Mergers and Acquisitions

Individual Reading Assignment

on
“The Profitability of Mergers”
A Research Paper authored by David J. Ravenscraft and F.M. Scherer
Final version received March 1988

Submitted To:
Prof. Sushil Khanna

Submitted By:
Aniruddha Nath (PGP/1110/06)
Main objective of the research paper
The main objective of the research conducted by the authors, David J. Ravenscraft and F.M.
Scherer were to analyse the pre-merger profitability of the acquisition targets and compare it
with the post-merger operating results over the years spanning from 1957-77. There could be
many motivations for corporate mergers which occurred in the US. Some of the motivations
would be the following:
 To replace inefficient management
 To achieve economies of scale and economies of scope in production, distribution and
financing
 To enhance the monopoly or monopsony power of the acquiring firm
 To make acquisition in order to benefit from tax reduction opportunities
 To increase foothold in the industry by taking advantage of the “bargains” in the
public stock market or in the private “company for sale” market
Nonetheless, the main motive of the study is to test the hypotheses claiming the first two
motivations for corporate mergers. Two main hypotheses are tested in the study:
 To test the claim that mergers displace managers who have performed poorly at the
task of profit maximisation. If the following hypothesis turns out to be true, then the
acquired companies should have lower average pre-merger profitability than their
industry group peers.
 To test the claim that corporate mergers lead to economies of scale and economies of
scope. If the following hypothesis turns out to be true, then the post-merger profits
should rise relative to the pre-merger profits of the firm and/or their industry peer
averages, if rest other things are held constant.
To test these two hypotheses, the pre-merger and post-merger outcome data have been taken
and analysed for the actual acquisitions which have taken place in the United States.
Data sources for testing the hypotheses
The main data source for testing the above hypotheses came from the US Federal Trade
Commission’s Line of Business surveys for the years 1975-77. Between 459 and 471 US
corporations had reported their income statement and balance sheet data and those data were
instrumental in finding out the pre-merger and post-merger profitability of the merger
acquisitions. The sample corporations which were selected accounted for roughly three-
fourths of all the manufacturing and the mineral industry acquisitions, with the parameter
being the acquired companies’ asset values. Also, it may be important to mention that this
particular data set is well suited for measuring the profitability outcome of mergers since the
acquired company size is relatively small as compared to the acquiring firm, but large relative
to the individual reporting lines of business into which it is fitted. On an average, at the time
of acquisition, the acquired company’s assets accounted for nearly 20 % of the total 1977
assets for acquisition making Line of Businesses (LBs) which were already part of the
parents’ operations in 1950 and 48 % of the total 1977 assets for acquisition making Line of
Businesses (LBs) which joined the parents’ operations after 1950.

Accounting methods considered for hypothesis testing

The US corporations have used, mainly, two methods for accounting the assets acquired
through mergers. These two accounting methods are explained as follows:
  Pooling of interests accounting: Under this accounting method, the assets of the
acquired companies are recorded at their book values when the acquisition has been
completed. If the acquiring firm pays more (less) than the book value for acquiring
the assets, then the difference between the values is debited (credited) to the
acquirers’ stockholders’ equity account.
 Purchase accounting: Under this accounting method, the assets are valued at the
effective price paid for them by the acquiring firm, which is mostly acquired at a
premium than the asset book value. If a premium is paid by the acquiring company,
then the value of the acquired assets are increased by the premium amount relative to
the pre-merger book values.

If premiums are paid for the asset acquisitions, as has been the general case, then the post-
merger profitability, which is given by the return on assets or operating income/assets, of
purchase accounting acquisitions would be lower than the post-merger profitability of the
pooling of interests’ acquisitions. This is because the numerator term of the profitability ratio,
i.e., profits (operating income) would be lower in the case of purchase accounting method
because of increased depreciation in the asset value and the larger value of the denominator
of the profitability ratio, i.e., assets value.

Study methodology for pre-merger profitability

For the purpose of analysing the pre-merger profitability of the US acquisitions, a sample of
392 manufacturing company acquisitions were taken. These acquisitions were made by the
panel companies of the Line of Business during three years, 1968, 1971 and 1974. Also, these
companies were covered by the New York Stock Exchange listing applications. Out of these
392 companies included in the sample, 251 companies were linked to the filing made in
1975-77 by the Line of Businesses. These 251 linked acquired companies had a pre-merger
median asset value of $4.81 million. The remaining unlinked 141 acquired companies had a
comparatively lower pre-merger median asset value of $0.99 million.

