CHAPTER 4 Merger Types and Characteristics The 1950 amendments to the Clayton Act tightened restrictions against horizontal and vertical mergers. The regulatory agencies and the courts viggrously enforced the new antitrust provisions of the 1950 act. Asa result, few major horizontal and vertical mergers were completed, but conglomerate mergers increased especially during the decade of the 1960s, However, the changed regulatory and economic climate since 1980 produced an increase in the dollar amounts of mergers with ™most major mergers being the horizontal or related types. The nature of the different types of mergers was briefly described in Chap- ter 1. In the present chapter we explain more fully the different kinds of mergers, then seek to develop a rigorous theoretical framework to analyze and explain their rationale. We follow general practice by not distinguishing, between merg- ers and tender offers in the present discussion. We include all types of business Combinations, referring to all as “mergers” for convenience and brevity ECONOMIC RATIONALES FOR MAJOR TYPES OF MERGERS 82 Horizontal Mergers A horizontal merger involves two firms operating and competing in the same kind of business activity, Thus, the acquisition in 1987 of American Motors by Chrysler represented a horizontal combination or merger. Forming a larger firm ————_—| | Charren $ Muacen Tyres AND CHARACTERISTICS 3 may have the benfit of economies of scale. But the argument that horizontal mergers occur to realize economies of scale is not sufficient to be a theory of horizontal mergers. Although these mergers would generally benefit from large- scale operation, not all small firms merge horizontally to achieve economies of scale. Further, why do firms decide to merge at a particular time? Why do they choose a merger rather than internal growth? Since a merger theory should have implications on these aspects, it must be more than a theory of large firm size or a theory of horizontally integrated operation. Horizontal mergers are regulated by the government for their potential negative effect on competition. The number of firms in an industry is decreased by horizontal mergers and this may make it easier for the industry members to collude for monopoly profits. Horizontal mergers are also believed by many as potentially creating monopoly power on the part of the combined firm enabling. it to engage in anticompetitive practices. Whether horizontal mergers take place to gain from collusion or to increase monopoly power of the combined firm, in the presence of continuing government scrutiny of these mergers, is an empiri- cal question Vertical Mergers Vertical mergers occur between firms in different stages of production operation: In the oil industry, for example, distinctions are made between exploration and production, refining, and marketing tothe ultimate consumer. In the pharmaceuti- cal industry one could distinguish between research and the development of new drugs, the production of drugs, and the marketing of drug products through retail drugstores. There are many reasons why firms might want to be vertically integrated between different stages. There are technological economies such as the avoid- ance of reheating and transportation costs in the case of an integrated iron and steel producer. Transactions within a firm may eliminate the costs of searching for prices, contracting, payment collecting, and advertising and may also reduce the costs of communicating and of coordinating production. Planning for inven- tory and production may be improved due to mote efficient information flow within a single firm. When assets of a firm are specialized to another firm, the latter may act opportunistically to expropriate the quasi-rents accruing to the specialized assets. Expropriation can be accomplished by demanding supply of a good or service produced from the specialized assets at a price below its average cost. To avoid the costs of haggling which arise from the expropriation attempt, the assets are owned by a single vertically integrated firm. Divergent interests of parties to a transaction will be reconciled by common ownership. The efficiency and affirmative rationale of vertical integration rests primar- ily on the costliness of market exchange and contracting. The argument, for instance, that uncertainty over input supply is dissipated by backward integra- tion reduces to the fact that contracts are difficult to write, execute, and police. This difficulty is the result of bounded rationality and opportunism, as explainedCT Part IL BuILoiNG VaLur—Tue Stravecic Pensrecrive in Chapter 2 on the theory of the firm. When opportunistic inclinations are coupled with limited numbers of suitable firms to transact with, market contract- ing is exposed to hazards. (When the market is competitive with many suitable bidders, opportunism is discouraged because of the rivalry among the bidders Opportunistically behaving parties can be avoided at contract renewal since there are many alternative bidders.) As in the case of horizontal mergers, the affirmative reasons for vertical integration are not sufficient as a theory of vertical mergers. They have no general implications for the timing of a merger in the life of a firm or the charac- teristics of vertically integrating. firms, Further, firms are sometimes vertically disintegrated. A theory would be required to have implications on both integra- tion and disintegration. Anticompetitive effects have also been cited as both the motivation of these mergers and the result. Most conceived anticompetitive effects assume a mo- nopoly power of the integrated firm at one stage of operation. A monopolist input supplier may be able to practice price discrimination through vertical inte- gration, when the input is used by different industries having different elas ticities of demand. The purpose in this case is to prevent the resale of the input by low-price buyers (that is, final good producers with higher demand elas- Licities) to high-price buyers. The input monopolist directly produces final goods whose demand elasticities are high and continues to supply input to less elastic markets at higher prices It has been alleged that an integrated firm