A Focus on Resources in M&A Success: A Literature Review and Research Agenda to Resolve
Two Paradoxes
Margaret Cording Petra Christmann
L. J. Bourgeois, III
Darden School University of Virginia
To be presented at
Academy of Management, August 12, 2002
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A Focus on Resources in M&A Success: A Literature Review and Research Agenda to Resolve
Two Paradoxes
This paper reviews the empirical literature on mergers and acquisitions with an eye
towards identifying research questions that have not yet been addressed and that may help
resolve two paradoxes that emerge from the literature review. Despite the empirical evidence
that, on average, mergers fail to create value for the acquiring firm’s shareholders, corporations
continue to employ this strategy at ever-increasing rates (the “success paradox”.) The
diversification theory claim that related acquisitions should outperform unrelated ones has not
withstood the empirical test (the “synergy paradox”.) We suggest that the resource-based view
of the firm can be leveraged to illuminate the nature and characteristics of resources that present
difficulties in both the target valuation and integration processes, helping to resolve these two
paradoxes. Specifically, we argue that certain qualities of resource bundles are more challenging
when valuing target resources and resource combinations, as well as presenting ex post
uncertainties about acquired resources. Other resource characteristics, such as embeddedness,
tacit value creating routines, and human qualities, present an enigmatic integration process. It is
hypothesized that failures to understand these characteristics lead to a tendency to overvalue
targets and the possibility of destroying during the integration process the very value purchased.
By being consciously aware of these resource characteristics, and the difficulties encountered
when valuing and integrating target firms, firms may be better able to preserve and leverage the
value creating mechanisms of the acquired firm. Research propositions are proposed to test
these hypotheses.
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Words such as “Herculean”, “heroic”, “ultimate change management” and the like are
often used to describe the requirements for a successful merger or acquisition. Empirical
evidence has shown that creating value for the acquiring firm’s shareholders is a 50/50 bet at
best. Despite this dismal record, mergers and acquisitions continue to set records. In 1989,
3,407 m&a deals were completed with a total value of $230 billion (Mergers and Acquisitions,
1990); by 2000, the number of deals grew to 8,505, valued at over $1.7 trillion (Sikora, 2001.)
Moreover, the average purchase price of transactions has grown dramatically; the bets are getting
bigger.
For more than thirty years, scholars have researched mergers and acquisitions. Early
empirical work sought to identify the characteristics of successful mergers, especially as it relates
to diversification theory. Results were mixed, but most agree that, on average, mergers and
acquisitions fail to generate above normal returns for the acquiring firms’ shareholders. Why,
then, do corporate CEOs continue to employ this strategy? And what can they do to improve the
odds of success? Attention has also focused on understanding the variables that managers can
manipulate to bolster a given transaction’s probability of success: ways to improve the quantity
and quality of information gathered during due diligence, and potential impediments to the
integration of two firms.
This paper explores the literature with an eye towards identifying research questions that
have not yet been addressed and that may help resolve two paradoxes that emerge from the
literature review: the m&a success paradox and the synergy paradox. The literature is segmented
into three separate, but related, critiques: the measurement of success of a merger; empirical
evidence with respect to strategic diversification theory; and, empirical testing of integration
factors that may drive a transaction’s success. We then argue that a resource-based view of the
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resource bundle that an acquiring firm purchases and integrates can better illuminate the sources
of valuation and integration problems than the traditional approaches. We conclude with a
suggested research agenda that seeks to further develop and operationalize the resource-based
view of the firm in the context of mergers and acquisitions.
MEASURING M&A SUCCESS
It is widely agreed that the “success” of a merger or acquisition may be defined as the
creation of synergy: the value of the combined firm is greater than that of the two firms operating
separately. This reflects the simple observation that the price paid for a strategic asset must be
lower than its expected value if it is to add economic value to the acquiring organization.
Because the efficacy of a corporate combination is, at least in part, a function of how its outcome
is calculated, this section reviews the empirical literature with respect to measuring success in
mergers and acquisitions. Four principle methodologies have been employed: event study,
accounting-based measures, survey data and case studies.
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Traditionally, the capital asset pricing model (CAPM) has been the primary measurement
tool for determining the degree to which mergers and acquisitions create economic value.
Utilizing the “event study methodology” (Fama, 1968), the stock prices of both acquiring and
acquired firms are examined shortly after the merger announcement. The “cumulative abnormal
returns” are calculated (the increase in stock price over and above that which CAPM would
predict absent the merger), and the results assessed. The central underlying assumption is that
investors are capable of accurately predicting the combined firm’s future cash flows.
The event study methodology has several attractive features. First, the data is publicly
available, permitting empirical studies on large data samples. Second, it relies upon the well-
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respected efficient market hypothesis. Third, because “abnormal” returns are calculated, the data
is not subject to industry sensitivity, enabling a broad cross-section of firms to be studied.
These studies have provided support for the view that mergers and acquisitions create
economic value (Jensen & Ruback, 1983; Seth, 1990b; Singh & Montgomery, 1987.) Later
studies examined the distribution of this new wealth, and concluded that the stockholders of
acquired firms capture most of the gains (Chatterjee, 1986; Datta, Pinches & Narayanan, 1992;
Seth, 1990a; Singh & Montgomery, 1987; Sirower, 1997.) Indeed, the stock price performance
of acquiring firms raises serious concerns: only about 35% of acquirers report positive stock
market gains on the announcement date (for a useful review of these analyses, see Sirower,
1997.)
These event study results, however, may be due to its reliance on the assumption that
investors can accurately predict the combined firm’s future cash flows. This assumption
embodies the attractive feature of ensuring that non-m&a related factors are not influencing the
incremental stock behavior. Abandoning this assumption represents a direct challenge to the
efficient market hypothesis (Shleifer & Vishny, 1991.)
