Why Do Firms Merge
and Then Divest? A Theory of Financial Synergy
The theory of mergers and divestitures is developed in this
paper. This theory is not dependent on taxes or the acquirer having huge surpluses.
The inability of short horizon projects or firms which are marginally
profitable to finance themselves as independent entities due to problems caused
by agency between managers and potential claim holders is given as the
motivation behind mergers. Good performance of the once marginally profitable
projects allows for divestiture in the future. There exist two preconditions
for this theory to be applicable. One that financial distress must be being
experienced by one of the merging firms and the other that there must be severe
agency problems between the mangers and the claimholders of the distressed
firm. Therefore this theory is more applicable to mergers where one of the
merging firms is facing cash flow verifiability and is small in size.
The fact that positive net present value projects may be
denied funding where the cash flows can be manipulated by the management is
well known. Marginally profitable companies are sometimes unable to support
outside equity since the manager’s incentive constraint requires that he/she
receives a cut of project’s cash flow. Thus a merger can serve as a tool
whereby such firms can survive their distressed period as merged entity can
raise total finance easier than a standalone entity. Shareholder value is
increased according to the authors’ theory and empirical evidence as mergers
allow marginally profitable firms to get funding. However this financial
synergy may not persist. Once the project has reached a stage where it can
raise finance on its own there are coordination costs associated with mergers. This
stems the firms to divest.
On the Patterns and Wealth Effects of Vertical Mergers
This paper measures vertical relation between two merging
firms using industry commodity flows information in input output table. A merger
is classified as a vertical merger when one firm can utilize others’ services or
product as input for its final output or its output is the input for the other
firm. Significant positive wealth effect is generated through vertical mergers.
During the 3 day event window surrounding the announcement of mergers, the
average combined wealth effect is about 2.5%. The paper measures the vertical
relatedness by using an interindustry vertical relatedness coefficient. The merger
is classified as a vertical merger if the coefficient is more than 1% (lenient
criteria) or 5% (strict criteria). Further, those firms which exhibit vertical
relatedness with the lenient criteria (1%) and belong to different input-output
industries are identified as Pure vertical mergers by the author. To measure
the wealth effect of mergers the authors uses CRSP value weighted index as
Fluck, Z., & Lynch, A.
(1999). Why Do Firms Merge and Then Divest? A Theory of Financial Synergy. The Journal of Business,72(3), 319-346. doi:10.1086/209617
Fan, J., & Goyal, V.
(2006). On the Patterns and Wealth Effects of Vertical Mergers. The Journal of Business, 79(2), 877-902. doi:10.1086/499141