Academic journal article Journal of Applied Finance

M&As: The Good, the Bad, and the Ugly

Academic journal article Journal of Applied Finance

M&As: The Good, the Bad, and the Ugly

Article excerpt

M&As should be defined to include joint ventures, alliances and divestitures in addition to mergers and acquisitions. M&As represent a neoclassical theory of how firms seek to enhance their capabilities and resources (the Good). Good M&As are positive net present value external investments. Competing explanations of M&A activities include redistribution theories (the Bad) and behavioral theories (the Ugly). Using our broad definition of M&As we analyze prior literature and present a case study of the defense industry. We find that the neoclassical theory has more explanatory power than the other two competing explanations under our broad definition of M&As. [G33, G34]

Traditionally, mergers and acquisitions (M&As) have been defined to be the purchase of entire companies or specific assets by another company. In more general terms, this implies that a new combination of existing assets is formed. Neoclassical economic theory predicts that the new combination will be more productive than the sum of its parts; hence, synergy gains will be realized. In addition, for the seller to agree to the deal, it must be better off than before the sale (i.e., the seller's new combination of assets is more valuable than its prior combination). Moreover, new combinations of assets are formed through many other contractual arrangements than M&As, as traditionally defined. Joint ventures, for example, combine various assets from two or more separate firms into a completely new organization. Just as in an acquisition, this new combination of assets is thought to have greater value than the sum of its individual parts.

Therefore, a better definition of M&As should include mergers, acquisitions, takeovers, tender offers, alliances, joint ventures, minority equity investments, licensing, divestitures, spin-offs, split-ups, carve-outs, leveraged buyouts, reorganizations, restructuring, and recontracting associated with financial distress and other adjustments. Purchases of entire companies or divisions are the most drastic ways in which firms recombine assets to create value, but are not the only ways. Because the other forms of M&As are less severe than mergers, they actually happen much more frequently. Moreover, firms engage in multiple M& A activities over a period of years, with many deals occurring simultaneously. Yet, prior research has focused predominately on purchases of entire companies, with relatively little research into the other forms of M&As, and even less into the interactions between the various forms of M&As and the growth strategy of a firm.

This paper argues that M&As represent a neoclassical theory of how firms seek to enhance their capabilities and resources. Firms engage in internal investments and in M&A programs over a continuing succession of years to strengthen their managerial capabilities and resources in relation to the product-market areas in which they enter and exit over time. Change forces and competitive pressures require adjustments to changing environments and compel these efforts.

We compare the implications of three competing theories of M&As. Specifically, the neoclassical theory (the Good) is compared to two alternative theories of traditional mergers and acquisitions: 1) redistribution (the Bad) and 2) behavioral theories (the Ugly). Through an extensive review of the literature, we examine how well these other theories explain our broader definition of M&As. We test the implications of the three competing theories using data from the top five domestic defense contractors over the period 1990-2004.

The first section presents the neoclassical theory of M&A activities. The second section considers redistribution theories. The third section discusses behavioral theories. In the fourth section, a conceptual framework is set forth. The fifth section concludes.

I. The Neoclassical Theory of M&A Activities

The business rationale for mergers is that they can be positive net present value investments. …

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