that these accounting manipulations made fire and casualty insurance companies popular takeover targets during this period.36 Conglomerates found their large portfolios of undervalued assets to be particularly attractive in light of the impact of a subsequent sale of these assets on the conglomerate's future earnings. Even the very large Hartford Insurance Company, which had assets of nearly $2 billion in 1968 (approximately $13.9 billion in 2014 dollars), had assets that were clearly undervalued. ITT capitalized on this undervaluation when it acquired Hartford Insurance.
Another artificial incentive that encouraged conglomerate acquisitions involved securities, such as convertible debentures, which were used to finance acquisitions. Acquiring firms would issue convertible debentures in exchange for common stock of the target firm. This allowed them to receive the short-term benefit of adding the target's earnings to its EPS valuation while putting off the eventual increase in the acquirer's shares outstanding.
The decline of the conglomerates may be first traced to the announcement by Litton Industries in 1968 that its quarterly earnings declined for the first time in 14 years.37 Although Litton's earnings were still positive, the market turned sour on conglomerates, and the selling pressure on their stock prices increased.
In 1968, Attorney General Richard McLaren announced that he intended to crack down on the conglomerates, which he believed were an anticompetitive influence on the market. Various legal changes were implemented to limit the use of convertible debt to finance acquisitions. The 1969 Tax Reform Act required that convertible debt be treated as equity for EPS calculations while also restricting changes in the valuation of undervalued assets of targets. The conglomerate boom came to an end, and this helped collapse the stock market.
Little evidence exists to support the advisability of many of the conglomerate acquisitions. Buyers often overpaid for the diverse companies they purchased. Many of the acquisitions were followed by poor financial performance. This is confirmed by the fact that 60 % of the cross-industry acquisitions that occurred between 1970 and 1982 were sold or divested by 1989.
There is no conclusive explanation for why conglomerates failed. Economic theory, however, points out the productivity-enhancing effects of increased specialization. Indeed, this has been the history of capitalism since the Industrial Revolution. The conglomerate era represented a movement away from specialization. Managers of diverse enterprises often had little detailed knowledge of the specific industries that were under their control. This is particularly the case when compared with the management expertise and attention that are applied by managers who concentrate on one industry or even one segment of an industry. It is not surprising, therefore, that companies like Revlon, a firm that has an established track record of success in the cosmetics industry, saw its core cosmetics business suffer when it diversified into unrelated areas, such as health care.
Trendsetting Mergers of the 1970s
The number of M&A announcements in the 1970s fell dramatically, as shown in Figure 2.3. Even so, the decade played a major role in merger history. Several path-breaking mergers changed what was considered to be acceptable takeover behavior in the years to follow. The first of these mergers was the International Nickel Company (INCO) acquisition of ESB (formerly known as Electric Storage Battery Company).
Figure 2.3 Merger and Acquisition Announcements, 1969–1980. Source: Mergerstat Review, 2014.
After the third merger wave, a historic merger paved the way for a type that would be pervasive in the fourth wave: the hostile takeover by major established companies.
In 1974, Philadelphia-based ESB was the largest battery maker in the world, specializing in automobile batteries under the Willard and Exide brand names as well as other consumer batteries under the Ray-O-Vac brand name. Although the firm's profits had been rising, its stock price had fallen in response to a generally declining stock market. Several companies had expressed an interest in acquiring ESB, but all these efforts were rebuffed. On July 18, 1974, INCO announced a tender offer to acquire all outstanding shares of ESB for $28 per share, for a total of $157 million. The Toronto-based INCO controlled approximately 40 % of the world's nickel market and was by far the largest firm in this industry. Competition in the nickel industry had increased in the previous 10 years while demand proved to be increasingly volatile. In an effort to smooth their cash flows, INCO sought an acquisition target that was less cyclical.
INCO ultimately selected ESB as the appropriate target for several reasons. As part of what INCO considered to be the “energy industry,” ESB was attractive in light of the high oil prices that prevailed at that time. While it featured name brands, ESB was also not in the forefront of innovation and was losing ground to competitors, such as Eveready and Duracell.
Because the takeover was an unfriendly acquisition, INCO did not have the benefit of a detailed financial analysis using internal data. Before INCO acquired ESB, major reputable corporations did not participate in unfriendly takeovers; only smaller firms and less respected speculators engaged in such activity. If a major firm's takeover overtures were rebuffed, the acquisition was discontinued. Moreover, most large investment banks refused to finance hostile takeovers.
At this time, the level of competition that existed in investment banking was putting pressure on the profits of Morgan Stanley, INCO's investment banker. Although it was seeking additional sources of profits, Morgan Stanley was also concerned that by refusing to aid INCO in its bid for ESB, it might lose a long-term client. Morgan Stanley, long known as a conservative investment bank, reluctantly began to change posture as it saw its market share erode because of the increasingly aggressive advance of its rivals in the investment banking business. Underwriting, which had constituted 95 % of its business until 1965, had become less profitable as other investment banks challenged the traditional relationships of the underwriting business by making competitive bids when securities were being underwritten.38
Many banks, seeking other areas of profitability, expanded their trading operations. By the 1980s, trading would displace underwriting as the investment bank's key profit center.39 This situation would change once again toward the end of the 1980s as fees related to M&As became an increasingly important part of some investment banks' revenues.
ESB found itself unprepared for a hostile takeover, given the novelty of this type of action. INCO gave it only a three-hour warning of its “take it or leave it.” ESB had installed some antitakeover defenses, but they were ineffective. It sought help from the investment bank of Goldman Sachs, which tried to arrange a friendly takeover by United Aircraft, but by September 1974, INCO's hostile takeover of ESB was completed.40 The takeover of ESB proved to be a poor investment, primarily because INCO, as a result of legal actions associated with antitrust considerations, was not given a free hand to manage the company. Not until 39 months after INCO had completed the acquisition did it attain the right to exercise free control over the company. Moreover, as noted previously, ESB's competitors were already aggressively marketing superior products. By 1981, ESB was reporting operating losses; INCO eventually sold it in four separate parts. INCO continued to be the world leader in the nickel business. Interestingly, it stepped into the role of white knight in 2006, when it made a bid for Canadian Falconbridge, a leading copper, nickel, and zinc producer, which was the target of an unwanted 2005 bid from the Swiss mining company Xstrata. This led to a long and complicated takeover battle involving several companies. Eventually, INCO was acquired for approximately $17 billion by the world's largest producer of iron ore, Brazilian company CVRD.
Although the ESB acquisition was not financially successful,
Steiner,
Stanley H. Brown,
Ken Auletta,
For an excellent discussion of this merger, see Jeff Madrick,
