Friday, October 31, 2014

How M&As exhibit wavelike behavior when faced with a location problem.

A prey acquired by a wolf. Credit: Mariomassone
Every industry produces according to a supply chain to increase its market share, or extend its market to overseas borders. When a firm decides to acquire another, either two of the above reasons holds, or a third - acquiring the subsidiary for purely risk reduction purposes. Mergers – horizontal, vertical or conglomerate – are the most dominant form of foreign direct investment (FDI), a sign that the international markets are confident about an economy’s ability to reward them in profits. For multinational enterprises (MNE), mergers are strategic. Understanding the behavior of mergers is really important for any economy.

It is unarguable that mergers constitute 80% of FDIs, especially for developed countries. Whether a multinational seeks to gain access to foreign markets through horizontal mergers, exploit differences in factor endowments and low wages through vertical mergers, or pursue motives related to ameliorating its financial and managerial imperfections, mergers and acquisitions affect both developed and emerging economies. Therefore, it is in their best interest to understand the wavelike behavior of mergers.

Consider an atypical MNE. Why would it decide to acquire a subsidiary in a foreign market that is in the same industry? To increase its market share, of course. What really matters to this MNE is the size of that country’s GDP. Corruption and high corporate taxes might be turnoffs, but the size of the GDP is a reflection of the size of the market. What if it decides to acquire a company that manufactures a product that is part of its production process and involves intensive labor? Then, rather than GDP, low wages and wage differences, as well as the available factor endowments in the host country, would be determining factors. Sometimes, though, M&As occur for reasons outside the normal line of activities of the MNE. It might want to please its shareholders, or buy up undervalued firms in weak markets where it sees an opportunity for financial arbitrage, or because the host country has poor shareholder protection.

According to Nils Herger and Steve McCorriston in a discussion paper titled: Horizontal, Vertical, and Conglomerate Cross Border Acquisitions, horizontal and vertical mergers are by far more stable and most prevalent, while conglomerate mergers are much more noticeable just after a financial crisis. The wavelike nature of M&As are largely in favor of firms in markets that are unrelated to the primary business of the MNE because it is pursuing a strategy of risk reduction in lieu of a financial crisis.

CBAs over time and their composition: 1990-2011. With the amiable permission of the authors.
Two cases in point were in 2000, after the dotcom bubble burst, and 2007, the beginning of a global financial crisis. Excepting a crisis, conglomerate mergers are not too common. This might be because acquisitions are a sort of a location choice solution in the market for corporate control. If the search for a location for expansion was the problem, then horizontal mergers and vertical mergers would be the variables under consideration.

A choice for horizontal expansion is then a corporate desire to increase market share, for access to new markets and cultures. This is more noticeable in manufacturing such as food production and electrical equipment, in the services sector as in engineering and accounting firms, and also in the oil and gas extraction industries.

A choice for vertical expansion becomes a desire of possessing suppliers at the intermediate stages of the production process, especially where labor constitutes a significant part of it. The highly labor intensive manufacturing sector is a first culprit.

The wise investor seeks to understand what motivates MNEs to merge and acquire other firms in other countries, and why the international market for corporate control seems volatile, at times, with no apparent rationale. The wise investor who understands the difference between portfolio investment and FDIs and what drives both would not be taken unawares.
This article was inspired by the discussion paper from the University of Exeter, UK, titled: Horizontal, Vertical, and Conglomerate Cross Border Acquisitions..

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