A Theory of Mergers

In our forthcoming Journal of Finance article Eat or Be Eaten: A Theory of Mergers and Firm Size we propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Two of the most important stylized facts about mergers are the following: First, the stock price of the acquirer in a merger decreases on average when the merger is announced. Second, mergers concentrate in industries that have experienced regime shifts in technology or regulation. The view that mergers are an efficient response to regime shifts by value-maximizing managers, the so-called neoclassical merger theory, can explain this second stylized fact. However, it has difficulties explaining negative abnormal returns to acquirers. Theories based on managerial self-interest such as a desire for larger firm size and diversification can explain negative acquirer returns. However, they cannot explain why mergers are concentrated in industries undergoing a regime shift. Our theory of mergers is able to reconcile both of these stylized facts.

The basic elements of our theory are as follows: First, we assume that managers derive private benefits from operating a firm in addition to the value of any ownership share of the firm they have. Second, we assume that there is a regime shift that creates potential synergies. The regime shift makes it more likely that some future mergers will create value, with larger targets being more attractive merger partners due to economies of scale. Third, we assume that a firm can only acquire a smaller firm, which is consistent with the majority of actual market acquisitions.

In our models, the anticipation of potential mergers after the regime shift creates incentives to engage in additional mergers. We show that a race to increase firm size through mergers can ensue for either defensive or “positioning” reasons. Defensive mergers occur because when managers care sufficiently about staying in control, they may want to acquire other firms to avoid being acquired themselves. By growing larger through acquisition, a firm is less likely to be acquired as it becomes bigger than some rivals. This defensive merger motive is self-reinforcing and hence gives rise to merger waves: one firm’s defensive acquisition makes other firms more vulnerable as takeover targets, which induces them to make defensive acquisitions themselves. This leads to an “eat-or-be-eaten” scenario, whereby unprofitable defensive acquisitions preempt some or all profitable acquisitions. We show that in industries in which many firms are of similar size to the largest firm, defensive mergers are likely to occur.

A central implication of our models is that the firm size distribution in an industry matters for merger dynamics. In particular, our models predict that acquisition profitability is positively correlated with the ratio of the size of the largest firm in an industry to the size of other firms in the industry. Additionally, it predicts that firms in industries with more medium-sized firms have a higher probability of making acquisitions. We use data on U.S. mergers during the period from 1982 to 2000 to test these hypotheses and find support for them.

The full paper is available for download here.