12.2 — The Reasons for Growth by Acquisition or Merger

Specific Reasons for Merger / Acquisition

The following reasons have been suggested as to why entities merge or acquire.

In a market with limited product differentiation, price may be the main competitive weapon. In such a case, large market share may enable an entity to drive prices—for example, reducing prices in the short term to eliminate competition before increasing prices later.

Economies of Scale

These result when expansion of the scale of productive capacity of an entity (or industry) causes total production costs to increase less than proportionately with output. It is clear that a merger which resulted in horizontal or vertical integration could give such economies since, at the very least, duplication would be avoided. But how could a conglomerate merger give economies? Possibly through central facilities such as offices, accounting departments and computer departments being rationalised. (Indeed, both sets of management are unlikely to be needed in their entirety.)

Combining Complementary Needs

Many small entities have a unique product but lack the engineering and sales organisations necessary to produce and market it on a large scale. A natural course of action would be to merge with a larger entity. Both entities gain something—the small entity gets 'instant' engineering and marketing departments, and the large entity gains the revenue and other benefits which a unique product can bring. Also if, as is likely, the resources which each entity requires are complementary, the merger may well produce further opportunities that neither would see in isolation.

Improving Efficiency

A classic takeover target would be an entity operating in a potentially lucrative market but which, owing to poor management or inefficient operations, does not fully exploit its opportunities. Of course, being taken over would not be the only way of improving such a poor performer, but such an entity's managers may be unwilling to give themselves the sack.

A Lack of Profitable Investment Opportunities – Surplus Cash

An entity may be generating a substantial volume of cash, but sees few profitable investment opportunities. If it does not wish to simply pay out the surplus cash as dividends (because of its long-term dividend policy, perhaps), it could use it to acquire other entities. A reason for doing so is that entities with excess cash are usually regarded as ideal targets for acquisition—a case of buy or be bought.

Tax Relief

An entity may be unable to claim tax relief because it does not generate sufficient profits. It may therefore wish to merge with another entity which does generate such profits.

Reduced Competition

It is often one benefit of merger activity—provided that it does not fall foul of the competition authorities.

Asset-Stripping

A predator acquires a target and sells the easily separable assets, perhaps closing down or disposing of some of its operations.

The Following Reasons Are of Questionable Validity

Diversification, to Reduce Risk

While acquiring an entity in a different line of activity may diversify away risk for the entities involved, this is surely irrelevant to the shareholders. They could have performed exactly the same diversification simply by holding shares in both entities. The only real diversification produced is in the risk attaching to the managers' and employees' jobs, and this is likely to make them more complacent than before—to the detriment of shareholders' future returns.

Shares of the Target Entity Are Undervalued

This may well be the case, although it would conflict with the efficient markets theory. However, the shareholders of the entity planning the takeover would derive as much benefit (at a lower administrative cost) from buying such undervalued shares themselves. This also assumes that the acquirer entity's management are better at valuing shares than professional investors in the marketplace.

Relevant IFRS / IAS Standards

The following standards from Module 14 — IFRS and IAS apply directly to the reasons and motivations covered in this section.

Standard	Why Relevant to This Section
IFRS 3 — Business Combinations	All the reasons discussed ultimately lead to a transaction accounted for under IFRS 3 — synergies are reflected in goodwill; efficiency gains must survive the impairment test
IAS 12 — Income Taxes	Directly relevant to the Tax Relief motivation — recognition of deferred tax assets on unused tax losses requires probability of sufficient future taxable profits
IFRS 5 — Non-current Assets Held for Sale	Directly relevant to Asset-Stripping — assets acquired with the intention to sell must be classified as held for sale and measured at the lower of carrying amount and fair value less costs to sell
IAS 36 — Impairment of Assets	When efficiency gains or synergies do not materialise, the goodwill allocated to the CGU fails the impairment test — this is the accounting consequence of a failed acquisition rationale
IAS 37 — Provisions, Contingent Liabilities and Contingent Assets	Reduced Competition as an intended benefit creates regulatory risk — provisions may be required for competition authority fines, remedies, or mandated disposals
IAS 7 — Statement of Cash Flows	The Surplus Cash motivation is directly visible in the cash flow statement; strong operating cash flows with limited investing opportunities is the financial signal that drives this rationale
IFRS 13 — Fair Value Measurement	Relevant to the Undervalued Shares rationale — fair value measurement principles (Levels 1, 2, 3) define what "undervalued" means relative to a market participant's price