Types of Synergy and Economic Value: The Impact of Acquisitions on Merging and Rival Firms

Transcription

1 / c Strategic Management Journal, Vol. 7, (1986) Types of Synergy and Economic Value: The Impact of Acquisitions on Merging and Rival Firms SAYAN CHATTERJEE Krannert Graduate School of Management, Purdue University, West Lafayette, Indiana, U.S.A. Summary Acquisitions, in general, have been demonstrated to create economic value. The intuitive reason underlying this value creation stems either from an ability to reduce costs of the combined entity, an ability to charge higher prices, or both. Current research in the area attributes these abilities to an opportunity to utilize a specialized resource. Our focus in this study is to compare three broad classes of resources that contribute to the creation of value. Following the conventional wisdom, these resources are classified as cost of capital related (resulting in financial synergy), cost of production related (resulting in operational synergy), and price related (resulting in collusive synergy). Given the limitations of our sample and research design, we find that collusive synergy is, on average, associated with the highest value. Further, the resources behind financial synergy tend to create more value than the resources behind operational synergy. INTRODUCTION A takeover wave is rolling across corporate America (New York Times, 3 July 1984). Whether or not they do in fact occur in waves, mergers have always been an endemic feature of corporate America and consequently they have drawn the attention of academicians since the mid-1950s. Researchers have attempted to answer many different questions concerning acquisitions. However, the question that should be of primary interest to managers concerning mergers is what are the strategies... of acquisition that offer the potential for creating real economic value (Salter and Weinhold, 1979). While acquisitions in general have been demonstrated to create economic value (Jensen and Ruback, 1983), very few studies have sought to identify the value related to specific acquisition strategies (the exceptions being Singh 1984; Lubatkin, 1983, 1984). An intuitive reason for this value creation is that it comes about either because the combined entity can enjoy reduced costs, charge higher prices for its products, or both. Current research in this area suggests that the increased value results from an opportunity to utilize a specialized resource which arises solely as a result of the merger (Jensen and Ruback, 1983; Bradley, Desai and Kim, 1983). The purpose of this study is to examine different types of acquisition strategies, and to begin objectively exploring the determinants of the performance differences. In order to observe these differences, the changes in equity values of merging firms and their direct /86/ $ by John Wiley & Sons, Ltd. Received 25 May 1983 Revised 27 September 1984

2 120 S. Chatterjee competitors are ascertained at the time of the merger announcement for portfolios of firms which are formed based on the imputed specialized resources utilized as a result of the merger. Following the conventional wisdom, these resources are classified as cost of capital related (resulting in financial synergy), cost of production related (resulting in operational synergy) and price related (resulting in collusive synergy). I Given the limitations of our sample and research design, we find that collusive synergies tend to be associated with more value than either of the two other types of synergies. Further, financial synergies, on average, tend to be associated with more value than do operational synergies.* A review of related research Most of the recent work on acquisitions has been done in the area of finance using capital market data aggregated over a large number of merging firms. These studies demonstrate that on average a wealth gain accrues to the stockholders of the merging firms as measured by the cumulative abnormal returns (CAR) of the firms stock prices during the merger announcement period (see the section on methodology for details). The wealth gain is attributed to the utilization of resources resulting in different types of synergies as discussed earlier (see Eckbo, 1983; Bradley et af., 1983). However, while there do exist comprehensive theoretical reasons purporting to explain the underlying resources which give rise to these synergies, a serious effort to link the type of synergy to the amount of economic value created is absent from the literature. Two studies in the field of business policy (Singh, 1984; Lubatkin, 1984) have taken steps to fill this gap by analyzing the economic value associated with different types of mergers. The focus on types of mergers was possibly, in part, motivated by the findings of other business policy studies that indicate that related diversification strategies outperform unrelated diversification strategies (Rumelt, 1974, 1982; Montgomery, 1979; Bettis, 1981). In order to test these findings using the CAR methodology, the comparison of economic value by types of acquisition is necessary. However, since there is usually more than one type of synergy associated with the different types of mergers (see Table l), this approach requires modification before the relative effects of the synergies can be directly compared. At this point one might question why a typology of synergies is of interest. To answer this question, a conceptual framework of the creation of economic value is developed in the next section. A model of the creation of economic value For an acquisition strategy to create economic value, a distinctive competence (i.e. scarce resource) must be matched to an opportunity in the environment (Andrews, 1971). This leads to a resource-based view of the firm as developed in Wernerfelt (1984). Given this perspective, the amount of economic value that will result from a merger will depend on: By price related we mean the ability to increase prices because of collusion among the industry participants. The resources related to cost of production can be used to lower the final price of the product, but this is an indirect result due to operational synergy which in the first place had enabled the merged entity to produce at a cheaper cost than was possible before the merger (also see Steiner, 1975:47-74). The term synergy is used in the literature because the value creation implies a breakdown in the value additivity principle for the merged entity (Steiner, 1975:47-74; Salter and Weinhold, 1979:9). It should be noted that it is the utilization of the resource that creates the value. Thus when we say that financial synergy is associated with higher level of value creation than operation synergy, we mean that the resources related to cost of capital create more value than do resources related to cost of production. The typology of synergies is, therefore, being used as an abbreviated way of linking the value created to the underlying class of resources. (See the section on A classification of scarce resources by synergies, for further discussion of this point.)

