There are a number of reasons for firms to engage in merger and acquisition activity including globalisation, economic development, technical innovation which acts as catalysts to the growing popularity of M&A. According to Kaushal (1995), with the changing legal, economic and social environments, there is notably a change in factors affecting mergers.
Two widespread reasons which are derived out of mergers and acquisitions based on Business Organisation structure are efficiency gain and strategic rationale (Neary, 2004). Efficiency gain would be the result of economies of scale and scope due to the integration of the volumes and efficiencies of the merged organsations. And the change in structure of the 2 firms having a positive effect on profits will lead to strategic gain.
However, the appeal and frequency of merger and acquisition activity motivate academics not only to assess the motives behind merger and acquisition, but also to enquire about their effect on shareholders' value.
The motives which are related with shareholders' value are studied. Different motives have different characteristics which contribute differently to shareholders' value. Accordingly, the motives can be broadly classified into three categories as follows: motives which increase or decrease shareholders' value or have uncertain impact on shareholders' value.
I decided to provide a detailed study each of the motives so as to outline the theoretical implications of M&A and strategic alliances activity effect on shareholders' value.
2.1.1 Theoretical Literature: The Motives with Positive Impact on Shareholders Wealth
2.1.1.1 The Synergy Motive
The synergy is perceived to be the most common motive for M&A activity. Pearson (1999) refers to synergy as 2+2=5. Otherwise stated, the whole would be bigger than the sum of its parts (Sherman, 1998). That is, the collective management of different activities in a single combined organization is better, larger or greater than it would be in two separate corporate bodies (Bakker, Helmink, 2004). One main source of synergy is from the handover of some valuable intangible assets, such as know-how, between targets and acquirers (Seth et al., 2000). Among the major tasks of managers is that of assessing the synergy effects from merger and acquisition deals. Indeed, the correlation between targets and total gains is positive implying the higher the synergy, the higher the target gains as well as the acquiring entity's shareholders' benefits (Berkovitch & Narayanan, 1993).
Empirical outcomes show that the synergy motive has a positive effect on targets, acquirers and total gains (Berkovitch & Narayanan, 1993; Gondhalekar & Bhagwat 2000; Bradley et al., 1983). Sudarsanam et al. (1996) also support the opinion that the synergy motive creates shareholders value for the acquirer and the acquired or the new company.
Explicitly speaking, according to Chatterjee (1986), there are three types of synergy creation: operational synergy, financial synergy and collusive synergy.
Operational Synergy
According to Chatterjee (1986), operational synergy symbolizes the realization of production and/or administrative efficiencies. It can further be sorted into revenue-enhancing operating synergy and cost-reducing operating synergy (Gaughan, 1999). As Copeland et al. (2005, p.762) report that "the theory based on operating synergies assumes that economies of scale and scope do exist in the industry and that prior to the merger the firms are operating at levels of activity that fall short of achieving the potential for economies of scale". In other words, either economies of scale which is a reduction in per unit costs or economies of scope representing the capability to use combining inputs or production facilities and offer a wide range of products and services can lead to operational synergy. Moreover, operational synergy can support institutions to recognize potential benefits such as purchasing, training programs, common parts and the development of larger scale manufacturing facilities (Harrison et al., 2001). Common technology, marketing techniques and manufacturing facilities form the vital components of operational synergy (Peng, 2009).
Financial Synergy
According to DePamphilis (2005), financial synergy relates to the effect of merger and acquisition activity on decreasing cost of capital of a merged or newly formed corporate body, When the capital of two distinct companies is pooled and impacts in the reduction of the cost of capital accompanied by a higher cash flow, that is so called financial synergy (Fluck & Lynch, 1999; Chatterjee, 1986). Indeed, financial synergy applies into funding expensive investment projects which are challenging to achieve on an individual basis (Chatterjee, 1986). financial synergies also lead to increased borrowing power (Hankin, Seidner and Zietlow, 1998).
