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As shown in figure 1.1, M&As are becoming increasingly popular and ever more important for today’s economy. Nevertheless, as shown in section 1.1, at the same time the rate of failure is very high.

It should be mentioned that M&As are not strategies in themselves, but rather ways of implementing a company’s given strategy (Jarillo 2003). Due to M&As’ high failure rate, the first logical question in this context is, “Why do companies still carry out M&A activities?” In other words, “What is the logic behind M&A activities?”

In the extant literature, there are multiple theories that try to explain the motives for M&A activity. The most relevant theoretical explanations for M&A will be summarized and described in the following section, focusing on the theoretical clusters into which justifications for M&As have been grouped. Those rationales that are most dominant in business and economic research are discussed first. This is followed by an

explanation of organizational approaches (2.3.2). How these rationale differ is explained in section 2.3.3, followed by the conclusion of this chapter.

2.3.1 Business and economic explanations

According to Salter and Weinhold (1982), the upswing in merger and acquisition activity has rekindled an interest in motives for mergers. Since any discussion of such motives inevitably leads to an assessment of managerial motives, the analysis of the current merger activities starts with a brief digression to managerial goals. This will provide some important clues for interpreting the current activities.

Most observers agree that mergers are driven by a complex pattern of motives, and that no single approach can render a full account (Ravenscraft and Scherer 1987(b), and Steiner 1975). Authors like Ravenscraft (1987(c)) identified up to 15 motives for acquisitions that ranged from tax savings and monopoly power to empire building and hubris. Other authors, like Hayward and Hambrick (1997), identified just three main motives for M&As: poor target company management, synergy and hubris (Berkovitch and Narayanan 1993; Walsh 1990). An overview of the basic motives for undertaking M&A activity has been provided by Trautwein (1990) as shown in the following table:

Table 2.1: Theories of merger motives Merger as a rational

choice

Merger benefits bidders Net gains through synergies

Efficiency theory Wealth transfers from

customers

Monopoly theory Wealth transfers from

target’s shareholders

Raider theory Net gains through

private information

Valuation theory Merger benefits managers Empire-building theory

Merger as process outcome Process theory

Merger as macroeconomic phenomenon Disturbance theory

The motives for M&As, on which this study focuses, are those that are often quoted in the M&A literature. They are usually clustered into three different groups: real motives (the monopoly and efficiency theories), speculative motives (the speculation and raider theories) (Hughes et al. 1980), and managerial motives (the managerial or agency as well as the empire-building theories). Meanwhile, the number of potential merger motives has been increased by approaches that consider capital markets’ lack of efficiency as the fundamental cause of M&As. The following discussion of the most important theories does not, however, group the different approaches, but presents them independently. Every explanation includes a short description of the major motives for M&As as well as the relevant empirical evidence.

2.3.1.1 The efficiency theories

In the strategy and industrial organizational research, M&As are frequently described in terms of synergies or efficiencies. These descriptions are based on the hypothesis that due to operational, managerial and financial synergies, combined companies produce more benefits than two companies working independently.

Operational synergies produced by an M&A refer to economies of scale, scope, as well as experience. The theory of economies of scale is based on decreasing marginal production costs while increasing the output volume (Hughes et aI. 1980) through which plant-specific and product-specific economies of scale can be achieved. If a company is below the minimum efficient size, it can decrease its costs by increasing or reorganizing its manufacturing output after an M&A. Cost savings can also be obtained because a bigger production volume allows the utilization of another, more efficient manufacturing technology. Contrary to the theory, actually achieving these advantages is quite difficult. According to Scherer and Ross (1990, 164), manufacturing plants already exist when two companies merge and "not much can be done in the short run to inbuilding them and achieve the principal plant- specific economies of scale."