3 Types of Synergy and Economic Value 12 1 (a) (b) the amount of the resource held by the firm, relative to the total amount present in the economy, and the availability of opportunities to utilize this resource. While the supply of a resource to meet existing demands will always create value for the economy as a whole, an individual firm will earn only a competitive rate of return (i.e. zero economic profit) unless the firm has monopoly access to the resource. In other words, to create economic value for the firm, the resource it owns has to be scarce. Further, as Wernerfelt (1984) points out, resources can have multiple uses. This leads us to posit that the more ways in which a scarce resource can be utilized, ceterisparibus, the greater the expected economic value that it can potentially give rise to. Formally stated, Expected economic value = F (Scarcity of resource, Availability of opportunities) An additional element needs to be incorporated into the above model. The concept of strategy emphasizes the matching of strengths (resources) to opportunities (uses). One aspect of this matching is the difficulty of implementation. This difficulty, if present, will adversely affect the chances of creating economic value. We shall therefore, use the following modified model as the conceptual basis of this study. Expected economic value = F Scarcity of resource Problems in implementing Availability of opportunities A classification of scarce resources by synergies Ultimately, the purpose of a study like this is to enable the potential acquiring managers and owners to make an informed decision about which of the firm s resources would create the most value upon a merger. To tackle this problem at the individual firm level requires a clinical study, the results of which may or may not be generalizable. However, the differences in the level of value created by two or more different classes of resources can be studied using a large sample design. We think that this is an improvement over examining the level of value creation by type of merger because, in any given merger, more than one class of resources may be utilized. A firm may have only a subset of all the different classes of resources at its disposal. For such a firm the value-creating potential of different classes of resources is more important than that of different types of mergers. The typology of synergies that exists in the literature provides a convenient means of classifying the scarce resources. While other authors have used varying levels of detail in their typologies (Lubatkin, 1983), the three broadest categories are used here. Thus, collusive synergy represents the class of scarce resources leading to market power. Operational synergy represents the class of scarce resources that leads to production and/or administrative efficiencies. Financial synergy represents the class of scarce resources that leads to reductions in the cost of capital3 This type of synergy is not generally accepted by financial economists because it implies privileged access to capital by some firms, an impossibility if the capital market is fully arbitraged. However, reality (the existence of the prime rate), academicians in general (Steiner, 1975:64) and theoretical economists (Grossman and Stiglitz, 1976; Stiglitz, 1981; Teece, 1983) lead 11s 10 believe otherwise. From the theoretical economic perspective, privileged access to capital cannot exist if and only if information is costless (i.e. if and only if strong-form efficiency, as defined in the finance literature exists) (Stiglitz, 1981; Teece, 1983). That this is patently not the case is admitted by the financial economists. We therefore argue for the existence of financial synergies via what Williamson (1975) calls the internalization of the capital market by (conglomerate) mergers.

4 122 S. Chatterjee To reiterate, our goal is to compare the values associated with these different types of synergies and, hopefully, to explain any differences present by referring to the three factors in the conceptual model. If we have a defensible concept of the economic potential of each of the different types of synergies, we are in a much better position to explain the economic potential of different types of mergers, because the value created by a merger is associated with one or more of these types of synergies. (This point is discussed in greater detail in the section dealing with the research design.) Effects of mergers on rival firms Let us assume that we have managed to control for the impact of collusion in our sample of mergers. Then the wealth gain attributable to the merger should be related to either an operational and/or a financial synergy. A cost-efficient production and/or investment policy will enable the merged firm to sell the product at a lower price than can its rivals. Also a cost-efficient production process will reduce the demand for factor inputs, thus increasing factor prices. So the net effect of the cost-efficiency is that the rivals face a lower final price of the product and also a higher cost of raw materials. Therefore, unless the rival firms can adopt the same cost-efficient production process made possible by the merger, they will not be able to be cost-competitive. Hence, the net impact on the rivals will be a reduction in their market value. We shall call this the product/factor price effect. It needs to be noted that the product/factor price effect is contingent on the rival firms inability to adopt the same cost-efficient production process and they, therefore, suffer a loss in market value. However, the merger announcement may contain information about a process innovation or a technological innovation which makes these cost-efficiencies possible. In order to implement these innovations the rival firms, therefore, become possible merger targets to take advantage of the technological complementarities (related diversification) or simply to provide capital which is not readily available in the capital market (unrelated diversification). Jarrell and Bradley (1980) have demonstrated that the stock price of the rivals will be bid up in anticipation of the gains from such mergers. We attribute this increase in value to the information effect of the mergers. The total wealth impact on the rivals is the sum of the (negative) product/factor price effect and the (possibly offsetting positive) information effect given as follows. Dw = Information effect (gain) + Price effect (loss) where Dw is the net change in market value of the rival firm before and after the merger announcement. If we make the assumption that with a large sample the information effect of any merger will be roughly equal across different classes of rivals, then the relative magnitude of the wealth gain/loss of the rivals will be indicative of the negative (product/factor price) effects on rivals in each class of mergers. In other words, our arguments lead to the prediction that the relative wealth gain/loss of the rival firms should be inversely related to that of the merging firms in each class. For example, suppose that we are examining the impact of related and unrelated mergers. If the targets of related mergers exhibit a proportionally greater wealth gain than those of unrelated mergers, then it is reasonable to think that the combined related firms are a more cost-efficient corporate entity than are the merged unrelated firms (Eckbo, 1983). In such cases we would expect the rivals of the related target firms to experience a more negative change in market value due to the product/factor price effect than the rivals of the unrelated targets. Even if this negative change in wealth were

5 Types of Synergy and Economic Value 123 partially or fully offset by the information effect resulting in a net gain to the rivals of both classes of mergers, we would expect the gains to the rivals of the unrelated targets to be higher than the gains to the rivals of the related targets. This analysis leads to testable implications which will serve as a check to the results of the merging firm. RESEARCH DESIGN, DATA AND METHODOLOGY Research design In general, it is almost impossible to estimate the economic value of a particular strategic move. However, the studies by Lubatkin (1984) and Singh (1984) utilize the CAR methodology which provides an indication of the economic value created in an individual acquisition. The same approach is used here to determine the economic value of the three different types of synergy. Merging firms Ideally, to study the three types of synergy, we would like to be able to draw the following links: Horizontal mergers = Collusive synergies Related or vertical mergers = Operational synergies Unrelated or conglomerate mergers = Financial synergies These equivalencies imply that there is no difference between the type of mergers and the type of synergy. Unfortunately, mergers in general are unlikely to fit into such a classification. For example a horizontal merger, by definition, is a related acquisition and may involve utilization of economies of scale and/or scope both in production and distribution. This may lead to reduced costs (i.e. operational synergies), apart from any collusive gains. By the same logic, financial synergies may also be present in horizontal mergers (see Table 1). Hence, the types of synergies cannot be classified based on types of mergers. In order to empirically separate operational and collusive synergies, a research design is required that is beyond the scope of this study. Here, we are concerned solely with Table 1. Different types of mergers and the associated synergies Type of merger Related Type of synergy Horizontal* Non-horizontal Unrelated Collusive Possible Unlikely Unlikely Operational Possible Possible Unlikely Financial Possible Possible Possible * Horizontal mergers are eliminated from this study as discussed in the section on Research design and in footnote 4.

