M&A as a tool for corporate strategy

According to Trautwein (1990), most observers agree that M&As are driven by a complex pattern of motives, and no single approach can render a full account. At the bottom line, however, the rationale comes down to being about creating value for the corporation’s shareholders.

According to Lubatkin (1988), M&As can create value for its

Power difference

Merger Acquisition

Figure 3.1 Merger and Acquisition as idealized states with power difference as running variable.

shareholders in two ways: either through an increase of stock returns (appreciation plus dividends) or through a decline in shareholder risk.

Shareholder risk, or systematic risk as it also labeled, is basically the variability in a firm’s stock returns. Different strategic perspectives provide different explanations on how this value creation may be pursued. Contemporary strategy research may be summarized in three broad perspectives: Porter’s Industrial Organization (I/O), the Resource Based View (RBV) of the firm and the strategic process perspective (Hedman & Kalling, 2003). These three perspectives will be used to describe the strategic potential of the M&A act. The following text is an extended and elaborated version of a discussion on the subject matter that was initially published in Henningsson (2007).

3.2.1 Industrial organization

During the 1980s a number of studies surveyed the potential of M&A to actually create additional shareholder value. Generally, these studies had difficulties in establishing any relation between increased value and the M&A initiative; in contrast, it was generally agreed that as much as two thirds of all consolidation initiatives actually failed in increasing shareholder value. Based on the ‘at that time’ prevailing strategic paradigm largely dependent on Michel Porters theories of the I/O (Porter, 1985), researchers searched to explain which mergers succeeded and which did not. The underpinning suggestion of the I/O perspective is that external conditions act as forces that are decisive for the success of a company (Porter, 1985).

The concept of synergy is fundamental to understanding the rational reasons as to why companies participate in merger activities, as synergies in this context are defined as to what is occurring when two units can be run more efficiently and/or more effectively together than apart (Lubatkin, 1983). Based on the strategic literature, it was argued that all mergers were fundamentally different in nature and the different types of combinations that enabled different potential synergies. The literature describes three basic types of positive synergies as possible outcomes of mergers: technical economies, pecuniary economies and diversification economies (Lubatkin, 1983).

Lubatkin (1983) manages to identify six types of technical economies in the literature (Table 3.1). Marketing, production, experience, scheduling, banking, and compensation are all economies of

scale that occur when the physical processes inside the firm are altered so that the same amounts of inputs produce a higher quantity of output, or the same quantity of output is produced using fever resources. Pecuniary economies correspond to the firm’s capability to dictate market prices by making use of market power achieved primarily by size. The two sorts of pecuniary economies monopoly and monopsony come from the corporation’s ability to force buyers to accept higher prices, and the ability to force suppliers to accept lower prices, respectively. Pecuniary economies do not offer any genuine efficiency improvements, compared to technical economies that lower the cost per produced unit, but rather represent a relocation of revenue from the less powerful to the more powerful (Lubatkin, 1983).

Table 3.1 Synergies related to mergers and acquisitions

Synergy Source Description

Technical economies

Marketing Shepard (1979) Scale economies in marketing and branding Production Shepard (1979) More efficient production of larger quantities

Experience Boston Consulting

Group (1968)

Reduction in cost that come with accumulated experience with a common technology

Scheduling Shepard (1979) Occur in vertical mergers when two levels of production are joined

Banking Howell (1970) Reduction in outstanding cash balances as consolidation reduces banking relationships

Compensation Howell (1970) Consolidation can lead to savings per employee for offerings such as health and life insurance

Pecuniary economies

Monopoly Porter (1980) Ability to force buyers to accept higher prices Monopsony Porter (1980) Ability to force suppliers to accept lower prices Diversification economies

Portfolio Management

Lewellen (1971) Consistency of assets which markets’ development are negatively correlated with each other

Risk Reduction Higgens and Schall (1975)

Lower transaction costs to stakeholders

Source: (Lubatkin, 1983)

Finally, diversification economies are achieved by improving the firm’s performance relative to its risk attributes, meaning to spread risk among unrelated markets and products through a strategic product portfolio (Lubatkin, 1983). Following portfolio theory, the best set of products and markets is where the earnings in one industry are negatively correlated with earnings in another industry included in the portfolio (Lubatkin, 1983).