having monopoly over an input ‘may raise the input price to independent firms and engage in predatory pricing in the final good market to squeeze out those independent firms. However, it is Rot always correct to accept this reasoning as a valid rationale for forward integra- tion. The input monopolist can extract all monopoly profits even in the absence of integration and its profits cannot be increased by integration. One exception occurs when input proportions for the final good production are not fixed but variable. When inputs are used in variable proportions, the final good industry will reduce the use of the monopoly-priced input, relative to the case where the input is priced at its marginal cost. Thus, the input monopolist integrates for- ward and squeezes out independent firms to “correct” the proportion of inputs used in the final good production. The resources saved in the process represent a social welfare gain. But the integrated input monopolist may raise the price of the final good above the preintegration level, which reduces social welfare. The net effect of the forward integration on social welfare is ambiguous and depends on demand and supply conditions When the market share of an integrated firm at one stage is large, nonintegrated firms at the other stage may be foreclosed from their customers or suppliers. If monopoly power exists at one stage, vertical integration can thus have anticompetitive effects. This same condition, it is suggested in the litera- ture, can raise entry barriers because new entrants need to enter both stages of an industry unless new entrants occur simultaneously at the other stage. The difficulty of entry arises because the capital and knowledge required to operateChapren 4 Mercer Tyres anb CHARACTERE 85 in both stages of production are greater than in the case of single-stage opera- tion. Lack of experience in the other stage or incomplete investor information on its qualifications will raise its cost of capital relative to firms already in the industry. If the industry were not integrated, the new firm could enter only one desired stage and rely on existing firms in the other stage to expand appropri- ately by acquiring capital at lower costs. Teece (1976) points out that the key issue is a new entrant's disadvantage relative to what its position would have been had single-stage entry been possible, and not the new entrant's disadvantage relative to the position of existing firms at the time of entry, which will naturally command a ren on their experience, information, and competence Conglomerate Mergers Conglomerate mergers involve firms engaged in unrelated types of business activ- ity. Thus, the merger between Mobil Oil and Montgomery Ward was generally regarded as a conglomerate merger. Among conglomerate mergers, three types have been distinguished. Product-extension mergers broaden the product lines of firms. These are mergers between firms in related business activities and may also he called concentric mergers. A geographic market-extension merger involves two firms whose operations have been conducted in nonoverlapping geographic ar- eas, Finally, the other conglomerate morgers which are often referred to as pure conglomerate mergers involve unrelated business activities. These would not qualify as either product-extension or market-extension mergers. By contrasting four categories of companies, the economic functions of conglomerate mergers may be illuminated. Investment companies can be com- pared with three categories of multi-industry firms to highlight their characteris- tics. A fundamental economic function of investment companies is to reduce risk by diversification. Combinations of securities whose returns are not perfectly correlated reduce portfolio variance for a target rate of return. Because invest- ment companies combine resources from many sources, their power to achieve a reduction in variance through portfolio effects is greater than that of individual investors. In addition, the managements of investment companies provide pro- fessional selection from among investment alternatives Conglomerate firms difter fundamentally from investment companies in that they control the entities to which they make major financial commitments. Two important characteristics define a conglomerate firm. First, a conglomerate firm controls a range of activities in various industries that require different skills in the specific managerial functions of research, applied engineering, produc- tion, marketing, and so on. Second, the diversification is achieved mainly by external acquisitions and mergers, not by internal development. FINANCIAL CONGLOMERATES Within this broader category, two types of conglomerate firms should be distinguished. Financial conglomerates provide a flow of funds to each segment of their operations, exercise control, and are the ultimate financial risk takers. In theory, financial conglomerates undertake strate-86 Part il Burtoine Varue—Tne Sreatecic Pensercrive gic planning but do not participate in operating decisions. Management conglom- erates not only assume financial responsibility and control, but also play a role in operating decisions and provide staff expertise and staff services to the operating entities. The characteristics of financial conglomerates may be further clarified by comparisons with investment companies. The financial conglomerate serves at east five distinct economic functions. First, like investment companies, it im- proves risk/return ratios through diversification. Second, it avoids “gambler’s ruin (an adverse run of losses which might cause bankruptcy). If the losses can be covered by avoiding gambler's ruin, the financial conglomerate maintains the viability of an economic activity with long-run value. Without this form of risk reduction or bankruptcy avoidance, the assets of the operating entity might be shifted to less productive uses because of a run of losses at some point in its development. A third area of potential contributions by financial conglomerates derives from their establishing programs of financial planning and control, Often, these systems improve the quality of general and functional managerial performance, thereby resulting in