Thursday, June 30, 2005

The Love Song of J Alfred Prufrock and Company, Investment Bankers.

Have you ever noticed how so many concepts in management and business can be applied to social / romantic relationships as well? This is true not only of the more sociological / psychological parts of management, which are clearly trying to explain human behaviour, but also of the more economic / financial side of business. And it's not just that you can stretch a concept to fit romantic relationships - if you really think about it, a proper application of business theory can actually offer fresh insights and provide a more structured way of thinking about these situations.
Take, for instance, the theory around successful M&A (which I've been reading a lot of recently). What follows is an extremely basic elaboration of some of the main points of this literature, except that everything included in it can be profitably applied (forgive the pun) to romantic relationships as well. Just try and spot the differences:
The Rationale behind M&A
Let's start with the most basic question of all. Why do people enter into mergers anyway? The literature provides a number of reasons:
Economies of Scale and Scope
The first reason for mergers comes from the existence of scale-free assets and asset indivisibilities. As a result, the marginal cost of applying these assets to another person is low, so that greater efficiency and return on investment can be achieved by merging with another person. (As an example, think about being well-read as an asset. You can't be slightly well-read - there's a certain minimum scale of reading you have to do. At the same time, once you are well-read, there's very little effort that goes into sharing that with one additional person). The old chestnut about how if you share your happiness you double it is actually true - if you spread a fixed resource over twice the number of units (without any additional cost) - you get twice the profit.
Mergers may also create possibilities for division of labour and specialisation of capabilities. It's not just that the resulting entity possesses the best of both worlds - it's also that each party has now greater scope to specialise in the things they're truly good at, so that the overall performance is better. Also, to the extent that the two parties are in the same or similar businesses (have the same or similar tastes) mergers may allow for the sharing of certain basic administrative costs (rent, music, books, etc.) and may create efficiencies by eliminating duplication of effort (you don't both need to send Christmas cards, for instance).
Market Power
A second important source of value from mergers is the increase in market power that both parties experience. As a joint entity, the merged parties are able to better coordinate their demands / offerings and therefore have a greater ability to bully suppliers and may be able to make better deals with consumers, effectively charging them higher prices. (Anyone who's ever tried having dinner alone with a married couple has probably felt this - that sense of being ganged up on, the way one person will always hang around to keep you 'entertained').
Risk Mitigation
A third source of value from a merger is the almost purely financial one of creating a lower risk portfolio. The basic idea here is that to the extent that both parties will not experience distress together, the distress of one can be supported by the other, so that the overall entity has a more stable earnings / benefit profile. Thus, even though the actual cash flows (happiness flows) of each party may remain the same (or may even decline somewhat because of rigidities created by the merger), the overall value of the party is higher because greater stability of cash flows means that discount rates on future cash flows are lower. (Notice that this assumes that risk is not completely covariant, in which case there would be no benefit. Notice also that this is only a valid reason when financial markets are inefficient - if we could simply invest in each other's happiness without getting together, we could achieve the same portfolio effect without getting into romantic relationships. In some ways that's what friendships are for - and you thought it was coincidence that it was called the bond market!)
Restructuring and momentum for change
A fourth argument made for benefits from M&A is the possibility of restructuring - change in management can create opportunities for superior performance through innovation and fresh thinking. In fact, the acquiring party may often enter the acquisition purely because he / she sees the opportunity to fundamentally remake the target in order to dramatically increase profitability. This is the classic Pygmalion story, of course, but it is also the logic of getting together with someone out of sympathy and with the hope of making their life better. In some ways, of course, this is just a special case of the capabilities / specialisation argument - the strategy only works to extent that the acquirer has superior talent / insight and can do better by applying these to the other party than internal to itself.
There are also, of course, disincentives to mergers. First, mergers tend to reduce focus and the removal of investment decisions from the market may lead to sub-optimal investments and the toleration of inefficiencies that would otherwise not be allowed (this leads to the famous diversification discount). Second, mergers are highly disruptive acts - not only do both parties incur fairly high short run adjustment and transaction costs, rigidities and coordination problems imposed by the merger may actually cause each party's growth to slow or even stop entirely.
The efficient market problem and why mergers may work
A fundamental problem underlying all the reasons for mergers given so far is that we have not, so far, taken into account the problem of valuation. Economic theory tells us that in the presence of efficient markets, the valuation of each party to the transaction (and therefore the cost paid by the counterparty) should exactly represent the value realisable by the party from the transaction. If this is true, then all mergers would be value neutral transactions, and as such there would be no point getting into them.
In the presence of heterogeneity of participants, however, this theorem is not strictly true. To see why not, let us consider the potential of merger between two parties - say A and T. Let us assume that A is considering two potential counterparties: S and T while T in turn is considering two partners: A & B. Let us further define a function G(X,Y) as being the value to Y of a partnership with X and C(X,Y) as being the cost to Y of a partnership with X.
