An Examination of Industrial Relatedness, Potential Industrial Synergies, and Merger Premiums in Large Corporate Merger Transactions

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ABSTRACT

Many business combinations are justified by management on the basis of expected synergistic benefits from the post-combination operations. This study analyzes the top four product lines of the 442 largest business combinations between U.S. publicly owned companies during 1995-2000. The study shows a high association between the industrial product lines of the acquiring and acquired companies. This suggests that expected operating synergistic benefits may be obtainable by the post-combination entity. However, a study of the correlations between the amount of the premiums paid by the acquiring companies to the acquired companies, and the degree of industrial association between the companies, showed that the premiums are not related to the degree of industrial associations between the companies.

INTRODUCTION

Corporate mergers and acquisitions are a major aspect of business activity and involve billions of dollars. The extant finance and accounting literature suggest a variety of strategic policies for the selection of combination candidates. One of these strategic policies is to acquire another company in order to obtain synergistic gains from the operation of the combined entity by utilizing scale and scope economies. Specifically, it has been posited that operating synergies are more likely in a business combination involving similar industrial lines because the factors of production and the market factors have the highest degree of association and can most easily be integrated.

The fair market value of the company as a stand-alone entity is measured by its total stock market capitalization. The merger premium is the difference between the target company's market value prior to the announcement of the combination and the offering price for the target company and it should reflect the expected synergies that will be generated from the post-combination entity.

Although the business press often states that seeking synergy is one of the basic reasons for business combination activity, the empirical search for the synergistic return has been inconclusive. Early studies by Bradley, Desai, and Kim (1983), and Ravenscraft and Scherer (1987), suggest that the post-combination stock prices do not provide evidence for synergistic premiums due to poor post-takeover performance of the combined firm. Porter (1987) found that many acquired firms are subsequently divested, and some very shortly after the acquisition. Roll (1986) proposes the "hubris hypothesis" to explain that bidding firms infected by hubris simply pay too much for their targets, and that the acquisition premiums are not related to synergy. Varaiya and Ferris (1987) use the explanation of the "winner's curse" for explaining the acquisition premium paid to the target in cases in which there is competition for a takeover candidate. For 96 acquisitions between 1974 and 1983, they find that the winning bid premium, on average, overstates the market's estimate of the takeover gain, and that, following the acquisition, a majority of the acquiring firms have a significant, negative cumulative average return in their stock prices.

In contrast to the above studies, Henning, Lewis, and Shaw (2000) find that the synergy created from business combinations is valued by the market. Henning et al. (2001) measure the synergy component of accounting goodwill by combining the cumulative abnormal returns of the acquiring firm and the target firm. Using a sample of 1,576 purchase combinations from the period 1990--1994 in a levels model, Henning et al. (2000), find that the market values the synergistic component of goodwill.

We find that although companies tend to buy other firms in similar industrial lines implying synergy, there is no relation between the premium paid and the proximity of the industrial association.

OBJECTIVES OF THIS STUDY AND RESEARCH QUESTIONS

It is expected that industrial synergies would be more possible in combinations between companies in the same or similar industries. …