more efficient operations and better resource allocation for the economy. A fourth benefit also results from financial planning and control. If manage- ment does not perform effectively but the productivity of assets in the market is favorable, the management is changed. This reflects an eftective competitive process because assets are placed under more efficient managements to assure more effective use of resources. A contribution to improved resource allocation is thereby made Fifth, in the financial planning and control process, distinction is made between performance based on underlying potentials in the product-market area and results related to managerial performance. Thus, adverse performance does not necessarily indicate inadequate management performance. If management is competent but product-market potentials are inadequate, executives of the finan- cial conglomerate will seek to shift resources by diverting internal cash flows from the unfavorable areas to areas more attractive from a growth and profital ity standpoint. From the standpoint of the economy as a whole, this also im- proves resource allocation MANAGERIAL CONGLOMERATES — Managerial conglomerates carry the attributes of financial conglomerates still further. By providing managerial coun- sel and interactions on decisions, managerial conglomerates increase the poten- tial for improving performance. One school of management theory holds that the generic management functions of planning, organizing, directing, and con- trolling are readily transferable to all types of business firms. Those managers who have the experience and capability to perform general management func- tions can perform them in any environment. This theory argues for management transferability across a wide variety of industries and types of organizations, including government, nonprofit institu-at aera se CHAPTER 4 MencEr Tyres AND CHARACTERISTICS 8 tions, and military and religious organizations. To the extent that this proposi- tion is valid, it provides a basis for the most general theory of mergers. When any two firms of unequal management competence are combined, the perfor- mance of the combined firm will benfit from the impact of the superior manage- ment firm and the total performance of the combined firm will be greater than the sum of the individual paris. This defines synergy in its most general form. In the managerial conglomerate, these economic benefits are achieved through corporate headquarters that provide the individual operating entities with exper- tise and counsel on the generic management functions CONCENTRIC COMPANIES The difference between the managerial con- glomerate and the concentric company is based on the distinction between the general and specific management functions, If the activities of the segments brought together are so related that there is carry-over of specific management functions (research, manufacturing, finance, marketing, personnel, and so on) or complementarity in relative strengths among these specific management func- tions, the merger should be termed concentric rather than conglomerate. This transferability of specific management functions across individual segments has long been exemplified by the operations of large, multiproduct, multiplant firms in the American economy. The characteristic organizational structure of these firms has included senior vice presidents who perform as staff specialists to corresponding functional executives in operating depariments, Definitions are inherently arbitrary. 1s there any reason to distinguish be- tween managerial conglomerates and concentric companies? The two types have in common a basic economic characteristic. Each transfers general management functions over a variety of activities, using the principle of spreading a fixed factor over a larger number of activities to achieve scale economies and to lower the cost function for the output range. Concentric companies achieve these economic gains in specific management functions as well as in general manage- ment functions, A priori the potential economies for the concentric companies might be expected to be larger. But the magnitude of economies gained in gen- eral rather than specific management functions may vary by industry and by industry mix. Further, in the multiproduct, multiplant firms that have achieved economies of carry-over of both specific and general management functions, the ns may be so great that it is impossible to differentiate between the Similarly, a managerial conglomerate which originally provided expertise on general management functions may increasingly act on specific management functions as its executives become more familiar with the operations of the individual entities, Financial conglomerates also may increasingly provide staff service for both general and specific management functions ‘Additional illustrations will clarify these concepts and their economic impli- cations. If one company has competence in research, manufacturing, or market- ing that can be applied to the product problems of another company that lacks that particular competence, a merger will provide the opportunity to lower costA FRAMEWORK FOR ANALYSIS OF MERGERS: Pawr Il BUILDING Varur—Tite Srmarecte Pexsrectivn functions. For example, firms seeking to diversify from advanced technology industries may be strong, on research but weaker on production and marketing capabilities firms in industries with less advanced technology. To this point we have described the different kinds of mergers and ex- plained some of the reasons why they appear to take place. In the following section we seek to develop a rigorous theoretical framework which provides a more fundamental understanding of the processes observed It was observed in Chapter 2 that the distinguishing feature of the firm is its possession of organization capital. With the purpose of explaining different types of mergers, we first examine the concept of organization capital in greater detail. Second, a moxel of the firm with organization capital as.a factor of produc- tion is presented, in which the firm may earn economic rents to its organization capital (or positive economic profits) under competition, Investment