For the partnership to work, it must be true that
G(A,T) > = C(A,T) and G(T,A) >= C(T,A) - otherwise one or the other party will not agree to participate (strictly speaking the relationship should be positive - if either relation is equal, then the party is indifferent between entering the partnership or not entering the partnership)
Assuming markets are efficient, and that B and S are the next best alternatives to A and T respectively, we can infer that:
C(A,T)> = G(A,S) and C(T,A) >=G(T,B), since any bid lower than this would be matched by a competitor in the market.
It follows that, for a successful merger:
G(A,T) >= G(A,S) and G(T,A) > = G(T,B)
That is to say, both parties must hope to get some unique value from the other party, value they could not get elsewhere.
Before we look into critiques of this model, there are two issues we need to address:
First, it's important to notice the importance of heterogeneity in this system. If all participants were identical then there would be an equal value from partnerships with any other party, but the value of all these partnerships would be zero. As the heterogeneity of participants increases, the potential benefit from a transaction also goes up, but so does the potential cost of excluding any party from your consideration set. (This actually leads to an interesting discussion on probability distributions and the importance of sampling frames, but let's come back to that in a later post). Notice that this is not specific to mergers alone, but is in fact, the very basis of scarcity rent.
The second issue is of course the need for non-market transactions. After all, even if these benefits exist, why can they not simply be realised through trade on the open market rather than requiring a close integration of the two parties? A first answer to that question comes from Transaction Cost theory. While the implications of TCE for relationships are too manifold and interesting to cover in detail here (sigh! another post waiting to happen) the basic intution is that in the presence of incomplete contracts (given the impossibility of defining every future situation in full detail) the creation of specialised assets creates opportunistic hazards - given that specialised relationships, once created, cannot be traded on the market, there is the potential for hold-up - for the party benefiting from these relationships to pay significantly less now that you're in the relationship than he would have had to pay to get you to agree to enter the relationship in the first place. Hence the need for internalisation of the transaction. A second answer, comes from the tacit and uncodified nature of knowledge / capabilities, which essentially means that you cannot simply pass on what you know to the other party but have to interact with them over an extended period of time to make the transfer possible.
Deviations from market efficiency
If you think about the model outlined above, you would think that it would be extremely difficult to arrive at a merger proposal that both parties would agree to. You would basically have to find two parties who both valued what the other had and couldn't get it from anywhere else. In a truly efficient market with full information, this would be hard (or looked at another way, it would be easy. Basically you could get the same benefits by paying for them at cost on the open market - there would be little or no incentive to get into mergers)
Why then do so many mergers actually take place? There are a number of deviations from the model that must be considered:
Endogeneity of benefits
The first problem with the model is that it assumes that all value from the merger derives from the combination of resources of the two parties - that being in a merger per se has no value. This may not be true. The basic effect here is isomorphism - the tendency, over time, of participants in the same market to come to resemble each other. If all participants around you are merging, this may lead to feelings of doubt or inadequacy, and may prompt you to merge even if it's not really in your best interest. Part of this could be oligopolistic reaction - in a highly competitive market, you would want to maintain absolute parity with those you consider your peers. Even if you saw no real value in a merger, you may still enter into one if your peers do, simply so as not to risk being left behind (of course, this is a risk averse strategy - you could also choose not to merge in the expectation that this will lead to higher returns, but that would be a lot riskier). At the same time, mergers may be an important signalling mechanism, sending the message to the market that you are a viable and high performing entity. Third, the market, in the throes of a bubble or a merger wave may react illogically to merger activity, causing your stock to go up even though there are no underlying fundamentals to justify this.
Of course, if the benefit from entering into a merger were the same for all parties then it would simply cancel itself out. It's only if the merger value is different (some parties are more desperate to merge than others) that this can have an influence on merger valuation, with parties that value mergers for the sake of merger per se being willing to bid higher and therefore enter more easily into mergers than those who value mergers based purely on fundamentals. At the extreme of this case is a scenario where one party simply wants to exit the market and will basically sell out even at a loss.
Imperfect information / markets
A second problem, of course, is that markets are often far from perfect. First, all relevant parties may not participate in the market, or information about them may not be readily available at any one time. Given that it's often difficult to know if / whether a potential counterparty is looking for a merger (except through informal sources / hearsay or through the observation of explicit moves in the past) the best one can hope to do is pick a consideration set of likely candidates, but this may often mean leaving out high potential candidates who escape our attention.
Second, full information about parties even in one's consideration set is notoriously hard to come by. Even if basic factual information about their current status is available, knowledge of their future plans and strategies is almost always impossible to get. Moreover assessments of their skills / capabilities may be largely anecdotal, and it may be difficult to get full access to them without entering into the relationship. All of this means that predicting future returns from the partnership is more of an art than a science, and valuations of the same counterparty can be subject to considerable standard error, making for a range of value. It is this uncertainty that leads many parties to get into mergers with expected values that are frequently not realised.