Over the past fifteen years, scholarly attention shifted to exploring different dependent
variables. Perhaps the issue was not one with m&a “success”, but rather with the event study
methodology’s assumptions regarding success. Studies began using accounting-based measures
of performance, market share data, and survey responses, and regressed these against various
factors hypothesized to drive financial performance. The definition of “success” began to take on
a longer-term perspective: perhaps it took three to five years to fully reap the benefits of the
combined firm. Krishman, Miller and Judge (1997), for example, hypothesized that the ability of
top management teams to work effectively together would drive m&a success, measured by
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return on assets. Ramaswamy (1997) explored the impact of strategic similarity in mergers
occurring in the banking industry. Again, return on assets was used to measure performance
over a three-year period.
But accounting measures are subject to one of the same limitations as are long-term stock
price measurements: factors other than the merger or acquisition may be driving the numbers. In
addition, accounting measures reflect the past, rather than present financial performance
expectations (Montgomery & Wilson, 1986.) Nor do they reflect changes in the firm’s risk
profile. Some academics have opted to use survey measures to elicit the management team's
views on whether or not the merger was a success (Cannella & Hambrick, 1993; Capron, 1999;
Chatterjee, Lubatkin & Weber, 1992.) In theory, a merger or acquisition should be deemed a
“success” if the objectives identified during the due diligence process are met. In other words,
the key question may be, “Did we accomplish what we set out to accomplish, regardless of other
exogenous or endogenous factors simultaneously at work?” Capron’s recent survey-based work
claims: “…traditionally available financial data are too gross to permit differentiation between
the types of fine-grained value-creating mechanisms…” (Capron, 1999: 993.) While these
approaches rely on self-reported perceptions of long-term performance, they reduce some of the
noise that may accompany publicly available information.
Because every merger and acquisition is a unique event, occurring in a unique
environment that is subject to innumerable influences, case studies have also provided a rich
stream of research (Haspeslagh & Jemison, 1991; Marks & Mirvis, 1998; Shanley & Correa,
1992.) While it is not possible to generalize to other specific situations, the case study
methodology does enable one to generalize to theoretical constructs. This analytic device
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enables the analysis of processes of value creation, rather than simply events seeking to create
value.
These results, combined with the observation of continued growth in merger and
acquisition activity, gives rise to the “m&a success paradox.” If we assume that managers are
rational, and that corporate governance structures serve as a check and balance on poorly
conceived strategic actions, we would expect the level of m&a activity to taper off, which has
not been observed. To date, scholars have been unable to unravel the m&a success paradox.
TESTING DIVERSIFICATION THEORY IN M&A
While the event study literature demonstrates that the acquired firm’s shareholders reap
above-normal returns (due to the payment of a premium for the firm), this represents value
capture, not value creation (Seth, 1990a.) The newly combined entity is left with the task of
creating value in excess of the premium paid. Strategy theory tells us that value is created in an
m&a through the identification and exploitation of synergy. While different terminology is used,
three broad classes of synergy are the usual focus of researchers. First, operating synergies arise
when economies of scale or scope are captured across a variety of the firm’s activities. Financial
synergies are driven by reductions in the cost of capital due to a reduction in bankruptcy risk, an
increase in the size of the firm, or internal funding of the target’s investment projects at a cost
lower than that available in the capital markets. Collusive synergies – sometimes called “market
power” – enable the firm to either extract a higher price for its products or services or pay
suppliers a reduced price. (Chatterjee, 1986.)
Diversification theory claims that related acquisitions should have greater potential for
synergy creation than unrelated acquisitions (Rumelt, 1974; Salter & Weinhold, 1978.) This is
because the greater the points of contact and overlap between two firms’ value chains, the higher
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the potential for capturing operational synergy. Singh and Montgomery (1987) hypothesize that
because all three forms of synergy are theoretically available in related acquisitions, and that
because only financial synergies and administrative efficiencies are available in unrelated
mergers, related acquisitions will create more value than unrelated ones.
Given this model of value creation possibilities, scholars sought to understand what types
of mergers might lead to above normal shareholder value. While the above diversification
theory is intuitively appealing, Lubatkin (1983) noted that the concept of “synergy” had never
been tested. Attention therefore focused on measuring the results from related versus unrelated
mergers, again using the event study methodology. The presence of a related skill, market,
resource or purpose of two merging firms was the usual definition of relatedness employed
(Rumelt, 1974.) Researchers operationalized this concept generally by using the U.S. Federal
Trade Commission’s Standard Industry Classification at either the two- or four-digit level.
In a review of these empirical studies (all using the event study methodology),
conflicting results have been achieved. For example, Lubatkin (1987) found no statistically
different results in related versus unrelated mergers, while Elgers and Clark (1980) found that
unrelated mergers outperformed related ones. However, Singh and Montgomery (1987) found
that total dollar gains, standardized on the value of acquired assets, showed statistically
significant differences between related mergers and unrelated ones at the .05 level, with related
mergers outperforming unrelated ones. However, target firms obtained the lion’s share of these
gains, while the acquiring firm did not experience any statistically significant wealth gains.
Chatterjee (1986) attempted to empirically isolate the effects of various sources of
synergy. Arguing that the type of synergies captured cannot be classified based on the type of
merger due to the potential presence of multiple sources of synergies in, say, a related merger,
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Chatterjee examined non-horizontal related mergers versus non-related, conglomerate mergers.
His hypothesis was that if horizontal mergers were excluded from the study, he could eliminate
the impact of any collusive synergies and zero-in on operational and financial synergies.
Financial synergies may be present in any type of merger, but operational synergies would only
be available to a firm that acquired a related business. Furthermore, Chatterjee argued that the
observation that two sources of synergy may be present in a related merger while only one in an
unrelated merger does not logically lead to the expectation that the former type of merger will
outperform the later. Using event study methodology, he found, counter-intuitively, that firms
acquired by non-related acquirers fared much better than their counterparts acquired by related
firms. Interpreting the results of targets involved in a related acquisition, Chatterjee suggests that
operational synergies may prove very difficult to implement.
