L9 - Horisontal mergers

Question 1

What are the different types of mergers?

Answer 1

Horizontal integration/merger - involves firms producing the same products and services. The large majority of mergers, often attract scrutiny of competition authorities to make sure market power is not abused, market power can also make efficiency improvements

Vertical integration/merger - firms operating at different stages of the same production process. More complicated to assess damage to consumer welfare

Conglomerate merger - involves firms that produce different goods or services. Possible motive - exploitation of something they have in common, e.g. raw materials or technology - economies of scope.

Question 2

What is synergy?

Answer 2

Synergy (most common justification of merger) - refers to the increased market power of the merged entity, and potential costs savings due to economies of scale

Question 3

Why might a firm want to merge with another firm (in terms of market power)?

Answer 3

Recall Oligopoly - success of firm depends on actions of its rivals - Interdependence creates uncertainty in strategic planning - One way to reduce this uncertainty is to collude either explicitly or tacitly › When collusion is difficult or too costly - merger as possible alternative strategy

A horizontal merger may result in larger market share for newly integrated firm

Can eliminate a close rival from the market, making entry more difficult

May also make collusion easier

Either way - raises ability to exploit market power

Can also be motivated by desire to protect the dominance of an incumbent firm - e.g. acquiring new firm with new product (maybe less risky than developing rival product)

Question 4

When is a merger more likely to be perceived as anticompetitive?

Answer 4

• Merger more likely to be perceived as anticompetitive if it both increases seller concentration and makes entry more difficult

Question 5

What are 5 factors that influence the degree of market power following a merger?

Answer 5

Degree of seller concentration, productive capacity of rivals, ease of entry, market demand and level of buyer concentration

Question 6

How does degree of seller concentration influence the degree of market power following a merger?

Answer 6

Mergers between small companies in fragmented markets hardly give market power (-)

Mergers between large firms in concentrated markets increases market power and increases the likelihood of coordinated behaviour (+)

Question 7

How does the productive capacity of rivals influence the degree of market power following a merger?

Answer 7

If rivals do not have idle capacity cannot benefit from higher prices, which is often the consequence of a merger - higher market share for the merged firm (+)

Otherwise depends on how much idle capacity the rival has (+/-)

Question 8

How does ease of entry and market demand influence the degree of market power following a merger?

Answer 8

(3) Ease of entry - The faster market entry the harder it will be to sustain market power - even after a merger (-)

(4) Market demand
- If price elasticity of demand is low - more opportunity to increase price (+), otherwise (-)

Question 9

How does the level of buyer concentration influence the degree of market power following a merger?

Answer 9

Few large buyers will bargain on price increases which puts a constraint on market power and the gains from a merger decrease (-)

If many buyers (i.e. not concentrated), merged firm can set higher prices (+)

Question 10

Why might a company engage in a merger rather than an internal expansion?

Answer 10

• The combined size of two firms allows cost savings to be realized through a greater extent than would be possible through internal expansion
• The second part of the previous sentence is crucial! - a merger delivers cost savings that otherwise would not be possible!

Question 11

What are five sources of cost savings?

Answer 11

Rationalisation (economies of scope), economises of scale, R&D, purhcasing economies and productive inefficiency

Question 12

How can a merger result in cost savings through rationalisation?

Answer 12

Overheads are distributed on multiple plants
Transportation costs lower - regional units provide such regional areas

Economies of scope (EoS) - by multi-product production needed fewer shifts at the individual plant that can be used specializing in single products

Produce, so that MC is minimized and equalized across all plants (shift production from high MC plants to low MC plants) - extreme case: close the plant if MC is above the ‘survivor’ plants

Question 13

How can a merger result in cost savings through economies of scale?

Answer 13

(2) Economies of scale - realised when long-run average costs decreases as the scale of operation increases

Question 14

How can a merger result in cost savings through R&D?

Answer 14

R&D - integrating R&D activities might allow cost savings. Transfer of knowledge or technical superiority to other firm or alternatively two firms with complementary skills. Both parties may benefit - diffusion in both direction. As number of competitors is reduced - might be less risky to engage in R&D as lower risk of imitation.

Question 15

How can a merger result in cost savings through purchasing economies?

Answer 15

Purchasing economies - increase in bargaining power i.e. lower prices from suppliers, may be able to raise finances at lower costs

Question 16

How can a merger result in cost savings through productive inefficiency and organisational slack?