6 124 S. Chatterjee separating financial and operational synergies so that the effects of these can be compared in a meaningful fashion. In selecting the sample of merging firms, we go through the following steps: (a) elimination of collusive synergies, (b) elimination of speculative effects, (c) emphasizing financial synergies, and (d) standardization of synergistic gains. Each of these is discussed in detail below. Elimination of collusive synergies. For a merger to be motivated by demand-side collusion, it will of necessity have to be horizontal, i.e. the merging firms must be in the same industry. Note that the universe of all related mergers contains both horizontal and non-horizontal mergers (such as mergers undertaken for product or market extension by firms that are not in the same ind~stry).~ If, therefore, we restrict our sample of related mergers by excluding all horizontal mergers we can control for demand-side collusion that might motivate such mergers. This sample of related, non-horizontal mergers can, of course, contain firms which experience both operational and financial synergies. This sample can be compared with a sample of unrelated mergers which are likely to have only one form of synergy present, i.e. financial synergy. Elimination of speculative gains. The second fact that we need to consider is the measure of economic value. Singh (1984) and Lubatkin (1984) provide a detailed discussion as to why the CAR methodology is appropriate in examining the future economic value of the combined firm. The interested reader is referred to these studies. In order to maintain consistency in comparing the CARS of individual acquisitions, only merger proposals will be examined. Tender offers are not included in order to eliminate the effect of any speculative gains that may occur due to the presence of risk arbitrageurs: This discussion has at least partial support from the empirical results in the finance literature. The abnormal returns exhibited by target firms in the case of tender offers is on the average 10 percentage points higher than the abnormal returns exhibited by targets who enter into a mutual agreement to merge (Jensen and Ruback, 1983:7). Thus if one of our sample groups contained an abnormally large proportion of firms receiving tender offers, the abnormal returns to that group would tend to be inflated due to speculative motives, masking the true gains that we are trying to identify. Thus, irrespective of the fact that Eckbo (1983) has examined horizontal mergers in detail. For this reason, horizontal mergers are not considered in this study. Unfortunately, Lubatkin (1984) groups horizontal mergers with mergers made for market extension purposes. If these had not been combined, his results would have provided a check on Eckbo s and our results. We do share one concern in common with the lay person that sometimes stock price movements may be caused solely by stock market jockeys (risk arbitrageurs, to use the technical term). Fortunately, there are some indications as to when the market is reacting in a speculative manner. Acquisitions are usually carried out through one of three means: merger agreements, tender offers, and proxy fights. Proxy fights are eliminated from this study due to data problems. Tender offers differ from mergers in that (a) the announcement of a tender offer is no guarantee of an eventual merger, and (b) the price of the target firm s shares is artificially raised by the fact of the tender bid. The price, in this instance, is not a market consensus about the change in the future performance of the merged entity, but simply represents what the bidding firm is willing to pay for the target. This is a situation rife for speculation and the target firm s stockholders will try to second-guess the bidding firm s offer. Almost invariably, risk arbitrageurs will buy the target firm s shares in hopes that a higher tender bid will be forthcoming. Thus the price change during a tender offer may include a substantial speculative element apart from any changes in expectations about the merged firm s future performance.

7 Types of Synergy and Economic Value 125 tender offers may lead to speculation, we need consider only mergers, eliminating tender offers from the sample. Emphasizing financial synergies. We make the following assumption that is well accepted in academia (except, perhaps, by financial economists, as discussed in footnote 3) and by practitioners. This is that on average a large firm has cheaper access to capital than does a small firm (Steiner, 1975:64). To highlight the financial synergy aspect of unrelated mergers one should, therefore, choose only those unrelated mergers where the bidding firm is significantly larger than the target firm.6 The reasons for this are as follows. Any synergy that is generated by the merger is limited by the size of the target firm. For example, any operational synergy is limited by the economies of scale/scope that the (postmerger) target firm is capable of generating. The amount of synergy present should thus be correlated with the target firm s size and hence can be proxied by it. Similarly, any capital infusion provided by the acquiring firm is useful only to the point that it can be absorbed by the target. By choosing relatively large acquiring firms compared to the targets in the unrelated sample, we are simply trying to ensure that there is an overkill in capital availability, i.e. the potential financial synergy arising out of the merger can be fully exploited. Hence, after selecting the sample as described above, if we choose targets which are the same size on the average in related and unrelated samples, then the comparison of the relative profitabilities should be at least indicative of the relative economic value of financial synergy as compared to operational synergy. The related mergers should again ideally be stratified according to the relative sizes of acquiring firms to their respective targets in order to try to capture the differential impact of financial synergies in such mergers.s Standardization of gains. It would be almost impossible to select target firms that are the same size in both samples. Since we are interested in comparing the absolute wealth gains for the same size in the two samples, we have to standardize the wealth gain to the same asset base for each of the two samples. (If the absolute size of any one target varies significantly from the rest of the sample, it was felt that it was better to eliminate it from the sample than to control for any differential impact of absolute size.) Rival firms In the absence of any information effects, the gains experienced by the target firms should equal the losses experienced by their rival firms. However, three problems arise in attempting to measure these wealth transfers: (a) all possible rivals cannot be accounted for because only a fraction of them have stocks which are traded publicly, (b) the impact of the product/factor price effect on an individual rival will depend on how much stake the rival firm has in the affected industry, and (c) the discernible effect on an individual rival will decrease as the number of rivals increases. This should be done in two steps. Our original hypothesis was that the acquiring firms in conglomerate mergers would have a larger relative size compared to that of the related acquiring firms. Further, within the conglomerate class we expect there would be a correlation between relative size and wealth gains. While these expectations are supported by casual observation, the sample size does not permit any conclusions to be drawn with acceptable statistical rigor. Strictly speaking, this fact should be incorporated in the research design only if a positive correlation is present. We are, therefore, relying on intuition in choosing larger relative size of the bidding firm as compared to the target firm to highlight the presence of financial synergies. Size, per se, does not guarantee capital availability although it might imply a cheaper cost of capital. To ensure capital availability the acquiring firms need to be screened using some measure of liquidity. Also size may be a proxy for degree of diversification. This might mean that a large firm has diversified to the point where all of its future acquisitions are of the conglomerate type (Ansoff, 1965). This could explain why the unrelated acquiring firms tended to be larger than the related acquiring firms. We were unable to do this in this study due to the paucity of sample points.