Seth (1990a) built upon Chatterjee’s argument that there is no a priori theoretical reason
to suppose that value creation is a function of the number of potential synergies. She found
“overwhelming evidence” that mergers and acquisitions create value when the target and bidder
firm are viewed together, but only “limited evidence” that this value creation occurs to a greater
extent in related acquisitions versus unrelated. Seth concludes that, “…the finding that related
acquisitions do not unequivocally outperform unrelated acquisitions provides evidence that the
sources of value creation associated with unrelated acquisitions provide similar magnitudes of
synergy compared with the sources of value creation associated with related acquisitions.”
(Seth, 1990a: 112.)
Methodologies other than event study have also been used to test diversification theory in
mergers and acquisitions. In an analysis that controls for industry, Hopkins (1987) found that all
firms pursuing an acquisitive strategy in fact lost market share, suggesting that improving a
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firm’s market position via acquisitions may be an unrealistic goal. He states, “Managers
concerned with the position of their firms may want to consider internal growth as an alternative
to growth through acquisitions.” (Hopkins, 1987: 544.) However, firms with a strong marketing
position (i.e., brand loyalty) lost less market share than those with a particular strength in
technology, and in conglomerates. Hopkins hypothesizes that this is due to the relative
attractiveness of industries that have high marketing related barriers to entry. Supporting this
view is Lubatkin’s (1983) observation that predicted synergistic benefits are highest for
marketing concentric mergers.
Seeking to operationalize certain views of diversification that may be classified under the
resource-based view of the firm, Farjoun (1998) argues that the above studies on related versus
unrelated acquisitions suffer from too narrow a view of relatedness. Examining diversification
activity in the manufacturing sector, Farjoun explored degrees of relatedness with respect to
physical assets (e.g., production lines) and human skills (e.g., similar engineering skills), and
how these factors of relatedness might be correlated with financial performance (operationalized
as return on assets, return on sales, market-to-book ratio, and Jensen’s alpha measure.) He found
that when viewed separately, the existence of neither physical asset relatedness nor skill
relatedness was correlated with financial performance. However, when viewed together – i.e.,
the presence of both related physical and skill bases – and controlling for industry effects, a
strong effect on performance emerged. Farjoun concludes that the joint effects of relatedness are
synergistic in nature: “each base thus extends the other.” (Farjoun, 1998: 614.)
Perhaps these conflicting conclusions speak more to measurement and classification
problems than to the true economics underlying mergers and acquisitions. Indeed, the above
researchers would often group the various FTC classification schemes differently. Hence, an
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underlying problem may be one the definition of related versus unrelated acquisitions.
Alternatively, the potential synergy gains available in related acquisitions may be priced out
during negotiations (particularly to the extent that it is based on publicly available information)
making value creation in horizontal mergers a particularly difficult task (Barney, 1988.) There
may in fact be no a priori reason to expect greater abnormal returns from a related acquisition
than from an unrelated one (Zollo, 1998.)
To sum up so far, the empirical evidence has been conflicting as to what type of
diversification strategy can in fact create value for the acquiring firm’s shareholders.
Diversification theory has not yet been empirically confirmed. Assertions that mergers and
acquisitions are a useful and productive method for diversification and growth, and that
synergies are more readily and easily captured in related acquisitions, do not withstand the
empirical test. Difficult as they may be, mergers are often viewed as a more favorable strategy
than, say, building the business internally (Singh & Montgomery, 1987), giving rise to the m&a
synergy paradox.
FACTORS INFLUENCING M&A OUTCOMES:
EIGHT SCHOOLS OF THOUGHT
While the above empirical work focused on the average distribution of various
performance measures, scholars have also sought to isolate those variables that may drive
superior performance. The question then turns to what obstacles are faced in generating wealth
for the acquiring firm’s shareholders; i.e., what variables management should manipulate to
improve the odds of success? This section reviews eight schools of thought that emerge from the
literature regarding the key issues that must be tackled to make a strategic acquisition work in
terms of financial performance. These schools are: Overpayment; Agency Problems; CEO
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Hubris; Top Management Complementarity; Experience; Employee Distress; Conflicting
Cultures; and, Process.
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The School of Overpayment
Most researchers assume, either implicitly or explicitly, that acquisitions occur in a
highly competitive market (i.e., the market for corporate control) and that prices are bid up to
their “fair” value. Sirower (1997) presents a direct challenge to this assumption: “The first step
in understanding the acquisition game is to admit that price may have nothing at all to do with
value. I call this the synergy limitation view of acquisition performance. In this view, synergy
has a low expected value and, thus, the level of the acquisition premium predicts the level of
losses in acquisitions.” (Sirower, 1997: 14, emphasis in original.) While the premium is known
and paid up-front, the synergy gains are uncertain, derived in the future, and difficult to obtain.
When calculating the net present value of these future synergies, a relatively high discount rate
should be used, reflecting the risk of actually generating the synergistic effects.
Pointing out the risks involved in paying a premium, Sirower (1997) urges executives to
be clear about how synergy gains are to be extracted and the strategies for doing so. Some
researchers warn executives to “walk away” if the price exceeds what they were originally
prepared to pay (Haspeslagh & Jemison, 1991; Kusewitt, 1985.) Sirower (1997) argues that the
presumption of outcomes should be failure.
Others have pondered why managers may overpay for an acquisition. The process of
identifying a suitable acquisition candidate and negotiating its price is riddled with problems.
The analyses often occur in secrecy and under significant time constraints. Complete data is
often not available. Haspeslagh and Jemison (1991) report that a majority of executives feel that
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a breakdown in the due diligence process led to a poor purchase decision. One aspect of the
problem is the occurrence of “fragmented perspectives”; due to the complexity and speed
required, it is difficult for any one person to develop a broad, but detailed, view of the acquisition
opportunity (Jemison & Sitkin, 1986.) Given the bounded rationality (Cyert & March, 1963;
Lubatkin, 1983), the opportunity to misjudge qualities in this due diligence environment is quite
high.
The building of momentum to complete the transaction further exacerbates this danger
zone. Momentum builds in an unpredictable way, reflecting increased personal commitment on
the part of the due diligence participants, the environment of secrecy and intensity, and the
influence of outside advisors. (Haspeslagh & Jemison, 1991.)
