Foreign direct investment ("FDI") can take three forms: establishment of a branch or a subsidiary in a foreign country, establishment of an existing branch or subsidiary in a foreign country and acquisition of a foreign enterprise or its assets. This paper is primarily concerned with the third form of FDI, i.e., mergers and acquisitions ("M&A") and will subsequently; discuss the complexities, potential costs and benefits with respect to foreign target acquisitions from the acquirer's perspective.
Over the years, the globe has witnessed a tremendous increase of merger and acquisitions, of which Britain has continued to be a major participant. In fact during 2000, UK was considered to be biggest acquirer in cross border M&A deals, spending $337 billion, followed by France ($137 billion) and the United States ($136 billion). (Devine, 2002).
According to Dealogic, the global M&A volume in August, 2010 is estimated to be $172.7 billion which is so far the highest since 1995 when Dealogic began keeping track. Some recent deals include Intel's acquisition of security software maker McAfee for $7.7 billion; private equity firm Blackstone Group's acquisition of struggling power generator Dynegy Inc. for about $542 million plus billions in debt; New Zealand's Rank Group's purchase of Hefty-bag maker Pactiv Corp. for about $4.5 billion; and PC maker Dell Inc.'s acquisition of data-storage company 3PAR Inc. worth $1.15 billion. (Chatterjee, 2010)
Although such high level of M&A activity might come off to be surprising at first, industry trackers assert that it's actually not surprising due to many companies having high cash reserves after hoarding during the financial crisis. In addition, the recent downturn in equities market could have left potential targets looking more attractive to acquirers. (Chatterjee, 2010)
Mergers and Acquisitions can be categorized into the following:
Horizontal: A horizontal merger takes place when two firms merge across similar products or services. A company to increase its market share by merging with a competitor uses such a strategy. For example, the merger between Exxon and Mobil allows both companies to capture a larger share of the gas and oil market. (Evans, 2000)
Vertical: A vertical M&A happens when two firms along the value-chain are merged. Companies use vertical mergers as a tool to gain a competitive advantage within the market. For example, Merck, a large pharmaceuticals manufacturer, merged with Medco, a large pharmaceuticals distributor, in order to gain an advantage in distributing its products. (Evans, 2000)
Conglomerate: A conglomerate occurs when two firms in entirely different industries merge, such as a technical services company merging with a financial advisory company. Conglomerates are usually used as a means to smooth out large fluctuations in earnings and provide more stability in long-term growth. For example, General Electric (GE) through conglomerates has diversified its business line by getting into new areas like financial services and television broadcasting. (Evans, 2000)
The Causes of M&As
Why is it crucial to have a clear understanding of how M&As work? Well to begin with, M&As are now a normal way of life within the financial world and they are sometimes the only instrument used by companies for long term survival. For instance, mergers are utilized by Cisco Systems for generating long term growth. For a successful M&A to take place, it is imperative to understand the causes of it. (Evans, 2000) Moreover, it is vital to understand that the reasons for M&As are complex and often, there is not a single reason for a takeover, but rather a number of reasons which are as follows:
Synergy
The underlying rationale behind M&As is the pursuit of synergistic benefits. It basically means 2+2=5. For instance the value of Company X is $2 billion and the value of Company Y is $ 2 billion, but on merging them together we get a total value of $ 5 billion.
The explanation given for synergy is that the combination of two companies can produce economies of scale as opposed to them operating at a level below optimum. Furthermore, through synergy, a combination of two companies can realize higher revenue, lower expenses, and a lower cost of capital than if they were operating separately. (Evans, 2000)
Create or Gain access to new products, technologies, distribution channels and new markets
Many companies resort to M&As in order to capture a larger market share. For example, the ill-fated deal between Daimler-Benz and Chrysler was done to broaden its market share. (Devine, 2002) Through mergers, companies maximize their ability to offer newer products at lower costs via specialization. In addition, with the help of M&As, firms can gain access to new distributors and suppliers that were earlier inaccessible to them.
Diversification
Another motive for M&As is diversification wherein companies seek to lower their risk and exposure to particular unstable industries by diversifying to other industries. However, there is considerable evidence that supports the view that diversification is of no value to shareholders since they can diversify their portfolios more cheaply than can be achieved by companies. (Cooke, 1988)
Tax Differentials
An acquirer may wish to acquire a company in order to take advantage of certain allowances such as unused investment tax credits, excess foreign tax credits or accumulated tax losses. Whether the acquirer will be able to avail these tax benefits depends upon the domicile's taxation system. (Cooke, 1988)
Acquisition by management-leveraged buyouts
Large companies face a problem in decision making. They respond slowly to changes in the business environment. In order to resolve this problem, leveraged buyouts by the existing management take place. The advantages of acquisition by management are many, for instance leveraged buyouts enable shareholders to divest their peripheral activities to the management and at the same time allows them to focus on more important matters. Another benefit of such deals is that the company is sold to an insider (management) rather than to an outsider (competitors). (Cooke, 1988)
Therefore, as witnessed by the increasing trend in M&As over the past decade one can safely conclude that the reasons for acquirers to take over companies are manifold.
