FEBRUARY 15 1986 - VOLUME 7 - NUMBER 3
The Myth of Mergers
by Mark Green and John F. Berry
There are at least two reasons for the recent spate of corporate mergers-the economic and the egocentric. The economic incentives to merge include low-priced corporate stock, undervalued corporate assets, and skewed tax laws. A common explanation for one company's acquiring another is that it's easier to buy than to build. It's cheaper and faster to acquire a company with valuable existing assets-unique consumer products, advanced industrial technology, rich natural resources than it is to develop them from scratch. The stock market's valuation of companies has been relatively low in recent years, while the costs of labor and materials have been rising. As a result, the merger makers find that it's cheaper to "drill for oil on Wall Street" by acquiring a company than it is to sink a well in Prudhoe Bay, Alaska.
What adds kindling to the merger fires is that many companies are suddenly cash rich: some because of economic upturns, others because of selling off unproductive assets, and still others because they have been hoarding profits instead of investing in new equipment and in research and development. The cash-rich company, fearful that someone will try to acquire it for its cash hoard, gets rid of the cash by using it to buy another company.
The Internal Revenue Service has been an important partner to the merger makers. By permitting corporations to deduct all expenses incurred in a takeover battle, the IRS actually encourages corporations to grow by acquisitions instead of by innovative internal expenditures. When T. Boone Pickens spent a month in New York in 1982 fighting for control of Cities Service, he laid out $12 million for investment bankers, lawyers, and living costs for his band of raiders, one half his profit on the deal. "We gave a party, and it was expensive," commented Pickens, who probably wouldn't have been so cavalier if he hadn't been able to write off a big part of it on his taxes. Then, too, if cash-rich Company A acquires debt-heavy Company B, B's debts can be used to reduce A's taxes. And when fully depreciated or otherwise undervalued assets are acquired, tax write-offs can begin again at a new, higher value.
Hungry bankers have done their part to spur mergers. Flush with billions of deposits from Individual Retirement Accounts (IRAs) and money market accounts and eager to lend, banks in recent years actually have been pressing loans on companies for mergers and other big deals. While a bank is limited by federal law on the amount it can lend to a single customer, the sky's the limit for a consortium of banks making a loan. For instance, when Socal sought to acquire Gulf in 1984, it obtained a record $14 billion from several banks headed by Bank of America, while would-be suitor Atlantic Richfield waited in the wings with a $12-billion package put together by Chase Manhattan et al. Reflecting on these stratospheric sums, Fortune speculated that even Exxon, with a stock-market value of $32.5 billion, is vulnerable. "I think if the right people wanted to do it, they could get anybody," a senior lender at a major bank told the magazine.
In 1984 a new, almost revolutionary financial incentive to corporate raiders appeared called junk financing. Created by the New York investment banking firm Drexel Burnham Lambert Inc., junk financing-so called because it involves the use of unsecured, high-interest securities-permits a raider to borrow 100 percent of the money needed before even beginning a raid. Not surprisingly, Drexel's clients include such famous raiders as Saul P. Steinberg, T. Boone Pickens, Sir James Goldsmith, and Victor Posner. In junk financing, the would-be buyer creates a paper company; then Drexel goes to several hundred corporate and individual investors to get letters of commitment to buy the new junk securities to help finance the takeover. The raider, for his part, plans to use the assets of the acquired company to pay off the junk financing.
The bottom line is that junk securities are financing corporate raids that wouldn't be possible otherwise. These low-grade securities are being picked up by institutions and individuals eager to get a piece of the merger-mania action. The trouble is, junk financing means just that-i.e., the quality of that debt is questionable and the possible debt burden on the surviving firm onerous.
Finally, there are the Wall Street money managers who put tremendous pressure on corporate managers for shortterm profits. And what easier way to produce quick profits than by a merger? The reason that money managers have so much power is that they manage the investment of pension funds, mutual funds, and the like which control about 60 percent of the stock of Big Board corporations. Their clients pay them for results, so the money managers, in turn, demand results from the corporations. Often money managers control large blocks of stock in a single company, and they show unhappiness in a management's profit performance by selling those shares. These short-term demands-often precipitating unwarranted mergers caused Business Week to ask in a recent headline, "Will Money Managers Wreck the Economy?"
Despite all these economic incentives-depressed stock prices, abundant cash, IRS cooperation, helpful bankers, high-pressure money managers-the best evidence indicates that hostile tender offers and most large mergers are a costly waste of managerial time and talent that generally produce not one new job, not one more barrel of oil, not one more bolt of steel. And they leave the surviving company saddled with massive debt. If this is so, then whey do mergers continue at such breakneck pace?
