
  firms selling the same or related products
  (horizontal or related mergers)

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Vertical Mergers

• Firms which are in a vertical relationship as
  buyer and seller can also merge to save costs of
  arms length transaction by merging (vertical
  mergers)
• Vertical mergers, in addition to saving
  transaction costs, can also enhance market power
  because of control over sources of inputs or
  distribution channels

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Competitive Strategies

• Porters 5-forces model describes the competitive
  structure of an industry. A firm faces
  competitive pressure from
• Existing competitors
• Threat of new competitors selling the same
  product
• Threat of substitute products
• Suppliers negotiating power
• Buyers negotiating power

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The Key Structural Features of Industries

• Strength of competitive force
• Industry profitability
• The goal is to
• Identify its position in the industry
• Can best defend itself
• Can influence them in its favor

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Competitive Pressure

• Critical strengths and weaknesses
• Its positioning in its industry
• Clarifies the areas where strategic changes may
  yield greatest payoff
• Opportunities
• Threats

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Forces Driving Industry Competition
POTENTIAL ENTRANTS
Threats of new entrants
Bargaining power of buyers
Bargaining power of suppliers
INDUSTRY COMPETITORS Rivalry among Existing
Firms
BUYERS
SUPPLIERS
Threat of substitute products or services
SUBSTITUTES
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Five Competitive Forces

• Barrier to entry
• Economies of scale
• Declining in unit costs of a product as volume
  increases, functional area
• Product differentiation
• Customer loyalties
• Risk of building up brand name
• Example baby care products, over-the-counter
  drugs, cosmetics, and investment banking

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Five Competitive Forces

• Barrier to entry
• Capital requirement
• Large financial resources
• Switching costs
• Investment in new hardware
• Access to distribution channels

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Five Competitive Forces

• Barrier of entry
• Cost disadvantages (independent of scale)
• Proprietary independent of scale
• Favorable access to raw materials
• Favorable locations
• Government subsidies
• Learning or experience curve
• Government policy
• Regulated industries like railroads, liquor
  retailing and utilities

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Five Competitive Forces

• 2. Rivalry among existing competitors
• Cutting price
• Slow industry growth
• High fixed or storage costs
• Exist Barriers
• 3. Pressure from substitute products

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Barriers and Profitability
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Five Competitive Forces

• 4. Bargaining power of buyers
• Concentrated sales
• Significant fraction of a buyers costs
• Products are standard or undifferentiated
• Few switching costs
• Low profits
• Backward integration
• The buyers has full information

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Five Competitive Forces

• 5. Bargaining power of suppliers
• A few company dominate
• A few substitute products
• Not an important customer of the supplier group
• Suppliers product is important to the industry
• Suppliers products are different
• Switching cost
• Threat of forward integration

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Analysis

• Positioning the firm so that its capabilities
  provide the best defense to the existing away of
  competitive forces
• Influence the balance of forces through strategic
  moves, thereby improving the firms relative
  position or
• Anticipating changes

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Three Generic Strategies

• Cost leadership
• Differentiation
• Focus

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Three Generic Strategies
Strategic Target
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Cost Leadership

• Efficient-scale facilities
• Cost reduction from experience
• Tight cost and overhead control
• Requires a high market share
• Favorable access to raw materials

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Differentiation

• Unique
• Design or brand image
• Technology
• Features
• Customer service

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Focus

• Focusing on a particular buyer group, segment of
  the product line, or geographic market

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Other

• Stuck in the middle

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Determinants of Strength of the Five Competitive
Forces
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Game Theory

• Firms may undertake mergers to alter one or more
  of the five competitive forces in their favour
• When one firm seeks to alter the competitive
  structure, its rivals may counteract through
  similar competitive moves
• Game theory models the moves and countermoves of
  competitors when competitive forces undergo
  change or are changed by the actions of the
  competitors themselves

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Profits to Tweedledum and Tweedledee when they
play the capacity game (profits in 000)
Source Adapted from D. Besanko, D. Dranove and
M. Shanley, Economics of Strategy (New York John
Wiley Sons, 2000), pp. 3640
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Decision tree in a sequential capacity expansion
game (profits in 000)
Source Adapted from D. Besanko, D. Dranove and
M. Shanley, Economics of Strategy (New York John
Wiley Sons, 2000), p. 37
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Game Theory

• The game stops when the players reach Nash
  equilibrium, any move from which leaves the
  player worse off.
• Industry clustering of mergers described in
  Chapter 2 resembles a competitive game
• In recent years M A in industries like oil and
  pharmaceuticals resemble moves and counter-moves
  of a sequential competitive game