8 126 S. Chatterjee To deal with these problems, note that the target firms are usually involved in a single line of business which accounts for the majority of their sales. This is usually the business that the acquiring firm is interested in obtaining. In contrast, the acquiring firms are, on average, much more diversified. Further, the observed abnormal returns of the target firms are usually much larger than those of the respective acquiring firms (see section on Results for target firms, for an explanation). These facts prompt us to analyze the wealth gain/loss to the rivals of the target firms for two reasons. First, if the merger indeed improves the cost-efficiency of the merged firms, we have a well-defined industry (based on the target s line of business) in which to look for the effects on the rivals. On the other hand, while theoretically the acquiring firm should also become a stronger cost-efficient entity after the merger, we do not know for certain which of its many diversified businesses is most strengthened, and therefore it is difficult to determine the appropriate rival firms of the acquiring firms. Second, the wealth gain/loss to the rivals needs to b: compared with the wealth gains of the merged entities to reach any meaningful conclusions. Since the acquiring firms abnormal returns are invariably much smaller than those of the targets, it is easier to focus on the more apparent abnormal returns of the targets as a yardstick against which the rivals gains/losses can be compared. Prediction of differential gains At this point one might hypothesize that horizontal mergers produce the most value, followed by related, non-horizontal mergers, with unrelated mergers creating the least amount of value. The logic behind such a hypothesis would be as follows. Horizontal mergers can be expected to have all three forms of synergy and hence to exhibit higher gains than the related, non-horizontal mergers which do not have the collusive synergy component. The related, non-horizontal mergers can, in turn, be expected to result in higher gains than unrelated mergers which should not have any operational synergies. The fallacy in this logic is that there is no reason to believe that all three types of synergy contribute equally to a particular merger, i.e. a horizontal merger generates three units of synergy, one each of collusive, operational and financial and an unrelated merger only one unit, that of financial synergy. This point requires elaboration. Assume that firms A and B enter into a related merger exploiting an economy of scope. This leads to operational efficiencies that are reflected in cost reductions. The increased profits may be represented by $XAB. Suppose firms C and D enter into an unrelated merger where firm C infuses capital into a project that firm D can pursue at a cost of capital significantly cheaper than what it could obtain in the capital market. This project then leads to an increased profit of $YcD. Admittedly, firms A and B may also have opportunities for resource pooling leading to a reduction in the merged firm s cost of capital and an incremental profit of $YAB associated with this financial synergy. The conventional wisdom would suggest that: However, this statement need not always hold true, for two reasons. First, this relation is realistically probabilistic in nature. In other words, the expected values of the amounts on We are making the somewhat arbitrary assumption that synergies are additive. This need not be so. However, the argument that follows is not dependent on the functional form of the expression on the left-hand side of the equation as long as the righthand side of the inequality has only one form of synergy.

9 Types of Synergy and Economic Value 127 both sides of the inequality must be considered. This by itself may reverse the sign." Second, the actual values of SX,,, SY,, and SY,, must be considered. If SY,, happens to be a large number with a high probability of occurrence, then the expected value of the synergistic gains from the merger of firms C and D may be higher than that from firms A and B. The actual values of SX,,, SY,, and SY,, would depend on the scale of capital utilization and the magnitude of cost reductions that can be achieved in the unrelated and related mergers respectively, as discussed earlier. The values above are absolute profits, but if the target firms in each group are roughly the same size on average, then the quantities become commensurate with profitability and are then directly comparable. If the returns are compared directly, and if rational behavior on the part of the managers of the acquiring conglomerate is assumed, we would expect them to invest their excess capital in a project (in this case the acquisition) which would generate a return greater than the next-best use. In a study utilizing published data there is no way of ascertaining what alternative uses are open to the acquiring firm. We shall, therefore, leave that as an empirical question. Data The merger data were gathered primarily from the Federal Trade Commission's (FTC) Statistical Report on Mergers and Acquisitions. This report contains all completed mergers occurring between 1948 and 1976 where the merging firms had an individual asset base of $10 million or more. The time period examined in this study, 1969 to 1972, was chosen on a random basis." Initially, a sample of 157 mergers was selected with at least one of the firms involved in the merger being present on the Center for Research on Security Prices (CRSP) tapes. The sample of rival firms consists of firms whose business is the same as that of the major business of the target firm during the period of this study.!* Selection of the six sample portfolios 'Product extension conglomerate mergers' as classified by the FTC were used as the starting point for forming the portfolios of related, non-horizontal mergers. 'Other conglomerates' as classified by the FTC were used as the basis for forming the unrelated mergers portfolios. Reference will be made to Eckbo's (1983) study of horizontal mergers in order to compare our results with those of horizontal mergers where collusive synergy is most likely to be present. Each individual firm in our data base was scrutinized to ensure that it met the restrictions imposed on the ~amp1e.l~ The firms were then examined to see if there were any events which might bias the estimated regression coefficients which are based on a window of 200 days prior to the announcement date of the proposed merger. The sample of mergers was, lo Lubatkin (1983) predicts synergistic benefits based strictly on the probabilities that a certain type of synergy may be present. While the probabilities that he assigns reflect subjective points of view, we do not take argument with them. However, we disagree on the simple summation of the probabilities and the use of the resultant scores to predict total synergistic benefits in each class. " Michael Lubatkin has pointed out to me that these years also happen to be very active in terms of the number of antitrust rulings. The elimination of these potentially collusive synergies actually helps our research design. '' The majority of the rivals had only one line of business as identified by the SIC codes used in the Dun and Bradstreet Million Dollar Directory. If the target firms had more than one business, then the two primary businesses were used to identify the rivals. It was impossible to completely restrict the rivals to just one or two businesses, but even for a diversified rival, 30 per cent or more of its business was in the same industry as that of the respective target. 'I In some cases the FTC report classifies some mergers as product extension mergers even though the acquiring company was classified under the SIC code of 671 1, which indicates that the firm is a holding company. These cases were then eliminated from the related, non-horizontal portfolio since a holding company is unlikely to contribute any operational synergy to the target firm.

