Does Financial Synergy Provide a Rationale for Conglomerate Mergers?

• Author: Hyeongsop Shim,Tim Mooney
• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/ajfs.12099
• Date: 01 August 2015

Does Financial Synergy Provide a Rationale

for Conglomerate Mergers?

Tim Mooney

School of Business, Pacific Lutheran University

Hyeongsop Shim**

School of Business Administration, Ulsan National Institute of Science and Technology

Received 3 April 2014; Accepted 5 March 2015

Abstract

We examine two sources of financial synergies —coinsurance effects and asset liquidity —

in mergers and test whether financial synergy is greater in conglomerate mergers than hori-

zontal mergers. We find that a reduction in cash flow volatility for consolidated firms helps

enhance shareholder value. Consistent with theoretical predictions of earlier studies, our

results indicate that a merger can increase shareholder value when the cash flow volatility of

the consolidated firm is less than the current cash flow volatility of the acquiring firm. We

present new evidence that the source of financial synergies in conglomerate mergers comes

mainly from higher asset liquidity. Our test results also suggest that liquidation values are

higher in conglomerate mergers than horizontal mergers holding the coinsurance effect con-

stant, particularly when the target is financially constrained.

Keywords Mergers and acquisitions; Coinsurance effect; Asset liquidity

JEL Classification: G34, G32

1. Introduction

While the sources of gains from horizontal mergers are well established, the sources

of gains from conglomerate mergers have received much skepticism because con-

glomerate mergers are assumed to lack operational synergy.

1

Conglomerate mergers

**Corresponding author: Hyeongsop Shim, School of Business Administration, Ulsan

National Institute of Science and Technology, UNIST-gil 50, Eonyang-eup, Ulju-gun, Ulsan

689-798, Korea. Tel: +82-52-217-3132, Fax: +82-52-217-3109, email: hshim@unist.ac.kr.

1

There are several explanations for why conglomerate mergers could generate operational syn-

ergy. Penrose (1959) argues that diversified firms could benefit from economies of scope.

Morck and Yeung (2003) contend that takeovers across industries could increase stockholder

value only when information-based assets, such as R&D or marketing could be enhanced. Mat-

susaka (2001) suggests that diversification is a dynamic search and matching process that maxi-

mizes shareholders’s wealth if the process could not be completed due to uncertainty. These

vindications for conglomerate mergers are in line with neoclassicial theories on “diversification

discount”, such as Maksimovic and Phillips (2002), Gomes and Livdan (2004), and Maksimovic

and Phillips (2008) in that managers of diversified firms also maximize shareholder value.

Asia-Pacific Journal of Financial Studies (2015) 44, 537–586 doi:10.1111/ajfs.12099

©2015 Korean Securities Association 537

are unlikely to increase market share or to improve efficiency due to economies of

scale. Nevertheless, we continue to observe firms that acquire target firms in unre-

lated industries even though diversification seems to generate no economic gains.

We address this issue by examining the role of financial synergy in conglomerate

versus horizontal mergers.

There are two competing explanations for the motivation of conglomerate

mergers. Agency cost theory argues that conglomerate mergers are motivated by

entrenched managers who consider their own self-interests at the expense of share -

holders. Self-interested managers can build empires via diversification, offering

more authority and power and entitling them to greater prestige and compensation

(Jensen, 1986; Jensen and Murphy, 1990). These managers can also improve their

own job security by investing human capital in manager-specific skills (Shleifer and

Vishny, 1989; Aggarwal and Samwick, 2003). Managers diversify their portfolios

because their assets are tightly tied to a specific firm (Amihud and Lev, 1981). This

explanation based on agency cost theory suggests that diversification leads to

destruction of shareholder value. This agency cost explanation is also in line with

the diversification discount literature.

2

Another strand of literature argues that conglomerate mergers are pursued for

financial benefits rather than economic gains.

3

Levy and Sarnat (1970) and Lewellen

(1971) argue that conglomerate mergers reduce default risk and increase debt

capacity when bankruptcy is possible and the cash flows of two firms are not per-

fectly correlated. This reduction in default risk is termed the “coinsurance effect”.