The School of Agency Problems
Researchers began to query the role of agents in the acquisition process, especially those
involved in negotiating the transaction’s price. Kesner, Shapiro and Sharma (1994) investigated
how investment bankers’ influence the size of the premium. Because compensation paid to these
bankers is positively related to the purchase price, managers may harm the long-term health of
their firms rather than securing the best possible value. (Kesner, et al, 1994.)
Focusing on a possible agency problem between the interests of the chief executive
officer and shareholders in mergers and acquisitions, several studies have found that CEO
compensation increases with the size of the firm, regardless of firm performance. (Lubatkin,
1983, Schmidt & Fowler, 1990.) There thus seems to be an incentive for CEOs to increase firm
size rather than firm profitability.
Kroll, Wright, Toombs and Leavell (1997) investigated the nature of acquisition
decisions from the perspective of corporate ownership and control. They categorized firms along
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three dimensions. Manager-controlled firms are those firms with diffused external shareholder
ownership; no single shareholder owned more than 5% of the firm. Owner-controlled firms had
at least one shareholder with a 5% or greater stake. Owner-manager-controlled firms were those
firms where at least one senior manager owned 5% or more of the company. Kroll, et al (1997),
using the event study methodology, found that acquisitions purchased by manager-controlled
firms generated significant negative returns. For owner-manager-controlled and owner-
controlled firms, these transactions generated positive returns.
The School of CEO Hubris
Another stream of research attempting to explain the dismal track record of acquisitions
has focused on hubris of chief executive officers (Roll, 1986.) Hubris, or exaggerated self-
confidence, may lead to otherwise unsound decisions. Premiums paid represent a significant
signal of the amount of value that the acquiring firm believes it can create via the acquisition
(Hayward & Hambrick, 1997.) If CEOs believe that they can defy all odds and efficiently
extract above normal returns from an acquisition, then those CEO are likely to overpay. Clearly,
the role of the board of directors should serve as a check on this behavior, but when the board
has a significant number of insiders on it, and when the CEO is also the board’s chairman,
Hayward and Hambrick (1997) found that the relationship between CEO hubris and the size of
premiums paid is particularly striking.
The School of Top Management Complementarity
Some scholars have investigated the influence of two distinct top management teams’
ability work together after a corporate combination. Shanley and Correa (1992) queried whether
agreement between top management teams improves expectations for post-acquisition
performance. Following Bourgeois (1980), the researchers hypothesized that if the two top
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management teams perceived agreement and actually agreed on the strategic objectives of the
acquisition, that post-acquisition performance would improve through healthy cooperation.
Alternatively, if perceived and actual agreement were low, then conflict may arise that could
thwart the achievement of objectives. Shanley and Correa’s (1992) results confirm these
hypotheses. Datta (1991) also found that differences in top management styles had a negative
influence on merger performance.
Walsh (1988) investigated whether the conflict among top management teams involved
in an acquisition leads to a higher turnover rate than in firms that have not gone through a
merger. He found a significantly higher rate of turnover within five years of a merger. In
addition, the type of acquisition – related versus unrelated – did not mitigate this relationship.
The resource-based view of the firm (Barney, 1986; Kogut & Zander, 1992; Wernerfelt, 1984)
claims that knowledge specific to a firm is often tacit, and not easily replaced. Losing a majority
of the combined firms’ top management team may represent a hurdle so high that it is difficult to
overcome. This conclusion was reinforced by the work of Cannella and Hambrick (1993). In an
analysis of 96 large acquisitions, the authors conclude that, “…executives from acquired firms
are an intrinsic component of the acquired firm’s resource base, and that their retention is an
important determinant of post-acquisition performance.” (Cannella & Hambrick, 1993: 137.) In
addition, top management retention was important in related acquisitions as well as unrelated
ones.
Closely related to culture-based studies (see discussion below), Krishnan, Miller and
Judge (1997) explored the relationship between post-merger performance and the
complementarity of top management teams, where complementarity was defined as differences
in functional backgrounds. Krishnan, et al (1997) found that a complementary management
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team was positively related to post-acquisition performance, and negatively related to the
acquired firm’s top management team turnover. Organizational learning led to a successful
acquisition process, according to the authors, and this learning occurred more readily and easily
when the top management teams were blended. Krishnan, et al conclude that, “…it appears that
organizational learning, and hence synergy, appears to be most enhanced by acquiring firms that
are run by complementary top management teams and then by limiting the turnover with the two
teams after the acquisition.” (Krishnan, et al, 1997: 371.) Singh and Zollo’s (1998) study of the
U.S. banking industry also concluded that high levels of replacement of acquired firm’s
executives had a negative impact on performance.
The School of Experience
It seems natural to assume that the greater the experience with acquisitions, the lesser the
risk that potential value will not be captured. Haleblian and Finkelstein (1999) argue that the
experience curve associated with mergers and acquisitions is U-shaped. In this study,
“antecedents” refer to present conditions, while the past determinants of behavior are termed
“consequences”. When an antecedent is similar to past situations, generalization of past
behavior should be observed. When an antecedent is dissimilar to past experience,
discrimination should occur. During the first acquisition, managers have no prior experience and
will therefore interpret events as unique. As experience builds, however, managers may assume
that past situations are at play, failing to appropriately discriminate the current situation from
previous ones. Once experience with this failed generalization is assimilated, managers develop
the ability to discriminate when appropriate, resulting in the U-shaped distribution. It was also
found that firms who acquired firms similar to those it had acquired in the past were better
performers.
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Singh and Zollo (1998) demonstrate that for firms in the banking industry, the tacit
knowledge acquired from previous acquisitions positively impacts performance provided that the
two integration experiences are homogenous. When the type of acquisition or integration
process is substantially different, caution is warranted. They argue that, “Learning curve effects
in the context of highly infrequent and heterogeneous events…are heavily taxed….” (Singh &
Zollo, 1998: 30.)
