Efficiency Theories Differential Efficiency Operating Synergy

Published Date: 02 Nov 2017

Merger is corporate combination of two or more independent business corporations into a single enterprise, usually the absorption of one or more firms by a dominant one. A merger may be accomplished by one firm purchasing the other’s assets with cash or its securities or by purchasing the other’s shares or stock or by issuing its stock to the other firm’s stockholders in exchange for their shares in the acquired firm (thus acquiring the other company’s assets and liabilities).

Mergers are of several different types: horizontal, if both firms produce the same commodity or service for the same market; market-extensional, if the merged firms produce the same commodity or service for different markets; or vertical, if a firm acquires either a supplier or a customer. If the merged business is not related to that of the acquiring firm, the new corporation is called a conglomerate. [Source: Encyclopaedia Britannica]

The efficiency theories of merger states that mergers will only occur when they are expected to generate enough realizable synergies to make the deal beneficial to both parties it is the symmetric expectations of gains which results in a 'friendly' merger being proposed and accepted. If the gain in value to the target was not positive, it is suggested, the target firm's owners would not sell or submit to the acquisition, and if the gains were negative to the bidders' owners, the bidder would not complete the deal. Hence, if we observe a merger deal, efficiency theory predicts value creation with positive returns to both the acquirer and the target.

There are different efficiency theories of mergers

Differential Efficiency Theory

Inefficient Management Theory

Operating Synergy

Pure Diversification

Strategic Realignment to changing environment

Undervaluation

Differential Efficiency Theory

A merger in simple words refers to combining of two companies into one. According to differential theory of merger, one reason for a merger is that if the management of a company X is more efficient than the management of the company Y than it is better if company X acquires the company Y and increase the level of the efficiency of the company Y.

According to this theory if some companies are operating at level which is below the optimum potential of the company than it is better if it is taken over by another company. This theory also implies that management of a company is also not efficient in running the company and therefore there are always chances that it will be taken over by other companies.

Differential theory can be particularly helpful when a company decides to take over other company in the same industry because than it would mean that company which is taking over other company can expand without much cost because of the efficient utilization of all the resources. However there is one risk to this, which is if the acquiring company pays too much for acquiring the company, but in reality the resources do not get utilized in a manner which is forecasted than it can lead to problems for acquiring company.

Operating Synergy

The operating synergy theory of mergers states that economies of scale exist in industry and that before a merger take place, the levels of activity that the firms operate at are insufficient to exploit the economies of scale. Operating economies of scale are achieved through horizontal, vertical and conglomerate mergers. Operating economies occur due to indivisibilities of resources like people, equipment and overhead. The productivity of such resources increases when they are spread over a large number of units of output. For instance, expensive equipment in manufacturing firms should be utilised at optimum levels so that cost per unit of output decreases.

Operating economies in specific management functions such as production, R&D, marketing or finance may be achieved through a merger between firms, which have competencies in different areas. For instance, when a firm, whose core competence is in R&D merges with another having a strong marketing strategy, the 2 businesses would complement each other. Operating economies are also possible in generic management functions such as, planning and control. According to the theory, even medium-sized firms need a minimum number of corporate staff. The capabilities of corporate staff responsible for planning and control are underutilised. When such a firm acquires another firm, which has just reached the size at which it needs to increase its corporate staff, the acquirer’s corporate staff would be fully utilised, thus achieving economies of scale. Vertical integration, i.e. combining of firms at different stages of the industry value chain also helps achieve operating economies. This is because vertical integration reduces the costs of communication and bargaining.

Pure Diversification

Diversification provides several benefits to managers, other employees and owners of the firm as well as to the firm itself. Moreover, diversification through mergers is commonly preferred to diversification through internal growth, since the firm may lack internal resources or capabilities required. The timing of diversification is an important factor since there may be several firms seeking to diversify through mergers at the same time in a particular industry.

Employees: - The employees of a firm develop firm-specific skills over time, which make them more efficient in their current jobs. These skills are valuable to that firm and job only and not to any other jobs. Employees thus have fewer opportunities to diversify their sources of earning income, unlike shareholders who can diversify their portfolio. Consequently, they seek job security and stability, better opportunities within the firm and higher compensation (promotions). These needs can be fulfilled through diversification, since the employees can be assigned greater responsibilities.

Owner-managers: - The owner-manager of a firm is able to retain corporate control over his firm through diversification and simultaneously reduce the risk involved.

Firm: - A firm builds up information on its employees over time, which helps it to match employees with jobs within the firm. Managerial teams are thus formed within the firm. This information is not transferred outside and is specific to the firm. When the firm is shut down, these teams are destroyed and value is lost. If the firm diversifies, these teams can be shifted from unproductive activities to productive ones, leading to improved profitability, continuity and growth of the firm.

Goodwill: - A firm builds up a reputation over time in its relationships with suppliers, creditors, customers and others, resulting in goodwill. It does this through investments in advertising, employee training, R&D, organizational development and other strategies. Diversification helps in preserving its reputation and goodwill.

Financial and tax benefits: - Diversification through mergers also results in financial synergy and tax benefits. Since diversification reduces risk, it increases the corporate debt capacity and reduces the present value of future tax liability of the firm.

Strategic Realignment to changing environment

It suggests that the firms use the strategy of Mergers and Acquisitions as ways to rapidly adjust to changes in their external environments. When a company has an opportunity of growth available only for a limited period of time slow internal growth may not be sufficient

Change in environment which may necessitate Mergers and Acquisitions may include regulatory, tax, technology / Globalization impact etc. E.g. Banking/Insurance/Telecom/ Pharmaceuticals /FMCG/Aviation etc

Sometimes the firm may have limited period of growth. Adjustment through internal adjustment may take time. So, external acquisition will help to reduce time involved.

Otherwise, competitors may exploit the situation

Undervaluation

Undervaluation theory states that mergers occur when the market value of the target firm stock for some reason does not reflect its true or potential value or its value in the hands of alternative management.

Firms may be able to acquire assets for expansion more cheaply by buying the stocks of existing firms than by buying or building assets when the target’s stock price is below the replacement cost of its assets

Overvaluation

 Overvaluation might drive the firm to use its overpriced stocks to acquire other firms. It is however controversial if deals of this type benefit acquiring firms' existing shareholders.