In many instances, businessmen seem almost compelled to acquire or be acquired. Company A fears if it doesn't swallow Company B, then Company C will swallow it. Personal concerns overcome management responsibilities as incumbent managers fear they will lose their pay and perks, which moves chief executive officers (CEOs) and boards of directors to constantly worry that their company is targeted or should be targeting another. Those interviewed also cited the unspoken belief of many chief executives that status positively correlates with size. "A great deal of it is ego. It's a major factor," says Martin Lipton, of Wachtell, Lipton, Rosen and Katz, a New York City law firm specializing in mergers and acquisitions.
Kenneth M. Davidson, an FTC attorney, agrees. In describing the results of an FTC study in which fourteen prominent merger experts were asked why companies merged, Davidson said, "A number of participants cited examples of executives meeting at management training programs or country clubs, introducing themselves in terms of their titles and the sales volumes of their companies or units. . . . Social status, not management power, may be the realm where size counts most." The participants believed "that the market consequences of mergers are often unclear and that the decision to merge is ultimately made by the CEO on unquantifiable factors." They added that the decision could result simply from a friendly investment banker reaching the CEO by phone. More than three decades ago, Henry Simons, founding father of what has come to be called the conservative Chicago school of economics, described the role of ego in building a corporate giant: "Few of our gigantic corporations can be defended on the ground that their present size is necessary. Their existence is to be explained in terms of opportunities for promoter profits, personal ambitions of industrial and financial `Napoleons,' and advantages of monopoly power."
"They're destructive" is how Harold Williams describes most mergers, and Williams clearly ranks as an expert on the subject. He is a former Securities and Exchange Commission chairman, former president of Hunt Wesson Foods (later Norton Simon, Inc.), and dean of the UCLA Graduate School of Management. Most recently, as chief executive of the J. Paul Getty Trust, Williams played a key role in the sale of Getty Oil to Texaco. "Short term, they're distracting," said Williams. "Managers that are subject to a takeover spend too much time defending themselves. It enhances their willingness to distort earnings, to phony them to keep the price of their stock up [so they're not so vulnerable to takeover]. Some companies even dissipate assets, getting rid of cash and buying credit-which is like shooting yourself in the foot to avoid being drafted. On the other side, the acquiring company has decided to grow more by financial manipulation than by building the quality of their business."
MIT professor David Birch examined 6,400 independent firms that were acquired by conglomerates, comparing their growth rates before and after acquisition with those of 1.3 million independent firms that were not acquired. He found that conglomerates tend to acquire the faster growing independents, whose growth rates subsequently slow compared to firms that remain independent. In 1982, Fortune looked back at the ten biggest conglomerate mergers of 1971 by companies on its list of 500 largest industrial firms to see how they fared during the intervening decade. Its study, said the magazine, "strongly supports the notion that investing in unfamiliar businesses is unduly perilous-just as the critics maintain. Most of the acquirers evidently were lured into buying unstable companies, or into committing foolish mistakes that harmed stable ones."
A 1982 study of 206 corporations by Hay Associates in conjunction with the Wharton School similarly questions the value of diversification by acquisition. "after corporations take the first step in diversifying their products, the maximum level of performance attained decreases with every further move forward in diversification." T.F. Hogary, writing in St. John's Law Review, asked rhetorically, "What can fifty years of research tell us about the profitability of mergers?" and answered, "Undoubtedly the most significant result of this research has been that no one who has undertaken a major empirical study of mergers has concluded that mergers are profitable, i.e., profitable in the sense of being `more profitable' than alternative forms of investment." University of Maryland professor Dennis C. Mueller joined fourteen economists at the International Institute of Management in Berlin, West Germany, studying 765 mergers that occurred between 1962 and 1972 in Europe and the United States. The mergers generally didn't increase profits or sales, says Mueller, and in the United States "we saw a significant decline in growth rates of companies that had merged."
All these studies make clear that, contrary to claims of efficiency, billions of dollars have been spent joining companies whose managements had no clear vision of what would happen after the acquisition. Instead of efficiency, such seat-of-the-pants mergers squander resources, lives, time, and capital.
Mark Green is the director of the Democracy Project and John F. Berry is a former Washington Post reporter. This article is excerpted from their book, The Challenge of Hidden Profits: Reducing Corporate Bureacracy and Waste, published by William Morrow and Company, Inc.