Mergers and acquisitions in Poland value creation in different types of transactions and the impact of culture on shareholders wealth

Mergers and acquisitions in Poland value creation in different types of transactions and the impact of culture on shareholders wealth Master Thesis MSc in Finance and International Business Authors: Sebastian Nawrocki (SN) Aneta Wielgus (AW) Academic Advisor: Jan Bartholdy Department of Business Studies Aarhus School of Business, University of Aarhus February 2011 0

Table of Contents 1. Introduction (SN & AW)... 1 1.1. Definitions... 6 1.2. Problem statement... 8 1.3. Aim of the paper... 9 2. Theoretical foundations of merger waves (SN)... 9 2.1. Empirical evidence on merger waves... 12 2.2. Summary of theoretical foundations and empirical evidence on merger waves... 15 3. Motives for merger and acquisition transactions (AW)... 16 3.1. Growth... 16 3.2. Synergies... 17 3.2.1. Revenue-enhancing synergies... 17 3.2.2. Cost-reducing synergies... 18 3.2.3. Financial synergies... 18 3.2.4. Diversification... 19 3.2.5. Better management... 20 4. Shareholders rates of return in M&A transactions (SN & AW)... 20 4.1. Research approaches to M&A profitability measurement (SN)... 24 4.2. Review of empirical evidence (AW)... 27 4.2.1. Empirical evidence on short term wealth effects... 28 4.2.2 Empirical evidence on long-term wealth effects... 34 4.2.3. The impact of cultural values on M&A wealth effects... 35 4.2.4. Summary of empirical study on M&A wealth effects... 37 4.3. Research hypothesis (AW)... 37 4.3.1. Impact of different types of merger on value creation... 38 1

4.3.2. Impact of cultural values on shareholders wealth... 39 5. Research methodology and data description (SN & AW)... 39 5.1. Abnormal rates of return (SN)... 39 5.2. Statistical tests used (SN)... 41 5.2.1. Parametric test cross-sectional dependence... 42 5.2.2. Testing cultural effects of M&As... 44 5.3. Data description and descriptive statistics (AW)... 45 5.3.1. Wealth effects... 45 5.3.2. Cultural effects... 69 6. Empirical evidence (hypotheses testing)... 75 6.1. Domestic vs. Cross-border M&As do they create value to shareholders (SN)... 75 6.2. Horizontal vs. Vertical M&As do they create value to shareholders (AW).... 83 6.3. Cultural aspects cultural distance and its effect on shareholders wealth (SN)... 90 7. Conclusion (SN & AW)... 92 8. References... i List of tables... vi List of figures... viii 2

1. Introduction The field of mergers and acquisitions (M&As) is again entering the phase of rapid development and becomes more and more important part of corporate finance and strategy. One can observe an increasing number of different types of consolidation processes, merger waves became longer and the gaps between them shorter. The latest M&A waves spread not only across the United States of America but also across Europe, Asia and Latin America, becoming truly global phenomenon. Historically, the literature distinguishes five periods characterized by large number of M&A transactions i.e. merger waves. The first four waves were predominantly present in the United States of America and included periods of 1897-1904, 1916-29, 1965-69, and 1984-89. The fifth wave of 1993-2001 was not only present in the USA but substantial part of its transactions was made in Europe. Some authors like Gaughan (2010) and Martynova & Renneboog (2008a) distinguish sixth merger wave which started around 2004 and was ended by the financial crisis at the end of 2007. The cyclical character of M&A waves phenomenon shows Figure 1. Figure 1 Number of announced M&A transactions in the USA. Source: Martynova & Renneboog (2008a) Different merger waves were triggered by different factors and their outcomes in terms of transactions profitability were not the same. However, despite many 1

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 $ billions differences one can show some similarities, e.g. each wave was preceded by an economic or technological shock which took place during booming economy and rise on capital markets. Furthermore, each wave ended with economic downturn and fall on capital markets. Figure 2 shows the value of M&A transactions which took place during last three waves. Figure 2 Value of announced M&A transactions during the period of 1981-2007. 1 800 1 200 600 0 Europe US Year Source: http://eu.wiley.com/wileycda/section/id-305542.html, accessed 04.05.2010 The first merger wave was characterized by large number of horizontal transactions and consolidation of such industries as mining, metal or petrochemical. The wave resulted in creation of large number of monopolies, e.g. U.S. Steel which controlled about 75% of industry s production capacity in the USA. The introduction of antitrust law in the USA resulted in a shift from horizontal to vertical M&A transactions. During the second merger wave the first oligopolies and conglomerates were born. Smaller companies, which were not part of monopolies formed during first wave, were merging in search of economies of scale and better market position against the dominant companies. During second merger wave such companies as IBM and General Motors were formed. The wave ended in 1929 along with the beginning of the Great Depression. 2