opportunities are defined in this context and mergers are hypothesized to represent a process of reallocating resources across activities or industries in the firms’ efforts to internalize investment opporiunities, that is, to earn rents from their organiza- tion capital, Next, two separate synergy effects, managerial and financial, are introduced to describe how the investment opportunities are captured. The hy- pothesis developed here is that mergers between firms in related industries involve managerial synergy and pure conglomerate mergers involve financial synergy, althougi in reality both effects are present in any particular merger in varying degrees. Organization Learning and Organization Capital Organization capital is accumulated through experience within the organization called the firm. To avoid any confusion that may exist in the literature on the concept and role of organization capital and to sharpen the theoretical exposi- tion, we introduce a separate concept that we call organization learning and define it as improvement in the skills and abilities of individual employees through learning by experience within the firm We distinguish three types of organization learning. Rosen (1972) in explain- ing what could constitute “production knowledge” suggests that one case of learning is in the area of entrepreneurial or managerial ability to organize and maintain complex production processes economically. A useful dichotomy of this managerial learning is between general and industry-specific experiences. The first form of organization learning may be termed raw managerial experi.Cuarren4 Mercer Tres aNp CHARACTERISTICS 89 ence which refers to the capabilities developed in generic management functions of planning, organizing, directing, controlling, and so on as well as in financial planning and control.’ The second form consists of industry-specific managerial experience, which refers to the development of capabilities in specific manage- ment functions related to the characteristics of production and marketing in particular industries. The third type of organization learning is in the area of nonmanagerial labor input. The level of skills of the production workers will improve over time through learning by experience. The stock of organization learning in the three areas—generic managerial, industry specific, and nonmanagerial—has no significance by itself in the theory of the firm. This is because we identify organization learning with improvements in individual ability through experience in the firm and each individual thus will be free to move to another firm. Organization learning becomes significant, however, when it is combined with firm-specific information or organization capital and thus cannot be transferred freely to other firms through the labor market The most detailed discussion of organization capital has been provided by Rosen (1972) and by Prescott and Visscher (1980). The first type of organization capital is firm-specific information embodied in individual employees and is called employee-embodied information. This information is obtained when employ- ees become familiar with the firm’s particular production arrangements, manage- ment and control systems, and to other employees’ skills, knowledgeability and job duties in the firm. The second and third types of organization capital may be termed teant effects. That is, the role of information here is to allow the firm to organize efficient managerial and production teams within the firm. The second type consists of information on employee characteristics, allowing an efficient match between workers and tasks to the extent that some tasks are better fulfilled by particular talents and skills. In the formulation of Prescott and Visscher, new employees are initially assigned to a screening job which can be performed equally well by workers with different talents. After information on characteris- tics is obtained, workers are assigned to jobs that can be better implemented by workers with particular characteristics. The precision of the information will depend on the length of time that workers spend on the screening job. The third type of information is used in the matching of workers to work- ers, since how well the characteristics of an individual mesh with those of others performing related duties is important to the overall performance of the team. The types of information that we have included in organization capital are likely to be firm specific. Information on workers that gives rise to team effects may be better known to the firm’s owners (managers) than to the workers themselves. It would be transferred to other firms only with noise and subject to transactions costs. Employee-embodied information is firm specific by defini- ‘While finance is a specific management function, its role in the generic functions of planning and control and the broad generality of its applications suggest its treatment as a general management function as wellTABLE 4.1 Pare ll BUILDING VALUE—Twe Srearecic Prsrecrive tion, since it is information on workers and systems that are components of the firm. To an extent, organization capital is a joint product which does not involve extra costs in production. Greater investment and production activity in one period will therefore lead to a greater amount of organization capital in the next period. However, since it can be preserved in the firm into the future and its value in future production will be positive, it is in the firm’s interest to produce the firm-specific assets at its own cost. For example, new employees often re- ceive on-the-job training that is specialized to the firm. Also, management spends real resources to organize efficient production and managerial teams. However organization capital is obtained, the important point is that it increases and accumulates within the firm over time, at least until its depreciation becomes fast enough, if it ever does, to offset the additions. The concepts used to this point are summarized in Table 4.1 which lists the elements of organization learning, and organization capital. This provides a framework for discussing the combination of organization learning and organiza- tion capital which follows