Thus the existence of bidder and target relatedness, per se, is not a source of superior returns to the shareholders of bidding firms. However, if a market for corporate control is imperfectly competitive, then bidding firms may be able to obtain a superior return for shareholders from imple- menting merger and acquisition strategies. Three ways that these markets can be imperfectly competitive—including (a) when private and uniquely valuable cash flows exist between a bidder and target, (b) when inim- itable and uniquely valuable cash flows exist between a bidder and target, and (c ) when unexpected synergistic cash flows exist between a bidder and target—are examined below. The first two of these cash flows reflect valuable, rare and private and valuable, rare, and costly to imitate resources controlled by bidding firms.
1. PRIVATE AND UNIQUELY VALUABLE SYNERGISTIC CASH FLOWS
One way such an imperfectly competitive market could exist is when a tar- get is worth more to one bidder than it is to any other bidders—and when no other firms, including bidders and targets, are aware of this additional value. The price of a target will rise to reflect public expectations about the value of a target. Once acquired, however, the performance of this special bidder will be greater than expected, and this will generate superior returns for its shareholders.
Consider, for example, the simplest case where the combined cash flow between bidder A and target firms has an NPV of $12,000, whereas the combined cash flows of all other bidders and targets have an NPV of $10,000. Suppose also that, while no other firms are aware of A’s unique status, they are aware of the value of the cash flow of all other bidders combined with targets (i.e. $10,000). If the current cash flow of all bid- ders has an NPV of $5,000, then firm A will obtain a superior return from acquiring a target if it pays less than $7,000 (P = $12,000 − $5,000), while all other bidders will obtain a superior return from acquiring a target if they pay less than $5,000 (P = $10,000 − $5,000). All publicly available information in this market suggests that a target is worth $5,000. Thus, the price of targets will rise to this level, ensuring that if bidding firms, besides firm A, acquire a target, they will not obtain superior returns.
If there is only one target in this market for corporate control, then firm A will be able to bid $5,000 + ε, that is, just slightly more than any other bidder, to obtain the target. At this level, firm A obtains a superior return of ($7,000 − ($5,000 + ε)), that is, the added value of the combined cash flow minus the price of obtaining that additional cash flow. No other firm will bid higher than firm A because, from these firms’ point of view, the acqui- sition is simply not worth more than $5,000. If there are several targets in this market for corporate control, then firm A, along with several other bidding firms, will all pay $5,000 for a target. While all other successful bidding firms will not obtain superior returns from their bidding activities, firm A will obtain a $2,000 economic profit.
For firm A to obtain this return, the existence of its uniquely valuable synergistic cash flows with targets cannot be known by other firms, both bidders and targets. If other bidding firms know about this additional value associated with acquiring a target, they are likely to try to dupli- cate this value for themselves. Typically, this would be accomplished by other firms duplicating the type of relatedness that exists between A and targets by acquiring the resources and capabilities that create technical economies, pecuniary economies, diversification economies, or some com- bination of these types of relatedness between A and targets. Once other bidders acquired the resources and capabilities necessary to obtain this more valuable combined cash flow with targets, they would be able to enter into bidding, thereby increasing the likelihood that the shareholders of successful bidding firms would earn zero economic profits.
The acquisition of these resources and capabilities would not even have to be completed before bidding began, because bidding firms can anticipate that they will be able to acquire them at some point in the future, and thus the NPV of the expected combined cash flow with a target for these bidders is the same as for A (Barney 1986a). In this setting the price of an acquisition will rise to the point where k = 0. Firm A is shielded from this perfect competition if other bidding firms are unaware of the higher synergistic cash flow available to A and the sources of this higher synergistic cash flow (Lippman and Rumelt 1982).
Target firms must also be unaware of A’s uniquely valuable synergistic cash flow for A to obtain superior returns from a merger or acquisi- tion. If target firms are aware of this cash flow and its sources, they can inform other bidding firms. These bidding firms could then adjust their bids to reflect this higher value, and the competitive dynamics discussed previously would reduce superior returns obtained by bidders to a fully competitive level. Target firms are likely to inform bidding firms in this way because increasing the number of bidders with a more valuable combined cash flow increases the likelihood that target firms will extract all the eco- nomic value created in a merger or acquisition (Jensen and Ruback 1983; Turk 1987). Although there may be many different managerial motives behind target firms seeking out ‘white knights’ as alternative merger part- ners after an acquisition attempt has been made, the effect of such actions is to increase the number of fully informed bidders for a target. This, in turn, reduces the superior returns that successful bidding firms obtain.
Table 10.1. NPV of synergistic cash flows and NPV of four idiosyncratic bidding firms ($)
Thus far, it has been assumed that only one firm had a more valuable combined cash flow with targets (in the example, worth $12,000). How- ever, the argument also applies to the more complex case when several firms have combined cash flows with targets greater than what is publicly known. As long as the number of targets is greater than or equal to the number of firms with these more valuable combined cash flows, each of these bidding firms can complete an acquisition, and each can earn varying amounts of superior returns (depending on the value of each of these bidding firm’s combined cash flows) for their shareholders.
The impact of private and uniquely valuable synergistic cash flows on superior returns for shareholders of bidding firms even holds when differ- ent bidding firms all have different independent cash flows, and when they all have different combined cash flows with targets, that is, where each firm acting in a market for corporate control is unique. Consider the example outlined in Table 10.1. The NPV of the cash flows of firms A, B, C, and D in this table vary from $5,000 to $2,000, and the NPV of the combined cash flows with targets range from $12,000 to $9,000. From equation (10.2) it is clear that firm A must pay less than $9,000 for a target to obtain superior returns, firm B less than $6,000, firm C less than $7,000, and firm D less than $7,000.