If just the most efficient plant is used after an M&A, it could be asked why the other plant had been acquired in the first place. However, horizontal M&As can help to realize economies of scale in the longer term. To begin with, a merged firm "is likely to have more capacity due for replacement at any interval in time" (Scherer and Ross

1990, 164). In the second place, a firm with a superior market share can expect to benefit from being larger as this might help it to buy many new plant units (Scherer and Ross 1990). In comparison to production-specific economies of scale, product- specific economies are simpler to realize. At this point, the fused companies’ manufacturing process just needs to be reorganized and not totally replaced. The term economy of scale is often utilized in an extremely wide sense, referring to a wide-ranging decline in costs by increasing manufacturing volume. By removing duplicate operations, fixed costs, such as those for advertising, R&D and administration, can then be assigned to a larger number of products, thus decreasing the product costs.

Economies of scope can also generate operational synergies that arise from the advantages provided by a multi-product company and lacking in a single-product company. This is, however, only relevant where an M&A enlarges a firm’s product line and where there are complementarities, such as the multiple usages of brand names (e.g., Nestlé sells different types of product under the same brand name), distribution channels, or a customer base. These complementarities might simplify the process of entering other markets, or just help to achieve a larger market share. Besides this, companies can lower prices through bundling strategies, which means linking the sales of various products.

An additional competitive advantage produced by M&As is economies of experience. This term refers to the learning curve outcomes and the exchange of management know-how between the two firms involved in an M&A. According to Scherer and Ross (1990, 166), benefits can be achieved from R&D as soon as "ideas and money...are brought together through a merger". This reason for M&As is frequently mentioned in respect of M&As in the pharmaceutical industry when small research-based firms are acquired by larger firms. Although economies of scale and economies of experience frequently go well together, they are evidently different. Strictly speaking, economies of scale indicate the efficient utilization of production technologies and machinery throughout a certain time, while economies of experience are difficult to grasp and refer to each company employee’s cumulative knowledge.

Managerial synergies are sometimes coupled with economies of experience and constitute another possible motive for a merger (Hughes et al. 1980, Trautwein 1990, and Ravenscraft 1987(c)). This occurs when it is presumed that the bidding company has greater management skills, which will allow it to run the acquired company more efficiently. In addition, a change of ownership and management could streamline a firm’s managerial overheads (Scherer and Ross 1990). Despite the fact that, theoretically, this could also be obtained through change in management styles, it is usually a lot easier and more beneficial to alter the management itself.

Differing completely from M&As being undertaken to achieve managerial synergies is the concept of undertaking M&As to achieve a market for corporate control.19 _The market for corporate control can be defined as "a market in which alternative managerial teams compete for the rights to manage corporate resources" (Jensen and Ruback 1983, 6). Contrary to M&As being undertaken to achieve managerial synergies as mentioned above, this concept concentrates on a firm’s market valuation and the optimal utilization of its assets. The hypothesis that a management’s main objective is to maximize shareholder value is also fundamental to this motive. If a firm’s management invests in disadvantageous projects instead of returning the money to the stockholders, rival companies’ management teams, who identify these management inefficiencies, will try to buy the particular company and replace the executives. Jensen and Ruback (1983, 6) claim that the "competition among managerial teams for the rights to manage resources limits divergence from shareholder wealth maximization by managers and provides the mechanism through which economies of scale or other synergies available from combining, or reorganizing control and management of corporate resources are realized." To summarize, M&As are used as a disciplinary measure exerted by the capital market as a replacement for the lack of internal control by the stockholders (Jensen and Ruback 1983).

As the last of the efficiency theory cluster, achieving financial synergies will be discussed as a possible cause of M&As (Jensen and Ruback 1983, Ravenscraft

19 _{The concept of a market for corporate control was initially presented by Manne (1965). It was}

also examined by Jensen and Ruback (1983), who established the empirical evidence for this concept.

1987(c), and Trautwein 1990). A company could try to systematically increase its business or safety through a strategy of diversification. An M&A could also allow a small company to gain the right to use a larger company's lower cost of capital. Furthermore, efficiencies could be obtained through the founding of an internal capital market after an M&A.

As the internal market has access to better information, this implies that it can allocate capital more efficiently (Trautwein 1990). Potential tax savings are another reason that is often cited as a motive for M&A activities (Ravenscraft and Scherer 1987(b), and Steiner 1975). Internal capital transfers, as well as the pooling of losses might lessen the acquirer's tax obligations. Compared with the other efficiency benefits mentioned above, these tax advantages are only for the companies involved, but do not benefit the economy in general (Hughes et al. 1980).