The Great Depression of the 1930s, the Second World War, and the following reconstruction delayed the third merger wave until 1960s. The wave is often called the era of conglomerates, because at that time majority of target companies were operating in completely different business than acquiring companies. The main reasons for building conglomerates were diversification and entering markets with high growth potential not related to acquirer core business. The third merger wave reached its peak in 1968, and ended in 1973 when oil crisis caused a global recession. The number of mergers and acquisitions started to rise again from 1981. The economy started to recover from the recession, new financial instruments were introduced (e.g. junk bonds), and information technology started to develop in very fast pace. The fourth merger wave of 1984-89 was characterized by large number of hostile takeovers, the first mega-mergers took place, and large number of transactions was financed with debt leveraged and management buyouts were a common practice. After couple of years of lower M&A activity the number of transactions stared to rise from 1992. During that period the globalization of the world economy began, many technological innovations were introduced and deregulation and privatization processes started. The fifth merger wave was characterized by even larger transactions than in the fourth one and the expansion of the M&A activity from the USA to Europe and Asia. As an example of megamerger of that time one can take an almost $200 billion takeover bid made by British Vodafone for German Mannesmann. Moreover, a large number of deals of the fifth wave was crossborder, initiated by the companies looking for a way to cope with increasing competition on global markets. The fifth merger wave ended along with the economic crisis of 2000. The outcome of described above cycles was the transformation of the global economy from the one with huge number of small local players into the one with thousands of multinational corporations. Table 1 shows the top ten M&A transactions by value. 3

After a slowdown, since 2003 the number of M&As started to rise again. The companies from Eastern Europe, Asia, and Latin America became more important. Factors indicating the creation of the sixth wave include economic recovery after the dot-com crisis at the beginning followed by financial sector crisis of the late 2007 and early 2008 at the end. During the period of 2006-2007 the global value of M&A transactions increased by 23%, from $3.9 to $4.8 trillion, however during third quarter of 2007 the M&A activity slowed significantly. The US market suffered the most due to the crisis, while at the same time the emerging M&A markets grew by 43%, mainly thanks to Russia, China and India. 1 Gaughan (2010) indicates that the period of 2008-2009 was the time of recession on the M&A market, mainly due to weak credit market and unwillingness to lend. According to Bloomberg 2011 M&A Outlook, global M&A activity in 2010 increased in volume terms by 12% against 2009. Moreover, the total value of announced transactions as of the end of November 2010 amounted to $1.9 trillion. 2010 was the first year of increase in M&A activity after the stagnation of 2008-2009. According to Bloomberg 2011 M&A Outlook, financial market professionals are optimistic about the continuity of increase in deal-making activity in 2011. The summary of described above merger waves presents table 2. Table 1 Top ten worldwide M&As by value of transaction Acquirer name and country code Target name and country code Date announced Deal values th USD 1. Vodafone Airtouch plc GB Mannesmann AG DE 2000-02-04 194,759,649 2. America Online Inc. US Time Warner Inc. US 2000-01-10 181,950,000 3. RFS Holdings BV NL ABN Amro Holding NV NL 2007-05-29 112,233,622 4. Pfizer Inc. US Warner-Lambert Company US 2000-02-07 90,000,000 5. Royal Dutch/Shell Group NL The Shell Transport & Trading Co plc GB 2005-06-27 87,044,189 7. Comcast Corporation US AT&T Broadband LLC US 2001-12-19 72,000,000 8. Wells Fargo & Company Inc. US Wachovia Corporation US 2008-10-03 68,111,985 9. Pfizer Inc. US Wyeth US 2009-01-26 68,000,000 10. AT&T Inc. US BellSouth Corporation US 2006-03-06 67,000,000 Source: Zephyr Database, accessed 04.05.2010 1 Global M&A Outlook, 2008. World Economic Prospects, Oxford, p. 15. 4

Table 2 Summary of merger waves Wave 1 Wave 2 Wave 3 Wave 4 Wave 5 Wave 6 Period 1897-1904 1916-1929 1965-1969 1984-1989 1993-2001 2003-2007 Geographical scope USA USA USA, UK, Europe USA, UK, Europe, Asia USA, UK, Europe, Asia USA, UK, Europe, Asia M&A outcome Creation of monopolies Creation of oligopolies Growth through diversification Elimination of inefficiencies Adjustment to globalization processes Global expansion Industry relatedness Focus Focus Diversification Focus Focus Focus Industries Dominant source of financing/ means of payment Hydraulic power, textile, iron Steam engines, railways, steel Cash Equity Equity Electricity, chemicals Petrochemicals, aviation, electronics, communication technology Debt financed/ cash paid Communications/ information technology Equity n.a. Debt and cash finances/ cash paid Hostile takeover activity n.a n.a. None (US & UK) High (US and UK) None (Europe and Asia) Some (US and UK) High (Europe) None (Asia) Some Cross-border M&A activity n.a. n.a. n.a. Some Medium High Other specifics Events coinciding with beginning of wave Events coinciding with end of wave Economic expansion, industrialization, development of trading on NYSE, changes in technology Stock market crash, economic stagnation, beginning of the First World War Source: Martynova & Renneboog (2008a) Economic recovery after the market cash and the First World War, enforcement of antimonopoly law Stock market crash, beginning of the Great Depression Economic recovery after the Second World War, tightening of antitrust regime Stock market crash, oil crisis LBO, MBO, going private deals, and divestitures Economic recovery, changes in anti-trust policy, deregulation of financial services sector, new financial instruments and markets, technological progress in electronics Stock market crash Mega deals, divestitures Economic and financial markets boom, globalization processes, deregulation and privatization Stock market crash, 9/11 terrorist attacks Deal by private equity funds Economic recovery after the downturn in 2000-2001 Stock market crash, financial sector crisis (credit crunch) 5