Common medium of exchange
Another problem, though one perhaps less important in purely financial transactions, is the question of the medium of exchange. As long as the deal is made purely in money, of course, this is not an issue. But as soon as other issues of control and governance play into the picture, we encounter the problem of different parties ascribing different values to the same thing. The result is that a common solution may actually be easier to reach because each party can be given more of what they value. In some ways this is the same thing as the argument in the model - it's just important to note that the differences in value may be entirely perceptual rather than having basis in any objective fact.
Obtaining Value from M&A
Given this background, we are now finally in a position to consider what leads to generation of value in a merger. This is an important question that has been the subject of much research, simply because it is an observed fact that in most cases mergers that start with much fanfare end up creating very little value for their respective shareholders.
Related vs unrelated mergers - Strategic Fit
A first consideration is of course the question of how the two parties are related. Received theory (backed by some empirical evidence, though the findings are mixed) suggests that mergers between related parties (i.e. parties with some common interests - markets, products, etc. ) perform better than those between unrelated parties (e.g. conglomerates). This is essentially because the value of economies and market power are much higher when the two parties are related, while in the case of unrelated mergers the chief benefit is only risk reduction, which could conceivably be achieved through market transactions anyway. That said, it would seem that mergers between identical parties may produce less value than those between parties that bring somewhat different but related (complementary / supplementary) assets to the table. While there is some evidence of this, it is unclear whether we can safely conclude this to be true.
Organisational fit
While the question of broad interests and assets and their relatedness is clearly an important one, there is a second issue that is of critical importance, and that is more often overlooked by managers. This is the problem of organisational fit. Even though two parties may be aligned on overall objectives, interests, etc. they may have fundamentally different work-styles / cultures / routines and may take very different approaches to getting things done. To the extent that the value of the merger lies in a close integration of the activities of these parties, we may find that in the absence of this more day to day fit, deals that look very good on paper may prove to be completely impossible to make work on the ground. Understanding and assessing differences on these important day to day dimensions is therefore critical to merger performance
The effect of size
A third finding much touted in the literature is the effect of size - in general, studies of acquisition have found a disproportionate amount of the value creation going to the target rather than to the acquirer. One reason for this is that the acquirer (or the dominant partner) is usually larger and more successful, so that the value added by the new partners has little effect on its overall profitability. A second reason may be that given that targets are often required to completely forsake their own identity in being acquired, the market may give them greater bargaining power to start with, allowing them to demand a higher up-front price (and giving them a greater range of potential partners to evaluate and reject) than the acquirer. That is why short-run studies of mergers may show the target enjoying a much higher return, not taking into account the final annhilation of the target's identity.
Process issues
Researchers have also pointed to a number of process issues that may lead to subsequent failure of mergers:
First, there is the problem of fragmented focus - which means that decision makers may prioritise a few highly salient features of the relationship (typically things they lack and may not be able to get easily on the open market; like sex, for instance) without paying sufficient attention to the overall picture and thinking through the integration challenges at all levels. The result is that the merger goes through, but then does not yield the hoped for results, because problems in other overlooked areas persist.
Second, there is the notion of escalation of commitment. Once parties have initially entered into a negotiation, there is a tendency to distort negative information received, and a set of perverse incentives to close the deal prematurely and without due evaluation. Part of the reaons for this is that parties feel that their own judgement and reputation is at stake and so are unwilling to admit to having made a mistake. Another part of the problem is that negotiations are high stress, disruptive situations, causing parties to seek early closure. Finally, there is key role played by third parties to the transaction (investment bankers, consultants, that annoying aunt who - knowing nothing about you - is always tell your parents how you should live your life) whose interests are often aligned behind making the transaction happen rather than around the participants' subsequent performance. These parties exert pressure for early closure.
A third issue is the problem of ambiguity - by its very nature, negotiation implies incomplete disclosure. Parties will both try to hide negative facts about themselves (in order to keep their valuation high) and not disclose their real plans for the other party (in order to keep valuation low / avoid pre-deal conflict). This ambiguity creates problems in the post-merger situation, when the unexpected truth is revealed and becomes the focus for much internal conflict within the new entity.
A fourth issue from the process side is managerial arrogance and mismanagement. In the aftermath of the merger, each party may feel that they are in a position to help and improve the other parties situation, without really understanding the full dynamics of the other side. Therefore they may try (either well-meaningly or out of hubris) to take steps to 'help' the other side which may not be appreciated and may lead to conflict.
The importance of prior experience - how to make mergers work
What then leads to a good merger? One important factor is the prior experience of the merging / acquiring parties. To the extent that parties have been involved in mergers before and have been able to codify and learn from their experiences there, they will be in a better position to manage this new merger more effectively, avoiding some of the mistakes listed above. Beyond this, sensitivity to the other party, willingness to learn, and an objective evaluation of both the big picture and of day to day fit before getting into a merger are important determinants of merger success.
Another issue to think about in achieving value from mergers is the optimal level of integration required. In many cases, full integration may not be the best solution for the two parties - it may be better to achieve some sort of basic / partial integration and then let both parties develop independently, without binding them together to a point where it becomes constraining.
See what I mean?


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