As with M&As motivated by monopoly intentions, there is little statistical proof to underpin the various efficiency theories. The achievement of financial synergies by means of an M&A has been criticized from a theoretical point of view. If anyone presumes that efficient capital markets actually exist, these synergies cannot be real. Empirical research has in fact indicated that M&As do not lessen risks systematically, nor improve internal capital markets (Ravenscraft 1987(c)). In capital markets, only benefits relating to size could be identified after an M&A (Trautwein 1990). The research undertaken to examine possible M&A benefits is unsatisfactory, too. In an study of 318 M&As during the period 1968 to 1983, Auerbach and Reihus (1988) could not identify any key tax savings as a result of these M&As. In fact, only 20% of their sample demonstrated tax savings large enough to have potentially acted as a stimulus for an M&A. And even where they discovered tax savings, they found no evidence that "they have played an important role in the structure and frequency of mergers and acquisitions" (Auerbach and Reihus 1988, 81).

One of the empirical research’s main streams is dedicated to operational and managerial synergies as a possible motive for M&As. According to case studies and interviews, the efficiency rationale is the most often cited motive to explain M&As (Trautwein 1990). The interviews in the Ravenscraft and Scherer (1987(a)) M&A study of the U.S. market showed that some efficiency was achieved through M&As.

Simultaneously, though, they also indicated that often the expected synergies were not realized. In general terms, the statistics regarding post-M&As’ success and efficiency gains point in the same direction: efficiency usually decreases after an M&A (Scherer and Ross 1990, Trautwein 1990, and Ravenscraft 1987(c)). However, it has to be acknowledged that there are substantial deviations from this fundamental trend, as almost all of the recognizable efficiency benefits have to a certain extent been proven in principle. Jensen (1984, 120), for instance, explored empirical evidence for his model of a market for corporate control and states that "the scientific evidence indicates that activities in the market for corporate control almost uniformly increase efficiency and shareholders’ wealth."

Generally speaking, event studies’ results confirm the efficiency hypotheses, whereas research based on a firm’s concrete productivity rejects the efficiency motives (Trautwein 1990). For anyone who assumes that capital markets are efficient, it seems that the publicly available information to be found in financial statements differs from that with regard to share prices, although these distinctions ought not to exist. In addition, in respect of the legitimacy of the efficiency motivation, there is no empirical proof of the efficiency theory’s management substitution motivation as a reason for M&As. According to the M&A sample in Ravenscraft (1987(c)), acquirers typically looked for well-managed firms and attempted to keep this management. This tendency was also established by other empirical research, so that Scherer and Ross (1990, 162) stated that "as a rule, merger makers seek healthy acquisition targets, not basket cases." This result obviously does not support the managerial synergies motive.

2.3.1.2 The monopoly theory

The oldest M&A rationale in the literature of industrial organization is based on the monopoly power theory, which takes a company’s market share and its barriers to entering other markets into account. There is a clear relationship between barriers to entry, market share, and a company’s profits. The greater the market share, and thus a company’s monopoly power, the greater autonomy it has to fix its prices and increase its profitability.

M&As, especially horizontal M&As, imply a quick and easy ability to increase a company’s market share and reduce rivalry in a specific industry. Vertical and conglomerate M&As could help to increase a firm’s market power by hindering possible market entrants. Vertical M&As could, for instance, present a barrier to entry for any potential entrant, because to successfully compete with the vertically integrated company, a potential entrant would have to simultaneously enter all markets in which the vertically integrated company has acted. In terms of the required management know-how and resources, this could be well beyond the possible entrant's abilities (Hughes et al. 1980). An additional advantage of the diversified or vertically integrated company lies in its ability to cross-subsidize products. The financial gains from one market could be utilized to start and survive a potential price war in another market (Trautwein 1990).