If information is publicly available suggesting that firms with the right resources and capabilities can obtain an incremental growth in cash flow worth $7,000 from acquiring a target, then several things are likely to occur. First, firm B is likely to add to its resources and capabilities those attributes that allow firms C and D to obtain a $7,000 NPV increase from acquiring a target. Next, the price of a target is likely to rise to $7,000. If there are sev- eral target firms available, all the firms in Table 10.1 will be able to acquire a target, but only firm A will make a superior return (equal to $2,000). If only one target is available, only firm A will complete the acquisition or merger, and its abnormal return, though still positive, will be slightly smaller ($2,000 − ε). If there are not enough targets for all bidding firms, then which firms (B, C, or D) will complete an acquisition is indeterminate, although whichever of these firms does will not obtain a superior return. In this case, as well, firm A will complete an acquisition and still earn a superior return for its shareholders equal, in total, to $2,000 − ε.
Adding a fifth firm (firm E) that is identical to firm A in Table 10.1 highlights the requirement that the number of firms with a more valuable synergy with targets must be less than or equal to the number of targets in order for these bidding firms to obtain superior returns. If there are two or more targets, then both firms A and E can execute an acquisition for such returns. However, if there is only one target, then firms A and E are likely to engage in competitive bidding, perhaps driving the price of this target up to the point where k = 0 (i.e. to $9,000) and in this process shifting superior returns from their shareholders to the shareholders of acquired firms.
2. INIMITABLE AND UNIQUELY VALUABLE SYNERGISTIC CASH FLOWS
The existence of a firm with private and uniquely valuable synergistic cash flows with targets is not the only way that a market for corporate control can be imperfectly competitive. If other bidders cannot duplicate the uniquely valuable combined cash flow of one bidder and targets, then competition in this market for corporate control will be imperfect, and the shareholders of this unique bidding firm will earn superior returns. In this case the existence of uniquely valuable combined cash flows does not need to be private, for other bidding firms cannot duplicate these cash flows, and thus bids that substantially reduce returns to the shareholders of this special bidding firm are not forthcoming.
Typically, other bidding firms will be unable to duplicate the uniquely valuable combined cash flow of one bidder and targets when the relat- edness between this bidder and targets stems from some nonimitable resources or capabilities controlled by this bidding firm. Such resources and capabilities tend to be path dependent, causally ambiguous, socially complex, or have other attributes that increase the cost of their imitation identified in the resource-based literature (Dierickx and Cool 1989; Barney 1991a). Barney (1986b) has given several examples of inimitable resources and capabilities, including a firm’s culture, its unique history, its product reputation, etc. If any of these resources and capabilities are rare and, when combined with a target, generate a more valuable cash flow than any other bidders can obtain when combined with a target, then the shareholders of these firms will obtain superior returns from acquisitions. This would occur even if all firms in this market for corporate control were aware of this more valuable synergistic cash flow and its sources. This superior return will not be obtained by the shareholders of target firms because competitive bidding dynamics cannot unfold when the sources of a more valuable synergistic cash flow are inimitable.
As before, the number of firms with this special synergistic cash flow with targets must be less than the number of targets for the shareholders of these firms to obtain superior returns. If there are more of these special bidders than there are targets, then these firms are likely to engage in competitive bidding for targets, once again shifting superior returns from bidding to target firm shareholders.
If the number of bidding firms with these special attributes is less than the number of target firms, then these bidding firms enjoy some of the advantages of a monopolist, and the level of superior return they obtain will be approximately the same as for bidding firms with private and uniquely valuable synergies. However, if the number of special bidders and number of targets are the same, the market for corporate control takes on many of the attributes of a bilateral monopoly. In this setting, the level of return obtained by shareholders of bidding firms depends on their negotiating skill (Hirshleifer 1980), and is thus indeterminant. When all bidders and targets know the value of a target for a particular bidder, this negotiated price is likely to fall somewhere between the value of targets for firms with the highest value combined cash flows and the value of targets for other bidding firms.
Of course, it may be possible for a unique and inimitable synergistic cash flow to also be private. Indeed, it is often the case that those attributes of a firm that are inimitable are also difficult to describe (Barney 1991b), and thus can be held as proprietary information. In this case the analysis of superior returns associated with unique and valuable synergistic cash flows presented earlier applies.
3. UNEXPECTED SYNERGISTIC CASH FLOWS
The analysis thus far has adopted, for convenience, the strong assumption that the NPV of synergistic cash flows between bidders and targets are known with certainty by individual bidders. This is, in principle, possi- ble, but certainly not likely. Most acquisitions and mergers are massively complex (Jensen and Ruback 1983), involving numerous unknown and complicated relationships between firms (Ruback 1982). In these settings, unexpected events may occur after an acquisition has been completed, making the synergistic cash flow from an acquisition or merger more valuable than what was anticipated by bidders and targets. The price that bidding firms will pay to acquire a target will only equal the expected value of that target when it is combined with the bidder. The difference between the unexpected synergistic cash flow actually obtained by a bidder and the price the bidder paid for the acquisition is a superior return for the shareholders of this bidding firm.
Of course, by definition, bidding firms cannot expect to obtain unex- pected synergistic cash flows. Unexpected synergistic cash flows, in this sense, are surprises, a manifestation of a firm’s good luck, not its skill in acquiring targets (Barney 1986a).
Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.