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The previous chapter illustrated that there has, to some extent, been research on M&As’ performance. Yet King et al. (2004) suggest that the number of studies is not nearly sufficient to allow their results to be accumulated by means of meta-analysis. This indicates that additional theory development and empirical research on M&As are required.

3.1.1 The need for a comprehensive model

Trillions of dollars have been wasted on the acquisition of tens of thousands of firms (Gupta and Gerchak 2002), with quite a few studies having been produced on post- acquisition performance. These studies do not, however, universally confirm managers’ obvious enthusiasm for the practice, as M&As’ influence on post- acquisition firm performance remains ‘inconclusive’ (Agrawal and Jaffe 2000; Haspeslagh and Jemison 1991, and Sirower 2000). Moreover, the existing empirical post-acquisition performance studies have not recognized any prerequisites that would be useful in forecasting post-acquisition performance (Hitt et al. 1998; and Sirower 2000). All this emphasizes that M&As are relative complex events that involve the interaction of a large number of company life variables and are insufficiently comprehend. The reason for this is, to some extent, because researchers have tended to consider only certain explanations for M&As.

As stated in Hayward (2002), acquiring companies could be following an incorrect strategy: choosing the wrong target, paying too much for it and then integrating it poorly (Gilson and Black 1995, and Haspeslagh and Jemison 1991). According to Cartwright and Cooper (1993, 58), “financial and strategic considerations dominate the selection of a suitable acquisition target or merger partner. Decisions are driven by issues of availability, price, potential economies of scale, and projected earning ratios. Consequently when the combination fails to realize financial expectations, the post-mortem analysis of merger failure or underperformance tends to focus on re- examination of the factors that prompted the initial selection decision. Typically, poor selection decisions are attributed to an over inflated purchase price, managerial incompetence in achieving projected economies of scale, or that the organizations are strategically mismatched.”

Also when viewed as a whole, the various studies indicate that strategic, organizational behavior and financial variables play a very important role.

To date, M&As’ performance has been mainly examined through three theoretical lenses. First, as was described in the previous chapter, the field of strategic

management, basically embedded in an economic paradigm, has studied M&A as a

combinations (Salter and Weinhold 1981, and Walter 1990), and their performances’ effects (Lubatkin 1987; Seth 1990; Shelton 1988; Singh and Montgomery 1987; Datta et al. 1992, and King et al. 2004). This research has emphasized factors such as economies of scale and market power as motives for M&A, and their findings of the studied M&As’ performance are mainly based on the relevant accounting results (Ravenscraft and Scherer 1987(b), and Steiner 1975).

In contrast, finance scholars have usually studied M&A performance by relying on stock market-based methods (Jarell et al. 1988; Jensen and Ruback 1983, and Weston and Kwang 1983). Furthermore, they focus on the acquisition premium (Slusky and Caves 1991, and Ravenscraft and Scherer 1987(a)) in order to calculate the price paid for post-acquisition performance.

In the area of integration, the organizational behavior school has basically concentrated on the post-integration process (Haspeslagh and Jemison 1991, and Pablo 1994) by emphasizing the company culture (Nahavandi and Malekzadeh 1988; Buono and Lewis 1985; Larsson and Lubatkin 2001; Lubatkin and Calori 1998, and Chatterjee 1992(a)) as well as conflict resolution (Blake and Mouton 1985, and Mirvis 1985). In this area, studies on human resource management have also emphasized psychological factors (Levinson 1970; Astrachan 1990, and Marks 1982), the importance of effective communication (Schweiger and DeNesi 1991), and how M&As affect careers (Hambrick and Cannella 1993; Walsh 1989, and Lubatkin et al. 1999). Although these various fields of research do not exclude one another, there has not been much mutual exchange or consideration of the others’ information (Larsson and Finkelstein 1999). The division into different research streams has, in fact, resulted in limiting the development of integrative studies on M&As. There is therefore a recognized need for research to present a theoretical framework that can help explain acquisition performance (Hitt et al. 1998; King et al. 2003; Hoskisson and Hitt 1994, and Sirower 2000).