One such classification that has been a common starting point for many M&A researchers is the FTC-Framework (1975). The classification scheme is based on potential synergies, and classifies M&A into horizontal, vertical, product concentric, market concentric, and conglomerate categories. Larsson (1990) made an effort to improve the model into a systematic framework (Figure 3.2). In Larsson’s framework the category of vertical integration is split into two categories, vertical backward and vertical forward. Apart from this refinement, the categories correspond to the FTC categories. In the framework M&As are categorized by the two companies relation in terms of: a) the company’s products relation in a potential value chain, and b) the company’s market relation.

Both dimensions of the FTC-framework have been claimed related to Porters models, which does not seem unlikely. Porter’s value chain model (1985) relates to the product relation-dimension, where the place in an industry’s value chain determines whether the M&A is horizontal, long-linked or unrelated. Horizontal means that the combining units are potential competitors, occupying the same position in an industry’s value chain. The long-linked relation means that the two units are active in the same industry but hold different positions in the value chain. The units have thus a potential buyer-seller relationship. Finally, the unrelated product extension means that the two units are active in different value chains. Porter (1987) argues that the last category of M&A normally does not deliver added financial value as it does not fit in the competitive strategy of an organization.

Market relation

Production relation

Same

Long-linked

Unrelated

Same Different

Horizontal Market extension

Vertical backward

Vertical forward

Product extension

Conglo-merate

Figure 3.2. A systematic framework for the FTC typology of M&A. Source: Larsson (1990)

Porter found that 74% of the unrelated M&As were divested again within a few years.

The second dimension in the FTC-framework is market relation.

According to Porter (1987), only M&As into attractive markets are normally able to deliver added financial value. In Porter’s view, five forces determine the competitive rivalry within a market:

• The intensity of competitive rivalry: Numbers of competitors, industry growth, etc.

• The bargaining power of customers: Buyer concentration to firm concentration ratio, buyer volume, buyer price sensitivity, etc.

• The bargaining power of suppliers: Supplier switching costs relative to firm switching costs, degree of differentiation of inputs, etc.

• The threat of the entry of new competitors: the existence of barriers to entry (patents, rights, etc.), brand equity, capital requirements, etc.

• The threat of substitute products: Buyer propensity to substitute, buyer switching costs, etc.

M&As can be used to change the conditions for the market, striving to make it more profitable (Porter, 1987). If the two units in an M&A occupy the same position in the value chain in the same market, they contribute to the first force above, the intensity of competitive rivalry.

By merging, they thus reduce the competition within the market.

Similarly, M&As can alter the basis for the other forces. If pressure from customers or suppliers is too intense, a vertical M&A may alter the conditions. M&As can also be used to meet the force of new competitors (by simply acquiring promising competitors) or meet the force of substitute products through M&A entering into a new market that may rule out existing businesses.

M&As can thus be made to change the structure of an industry (described by the five forces model) and to change a company’s position within an industry. Porter’s three generic strategies that, according to Porter (1980), can lead to profitable business suggest that companies should strive for cost leadership through company size or focus on a certain niche of the industry. An M&A can be made to acquire market

leadership in terms of size and turnover or to address a more profitable niche of the industry (Porter, 1987).

The limitation of the framework above is that although an M&A at the bottom line is about making two units function as one, Porter’s models, and consequently the framework that extends his work, do not consider the inside of the organizations and the possibility of actually merging the units.

3.2.2 RBV

The I/O perspective emphasizes the contextual pressure and the ability to adjust accordingly to changes in the environment as decisive for successful corporations. In contrast, RBV put forward individual and combined internal resources as determinants for success (Barney, 1991).

According to Eisenhardt and Martin (2007), the RBV stipulates an organization being the aggregation of its resources. How successful a corporation is, is dependent on the value, rareness, and substitutability of its resources. A resource is valuable if it contributes to the organizational performance by lowering costs or increasing selling prices. If the resource also is rare and difficult/expensive to imitate or substitute, the resource contributes to sustained competitive advantage.

Organizational capabilities, the ability to perform an action using the available resources, can be seen as a particular category of resource.

Grant (1996a) describes organizational capabilities as the integration of knowledge from different individuals within an organization to perform specific activities. Examples of organizational capabilities include new product development, fast response capability, and innovation (Grant, 1996b).

A development of the capability concept is the concept of dynamic capabilities. Explained by Teece et al. (1997, p. 515):

We refer to this ability to achieve new forms of competitive advantage as 'dynamic capabilities' to emphasize two key aspects […]. The term 'dynamic' refers to the capacity to renew competences so as to achieve congruence with the changing business environment; certain innovative responses are required when time-to-market and timing are critical, the rate of technological change is rapid, and the nature of future competition and markets difficult to determine. The term 'capabilities' emphasizes the key role of strategic management in appropriately adapting, integrating, and reconfiguring internal and

external organizational slulls, resources, and functional competences to match the requirements of a changing environment.