1.1. Definitions For the purposes of this paper it is assumed that merger is a combination of two companies, which results in one of the merging companies ceasing to exist. Dominating company in the transaction retains its own legal personality and acquires all of the assets and liabilities of the other entity. Merger can also be understood as the inclusion and schematically presented as follows: A + B = A, where B is the company merged into company A. The consolidation will differ from the merger in such respect that the consolidated companies form a new entity. As a result of consolidation two parties of the transaction lose their legal status and become part of a newly established entity. In this type of transaction the shareholders of both companies receive shares of the new company in exchange for shares of companies that have been consolidated. Consolidation can be represented schematically as A + B = C. The term acquisition (or takeover) means the purchase by one company, usually economically stronger, shares or assets of another company, in order to gain control over it. The main feature of the acquisition is the transfer of rights to control and manage the business from one group of shareholders to another. In the case of acquisition of shares, acquirer not only can control the way the assets of purchased entity are utilized but also may dispose of his property. In the case of the acquisition by purchase of assets, the buyer does not receive ownership of the target company. The above terminology may be presented schematically as showed on Figure 3. It should be taken into account that in the literature these concepts are often used interchangeably and the distinction between mergers and acquisitions is blurred and mainly conventional. In practice it is often difficult to clearly classify individual transactions, and the case of nomenclature remains open. Moreover, since the essence of the consolidation processes is to change the control holder over the company it is increasingly often assumed that an acquisition is the basic transaction and a merger is regarded as its specific kind. 6

Figure 3 Types of transactions in consolidation processes Source: Gaughan (2007) For the purposes of this paper the division and definitions presented above are sufficient, as the most of the transactions included in the study is in nature the acquisition by purchase of shares. In business practice, the most common forms of transactions are horizontal, vertical and conglomerate mergers (Gaughan, 2007). Horizontal merger occurs when firms in the same industry, which directly compete with each other, combine. The examples of horizontal mergers include a merger of Exxon and Mobil in the petrochemical industry or Daimler-Benz and Chrysler Corporation in the automotive industry. The vertical merger is a combination of companies with the buyer-seller relationships. This type of merger may reach up or down the value chain, giving the acquiring company better access to material supplies or distribution networks. Conglomerate transactions can be defined as those where the merging firms are neither competing with each other nor are successive links in the value chain. Examples of such transactions may be the acquisition of the companies from the food industry such as General Foods (1985) and Kraft (1988) by tobacco company Philip Morris. A good example of conglomerate is General Electric, which is active in such industries as finance, energy and media. 7

1.2. Problem statement A growing number of mergers and acquisitions and cyclic accumulation of consolidation activities raise questions about the causes of such phenomena. There are two issues here: first, what leads to increased activity of firms in the market of control, and second, what motivates entities to conclude transactions. Moreover, if listed companies are the parties of the transaction, the announcement of merger or acquisition should be included in their share price (assuming market efficiency). If assumed that the acquisition decision is based on rational economic premises the transactions should lead to increased shareholder value, i.e. the increase in the share price. In practice the acquirer pays for the target more than target s market value and the acquirer s share price either slightly decreases or remains unchanged. Higher purchase price reflects the premium the buyer pays for the control over the acquired company as well as the expected synergies resulting from the merger. Poor market's reaction concerning acquirer s share value is usually caused by skeptical approach of the market to the declared synergies from the transaction. At the same time the target company shareholders typically gain above-average returns on the shares held. This is due to the premium received from the acquiring party. Moreover, research papers analyzing cultural aspects of M&As indicate that cultural proximity of merging parties results in higher shareholder returns. On the other hand when cultural distance between companies is relatively high the market corrects the returns downwards. In conclusion, in merger and acquisition transactions, the acquirer s shareholders do not receive above-average returns on their shares, the share price remains unchanged or slightly declines. On the other hand, the value of target s shares increases and the shareholders record above-average returns. Presented patterns of price changes occur on the day of transaction announcement assuming that the market is at least semi-efficient. Moreover, when merging companies share similar cultural values shareholders tend to benefit more from this kind of transactions. 8