Such a theoretical framework is sorely required to resolve the ongoing controversy between researchers using a strategic management perspective, thus reporting a lack of M&A performance as a whole, and those using a financial perspective, and often show the opposite (Slusky and Caves 1991; Caves 1989, and Jensen and

Ruback 1983). Furthermore, as stated by Lubatkin (1983), there is a gap between the frequently untested contingency frameworks found in strategy and industrial organization, and the empirical work in the area of finance that tends to disregard strategic differences across M&As. Lane and Cannella (1999) also argue that there are important differences between financial economics and strategic management, leading to different beliefs, norms, methods and interpretations of empirical results. Nevertheless, more recent studies have started to reconcile the differences between the strategy and finance perspectives (Lubatkin 1987; Shelton 1988; Singh and Montgomery 1987; King et al. 2004, and Kusewitt 1985), although they generate opposing outcome (Seth 1990).

A major explanation for these different outcomes is based on a third problem regarding M&A studies’ non integrative character: strategic and financial M&A studies tend to ignore the integrating issues that are a fundamental part of the M&A process, and that could play an enormous role in determining M&A failure or success (Chatterjee et al. 1992(a), and Datta 1991). On the other hand, from an implementation perspective many of these studies do not integrate essential concepts from the research on strategy or finance (Schweiger and Walsh 1990). However, according to Hayward and Hambrick (1997), acquisition premiums, defined as the ratio of the ultimate price paid per target share and the price prior to the takeover news, have also been generally ignored by strategy and organization researchers.

It can therefore be concluded that M&As are clearly a complex area that is poorly understood as a result of the partial use of theories in specific areas (Larsson and Finkelstein 1999).

The fragmented studies on M&As may, in fact, encourage a theoretical synthesis. M&As’ strategic incentives can be viewed as potential benefits that are realized through good integration management, all of which will influence the resultant performance. The research question regarding the way in which potential strategic intent can be achieved through M&As’ organizational integration without it being ultimately too costly, is reason enough to cross different streams of research. The small number of studies in this direction reveals the potential importance of

integrative research, and includes approaches connecting the different viewpoints (Haspeslagh and Jemison 1991; Larsson and Finkelstein 1999; Hitt et al. 2001(a); King et al. 2004, and Kusewitt 1985). Although these works’ contributions are substantial, the studies are limited in scope, and scarcely test M&A performance relationships across all research streams empirically.

3.1.2 The need for representative factors

There is no doubt that M&As have been and continue to be a popular strategic alternative to organic growth. It was mentioned above that strategic management, the organizational behavior school, and the financial school provide all the important general prerequisites required for M&A performance. Taken individually, none of these dimensions and factors are new to the literature. Together, however, they provide a synthesis of the present state of research on strategic, organizational and financial influences on M&As.

In addition, a fundamental contribution of the integrative model developed by this author is its ability to present the three dimensions’ important influence simultaneously. It therefore not only provides an understanding of how the primary prerequisites of M&A success are interrelated, but facilitates the examination of how M&As’ critical aspects affect their performance.

Dependent on a number of factors, acquiring firms could either gain or lose from their acquisition activity, which is similar to what the contingency approach - which includes variables from strategic, organizational and financial perspectives – proposes, and is also related to post-acquisition strategic performance effects. Knowing that no combination of factors could, in fact, fully capture a phenomenon as complex as M&As, this author has included each dimension’s most representative factors.

3.1.2.1 Strategic factors

Park (2003) argues that the causal relationship between strategy and M&A performance is not clear. According to Lubatkin (1983), selecting the proper merger candidate may be more an art than a science. Hence, a brief review of some of the important aspects that are presumed to influence post-M&A performance is presented from the strategic literature.

Strategic management theories suggest that related firm mergers can create synergistic value and enhance the performance of the merged firms. Previous studies of mergers and acquisitions, however, show inconclusive and controversial empirical findings (Ravenscarft and Scherer 1987 (b), Loughran and Vijh 1997, and Campa and Kedia 2002). According to Rumelt (1986), strategic management research normally defines conglomerate companies as those exhibiting significant unrelated product-market diversification32_{. A wider definition of conglomerates is provided by} the Federal Trade Commission (FTC) database (for the period 1948 to 1979) of M&A activity, which is used in very many of the existing studies on the outcome of conglomerate diversification on post-M&A performance. Conglomerate M&As, as defined by the FTC, involve the acquisition of completely unrelated companies, companies in different geographic markets, or companies whose products do not directly compete with those of the acquiring company. Nevertheless, empirical research on the influence of diversification on post-M&A performance is contradictory, with research indicating that some companies profit from diversification, but that most firms generally do not (Loughran and Vijh 1997).