10 128 S. Chatterjee therefore, as clean as possible, which is of paramount importance given the relatively small sample that resulted from the screening procedure^.'^ It was impossible, within the scope of this study, to obtain a similarly clean sample of rival firms. Hopefully, the large number of the rival firms eliminates any individual idiosyncrasies during the estimation period. The composition of the six portfolios examined are shown in Table 2. Table 2. Composition of portfolios Merging firms Horizontal rivals Merger types Acquiring firms Target firms of target firms Related, non-horizontal 16 Unrelated 9 17 I Methodology The methodology used to identify the wealth gain to the stockholders is that introduced by Fama et al., (1969). First, the expected rate of return for each firm for the period under investigation is calculated using the market model. The market model allows one to predict the expected value of a firm s return based on the following regression model: Ri = a + pr, + Ei9 where Ri is the individual firm s return and R, is the return on a market index for the same period. If, for any (short) interval of time, the observed return is significantly different than that predicted by the market model, we can infer that some new information about the firm s future performance has reached the market during the period under study. The daily returns of all of the firms in the sample were obtained for a period ranging from 200 days prior to the merger announcement in the Wall Street Journal (day - 199), to 50 days after the merger announcement day (day +50). The merger announcement day was considered to be day zero. The market model was estimated for each firm from day to day - 50 (i.e. for 150 days) and the estimated model was used to predict the returns for each firm from day - 49 to day The differences between the predicted return and the observed return (i.e. the regression residuals) were averaged for each of the six portfolios of firms (i.e. acquiring-unrelated, target-related, etc.). The average abnormal returns (i.e. the average residuals were then cumulated for each day beginning with day -49 through day +50 for the six portfolios. These cumulative average abnormal returns (CAAR) are presented in Table 3. RESULTS Three of the six sample portfolios experienced statistically significant(a I 0.01) wealth gains during the 5-day period surrounding the merger announcement reported in the Wall Street Journal. These were the two portfolios of target firms and the rivals of the related, nonhorizontal target firms. The two portfolios of acquiring firms and the rivals of the unrelated target firms also experienced wealth gains, significant at the 11, 20 and 15 per cent levels of confidence respectively. These results are presented in Table 4. See Lubatkin (1983) for possible problems with non-clean data.

11 Table 3. Cumulative average abnormai returns of the six portfolios of firms Types of Synergy and Economic Value 129 Types of mergers Related, non-horizontal Unrelated Days Targets Acquiring Rivals Targets Acquiring Rivals ~ , , Table 4. Cumulative abnormal returns* of the six portfolios of firms over the 5 days surrounding the merger announcement Related, non-horizontal mergers Unrelated mergers Target Bidder Rival Target Bidder Rival firms firms firms firms firms firms Abnormal returns (8.693)t (1.594) (2.941) (10.941) (1.291) (1.346) * The cumulative abnormal returns represents the sum of the average abnormal returns from day - 2 to day + 2. t Figures in parentheses are &statistics. Wealth gain of the target firms As explained in the research design, the wealth gains of the target firms are standardized by the same asset base.i5 These results, along with the wealth gains for the other categories, are Is It makes more sense to calculate the wealth gain with respect to market value. However since the market value of the horizontal targets in Eckbo's study was not available, we are using the asset base (as reported by Eckbo, 1983:4-5) to standardize the wealth gains. The conclusions that are drawn are the same for both measures of wealth gain.

12 130 S. Chatterjee presented in Table 5, which also contains the wealth gains experienced by two samples of horizontal mergers (one of them challenged by the antitrust authorities) as reported by Eckbo (1983).16 Table 5. Wealth gains* by merger type during the 5 days surrounding the merger announcement ($ in millions) Target Firms Acquiring firms Related, Horizontal? Related, non- Un- nonhorizontal Unrelated, Challenged challenged horizontal Unrelated Number of firms Average asset base$ $68.54 $66.67 $ $65.00 $ $ Average market value of equity $83.26 $64.21 $ $ Average wealth gain Asset base Market value $8.44 $11.65 $42.12 $9.11 $10.25 $24.00 $10.26 $ $8.25 $30.89 Standardized average wealth gain Asset base $8.21 $11.65 $16.68 $9.35 $19.27 $24.00 Market value $7.92 $11.23 $24.80 $30.89 * The wealth gain is calculated on the total asset base as well as the market value of the firm 10 days before the event. t Computed from Eckbo (1983: 6-7, 14-15). $ Taken from the FTC report and the Compustat file except for the horizontal mergers which have been computed from Eckbo (1983:6-7). It is interesting to note that the targets in unrelated mergers fared much better than did the targets involved in related, non-horizontal mergers. On average, the target in an unrelated merger gained per cent during the 5 days surrounding the merger announcement as opposed to a gain of per cent for the targets in related, nonhorizontal mergers. After standardizing the results for size, the average related target gained $8.21 million and the average unrelated target gained $11.65 million based on an average asset size of $66.67 million. As a point of comparison, Eckbo s (1983) results are shown in Table 5. They indicate that the average challenged horizontal target gained $42.12 million during the merger announcement period. Since the average size of the targets of the challenged mergers in his study is $ million, the standardized wealth gain for an average horizontal merger challenged by antitrust authorities comes to $16.68 million, greater than the standardized gain for either of the two types of target firms in this study. Evidently, if we had included horizontal mergers in the sample of related, non-horizontal mergers, the related mergers as a portfolio would have performed at least as well as the unrelated merger portfolio and there would be no anomaly with the related is better hypothesis. I6 The challenged mergers are most likely to be collusive. The unchallenged mergers are included in order to compare them with the related, non-horizontal mergers. The challenged mergers come from two samples. One sample represents mergers challenged by the U.S. Justice Department and the other by the FTC. The asset size of $ million is a weighted average of these two samples.