For the purpose of calculating the pre-merger profitability, the SUPRA values were analysed
for the 251 linked companies. The pre-merger profitability was measured for each linked
acquired company as the percentage of operating income over the end of period assets. Now,
from these returns, the corresponding percentage of the linked acquired company’s principal
industry group was subtracted to control for the industry differences. The resulting difference
gives us the pre-merger supra-normal returns, otherwise known as the SUPRA values. These
SUPRA values are basically a measure of the linked company’s returns above the home
industry returns. The resulting SUPRA values are as shown below for the 251 linked acquired
companies by year and merger accounting method.
The results of the above table would be as follows:

 The average SUPRA values for all year and all accounting types for all the
acquisitions was 9.29% and significantly above zero with a t-stat value of 9.23.
 The SUPRA differences across the years were not statistically significant, with an
F-stat of 2.33 whereas the 5% significance level F-stat was 3.89.
 The SUPRA differences between the accounting types were highly significant, with
an F-stat of 5.20.
 Pooling accounting acquisitions had a higher SUPRA value than the purchase
accounting acquisitions. This showed that pooling accounting was favoured
following the acquisition of highly profitable companies. Purchase accounting was
favoured for companies with normal profitability.
To gauge the relationship between the SUPRA values and the acquired company size, a
regression analysis was done for the 251 linked firms resulting in the following regression
equation.

Here, PDUM is a purchase accounting dummy variable and LOGAST is logarithm to the
base 10 of the acquired company’s assets (in thousands of $). The t-stat values are provided
in brackets. The above equation shows that smaller the size of the acquired company, the
more acquirers favoured firms of superior profitability. The SUPRA value becomes zero at
asset values ranging 464 to 524 million $. From this, we can arrive at the conclusion that
there is no support for the first hypothesis which claimed that acquired companies that sub-
normal performance before mergers with lower profitability owing to inefficient managers.
For the purpose of arriving at the post-merger profitability, the 251 linked acquired
companies were classified into four major categories. They were as follows:

 HORIZ: Acquiring companies had at least 5 years’ experience in the same category
before acquisition
 VERT: Acquired company made at least 5% of its sales to, or purchases from,
another unit operated by the parent company for at least 5 years before acquisition
 RELAT: Acquiring company had at least 5 years’ experience in the same industry
group before acquisition, but had no horizontal or vertical connection
 CONGLOM: None of the above criteria is satisfied
The acquired company pre-merger SUPRA values by type of acquisition is as shown below:
The horizontal acquisitions had superior pre-merger profitability and the vertical acquisitions
had the least pre-merger profitability. The pre-merger profitability of the pure conglomerate
and related business acquisitions were in between. The differences in SUPRA values across
all the 5 types of acquisitions was also statistically significant at the 5% significance level
with a F-ratio of 2.82.

Study methodology for line of business cross-sectional analysis

For the purpose of analysis of post-merger profitability, three profitability variables were
defined, each being the unweighted average of the individual lines’ values for the years 1975,
1976 and 1977. The three variables are:

 PROF: A: Operating income/end-of-year assets

 PROF: S: Operating income/sales
 FLOW: S: Cash flow (operating income plus depreciation)/sales
The values of these 3 profitability variables are subject to the type of accounting method.
Next, we have taken a sample of 2732 Lines of Business on which the profitability data were
available for the 3 years which we had considered, i.e., 1968, 1971 and 1974. Then, we
defined the following explanatory variables:

 MERGSHR: Measures the extent of merger activity in a line. The MERGSHR value
is arrived at by calculating the average of the 3 years’ asset values acquired at the time
of acquisition and dividing it by the corresponding asset values of the Lines of
Business for the years 1975, 1976 or 1977.
 POOL: MERGSHR times the fraction of assets acquired under pooling accounting.
 PURCH: MERGSHR times the fraction of assets acquired under purchase
accounting.
 HORIZ, VERT, RELAT and CONGLOM: These variables are subsections of the
MERGSHR variable and correspond to horizontal, vertical, related business and pure
conglomerate type mergers.
 NEW: A dummy variable having a unit value for 258 Line of Businesses, in which
the parent company was not operational in 1950 and for which, no acquisitions were
recorded. These represent growth by internal development.
 EQUALS: A dummy variable similar to NEW and having a unit value for 251 Line
of Businesses, in which the parent company and the acquired company did not differ
in their sizes by a factor of 2, also referred to as the merger of equals.
 SHR: Measures the market share of the Line of Business in its category of industry
After defining the explanatory variables, the post-merger profitability was analysed by
running a fixed effects regression model to estimate the relationship between the merger
intensity and the accounting method, keeping other variables as constant. The results of the
regression analysis for all the 2732 Lines of Business over the years of 1975-77 is shown in
the table below.
The results for the post-merger profitability are summarized as below:

 Purchase accounting acquisitions had a negative profitability, and the negative effect
increases when there is no control of the Line of Business market share.
 Pooling accounting acquisitions had a weak negative to a weak positive profitability
when there is a control of the Line of Business market share.
 As per regression equation (3d) and (3e), for pooling acquisitions which had no
accounting adjustments made, there was little difference in the post-merger
profitability returns. For purchase acquisitions, the value of the PURCH variable
becomes less negative. This shows that the returns value as obtained from regression
equation (3c) was lower owing to the effect of purchase accounting where the asset
values of the acquisitions are increased or “stepped up” by the amount of the premium
paid for the acquisition. This, along with evidence indicating pre-merger profit returns
for purchase accounting mergers were insignificantly different from industry
standards, refutes the notion that mergers increased average purchase accounting
acquisition profitability. The evidence against the 2nd hypothesis of merger-induced
profitability benefits is significantly stronger in the case of pooling of interests
acquisitions. The test shows that post-merger returns have fallen and not risen.
 There is weak evidence that for the EQUALS mergers, there is an increase in post-
merger profitability supported by the positive values of EQUALS coefficients.
 Growth by purchase acquisitions was found to be less profitable than growth by
internal development. This is supported by comparing the PURCH and the NEW
coefficient values, where the PURCH values are comparatively more negative than
the NEW values.
 Among the four types of merger classes namely HORIZ, VERT, RELAT and
CONGLOM, the related businesses pooling acquisitions had the highest post-merger
profitability and the vertical pooling acquisitions had the least.
A comparison between pre-merger and post-merger analysis
The reasons for the apparent decrease in the profitability post-merger would be the following:

 There is a tendency for abnormal returns to regress over time to normal returns.
 There is a loss of control by the parent company due to economies of scale and
economies of scope.
 The parent company treated acquisitions as cash cows.
 The supra-normal pre-merger profitability of the acquired companies following
pooling of interests accounting may have been caused by the typically private firms’
inability to finance all attractive investments.
The comparison analysis between pre-merger and post-merger profitability returns was
performed based on a regression model involving two variables, including pre-merger
comparable ratio and the percentage growth rate of the unit assets of the acquired company.
The post-merger operating income per assets was regressed over the variables with
normalization and macro-adjustments.
The results could be summarized as below:

 For the sample of 67 merger companies which was taken, the regression towards
normal was significant.
 For a combined sample of merger corporations and individual survivors, the
regression towards normal was not significant. However, merger companies regressed
rapidly indicating that with mergers, the regression tends towards normal.

Conclusion and key learnings

For the first hypothesis which claims that mergers replace inefficient management and that
the acquired companies are profit underperformers pre-merger, the following inferences can
be concluded:

 No broad statistical support was found.

 The late 1960s and the early 1970s had shown selection bias towards extremely
profitable companies.
 This phenomenon was failed to be detected because the acquisitions were limited to
public companies with publicly-traded securities.

For the second hypothesis which claims that mergers improve profitability on an average and
that the post-merger profitability returns increase, the following inferences can be concluded:

 This hypothesis turns out to be true only in the case of “mergers of equals”.
 Post 7-8 years following the merger, the acquired company’s profitability returns had
declined sharply. This may be attributed due to one of the following reasons:
1. Control loss
2. Under purchase accounting acquisitions, due to asset step-ups
3. Under pooling of interests accounting acquisitions, there is evidence from
Galtonian regression.