1.3. Aim of the paper The aim of this paper is to investigate whether M&As create value to the shareholders of companies involved in such transactions. We will analyze M&A announcements of public companies quoted on Warsaw Stock Exchange during the period of 1998-2010. To check for wealth effects of M&A transactions we will look at abnormal stock returns at the announcement day. The analysis of abnormal stock returns prior and after the day of transaction announcement will also allow us to check for market efficiency. The identified transactions will be divided into two sub-groups, where we plan to check how the creation (or destruction) of value is distributed between acquirers and targets when domestic and cross-border transactions are analyzed, and if there is a different pattern of wealth distribution when horizontal and vertical M&As take place. Moreover, this paper will try to answer the question whether the cultural background of merging companies influences the shareholders value. The reminder of the paper is organized as follows. The next chapter reviews literature and empirical evidence on merger waves. Third chapter presents motives for M&A transactions. Chapter four reviews literature and empirical evidence on shareholders rates of return and formulates the research hypotheses. In chapter five, the research methodology and data used is described. Chapter six contains empirical evidence and the results of hypotheses testing, chapter seven summarizes the paper. 2. Theoretical foundations of merger waves The literature on merger waves suggests that there are two major groups of theories explaining the formation of merger waves. First group includes neoclassical theories while the second group includes behavioral theories. Neoclassical theories assume that managers maximize shareholders wealth, mergers create value and capital markets are efficient. Behavioral theories drop some of the neoclassical assumptions e.g. market efficiency and/or shareholders wealth maximization. Gugler et al. (2006) and Martynova and Renneboog (2008a) 9

categorized the most tested theories on merger waves into four groups. First group of tests is neoclassical and states that takeovers cluster due to industry shocks. Next three groups of models are behavioral and assume that merger waves are created by agency problems, irrational managerial behavior and valuation timing by management, respectively. First of the above mentioned hypotheses assumes that merger waves in different industries are caused by different shocks, such as economic, political, technological or regulatory. Moreover, the structure (the number and size of companies) of a given industry depends on available technology, laws in force and economic conditions. The economic shock usually occurs as rapidly growing demand and dynamic economic expansion. In order to meet the increasing demand companies have to develop internally (through investments) or externally (through takeovers). Because the companies response to changing market conditions should be as quick as possible majority will choose external development which is usually faster. The example of regulatory shock could be a shift of some legal barriers imposing restrictions on M&A activity in certain industry. Technological shocks usually occur as innovations or improvements which result in greater productivity in a given industry. During first and second merger waves such technological factors could include electricity or petrol engine, and during the fourth wave introduction of microchips and development of IT. Except for the shock factors described above, in order to make the takeover wave happen the overall capital liquidity is needed to ensure low transaction costs (Mitchell & Mulherin, 1996, Hartford, 2005). Another theory connected with the industry shocks hypothesis is a Q-theory of mergers. The theory is based on the Q ratio introduced by James Tobin. It measures the ratio of firm s market value to its replacement cost of capital. If the ratio is between 0 and 1 this means that the replacement cost of assets is higher than the company s market value i.e. company s shares are undervalued. Analogically, Q ratio above 1 indicates that company s shares are overvalued. The Q theory of investment states that the company will increase its investments along with growth in the Q ratio. Investments can include a purchase of individual assets, 10

such as machines or buildings, or a purchase of a whole company, along with its assets. Moreover, Q ratio can be seen as measurement of future growth opportunities. The industry shock changes the future growth prospects of different companies and triggers the flow of assets from low-q firm to high-q firms (Jovanovic & Rousseau, 2002, Martynova & Renneboog, 2008a). Shleifer and Vishny (2003) proposed an overvaluation hypothesis which states that the company s financial policy depends on the market valuations of itself and its competitors. According to the authors the number of M&A transactions will depend on the market valuation of merging companies. Moreover, it is assumed that capital market is not fully efficient, shares can be miss-valued, but managers are rational and are able to exploit market inefficiencies. In this model mergers and acquisitions are the result of arbitrage made by rational managers on inefficient markets. When a market overvalues stocks, acquisition of shares which are undervalued or less overvalued will be financed with overvalued shares, whereas when the majority of companies is undervalued acquisitions will be financed with cash. Large number of takeovers does not create value to shareholders. Therefore some theories try to explain this phenomenon by managerial self-dealing. Gugler et al. (2006) indicate that, managers utility increases along with the size of the company they manage. Such correlation is due to the fact that managers salary is often connected to company s growth rates and income, moreover, they receive so called psychic income related to running bigger business. Additionally, a factor that drives acquisitions is often a fear of being taken over and losing current position. Such empire-building tactics can be observed during booming markets which usually accompanies merger wave and are connected with access to free cash flows and agency problems (Jensen, 1986). In this case managers instead of returning cash flows to shareholders (by paying dividends or buying back shares) have an incentive to grow the business beyond its optimal size in order to derive personal benefits. Last group of theories explaining creation of merger waves suggests that managers irrational behavior is a dominant factor. Roll (1986) suggests that 11