On one hand, Ravenscraft and Scherer (1987(b)) note that the 13 most acquisitive conglomerate companies account for 16 percent of all FTC-recorded M&A activity, experienced returns 3.6 times greater than the S&P500 between 1965 and 1968, and 2.7 times greater than the SP500 between 1965 and 1983. Campa and Kedia (2002) additionally infer that diversification is a value-increasing strategy for companies. They surmise that conglomerate companies have a positive influence on

32 _{Relatedness is also often used as a synonym for research that links M&As’ diversification topics}

to performance issues. In this thesis the terms “relatedness” and “diversification” are both used in the same context.

performance, as they seem to possess a business integration competence that allows them to create value rather than just obtaining it through M&A activity (Salter and Weinhold 1978). The assumed presence of what might be termed a ‘conglomerate effect’ on post-acquisition performance has led to several studies in this area (Agrawal et al. 1992, and Lubatkin 1987).

On the other hand, some research indicates that there is a ‘diversification discount’ (Agrawal et al. 1992; Anand and Singh 1997; Berger, and Ofek 1995; 1999). Berger and Ofek (1999), for example, studied the situation prior to and the outcomes of refocusing episodes by 107 diversified companies that were not taken over between 1984 and 1993. These companies had more value-reducing diversification policies than diversified companies that did not refocus. The cumulative abnormal returns above the latter companies’ refocusing-related announcements averaged 7.3%, and were significantly related to the value reduction associated with the refocuser's diversification policy. In 1995, Berger and Ofek (1995) estimated the effect of diversification on firm value by attributing stand-alone values to individual business segments. By comparing the sum of the independent values with the firms’ values, there was an implied 13% to 15% average value loss due to diversification. An example of the logic that suggests that conglomerate firms’ stock performance is discounted is that there is more uncertainty in predicting their cash flow, since their financial performance depends on that of several divisions.

Within the same context, this subject is also often discussed under the heading ‘relatedness’. Acquired firms’ relatedness to their acquirers - with relatedness defined in term of resource or product-market similarity, or complementarity - is often assumed to impact the acquiring firms’ post-M&A performance. The bulk of M&A literature specifically suggests that acquiring related firms leads to increased post- acquisition performance (Capon et al. 1988; Kusewitt 1985; Palich and Cardinal 2000, and Rumelt 1982; 1986). Business relatedness is said to enable the acquiring firm’s managers to effectively employ their dominant logic, or common conceptualization of the requirements for success in an acquired business (Prahalad and Bettis 1986). Industry familiarity could eliminate or significantly diminish the acquiring firm managers’ need to ‘learn’ the acquired firm’s business, and facilitate learning from the acquisition process itself (Hitt et al. 2001). In the context of acquisitions that require significant managerial involvement, familiarity with the

acquired firm’s market is often key to the acquired business’s successful post- acquisition integration (Roberts and Berry 1985).

In a study of 98 large European bank M&As between 1985 and 2000, Beitel et al. (2004) investigated the drivers of excessive returns for the target companies’ shareholders, for the bidders, and for the combined bidder and target entity. Their findings are largely consistent with the US experience and confirm stock markets’ preference for focused transactions and not specifically for diversification. Related acquisitions could moreover productively leverage the acquiring firm’s pre-existing resources to new business in which those resources are more likely to be valued and relevant. These arguments are not meant to suggest that related acquisitions are without risk. As observed by Berg (1997), acquisition relatedness may simply reduce the financial risk inherent to acquisitions.

It is thus obvious that empirical research on diversification, or relatedness’s influence on post-M&A performance is contradictory (Loughran and Vijh 1997), with research indicating that some companies profit from diversification but that generally most firms do not, and should therefore rather focus on related companies.

According to Singh and Montgomery (1987), value creation in related acquisition can arise from three sources: Economies of scale, economies of scope, and market power.

3.1.2.1.1 Economies of scope

Economies of scope are achieved when a given set of resources are utilized in the joint production of two or more products. For example, if some of the assembly facilities in an automobile plant (body production) are used for both cars and light trucks, economies of scope could be achieved. It is important to mention that the resource’s indivisibility provides economies of scale as soon as capacity is improved through the production of two or more products. Economies of scope are therefore provided by the utilization of the indivisible shared resource.

It is furthermore important to mention that economies of scope can arise outside the production field. Distribution systems as well as intangible assets, like trade names, can be the basis of economies of scope if they are utilized for more than one product. The act of sharing focused know-how is a further important basis of economies of scope (Teece 1982, and Williamson 1979). Knowledge management (Probst et al. 2000), or strategic knowledge management (Leipold et al. 2002) therefore offers practical tools and concepts with which to increase these economies within a firm. Market imperfections could, however, lead to this know-how being unavailable to other companies in the market place at the same cost.

