Working Papers

No. 4: The Economic Impact of Mergers and Acquisitions on Corporations

Prepared by Gilles McDougall, Micro-Economic Policy Analysis, Industry Canada, February 1995

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Summary

While interest in mergers and acquisitions is not new, it has intensified recently as a result of a plethora of mergers and acquisitions in the 1980s. The importance of takeovers by foreign interests also increased in relative importance during that period. Several studies were conducted at that time to shed light on the motives for these transactions and to determine the consequences by evaluating the costs and benefits for both the corporations and the countries in which they were located. In the current climate of globalization, it is not surprising that interest in the mergers and acquisitions phenomenon has remained high.

The studies evaluating the profitability of corporations which were the objects of mergers or acquisitions have been using two different approaches:

The financial approach examines trends in the share prices of corporations involved in mergers or acquisitions and compares them to a reference group of corporations. Corporate performance is considered to have improved if the returns to shareholders are greater after the acquisition or merger. The results obtained using this approach, largely in the United States but also in Canada, show that corporate takeovers generally have favourable consequences for shareholders. Stock markets seem to take a positive view of announcements that corporations will be merged or taken over.

The industrial organization approach examines certain financial or economic performance variables of corporations before and after they have been taken over. Trends in these variables, as compared to a reference group, provide an indication of the net effect of the acquisition on profitability rates.

This study adopts the second approach. As part of Industry Canada's larger research program into the overall micro-economic adjustment process of corporations, this paper hopes to analyze the impact of mergers and acquisitions on corporate decisions and corporate performance.

The data used in this research was constructed by Statistics Canada for the specific purpose of the study. It is based on a list of firms that were the objects of merger or acquisition between mid-1985 and end of 1987. The observations are those takeovers that had to be approved under the Investment Canada Act. Because the Act establishes a minimum threshold on the value of the transaction to be reviewed, the firms included in the sample are of a large size. They are also, by definition, firms that become foreign-controlled after the transaction.

The usual statistical techniques were used to disentangle the impact of the takeover on the performance of the continuing firm.

Some of the important findings of the research are:

• Corporations that have been taken over by foreign interests increase their capital investment and their R&D spending.
• However, short-term profitability is not positively affected by foreign takeovers. In fact, the profit to sales ratio declines sharply immediately after takeovers by foreigners. The profit to equity ratio behaves in the same way.
• High levels of R&D spending seem to be associated with high profitability. In other words, a high level of investment in the production and use of new technologies is causing the profitability of firms to increase.
• Firms appear to undertake capital investment in tandem with R&D spending, implying complementarity between the two inputs in the production process.
• There exist economies of scale in the R&D activity sphere. This means that as the firm is growing in size, the relative amount of R&D spending it needs to do declines.
• The behaviour of corporations taken over by foreign interests differs significantly from corporations taken over by Canadian interests. The latter seems to show an increase in short-term profitability and, at best, no change in investment in physical capital or research and development.

These findings imply an interesting adjustment process to a foreign takeover. Immediately after the change of ownership, corporations seem to take a longer-term perspective and invest in R&D, or physical capital. To do this, they are prepared to accept a short-term reduction in profitability.

This research shows, in our view, the importance of analyzing the longer-term consequences of mergers and acquisitions. The relatively poor profitability of the target firm in the first few months and years after the transaction apparently reflects a period of adjustment during which the two different work cultures get to know each other and learn how to co-operate. In addition, corporations that invest in acquisitions have to take the time to recognize and use, in a profitable way, all aspects of the assets they have acquired.

Corporate assets are becoming increasingly intangible. This means that assets are increasingly composed of ideas, knowledge and know-how that cannot be easily codified. There may be embodied in a piece of equipment, or in the people within the firm. The internalization and technological competence theories suggest that acquiring these intangible assets is an important motive in making acquisitions. To profit fully from these intangible assets, corporations need time and complementary investments in physical capital and research and development. The findings of our research suggest that these two theories might lead to a correct interpretation of the motives for mergers and acquisitions activities.

Working Papers