In the merger and acquisition (M&A) market, conventional wisdom holds that merger and acquisition deals are a way to reallocate physical capital from low productivity firms to high productivity firms. The thinking is that, theoretically at least, the acquirer's more productive way of operating will make the target's assets that much more profitable.
In my own research, I looked at the characteristics of firms that are acquirers and those that are targets. I also developed a model that moves away from the old economy scenario described above and toward a more modern setting. In this interpretation, it's not just about tangible and physical assets; it also incorporates the intangibles and productive opportunities—things like ideas, proprietary methods, and product formulas.
WSB Associate Professor Oliver Levine
Think about the standard high-tech startup, for example. A company has a great entrepreneurial idea in development. Once that technology demonstrates potential on a broad scale, a well-established firm might buy that technology through acquisition of the company. The acquiring firm can then roll that technology out across a much bigger set of customers, possibly launching it more cost-effectively at the same time. So, ultimately, there's often a distinction between the firms that are developing the ideas and those that are taking them to market on a larger scale. In this context, firms can use the M&A market to reallocate investment opportunities to those companies best equipped to take advantage of them. Acquisitions of this sort, often termed inorganic growth, are driven by the success of the target, not because of its deficiencies.
Understanding the motivation for M&A deals has implications for the types of firms that choose to become targets and acquirers, and the role each firm plays in a merger. Here are four things to know about how mergers reallocate investment opportunities in the economy and the roles each side plays:
1. Targets and acquirers have distinct characteristics.
In the study, I show that the target and the acquirer have distinct characteristics in ways that contrast with the typical old-economy view of M&A. Firms that are targets have higher than average productivity, sales growth, and investment rates, which suggests that they have quality projects. They may have low profitability, which indicates that their costs are higher than average. Conversely, firms that are acquirers have both high productivity and low costs.
2. Acquirers are often constrained in their investment opportunities.
One of the outcomes of the model is that firms that acquire other companies are constrained in their investment opportunities; they lack options for how to grow organically, so they're looking for outside opportunities like buying other companies. They also are very profitable at their current scale because they lack the ability to grow organically.
3. Acquirers seek targets to obtain the assets that they lack.
In the model, acquiring firms look for targets to gain the assets, such as growth opportunities, that they themselves lack and can produce at a lower cost.
4. After acquisition, acquirers experience a drop in profitability.
Consistent with the data, the merger transaction results in a drop in profitability for the acquiring firm, even though the merger itself adds value and benefits both parties. The fact that they are growth-constrained (see above) indicates that what they are currently doing, they are doing well. This is essentially the notion of diminishing returns to scale: the more you do and the larger your scale, the less profit you are able to get out of each additional unit of investment you make.
Read the paper “Acquiring Growth” published by Journal of Financial Economics.
Oliver Levine is the Howard and Judith Thompson Professor and an associate professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business.