The School of Employee Distress
Researchers also began to focus on the process of merger integration, and on the impact
mergers have on employees. Buono and Bowditch (1989) hypothesized that:
Some mergers do fail because of financial and economic reasons. However, because of
the myriad questions about merger and acquisition success, attention has begun to shift
toward human resource concerns, the cultural ramifications of merger activity,
management of the overall combination process, and specific efforts aimed at post-
combination integration. In fact, most of the problems that adversely affect the
performance of a merged firm are suggested to be internally generated by the acquirers
and by dynamics in the new entity. The reality may be that many merger- and
acquisition-related difficulties are simply self-inflicted. (Buono & Bowditch, 1989: 10.)
Buono, trained as an organizational sociologist, and Bowditch, an industrial and
organizational psychologist, provide a much different perspective from the scholars referred to
above. Their focus is on the individual experience, and how the organization can either help or
hinder that experience. Because mergers and acquisitions precipitate major life changes for
organizational members, and because it is these same members that can harm or enhance the
outcome of the merger, they argue that attention to the human side of mergers is imperative.
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Basic human responses such as lowered commitment, drops in productivity, organizational
power struggles, office politicking, and loss of key organizational members, represent hidden
costs to a merger. If managed well (i.e., in an open, honest and participative way), Buono and
Bowditch (1989) argue that these costs, while not eliminated, can be minimized.
Haspeslagh and Jemison (1991) also focus on the employee side of the m&a integration
process. They argue that an atmosphere that stimulates peoples’ willingness to work together is
critical, and that the barriers to cooperation in an m&a context that ought to be managed include
fears about job security, a loss of power and resources, process changes, reward system changes,
and fear of the unknown.
The School of Conflicting Cultures
Another school of thought centers on the role that the two cultures, and the closely related
acculturation process after a merger or acquisition, play in determining the financial success of
the merger. The above human problems get exacerbated when the underlying national, corporate
or business unit cultures of the two organizations are incompatible. As it relates to m&a
research, however, Nahavandi and Malekzadeh (1988) provide a broad definition of culture:
“…the beliefs and assumptions shared by members of an organization.” (Nahavandi &
Malekzadeh, 1988: 80.) There are two broad layers, or sources, of organizational culture. First
is how the organization accomplishes its objectives, and the values and beliefs that underlie these
routines. Also informing this “corporate” culture, however, is national culture. In addition, an
organization may have multiple cultures within it. The challenges encountered when merging
two different cultures is that either one or the other (or both) needs to change. The issue, then,
becomes not just culture awareness, but culture change management during the integration
period. The process of acculturation follows a three-stage process: contact, conflict and
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adaptation (Berry, 1983.) Clearly, the more quickly one can achieve adaptation, the lower the
risks of unproductive conflicts.
One stream of research presupposes that the more similar the cultures of the target and
bidding firms, the fewer the integration and acculturation problems that will be encountered.
Indeed, Chatterjee et al (1992) found a strong negative correlation between the perceived cultural
differences between the two top management teams and stock market gains to the buying firm.
Nahavandi and Malekzadeh (1988) argue that the process of acculturation is a function of
the preferred approach for both the acquired and acquiring firm. From the perspective of the
acquired firm, the desired process is driven by the degree to which it values its own culture and
seeks to preserve it, and its perception of the attractiveness of the acquirer. If, for instance, the
acquired firm highly values its culture and does not rate the acquirer as highly attractive, then its
acculturation is likely to be "separation”, in which it will seek to avoid the acquirer’s culture.
From the perspective of the acquirer, the two dimensions driving the acculturation process are
the degree of tolerance for multiculturalism versus seeking one, unified culture, and the degree of
relatedness between the merging firms. Nahavandi and Malekzadeh (1988) generate several
hypotheses about how the integration process will proceed for each possible pair of processes.
For instance, “If there is congruence between the two companies regarding the preferred mode of
acculturation, minimal acculturative stress will result and the mode of acculturation … will
facilitate the implementation of the merger.” (Nahavandi & Malekzadeh, 1988: 87.)
Cartwright and Cooper (1992) performed empirical analyses of firms involved in
horizontal mergers that required a significant degree of integration. They conclude that it is not
cultural differences that matter per se, but rather that the two companies can work together.
This, in turn, is driven by the extent to which employee individual freedom is affected. If the
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two cultures are distinctly different, and individual freedom declines, Cartwright and Cooper
(1992) assert that problems will likely arise. They acknowledge that the closer the two cultures
are to each other, the easier the acculturation process.
In an effort to assess each firm’s cultural preferences before agreeing to merge,
Forstmann (1998) developed a “cultural analysis” to be performed during the merger
negotiations. Arguing that the process by which cultural acculturation occurs determines the
success of the merger, he recommends, “...the integration strategy should be made dependent on
such cultural differences, rather than only portfolio goals, as is typically done currently.”
(Forstmann, 1998: 58.)
The School of Process
Perhaps the most comprehensive research on post-merger integration is the work done by
Haspeslagh and Jemison (1991.) In discussing the challenges involved in effectively combining
two firms, the authors note that, “Integration is an interactive and gradual process in which
individuals from two organizations learn to work together and cooperate in the transfer of
strategic capabilities” (Haspeslagh & Jemison, 1991: 106.) The key to success lies in creating
an atmosphere in which this transfer can occur. Implicitly, the authors believe that even if the
profitability targets are well conceived, if the process of resource or capability transfer is flawed,
value creation will be seriously limited.
Haspeslagh and Jemison (1991) identified three types of problems that stand in the way
of capability transfer. While all acquisitions wrestled with these problems, the successful ones
actively managed the underlying dynamics, while unsuccessful ones did not. “Determinism”
occurs when management is unable to adjust its integration strategy in light of new information.
Flexibility in acquisition integration is therefore important. Value destruction is the flip side of
21
the value creation coin. In the process of creating value for shareholders, employees may be
asked (or perceive to be asked) to destroy value for themselves. The authors report that in
situations in which (employee) value was destroyed, individuals’ commitment to the firm or to
making the acquisition work declined because they perceived a qualitative change in the nature
of their relationship with the firm. One central decision, therefore, is when to accommodate
peoples’ needs and concerns and when to press ahead. Managing the people process then
becomes critical. Finally, the third integration problem is a “leadership vacuum”; unless both
institutional and interpersonal leadership were provided, the possibilities for creating the
atmosphere necessary for capability transfer were limited.
