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By | Tim Worstall 11th January 2013 11:02

Why mergers LOSE money, but are GOOD for the economy

Takeovers never deliver... and disties are no different

So the distribution sector has had yet another round of consolidation. Mergers, takeovers - these are the things that make an M&A banker's heart* thumpety-thump with joy.

The big question, though, is whether this actually does any good for the shareholders of the various companies - you know, the people who actually own them? The usual answer from the economist is, 'No, not really, at least not very often'.

It doesn't really matter, for our purposes here, who has been buying whom or why. In fact, given the reasoning I'm going to use, it's probably better that we don't run down the list. It's also true that the analysis isn't specific to the distribution channel: as a general rule economists are convinced that the average merger or takeover reduces value, not adds to it. And the people who usually lose the most are the shareholders of the acquiring company.

On the other side the beancounters are also convinced that such mergers and takeovers are, in one sense at least, absolutely vital for the continuing functioning of the economy. So we've got a bit of a bind here: something that's usually value-reducing but also something vital.

The path through this contrariness comes in four parts.

1: Sometimes, it just makes sense

The first is the traditional justification for a takeover. We see something in that other company over there that no one else does. We can get that hidden gem very cheap, before anyone else realises.

This does actually happen at times. But it's rare: at least economists think it's rare. For the general assumption is that no one's all that clever and everyone else is all that stupid. Things tend to get valued at around and about what everyone thinks they're worth, and that tends to be close to the realistic level of profits that can be made out of it in the future: or at least closely related to it.

There are exceptions: say your new product needs vast quantities of unobtanium and you're able to buy the world's unobtanium mine before anyone knows that. OK, that would work. But that isn't where we think that most takeovers germinate. That's rather more something to do with the principal/agent problem.

2: Extra cash for CEO, or profit for the shareholders?

This is one of the thorny problems in economics that doesn't really have a solution. There's the people that actually own something, the principals (it has wider application than this but let's stay simple), and then there are the agents they hire to run it for them - for example, the shareholders and the management. And the interests of these two groups diverge to some extent. Managers would like huge salaries and job security, while shareholders would like a rise in profits. These aren't the same thing - for example, it's entirely possible for managers to reduce profits by awarding themselves huge pay rises. This is just an example but the basic problem, the divergence of interests, can be acute.

One of the ways of getting a huge salary is to be running a huge firm. Everyone knows that the top banana at a firm of 100,000 people deserves to go first class through life with millions in winga each year. But the bloke running a profitable company of only 5,000 people doesn't get to turn left on entering the plane. Nor is he feted nationally or fawned over by reporters. Which is one of the things that economists think drives merger mania.

It might be a conscious effort (if I buy lots of companies then I'll earn the dosh) or it might be an unconscious willingness to overlook the risks (it really is a good deal, honest) but many economists postulate that at least some of the temptation for management to expand by acquisition is this very status and income motivation. The problem is, as we've seen above, that the same economists are also convinced that most such acquisitions do not benefit the shareholders of the acquiring company. Far from it in fact. So much so that the standard action on hearing of a stock market takeover is to buy the shares of the company to be bought and sell those of that which is buying it. The former will rise, the latter fall - purely as a result of the offer.

It's that principal/agent problem. Or here, what makes the management rich may well not make the shareholders rich but it's the agents who have most of the say over what happens.

The third line of reasoning for an acquisition is an adaptation of this aforementioned problem. There really are times when it's better for the shareholders that a company just dies.

Not immediately of course: but over time.

3: Reinventing the wheel

Imagine a company that is making shedloads of money, but the business isn't really going anywhere. Give it 15 years and we're pretty sure that not only will there not be any profits, there won't be a company anymore. The market niche pumping out those vast rivers of profit will just have vanished. Think about - oooh, I dunno - a buggy whipmaker in 1910. Or the near-monopoly producer of desktop operating systems and productivity suites in 2012.

There are two things that could be done. One is to frantically thrash around trying to find some new business to replace the old... Go into making leather seats for the newfangled cars, for example. Try buying a VOIP phone company. Or snap up a search engine.

It's possible that these new adventures will boost the shareholders' long-term income. But that's not the way that the economists usually bet. The management of the firm doesn't have anything special to add in these new areas. The shareholders themselves are just as capable, in fact probably more so, at picking the new winners if they just had their profits returned to them to invest themselves.

There's an argument that the current opportunity should just be sweated for the cash it can make and damn the "future new lines of business". There's nothing special about the existence of a particular company, so suck out the money, send it back to the owners and let them do as they wish. But this particular line of thinking isn't, of course, what the management of the company wants to hear. And they most certainly hate doing it - even if they ought to.

Here's an interesting thought experiment. Do you think that Microsoft shareholders would have been (or even will be) better served by the company just sweating out the remaining years of the Windows/Office franchise? Or do you think the firm did well to buy Skype, build Bing, create Surface and Windows Phone and all the other new products? Given the vast amounts of cash thrown off by that franchise, it's not even a close call. Continue to develop them, yes, but send all the rest of the profits back out as dividends is the obvious winner, I would have thought.

4: Ultimately, it's good for the economy

The final one of the four is the vital part that takeovers play in the clean up of the economy's failures. Take a company that goes bust. The whole point of bankruptcy proceedings is to make sure that its assets aren't then left, orphaned, or chained to an unpayable debt. The idea is to get them off into someone else's hands where they might be put to good use. This is true of contracts, or the workforce, of the land and any other asset. It might be that the machinery is worth most as scrap. Or the factory is worth most as a supermarket. Or it could be that the OS coders and their desks would be best put to writing games: but under different management.

And it's this last part of the whole system that our economists think is the most important. When failure happens, the vital thing is to clean up the mess and quickly. Don't leave potentially useful assets orphaned but auction them off and get them working again. The price that is realised doesn't matter very much at all: from the view of the entire economy, getting people and assets back to work pronto is the vital part. So important is this that we're urged to overlook all of the above problems with takeovers and mergers to allow this part of it to function as efficiently as possible.

Yes, most takeovers lose money for the shareholders of the company doing the buying. This is often because the interests of the management diverge from those of those owners. Similarly, many companies are kept running longer than they should be for those selfish management reasons. But we put up with all of that (although try to constrain it) so that the scavenging upon the assets of the bankrupt can be as efficient as possible. For this is the very heart of the success of capitalism: Not how the successful make profits, but how the system deals quickly and cleanly with failure.

As to which of these various models best describes the current activity in the distribution channel: well, we've all our own thoughts and none of us are going to publish them without consulting m'learned friends. Or at least I'm not.... ®

*Well, we assume, being humanoid at least, that they have them.

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