Mergers and Acquisitions: Basic Terminology

In order to grow and/or achieve adequate diversifications, companies often take the route of mergers and acquisitions. An acquisition is when a portion of a company, or the company in its entirety, is purchased by another company.

If the latter is the case, the acquisition of the entire company is also referred to as a merger or the complete amalgamation of one company by another. In most cases, mergers occur when two smaller companies combine their assets and liabilities to form a bigger company.

Mergers can also be defined as takeovers, although a takeover usually implies a hostile transaction. In contrast, in a friendly transaction (takeover), management of both companies usually agrees on the merger and encourages its approval with their respective stakeholders.

Statutory Mergers

When one company ceases to exist as a legal entity and merges all of its assets and liabilities into the purchasing company, this type of a merger is called a statutory merger. There are two types of statutory mergers:

  • a subsidiary merger; and,
  • a consolidation.

In a subsidiary merger, the purchased company (target company or simply target), becomes a subsidiary of the acquiring company (or acquirer). The reason why is often that the target company owns a popular brand and renaming it could potentially cause customer alienation.

In a consolidation, both merging entities cease to exist as former legal entities and agree to form a completely new legal entity. This type of statutory merger occurs when two companies are approximately similar in size and operations.

Horizontal Mergers

In a horizontal merger, the two merging entities operate in the same kind of market, typically as competitors. One of the main reasons why companies pursue horizontal mergers is to achieve economies of scale, which is achieving larger combined operations through consolidation of operations, resources, and trimming of the excess “fat.” As a by-product, with two former competitors now operating as one, higher market presence is also achieved by having one less competitor to worry about and by becoming a larger entity that cannot be easily “pushed around” by other players.

Vertical Mergers

In a vertical merger, the two companies merge along the production process. For example, the acquirer could be a supplier targeting a distributor. Through this type of merger, aside from cost savings, a newly formed entity achieves greater control of the production and distribution.

If an acquirer buys a target company ahead of it in the production chain (e.g. a jewelry manufacturer buying a precious metals mining company), this type of vertical merger is called backward integration. Alternatively, when the acquirer buys a company that is down from it on the production chain (e.g. an iron ore mining company buying a steel manufacturer), this is called a forward integration.

Conglomerate Mergers

Conglomerate mergers occur when the two merging entities’ core businesses are unrelated to each other. For example, General Electric transformed itself into a conglomerate after purchasing numerous companies operating in a wide spectrum of industries, from home appliances, finance, aircraft parts, media, and medical equipment.

Conglomerate corporate structure was very popular during the 1960s to 1980s. The rationale was diversification across both cyclical and non-cyclical industries in an effort to offset potential cash flow volatilities.

At this point, it would be useful to review a short history of mergers in the U.S., which can be read about in the next article in the series.

History of Mergers in the U.S.: Blueprint of the M&A Activity Since the Early 20th Century

Through each wave, mergers and acquisitions varied, usually depending on how much and in what manner the regulatory landscape had changed. The same could be said about the types of industries most heavily involved in each of the waves. Usually, the majority of the M&A activity clustered in a relatively small number of industries as they went through dramatic transformations, such as industry deregulation or technological evolution.

Starting with the Reign of Horizontal Mergers (1897 to 1904)

As the 19th century came to a close, regional markets experienced greater growth rates, mostly due to railroads. With more and more railroads weaving a complex web all over the country, many companies managed to capitalize on the fast-emerging U.S. economy. Operating within a rather lax regulatory environment, many horizontal mergers contributed to the creation of almost monopolistic-type markets in a number of industries. By 1904, the U.S. Supreme Court brought the first wave to a halt with its landmark decision that significantly limited this type of mergers.

Vertical Mergers Take Over (1916 – 1929)

By the time the 1920s arrived, cars, radios and vastly improved transportation infrastructure further advanced the U.S. economy. The second wave of mergers and acquisitions, much like the first wave, was marked by sharply rising stock prices.

However, the regulatory landscape was not exactly favorable towards horizontal mergers and the resulting creation of huge companies that would often monopolize their market segments. Instead, vertical mergers became increasingly popular, as many companies sought to integrate forward or backward along the production chain, which, in turn, led to the creation of oligopolies.

Note that this wave of mergers came to a screeching halt with the devastating stock market crash of 1929.

Conglomerates Rise from the Ashes (1965 – 1969)

By the time capital markets recovered from the 1929 crash, the regulatory environment was vehemently opposed to both horizontal and vertical mergers because both types were perceived as an obstacle to healthy competition with any industry.

Companies that wanted to achieve higher growth rates had to look outside their own market segments, which is how conglomerates stepped onto the scene. Truth be told, many of the conglomerates formed during this period eventually ended up underperforming the market. And their reign effectively ended in 1969 when antitrust laws took a sharper turn, “curbing the enthusiasm” of the conglomerates in the process.

All Mergers Are Back in Vogue, Including Hostile Takeovers (1981 – 1989)

In the 1980s, all types of mergers were much more favorably accepted than was the case two decades earlier. It was a combination of factors, including decreasing interest rates and increasing stock prices, both of which contributed to the popularity of leveraged buyouts. Although hostile takeovers were not exactly a novelty, tapping into the high-yield bond market enabled many takeovers that would not have happened otherwise.

This period was also marked by sophisticated takeover strategies, including corporate raid and its variants, such as greenmailing. A corporate raid is a term used to define a certain type of hostile takeovers, whereby the acquirer immediately sells all of the assets of the target company, essentially dissolving the target.

Greenmailing also involves asset selloffs of a target company, only instead of actually going for it, the acquirer promises to withdraw the takeover offer, provided the target buys back the already purchased assets at usually a stiff premium. Either way, shareholders of takeover companies usually ended up shortchanged.

The Long-Running Bull Market Boosts Merger Activity (1992 – 2001)

After the early 1990s recession, mergers and acquisitions intensified yet again. Many companies enjoyed high market valuations, enabling them to engage in takeovers and to pay for them with their equity. In addition, the regulatory landscape became more open to consolidations and foreigners gaining access to North American capital markets via takeovers. Industries such as banking, healthcare, defense and telecom were among the particularly active ones. Note that the fifth wave ended with another crash; that of the tech bubble in 2001.

The Bigger the Better (2003 – Present)

A more pronounced M&A activity returned in 2003, with a bounty of new deals coming to the table. It appears we are currently in the midst of the sixth wave, which is marked by high transaction volumes, more consolidations, and the creation of large companies that are much better equipped to deal with the cutthroat global competition.