Mergers and acquisitions. They are generally a negotiated deal with one company's board of directors with another company, where the buyer makes something called a tender offer. And that's to purchase the shares from shareholders. There's a few types, there's a horizontal merger. This is the purpose is to scale to try to get your products to reach a larger market. An example would be in pharmaceuticals, Shoppers Drug Mart have a collaboration, a merger of a whole bunch of different drug companies together.
An advantage of doing horizontal mergers would be collective databases. Another example is you can access other markets, for example, the inter continental Stock Exchange bought out the New York Stock Exchange. And the reason is because the internet continental Stock Exchange wanted a derivatives exchange. The way they did that was to just bought out another exchange. It was already there. So they went and did that.
Another example of a merger would be something called a roll up. And a roll up is where you try to consolidate a bunch of fragmented pieces of different industries and put them together. This is more common in third world countries. Another example would be Supercuts, which is a haircut salon franchise and they just consolidate a bunch of different hair salons and together under one brand name. There's another type of merger called a vertical merger. This is motivated by production technology and contracting costs they're trying to reduce the costs make it more efficient.
An example of a vertical merger would be when GM and Fisher body parts Fisher body parts was a company that created GM metal frame parts for the vehicles. As demand for the cars increased GM wanted to renegotiate rates With your body parts, the original contract terms was the cost of parts plus a required return plus 10 to 12% of gross margins. Fisher body parts said no to me negotiating renegotiation of rates. So in response, GM just bought fish or body parts out, and then they were able to get the rates they wanted. Another example is with Porsche was going to buy out Volkswagen. This was around 2007.
And then the 2008 crash happened. And the banks that had been backing Porsche, they got cold feet, and they refused to provide the money to buy Porsche. Porsche was left exposed with a ton of shares but not quite enough to acquire Volkswagen. Volkswagen still wanted the merger. And so they bought up Porsche. Historically, there's a bunch of examples such as Thomas Edison, he was a corporate raider and he would buy out other companies merge them together.
And we now know, the companies that he combined his General Electric. He was claiming credit for a lot of inventions. And you can see that he's known for hundreds and hundreds of inventions. But really, a lot of them were from companies he bought out. There's something called closed end funds. And this is where investors can buy shares in holding companies.
And the holding company, what they will do is specifically mergers and acquisitions. They will just buy out other companies. So they'll take the money from the investor, they'll use that money to acquire other companies. And so they don't actually need to have any kind of product or revenue of their own. They'll just use that. jp morgan did a bunch of takeovers.
And the way he did it was he would buy company's shares in exchange for shares of his standard trust shares. So he had a standard trust. He would issue shares, the shares would be given to other companies. What did the trust hold, trust hold held shares in other firms. So this was a very, very ingenious financial move to buy firms using the money of other firms. He didn't actually have to put up money on his own.
He could just buy companies with shares of other companies. So you can see that when it comes to mergers and acquisitions, it's usually based down to negotiating some kind of haggling. But when you actually go and you want to go buy a stock on stock change, you're going to see a fixed price. You can't negotiate that easily. Why did this come about? Why do we have fixed prices anyways, where the fixed prices come from?
Why do we just not haggle for free? Well, historically, we did. We actually had haggle and barter for everything. If you wanted something you had to haggle for it. And the reason that we haggle a lot less and that we have fixed prices is due to advances in communication. For example, telephones, roads for cars, where we no longer have to rely on railroads that was a slow form of communicating prices, radios, the easy way to tell people what a price was.
The invention of the telephone was interesting because alongside it came the idea of phone catalogs. And people could go and they could get this catalog of products. And then they could find the item they wanted to buy, call a number in the catalog, and they would buy it for the price in the catalog. And when that happens, they can now take that and say to a shop, hey, you are selling more than this price in the catalog. You have to drop your price to this or I will just buy it from the magazine. So that was was one way to standardize prices to a certain extent.
And of course, also movies and television. When a company announces that it's going to acquire a company, we notice some interesting things. The acquired company stock tends to go up 40%, at least in the US markets. And this tends to happen immediately after the announcement. It's not like this always, not all countries. For example, in Canada, the stock price tends to rise gradually in the months leading up to the announcement.
One of the reasons is might be is because insider trading laws are strictly enforced in the United States, but they're not so much in Canada, very few people go to jail in Canada for insider trading. This is a one of the reasons why Alibaba had their IPO in the US rather than in China is they wanted to get the maximum value for their shares and they didn't want to have too much insider trading. The US has one of the most efficient equity markets in the world because they really are very diligent and hammering and prosecuting people for insider trading. If a hostile takeover occurs, stock prices rise slower than mergers or friendly takeovers. Why would this be? Perhaps shareholders believe that the acquirer will make improvements in the share price will increase.
Why does the stock price rise before I take over though, One theory is that the two firms the buyer and the seller they become closer to a monopoly because now there's less competition you can raise the prices of your products and sell those for more. But this doesn't hold up if you drop your prices of the products afterwards. When a merger occurs, the price have other firms in the industry also tend to increase as well. But if the merger gets cancelled, we noticed that the price of other stocks in the industry they don't seem to fall afterwards. So monopoly theory doesn't really hold up that much. Do monopoly profits motivate mergers and acquisitions?