The final human capital resources available to the firm as inputs for produc- tion are the output resulting from the combination of organization learning and organization capital. The first of these human capital resources may be termed generic managerial capubilities to represent the combination of organization learn: ing in the generic managerial functions and the relevant organization capital The second is called industry specific managerial capabilities. Finally, the third in- cludes all others and can be called nonmanagerial human capital Given that the three types of human resources are specialized to the firm to some extent, we need to examine the implications and degrees of their specific- Organization Learning and Organization Capital Mm W. Organization Learxing—-tmprovement in skills and abilities through learning within firm A. Generic managerial B. Industry-specific managerial C. Nonmanagerial Organizational Coptel—Finen-specific informational assets ‘A. Employee-embodied B. Match between worker and job (team effect) C. Match between worker and other workers (team effect) Combination of Organization Learning and Organization Capital A. Generic managerial capabilities (C,) B. Industry-specitic managerial capabilities (C.) C. Firm-specific nonmanagerial human capital (C,) Transfer through Mergers ‘A. C, = Transferable to most other industries B.C, = Transferable only to related industries C. C= Difficult to transfer even to other firms in the same industryistics 91 Chapter 4 Mencer Tyres anp CHARA ity. The jobs of nonmanagerial production workers are specified according to the details of the production facility. Once a team of workers is organized with each worker assigned to a different job based on specific information on their charac- teristics, the team is specialized to the facility. Therefore, it is specialized to the firm's production establishment or can at best be transferred to a similar estab- lishment. A merger between firms even in related industries will therefore not include the transfer of nonmanagerial human capital between the firms. Its transfer between firms is only feasible in horizontal mergers. ‘The industry-specific managerial capabilities can be transfered to other firms in related industries without impairing the team effect, as they are not identified with a particular establishment. The requirement that managers should be transferred as a team is met by a merger initiated to carry over industry-specific managerial capabilities. The team-effect portion of organization capital will be preserved through a merger, although the other type of organiza- tion capital (that is, employee-embodied firm-specific information) has to be reacquired for the new setting of the acquired or combined firm. Mergers be- tween firms therefore are more efficient than the movements through the labor market of individual managers in transferring these capabilities. Mergers thus cause the supply of managerial capabilities in the market to be more elastic. The generic managerial capabilities can, of course, be carried over through a merger with a firm even in an unrelated industry. Again, to the extent that team effects are important, a merger which can preserve these effects is more efficient than interfirm movements of managers as individuals. However, there are reasons to believe that invoking a merger to acquire or to carry over generic managerial resources will not be as compelling as in the case of industry-specific resources. First, the team size to produce generic managerial service is in general smaller than that for managerial resources related to production and marketing, Thus, the organization of a mangerial team for control, coordination, and plan- ning requires less time than the organization of a team for other managerial capabilities. Second, information on top-level managers who perform the control and coordination functions may be more public than on lower-level managers for the production and marketing functions. This also makes team organization more expedient. Third, managers for generic functions can come from even remotely related industries, whereas managers in specific function areas should have experience in closely related industries. Thus, the supply of the former type of managers is more elastic than that of the latter. Assuming that these are empirically valid observations, the case for a merger for the purpose of transfer- ring generic managerial resources would seem weaker than for the transfer of industry-specific resources. Investment Opportunities Investment (or growth) opportunities exist for a firm if the present value of an investment project is positive. Given this definition, a value-maximizing firm will attempt to internalize whatever investment opportunities it can find. The literature has not been ciear, however, on what factors in general give rise to2 Parr ll Bun.pinc Vauur—Tue Srrareore Pexsrecrive investment opportunities in competitive industries. Miller and Modigliani (1961, p. 416) give only a cursory hint: [Investment] opportunities, frequently termed the ‘good will’ of the business, may arise, in practice, from any of a number of circumstances (ranging all the way from special locational advantages to patents or other monopolistic advantages) Further insights of the nature of investment opportunities can be provided by treating organization capital as a factor of production, as in Rosen (1972) Recall that organization capital is defined as firm-specific informational assets Then we can envisage a simple production process having organization capital and investments as the only two input variables. Given the short-run fixity of organization capital as a factor of production and the elastic supply of capital, any adjustment in the output quantity occurs by changing the amount of capital investments. But in general as investments are increased, output is increased only at a decreasing rate. That is, investments are subject to diminishing returns in the short run. This implies that the marginal Cost of output is increasing due to increasing capital input per output and the fixed factor (organization capital) will earn the Marshallian quasi-rent. Thus, any Positive net present value of a project is the quasi-rent accruing to organization capital.’ It is in this sense that the existence of investment opportunities hinges on the organization capital vested in the firm MANAGERIAL SYNERGY AND HORIZONTAL AND RELATED MERGERS We next develop a liypothesis on horizontal mergers and mergers between firms in related businesses or industries. The hypothesis also has implications on vertical mergers to the extent that these mergers involve firms in related indus- tries. The immediate theoretical questions are directed to why such mergers occur and what types of firms are involved in such mergers. Now imagine a production process employing four factor inputs—generic managerial capabilities, industry-specific managerial capabilites, firm-specific nonmanagerial human capital, and capital investment. The firm-specific non- managerial human capital can only be supplied by a long-term learning effort or *The quasi-ent accruing th the organization capital will normally be divided among, the stakeholders ‘of the firm including the capital owner, the employees, the suppliers, and so on. Therelore, the “value of the firm” in the ordinary usage of the term will reflect only a portion of the quasi-rent and the rest will be distributed to other stakeholders. Existence of labor unions may be at least partly explicable by the accrual of rents to organization capital, as discussed in Chapter 2. In the extreme ¢ase of a monopolist labor union and competiive firms, all rents may be captured by labor, although there will be bargaining between stakeholders on the division of the rents. However the rents are distributed, the behavior ofthe firm as a coalition will approximate that of maximizing the rents to xganization capital as long asthe coalition participants behave rationally to maximize the total "pie" available for allocation,Curxeter 4 MeRceR Tyres AND CHARACTERISTICS 3 by merging with existing firms in the same industry. The industry-specific mana- gerial resources can be obtained by internal learning or by merging with a firm in the same or related industries. An additional way of obtaining industry-specific resources may be to employ managers with industry-specific knowledge ac- quired while they were employed by other firms in the same or related indus- tries, However, as discussed earlier, this route of obtaining industry-specific resources in large scale is inefficient and may be infeasible since they are a tearm product and the managers have firm-specific information whose value is appreci- ated only by the current firm. Generic managerial capabilities may be obtained by any of the three means and their supply in the labor market is likely to be more elastic than industry-specific resources. We assume here that generic mana- gerial resources can be obtained through the market. Suppose that a firm, call it B (Bidder), has “excess capacity” in industry specific resources and that another firm in a related industry, call it T (Target), experiences “shortages” in these resources. Or more generally, suppose that the ratio of industry-specific managerial capabilities to firm-specific nonmanagerial human capital is greater for B than for T; in other words, the ratio of the two factors that are fixed in quantity in the short run is greater for Bidder relative to Target. The acquisition of T by B will make the firms realize more balanced factor proportions between industry-specific and firm-specific resources by transfer- ring the excess capacity of B in the industry-specific capabilities to Given the transferability of industry-specific resources through a merger be tween firms in related industries, efficiency in factor proportions is achieved by the merger through the equalization between B and T of the marginal rates of factor substitution in industry-specific managerial capabilities and nonmana- gerial human capital. An example of the T-type firm will be an R&D oriented firm lacking marketing organizations and being acquired by a B-type firm with strong marketing capabilities in related fields ot business. Several theoretical questions need to be illuminated: (1) why B with excess capacity in industry-specific resources does not remove managers; (2) why the two firms cannot use contracting instead of merging; and (3) why T does not develop industry-specific resources internally. Question 1 (or 3) can be similarly phrased in terms on nonmanagerial human capital of T (or B). Answers to all three questions should necessarily be related to the theory of the firm and thus to the concept of organization capital The response to the first has already been suggested. Managers as employ- ees typically have made investments in firm-specific knowledge. Thus, manag- ers themselves are a part of the firm-specific assets and their value within the firm is greater than their market value. Movement of managers entails a loss of employee-embodied firm-specific information. More importantly, the excess ca- pacity in industry-specific managerial capabilities is likely to be the result of superior team organization and not necessarily of an excessive number of manag- ers. Therefore, dividing up the team may result in the loss of these resources. Merger provides an efficient way of transferring the services of industry-specific resources to other firms without impairing their total capacity. operationParr Il BuiLoinc Vatue—The Srravecie Prasvecrive With respect to the second question, note that merging as opposed to contracting amounts to a kind of vertical integration between firm-specific nonmanagerial resources (of T) and industry-specific managerial resources (of B). Rendering managerial services to T under a long-term contract will still re- quire investment in information or knowledge specialized to T. Once B's manage- ment acquires the specialized information, it becomes subject to appropriation by T since its value to the next best use is zero in this case. If B's management refuses to make investments in T-specific knowledge in anticipation of such opportunistic behavior, its managerial service is ineffectual. With the necessity of investments in specialized knowledge, the threat of appropriability of the quasi- Tent accruing to such assets leads to integration into a single