Theories of Merger and Acquisition
– By Adv. Ishita Gupta
The theories of M&A depict the various reasons or purposes due to which companies execute Mergers and Acquisition. Hence, there are approx. six theories[1] of M&A which will we discussed in detail. The six theories are depicted in brief as follows.
First is the synergy theory. Under this theory M&A is executed to increase the overall value of the company. Second is undervaluation theory. Here, the companies execute M&A because their value is undervalued. Third is Market Power theory. Under this, M&A is executed to increase the market share and profitability. Forth is Agency theory. M&A is executed to resolve the disputes between shareholders and the management of the company. Fifth and the last is diversification theory. Here the M&A is executed t diversify the funds of the company. All these theories are discussed as follows in detail:
2.4.1.1. Synergy Theory
Under the concept of synergy, the entire worth of the company is improved. This logic is the primary force for the companies to execute M&A. The professionals such as the investment bankers and the corporate executives habitually use synergy for the execution of the M&A deal.[2] The value of the resultant company always turns higher as compared to two separate companies.
As per the business terminology, synergy is a mutual and a beneficial concurrence of diverse businesses to combine their elements including resources and services.[3] Applying the synergy theory to M&A, it leads to an idea that combines the value and performance of two independent working companies.
From the initial planning of M&A, the purpose of is to build synergies in the long run. Synergy is built by escalating the market share, widen customer base, and enhance the corporate financial strength.[4] Overall, the synergy is the potential to achieve higher financial benefits post the execution of merger.
M&A result in the formation of synergies. Hence, this type of synergy is regarded as the operational synergy. It is seen predominantly in the manufacturing industries.[5] The aspiration to execute mergers and acquisitions is to achieve the improved capacity for both the combining companies.
2.4.1.2. Undervaluation Theory
Undervaluation theory highlights the perceptive that the merger is executed when the market value of the target company fails to reflect its true potential. The reason for a condition can be due to any internal or external forces of the company. This theory is the best theory to address the problems of sick companies. Hence, the sinking company decides to provide their company in the hands of alternative management to revive their operations.[6]
Companies acquire the assets of the other companies for ensuring expansion. This expansion is achieved by purchasing shares of other company at cheap prices. Hence, the shares are bought at the stage when stock price of the target company is below the replacement cost of their assets.[7]
2.4.1.3. Market Power Theory
Market power theories suggest that mergers engender larger monopoly power of the companies once they combine with each other. With respect to the monopolistic collusion between the rivalries, the horizontal merger reduces the total number of companies in the existing industry. Mergers facilitate industry-wide complicity by lowering the overall monitoring costs.
By restricting the supply of the product, merging companies in the industries can increase the selling price of product at the competitive level. This can be done to expropriate the monopoly position at the expense of the sick companies.[8] Despite the existence of exceptional cases, it is empirically evident that the market power theory is actually not supportive in nature.
It is found that due to horizontal mergers, the market power directly examines the product price changes post merger. Market power means[9] the ability of a company to raise and hence maintain the prices of the product above the level that is considered prevalent under the competitive practices. Hence, it leads to a monopolistic power in the market.
2.4.1.4. Agency Theory
Agency theory is concerned with the differentiation of interests that exists between the company’s owners and the managers. The maximization of utility function is the main assumption of agency theory.[10] With respect to the corporate governance, the principal is regarded as the shareholder while the agent is the management of the company.
The neo-classical theory of the company assumes the concept of profit maximization. Recently, as per the economics literature, other theories been proposed.[11] The management in a diversified company fails to own a large proportion of the shares of the company. Hence, the management has more interested in the pursuit of greater control of the company. The higher the compensation the better the management works for a company.
It is highlighted that the PAT is a method for analyzing the problems of the company. Under this theory, one party i.e. the principal hires another party i.e. the agent to perform the functions of the company.[12] It tends to investigate the phenomenon of opposition of interests as well as information asymmetry. This is considered as a quite often reason for the unsuccessful M&A-transactions.
2.4.1.5. Diversification Theory
The diversification theory deals with acquiring the company’s core product line or market share. In this may the resultant company can diversify its own business. This tends to lead the company to achieve the higher growth prospects in the competitive market. However, the research reveals that the investors never benefit from the diversification of the company. Investors normally perceive that the company diversification in unrelated areas turns their investment risky.[13]
The diversification done by the managers and the other employees of the company is executed primarily after merger. Hence, the management has the main stress to preserve the organizational and reputational capital of the company. Diversification through mergers is commonly referred as the diversification through the internal growth of the company.
[1] Brief of six theories of M&A, Available at http://accioneduca.org/admin/archivos/clases/material/mergers-and-acquisition_1564415367.pdf (Last visited on March 9, 2022)
[2]Synergy Meaning, Available at https://corporatefinanceinstitute.com/resources/knowledge/deals/synergy/ (Last visited on March 9, 2022)
[3] Synergy Model under M&A, Available at https://www.wallstreetmojo.com/types-of-synergies/ (Last visited on March 9, 2022)
[4] Importance of synergy, Available at https://dealroom.net/blog/types-of-synergies-in-mergers-and-acquisitions-with-examples (Last visited on March 9, 2022)
[5] M&A and synergy theory, Available at https://www.proquest.com/docview/1638898681 (Last visited on March 9, 2022)
[6] Undervaluation theory, Available at https://www.uniassignment.com/essay-samples/finance/efficiency-theories-differential-efficiency-operating-synergy-finance-essay.php(Last visited on March 9, 2022)
[7] Undervaluation theory, Available at https://www.cvs.edu.in/upload/Theories%20of%20merger.pdf (Last visited on March 9, 2022)
[8] Market Power theory of merger , Available at https://www.research.manchester.ac.uk/portal/files/84021282/FULL_TEXT.PDF (Last visited on March 9, 2022)
[9] Market Power Meaning, Available at https://stats.oecd.org/glossary/detail.asp?ID=3256 (Last visited on March 9, 2022)
[10] Agency theory, Available at http://what-when-how.com/finance/merger-and-acquisition-definitions-motives-and-market-responses-finance/ (Last visited on March 9, 2022)
[11] Agency theory, Available at https://www.kobo.com/us/en/ebook/principal-agency-theory-in-mergers-and-acquisitions (Last visited on March 9, 2022)
[12] Agency theory and M&A, Available athttps://www.grin.com/document/302640#:~:text=The%20PAT%20is%20a%20method,reason%20for%20unsuccessful%20M%26A%2Dtransactions. (Last visited on March 9, 2022)
[13] Diversification theory, Available at https://www.slideshare.net/Rojagowda/theories-merger (Last visited on March 9, 2022)