When Do Merges Create Value?

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When do vertical mergers create value?

This paper studies the market reaction to vertical mergers and explores the many rationales for vertical integration proposed in the industrial organization literature. Abnormal returns for vertical merger announcements are positive until the late 1990s, and turn negative afterward. Acquirers suffer most of the losses. We find support for the most fundamental insight in the industrial organization literature, namely, that vertical mergers generate the greatest value when undertaken in imperfectly competitive markets. We find some evidence to support ideas of asset and site specificity, that is, creating value when market exchange is difficult. We do not find support for information-based or price uncertainty theories.

If markets were competitive, with no frictions, then transactions between firms could be efficiently executed with arm's length contracts. However, market frictions can lead to a rationale for integration and mergers. This insight can be traced back to Stigler (1950) and its implications are explored in numerous subsequent studies. In this paper, we classify mergers into vertical, horizontal, and conglomerate deals. We study the market reaction to these deals and, in particular, vertical mergers' announcements and examine how they are related to the underlying rationales for vertical integration modeled in the large industrial organization literature. Although conglomerate mergers and horizontal mergers have been the focus of many studies, ours is one of the few papers that examine vertical mergers.

A significant obstacle to the study of vertical mergers had been the identification of vertically related transactions. Horizontal mergers are more easily classified and were studied by Eckbo (1983, 1985) in the 1980s and, more recently, by Fee and Thomas (2004), Shahrur (2005), and Gugler and Siebert (2007). Early researchers (e.g., Spiller, 1985) hand collected data on vertical deals and consequently had relatively small samples. Recently, Fan and Goyal (2006) used the Benchmark Input Output tables compiled by the Bureau of Economic Analysis to develop a classification system for vertical deals. Our measures are similar to the ones used by Fan and Goyal (2006), but we extend their analysis in several important ways. Fan and Goyal (2006) examine market reactions to the announcement of different deals between 1962 and 1996 and find that, on average, vertical mergers are associated with significant positive wealth effects. (1) We extend the sample to a later period ending in 2002. Consistent with Fan and Goyal (2006), we find that vertical mergers are indeed associated with positive wealth effects until 1998. However, in line with Moeller, Schlingemann, and Stulz (2005), we find that vertical deals after 1998 are associated with losses to acquirers. (2)

More importantly, we complement Fan and Goyal's (2006) findings by linking market reactions to vertical deals to the underlying rationales for vertical integration. A large body of work in industrial organization, discussed in detail in the next section, indicates that vertical integration can generate value in the presence of imperfect competition. Although assumptions, details, and specifications vary across different models, the essential result that emerges is that due to the possibility of rationing inputs, shutting out competitors, and price discrimination, vertical integration is value enhancing in the presence of imperfect competition. Consistent with this theory, we find that vertical deals in noncompetitive environments are associated with higher returns relative to other vertical deals. This is not necessarily true for horizontal or conglomerate mergers. If the increased ability to shut out rivals is a source of gains in vertical mergers, then this should be reflected in losses to rivals upon the announcement of mergers. Indeed, we find that vertical mergers are detrimental to competitors of the target,...
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