organization (see Chapter 2), For the third question, three different forces are likely to work together: economies of scale, timing, and constraints on growth. For T to develop industry-specific capabilities internally may not be feasible if their production is subject to economies of scale and ifthe size of T is not large enough to realize the full benefits of scale economies or, in the terminology of the management litera- ture, to reach the “critical mass” in managerial team production. By sharing the resources of B, managerial economies of scale become available. Utilizing excess managerial capabilities of B without merger requires developing firm-specific nonmanagerial human capital for operation either in its own or in T’s indust However, accumulation of nonmanagerial human capital is a long-term process during which the excess managerial resources are underexploited and may fur ther accumulate, keeping the factor proportions continuously unbalanced. Fur- ther, since itis imperative to keep nonmanagerial human capital resources pro- Portional to the size of the firm, an increase in these resources requires the growth of the firm itself which should be governed by industry demand growth Similarly, internal development of industry-specific managerial resources by T is also subject to time requirements, and inelficient performance of the firm in the meantime may jeopardize the firm's survival. Firm and Industry Characteristics in Horizontal and Related Mergers So far we have hypothesized that horizontal mergers or mergers between firms in related industries are characterized by carry-over of industry-specific manage- rial resources. Firm T experiences a shortage and B an excess of these re- Sources. Since acquisition initiatives or programs more frequently start with the discovery of underutilized managerial resources, initiation of the merger will normally come from B rather than T. Thus, we define B, the firm with excess industry-specific managerial resources, as the acquiring firm (or bidder) and T, the one with a shortage, as the acquired firm (or target) in horizontal or related mergers. A prediction on the characteristics of T-type firms is that their performance heto ific (of re: xe on ont of six ee Charter 4 MenceR Tyres ano Caaacrenistics 95 measures (for example, profit rates) will not be high relative to their industry averages, other things being equal. The existence of excess or underutilized managerial assets in B may imply greater efficiency than a firm with no such assets. However, this is not necessary since the contribution of the excess capac- ity to the firm’s performance may be zero. ‘The excess in industry-specific managerial capabilities in B may have arisen because managerial capacity increases aver time (Penrose, 1959; Rosen, 1972; Rubin, 1973). “The services available from resources (and particularly from man- agement) grow over time, even if no new managers are hired” (Rubin, p. 939). The reason for the increasing capacity appears to be threefold. First, the ability of managers to organize production and marketing processes is increased by experi- ence. Second, the organization of the management team is improved over time by accumulating information on individual managers and matching jobs and skills in an efficient way. Third, once an efficient production team is organized by identifying superior combinations of inputs, the demand for managerial in- puts relative to firm outputs is reduced. In sum, the managerial services avail- able from given resources grow and the relative internal demand for managerial services declines over time. The time requirement for the development of excess managerial capacity may suggest certain industry characteristics in related mergers. No such charac- terization is relevant for horizontal mergers, although the following life cycle considerations yield some implications on industry characteristics in horizontal mergers. The deficiency in managerial resources of the acquired firms implies that they may have grown fast physically presumably because industry demand has grown fast—faster than the growth in managerial capacity could support Therefore, other things being equal, the growth rates of these acquired firm industries (or lines of business) for a premerger period will be greater than the average for the economy. From the investment opportunities consideration, it is also predicted that the acquired firm industries will not be those whose demand growth is lagging relative to the economy. This is because the value of increased productivity of investment resulting from the improvement in factor proportions through the merger will be greater, the higher the growth rate of the industry. Simply put, the demand for extra resources, in particular for industry-specific managerial resources, will be greater in industries or lines of business with greater increases in product demand As for the acquiring firms in related mergers, their excess managerial capac- ity should indicate their long-time presence in industries with long histories, This would imply their product demand growth rates will generally be no greater than an average industry in related industry groups. A similar prediction would also follow from investment opportunities arguments. One motivating factor for the acquiring firms is that they find better opportunities in related than in strictly their own industries or lines of business for the utilization of excess managerial capabilities, and this will be more likely if investment opportunities in their own industries are more difficult to find. These statements are, of course, subject to the problems of defining industries and lines of business:9% Parr Il Buivoinc Vate—Tue Srearccie Pensrecrive FINANCIAL SYNERGY AND PURE CONGLOMERATE MERGERS Mergers between firms in unrelated industries do not involve, by definition, the carry-over of industry-specific managerial capabilities. Therefore, any benefits related to managerial capabilities have to be in the area of generic managerial functions, Whether a merger is desirable to effect the transfer of generic manage- rial resources from one firm with excess capacity to another with excess demand again depends on the factors previously