Why Do Mergers and Acquisitions Occur?

The M&A wave of recent years has been driven by technological changes and market conditions which forced companies to either develop technological solutions by themselves or, alternatively, buy or merge with companies which could provide them with the technological market edge or another relative advantage, such as a managerial advantage; an advantage of scale in production capacity, marketing or cost structure; a complement to their line of products or services, and so forth.

From the perspective of the acquired, merging, or selling party, the decision to make the move is often driven by the recognition that the company's operating results could improve if the company were part of a larger entity, whether in the form of an association of similar-sized companies or by being incorporated into a larger entity. In other cases, the decision to sell a business division results from the recognition that the division does not fit in well with the company's activity strategically or, alternatively, that the company has no competitive edge in its management of such division. Another main consideration is that of the investors or entrepreneurs, for whom the acquisition typically provides an opportunity to liquidate their investment by receiving cash or shares in a publicly listed company.

The main sources of value in mergers and acquisitions may be classified into several main categories, as specified below.

Reducing Development Times and Acquisition of Rapid Growth Options

Many acquisitions have a strategic value in that they enable the acquirer to gain or maintain a competitive advantage in its business environment. One of the most important strategic benefits of acquisitions of startups is the reduction of development time. Many large companies seek out companies worthy of acquiring only after they identify that a substantial market had been created. When a large company recognizes the creation of a market in which it has no leading product, there are benefits in acquiring a small company with a suitable product, which will reduce the time it would take it to offer similar products to the market and save the time and cost required for in-house development.

Furthermore, buying a product which has already undergone the "trial and error" phase enables the acquirer to choose the most suitable acquisition from among the variety of companies and products in the market, even if such products were not initially on the company's planning agenda. Cisco, for instance, acquired hundreds of companies during its growth years, which acquisitions enabled the company to enter new, high-growth fields quickly, reducing the need to set aside operating resources of the company for R&D. In that respect, acquisition costs were an integrated component of the company's R&D efforts. This is also a pattern that has been observed in the pharmaceutical industry for many years.

Operational Synergy

Most announcements of mergers and acquisitions mention the synergy phenomenon. What is meant by this is the totality of effects which a merger or an acquisition has, due to which the value of the components after the merger or the acquisition is higher than the total of such components beforehand. In fact, all operating advantages such as saving in costs and integration into a line of products are types of synergies. When analyzing the effects which a merger or an acquisition will have, we have to try to evaluate which components will create synergies. For instance, if the merger is supposed to increase the usage of production equipment, we would examine the relationship between equipment usage and profitability in similar companies.

The pooling of marketing and manpower resources may also save on the cost of many overlapping activities performed by both companies. Common duplicities exist in financial and marketing functions and, depending on the character of the companies, savings may be achieved also in development and manufacturing functions.

Vertical mergers have another advantage: The transaction costs of different entities may be reduced since some of the negotiations between independent companies become a discussion between parties to a transaction working within the same entity.

However, alongside the positive synergies, there is also much importance attached to problems which could arise after the merger, particularly on the human level. For instance, many mergers of companies, particularly those in technology, fail due to an incompatibility of the companies' management cultures. In addition, attempts to cut down on duplicate functions may lead to uncertainty and complaints among employees, which could reduce their productivity.

Where startups are concerned, operating synergies are expressed in the integration of the startup's technology with the acquirer's capabilities in the fields of research, marketing, distribution, and finance. Companies are constantly seeking technological or marketing advantages and are attempting to utilize the advantages inherent in scale. Large companies prefer to invest in young and fast companies with innovative technological solutions, whereas small companies seek large partners which will provide them with financial and marketing support. Many small companies suffer from a global access and marketing problem, and joining forces with an industrial giant provides them with fast access and presence around the world while reducing the risk of losing their technological edge to competitors. On the other hand, entities with a global presence are interested in adding products to their packages in order to offer their customers a broader range of products and streamline their usage of the mechanisms in which they invested much time and money.