One major source of financial synergy is the lesser cost of internal financing relative to external financing (Copeland et al., 2005). The value creation of financial synergy is a result of the advantage of lower cost of internal funds and greater growth investment of extra cash flow. Sudarsanam (2003) also points out cost of savings are one aspect of value creation in merger and acquisition activity. The savings of transaction costs from economies of scale is also viewed as an advantage of financial synergy (Copeland et al. 2005).
Another source of financial synergy is from the possible benefits of tax savings on investment income, because of the greater debt capacity of the new firm than the sum of the two individual firms' capacities after merger and acquisition activity. Financial synergies also lead to increased borrowing power (Hankin, Seidner and Zietlow, 1998). They are more focused and include tax benefits, diversification, a higher debt capacity and use for excess cash. (Damodaran , 1994)
Furthermore, it is supported that "financial synergy, on average, tends to be associated with more value than do operational synergies" (Chatterjee, 1986, p.120). Also, according to Peck and Temple (2002), financial synergies are potential both between related and unrelated firms unlike operational synergies which is only possible between related entities.
Collusive Synergy
Collusive synergy implies that the scarce resources are grouped together resulting in an increase in market power. Furthermore, researchers have found that collusive synergy creates more value than operational synergy and financial synergy (Chatterjee, 1986).
2.1.1.2 The Improved Management Motive
Efficient management essentially originates from the possible benefits of the combination between two firms' unequal managerial capabilities. The acquisition by large businesses with high level of management know-how when the target is a company lacks such resources is a major motive. It involves a greater degree of managerial sophistication to control a larger organisation than a small business. A company which is efficient may choose to merge or to acquire a target which is relatively inefficient to improve managerial efficiency by restructuring its operations (Copeland et al., 2005).
According to Martin & Mcconnell (1991), the improvement of managerial efficiency in M & A may be attributed to two methods. On one hand, the market for corporate control plays an important part in improving the managerial efficiency of target firms such that potential bidders may pose a risk on managers' positions and monitor their performance as well (Jenson & Ruback, 1983). Hence, executives and managers will improve managerial efficiency to escape from dismissal after the merger or acquisition and minimize non-value maximizing behaviour (Manne, 1965; Alchian & Demsetz, 1972). On the other hand, when the threat of merger and acquisition activity cannot reduce executives' non-value maximizing behaviour, the acquirer will change the management of the target firm (Martin & Mcconnell, 1991). Inefficient managers can be substituted with better performing ones. Consequently, the improved managerial efficiency may induce managers operate the company efficiently and maximize shareholders' value since managers' salary is linked to the size of the firm.
However, mergers and acquisitions may not be the sole technique to improve management efficiency, but sometimes it may be the best practical and simple technique (Brealey et al., 2006).
2.1.1.3 The Achievement of Economies of Scale and Scope
Economies of scale and economies of scope lead to a reduction in production costs through merger and acquisition activity. Indeed, low costs is essential for firms to sustain their profitability, success and survival (Brealey and Myers, 2004).
Economies of scale relate to the decreasing average unit cost of production as production increases (Brealey et al., 2006; Seth, 1990). Achieving these economies of scale is the usual objective of horizontal mergers as well as conglomerate mergers. In other words, they are achieved when applied to the same line of business. Such economies arise when distributing core services such as office management and accounting, financial control, top-level management and executive development (Brealey et al., 2006).
Economies of scope arise from a rise in the variety of products leading to the declining cost of production. Economies of scope are more reaped in vertical merger and acquisition in seeking vertical integration (Brealey et al., 2006). Subcontracting the provision of several services and various types of production may be more efficient for institutions and this can be done by merging with or acquiring a supplier or a customer.
Economies of scale and scope from merger and acquisition activity may be achieved through the amalgamation of marketing and sales force, improving customer base and sharing technological innovations within the newly set up corporation. Greater pricing power resulting from reduced market power and larger markets allows higher sales growth and profits (Damodaran, 1999).
Nevertheless, according to Sudarsanam (2003), diseconomies of scale and scope can also crope up in merger and acquisition process as a result the diffusion of control, the ineffectiveness of communication and the complexities of monitoring the new entity.