The US Federal Trade Commission uses something called a concentration ratio and a her Findel index to measure monopoly profits. And the idea is that if we notice that monopoly profits are increasing a lot, then they might step in and say you can't have a monopoly you can't merge together. But what we noticed is that monopoly profits don't seem to go up that much most of the time. One of the reasons for this is that acquired firms tend to be broken up and sold into smaller pieces. Joseph Schumpeter who we mentioned a little while ago He has a term called creative destruction. creative destruction is the idea that there's a industry industrial mutation that's constantly evolving over time.
And the idea is that whenever you have some kind of innovative firm or products that forms in the market, it will essentially destroy the Old Market. It'll take over, and it'll create a new market. Creative Destruction essentially lets innovative firms dominate and takeover until a more innovative firm comes along and beats it. monopolies can be good if it's the result of creative destruction, because you're getting more innovation. monopolies are bad if they're due to some kind of artificial barrier. So for example, tariffs or something like that.
This isn't quite a black and white issue, though. It's hard to say whether monopoly is good or bad. For example, is Microsoft good or bad? monopoly. It's been very difficult for companies to compete with Office software. But Microsoft's products are quite innovative.
So it's not always a black and white issue. All right, what happens after a merger occurs? Do layoffs increase? Not, on average, do wages fall? Not an average. We do notice that white collar layoffs occur and a company tends to hire more blue collar employees.
We also noticed that money tends to be removed from overfunded pension plans. share prices rise on the news of layoffs. No, we notice in general that share prices tend to fall. Do tax savings and benefits motivate mergers and acquisition? Well, they might a little bit, but as we mentioned earlier, we tend to notice that the acquired company stock tends to go forward percent after a company announces is going to be acquiring it. So is tax savings 40%?
Not that high, contribute to a little bit, but not that much. Why do stock prices increase 40%? On average? Are they undervalued, and the takeover alerts everyone that the stock is undervalued and that they should go buy it? And that's the reason. Well, people might believe that people might see a takeover and say, Oh, that must be a good investment.
But that doesn't necessarily mean the stock was undervalued to begin with. Let's give an analogy to show why this might not be. Michael Spence, a Nobel Prize winning economist wondered why people pay so much for higher education, post secondary education, university education. And here's a few reasons. It signals to employers that you were good enough to get into the post secondary education to get good grades. Undergraduate, but they don't really care what your major minor was, they just want to know that you were good enough to get through.
Sounds quite familiar to some of you. Another example in the biology world is that biologists think that people's meaning male peacocks, they spend so much time foraging, just to have the energy to grow these massive tails to indicate to females that they have food. It's like a litmus test for the females to say, he's got the biggest tail, therefore he is food. And another analogy is hyda, potlucks. This was a feast that villagers would save for, they'd spend years collecting enough money so that they could pay for these great big ceremonies. And, in fact, they was so expensive that they would have to cut out other things in their lives just to afford these potlucks and it slowed down economic progress.
So, taking these sweet analogies together, post secondary education, overpriced, giant peacock tails, a really energy depleting way to indicate that you have food. And potlucks are extremely expensive. Just to say that you have some social status. The implication is that saying you have to take over a firm to indicate that the stock is undervalued. That seems a little bit excessive and unlikely that the firm was underpriced in the first place. What about the company that is buying the other company?
What if their shares are overpriced? If you have bad money, spend it quickly before it's gone. In 1999, AOL purchased Time Warner at the time, AOL price earnings was around 200 times, it realized that its shares were overvalued. This was, at the time the largest merger in US history for 450 billion dollars. Steve Case from AOL met with Gerald Levine from Time Warner. And they made a deal where AOL ended up owning 55% of Time Warner, and they paid just in AOL shares.
Why would a company give so much money to own you? At the time, the share price of AOL was six times that of Time Warner, Jerry Levine made the merger deal, and he didn't even discuss it with the Time Warner executives. He thought it was such a good deal at the time. Then, in May 2000 the.com, bubble burst news of AOL misstated earnings started leaking out. But by this time the AOL executives had already sold off all of their shares. But back to that idea, are the buyers shares overpriced?
What do we see? Well, we noticed that the acquirer firms, they tend to be in popular industries, whatever's hot at the time. The acquire affirm top executives they tend to sell the shares that they own at the time of takeovers. We noticed that the acquire a firm shares tend to fall abnormally months or years after the takeover. CEOs who own their own company stock, they tend to pay lower premiums for acquisitions. The rationale might be perhaps when a merger successful, the CEO benefits but when a merger fails, the CEO doesn't bear the losses.
So if a CEO owns their own company shares and they have more incentive To make better decisions, and we noticed that firms with stronger boards tend to make better decisions. Fano course had a another idea. This was something he spent years coming up with, which is the theory of a firm. What is a firm? When you have a merger, a firm buying another firm? What is it?
What is a firm in the first place? His idea is this. A firm is an alternative to organizing economic activity. It's saying where the cost of building things on your own is approximately equal to the cost of outsourcing. So technological improvements cause the cost of production to decrease. The total gains theory is the idea like this a firm acquisition buying another firm is just like any other net present value calculation is just like any other financial decision.