While the reduction of default risk primarily benefits bondholders, it could also

increase shareholder wealth by increasing debt capacity and the availability of inter-

est tax shields.

Leland (2007) argues that the propositions of these earlier studies of coinsurance

are incomplete in that they assume that future cash flows are always positive.

Assuming that bankruptcy is costly and that future cash flows could be negative,

Leland develops a theory that identifies joint conditions under which positive or

negative coinsurance effects are generated. His model assumes neither agency costs

nor asymmetric information and generates two key predictions. First, a greater dif-

2

See the surveys of Erdorf et al. (2013) and Martin and Sayrak (2003).

3

In addition to the coinsurance effect and asset liquidity that we investigate in this paper,

there are other sources of financial gains. Stein (1997) suggests the “efficient internal capital

market” benefits in the presence of information asymmetry between outside investors and

firm managers. Managers of diversified firms can allocate pooled internal capital to their best

projects across divisions. Hubbard and Palia (1999) review the conglomerate merger wave in

the 1960s and present evidence supporting the efficient internal capital market hypothesis.

They find that bidder returns are maximized when bidders without financial constraints

acquire financially constrained targets. Fluck and Lynch (1999) suggest that the combined

value of bidders and targets could be enhanced by financing positive net present value pro-

jects which are marginally profitable and cannot be financed without mergers.

T. Mooney and H. Shim

538 ©2015 Korean Securities Association

ference in cash flow volatilities of acquirer and target would reduce the financial

gain from a merger when the cash flow correlation between two firms is high. Sec-

ond, a greater difference in cash flow volatilities would produce greater financial

benefits when the merging firms have low cash flow correlation, low cash flow

volatilities, and when the market capitalization-weighted difference in cash flow

volatilities is lower than the firms’ individual cash flow volatilities. Shleifer and

Vishny (1992) argue that conglomerate mergers can be superior to horizontal merg-

ers when agency costs or adverse selection costs are involved. While debt overhang

is an efficient way to control agency costs, it also increases the probability of costly

liquidation during an economic downturn. The authors argue that firms with more

liquid assets have higher debt capacities and that conglomerate mergers improve

asset liquidity more than horizontal mergers.

In this study, we first test Leland’s (2007) two predictions about the coinsurance

effect and show evidence that strongly supports both predictions. Results show that

cash flow volatility difference negatively affects shareholder value when the cash

flow correlation of two firms is high, and that it has no effect when their cash flow

correlation is low. In contrast, results also show a positive relation between volatility

difference and shareholder value for mergers where the volatility of the consolidated

firm is most likely to be lower than acquirer’s volatility. This positive coinsurance

effect is not observed in the sample of mergers where volatility reduction is not

likely.

We then expand Leland’s (2007) model to incorporate agency costs and adverse

selection costs suggested by Shleifer and Vishny (1992). We argue that the maxi-

mum reduction in cash flow volatility of a consolidated firm should be multiplied

by a quadratic function of the cash flow correlation between the merging firms.

The quadratic function of cash flow correlation observed before the merger

announcement reflects a discount in the value contribution attributable to the

attainable maximal reduction in cash flow volatility after the merger. We show how

the levels of adverse selection and agency costs vary with cash flow correlation and

also how cash flow volatilities have varying impacts on shareholder value depending

on the level of past cash flow correlation between merging firms and merged firms .

We also investigate the impact of target firm financial constraints associated

with a merger.

4

Mergers involving financially constrained targets may derive greater

benefits from coinsurance, since constrained firms are more likely to face higher

costs of financial distress than unconstrained firms (Lewellen, 1971; John, 1993).

Therefore, we classify firms in our sample as constrained or unconstrained accord-

ing to the SA index of Hadlock and Pierce (2010). Empirical findings are consistent

with our predictions: conglomerate mergers can be superior to horizontal mergers

by achieving higher liquidation values when agency costs or adverse selection cos ts

are involved, especially when the target is financially constrained. We find greater

4

We appreciate this insightful suggestion by an anonymous referee, which enhances the qual-

ity of our paper.

Financial Synergy and Conglomerate Mergers

©2015 Korean Securities Association 539