3.1.2.1.2 Economies of scale

Economies of scale are achieved when productivity develops from a specific product’s increased production. In a resource-based framework, this would suggest that a given set of resources and assets is being used more comprehensively. Economies of scale can occur in specific fields, e.g. research, manufacturing, and development, distribution and selling - the traditional fields used to identify related M&As (Salter and Weinhold 1979, and Rumelt 1986) - as well as in more general financial management and administration fields.

3.1.2.1.3 Market power

Within industrial organization economies’ conventional framework, market power’s effects occur when a competitor in the market has the ability to influence a product’s quantity, price, as well as its nature (Sheperd 1970). Consequently, market power could lead to excessive returns. In related M&As, a company’s market power could be increased through horizontal acquisitions, which means that both companies, i.e. the acquiring and the acquired company, operate in the same product market, or through product and market extension acquisitions, which means that a company’s effective size is augmented relative to that of its competitors.

3.1.2.2 Organizational behavior factors

According to Lubatkin (1983), administrative problems (inefficiencies) could occur when two firms merge and nullify an M&A’s benefits. He furthermore states that there are no practical methods with which to measure these inefficiencies. In order to measure what is “inefficient”, what is “efficient” must first be measured, and there is no common acceptable measurement for efficiency (Sheperd 1979). These inefficiencies appear to be a common problem, although some firms are apparently able to avoid them (Kitching 1967, and Lubatkin 1983).

3.1.2.2.1 Relative size

According to Larsson and Finkelstein (1999), a target and acquiring firm’s relative size could be an important consideration for M&As’ success. First of all, because the combination potential is inevitably limited by size constraints if the acquirer is much larger than the target, (Kusewitt 1985, and Seth 1990). Without the necessary critical mass, relatively small acquisitions are less likely than larger M&As to offer a full range of a combination potential. Second, smaller M&As could receive insufficient managerial attention to turn the potential benefits into realized ones (Diven 1984, and Ravenscraft and Scherer 1987(b)).

In an early study by Kitching (1967), a strong positive relationship was indicated between target and acquiring firms’ sizes and organizational performance. In a sample of 69 acquisitions, he found that in 84% of the transactions classified as failures, the sales of the acquired firm constituted less than 2% of the acquirer’s sales. Soon after these findings, Kitching (1974) corroborated them after interviewing CEOs involved in M&As. The executives suggested that the prospect of success is improved if a target firm is larger rather than smaller than the acquiring firm. Other research also supports these arguments. Empirically, Kusewitt (1985) and Clark and Ofek (1994) found a negative correlation between relative size of acquisition. Biggadike (1979) found that large-scale entries into new ventures resulted in better performance than small-scale entries. These results are inconsistent with the belief

that it is desirable to enter a new area in a small way, to learn, and then expand (Lubatkin 1983).

In contrast, Kuehn (1975) suggested that acquiring a large firm requires more integration effort and, could strain the purchaser’s financial position even more. Newbould et al. (1976) found no relationship between relative sizes in acquisitions and returns for shareholders. Later, Kusewitt (1985) found significant negative relationships between the acquiree and acquirer’s relative sizes and performance measurement, but some evidence of a peaked (quadric) relationship. Kusewitt concluded that excessively small or large acquisitions should be avoided. Fowler and Schmidt (1989) also found that the relative size variable had a negative correlation in both the performance measurements that they had undertaken.

Research by Bieshaar et al. (2001) started with a sample of 479 corporate deals announced by 36 companies in the telecommunications, petroleum, and European banking industries over a five-year period. They found that the frequency with which companies pursue M&As does not have a positive effect on a company’s market cap at the time of such an announcement. Conversely, Larsson and Finkelstein (1999) found that the relative size variable is positively associated with organizational integration, combination potential and synergy realization. These authors’ results suggest that bigger acquisitions do better because they offer greater synergy, not because managers pay more attention to the integration process when the target companies are large.

As noted, previous studies on the relationship between relative size and organizational performance were inconclusive. Some of them found a significant positive relationship, while others observed a significant negative relationship.

3.1.2.2.2 Cultural compatibility

As in broader organizational contexts, culture is an important “internal variable” in M&A situations (Smircich 1983). That is, culture is critical in the configuration of a total organizational system, influencing the organization’s effectiveness in its environment (Pablo 1994). Thus, cultural integration and cultural compatibility are

expressions used throughout the literature on M&As (Marks 1999; Cartwright et al.