13 Types of Synergy and Economic Value c a V I I I I I 1 I I I I I I I I I I I, a c 0.08 a V = I I I I I I I I I I DRYS Figure 2. CAAR of unrelated targets Discussion of results for target firms The nature of the scarce resource that is contributing to the superior performance of the targets of the unrelated mergers requires explanation. Tentatively as suggested in the section on Prediction of differential gains, this resource may be the availability of capital. As mentioned in the research design, acquiring firms with relatively large sizes were chosen for the unrelated merger portfolios in order to highlight the availability of capital. It turned out

14 132 S. Chatterjee that the average related, non-horizontal acquiring firm is 8.6 times as large as the corresponding average target firm, and an average unrelated acquiring firm is times as large as its target. The asset ratio of the acquiring to target firms in unrelated mergers is nearly 1.5 times as large as is the ratio in the average related, non-horizontal mergers, corresponding very closely to the relative wealth gain (1.42) of the targets in the two samples. This seems to indicate that when a large firm merges with a smaller firm, the wealth gain of the target is proportional to the relative size of the bidder to the target. This result is not new. Kitching (1967) found a strong relationship between successful mergers and relative size. Biggadike (1979) also found that scale of entry into new ventures is related to performance. These studies led Lubatkin (1983) to observe the following. The results of both studies are contrary to the belief that it is better to enter small, learn as one goes, and expand the experience. It would be worthwhile, therefore, to develop a study that examines in more depth the issue of relative size. Our research design and the results provide a first step towards understanding this phenomenon. Further, given the fact that in this sample the unrelated mergers have a larger relative size, the results are indicative of one thing: relative size may be a good proxy for financial synergy. This is intuitively appealing but has not been examined empirically. However, the fact that financial synergy seems to be associated with more value than operational synergy is counterintuitive. In the discussion below some possible reasons for this result are explored. Note that if a target has no potentially profitable investment opportunities, no amount of capital infusion will generate synergy. However, assuming that the target does have such opportunities, the only reason it would engage in a merger with an unrelated firm would be if it cannot afford to raise the capital itself. This might occur if small firms must pay a risk and/or liquidity premium to obtain funds. Williamson (1975) argues that large firms which have proven themselves to be profitable over long time periods are required to pay a lower risk premium than are smaller or less well-established firms. If his argument, which is consistent with our findings, applies in the capital market, then the easier (cheaper) availability of capital would simply be a function of lower risk and consequently a lower cost of capital, even within the constraints of the capital market partial equilibrium model. One interpretation of our results is that (cheap) capital is a scarcer resource than are resources that contribute to operational synergies. This would not be very surprising if all forms of operational synergy could be acquired at a price. In fact, when firm A buys a related firm B, it is paying the price for being able to exploit (for instance) the economies of scope that the combined entity will realize. Extending this example, one could argue that the reason firm B did not acquire firm A to exploit the same synergy is because B did not have the capital resources needed to undertake the acquisition. So even though the synergy generated in this acquisition is operational in nature, it could be utilized only because firm A had the capital to buy firm B. In other words, the fundamental scarce resource is capital. Thus, if a firm is unable to afford the price for capital itself, then it is literally impossible to raise the required funds regardless of the presence of other types of synergies. Capital, following this logic, is a scarcer resource than are resources contributing to operational synergies and the holders of capital can extract a higher price for this synergy. This line of reasoning assumes that there exists a market for goods and services that leads to operational synergies. As Teece (1983) points out, however, there is no compelling reason for mergers to exploit these synergies. A firm can simply lease the goods and services

15 Types of Synergy and Economic Value 133 through market contractual mechanisms instead of combining with another entity. A merger, therefore, makes sense only if there is a market failure for this type of goods and services. In this case our assumption that all forms of operational synergies can be acquired at a price becomes invalid. A second interpretation of the results is that if the market for resources contributing to operational synergies fails, these might become as scarce as capital. Under such circumstances as Kitching (1967) notes, operational synergies may prove difficult to implement. This, as we have argued earlier in the discussion of a model of the creation of economic value, reduces the impact of resources related to cost of production on value creation. * These explanations underscore the fact that, to be definitive about our results, we have to be able to tie them to an economic theory of the diversified firm as Teece (1983) proposes. Finally, the superior performance of the targets of the (challenged) horizontal mergers can also be explained by the same logic. If horizontal mergers are indeed driven by collusive motives,i9 then the scarce resource is the market power generated by the merger. The only difference is that market power is created artificially at the expense of the consumer. It seems plausible that monopoly profits can be realized more rapidly than can the profits from non-collusive synergies, since the producer has control over both the price and production level. *O The results for the unchallenged sample of horizontal mergers as reported by Eckbo (1983) lend support to this argument. If unchallenged mergers represent a significantly reduced degree of collusion, then we would expect these results to be comparable to our related, non-horizontal sample. Their standardized wealth gain of $9.35 million justifies this belief. Wealth gain of the acquiring firms The CAARs of the acquiring firms are not strongly significant, a finding which is in accordance with almost all of the results of previous studies of mergers. However, the absolute wealth gain of $10.25 million for the average related, non-horizontal acquiring firm and $24.00 million for the average unrelated acquiring firm appears reasonable when compared to the average wealth gains of the respective target firms. The lack of strong statistical significance is possibly a reflection of the significantly larger size of the average acquiring firm as compared to the average target firm. Discussion of results for acquiring firms The proportion of the wealth gain accruing to the two portfolios of acquiring firms as shown in Table 6 highlights the nature of the scarce resource that is being utilized. The total wealth gain is likely to be divided equally between the acquiring and target firms unless one I am grateful to an anonymous referee of this journal for this second interpretation. Obviously, neither the product extension (the related, non-horizontal sample) nor the unrelated merger classification controls for supply-side collusion or monopsonic behavior by the merging partners. Also, the unrelated mergers cannot be chosen SO as to prevent all possibilities of multimarket contact type collusion. However, we argue that these effects can also be present in horizontal mergers over and above demand-side collusion. So, while we cannot claim that we have controlled for all forms of collusion, we can certainly claim that the degree of collusion, if any, would be much lower in our sample than in one containing horizontal mergers. 2o As a value creating resource, market power is possibly more powerful than cheap capital which accrues to a firm only after it has proven itself over a period of time, if we accept Williamson s (1975) argument. The magnitude of collusive synergy is constrained only by the collusive arrangement, the policing costs and (at least in the U.S.) what the cartel can get away with. In other words, a firm cannot reduce its cost of capital overnight (precisely the reason why mergers motivated by financial synergies take place) but a firm can literally enhance its market power overnight by a collusive merger.