2.1.1.4 The Improved Market Standing and Revenue Growth Motive
Mergers are often carried out to attain increasing market power in the sector of operation and for increasing revenue growth (Zheer & Souder, 2004). According to the American Bar Association (2005), market power is referred to as the capability of a firm to profitably charge prices which are above the competitive level for a continuous period of time in a market.
Another key concern when engaging in merger and acquisition process is the reduction in competition. Indeed, as George, Joll and Lyk (2005) opine, mergers can also be used to protect dominant positions. Hence, mergers are deemed to be successful if they can cause an increase in market power or eradicate the threat of increased competition. Andrade et al. (2001) state market power may be amplified by establishing monopolies or oligopolies. In addition, increased market power can help companies sustain revenue growth by lowering the prices of products which are highly price sensitive.
The financial position of the acquiring firm will be reinforced by an increase in market power and revenue growth. According to Sudarsanam (2003), the profitability of the firm will increase as well as the shareholders' value and this is consistent with Gaughan (2005) point of view.
2.1.2 Theoretical Literature: The Motives with Negative Impact on Shareholders Wealth
2.1.2.1 Managerial Hubris
The role that hubris or managerial pride plays in merger and acquisition process was first proposed by Roll (1986) and he concluded in his study that managers suffer from hubris and commit errors of over-optimism in evaluating mergers at the cost of the acquiring firm.
The hubris hypothesis takes place when the management of the acquirer undervalues the value of the target firm and usually overestimates the potential synergies (Berkovitch & Narayanan, 1993). Synergies as discussed earlier lead to a positive correlation between target and acquirer gains but hubris is expected to have a negative correlation. As a result, firms tend to overpay their targets due to negligence and overconfidence of managers leading to failure of mergers. Managers pursue merger and acquisition activity for their own benefits, rather than for the company's economic gains as the major motive specifically.
From the outlook of managerialism hypothesis, it can be said that in order to maximize their own competence, managers favor to carry on merger and acquisition process at the cost of shareholders (Firth 1980; Caves 1989). As cited in Seth et al. (2000), Marris (1964) reported that the fact managerial compensation is usually linked with the amount of assets which are under the control of managers; managers thus have a preference for higher growth to higher profits. Langeteig (1978) also supports the view that managerial welfare may be one motive to engage in merger and acquisition activity.
As a conclusive note, managerial motives are among the causes for failure of mergers (Morck et al., 1990). It has been confirmed that when M & A is forced by managerial hubris; there is a slight fall in the combined value of the target and bidder firms, the value of the bidding firm should fall, and the value of the target should rise" (Roll, 1986)
2.1.2.2 Free Cash Flow Theory
According to (Stowe et al, 2007), free cash flow refers to cash flows available to lenders or suppliers of money after allowing for all operating expenses and necessary investments and fixed capital. Such cash flow is termed as 'free' since managers can either used it to reinvest or distribute as dividends (DePamphilis, 2008).
It is argued that when a corporate body has excess cash flow available, managers prefer to engage in mergers and acquisitions so as to retain control of internal funds and maintain their power compared to payment of the high cash flow as dividends or share repurchase which can reduce managers' control and power. Despite that such acquisition do not increase shareholders' wealth; managers do enter in merger and acquisition activity so as to increase their empire and market power. According to Wubben (2007), any distribution of cash flows in the form of dividends would result in a decrease in resources at their disposal as well as loss of market power.
Jensen (1986b; 1988) claims that free cash flow is a source of value destruction for shareholders and that the returns for the combined firm are negative. In order tosupport his belief, Jensen (1986b) cites the oil industry in the 1970s and came to the conclusion shareholders' value destruction is the cause of excess free cash flow.
2.1.2.3 Increased Managerial Compensation and rewards.
There is a tendency among managers to engage in merger and acquisition activity for the lure of higher paid salaries and additional rewards. Where ownership and control are distinct, the agency problem infers that mergers and acquisitions take place when managers want to increase their wealth at the cost of the acquirer's shareholders' benefits (Berkovitch & Narayanan, 1993). This is usually the case in corporations where there is a relationship between rewards and performance of staffs.
