Value-Creating Mergers: Fact or Folklore?

Since 1983, over 12,000 companies and corporate divisions worth about one-fifth of the market value of all traded stocks have changed hands. Investment bankers and corporate lawyers have prospered, and words such as "raiders," "greenmail," "white knights," and "golden parachutes" have been added to our vocabulary. This enrichment aside, however, are mergers good for much else? The consensus of the popular business press, which continues to focus on mergers that backfire, seems to be ''no." Almost every month a major article appears with a title such as "The Decade's Worst Mergers," and "Have Mergers Gone Too Far?" These articles love to recount the details surrounding problem-plagued mergers such as Exxon's $1.2 million blunder with Reliance Electric, Kennecott's mismanagement of Carborundum, or Coca-Cola's surprising setback with Taylor Wines.' The position of more than two dozen bills recently introduced in Washington to restrict merger activity is also "no." Proponents of these bills assert that the U.S. economy has suffered because mergers squander resources in the pursuit of illusory efficiency gains. Among the backers of these bills is Andrew C. Sigler, who is president of the Business Roundtable, an organization made up of the 200 largest corporations. Sigler charges that mergers are "nothing but a grubby asset play" that is "damaging the capability of the economic system to perform."2 Financial economists such as Professor Michael Jensen of Harvard and Richard Ruback of MIT represent a more tempered opinion. They maintain that selling firms' shareholders do benefit, but that the buying firms' shareholders do not. At best, they say, the "bidding-firm shareholders do not lose." In addition, they find mergers to be ineffective in reducing shareholder and business risks.3 These observations present a sobering picture of corporate decision makers. If on average mergers do not create value for the acquiring firms, why do managers continue to initiate them? Are managers oblivious to the legacy of those who have failed before them? Or are managers acting in their own interests because their rewards are more closely tied to corporate growth than to corporate value? The purpose of this article is to suggest a different view, one that comes from a growing body of literature that considers the strategy underlying mergers. This literature recently has produced three dissertations that earned national awards for excellence from the Academy of Management as well as a growing number of published articles on mergers.4 It presents findings that challenge the widely held beliefs concerning the value of mergers. We begin with a review of the theory of corporate diversification as it pertains to mergers. The potential benefits and practical impediments of related and unrelated mergers are discussed as background to this basic question: Can a firm create value for its shareholders through merger? We investigated the questions from the perspective of two conditions that are valuable to shareholders. One is when stock returns (appreciation plus dividend) increase as a result of merging, and the increase is in excess of the merging firm's cost of equity and general stock market movements; that is, when a merger causes abnormal returns. Evidence is presented from the strategic management literature that examines abnormal stock returns from the perspectives of selling and buying firms' shareholders. The second condition is when shareholder risk (cost of equity) declines as a result of a merger to a degree greater than that which could be realized through a securities manager's investment in both businesses. Shareholder risk is basically the variability in a firm's stock returns that is caused by the variability in the market's returns. Another name for shareholder risk, therefore, is systematic risk. We consider evidence on mergers and shareholder risk, and mergers and the full variability in a firm's stock returns that is, total risk. Finally, we offer practical suggestions for improving the effectiveness of mergers. The suggestions are particularly timely in light of the increased attention currently focused on shareholder value and the fact that many executives are unsure of exactly how their firm's actions affect stock price. For example, a Louis Harris and Associates, Inc. poll found that 60% of executives surveyed do not agree with the market's valuation of their company.5