Change in Market Power

In theory, two companies may sometimes merge and adopt a pricing policy which will enable them to earn more than the market average. The acquisition of a competitor could naturally reduce the competition in the market, and the prices of products may consequently rise and make monopolistic profits possible. Obviously, there are institutions which supervise such cases (such as the Antitrust Division of the Department of Justice and the Federal Trade Commission (FTC) and prevent merger agreements which could reduce competition, or at least demand clarifications for and/or changes in the agreement. Obviously, it is not an easy task to distinguish between legal and illegal agreements. For example, there are many ways in which a merger could enable the utilization of the combined selling power by way of market segmentation which increases the manufacturer's profits. However, it should be kept in mind that the improvement in manufacturers' efficiency could compensate for the reduction in competition also from the consumers' point of view. The authorities perform economic benefit tests, which are usually guided by the interest of consumers (for more on that topic, see Chapter 17).

Ostensibly, the examination of the reduction in competition is more relevant in the merger of two companies with large market shares and less in the acquisition of startups by large companies. However, many acquisitions of startups could have the impact of reducing future competition, particularly in markets which are expected to expand (for a more detailed discussion of the reduction in competition and antitrust aspects, see Chapter 17).

Improved Managerial Capabilities

The existence of an active M&A market provides an excellent instrument of corporate governance. Companies whose performance is below the market average, if such poor performance is attributable to managerial decisions (which is almost always the case), are more likely to be a target for takeover. Managers are aware of this high probability and are therefore more sensitive to their performance. The more relevant factor for our current discussion is the improvement in the company's management following the acquisition due to the passage of management into the hands of more experienced managers in the field. If the original managers stay in office, the exposure to the management methods of a large international organization and the ability to tap into its managerial resources may also suffice to achieve an improvement in performance.

When a startup is growing rapidly, but lacks a complete internal managerial infrastructure, a merger can assist in rapidly creating an organization in which all of the necessary managerial positions are filled. Those who have reservations about this argument claim that it is usually cheaper and more efficient to recruit the necessary manpower from competitors than to merge with another company. However, it is possible to understand some cases in which the acquirer is better off merging with a target staffed by an experienced and well-accustomed-to-each-other management team since such a merger can eliminate the friction which could be caused if recruitment is performed on an individual basis.

Diversification and Capital Market Synergy

Managers and employees may benefit from diversification when a merger or an acquisition is made with a company which is sensitive to different economic parameters from their own company. This desire to diversify stems from the fact that the human capital, and often also most of the financial capital, of employees and managers is tied to the company and cannot be diversified, as opposed to the company's shareholders, who can create a diversified portfolio. As a result, one of the implications of this lack of personal diversification is sub-optimal investment decisions from the perspective of shareholders. Therefore, diversification of the company's operation which alleviates that concern may in fact be for the benefit of shareholders, in spite of the argument against conglomerate mergers.

In addition, many companies enjoy managerial reputation, reputation in the capital market, reputation in the product and service market, or reputation in the employment market. Such reputation is often transferable to other fields, and diversification reduces the likelihood that such reputation will be lost due to market volatility.

Furthermore, diversification may reduce the company's cost of debt due to the reduced volatility of the company's performance, as well as the company's tax liability over time.

A merger could also reduce the company's cost of debt by adding a stabilizing factor which results from the company's size. Furthermore, the existence of an internal financial reserve in the company could reduce its dependency on outside sources; divisions generating positive cash flows can finance other divisions in the same company while reducing the company's financing expenses. This consideration is crucial, particularly during times of crisis in the capital market when it is harder for companies to raise external funding.

Tax Advantages

When the acquirer has a cash surplus, the acquisition of other companies could replace the distribution of a dividend and in that respect is similar to stock repurchase. Thus, if the acquired company will yield for the acquiring company returns that compensate for its risks, many shareholders will reduce their tax liabilities since the tax on dividends is generally higher than the tax on capital gains imposed on the sale of shares.