managerial hubris leads to a large number of unsuccessful transactions. In his model overconfident managers overestimate the value of synergies and execute acquisitions that destroy shareholders value. Martynova and Renneboog (2008a) indicate that it is possible to explain M&A waves by connecting Roll s hubris hypothesis with herding. Herding means that managers tend to imitate actions of leaders in their industry. Therefore, after some successful M&A transactions in a given industry, other companies try to repeat the actions of competitors, not necessarily taking into account economic rationale of transactions. This way some M&As suffer from managerial hubris and herding which causes increased M&A activity with profitable transactions coming first and followed by value-destroying transactions. 2.1. Empirical evidence on merger waves Abovementioned factors which are crucial for the level of M&A activity are confirmed by a numerous studies. Mitchell and Mulherin (1996) tested the industry shocks hypothesis with respect to the fourth wave of 1985-89. The results of their study confirmed that the changes in the industries structures resulted from changing economic conditions (emergence of such financial innovations as junk bonds, increased international competition and high oil prices fluctuation). Very similar conclusions were drawn by Andrade et al. (2001). In the later research paper Andrade and Stafford (2004) added new evidence to the previous results by confirming a strong relationship between the industry shock and the fifth merger wave. They also concluded that the main aim of takeover activity of the 90 s was not restructuring of industries but growth. This was due to the fact that majority of transactions was made in industries with high growth potential, substantial level of profitability and almost full production capacity utilization. Hartford (2005) also confirmed the neoclassical theory of industry shocks. He compared it with the overvaluation hypothesis and stated that the first one better explains the cyclical character of M&A activity. Moreover, he concluded that the industry shock alone is not enough for merger wave to occur. The overall capital liquidity is needed which will allow for relocation of assets in the most efficient way. Jovanovic and Rousseau (2002) tested the Q-theory of mergers. In their paper they concluded 12

that first, second, fourth and fifth waves were caused by the opportunity of profitable relocation of capital, when high-q firms were acquiring low-q firms. Moreover, if Q ratio is treated as an indicator of management efficiency (companies which are better managed have higher ratio of market value to replacement cost of capital) it will turn out that companies under good management were acquiring those under poor management. This insight is confirmed by Servaes (1991) who analyzed takeovers of the 1972-87 period. The results of his study showed that higher shareholder gains from M&A transactions where present when low-q firm was acquired by high-q firm. On the other hand Rhodes-Kropf and Robinson (2008) showed that merging companies tend to have similar Q ratios. Their study indicated that consolidating companies have complementary resources. They suggested that an industry shock causes change in complementarity of resources which are controlled by different companies. Therefore, the shift in the resource complementarity triggers increase in the M&A activity. There is still quite little empirical evidence on the overvaluation hypothesis. Shleifer and Vishny (2003) made a synthesis of the previous research on this topic and concluded that during the merger wave of the 80 s the majority of acquisitions was related to undervalued companies (or their parts) and was financed with cash. On the other hand, during the stock market boom of the 90 s overvalued companies were acquiring those undervalued (or less overvalued) paying in stocks. The common problem with testing the overvaluation hypothesis is the selection of a proper measure of overvaluation. The most often used market-to-book ratio was sometimes substituted by forecasted profits or other accounting ratios. In later research paper Dong et al. (2006) found that acquirers are usually more overvalued than targets. Moreover, they showed that probability of financing the deal with stocks increases with the level of acquirer s overvaluation, and probability of hostile takeover decreases with the level of target s overvaluation. Furthermore, Rhodes-Kropf et al. (2005) showed that acquirers who finance the deal with cash are less overvalued than acquirers who finance the deal with stocks. This would 13

mean that premium attached to miss valuation of a target company has significant influence on the deal s way of financing. The empirical evidence on self-interested behavior of managers and their hubris as a factor causing merger waves is still inconclusive. The summary of evidence was presented by Martynova and Renneboog (2008a). They concluded that the third wave resulted from actions of management trying to maximize their own wealth. This was mainly due to the fact that prior 1980s shareholders did not have enough control over management to ensure that managers will maximize the owners wealth. Because transactions of the third wave were mainly aimed at diversification, this was a way of smoothing cash flows by the managers, and lowering the risk of bankruptcy. When the control of stockholders over managers increased in the 80 s a number of companies were selling some of their business segments (non-core) to concentrate on the core business. The management hubris had large impact on the transactions of the fifth wave in Europe as about two thirds of the acquisitions were caused by overoptimistic assumptions of managers and expected synergies did not materialize (Martynova and Renneboog, 2008b). Table 3 presents a summary of described above research and results. Table 3 Merger waves summary of empirical evidence Research Mitchell and Mulherin (1996) Andrade, Mitchell and Stafford (2001) Andrade and Stafford (2004) Period under investigation 1985-89 1973-98 1970-94 Hypothesis tested and results Industry shocks hypothesis confirmed with respect to fourth takeover wave. Industry shocks hypothesis deregulation as a main factor of higher merger activity. Industry shocks hypothesis concentration of M&As In the industries affected by the shock. Harford (2005) 1981-2000 Servaes (1991) 1972-87 Industry shocks hypothesis confirmation of the theory under assumption of sufficient capital liquidity. Q theory of mergers better managed companies acquire companies which are worse managed. Jovanovic and Rousseau (2002) 1890-1998 Q theory of mergers theory confirmed with respect to all merger waves except for the third one. 14

