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Mergers and the Economy

MERGER WAVES

Mergers come in waves. The first episode of intense merger activity occurred at the turn of the twentieth century and the second in the 1920s. There was a further boom from 1967 to 1969 and then again in the 1980s and 1990s. Each episode coincided with a period of buoyant stock prices, though in each case there were substantial differences in the types of companies that merged and how they went about it.

We don`t really understand why merger activity is so volatile. If mergers are prompted by economic motives, at least one of these motives must be БІАААмhere today, gone tomorrow,БІАААн and it must somehow be associated with high stock prices. But none of the economic motives that we review in this material has anything to do with the general level of the stock market. None of the motives burst on the scene in 1967, departed in 1970, reappeared for most of the 1980s, and reappeared again in the mid-1990s. Some mergers may result from mistakes in valuation on the part of the stock market.

In other words, the buyer may believe that investors have underestimated the value of the seller or may hope that they will overestimate the value of the combined firm. Why don`t we see just as many firms hunting for bargain acquisitions when the stock market is low? It is possible that БІАААмsuckers are born every minute,БІАААн but it`s difficult to believe that they can be harvested only in bull markets.

During the 1980s merger boom, only the very largest companies were immune from attack from a rival management team. For example, in 1985 Pantry Pride, a small supermarket chain recently emerged from bankruptcy, made a bid for the cosmetics company Revlon. Revlon`s assets were more than five times those of Pantry Pride. What made the bid possible (and eventually successful) was the ability of Pantry Pride to finance the takeover by borrowing $2.1 billion. The growth of leveraged buyouts during the 1980s depended on the development of a junk bond market that allowed bidders to place low-grade bonds rapidly and in high volume.

By the end of the decade the merger environment had changed. Many of the obvious targets had disappeared, and the battle for RJR Nabisco highlighted the increasing cost of victory. Institutions were reluctant to increase their holdings of junk bonds. Moreover, the market for these bonds had depended to a remarkable extent on one individual, Michael Milken, of the investment bank Drexel Burnham Lambert. By the late 1980s Milken and his employer were in trouble. Milken was indicted by a grand jury on 98 counts and was subsequently sentenced to jail and ordered to pay $600 million.

Drexel filed for bankruptcy, but by that time the junk bond market was moribund and the finance for highly leveraged buyouts had largely dried up.16 Finally, in reaction to the perceived excess of the merger boom, the state legislatures and the courts began to lean against takeovers.

The decline in merger activity proved temporary; by the mid-1990s stock markets and mergers were booming again. However, LBOs remained out of fashion, and relatively few mergers were intended simply to replace management. Instead, companies began to look once more at the possible benefits from combining two businesses.

DO MERGERS GENERATE NET BENEFITS?

There are undoubtedly good acquisitions and bad acquisitions, but economists find it hard to agree on whether acquisitions are beneficial on balance. We do know that mergers generate substantial gains to stockholders of acquired firms.

Since buyers seem roughly to break even and sellers make substantial gains, it seems that there are positive gains to mergers. But not everybody is convinced. Some believe that investors analyzing mergers pay too much attention to short-term earnings gains and don`t notice that these gains are at the expense of long-term prospects. Since we can`t observe how companies would have fared in the absence of a merger, it is difficult to measure the effects on profitability. Studies of recent merger activity suggest that mergers do seem to improve real productivity. For example, Healy, Palepu, and Ruback examined 50 large mergers between 1979 and 1983 and found an average increase in the companies` pretax returns of 2.4 percentage points.17 They argue that this gain came from generating a higher level of sales from the same assets. There was no evidence that the companies were mortgaging their long-term futures by cutting back on long-term investments; expenditures on capital equipment and research and development tracked the industry average.

If you are concerned with public policy toward mergers, you do not want to look only at their impact on the shareholders of the companies concerned. For instance, we have already seen that in the case of RJR Nabisco some part of the shareholders` gain was at the expense of the bondholders and the Internal Revenue Service (through the enlarged interest tax shield). The acquirer`s shareholders may also gain at the expense of the target firm`s employees, who in some cases are laid off or are forced to take pay cuts after takeovers.

Many people believe that the merger wave of the 1980s led to excessive debt levels and left many companies ill- equipped to survive a recession. Also, many savings and loan companies and some large insurance firms invested heavily in junk bonds. Defaults on these bonds threatened, and in some cases extinguished, their solvency.

Perhaps the most important effect of acquisition is felt by the managers of companies that are not taken over. For example, one effect of LBOs was that the managers of even the largest corporations could not feel safe from challenge. Perhaps the threat of takeover spurs the whole of corporate America to try harder. Unfortunately, we don`t

know whether on balance the threat of merger makes for more active days or sleepless nights.

We do know that merger activity is very costly. For example, in the RJR Nabisco buyout, the total fees paid to the investment banks, lawyers, and accountants amounted to over $1 billion.

Even if the gains to the community exceed these costs, one wonders whether the same benefits could not be achieved more cheaply another way. For example, are leveraged buyouts necessary to make managers work harder? Perhaps the problem lies in the way that many corporations reward and penalize their managers. Perhaps many of the gains from takeover could be captured by linking management compensation more closely to performance.