Why do M&As fail
A Mckinsey study established over the past decade that only 23 percent of acquisitions were able to recover the cost incurred during the acquisition. Furthermore, a Mercer Management Consulting study shows that less than 50 percent of takeovers outperformed the industry average and it was also found in the first year of acquisitions, nearly 50 percent of senior executives quit. Statistics show that roughly half of M&As fail. Consequently it is clear from earlier scientific studies and statistics that it is not mandatory for M&As to be successful and more often than not, they fail. (Mallikarjunappa & Nayak, 2007) The reasons for their failure are complex and are as follows:
Size Issues
One of the reasons why mergers fail is because acquirers acquire companies that are too big for them to handle or acquire small companies and subsequently, pay less than the required attentions it needs.
Diversification
Many studies have found that acquisition into related industries outperform acquisitions into unrelated with the former being associated with higher capital productivity, higher financial performance and an in depth knowledge about the industry. (Mallikarjunappa & Nayak, 2007)
Paying too much
Often it happens that an acquirer pays too much for a company and as a result, its long run average returns are not sufficient to cover up the acquirer's high premium cost. The acquirer misjudges the value of the target company and ends up paying too much for it which consequently, earns less money for its shareholders.
Culture clash
Culture clash results in huge inefficiencies, loss of time and internal confusion and in fighting. In order to implement a M&A successfully it is imperative to address cultural differences that exist in the new company such as differences of opinion, disagreements and arguments regarding the process of implementing a new business plan; perceived differences in organizational values, beliefs , degree of formality in style of dress, languages, work space and so forth. Therefore proper cultural due diligence is required for the success of M&As. (Mallikarjunappa & Nayak, 2007; Carleton & Lineberry, 2004)
Bank of America's acquisition of Merrill Lynch is a classic example of how mergers fail due to company cultures of the two firms being incompatible. (Rein, 2009)
Incomplete and inadequate due diligence
German automaker Daimler Benz and American automaker Chrysler Group merged in 1998 but their story is that of a failure. One of the reasons cited for its downfall was the cultural clash that existed between the two companies. Another factor attributed to its failure and that was inadequate due diligence. Daimler Benz was accused of not doing due diligence in terms of Chrysler's finance, management, physical assets as well as intangible assets before acquiring it. (www.pressbox.co.uk)
Failure to set the pace for integration
To make a merger successful, it is imperative to integrate the target with the acquiring company in every respect. All functions such as finance, marketing, production and distribution should be put in place and key personnel should be motivated and given opportunities to work in the combined organization. The speed of the integration is of essence otherwise the lack of which would lead to chaos and confusion within the organization. (Mallikarjunappa & Nayak, 2007)
Failure of top management to follow up and lack of proper communication
After the merger takes pace, top management follow up is essential to ensure that the objectives for which the merger has occurred is being achieved or not. Its responsibility is to tackle problems which will happen in the initial few months of the merger with speed.
Proper communication to employees about the M&A is important otherwise there will be a lost trust in management, large number of employees quitting their jobs, morale and productivity problems and so on. (Mallikarjunappa & Nayak, 2007)
Lost time is never found again
At times, companies waste their resources by allocating them the wrong way. For instance, Coca-Cola spent a lot of time trying to acquire Huiyan Juice, a Chinese company in conducting due diligence and waiting for regulatory approval but in the end it got rejected. It could have used its resources more efficiently by developing a new product or by aggressively expanding an expanding product. (Rein, 2009)
The potential costs of a failed acquisition are many. A failed acquisition breeds uncertainty, mistrust and low morale amongst employees. They operate at only a basic level and do not take any initiative to excel at their work as a result, productivity suffers. In addition, due to uncertainty, good performers leave their jobs and are easily hired by other companies. This phenomenon hurts the labour pool of the merged company badly. Corporate performance continues to slip faster than the expected efficiency gains are realized. Customers become dissatisfied as the oversold efficiencies fail to occur and, quality and customer service suffer and as a consequence the company's reputation suffers. The company eventually reaches a point where the losses outweigh the gains, with a corresponding decline of shareholder value. (www.interlinkbusiness.com)
Impact of M&As on shareholders' wealth and cross border M&As Vs domestic M&As
M&As symbolize an extremely big change for a business. The shareholders of both the acquirer and target companies are sceptical about how an acquisition will affect their wealth. The acquirer can become overoptimistic about a deal and as a result, pay too much for the target company. The acquirer feels that by doing so, he will be increasing the wealth of his shareholders. But in practice, this does not happen because the target company acquired will underperform in the long run and synergistic benefits will not be attained which would lead to a decline in shareholder value. Therefore, it is very important for the acquirer to check or do due diligence regarding whether the target company will be able to fulfil his objectives before acquiring it.