Table 3 cont d Rhodes-Kropf and Robinson (2008) Shleifer and Vishny (2003) Rhodes-Kropf, Robinson and Viswanathan (2005) 1980-2001 4 th and 5 th wave 1978-2001 Q theory of mergers and industry shocks hypothesis the change In complementarity of resources caused by the industry shock results in merger of companies with similar Qs. Overvaluation hypothesis confirmed. Overvaluation hypothesis overvalued acquirers finance the takeover transactions with own shares. Dong et al. (2006) 1978-2000 Overvaluation hypothesis confirmed for the transactions after 1990. Q theory of mergers confirmed for the transactions before 1990. Martynova and Renneboog (2008a,b) 3 rd wave 5 th wave Agency theory of mergers confirmed. Hubris hypothesis confirm with respect to European transactions. Source: Own compilation empirical evidence. 2.2. Summary of theoretical foundations and empirical evidence on merger waves The M&A activity increases due to industry, technological and/or regulatory shocks. If takeover actions result from industry shocks, and the management maximizes shareholders wealth, than the company s value should increase. Theories based on managerial self-dealing, hubris and herding explain the part of transactions which does not create value. The empirical evidence shows that none of the described above theories is able to fully explain clustering of M&A activity. The most convincing interpretation of the empirical evidence is that the transactions at the beginning of the wave are caused by external shock and result in value creation, while the majority of non-profitable transactions which is caused by irrational motives take part at the end of the wave. Moreover, large number of studies indicates that the overvaluation of acquiring companies is as a significant factor that causes increased M&A activity, especially when transactions are financed with shares or the mix of shares and cash. 15

3. Motives for merger and acquisition transactions At the level of individual companies growth and synergies are the main motives for merger and acquisition transactions. Other factors mentioned in the literature are diversification and better management. Furthermore, market power increase may be a motive for the horizontal transactions and the continuity of supply and access to specialized materials used in the production process for the vertical transactions (Gaughan, 2007). 3.1. Growth One of the main factors affecting the companies engaging in mergers and acquisitions is the growth. Enterprises can grow internally, through reinvestment of profits, or externally, through acquisitions. Since the growth through mergers and acquisitions is faster it allows seizing the market opportunities ahead of the competition. Another example of purchases executed to facilitate growth is geographic expansion through acquisitions, both within a single country or international. In both cases, mergers and acquisitions are faster and less risky form of expansion than internal growth. By acquiring a company already operating in the given region or country the buyer acquires a market specific knowledge, does not need to conduct recruitment process or build own distribution network and the case of international expansion also bypasses the language barrier. Another example of using the mergers and acquisitions to achieve growth are transactions in industries with low growth rates. As a rule, managers must demonstrate that the company is constantly expanding, especially in terms of sales. However, if the firm operates in an industry that used to have high growth rates and currently the demand is declining, it is difficult to reach a high sales growth. In this case the manager can use mergers and acquisitions to improve financial results. Moreover, the acquirer not only hopes to increase its revenues thanks to the simple consolidation of the sales of target and parent companies, but also to achieve an increase in profitability caused by the effects of synergy. 16

3.2. Synergies Synergy is a phenomenon in which a combination of two factors gives a greater effect than the sum of the effects of these factors individually. Synergy is commonly presented schematically by the equation 2 + 2 = 5. In the case of mergers and acquisitions synergies occur when the company established as the result of the merger of two or more entities is more profitable than the sum of the profits of individually operating entities. Synergy effects can be divided into two groups: operating and financial synergies. Operating synergies come in two forms: revenue enhancements (associated with an increase in sales) and cost reductions (associated with increased efficiency). The main possible financial effects resulting from the combination of companies are the lower cost of capital, higher debt limit and tax benefits (Damodaran, 2005). The distinction of synergies is schematically showed on the Figure 4. Figure 4 Forms of synergies Source: Gaughan (2007) 3.2.1. Revenue-enhancing synergies Revenue-enhancing synergy effects are usually associated with new opportunities arising from the merger and they are generally harder to achieve than the cost reduction effect. Examples of revenue enhancements include giving the reputation of a strong brand of one party of the transaction to the products of the other party. This kind of synergy may also materialize when the well-developed distribution network of one company is used to market the promising products of the other firm, 17

which otherwise would have trouble to market its products efficiently. Unfortunately, in practice, the revenue-enhancing synergies are often hard to achieve. It is also difficult to measure and incorporate these synergies in the valuation models. Due to abovementioned reason, in mergers and acquisitions planning process the emphasis is on cost reduction while the potential revenue increase is not specifically quantified. Precisely due to unclear assumptions and misevaluation of revenue synergies many mergers and acquisitions failed, for example, a merger of AOL and Time Warner in 2002. 3.2.2. Cost-reducing synergies Operational cost-reduction synergies are related to economies of scale and scope. Economies of scale are achieved when production unit cost decreases along with increase in the output, as the fixed costs are allocated to a larger number of units produced. Other sources of economies of scale are the increased specialization of workforce and more efficient use of capital, impossible to achieve at low production level. It is, however, ineffective to indefinitely increase production, as eventually it will lead to the diseconomies of scale (increase in unit production costs). Diseconomies of scale usually result from problems in managing the business of sub-optimal size. As an example one might consider, the horizontal acquisition of a competitor that should result in increase in the company's sales and production output and in a decrease in the production unit costs. Economies of scope enable to use the same resources to offer a greater range of goods and services. As a result of extending the product portfolio, the company reduces the unit cost of production. For example, Procter & Gamble may employ a team of designers and marketing specialists to work on different products from the company s wide offer. In this case, the costs of marketing, are allocated to the larger number of products, reducing the unit cost. 3.2.3. Financial synergies Financial synergy may materialize as the cost of capital reduction for the acquirer or merging companies. Lower cost of capital is associated with reduced risk after the merger or acquisition. If the cash flows of the merging firms are not perfectly 18

