overvaluation. Long-term abnormal returns of the combined firms in stock mergers are negative. (Pages 3–4)
The new theory of overvaluation and information asymmetry does little to explain the clustering of M&A activity in industries, but it advances our understanding of merger waves and lends a couple of practical implications. First, it helps explain the association between the buoyant stock markets of the 1960s, 1980s, and 1990s and the coincident large merger waves. Second, it presents a framework for thinking about the form of payment (about which more is said in Chapter 20). As a practical matter, then, this theory invites executives to consider three questions:
1 What is the level of the market today? Deal makers will be influenced by the relative levels of valuation. The practitioner can compare valuation multiples such as the price/earnings ratio or market/book ratio for the market averages today, with those prevailing in the past. During 1998–2000, such a comparison showed the market to be highly valued (“irrationally exuberant” in Robert Shiller’s terms).
2 What is the valuation of my firm relative to the market? If you want to figure out where your firm is likely to be in the food chain, focus on its valuation relative to other firms. The new theory suggests that more overvalued firms will be buyers, and less overvalued firms will be targets.
3 What do I know that the market doesn’t? This is one of the fundamental questions M&A practitioners should always ask. The new theory lends weight to it by suggesting that most practitioners ask it. The timing and form of payment of M&A activity is basically motivated by a disparity between one’s own assessment of the intrinsic value of the firm and the market price. The theory suggests that the main basis for believing that your estimate of intrinsic value is better than the market price is because of an information advantage.
Agency Costs and the Correction of Governance Problems
The wave of M&A activity in the 1980s differed from others in two important ways: the relatively high volumes of hostile takeovers and of leveraged buyouts. Arguments prominently associated with Michael Jensen suggest that this was a decade of the disciplinary response of investors to the mounting agency costs of entrenched managements. Agency costs are inefficiencies arising from such things as self-interested risk management,7 perquisites, and lax attention. These costs accumulate because of the failure of directors to monitor and control the management of the firm in the best interests of its shareholders. Shareholders bear the costs of agency problems in the form of depressed share prices. Taking over the firm and restoring it to more efficient operation rewards new management with profits in the form of dividends and capital gains.
A great deal of empirical evidence is consistent with this view. Chapter 6 summarizes findings that restructuring and redeployment of assets is profitable to investors. Chapter 20 surveys studies that report gains from leveraged buyouts and highly levered transactions. Holmstrom and Kaplan (2001) summarize findings that the 1980s were a wave of corrective M&A.
But did these corrective forces appear only in the 1980s and not in the other waves? The profit-seeking behavior should always be present. And what about the clustering of M&A activity within industries, or mergers between firms that are well governed? Still, the agency theory raises useful questions for the practitioner:
How efficient are my firm and the potential buyers and targets in its arena? Efficiency is a fundamental gauge to explaining who will be buyers and targets. The more efficient take over the less efficient firms.
To what extent do governance problems contribute to differences in efficiency? The quality of governance of a firm should be a telltale for the firm’s efficiency. Chapter 26 summarizes research findings that good governance pays and summarizes dimensions on which one could assess the quality of governance.
Monopoly, Competitive Positioning, and “Rent-Seeking” Behavior
The long literature in Industrial Organization within economics studies the relation between returns on one hand, and firm size or market power on the other. Chapter 6 summarizes some of these relations and the uses of M&A to enhance the position and market power of the firm. The literature suggests that the creation of monopolies and collusive oligopolies permits producers to extract excessive returns from consumers—this is the so-called “rent-seeking” behavior condemned by public policy analysts. Active antitrust enforcement by governments is a brake on the creation of monopolies through M&A. The M&A waves of the 1890s and 1960s were seriously curtailed by antitrust enforcement action. Chapter 28 surveys the antitrust laws in the United States and their implications for deal development. Still, within the confines of antitrust law, firms have some latitude to exploit product market inefficiencies. A stream of literature, stimulated by Michael Porter (1980) sketches techniques by which firms may enhance their competitive position—this is surveyed in Chapter 6.
A contributor to the appearance of waves of M&A activity may be a kind of multiplier effect induced by the breaking up or rationalization of acquired firms. For instance, a buyer may want only the target’s domestic operations, not foreign; or only certain product lines; or only specific assets. Thus, one acquisition triggers a cascade of other deals. Porter (1987) finds that 53 percent of acquisitions are sold within five years, evidence consistent with a process of asset rationalization.
The incentive to seek economic “rents” is always present. Theories of monopoly and competitive positioning have little to say about waves of M&A activity over time. But the theories help to rationalize tendencies toward industry consolidation. Exactly what triggers these consolidations is unclear in the theory. Still, the theory suggests two diagnostic questions useful to practitioners:
1 Does the structure of my industry provide opportunities for consolidation through M&A? Industries consisting of many small competitors may be ripe for consolidating mergers. Highly concentrated industries may pose barriers to entry through M&A.
2 What is the current antitrust policy in this country and toward this industry? Government policy changes with changes in administration and may be associated with different moods of constraint or buoyancy in M&A activity.
Industry Shocks
Nelson’s (1959) classic study of M&A waves suggested that surprising changes in demand could trigger firms’ acquisitions additional capacity through M&A. Acquisition is simply one branch of the “make or buy” decision. Gort (1969) suggested that the “economic disturbance” induced by industry surprises would trigger a wave of acquisition activity when it becomes cheaper to buy than to make. Gort’s idea was that industry shocks alter the mean and variance of investors’ assessments of intrinsic value for firms—such shocks could derive from unexpected changes in demand, changes in technology, movements in capital markets, and generally, changes in entry barriers within industries. Lambrecht (2002) extends the theory of industry shocks in a real options framework. He argues that firms always have the option to acquire instead of growing organically. Positive shocks increase the uncertainty or volatility of the firms’ asset values, and therefore the value of the “merger option.” This induces a rise