Many studies have been conducted to determine whether cross border M&As generate more returns to their shareholder than what domestic M&As generate.
Cross border M&As benefit from imperfections in product and factor markets, tax differentials, technological advancement and business diversification. At the same time, they are also exposed to foreign exchange exposure, political and economic risks. Therefore, it has been proven that costs associated with cross border acquisitions nullify the benefits and hence gains from cross border M&As are not superior to gains from domestic M&As on the announcement of takeover bids. The legal system in which the companies operate play a very important role in affecting the takeover's premium or discount, agency costs of the transaction and the costs of integrating the target firm in the acquirer's business environment. The value of such costs should be reflected in the acquirers' gains. (Barbopoulos et al., 2010)
Additionally, the legal system of the country of domicile of the target company affects the announcement period's gains and the long term performance of UK acquiring firms engaged in cross border M&As. Investors in common law countries enjoy the highest level of investor protection as opposed to investors in civil law countries. For this reason, acquirers have to pay a higher takeover premium in common law countries compared to civil law countries due to higher competition. Findings suggest that UK acquirers of targets based in civil law countries earn economically higher excess returns than acquirers of targets based in common law countries during the announcement period. Also, the degree of openness of the economy in terms of capital mobility affects shareholders' wealth. If the level of openness of capital mobility is not high then it can limit the net gains to UK acquiring companies. But on the other hand, regulatory constraints on capital can make investing in such economies inaccessible for individual investors and as a result, cross border M&As can add more value. (Barbopoulos et al., 2010)
It is essential to integrate an acquired company into the acquirer's existing organization and this process can be complex and costly if they are operating under different legal and cultural traditions. Since the legal environment of common law countries is similar to that of UK acquirers, the costs of integrating companies domiciled in common law countries into UK acquirer's existing companies is lower. Furthermore, the method of payment employed in a cross border M&A also influences the acquirer's returns. For instance in cash deals, acquirers of targets based in common law countries gain less than the acquirers of domestic targets whereas in the case of share deals, it is vice versa. Additionally, gains can be realized from acquiring undervalued targets in countries with a poor governance structure. (Barbopoulos et al., 2010; Moeller & Schlingemann, 2005)
Conclusively, the legal tradition interacts with various specific firm and deal characteristics in order to shape up the gains over the announcement period and long term performance of UK acquirers.
As per another study, which has been conducted by using a sample of US acquirers, announcement returns are inversely correlated with global diversification. In other words, a transaction resulting in an increase in global diversification shows evidence of lower announcement returns and consistent with this finding is the view that cross border acquirers relative to domestic acquirers experience significantly lower returns. Furthermore, it has been noted that acquirer gains are lower for acquiring targets in countries with a more restrictive institutional environment or have French civil law system with low shareholder rights with the exception of UK (Moeller & Schlingemann, 2005)
One of the studies state that the level of returns accruing to UK acquirers depend on the geographical region in which the target company is located. For instance, foreign takeover by UK acquirers in US produce returns in the short run that are positive but are not significantly different from zero, however over the long run, returns acquired are both economically and statistically significant negative. On the other hand, acquisitions in EU yield negative returns around the acquisition date but they exhibit positive abnormal returns in the long run though they are not significantly different from zero. With respect to acquisitions in the rest of the world they produce positive returns in the short run that are not statistically different from zero but in the long run, they produce significantly positive abnormal returns. Moreover, announcement period returns are influenced by short term factors such as exchange rate and policy changes (US tax reforms) but these factors cannot explain long run performance which is explained by improvements in research and development. (Gregory & McCorriston, 2005)
To sum up, the impact of M&As on shareholders' wealth depends on various factors such as the legal structure in which the target company is based, the geographical location of the target company, specific firm and deal characteristics and so on.
Conclusion
M&As, if properly executed can create greater value. An acquirer should compare and weigh the benefits and potential costs of acquring a company before doing so. If he is positive, based on thorough analysis and due diligence that benefits will outweigh costs then only should he proceed with the takeover.
It is very important to do follow up after the merger takes place. Finance, legal and HR departments collect data on various measures which can help in monitoring and assessing the success of an M&A such as increase or decrease in share price, revenue, operating profit, productivity levels, profitability, and market share and so on. (Carleton and Lineberry, 2004)
The key to the success of an M&A lies in the ability of the acquirer to manage the integration of the target company into his existing organization in all respects from winning the hearts and minds of his employees, resolving issues quickly and to eliminate any cultural differences that might arise subsequent to the acquisition. (Harrison, 2010)
