Merger and Acquisition Strategy

The Nature of Mergers and Acquisitions Strategy

A merger is a strategy through which two firms agree to integrate their operations on a relatively co-equal basis.

On a practical basis, deciding who will lead the merged firm, how to fuse what are often disparate corporate cultures, and how to reach an agreement about the value of each company prior to the merger are issues that commonly affect firms’ efforts to merge on a coequal basis.

An acquisition is a strategy through which one firm buys a controlling, or 100 percent, interest in another firm with the intent of making the acquired firm a subsidiary business within its portfolio.

After the acquisition is completed, the management of the acquired firm reports to the management of the acquiring firm.

Although most mergers that are completed are friendly in nature, acquisitions can be friendly or unfriendly. A takeover is a special type of acquisition where the target firm does not solicit the acquiring firm’s bid. Thus, takeovers are unfriendly acquisitions.

Firms have developed defenses (mostly corporate governance devices) that can be used to prevent an unrequested and undesired takeover bid from being successful.

Commonly, firms think of unsolicited bids as hostile takeovers. When such a bid is received, the takeover target may try to determine the highest amount the acquiring firm is willing to pay, even while simultaneously using defense mechanisms to prevent a takeover attempt from succeeding. Multiple exchanges may take place between a potential acquirer and its target before a resolution to the unsolicited bid is reached and these exchanges can become quite complicated.

Although popular as a way of creating value and earning above-average returns, it is challenging to effectively implement merger and acquisition strategies.

This is particularly true for the acquiring firms in that some research results indicate that shareholders of the acquired firms often earn above-average returns from acquisitions, while shareholders of the acquiring firms typically earn returns that are close to zero.

Moreover, in approximately two-thirds of all acquisitions, the acquiring firm’s stock price falls immediately after the intended transaction is announced. This negative response reflects investors’ skepticism about the likelihood that the acquirer will be able to achieve the synergies required to justify the premium to purchase the target firm.

Reasons for Merger and Acquisitions

Reason 1: Increased Market Power

Achieving greater market power is a primary reason for acquisitions.

Market power exists when a firm is able to sell its goods or services above competitive levels or when the costs of its primary or support activities are lower than those of its competitors. Market power usually is derived from the size of the firm, the quality of the resources it uses to compete, and its share of the market(s) in which it competes.

Therefore, most acquisitions that are designed to achieve greater market power entail buying a competitor, a supplier, a distributor, or a business in a highly related industry so a core competence can be used to gain a competitive advantage in the acquiring firm’s primary market.

Firms use horizontal, vertical, and related types of acquisitions to increase their market power. Active acquirers simultaneously pursue two or all three types of acquisitions in order to do this.

Horizontal Acquisitions

The acquisition of a company competing in the same industry as the acquiring firm is a horizontal acquisition.

Horizontal acquisitions increase a firm’s market power by exploiting cost-based and revenue-based synergies. Horizontal acquisitions occur frequently in the pharmaceutical industry.

Horizontal acquisitions result in higher performance when the firms have similar characteristics, such as strategy, managerial styles, and resource allocation patterns. Similarities in these characteristics, as well as previous alliance management experience, support efforts to integrate the acquiring and the acquired firm.

Horizontal acquisitions are often most effective when the acquiring firm effectively integrates the acquired firm’s assets with its own, but only after evaluating and divesting excess capacity and assets that do not complement the newly combined firm’s core competencies.

Vertical Acquisitions

A vertical acquisition refers to a firm acquiring a supplier or distributor of one or more of its products.

Through a vertical acquisition, the newly formed firm controls additional parts of the value chain, which is how vertical acquisitions lead to increased market power.

Through vertical integration, a firm has an opportunity to appropriate value being generated in a part of the value chain in which it does not currently compete and to better control its own destiny in terms of costs and access.

Related Acquisitions

Acquiring a firm in a highly related industry is called a related acquisition.

Through a related acquisition, firms seek to create value through the synergy that can be generated by integrating some of their resources and capabilities.

Reason 2: Overcoming Entry Barriers

Barriers to entry are factors associated with a market, or the firms currently operating in it, that increase the expense and difficulty new firms encounter when trying to enter that particular market.

Facing the entry barriers that economies of scale and differentiated products create, a new entrant may find that acquiring an established company is more effective than entering the market as a competitor offering a product that is unfamiliar to current buyers. In fact, the higher the barriers to market entry, the greater the probability that a firm will acquire an existing firm to overcome them.

A key advantage of using an acquisition strategy to overcome entry barriers is that the acquiring firm gains immediate access to a market that is attractive to it.

Cross-Border Acquisitions

Acquisitions made between companies with headquarters in different countries are called cross-border acquisitions.

Firms should recognize that cross-border acquisitions are not risk-free, even when a strong strategic rationale undergirds the completed transactions.

Reason 3: Cost and Speed of New Product Development

Developing new products internally and successfully introducing them into the marketplace often requires a significant investment of a firm’s resources, including time, making it difficult to quickly earn a profitable return. Concerns exist in firms about their ability to achieve adequate returns from the capital they invest to develop and commercialize new products.

An acquisition strategy is another course of action a firm can take to gain access to new products and to current products that are new to them.

Compared with internal product development processes, acquisitions provide more predictable returns as well as faster market entry. Returns are more predictable because the performance of the acquired firm’s products can be assessed prior to completing the acquisition.

Reason 4: Lower Risk Compared to Developing New Products

The outcomes of an acquisition can be estimated more easily and accurately than the outcomes of an internal product development process.