THE ROLE OF RESOURCES
The “best practices” that emerge from the literature indeed represent a Herculean task.
Simultaneously – and while running an existing business – managers are advised to not overpay,
beware of self-interest, check over-confidence, ensure management complementarity, develop
experience and competence in valuation and integration, manage employee and other stakeholder
emotions, acquire a similar culture, focus on the integration process, and so on. Perhaps a clearer
idea of the cause of the difficulties encountered could better inform management practice.
Underlying each of these best practices is the role of resources. How much should a firm
pay for another firm’s bundle of resources? How can the board of directors ensure that the
resource of the chief executive officer and other top managers and advisors are acting in the best
interest of the firm? What can managers do when certain human resources begin acting contrary
to what “rational” behavior would dictate? How can the firm adequately evaluate the target’s
organizational culture? How can managers ensure that they do not destroy the very value they
have purchased during the integration process?
22
This section explores the attributes of specific resources through the lens of valuation and
post-merger integration. We narrow our focus to horizontal acquisitions in which the acquiring
firm must integrate the resources and activities of the target. Following Barney (1991), we
define resources as “…all assets, capabilities, organizational processes, firm attributes,
information, knowledge, etc., controlled by a firm that enable the firm to conceive of and
implement strategies that improve its efficiency and effectiveness.” (Barney, 1991: 101.) Those
resource characteristics that make valuation and/or integration particularly treacherous are
summarized in Table 3.
- - - - - - - - - - - - - - - - - - Insert Table 3 about here - - - - - - - - - - - - - - - - - -
Broadly speaking, acquiring firms fail in their merger or acquisitions due to one or two
(or both) errors. First, the acquirer either overvalues the target – in which the hoped for
synergies simply cannot be attained – or it ineffectively integrates the target into its operation –
in which synergies that were theoretically available are not realized. We hypothesize that the
resource-based view of the firm can productively inform the problems of mergers and
acquisitions from both a valuation and integration perspective. With its emphasis on resource
rarity, value, heterogeneity and inimitability (Barney, 1991), the RBV has the potential to
facilitate understanding of the valuation and integration issues that arise in a merger or
acquisition.
In the resource-based view tradition, sustainable competitive advantage is achieved when
a firm is able to identify and leverage imperfections in factor markets when acquiring and
combining resources (Barney, 1986, 1988.) A necessary (but not sufficient) condition for
achieving this competitive advantage is the ability to acquire private and uniquely or inimitable
23
cash flows that are more valuable to it than to other firms, and that cannot be purchased in a
competitive market (Barney, 1986; Dierickx & Cool, 1989; Peteraf, 1993.)
Capron (1999) examined horizontal acquisitions from a resource-based perspective,
exploring how post-acquisition resource redeployment and asset divestiture influence acquisition
performance. In an extensive survey, she concluded that “…there is a significant risk of
damaging acquisition performance in the process of divesting and redeploying the target’s assets
and resources.” (Capron, 1999: 988.) We hypothesize that this result reflects a lack of thorough
understanding on the part of the acquirer as to the value creating mechanisms employed by the
target.
Valuation
As Penrose (1959) asked, “In the general case, that is to say, in the absence of special
individual circumstances, should we not expect the price of existing firms (i.e., their value to
themselves) to be, if anything, above their value to other firms?” (Penrose, 1959: 157.) Valuing
resource bundles can prove difficult in three broad ways: lack of information necessary to
accurately value the target firm; the potential uniqueness and inimitability of particular resource
bundles embedded in the target firm; and, ex post uncertainties about certain acquired resources.
Each of these qualities, when present, makes the identification and quantification of synergy
elusive. If the value of a target is a function of the synergy created for the combined firm, then
the presence of these broad characteristics makes that valuation highly difficult. As Penrose
(1959) observed, the decision propensity should lean towards caution rather than optimism. The
following discussion considers each characteristic in turn.
When valuing a target firm, the potential acquirer needs a wealth of information about the
target’s resources and their value creating capability. However, the absence of strategic factor
24
markets for many resource bundles (Barney, 1986) means that there is no competitive market
against which to check valuation. Combined with the second factor – information asymmetry
between seller and potential buyers (Barney, 1988) – leads to the necessity of making
uninformed assumptions, and relying on managerial discretion without the ability to objectively
check that judgment, during the valuation process. As Sirower (1997) points out, the
preponderance of evidence requires the assumption of failure that anticipated synergies will not
be realized. Tacit knowledge (Nelson & Winter, 1982) also presents difficulty in valuing target
resources.
The degree of difficulty presented by these factors is a function of the characteristics of
certain resource bundles. If, for example, the acquirer is purchasing a bundle of physical assets
in which the productive capacity can be (relatively) easily measured, then the absence of a
strategic factor market, information asymmetry and even tacit knowledge are weaknesses that are
(relatively) easily overcome. Other resource bundles, however, are more challenging to value.
Resource embeddedness (Nelson & Winter, 1982) – in which value creation capability is a
function of complex interactions with other resources of the target and/or acquirer – makes the
valuation process a function not only of a particular resource, but also of its reliance on, and
contribution to, the performance of other resources. We also hypothesize that synergy associated
with the creation of new capabilities is more difficult to estimate than that arising from the
addition and/or consolidation of existing capabilities (O’Shaughnessy & Flanagan, 1998.) In
addition, synergies arising from cost-reduction actions are considered more easily captured than
those related to revenue increases (Anand & Singh, 1997; Lubatkin, Avisnash, Schulze &
Cotterill, 1998.)
25
The ability of a firm to retain the resources it purchases is a function of the mobility of
those resources. When a significant degree of value is created with highly mobile assets (e.g.,
human capital), the risk of those resources exiting the combined organization increases. In
addition, resources acquired that have no role in the newly combined firm must be jettisoned, but
often there is a significant amount of uncertainty surrounding their disposal value, also hindering
the ability of the potential acquirer to accurately value the resource bundle.
