Why Do (Some) Mergers Fail?

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Why Do (Some) Mergers Fail?
Liam Arf
First draft: February, 2006
This version: September 10, 2006
This paper presents a model that incorporates product market competition into the standard neoclassical framework. The model explains why value-maximizing firms conduct mergers that in effect undermine shareholder value. In a Cournot setting, this paper demonstrates a prisoners’ dilemma for merging firms in a merger wave. Empirically, this paper identifies a negative relation between the performance of horizontal mergers and the clusteredness of horizontal M&A activities, which is consistent with the theory. Moreover, this relation is independent of the method of payment and increasing in acquirer’s managerial ownership, which rules out the alternative interpretations from existing theories. Finally, this relation is weaker for concentrated or durable-goods industries, which further supports the product market competition explanation of this paper.

*The Wharton School of University of Pennsylvania, Email: jyan@wharton.upenn.edu. I thank Philip Bond, Gary Gorton, Wei Jiang, David Musto, Jozsef Molnar, Vinay Nair, Michael Roberts, Pavel Savor, Rob Stambaugh, Geoff Tate, Ding Wu, Julie Wulf, Jianfeng Yu, Paul Zurek, and seminar participants at Wharton for helpful discussions. I am especially grateful to my committee members, Franklin Allen, Chris Géczy, Itay Goldstein, João Gomes, and Andrew Metrick, for their comments, guidance, and encouragement. All errors are my own. 11 Introduction

Why do some types of mergers lower shareholder value?
1 Agency theory attributes
the failure of mergers to principal-agent problem. Market timing theory attributes the negative post-announcement stock performance to overdue correction of mispricing. This paper proposes an explanation by incorporating the role of product market competition into the standard neoclassical framework in the absence of agency cost and market ine¢ ciency. In a neoclassical setting where mergers facilitate technology transfer between Örms, mergers that take place outside merger waves (hereafter, o§- the-wave mergers) increase shareholder value due to value maximization. However, if such horizontal mergers take place in a wave that is driven by technology shocks, 2

the improved technology of merging Örms and an increasingly concentrated market structure alters the competitive landscape for non-merging rival Örms. When complementarity of production strength between acquirers and targets is su¢ ciently high, the standalone Örms in an on-going merger wave may face a declining proÖt margin and a shrinking market share. The merger wave thus resembles a game of prisonersí dilemma: Each individual pair chooses to merge despite that their combined acts result in a lower shareholder value relative to that prior to the merger wave. Therefore, mergers that take place in a merger wave (hereafter, on-the-wave mergers) may lower shareholder value.

On the empirical front, this paper shows that on-the-wave horizontal mergers underperform o§-the-wave horizontal mergers, which is consistent with the model. The relation between merger wave and post-merger performance is robust to a number of performance measures, industry classiÖcations, and empirical approaches. Moreover, the underperformance of on-the-wave mergers is more pronounced in less concentrated or non-durable goods industries. And stand-alone industry rivals also underperform in horizontal merger waves. These Öndings further support the model. While the empirical relation between performance and merger wave supports this paperís model, it can also be explained by several existing theories in the literature, including market timing theory and agency theory. The market timing theory, exempliÖed by Shleifer and Vishny (2003) and Rhodes-Kropf and Viswanathan (2004), suggests that the acquirer uses its relatively overvalued stock as currency to purchase the target companyís stock. Such...
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