Applying RBV as strategic perspective thus implies a view that the creation and deployment of resources and capabilities are key managerial issues:

The key to a resource-based approach to strategy formulation is understanding the relationships between resources, capabilities, competitive advantage, and profitability - in particular, an understanding of the mechanisms through which competitive advantage can be sustained over time. (Grant, 1991, p. 114)

The RBV perspective is the currently predominating perspective in strategy research, and the use in IS research is becoming increasingly popular (Hedman & Kalling, 2003). In the M&A field it has primarily manifested its presence through articles addressing organizational compatibility as a hampering factor to consider when planning for the synergetic effects described above. Organizational compatibility has been addressed from many different perspectives. Risberg (1999) reports it being discussed in terms of financial fit, business style fit, fit of assets, management styles fit and cultural fit.

The reason behind many M&As is the desire to better utilize exiting resources by combining them with new ones (Cording et al., 2002). The view of Prahalad and Hamel (1990) is closely related to the rational between many divestments and acquisitions. As companies seek to focus on their core competences (the wording the authors use for key organizational capabilities), they divest units away from their core business and core competence in order to be able to strengthen their position in their main business. In doing so, they enable synergetic potentials related to a combination of unique resources, as well as better use of capabilities and of internal assets. However, for reasons such as insufficient integration, unawareness, and unfamiliarity, companies generally fail in utilizing the full combination potential that could be reached by combining resources across the former organizational border (Capron, 1999).

For companies, such as Mexican Cemex, who have M&A as an integrated part of their growth strategy, the ability to identify targets, plan, manage, and eventually implement M&As can be seen as a strategic organizational capability (Miller, 2002). Zollo and Singh

(2004) regard post-M&A integration as a capability that can be improved by deliberate learning processes. Both practitioners and researchers have often argued that firms with previous acquisition experience will do better than those without such experience (Lubatkin, 1983), an assumption that seems to make sense. However, Haspeslag and Jemison conclude that “nothing can be said or learned about acquisitions in general” (1987, p. 53); a study by Lubatkin (1982) surprisingly failed to find a significant relationship between acquisition experience and performance. Haleblian and Finkelstein (1999) explain the result of Lubatkin’s study by inappropriate measurements of acquisition performance². In their own study, Haleblian and Finkelstein (1999) found that there exists a U shaped relationship between acquisition experience and performance. Their findings propose that relative inexperienced acquirers, after making their first acquisition, inappropriately generalize knowledge to dissimilar acquisitions, while more experienced acquirers appropriately distinguish between their acquisitions. Other studies have also found positive relationships between experience and performance (Bruton et al., 1994; Fowler &

Schmidt, 1989; Hitt et al., 1993). These studies are, however, based on relatively small samples.

3.2.3 Strategic process perspective

While both I/O and RBV focus the content on the corporate strategy, the strategic process perspective focuses on the strategic process (cf Mohr (1982): variance vs process theory). I/O and RBV both have ideas of the optimal competitive situation, but say very little of how to actually go there. With the argument of more practical usefulness, research on the formation of corporate strategy as an ongoing process was added to the strategic field (Bengtsson, 1992). In process research the interest is in events, states and their relation to each other (Van de Ven & Poole, 1995). The strategic process perspective is less homogenous than the two earlier presented perspectives. Contributions have sometimes little in common, rather than the focus on the strategic process. A rough division can be made into contributions that apply a

2 Haleblian and Finkelstein (1999) argue that Lubatkin’s (1982) study was

constrained by a reliance on monthly market returns, instead of daily returns, to

rational, incremental or organizational (i.e. political, cultural, knowledge etc.) view of the strategy process.

The process perspective on M&A emphasizes that the M&A process is in itself an important factor, in addition to or even as an alternative to strategic and organizational fit, that affects the outcome (Risberg, 1999). Mintzberg (1994) noticed an implicit or explicit assumption of content oriented strategy models that the strategic process is rational and straightforward. Mintzberg (1994) contested this, arguing that the corporate strategy was made up retrospectively of the emergent actions a company took. Not by formal strategic plans.