correlated, then, after the merger their variability and thus the risk of bankruptcy will fall. Furthermore, financial markets may perceive a larger company as a safer investment than a small one. What is more, merger or acquisition may result in the change of liabilities and equity structure. Different ratio of debt to equity may reduce the weighted average cost of capital. Higher and more predictable cash flow may result in the greater debt financing opportunities available for the company. The post-merger firm will be able to use financial leverage to a greater extent than when acting as separate entities. Higher level of debt leads to tax benefits related to interest tax shield. Moreover, in the process of mergers and acquisitions, tax benefits may arise from the assets value increase and thanks to the net loss carry forward possibility. Higher value of assets will increase the tax costs thanks to higher depreciation. Whereas, when the target company was incurring losses, the loss amount may be carried forward, thus lowering the tax obligations of the post-merger company. 3.2.4. Diversification Another reason why companies enter merger and acquisition transactions is diversification. Diversification in terms of M&A is defined as an acquisition of a company operating in the industry not related to the buyer s core business. This motive was very common during the third merger wave of the 60s. Positive effects of diversification are however ambiguous. Most of the conglomerates formed during the third merger wave disassembled through spinoffs or divestitures in the 80s, which would suggest their ineffectiveness. However, there are examples of diversified companies e.g. General Electric (GE), that have not only survived on the market as a conglomerate, but also turned out to be very successful. The key to GE s success in diversification was the strategy of buying the companies with highest or second highest market share in the given industry. The theoretical background of diversification is related to the financial assets portfolio management according to which greater number of not correlated assets in a portfolio reduces its risk, analogically the risk of a company should decrease along with the acquisitions of firms operating in a various industries. Moreover, 19

through diversification, the company may seek to improve its overall performance by entering the industries characterized by high growth and profitability. In finance literature it is however underlined that managers should focus on the core business of the company and leave the diversification to shareholders, who may do it at a lower cost. 3.2.5. Better management Some of the mergers and acquisitions are driven by the belief of the buyer s management about their above-average skills and abilities to manage a target company better than the current management. If the company is indeed better managed after the merger, the value of the acquired business will increase. The motive of better management in M&A works best when small companies are acquired by larger entities. Fast-growing small companies, often run by ownerfounder, may, at some stage, find it difficult to develop any further due to insufficient knowledge and abilities of the managers. In such case a large company with experienced management team may be interested in the acquisition and further development of the promising company. 4. Shareholders rates of return in M&A transactions Mergers and acquisitions create value only when two companies together are worth more than the same two companies operating separately. The value created in the process of acquisitions usually is not distributed equally between the shareholders of acquirer and target. In this case it is worthwhile to investigate who and why benefits or loses in M&A transactions. To show benefits of different parties of transactions we will analyze the following example. 2 Company A acquires company B, and the value of combined companies is PV AB, while the standalone value of transaction parties is PV A and PV B, respectively. Under assumption that the transaction creates value the profit can be presented as the following equation (1). P = PV AB (PV A + PV B ) = ΔPV AB (1) 2 The example is based on Brealey et al. (2006), p. 881-885. 20

The acquisition will be economically viable if ΔPV AB is positive. Additionally it is necessary to look at the cost of acquisition of company B. In case of cash payment the cost will amount to: C = cash payment - PV B. (2) The net profit to the company A from a transaction will amount to the difference between the profit (1) and cost (2), which is: NPV = P C = ΔPV AB (cash payment PV B ). (3) The proposed above way of analyzing profits from a transaction allows not only capturing benefits, but also (through analysis of costs) the distribution of these benefit between merging companies. If we assume that the company A is worth 600m, company B 120m, and the merger of the two companies will result in cost synergies of 60m, than (by substitution to equation 1) the value of the two companies after transaction will amount to 780m. Additionally if we assume that company A acquired B for 156m in cash, the cost of the transaction will amount to 36m. The amount which is a cost to shareholders of A is a profit to shareholders of B. Therefore, in this case, B s shareholders captured 36m out of 60m of value created due to transaction, while shareholders of A received the residual 24m. If the market did not expect the transaction between companies, its announcement should result in increase in B s value from 120m to 156m, the increase of 30%. At the same time the value of company A should increase by 24m to 624m, i.e. only by 4%. Furthermore, the market can be skeptical about the scenario presented by company A s management and attach less value to expected synergies or conclude that A overpaying for B. If this is the case the A s share price will probably fall. The above illustration assumed that the market is not expecting that the company B will be acquired. However, when the market has signals that B could be a target of acquisition, the probability of company s overvaluation will increase. In this case we have to distinguish between the market value and intrinsic value of the firm. In 21