The presence of one or more of these characteristics makes valuing a target’s resources
particularly enigmatic, jeopardizing the probability of the acquisition’s success. The greater the
presence of these attributes, the greater the risk that the potential acquirer will overvalue the
target (leading to overpayment, or the direct destruction of shareholder value) or undervalue it
(which, if the target will not sell, leads to an opportunity cost incurred by the potential acquirer
from not purchasing the target.) To minimize these risks, managerial attention should be focused
on the types of resource characteristics embodied in the target firm during the due diligence
process.
Proposition 1-A: In horizontal mergers and acquisitions, the absence of strategic factor
markets for the target’s resources bundles, the greater the degree of information
asymmetry, and the importance of tacit routines, the greater the probability that the
acquirer will overpay for the target.
Proposition 1-B: In horizontal mergers and acquisitions, the greater the degree to which
valuation is a function of embedded resources, the ability to create new capabilities, and
the objective of revenue increases, the greater the probability that the acquirer will
overpay for the target.
26
Proposition 1-C: In horizontal mergers and acquisitions, the greater the degree of
resource mobility and the greater the necessity to dispose of some of the target’s
resources, the greater the probability that the acquirer will overpay for the target.
Integration
Once a purchase decision has been made and agreed to, the resource-based view also
enables a focus on the required degree of integration as a function of the nature of the two firm’s
resource relationships. When merging similar resource bundles, value creation may be
considered through the lens of consolidation, making the integration process simpler. Here,
value is often a function of cost reductions, as excess resources are eliminated and economies of
scale and scope are secured. (A recent study by Capron (1999), however, suggests that even
cost-based synergies are more difficult to achieve than previously thought.) When acquiring
complementary resources, however, value creation typically occurs through resource
combination, seeking to enhance revenues and/or reduce costs. This category can be segmented
into two sub-parts: sequential resources (e.g., sales force, product line) require relatively less
integration versus resources employed at the same point in the value chain (e.g., product
development teams with complementary capabilities) requiring higher level of integration.
This focus on the degree of integration required reflects the hypothesis that certain types
of resources are more difficult to integrate than others. In general, as the degree of required
integration increases, so too does the complexity of the integration process (Jemison & Sitkin,
1986; Kitching, 1967; Pablo, 1994.) Capron (1999) showed that, “Overall, the acquirer is better
skilled at rationalizing its own resources than rationalizing and using the target’s assets and
resources.” (Capron, 1999: 1010.) When purchasing a bundle of resources that require a high
level of integration, therefore, attending to the nature of those resources can help identify
27
potential problems, where the risk of destroying the value purchased during the integration
process is relatively greater. Characteristics that raise the question, “How should these resources
be integrated to avoid destroying their value creating capabilities?” include a high degree of
resource embeddedness and tacit value creating mechanisms.
Acquired resources based on human interactions and/or human capabilities tend to
exhibit these characteristics. In addition, they present the risk of a high level of mobility and
potential exit. Embedded tacit routines (Nelson & Winter, 1982) employed by employees and
other stakeholders are particularly at risk for value destruction during the integration process.
Due to their embeddedness, value creation can be harmed through failing to understand and
preserve the linkages across resources. Tacit routines are, by definition, inexpressible (Nelson &
Winter, 1982), creating a substantial risk of misunderstanding the very value creating
mechanisms that the firm sought to acquire.
We hypothesize that firms sometimes fail to understand the nuances of these resource
characteristics, and thereby actually destroy value during the integration process rather than
simply failing to secure the intended value. When engaging in a merger that requires a
significant level of resource integration for value realization, and which exhibit embeddedness,
tacit value creating routines, and a reliance on human interactions and capabilities, attention
should be focused on the avoidance of destroying the value creating mechanisms, developing a
thorough understanding of those mechanisms in the target, early planning (Haspeslagh &
Jemison, 1991), flexibility (Haspeslagh & Jemison, 1991), risk reduction, and careful
management of conflicts (Buono & Bowditch, 1989.) Capron (1999) supports this hypothesis
through demonstrating that the divestiture of the target’s resources does not reduce costs and
damages capabilities.
28
By being consciously aware of these resource characteristics, and the difficulties
encountered when integrating them, firms may be able to better preserve and leverage the value
creating mechanisms of the acquired firm. While other factors may lead to integration problems
as reviewed above, scholars have not yet studied the link between pre-merger routines, value
creation and the preservation or disruption of those routines in a merger or acquisition. Perhaps
the synergy paradox could be clarified by this focus on resources.
Proposition 2-A: In horizontal mergers and acquisitions involving the integration of
complementary resource bundles, the greater the degree of embedded, tacit value creating
mechanisms in the target, the greater the risk that the acquirer will fail to secure the
anticipated synergy gains.
Proposition 2-B: In horizontal mergers and acquisitions involving the integration of
complementary resource bundles, the greater the degree of reliance on human interactions
and/or human capabilities for value creation, the greater the risk that the acquirer will fail
to secure the anticipated synergy gains.
CONCLUSION
Empirical tests have not yet examined the driver of horizontal merger failures: Are they
typically driven by overpayment or by integration problems? An analysis of those transactions
in which the failure is in the valuation process should examine the prevalence of particular
resource characteristics to determine if some types of resource bundles lead to overvaluation
more often than others. When a fair value was paid for the target firm, what role did a failure to
understand and accommodate the embedded, tacit and human routines play in the inability of the
acquirer to secure the value it purchased? The concepts outlined herein can be empirically
tested, although operationalization of some of the variables may prove challenging. We suggest
29
that an emphasis on the degree of the resource characteristic – rather than on its presence – could
prove useful.
Depending on the empirical results, possible management prescriptions include:
Acquirers who are targeting firms that exhibit a relatively low degree of enigmatic resource
characteristics in both valuation and integration (i.e., valuation and integration are relatively
easy) should gain comfort that the transaction’s probability of success is relatively high. An
emphasis on due diligence should be employed when the target resources are difficult to value.