Mintzberg argued that uncertainty about the future leads to incrementalism, short planning cycles, and tentative actions. The implicit assumption of a rational and straightforward strategic process that Mintzberg maintains is highly visible in current M&A process research. Attempts to model the whole M&A process have frequently ended up in phase models that in the terminology of Van de Ven and Poole (1995) can be labeled as life-cycle models.

The typical progression of change events in a life-cycle model is a unitary sequence (it follows a single sequence of stages or phases), which is cumulative (characteristics acquired in earlier stages are retained in later stages) and conjunctive (the stages are related such that they derive from a common underlying process) (Van de Ven &

Poole, 1995, p. 515).

The category of theoretical contribution conforming to this pattern includes Haspeslagh and Jemison (1991), Graves (1981), Aiello and Watkins (2000), Breindenbach (2000), and Buono & Bowditch (1989). Basically they are conforming to the same underlying logic.

There is a pre-M&A period when the organization tries to elicit as much information about the other organization as possible, and try to envision how the two organizations could be joined in a way that implies a more efficient and/or effective total. After the deal is closed, the work of actually implementing the prospective plans is carried out.

The rational for using phase models has been to distinguish different events and activities of each stage, thereby furthering the understanding of the M&A process and how it can be managed (Haspeslagh &

Jemison, 1991). However, it should be noticed that the above reviewed models do have imprecisely established frontiers; many processes seem

to be active in more than one phase and it is hard to say when one phase ends and another begins (Lohrum, 1992; Risberg, 2003).

As stressed before, the underlying assumption is in conflict with Mintzberg (1994), but there is also a conflict with other strategic process writings. For example, Burgelman (1983) focuses on corporate innovation and entrepreneurship and concludes that an experimentation-and-selection approach is necessary. Also Quinn (1978) finds the real strategic process lacking resemblance with the theoretical models: “When well-managed major organizations make significant changes in strategy, the approaches they use frequently bear little resemblance to the rational-analytical systems so often touted in the planning literature” (Quinn, 1978, p. 7). The formal, rational strategic planning approach describes a teleological, goal oriented process. Although not frequently favored by strategy process researchers, contributions conforming to this strategic idealism do exist (e.g. Chakravarthy & Lorange, 1984). In a teleological process the direct relation between events of state is of minor importance; what glues the process together are the shared objectives towards which the process is directed. For this process, Mintzberg prefers to use the term

’strategic programming’ but, in contrast to Quinn (1978) and Burgelman (1988), he emphasizes the necessity of this activity.

The third class of studies on the M&A process has a focus on organizational factors such as politics, culture, and knowledge. M&As easily draw attention to political issues since they by nature have a dialectic process, as two units should be combined. Lubatkin (1988) notices that often the advantages of M&As that offer the greatest potential in theory also are the most difficult to achieve in practice, as M&As tend to destroy non-economic value for those who are supposed to create economic value. Explained by Haspelslagh and Jemison (1987, p. 56):

Ironically, acquisitions often destroy noneconomic value for those who are asked to create economic value after the transaction is made.

Creating economic value requires the cooperation and commitment of operating-level managers of both firms in order to combine the skills, resources, or knowledge of the two firms. Yet it is precisely this group and their subordinates for whom the acquisition destroys noneconomic value through the loss of job security, status, or career opportunities.

Acculturation in M&As is the outcome of a cooperative process whereby the beliefs, assumptions, and values of two previously independent work forces form a jointly determined culture (Larsson and Lubatkin, 2001). As anecdotal evidence pointed towards culture clashes being important reasons for failed M&As, researchers started to theorize on the phenomena during the 1980s. Larsson and Lubatkin (2001) examined prior research and found that the cultural issues had been studied in terms of person-organization fit, social anthropology, relational demography, the attraction-selection paradigm, social movements, relative standing, and national culture differences.

Together, these complementary theories help to explain why people at the target company often face considerable pressure to conform to the values and management practices of the acquirer, the reasons why these pressures tend to be resisted, and the consequences of that resistance.

To underscore the importance of cultural integration, Larsson and Lubatkin (2001) refer to a survey of 200 European chief executive officers (Booz, 1985) which drew the conclusion that the ability to integrate organizational cultures, acculturation, is more important to M&A success than financial or strategic factors. Larsson and Lubatkin (2001) highlight that culture clashes has been found to result in lower commitment and cooperation among acquired employees, greater turnover among acquired managers, a decline in shareholder value at the acquiring firm, and a deterioration in operating performance at the target.