Do mergers & acquisitions create shareholder wealth?

Following on nicely from my last blog which discussed different valuation methods which are vital in determining the price to pay for company - this blog is going to focus on the motives behind mergers and acquisitions and discuss whether such activity impacts shareholder wealth. We hear regularly in the news of mergers and acquisitions and last week (25^th March) was no exception. It was announced on Wednesday (25^th March) that US food giant Heinz plans to merge with Kraft Foods Group which could create the world's fifth-largest food and drink company (BBC, 2015). It was revealed that Heinz will hold the controlling interest with shareholders owning 51% of the combined company and Kraft holding a 49% stake (BBC, 2015). 

So what are the motives behind this possible merger?

This is an example of a horizontal merger as both Heinz and Kraft are engaged in similar business activities (Stillman, 1983). By doing this it is likely the combined organisations will benefit from synergies – the idea that the combined entity will operate more efficiently and be of more value than if the two organisations were to remain separate (Davis & Wilson, 2008). Both of the companies are finding it difficult to deal with a transition in the US where consumer attitudes are changing. Consumers are storing less packaged and processed foods, demanding fresh foods which has resulted in limited growth for the companies. Therefore by combining the companies they are hoping to operate more efficiently by benefiting from economies of scale following the merger.

One of the motives behind the merger, as stated by Alex Behring the chairman of Heinz, is to create “a strong platform for both US and international growth”. Given that Kraft generates 87% of its revenue within the US and Heinz generates around 60% of its revenue outside of the US I believe this is a good fit for the combined company. This will enable Heinz to use their global presence to expand Kraft’s products into new markets, as well as allowing Heinz to benefit from Kraft’s strong and established presence in the US. Consequently the merger is likely to facilitate growth both within the US and internationally which could result in high revenues and likewise increase shareholder wealth. 

Another motive behind the merger is that the combined company hopes to make significant cost savings, aiming to cut costs by $1.5bn by 2017. However this is likely to include changes which come at the cost of employees where large amounts of jobs are expected to be cut as well as slashing job perks. Linking this to stakeholder theory it would suggest that organisations should consider the needs of all of their stakeholders however it appears this was not the case whilst agreeing the merger. If they had followed stakeholder theory the merger may not have progressed to this stage as they would have considered the large potential of job losses and without these they may not achieve such large cost savings. In contrast, looking at this from a shareholders perspective, this merger could increase shareholder wealth if the combined entity is to make the planned cost savings it may allow any cash saved to be paid in dividends.

So are motives always in the best interests of shareholders? Unfortunately not.

There may have also been managerial motives behind the merger. This can result in managers making decisions which are in their own best interests, to maximise their utility rather than aiming to maximise shareholder wealth (Amihud, 1986) thus the agency problem is present. There are a number of reasons why managers may do this. Firstly, by merging the two companies the managers will have to be paid significantly more as a result of managing and controlling such a large company, linking to another possible motive of having a desire to build an empire - the prospect of securing an increased remuneration package is likely to be very attractive to managers and could be a significant motivation. Similarly it will increase the status of the managers involved as they would be seen to be leading the merger of the two well-known established companies which will receive a lot of publicity and is likely to be seen as a significant achievement. In addition, given that both companies are experiencing limited growth, it could be argued that the managers at Heinz may have considered this merger to protect their jobs. They may believe that they could be a target for a takeover and in order to protect themselves from being sacked or dominated by an acquiring firm, they made the decision to grow and merge with Kraft to prevent this. Again acting in their personal best interests rather than making decisions which will maximise the wealth of shareholders. Therefore if the motive behind this merger was due to managerial motives it is likely it will destroy shareholder value given that mergers have been shown to decrease wealth.

This leads nicely onto the effects the proposed merger has had for shareholders. Mergers and acquisitions have been heavily researched in order to determine the impact such activity has on shareholder wealth - what impact did the announcement of this proposed merger have for shareholders? Did it create wealth?