If a firm is a place where people come to contract with each other. If you're an entrepreneur and you're a single person, and you want to have your own business, you would have to hire someone to come up with the product. If you don't do that yourself, you'd have to hire someone to do the supplies, hire someone to get the supplies, to train to transport them from one place to another to do research and development, you'd have to hire someone to do sales, hire someone to do marketing, all these individual things, you'd have to have your own contract sport. That's really complicated. Whereas a firm is an efficient contracting house. Instead of everyone making individual contracts with other people.
We decide collectively that we are going to contract together with a fictional concept called a firm. And this firm is a way that we don't have to come up with individual contracts with everyone else will all work collectively together. This firm is then owned by shareholders. It's a essentially a form of property. Well, what is property? What is ownership of property?
Well, really the only thing that indicates for property is is that you're preventing other people from owning it. It's your property because other people aren't owning it. shareholders have a residual ownership of a firm. If you buy shares for money, the company will take your money, and there's no guarantee that you'll get anything back. But you kind of own it. This is where we bring into something called an agency theory.
Agency theory works like this. Shareholders don't run the firm. The managers of the firm run the firm. If the managers don't own shares, they are agents. What we mean by agents is that they don't really have an incentive to work for the shareholders. Why should an agent generate wealth for someone else?
They shouldn't, they should benefit themselves. This is where companies will give stock options to employees in an attempt to remove agency problems with company executives. This explains situations where the selling company benefits and the buying company loses is another way that companies might benefit from acquiring other firms. This is where they do so. In something we like to call it a price earnings game and the purpose is just to improve their own financial statements by buying another company. It works like this.
The buying company purchases the company with a lower price earnings. The hope is that the buying companies price to earnings ratio will transfer over to the acquired companies So the buying company pays a premium, they still end up increasing the share price. And the rationale is that the bond company thinks that price earnings ratio is overvalued and wants to spend the extra money while they can. Note that when this happens, the buying companies paying in shares, rather than paying in cash. Theoretically, there should be more takeovers during bad economic times, then good economic times. This is where a company would be struggling due to the overall economy rather than just being run poorly.
And so the price of their shares might be unnecessarily low undervalued and this would be a good time to buy. But what we notice is that they tend to be more takeovers during good economic times when the price of stocks might be overpriced. Is this just due to over optimism? Are people not bad? They're just over optimists. Why are they more merges during booming economies?
The neoclassical approach is a theory is that the stock market is just a reflection of the overall economy. Maybe an alternative is that firms overvalued and they have money they shouldn't have, at least not for long. And when they have this money that they only gonna have possession for for a short time, they spend it quickly on mergers. This doesn't happen everywhere in the world, though. For example, in Japan, when the economy's doing well, we noticed there's very few acquisitions, but during poor economies, there's a lot of acquisitions. But you'll also notice that Japan has a little bit of a different structure when it comes to how they issue shares.
Japan has a lot of cross web of shared ownership, where one company may own another company. is also owning their shares. A lot of interconnected companies, for example, Miss Mitsubishi shares owned by companies that deal with them by suppliers have shares the buyer and the buyer has shares with the suppliers. So everyone has aligned interests. So it's rare to have hostile takeovers. More likely there's a merger where a strong firm is buying out a weaker firm that's not doing so well.
But that's more the exception to the rule. Another reason that it might be a lot of acquisitions and mergers could be diversification benefits. A firm that specializes in one product could spread the fixed cost around if it diversifies. You can think of the example of a factory where you're making one product in the factory. You've already got this fixed cost you're paying for the building, you're paying for the laborers. You may as well make more than one product though.
You've already got that fixed cost you may as well make several There's something called the winners curse. And this is the idea that when a firm successfully acquires another firm, they pay too much. If you think about a silent auction, whoever wins a silent auction, they paid more than everyone else. And that's why they won. But the only time that they are actually able to receive that product to buy it is when they pay more than everyone else is willing to pay. So they can only win if they overpay.
So a successful company acquiring another company, perhaps is paying too much if you use this rationale. Bradley does say and Kim, have a theory that if the acquisition alerts people to under valued firms, then the rise in stock price The selling company should stay high afterwards. But what we notice is that usually falls after a deal collapses. So perhaps that's not true as well. Well, we do know, though, is there's a lot of competition amongst bidders to drive up the price of the seller stock. On the other hand, if there's only one single bitter, then the stock returns tend to not increase very much.
So why do firms acquire by merged with other firms? There might be a number of reasons it could be because that acquired company is undervalued. But it might also be because the acquiring companies trying to scale they're trying to diversify their products. They're trying to expand into other industries. Perhaps they're paying in shares. They're trying to take advantage of a high price earnings ratio or some other ratio.
And they're hoping that that will transfer on to the company that they are Quarter, or they're trying to obtain a financial ratio. And the way they do that is by buying companies that have the ratio they're looking for and that that will then dilute their own ratio. So there's a number of reasons why it might be beneficial for a company to purchase or merge with another company.