GENERALLY ACCESSIBLE
Theories of Mergers
& Tender Offers
By AV Vedpuriswar
June 2008
Theories of Mergers & Tender Offers
Efficiency theories
Information & signaling
Agency problems
Free cash flow hypothesis
Market power
Taxes
Redistribution
Efficiency Theories
The differential efficiency theory says that more efficient
firms will acquire less efficient firms and realize gains by
improving their efficiency.
Differential efficiency is likely to be a factor in mergers
between firms in related industries.
The inefficient management theory suggests that target
management is so inept that virtually any management could
do better.
This could be an explanation for mergers between firms in
unrelated industries.
The operating synergy theory postulates economies of
scale/scope and complementarity of capabilities.
Efficiency Theories
The financial synergy theory emphasises complementarities
in the availability of investment opportunities and internal cash
flows.
Is diversification justified?
Shareholders can diversify more easily.
But managers and other employees are at greater risk if the
single industry in which their firm operates should fail.
Firms may diversify to encourage firm specific human capital
investments which make their employees more valuable and
productive.
The organization and reputation capital of the firm is more
likely to be preserved by transfer to another line of business in
the event there is a decline in the prospects for the earlier
business.
Efficiency Theories (Contd)
The theory of strategic alignment to changing environments
says that mergers take place in response to environmental
changes.
External acquisitions of needed capabilities allow firms to
adapt more quickly and with less risk than developing
capabilities internally.
The undervaluation theory states that mergers occur when
the market value of the target firm stock for some reason does
not reflect its true or potential value or its value in the hands of
alternative management.
Firms may be able to acquire assets for expansion more
cheaply by buying the stocks of existing firms than by buying
or building assets when the target’s stock price is below the
replacement cost of its assets.
Information/Signaling Theory
The tender offer sends a signal to the market that the target
company’s shares are undervalued.
The offer may signal information to the target management
which motivates them to become more efficient.
The target management’s response to the offer and the
means of payment may also have signaling value.
Agency Theory
Agency problems may result from a conflict of interest
between managers and shareholders and between
shareholders and debt holders .
Takeovers are viewed as the last resort to discipline self
serving managers.
Managerialism
Takeovers are a manifestation of the agency problem, not its
solution.
Self serving managers embark on mergers to expand their
empire and improve their own career prospects.
Hubris Theory
Acquiring firms commit errors of optimism (winner’s curse) in
bidding for targets.
Consider Anil Ambani’s bid for MTN.
Free Cash Flow Hypothesis
Takeovers take place because of the conflicts between
managers and shareholders over the payout of free cash
flows.
Free cash flows should be paid out to shareholders thereby
reducing the power of management and subjecting managers
to the scrutiny of the public markets more frequently.
Debt-for-stock exchange offers are viewed as a means of
bonding the manager’s promise to pay out future cash flows to
stakeholders.
Market Power
Market gains are the results of increased concentration
leading to collusion and monopoly effects.
But anti trust authorities are on the prowl. So these kinds of
gains are becoming increasingly difficult.
Tax Effects
Carry over of net operating losses, tax credits and the
substitution of capital gains for ordinary income are among the
tax motivations for mergers.
Looming inheritance taxes may also motivate the sale of
privately held firms with aging owners.
Redistribution Theory
Gains from a merger may come at
stakeholders in the firm.
Expropriated stakeholders may
government and organized labour.
the expense of other
include
bond
holders,