Characteristics that present difficulties in the integration process should be managed with
caution. Finally, targets that embody difficulties in both valuation and integration should be
avoided.
- - - - - - - - - - - - - - - - - - Insert Figure 1 about here - - - - - - - - - - - - - - - - - -
30
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36
TABLE 1 Methodologies for Measuring M&A Success
Dimension Event Study
Accounting Measurements
Case Study
Survey Based
Basic Approach
Capital Asset Pricing Model used to calculate “abnormal returns” shortly after merger announcement
Return on equity, return on sales, return on assets over a multi-year period used to measure improvements in financial performance
In-depth analysis of a few acquisitive firms to determine if merger objectives were met
Managers involved in M&A are asked to rate the success of the merger
Strengths
Efficient market hypothesis; unbiased rational expectations of future cash flows; extraneous factors eliminated; data publicly available
Permits a multi-year perspective reflecting belief that it may take years before merger benefits are realized; data publicly available
A more robust and fine-grained understanding of the drivers of m&a success or failure
Recognizes the complexity and multi-dimensional nature of measuring m&a success
Weaknesses
Assumption that market participants are able to quickly and accurately calculate cash flow impact of the merger
Reflects the past, not the future; no adjustment for changing risk profiles; factors other than the m&a may be driving the numbers
Small sample size; inability to generalize to other situations; possible researcher bias
Self-reporting biases
Conclusions
At best a 50/50 bet for acquiring firm shareholders; mixed results on related vs. unrelated performance; m&a theory not empirically supported
Same as “Event Study”
The due diligence process, price paid and management of integration all must be deftly managed to ensure m&a success
Recommendations Beware of overpaying
Be prepared to “walk away”; be clear on sources of synergy; manage the integration process
Retain top management team of the acquired firm, regardless of whether it is a related or conglomerate merger
37
TABLE 2 Schools of M&A Success
School Key Authors Central Propositions Recommendations
Sirower (1997) Price does not equal value (i.e. the market for corporate control is not efficient); probable loss is equal to the amount of premium paid
Use a high discount rate when valuing future synergies to reflect risk of capture; presume failure Overpayment
Haspeslagh & Jemison (1991)
Escalating commitment and complexity, speed and secrecy of due diligence process can lead to overpayment Be highly aware of the potential pitfalls. Think.
Kesner & Shapiro (1994)
Acquiring firm’s investment bankers have an incentive to negotiate the highest possible price
Restructure typical contract so that bankers’ fees are not a function of the size of the deal
Lubatkin (1984); Schmidt & Fowler (1990)
Because CEO compensation tends to increase with the size of the firm, CEOs may engage in m&a to increase their own compensation
The board should seriously consider if this motive is driving the m&a recommendation Agency
Problems
Kroll, et al (1998)
Firms managed by substantial owners will generate positive returns from m&a; those managed by non-owners will experience negative returns
Boards of firms managed by non-owners should beware.
Hubris
Roll (1986); Hayward & Hambrick (1997)
Hubris, or exaggerated self-confidence in one’s management capability and/or ability to generate and capture synergies, may lead to poor purchase decisions
Shareholders of acquiring firms should be highly concerned with the degree of board vigilance when making acquisition decisions
Shanley & Correa (1992)
If top management of both the acquiring and acquired firms perceives agreement vis-à-vis merger goals, and in fact do agree, then post-acquisition performance will improve via healthy cooperation
Pay attention to the dynamics of the top management teams during due diligence and during integration Top
Management Complemen-tarity
Walsh (1988); Cannella & Hambrick (1993)
Top management turnover will be higher in firms that have merged than in firms that have not; retention of top management of the acquired firm is critical to the m&a success, even in unrelated mergers
Carefully manage these relationships to minimize any conflict and flight
Experience
Haleblian & Finkelstein (1999); Kusewitt (1985)
Experience with acquisitions improves management’s ability to productively integrate two firms Learn from your experience
38
TABLE 2 (Continued) Schools of M&A Success
School Key Authors Central Proposition Recommendations
Buono & Bowditch (1989)
Employees have the power to make the merger more or less successful; because a merger represents a major life event for employees, if handled poorly from the employee perspective, hidden costs may go up
Manage the merger process in an open, honest and participative way; focus on the employee distress level to achieve a healthy and strong new entity Employee
Distress Haspeslagh & Jemison (1991)
Merger success can be heightened in a cooperative environment, but must overcome barriers such as fears about job security, loss of power and resources, changes in reward systems, fear of the unknown
Recognize that these human emotions are at play, manage them effectively
Conflicting Cultures
Nahavandi & Malekzadeh (1988); Cartwright & Cooper (1992); Forstmann (1998) Chatterjee et al (1992)
Cultural differences between acquired and acquiring firms have the potential to thwart the effective integration of the two firms, and hence the achievement of merger goals
Asses cultural fit before agreeing to merge if possible; be highly sensitive to how cultural differences may affect the achievement of merger goals; actively manage the process of acculturation; base the integration plan on an understanding of cultural differences
Process Haspeslagh & Jemison (1991)
The key to merger success is to create an atmosphere in which the transfer of strategic capabilities can occur
Ensure reciprocal organizational learning; push cause-effect understanding of benefits down to the middle management level; clearly identify the resources and capabilities to be transferred; develop cooperation and trust
39
TABLE 3 Enigmatic Resource Characteristics
Valuation Integration Difficulties valuing target resources:
- No strategic factor market - Information asymmetry - Tacitness
Difficulties valuing resource combinations: - Embeddedness - New capability creation - New revenue creation
Ex post uncertainties about acquired resources: - Resource mobility - Disposal value of undesired resources
Uncertainties regarding integration process:
- Embeddedness - Tacit value creating mechanisms
Resource value based on human interactions and/or human capabilities:
- Difficulties in transferring resources (e.g., stakeholder relationships)
- High level of mobility and risk of exit
40
FIGURE 1 The Role of Resources in Valuation and Integration
Ease of Valuation High Low
High
Ease of Integration
Low
Buy it! Extreme focus on
due diligence
Proceed with
caution Walk away!