considered; namely, the extent that generic managerial capabilities are a team product, subject to economies of scale, and managers in these functional areas possess firm-specific information. How- ever, the coordination of demand and supply in the managerial Jabor market would seem more efficient in the case of generic than industry-specific manage- tiol resources for several reasons as discussed earlier. In any event, the case for a merger for the carry-over of generic capabilities only should be weaker than for the carry-over of both Besides the possible efficiency of mergers in transferring generie manage- nial capabilities, we formulate an alternative hypothesis on the mergers between firms in unrelated industries, The fundamental assumption is that the acquiring firms in these mergers are not motivated by the discovery of underexploited specialized resources within the firm, but by the realization that investment opportunities are limited in the areas of their existing activities. This assumption is at least consistent with the fact that these acquiring firms diversity into unre- Jated industries rather than related areas where the utilization of any industry- specific assets should be easier The hypothesis is that a pure conglomerate merger occurs when a firm in an industry with low demand growth relative to the economy acquires a firm which operates in another industry with high expected demand growth. The motive of the merger is to capture investment opportunities available in the acquired firm's industry by lowering the costs of capital of the combined firm through the merger and also utilizing lower-cost internal funds of the acquiring firm. The opportunity for utilizing the cash flows of the acquiring firm will be enhanced if the cash flow of the acquired firm is low. Thus, the hypothesis implies a process of (financial) Tesource reallocation in the economy from the acquiring firm's industry with low demand growth to the acquired firm’s industry with high demand yrowth. The hypothesized differences in industry demand growth rates indicate differential investment opportunities in the two industries. The reason why a firm needs to acquire another firm in order tointernalize in- vestment opportunities in the latter's indusiry is that the acquiring firm lacks the organization capital or production knowledge specific to the industry of the ac- quired. De novo entry by the acquiring firm may not be feasible if it does not possess any organization capital specialized to the new area, What distinguishes a merger or acquisition from the simple purchase of assets and employment of newCarrer 4 Mercer Tyres anp CHARACTERISTICS, ”7 workers is that the former involves the acquisition and preservation of organiza- tion capital. A theoretical definition of the pure conglomerate merger is provided by this consideration: When the acquiring firm completely lacks organization cap- ital applicable to the acquired firm's industry, the merger is purely conglomerate. The questions relating to the costs of capital are far from settled in the finance literature, and therefore the lowering of costs of capital through conglom- erate mergers should properly be treated as a hypothesis in the present theory. ‘The cost of capital may be lowered for a number of reasons. If the cash flow streams of the two firms are not perfectly positively correlated, bankruptcy proba- bilities may be lowered. This will decrease the “lender's risk” and the debt capac- ity will be increased (Lewellen, 1971). A more rigorous treatment of this proposi- tion has been provided by Stapleton (1982) in the option pricing model (OPM) framework, in which debt capacity is defined as the maximum amount of debt that can be raised at a given rate of interest. If bankruptcy costs are significant, the debt-capacity argument is reinforced. The decrease in bankruptcy probability may decrease the expected value of bankruptcy costs and increase the expected value of tax savings from interest payments for premerger debts, and thus increase the value of the combined firm by lowering its cost of capital. Apart from these, if the value of the firm is assumed to be unchanged, the increase in debt values as a result of the merger’s co-insurance effect is at the expense of equity values, as pointed out by Higgins and Schall (1975). But this shift can be offset by increasing leverage (Galai and Masulis, 1976; Kim and McConnell, 1977). A postmerger increase in leverage will allow the firm to realize an incremental stream of tax savings from interest payments on new debt,’ although the increased leverage can offset the other benefits of lower bankruptcy probabilities.* A potentially more important source of the lower cost of capital for postmerger invesiments in the acquired firm's industry stems from the distine- tion between internal and external funds. Internal funds do not involve transac- tion costs of the flotation process and may have differential tax advantages over external funds.° Further, internal financing can have an advantage over external financing if insiders (managers) have more information on the value of the firm's assets than outside investors and act in the interest of the current shareholders (Myers and Majluf, 1984). When the firm issues risky securities, this asymmetry in information causes investors to believe that the securities are overvalued and thus to react negatively. The potential importance of internal funds is provided by the hypothesized ‘Miller (1972) shows that lower personal laxation of equity investment income than interest income will decrease and can even completely offset the benefit of corporate tax savings on interest payment. The extent that the corporate tax savings are offset by the rise in interest rate to compensate the personal tax disadvantage of debt must be determined empirically. For further discussion on this and related issues on the cost of capital, see Copeland and Weston (1988), Chapters 13, 14, and 19. “For more discussion ort the subject, see Scott (1977). Miller and Scholes (1978) argue that there may be no tax advantage for internal funds, but Feldstein, Green, and Sheshinski (1979) hold that the argument of Miller and Scholes does not have empirical support