Answer 16

Technical inefficiency (failing to achieve max output that is technically feasible given inputs) or economic inefficiency (failing to employ most cost-effective combination of inputs given current factor prices).

By increasing the size and market power of the merged entity, a horizontal merger may reduce competitive pressure. This may increase the likelihood that the firm fails to achieve efficiency in production, or that it operates with organizational slack. By decreasing number of firms may increase market power and therefore increase inefficiencies, negative effect of merger (-)

On the other hand, a highly active market for corporate ownership can help impose discipline by reducing the number of inefficient firms, which may be acquired by other firms that believe they can be more efficient. Merger might reduce the number of inefficient firms, positive effect on costs savings, merger positive effect (+)

Question 17

What are four merger specific gains (synergies) ?

Answer 17

(1) Coordinating joint operations (utilisation of ‘hard to trade assets’)- when firms linked by joint management of resources, disputes over resource might be eliminated by merger
(2) Sharing complementary skills - Utilization of complementary skills in the merged companies › Each entity specializes on task in which comparative advantage – i.e. exploit complementary skills, more likely through merger than if two separate firms
(3) Improved interoperability - there might be benefits of e.g. developing compatible software
(4) Network configuration - Cutting costs for R&D, e.g. by having different entities in the network communicate directly and more frequent with each other rather than to wait for the publication of a patent of rival firm

Question 18

What are other motives for mergers?

Answer 18

Other motives for mergers: macroeconomic
conditions and risk diversification

Technology Development (extra - argument also related to entry)

Strong technology and product development in an industry often reduces the effect of a merger relatively quickly through new entrants

Recall industry life cycle: this happens when industry is still growing

Incumbent may find it optimal to buy the new technology so that not lacking behind in the future and secure market power – in favour for mergers (+)

Especially when incumbent is already in a more mature stage (relative to the market)

Question 19

How might managerial discretion be a motive for merger?

Answer 19

Managers might pursue alternative goals, e.g. as suggested by Marris - growth rather than profit, status, power, survival and remuneration of managers depend on achieving growth subject to min profit requirement

Managers could thus aim for external growth through a merger

Ownership and control are often separated, if management can pursue its own goals - conflict of interest. Can shareholders really be sure that management will optimize the company’s long-term value, i.e. the market price?

Often management will choose a combination of revenue maximization subject to a profit maximization constraint - Williamson

Question 20

How can threat of acquisition (the market for corporate control) be a motive for merger?

Answer 20

The financial markets often pose a greater threat to the management that

(1) pursues their own goals, or where
(2) performance is unsatisfactory - than the current owners do!

If the current management does not maximize the company’s present value a take-over is likely: the market believes that the company with the right management would be worth more, see the figure before.

A takeover is likely if the difference between the acquirer’s acquisition costs are less than the potential benefits of the acquisition.

However, even if the company is undervalued because of poor management can be expensive due to acquisition costs

Acquisition costs = legal costs of merger + Stock options for employees to be bought out + severance costs + Warranties for employees

Critics - raider would need info

Question 21

How does the failing firm hypothesis relate to motives for merger?

Answer 21

Mergers are a ‘civilised alternative’ to bankruptcy, providing a mechanism for the transfer of the assets of a failing firm to a successful firm.

The successful firm might wish to acquire the failing firm for possible short-term financial advantage, such as using the losses of the failing firm to offset its own tax exposure

Question 22

How does the capital redeployment hypothesis relate to motives for merger?

Answer 22

Main idea: incentives of managers to share information with the market distorted - difficult to distribute capital efficiently across firms

Mergers can help to overcome distorted incentives and managers of merged firms can redeploy capital more efficiently within firm than the external capital markets

How? Through internal system of rewards and penalties

Example: an owner that gives funds to a (merged) firm can incentivize the management of the merged firm the reallocation of capital from a nonperforming plant of the firm to a more profitable one. Without the merger and the incentive structure capital would not be reallocated
• Important here is also the conflict of interest between managers and owners

Question 23

How does the hubris hypothesis relate to motives for merger?

Answer 23

From greek: hybris (foolish over-confidence) à nemesis (downfall)

Mergers viewed as a bidding market for potential takeovers

Main idea: when bidding for target firms, manager tend to over-estimated the value of the target à they bid too high (hubris)

What does ‘too high’ mean? - Compare to rational expectations (i.e. no hubris). With rational expectations and randomly distributed payoffs, all bids will be close to the average bid which is equal to the true value of the firm that is for sale

With hubris the price paid for the acquired company is above the true value because it goes to the highest bidder - hence too high