As such, managers may view acquisitions as less risky. However, firms should be cautious when using acquisitions to reduce risk relative to the risk incurred when developing new products internally. Indeed, even though acquisition strategies are a common means of avoiding risky internal ventures, acquisitions may also become a substitute for internal innovation.

Over time, being dependent on others for innovation leaves a firm vulnerable and less capable of mastering its own destiny when it comes to using innovation as a driver of wealth creation.

Thus, a clear strategic rationale should drive each acquisition a firm chooses to complete. If a firm is being acquired to gain access to a specific innovation or to a target’s innovation-related capabilities, the acquiring firm should be able to specify how the innovation is or the innovation-based skills are to be integrated with its operations for strategic purposes.

Reason 5: Increased Diversification

Acquisitions are also used to diversify firms. Acquisition strategies can be used to support the use of both related and unrelated diversification strategies.

Based on experience and the insights resulting from it, firms typically find it easier to develop and introduce new products in markets they are currently serving. In contrast, it is difficult for companies to develop products that differ from their current lines for markets in which they lack experience. Thus, it is relatively uncommon for a firm to develop new products internally to diversify its product lines.

Firms using acquisition strategies should be aware that, in general, the more related the acquired firm is to the acquiring firm, the greater is the probability that the acquisition will be successful. Thus, horizontal acquisitions and related acquisitions tend to contribute more to the firm’s strategic competitiveness than do acquisitions of companies operating in product markets that differ from those in which the acquiring firm competes.

Reason 6: Reshaping the Firm’s Competitive Scope

The intensity of competitive rivalry is an industry characteristic that affects a firm’s profitability.

To reduce the negative effect of an intense rivalry on financial performance, firms may use acquisitions to lessen their product and/or market dependencies.

Reducing a company’s dependence on specific products or markets shapes the firm’s competitive scope.

Reason 7: Learning and Developing New Capabilities

Firms sometimes complete acquisitions to gain access to capabilities they lack.

Firms can broaden their knowledge base and reduce inertia through acquisitions and that they increase the potential of their capabilities when they acquire diverse talent through cross-border acquisitions.

Firms are better able to learn these acquired capabilities if they share some similar properties with the firm’s current capabilities. Thus, firms should seek to acquire companies with different but related and complementary capabilities as a path to building their own knowledge base.

Effective Acquisitions

Acquisition strategies do not always lead to above-average returns for the acquiring firm’s shareholders. Nonetheless, some companies are able to create value when using an acquisition strategy.

The probability of being able to create value through acquisitions increases when the nature of the acquisition and the processes used to complete it are consistent with the attributes of successful acquisitions.

In effective acquisitions, the target firm’s assets usually are complementary to the acquired firm’s assets.

With complementary assets, the integration of two firms’ operations has a higher probability of creating synergy. In fact, integrating two firms with complementary assets frequently produces unique capabilities and core competencies. With complementary assets, the acquiring firm can maintain its focus on core businesses and leverage the complementary assets and capabilities from the acquired firm.

In effective acquisitions, targets are often selected by establishing a working relationship prior to the acquisition.

Firms sometimes form strategic alliances to test the feasibility of a future merger or acquisition between them, an experience that can also contribute to acquisition success.

Friendly acquisitions also facilitate the integration of the acquiring and acquired firms.

Of course, a target firm’s positive reaction to a bid from the acquiring firm increases the likelihood that a friendly transaction will take place. After completing a friendly acquisition, firms collaborate to create synergy while integration their operations. This is in contrast to hostile takeovers, situations in which common disagreements, such as those concerned with the combined firm’s leadership structure and operational methods that will be used in the newly created firm, strongly increase the difficulty associated with attempts to create synergy through the integration process.

Additionally, effective due-diligence processes can facilitate an effective acquisition.

Due-diligence processes involve the deliberate and careful selection of target firms and an evaluation of the relative health of those firms (financial health, cultural fit, and the value of human resources) that contribute to successful acquisitions.

Financial slack in the form of debt-equity or cash, in both the acquiring and acquired firms, also frequently contributes to acquisition success.

Even though financial slack provides access to financing for the acquisition, it is still important to maintain a low or moderate level of debt after the acquisition to keep debt costs low. When substantial debt is used to finance acquisitions, companies with successful acquisitions reduce the debt quickly, partly by selling off assets from the acquired firm, especially noncomplementary or poorly performing assets. For these firms, debt costs do not preclude long-term investments in areas such as R&D, and managerial discretion in the use of cash flow is relatively flexible.

The firm’s flexibility and adaptability are the final two attributes of successful acquisitions.

When executives of both the acquiring and the target firms have experience in managing change and learning from acquisitions, they are more skilled at adapting their capabilities to new environments. As a result, they are more adept at integrating the two organizations, which is particularly important when firms have different organizational cultures.

Resources

Even More Reading

Related Concepts

Obstacles to Successful Acquisitions

References

Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2016). Strategic Management: Concepts: Competitiveness and Globalization (12th ed.). Cengage Learning.
Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2019). Strategic Management: Concepts and Cases: Competitiveness and Globalization (MindTap Course List) (13th ed.). Cengage Learning.
Hill, C. W. L., & Jones, G. R. (2011). Essentials of Strategic Management (Available Titles CourseMate) (3rd ed.). Cengage Learning.
Mastering Strategic Management. (2016, January 18). Open Textbooks for Hong Kong.

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