16 ~~~~ ~~ ~ ~ 134 S. Chatterjee Table 6. Proportion of the total wealth gain accruing to the acquiring and target firms standardized by asset base and market value Related, non-horizontal mergers Unrelated mergers Proportion of the total gain standardized by total asset base accruing to 0.45 Target Bidder Target Bidder firms firms firms firms Proportion of the total gain standardized by market value accruing to party in the merger has greater bargaining leverage (e.g. a scarce resource which does not depend on the other party's participation). Related complementarities can only generate synergy out of the joint participation of both parties, and thus one would expect that both firms should have equal bargaining power. Economic theory suggests that such a situation should lead to the classic bilateral monopoly solution of equal distribution of the resulting profits in the system.2' This is what we observe for the portfolio of related, non-horizontal mergers. If, however, one firm has a relatively cheap source of capital, it has a superior bargaining position since it can simply look for alternate projects (targets) for investment if needed. Thus acquiring firms which are motivated to exploit financial synergies can be expected to gain a larger share of the total wealth generated. The results appear to bear this out.= Further, the opportunities open to an acquiring firm motivated by operation synergies are necessarily restricted to a few target firms. But capital does not require any complementarities between the two partners. The acquiring firm, in a financial synergy motivated merger, ex ante has a broader selection of target firms to choose from, and thus has one additional degree of freedom as compared to the acquiring firms in the operational synergy case. Not only may the acquiring firm choose the best project (target) from a larger group, but further it determines the absolute profitability based on the proportion of the total profit that it is willing to appropriate through bargaining (i.e. how cheaply can the target be bought). Based on the model presented in the section discussing the model of the creation of economic value, the increased opportunities may be a factor in the superior performance of the acquiring and target firms in unrelated mergers, ceteris parib~s.~~ Effect on the horizontal rivals of the target firms The rivals of the related, non-horizontal targets gained 1.16 per cent as compared to the 0.89 per cent gained by rivals of the unrelated targets. These results are comparable to those *' This is just one of several possible solutions. For example, explicit or implicit competition would allocate all of the wealth gain to the target firm (see Bradley eta/ and Singh, 1984). However, all the firms in this sample have only one bidder, so any competition that might be present is implicit. The results, therefore, should be interpreted subject to this limitation. zz Again the other side of the coin is that the target may look for other acquiring firms who also have excess capital. To make any definitive conclusions would, therefore, require a much more careful sample selection procedure than the one used here. The target, however, may not have the expertise of the bidder in this market surveying ability (see footnote 23). z1 The author is currently looking at this issue. One way to operationalize the number of options would be competence in choosing targets which may be related to what Lubatkin (1983) calls experience. This competence may be reflected in the number of previous acquisitions (experience) or the presence of a formal acquisitions program. In this study we are simply coqiecturing that the acquiring conglomerate firms may have more options available for investment than the related, nonhorizontal firms.

17 Types of Synergy and Economic Value 135 reported by Eckbo (1983).24 However note that the rivals of the related, non-horizontal targets gain more than do the rivals of the unrelated targets while the relative gains for the targets in the respective classes are just the opposite-unrelated targets gain 0.5 times more than do the related, non-horizontal targets (17.48 per cent versus per cent) \ a Q a u I I I I I l I I I I I I 1 I I I I I ~ I I I U c a U DRYS Figure 4. CAAR of the rivals of unrelated targets *4 The small magnitudes of the percentage gains are not surprising since only a fraction of all the possible rivals are considered. Theoretically, the net wealth loss to the rivals should be equal to the wealth gain to the target.

18 136 S. Chatterjee Discussion of the results for rival firms If we assume that the rivals in the two portfolios are roughly the same size, then given the arguments of the section on Effects of mergers on rival firms, the relative wealth gain becomes an indicator of the product/factor price effect of the mergers in the two classes. Further, assuming that the information effect is on average equally present across the two portfolios of rivals, the lower wealth gain by the rivals of the unrelated targets can be attributed to unrelated mergers resulting in relatively cost-efficient corporate entities than related, non-horizontal mergers. This result corroborates the synergistic interpretation of the higher relative wealth gain of the unrelated targets as compared to the related, nonhorizontal targets. Again as a point of interest, note that the ratio of the wealth gains of the rivals in the two samples is 1.31 as compared to 1.42 (in the opposite direction) for the targets in the two respective groups. This supports the proposition that, in the absence of collusion, the wealth gain of the targets has to be at the expense of their horizontal Thus it seems the rivals of the unrelated targets lose a larger portion of the gain resulting from the information effect than the rivals of the related, non-horizontal targets. This is inferred from the higher net wealth gain by the rivals of the related, non-horizontal targets relative to the rivals of the unrelated targets. CONCLUSIONS After reviewing nearly 20 years of research on corporate acquisitions, Jensen and Ruback (1983) observe that we are: reaching the point of diminishing returns from efforts that focus solely on effects of stock prices (during acquisitions).... Further progress will be aided by efforts that examine other organizational, technological, legal aspects of the environment... the relationship between these other factors and stock prices will be of continuing importance to future research. It is encouraging to note that a number of business policy researchers have taken the pioneering role in examining the strategic variables in acquisitions. However, we feel that it is extremely important for all researchers in this emerging area to relate their results to past efforts. We will, therefore, try to reconcile our results with those of Singh (1984) and Lubatkin (1984). Singh found that the wealth gains to related targets were higher than those to unrelated targets. Lubatkin s results (CAR) do not show any difference between conglomerate and two classes of related mergers (except vertical mergers). Our results indicate that unrelated targets significantly outperform the related, non-horizontal targets. There are subtle but important differences in the research designs of these three studies which need to be considered before an attempt is made to reconcile the results. Lubatkin s classification is closest to the one used in this study. However, he uses monthly data to estimate his regression parameters. There are two basic problems with using monthly data: (a) the long estimation period is almost certain to pick up non-stationarity in the parameters * In the case of a colluding merger, the wealth transfer is from the consumers to the firms in the industry. In this case an of the firms in the industry should gain wealth.