The monopoly motivation was previously more dominant than it is at present. This motive, together with the speculative motive, is usually regarded as one of the main motivations for the first big wave of mergers in America, which occurred from 1887 to 1904 (Scherer and Ross 1990). Nevertheless, since M&As with the objective of achieving market power are just advantageous for the companies concerned and not for the economy in a general sense, as they lead to distorted markets, stifle competition as well as transferring wealth from the company’s clients to the company itself, many regulations have been enacted to limit this kind of action.20

Empirically, little proof has been found of the monopoly motivation. It is therefore not surprising that according to managers, M&As are not undertaken in order to realize monopoly power (Trautwein 1990). The performance- and event-based research done in this regard either couldn’t, or could just partially, verify the monopoly motive (Trautwein 1990; Ravenscraft and Scherer 1987(b), and Steiner 1975).

According to Ravenscraft and Scherer (1987(b), 211), "one that can be given low weight for our sample is the monopoly power theory .... Most of the horizontal acquisitions involved market shares too small to confer much monopoly power, in part because larger horizontal acquisitions were under intense antitrust scrutiny."

20 _{In 1890, the Sherman Antirust Act, the first American anti-trust legislation, was passed as a}

Therefore, according to Jensen (1984), M&A gains are not derived from the M&As’ construction of monopoly market power.

2.3.1.3 The speculation and raider theories

Historically, particularly throughout the large American wave of M&As between 1887 and 1904, the speculative theory played a major role.21 _{Those who usually organized} M&As also did so when these activities only had a modest probability of securing substantial monopoly power. Another ruse that these promoters employed to obtain additional large earnings for themselves was to manipulate the market by distributing fake information, such as rumors, or other suspect techniques. In America, these misuses led to the promulgation of the Securities Act of 1933 and the Securities Exchange Act of 1934 (Scherer and Ross 1990).

Although promoters are no longer as influential as they were, speculation could still be an issue affecting M&As. Hughes et aI. (1990), for instance, maintain that currently inside managers occasionally take on the role that outside promoters had historically taken. Earnings not based on real economic profits, could, for example, be made through pre-M&A speculation with the target company’s shares by managers of both the acquirer and the acquiree company. It is evident that these actions, like the historical ones, are illegal from the perspective of current legal norms. Scherer and Ross (1990), however, contend that throughout the conglomerate American M&A wave between the 1960s and 1970s, investing in a diversified firm was truly a game of pure chance, and that only some people were able to earn very big profits. But even in respect of those companies that had organized and led conglomerate M&A activities, the charge of unsatisfactory performance was not published for years, or even decades, if at all. “And meanwhile, the living was good" (Scherer and Ross 1990, 162).

A contemporary form of the speculative theory is Trautwein’s (1990) raider motive. This M&A theory is theoretically not very complex, but is, nevertheless, frequently cited in the business literature. Here, M&As are regarded as a few people’s outcome,

in other words raiders, who attempt to obtain some of the wealth of the stockholders of the firms for which they bid. This objective could be accomplished, for instance, by way of greenmailing22_{, or exorbitant payment demands following a prosperous M&A.} On the whole, Trautwein nevertheless dismisses this M&A motive as being irrational and discredited by empirical research, which discovered that normally it is not the acquiring company or its stakeholders, but the target's stakeholders who gain from an M&A (Trautwein 1990, and Jensen 1984).

2.3.1.4 The valuation or information theory

Studies explaining M&As from a financial instead of a strategic point of view presume

that a company’s present market price does not mirror its proper value.23

Expectations in respect of a firm’s future as well as market inefficiencies due to an asymmetric distribution of information can lead to undervaluation.24 _{The acquiring} firm may know more about the target company’s financial state than the market itself, and may be more knowledgeable regarding how to manage the company productively. As a result, it regards the target firm’s proper value as being higher than its current market price, in which case, the acquirer is stimulated to buy the company. The primary motive for such an M&A activity is therefore the market’s inefficiency and not the gaining of synergies.

This does not mean that the valuation and the efficiency assumptions are not linked to each other. A firm that purchases an undervalued company does so because it presumes it could manage the acquiree better than the existing management. This hypothesis therefore partially includes the gaining of synergies.