The Theory Of Efficiency

Published Date: 02 Nov 2017

The theory of efficiency suggests 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.

DIFFERENTIAL EFFICIENCY

In the differential efficiency theory of mergers, if the management of firm A is more efficient than the management of firm B and if firm A acquires firm B, the efficiency of firm B is to be brought up to the level of firm A, then this increase in efficiency is attributed to the merger.

According to this theory, some firms operate way below their potential and consequently they have low efficiency. These firms are likely to be acquired by other, more efficient firms in the same industry. This is for, firms with greater efficiency would be able to identify firms with good potential operating at lower efficiency. They would also have the managerial ability to improve the latter’s performance.

However, there would be difficulty when the acquiring firm overestimates its impact on improving the performance of the acquired firm. This may cause the acquirer to pay much more for the acquired firm. Alternatively, the acquirer may not be able to improve the acquired firm’s performance up to the level of the acquisition value given to it.

The managerial synergy hypothesis is another line of the differential efficiency theory. It states that a firm, whose management team has a greater competency than is required by the current tasks in the firm, may seek to employ the surplus resources by acquiring and improving the efficiency of a firm, which is less efficient due to lack of adequate managerial resources. Thus, the merger will create a synergy.

When these surplus resources are indivisible and cannot be released, a merger enables them to be optimally utilized. Even if the firm has no opportunity to expand within its industry, it can diversify into new areas. However, since it does not possess the relevant skills related to that business, it will attempt to gain a ‘toehold entry’ by acquiring a firm in that industry, which has organizational capital along with the inadequate managerial capabilities.

OPERATING SYNERGY

The operating synergy theory of mergers states that economies of scale do exist in the 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 because of 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 utilized at optimum levels so that cost per unit of output decreases.

Operating economies in some 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 example, when a firm, whose core competence is in R&D merges with another having a strong marketing strategy, the two businesses would complement each other in their own manner.

Operating economies are also viable in generic management functions such as, planning and control. According to theory, even medium-sized firms are in need of a minimum number of corporate staff. The capabilities of these corporate staff are responsible for planning and controlling is underutilized. 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 utilized, thus achieving the economies of scale.

Vertical integration -- Combining of firms at different stages of the industry value chain helps to 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.

FINANCIAL SYNERGY

The managerial synergy hypothesis is not relevant to the conglomerate type of mergers. This is because, a conglomerate merger implies several, often successive acquisitions in diversified areas. In such a case, the managerial capacity of the firm will not develop rapidly enough to be able to transfer its efficiency to several newly acquired firms in a short time. Further, managerial synergy is applicable only in cases where the firm acquires other firms in the same industry.

Financial synergy occurs as a result of the lower costs of internal financing versus external financing. A combination of firms with different cash flow positions and investment opportunities may produce a financial synergy effect and achieve lower cost of capital. Tax saving is another considerations. When the two firms merge, their combined debt capacity may be greater than the sum of their individual capacities before the merger.

The financial synergy theory also states that when the cash flow rate of the acquirer is greater than that of the acquired firm, capital is relocated to the acquired firm and its investment opportunities improve.

THEORY OF STRATEGIC ALIGNMENT

Theory suggests that firms use the strategy of M&As as ways to rapidly adjust to changes in their external environment.

Regulatory change: M&A s has more been happening in the industries like financial services, telecommunications, etc. that have been subject to major deregulation

Technological change: Increased use of information technology, short product life cycles, etc.

UNDERVALUATION THEORY

The 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 THEORY

The overvaluation theory states that mergers may occur when the market value of the target firm stock for some reason overtly reflect its true or potential value or its value in the hands of alternative management.

INFORMATION & SIGNALLING

The tender offer sends a signal to the market that the target company’s shares are undervalued. The offer may signal information to the target management which motivates them to become more efficient. The target management’s response to the offer and the means of payment may also have signaling value.

CASE STUDY

RIL bid for South African mobile giant MTN (2008)

Almost after three years Kokilaben Ambani announced on June 18, 2005 an "amicable settlement" between her warring sons, Anil and Mukesh, the feud between the two boiled over once again with the Mukesh Ambani-controlled Reliance Industries now putting a spoke in the proposed deal between Anil Ambani's Reliance Communications (RCOM) and South African telecom giant MTN.

RCOM and MTN have been in merger talks for about three weeks now. They initiated exclusive talks on May 24, 2008 for a combination that could be valued between $45 billion and $50 billion. Negotiations are moving in such a direction that Anil Ambani will be the largest shareholder in the merged entity.

Mukesh Ambani's RIL did shoot off letters to RCOM and MTN stating it has the first right of refusal to buy controlling stake in RCOM. The younger brother's Anil Dhirubhai Ambani Group (ADAG) has a controlling 65 per cent stake in RCOM, the second largest private telecom operator after Bharti Airtel in India.

Anil Ambani, however, refuted his elder brother's claims and said no such agreement was ever entered into with RIL. An MTN spokesperson in South Africa, meanwhile, said that as far as MTN was concerned nothing had changed and talks were proceeding as per the cautionary announcement made by it in May.

The two brothers have often locked horns in interpreting the family settlement announced by Kokilaben three years back. There have been differences over the nature of businesses each of them can enter into and also on the control of the various businesses of the empire built by their father Dhirubhai Ambani. The latest salvo by Mukesh Ambani's RIL is being seen in this context by industry observers.

An RCOM official said that RIL's first right of refusal claim was based on an agreement of January 12, 2006, unilaterally signed only by RIL executives when RCOM was under RIL control. The Bombay High Court had, however, held this as "unfair and unjust" vide its judgement of October 15, 2006.

An RIL spokesperson said, "RIL has in good faith notified both the ADAG and the MTN Group of the stipulation contained in an agreement, the validity of which has never been questioned so far by ADAG."

According to RCOM, the only reason why RIL was taking such a "disruptive action" was it did not want the RCOM-MTN deal to fructify. If the deal consummates, the Reliance-MTN combine would become a mammoth group with presence in a large number of countries, it said.

Before the Reliance Group companies formally split in early 2006, RCOM was under Mukesh Ambani's control. RCOM and Reliance Energy were given to Anil Ambani as part of the settlement of June 2005. The brothers are already locked in a legal battle over supply of gas from RIL's KG basin to ADAG's power unit at Dadri.

"RIL's claim is born out of mounting despair and frustration at Reliance ADA Group's continuing successes, and the support it enjoys from over 10 million investors, the world's largest shareholding family," RCOM said.

WHAT'S THE FUSS?

The roots of the spat

• Before the Reliance Group companies formally split in early 2006, RCOM was under Mukesh Ambani's control. RCOM and Reliance Energy were given to Anil Ambani as part of the settlement of June 2005.

First right of refusal

• RIL's right of first refusal claim was based on an agreement of January 12, 2006, unilaterally signed only by RIL executives when RCOM was under RIL control. The Bombay High Court had, however, held this as "unfair and unjust".

Is it valid?

• RIL says it has in good faith notified both the ADAG and the MTN the stipulation the validity of which has never been questioned so far by ADAG