19 Types of Synergy and Economic Value 137 and (b) the CARS are likely to be influenced by events which are not related to the merger. In a large sample these problems could occur and the results might not be seriously affected. However when the research is directed towards examining differences in the types of mergers, a sharper focus is required. The fact that Lubatkin s results in three of the four groups he examines are not significantly different may be caused by the masking effect induced by the use of monthly data. In this study and in other policy and finance studies which use this methodology the focus is on a single event, the announcement day, for all classes of mergers. Admittedly, by focusing on this event we are not capturing the effect of some of the merger-related information which is bound to be incorporated in the stock prices both before and after the announcement day. But as has been shown in almost all of the finance studies, the bulk of the price change is captured on the announcement day for targets. Thus we feel that by concentrating on a single day we are eliminating spurious events which might be highly firmspecific. Singh s methodology is essentially the same as ours but his sample differs. It should be a relatively simple matter to reclassify his sample according to the other two studies in order to reconcile the results. Further, neither Singh nor Lubatkin controlled for the speculative element. In fact, the magnitude of Singh s results using the FTC classification is over 30 per cent. The average CAR for tender offers is 30 per cent, while that for merger proposals is 20 per cent. There is, therefore, a strong possibility that Singh s results may be influenced by the inclusion of tender offers. But the one common fact between our results and Singh s is that the difference between the groups is significant. Finally, this study is designed differently from both of the other two studies. Here the sample is chosen to highlight the differences in the values associated with two types of synergy. Within these types this study uses a research design which eliminates certain unwanted factors and emphasizes others. Therefore, apart from methodological details, the design itself contributes to the difference in the results. The tentative conclusion is that relative size does appear to be an indicator of financial synergy and, within the limitations of this study, the results indicate that if financial synergy can be fully exploited (large relative size of the acquiring firm), then the merger-related gains appear to be greater than those which depend primarily on operational synergies. Further, it appears that horizontal mergers outperform the other two types of mergers. Indeed, if horizontal mergers were incorporated in our portfolio of related, non-horizontal mergers, then the results might have been reversed. The effects of the mergers on the rival firms, in general, support the direction of wealth gains observed in the different classes of merging firms. However, it should be kept in mind that the portfolios of rival firms were chosen in a fairly crude manner and the results are at least partially the product of ex-post screening of the sample after a trial run. This may have induced non-randomness in the sample. However, the magnitude of the results is comparable to those in other studies. FUTURE RESEARCH Because this is an exploratory study, its limitations should be acknowledged before embarking further. Some of the limitations, such as sample size and length of the time period, can be easily rectified. However, there remain other methodological and conceptual limitations which pose more serious challenges for the future researcher. These are outlined below.

20 138 S. Chatterjee The current level of knowledge relates merger type to performance. This study attempts to extend our knowledge of acquisitions by relating types of resources to performance. However, unlike a clinical study, the resources could be identified only at a broad level and further could only be investigated by using proxies (size) and by inference (elimination of collusion). To say the least, this is not a methodological ideal and future research will have to find ways to more directly measure the presence of various resources. One possible way is to supplement a carefully selected sample with clinical investigation of key data points, an approach used by Cowling et al(l980). There is a second limitation which bears mention. One of the supposed merits of a large sample study is its generalizability. However, the results are credible only to the extent that the hypotheses tested are rooted in a rigorous conceptual framework. The conceptual model that we use to try to explain our results does not represent anything more than a formal compilation of ideas from economics and business policy. We feel that a more rigorous framework should be developed which links the potential for the creation of economic value not only to the decision to diversify but also to the type of acquisition (related or unrelated) and the mode (de novo or acquisition) of diversification. ACKNOWLEDGEMENTS I am grateful for comments made by Cynthia Montgomery, Michael Lubatkin, Rob Kazanzian and three anonymous referees of this journal. Birger Wernerfelt, Cheenu Balakrishnan and Carla Hayn have been very helpful in discussing the conceptual issues. The opinions expressed in this paper and any errors remain the sole responsibility of the author REFERENCES Andrews, Kenneth R. The Concept of Corporate Strategy, Dow-Jones-Irwin, Homewood, Ill., Ansoff, Igor H. Corporate Strategy, McGraw-Hill, New York, Bettis, Richard A. Performance difference in related and unrelated diversified firms, Strategic Management Journal, 2, 1981, pp Biggadike, R. The risky business of diversification, Harvard Business Review, 1979, 57(3), pp Bleakley, Fred R. Surge in company takeovers causes concern, New York Times, 3 July 1984, p. 2. Bradley, Michael, Anand Desai and E. Han Kim. The rationale behind interfirm tender offers: information or synergy, Journal of Financial Economics, 11, 1983, pp Cowling, Keith, Paul Stoneman, John Cubbin, John Cable, Graham Hall, Simon Domberger and Patricia Dutton. Mergers and Economic Performance, Cambridge University Press, New York, Dodd, P. Merger proposals, management discretion and stockholder wealth, Journal of Financial Economics, 8, 1980, pp Eckbo, B. E. Horizontal mergers, collusion, and stockholder wealth, Journal of Financial Economics,,11, 1983, pp Fama, E. F. Foundations of Finance, Basic Books, New York, Fama, E. F., L. Fisher, M. Jensen and R. Roll, The adjustment of stock prices to new information, International Economic Review, February 1969, pp Grossman, S. J. and J. E. Stiglitz, Information and competitive price systems, American Economic Review, 66, 1976, pp Jarrell, G.A. and M. Bradley, The economic effects of federal and state regulation of cash tender offers, Journal of Law and Economics, 23, 1980, pp

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