case when there was no acquisition the market value of company B would be equal to its intrinsic value. In case when B is about to be the acquisition target and the market anticipates it the company s market value will be equal to the intrinsic value plus the value of synergies estimated by the market. If the second case is true the market value would be overstated when compared to intrinsic value. To illustrate the case we have analyzed the following example based on the below data. Company A Company B Share price 600 200 Number of shares 1 000 000 600 000 Market value of shares 600m 120m The company A plans to acquire B for 156m in cash. If the market value is equal to intrinsic value then the acquisition cost equals 156m 120m = 36m. However, if the market anticipated the transaction and the share price of 200 already includes the rise of let s say 40, the intrinsic value will be overstated by 40 * 600 000 = 24m. In this case the acquisition cost of B will amount to 156m ( 120m 24m) = 60m. Therefore, the net profit from the transaction to shareholders of A will amount to nil all benefits will be captured by the target s shareholders. Analogically one can analyze the example when B s market value is below its intrinsic value. If this was the case, shareholders of B would suffer a loss which would be a gain of shareholders of A. Due to the fact that majority of M&A transactions is financed with stocks it is worthwhile to analyze costs and benefits related to this form of payment. In case when acquirer pays in shares purchase cost can be presented as below: K = N * PV AB PV B, (4) where N equals number of shares purchased by the acquirer in the new company, PV AB equals share price of new company after acquisition announcement, PV B equals intrinsic value of a target company. If company A plans to acquire company B and offers 260,000 shares instead of 156m in cash, share price of A before the transaction equals to 600, and B s 22

intrinsic value equals to 120m, than the acquisition cost looks to be 260,000 * 600 120m = 36m. However, the announcement of the transaction triggers change in A s share price. The company after acquisition will have 1,260,000 shares worth 780m, which means that the price of one share will equal to 619.05. In this case real purchase cost will equal to 260,000 * 619.05 120m = 40.95m The calculated above cost of acquisition is at the same time a profit for B s shareholders, which can be also calculated using below formula: P B = α * PV AB PV B, (5) where α equals to percentage share of target company s shareholders in new company. Using formula (5) profit of sell-side of transaction equals to: 260,000/1,260,000 * 780m 120m = 0.2063 * 780m 120m = 40.95m. From the above examples follow that when a transaction is financed with cash the acquisition cost is constant, whereas when it is financed with stocks the acquisition cost depends on market valuation of benefits resulting from the transaction. Payments made in shares lower also the risk of over or undervaluation of companies involved in the transaction. For example, when company A acquires company B and overpays, assuming that payment is in shares, the negative effect of disclosing the lower value of company B will spread over shareholders of both companies (in case of cash payment the negative effect would impact only A s shareholders). The point above is connected with information asymmetry. The usual case is that the managers of company A have better information about the direction and pace of their company s development than the outsiders. Therefore, when the management has a reasonable assurance that the value of synergies is higher than the one predicted by the market, the payment usually will be made in cash. This way the majority of profit from the transaction will be captured by company s A shareholders. On the other hand, when the managers are not so sure whether the forecasted synergies are going to materialize they will prefer to pay in shares, so 23

that possible losses caused by share price decrease will be additionally spread over the shareholders of company B. 4.1. Research approaches to M&A profitability measurement In mergers and acquisitions, apart from the main parties, namely buyers and sellers, indirectly are also involved stakeholders of those companies such as employees, customers, creditors and advisors. Often the goals of these groups vary and they assess the outcome of the transaction differently, some of them benefit while others lose. In assessing the profitability of mergers and acquisitions, the most important element recognized in finance theory is the value created to shareholders of companies taking part in the transactions. This is justified by the fact that company s shareholders are the ultimate owners (in case of bankruptcy their claims are met in the last order), while the corporate management acts with their proxy and in their best interest. Therefore, when analyzing the gains from mergers and acquisitions it should be assessed whether they create value to shareholders of the buyer and/or target company. In addition, often the cumulative wealth effect of the acquisition is assessed. Due to the popular belief that mergers and acquisitions destroy value it is necessary to specify a benchmark against which the results of the transactions will be assessed. It seems that a good reference point is the rate of return required by the investor, or rate of return that an investor would receive from alternative investments of the same risk. In this situation there are three possible results. Value can be maintained, namely, return on investment is equal to the rate of return required by the investor. The investment creates value when its rate of return exceeds the one that required by an investor. In the third case, the investment is delivering lower returns than required by the investor and destroys the value. Given the three options presented the investment is considered to be successful in the first two cases (Bruner, 2002). According to Bruner (2002) the possibilities of M&A profit and loss analysis depend heavily on the methodology used. There are four analytical approaches: event studies, accounting studies, surveys of executives and clinical studies. Event studies investigate the abnormal returns to shareholders in the period surrounding 24