Studies have consistently shown that in a merger the target company’s shareholders gain significantly. Jensen and Ruback (1983) found that on average a target company’s share price will increase by 20% (Jensen & Ruback, 1983). Looking at Kraft’s share price (Figure 1) it increased significantly following the announcement of a possible merger and is therefore consistent with this theory, demonstrating how the proposed merger has increased the wealth of Kraft's shareholders. This could be because investors recognise that the merger will bring benefits from synergies and cost savings which essentially could increase their dividends in the longer-term.

Figure 1: Kraft Share Price (Bloomberg, 2015)

 

In terms of the bidding company's share price, Jensen and Ruback’s (1983) findings suggest that the shareholders would experience no gain nor a loss if the merger was successful. Given that Heinz is a private company I am unable to gain access to the share price to determine whether the movement complies with this study. However since Jensen and Ruback’s (1983) study, other studies have provided findings showing how in the short-term the bidding company either experiences no impact or a reduction in shareholder wealth. The results of longer-term studies are less consistent, some showing how it can significantly reduce wealth, some indicating it is value-neutral whereas a few show there is a possibility of increasing wealth.  
 

In contrast, if this merger is unsuccessful, we would expect to see a 5% loss on Heinz’s share price and a 3% loss on Kraft’s share price (Jensen & Ruback, 1983).  Currently we do not know whether the merger will be successful however research has shown that generally mergers are unsuccessful (Banal-Estañol & Seldeslachts, 2011). This could be due to the managerial motives, as discussed above, or hubris which is the concept of managers being over-confident and considering themselves to be better than and above everyone else (Petit & Bollaert, 2012). This can lead to managers being over-confident in their own abilities and very optimistic when considering possible mergers as they believe they have the ability to create a better business. It could be argued that the managers of Heinz have were over-confident when considering the merger as it could be very challenging to merge two companies which are currently experiencing little growth and make the changes required to allow successful growth in the US market which continues to be a challenging environment. In addition, in cases where there is free cash flow there is also scope for managers to reduce value. For example, if there is excess cash, following the objective of shareholder wealth maximisation, managers should look to distribute this back to shareholders. However in reality managers may want to keep this money under their control as distributing this to shareholders could be seen as reducing their power and control therefore they may use this to buy other firms which in turn links back to the managerial motives of status and remuneration. Overall this could reduce shareholder wealth.

To conclude, there are many motives which could be argued to be behind the merger of Heinz and Kraft including benefiting from cost savings and tackling the challenging business environment to managerial motives which have significant scope to destroy shareholder value. Given that studies have consistently shown that the bidding company often experiences a reduction in wealth, I believe it is vital merger and acquisition decisions are made with correct motives in mind, for example to benefit from synergies in order to increase shareholder value. Whilst both of these companies are currently facing difficulties, I think if the merger was successful, it would benefit both of the companies in the long-term as they can combine their expertise and experience in order to expand and enter new markets, creating value for shareholders whilst doing this.

 

References

Amihud, Y. (1986). Conglomerate mergers, managerial motives and stockholder wealth. Journal of Banking & Finance, 10(3), 401-410. doi:10.1016/S0378-4266(86)80029-2

Banal-Estañol, A., & Seldeslachts, J. (2011). Merger failures. Journal of Economics & Management Strategy, 20(2), 589-624. doi:10.1111/j.1530-9134.2011.00298.x

BBC (2015). Kraft shares soar on Heinz merger. Retrieved 29^th March 2015, from http://www.bbc.co.uk/news/business-32050266

Bloomberg (2015). Kraft Foods Group Inc. Retrieved 29^th March 2015, from http://www.bloomberg.com/quote/KRFT:US

Davis, D. D. & Wilson, B. J. (2008). Strategic buyers, horizontal mergers and synergies: An experimental investigation. International Journal of Industrial Organization, 26(3), 643-661. doi:10.1016/j.ijindorg.2006.12.004

Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control. Journal of Financial Economics, 11(1), 5-50. doi:10.1016/0304-405X(83)90004-1

Petit, V., & Bollaert, H. (2012). Flying too close to the sun?: Hubris among CEOs and how to prevent it. Journal of Business Ethics, 108(3), 265-283. doi:10.1007/s10551-011-1097-1

Stillman, R. (1983). Examining antitrust policy towards horizontal mergers. Journal of Financial Economics, 11(1), 225-240. doi:10.1016/0304-405X(83)90012-0