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Game Theory

• Game theory implies that me-too mergers may leave
  both the first movers in acquisitions and copycat
  movers no better off or even worse off given the
  cost of engaging in the game
• Strategy perspective places M A in the context
  of different competitive strategies of firms

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Alternative method

• An alternative to Porters competitive strategy
  model is the resource-based view (RBV) of
  competitive strategy.
• Under RBV, firms compete on the basis of their
  resources and capabilities
• Resources include tangible, intangible and human
  resources
• Capabilities are organizational capabilities or
  core competencies derived from functional
  capabilities and organizational learning about
  how to integrate and leverage them

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Organizational Resources of a Firm
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Classification of Organizational Capabilities
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Key Concepts and Points

• Sustainable competitive advantage depends on the
  firms capacity to preserve its superior
  resources and capabilities
• Firms can erode their rivals competitive
  advantage through poaching, imitation,
  replication and substitution of their resources
  and capabilities
• Mergers allow firms to access resources and
  capabilities of other firms quicker and more
  cost-effectively than through organic development

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Key Concepts and Points

• Capability acquisition and integration raises
  problems in strategic evaluation, valuation,
  negotiation and post-acquisition integration.
• Merger is a dynamic process of resource and
  capability accretion for competitive positioning
• Value chain, conceptualized by Porter, represents
  the breakdown of a firms revenue into costs
  associated with various activities from sourcing
  of inputs through production to sales and the
  value addition in the form of profit

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Key Concepts and Points

• Merger of two firms requires integration of their
  value chains and identifying which activities may
  be combined synergistically to create value
• Value chain activities are combined in different
  ways in different merger types
• Finance theory perspective of mergers rests on
  shareholder wealth maximization as the paramount
  goal of mergers
• Managers are agents and shareholders are
  principals in the agency model of the firm

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Agency problem

• Managers may pursue their self-interest to the
  detriment of shareholder interests and
  shareholders bear agency costs
• Internal corporate governance constrains
  managerial self-interest pursuit
• The market for corporate control (MCC) imposes
  external constraints on managers and is
  represented by hostile takeovers of firms that
  fail to serve shareholder interests

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Agency problem

• Corporate governance may make the market for
  corporate control as a disciplinary device
  redundant (the substitution effect) or facilitate
  the operation of the MCC (complementary effect)
• Effective MCC depends on the regulatory regime
  that governs hostile takeovers, which varies from
  country to country
• A real option is an option on a real investment
  in physical or intangible assets such as
  production facilities or research and development
  and not on financial assets

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Other Motives

• Real options are exploratory investments that may
  lead to future growth opportunities
• Many acquisitions are real options and may be
  valued using option valuation models
• Real options like acquisitions are difficult to
  evaluate because of their speculative nature but
  are increasingly important
• The managerial perspective of mergers is closely
  linked to the agency model

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Other Motives

• Managerial motives critically determine the
  incidence, rationale, type, deal structure and
  outcome of mergers
• Behavioural aspects of managerial decisions such
  as hubris, risk-avoidance are part of managerial
  motives
• Organizational perspective considers the
  decision-making process as not entirely rational
  but subject to pressures and pulls of a political
  nature

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Other issues

• Organizational management and decision processes
  influence both what acquisitions are made, how
  acquisition deals are done and how acquired firms
  are integrated with the acquirer.
• Organizational perspective raises soft issues
  that the rational models assume away

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Comparison of Different Perspectives on Mergers
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The Anti-trust Guidelines

• Concentration tests
• Economics of the industry
• How dangerous is Microsoft, Economist July 1995
• Microsoft held 80 of its market
• Market shares exceeded 20
• ? investigation

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1982 Guidelines

• Herfindahl-Hirschman Index (HHI) a
  concentration measure based on the market shares
  of all firms in the industry
• A sum of squared market shares of each firm in
  the industry

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For Example

• 10 firms in the industry and each held a 10 of
  market share
• HHI (10)2 10 1,000
• 1 firm held 90 and the other 9 firms held 1
  each
• HHI (90)2 9 (1)2 8,109
• Note Now having a dominant firm greatly increase
  the HHI

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HHI

• A merger in an industry with a resulting HHI of
  less than 1,000 is unlikely to be investigated
• A HHI between 1,000 to 1,800 is considered to
  represent moderate concentration
• Investigation depends on the amount by which HHI
  increased over its pre-merger level
• An increase of 100 or more may trigger an
  investigation
• An industry with a post merger HHI above 1,800 is
  considered a concentrated market.

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HHI