Mergers: When they can work and why they usually don’t
When thinking about the recent Microsoft, Facebook deal, I couldn’t help but talk about mergers generally. So are some general thoughts about what makes mergers work or not.
Research consistently shows that most corporate mergers are unsuccessful.
That is to say, when two companies combine the value of the merged
company rarely even equals what the individual companies were doing by
themselves. The reasons for this are numerous. Organizations face
diseconomies of scale as they grow. A simple example of such a
diseconomy of scale is increasing communications overhead — the number
of possible communication paths grows as N^2 for the number of people
in an organization, so if there is any cost associated with such paths
then the org will become less efficient as it grows past a certain
point. A typical example of this cost would be in trying to find the
right (best) person to handle a specific issue or task. At some point
finding the best person becomes too costly and workers instead choose
to duplicate the effort or work with a sub-optimal colleague. For
these and many other less quantitative reasons like cultural mismatch,
merged companies are generally less efficient.
So why do they keep happening? There’s an agency problem in upper management.
Everybody involved in this kind of M&A deal is personally
incentivized to see the deal go through. Investment bankers of course
want to see their commissions. But the bigger problem is that senior
management is typically compensated based not just on the economic
success of their organization, but also based on its pure size. That
is to say, the CEO of a company with 10,000 employees and a 5% ROE
(return on equity) will probably get paid more than the CEO of a
company with 5,000 employees and a 7% ROE. The 7% ROE company is
better run, more efficient, and doing better for its investors. But executives
have this perverse motivation to decrease the economic effectiveness of
their organizations in order to grow their empires. It’s a classic
agency problem whereby managers have a conflict between their personal
interests and their responsibilities as agents for stockholders.
Mergers only make sense when there is synergy. This term gets thrown around loosely quite often but it has a specific meaning. It refers to one company being able to make more effective use of its own resources when combined with resources from the other merged company. For example one
company has a product that they don’t have enough manufacturing
capacity to meet demand for, and the other company has excess
manufacturing capacity. Or one company has a new product that can be
sold more effectively at minimal marginal cost through an established
distribution channel that the other company has. In these rare cases, mergers make fundamental economic sense.
Stay tuned for more specific thoughts on the big players buying bits of each other…