Eat or Be Eaten : A Theory of Mergers and Firm Size ∗

We propose a theory of mergers that combines managerial merger motives and a regime shift that may lead to some value-increasing merger opportunities. Anticipation of the regime shift can lead to mergers, either for defensive or positioning reasons. Defensive mergers occur when managers acquire other firms to avoid being acquired themselves. Mergers may also allow a firm to position itself as a more attractive takeover target and earn a takeover premium. The identity of acquirers and targets and the profitability of acquisitions depend, among other factors, on the distribution of firm sizes within an industry. ∗ The views in this paper are those of the authors and may not represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. We thank Amit Goyal, Cabray Haines, Shah Hussain, Feifei Li, and Yihui Wang for excellent research assistance. We are grateful for helpful comments and suggestions by Andres Almazan, Antonio Bernardo, Sanjai Bhagat, Bhagwan Chowdhry, Michael Fishman, Gunter Strobl, S. Viswanathan, Ivo Welch, seminar participants at the University of Houston, Purdue University, and the University of Wisconsin-Madison, and conference participants at the AFA 2000 meetings and the Texas Finance Festival 2000. This is a substantially revised version of an early draft that was presented at these conferences. Of course, all remaining errors and shortcomings are solely our responsibility. Introduction The 1990s produced the greatest wave of mergers in U.S. history. Between 1995 and 2000, U.S. merger volume set a new record every year, expanding from $800 billion in 1995 to $1.8 trillion in 2000. Due to the growth and importance of mergers, a substantial academic literature has developed to examine them. However, existing merger theories remain unable to reconcile certain key facts about merger activity. Two of the most important stylized facts about mergers are the following: First, the stock price of the acquirer in a merger decreases on average when the merger is announced. Recent work shows that this result is driven by negative announcement returns for very large acquirers, while small acquirers tend to gain in acquisitions (Moeller et al. (2004) and Kahl and Rosen (2002)). Second, mergers concentrate in industries that have experienced regime shifts in technology or regulation. Mergers may provide an efficient strategy for managers coping with such a shift and seeking to maximize the value of their firms (see, for example, Mitchell and Mulherin (1996), Andrade, Mitchell, and Stafford (2001), and Andrade and Stafford (2004)). The view that mergers are an efficient response to regime shifts by value-maximizing managers – the so-called neoclassical merger theory (see, for example, Mitchell and Mulherin (1996), Weston, Chung, and Siu (1998), and Jovanovic and Rousseau (2002)) can explain the second stylized fact. However, it has difficulties explaining negative abnormal returns to acquirers. Theories based on managerial self-interest or a desire for larger firm size and diversification (for example, Morck, Shleifer, and Vishny (1990)) can explain negative acquirer returns. However, they cannot explain why mergers are concentrated in industries undergoing a regime shift. This paper provides a theory of mergers that combines elements from both of these schools 1 See “The Year of the Mega Merger. ”, Fortune Magazine, January 11, 1999, “Tales of the Tape: ’99 M&A Vol Hits Record. ”, Dow Jones News Service, December 29, 1999, and “Year-End Review of Markets & Finance 2000. ”, The Wall Street Journal, January 2, 2001. 2 Studies that find negative average returns to bidders include Asquith, Bruner, and Mullins (1987), Banerjee and Owers (1992), Bradley, Desai, and Kim (1988), Byrd and Hickman (1992), Jennings and Mazzeo (1991), Servaes (1991), Varaiya and Ferris (1987), and You, Caves, Smith, and Henry (1986). See Table 86 in Gilson and Black (1995). See also the recent survey by Andrade, Mitchell, and Stafford (2001). Bradley and Sundaram (2004) find, using a much larger sample of mergers in the 1990s, that most acquirers experience positive announcement returns. The negative announcement returns are concentrated among stock financed acquisitions of public targets that are large relative to the acquirer. 3 Other papers in which managerial motivations for mergers are prominent include Amihud and Lev (1981), Shleifer and Vishny (1989), and May (1995). Theoretical papers representing the neoclassical tradition include Gort (1969) and Rubin (1973). Negative acquirer announcement returns can be explained without appealing to agency conflicts between managers and owners if the takeover announcement reveals negative information about the acquirer’s profitability relative to expectations (see McCardle and Viswanathan (1994) and Jovanovic and Braguinsky (2004)).