High managerial compensation and management dividends are attributed to the bidders and acquirers while the shareholders of the acquiring firm tend to be losers in such circumstances. That is, when the agency motive is the main motive to engage in mergers, the returns to the target is positive while those attributed to the acquirer is more negative, thus the returns to the newly company is negative (Gondhalekar & Bhagwat, 2000). Thus, only value creating mergers must be rewarded. According to Gaughan (2005), issues like the differences between the CEOs of the acquirer and acquiring firm, their control and authority must be considered in merger process.
2.1.3 Theoretical Literature: The Motives with Uncertain Impact on Shareholders Wealth
2.1.3.1 Diversification
Many large firms seek to diversify their operations through external merger and acquisition activity rather than internal growth (Levy & Sarnat, 1970; Thompson, 1984). Indeed, it is argued that diversification motive is rather a reason for conglomerate mergers since they are deemed to place a company's eggs in various baskets and facilitate its diversification process. Nevertheless, it is claimed that the rationale for entering in mergers that are motivated by diversification is for managers' interest since shareholders have the option of diversifying their portfolios themselves (Goldberg, 1986).
According to Berger & Ofeck (1995), the effect of diversification on the shareholders' value is uncertain: either there is value creation or value destruction. Diversification helps increasing the value of the acquirer through market power economies of scale and scope For example, geographical diversification allows a firm to have access to larger markets and a bad state of affairs is unlikely to affect all the places during the same period of time and to the same degree. Higher operational efficiency, lower inducement for forsaking positive NPV investments, reduced taxes and higher credit worthiness are among the several potential positive outcomes of diversification.
Nonetheless, arguments against diversification have also been put forward. According to Berger & Ofeck (1995), possible drawbacks of diversification involve the cost of choosing projects with value destruction, misallocation of resources to poor performing departments and conflict of interest issue with regards to different managements. Graham et al. (2002) also opine that corporate diversification destroys firms' value. But, the benefits reaped from higher debt capacity and the lower taxation costs that resulting from the may mitigate the loss in corporate value from diversification.
Hence, as Berger & Ofeck (1995) affirm, the overall value of diversification cannot be clearly predicted.
2.2 Theoretical Literature: The Reasons and Motives behind Cross-Border Mergers and Acquisition
One of the central strategies which corporations are undertaking I today's globalised world is the process of internationalization in order to spread their operations in foreign territories. Bross border acquisition is a situation where the acquisitions are made by parent company having headquarters in one country and merger in diverse countries. International merger are considered difficult to execute compared to domestic ones. Cross border merger has become a popular strategic tool for multinational enterprises since they can provide for a better way of attaining other international business goals,
2.2.1 Exploiting Market Imperfections
Cross border mergers allow companies to further fully exploit market imperfections. For instance, firms can take location advantages such as differences in relative labour costs.
2.2.2 Technology Transfer
Firms having mew or superior technology can enter into cross border merger so as to open up new markets or fully exploit their business advantage. Moreover, the strategy is also tending towards a corporation purchasing an overseas company which has a new or superior technology so as to enhance the acquiring firm's competitive advantage both at home and abroad.
2.2.3 Overcoming Adverse Government Policy
Cross border mergers can be a very good strategy to surmount disadvantageous government policy, such as, to avoid protective tariffs, quotas or other barriers to free trade.
2.2.4 Product Differentiation
Large firms often acquire foreign companies so as to exploit the benefits of greatly differentiated line of products. likewise, purchasing certain intangibles such as good repute, helps to guarantee success on the global market. Lenovo's (China) acquisition of IBM's (United States) personal computer line is an example of such tactic.
2.2.5 Following Clients
Companies may enter in a cross border merger so as to follow and support clients more successfully. As an example, many German banks have established cross-border presences as to provide services abroad to their domestic clients.
