Firms have lots of cash on their balance sheet and it’s not earning anything. What to do? Buy the competition. FULL ARTICLE by Doug French
Source link: http://archive.mises.org/15694/merger-monday-and-the-destruction-of-wealth/
Merger Monday and the Destruction of Wealth
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While I agree with a whole; there have been massive mergers in the past; I would like to highlight this one passage “premium to what the stocks had been trading for — forget volume discounts. These guys aren’t just buying a cow or two but the whole ranch and paying a premium to the market price to boot.”
You should discuss that these shares are traded at a premium because of shared service, reduction of duplicate jobs and larger market share. Also, theses premiums are incentives for shareholders to accept this merger, acquisition or buyout to sell the company.
What most managers fail to realize is that any expansion, whether through mergers or expanding their business, comes at a cost. Many times this cost exceeds the gross profits of the new business. As a builder, I have built my business on limiting the number of houses to no more than 5 houses a year. Because my limited overhead expense, my net profits are greater than builders that build 10 houses a year. Furthermore I limit my liability and market exposure to allow me to adjust quickly to changes in the market or product liability. The problem is as the business expands, business owners spend less time working the day to day operations, and spend most of their time managing the expanded overhead.
Now on the other hand, product or business development is very expensive and takes time to develop. Mergers is a way to achieve a company’s goals at a minimal cost. This can be compared to an individual that chooses to buy into a franchise than to start a completely new business. Also, many times it makes more sense to buy into a market rather than add to the market from a competition standpoint.
M and A, business expansion and other business decisions are much more complex than reasoning the Fed is responsible. I think ego plays a more important role in bad decisions.
I think Doug’s point was that the Fed’s actions affect M&A decisions at the margin. For instance, a company content with its organizational structure would not be affected by the money printing, but a company that was on the brink before the Fed revved up the printing press might find itself convinced a merger is a great idea once the opportunity cost of not doing so–earning a pitiful interest dividend on their idle cash–seems less attractive.
The overarching point of Doug’s article is that this manipulation by the Fed encourages risk-taking behavior in ventures for which the risks are not well understood and thus poorly calculated. This is just an extension of interest rate theory in that any disparity between the Fed influenced interest rate and the “natural” interest rate causes (or increases the likelihood of) malinvestment. Any attribution to an inflated ego should not go without recognition that ego is subject to the influence of opportunity cost.
Nice! Thanks!
Hi Doug,
How is the M&A situation in countries that have had a relatively stable monetary base? Switzerland or some country like that. Have they been less mergers? Have the mergers been more successful?
-Prakash
I’ve grown accustomed to being looked at like a madman when I say this, so if you feel so inclined, help yourself: The growth of super big business is the road to total Communism. Why? We have in the last two years seen how rapidly big business can become a government business. (It might be helpful to look at chaos theory). As business gets more and more apparently powerful and arrogant, it looses more and more of the people’s support. As it approaches the “one store in town” Soviet Russia” look and people feel more and more “ripped off”, they very naturally care less and less about business freedom. Who will defend them when government decides to nationalize? We’ve already had that great defender of freedom George Bush remark he needed to take over the banks to save them from Socialism. Am I nuts? Time will tell, won’t it.
Australia has had a relatively stable monetary base, mergers are still extremly strong here with agricultural firms, mining firms and firms servicing mining being acquired at PE ratios of 20-30+ (quite often companies laden with debt from exploration and a year of more away from production are commanding massive prices).
Loose capital from China and elsewhere is flowing into our markets so a stable monetary base in one country doesn’t neccesarily preclude bubbles.
You might or might not be surprised at the extent to which one theme of yours dovetails with the position of the neo-Marxists at the Monthly Review: that corporations are loaded down with cash burning a hole in their balance sheets, with no productive outlet to invest it in. So naturally all that excess investment goes into the FIRE economy, with a growing share of GDP going to service debt on mergers and acquisitions.
The money’s also cheap in more ways than one. When interest on corporate debt is exempted from the corp income tax, and share transactions involved in mergers and acquisitions are exempted from capital gains, that’s a differential benefit to one kind of investment compared to another. Mergers and acquisitions become relatively more profitable compared to other uses of the same money which do fall under the corporate income tax.
And targeted tax breaks for debt mean for mergers and acquisitions specifically, since that’s the main thing debt is incurred for. Retained earnings are more than sufficient for whatever investment in actual new productive capacity takes place.
They money’s also cheap in that the folks in the C-suite — like the manager “playing entrepreneur” in Mises’ critique of the Lange model of “market socialism” — have no skin in the game. The money they risk is not the fruit of their own past abstention. And the incentive structure, as under Lange’s market socialism, is such that when they win they get a huge bonus and when they lose… they just don’t get a bonus that year. All the money lost is other people’s money. So there’s every incentive to gamble big.
I would add that the problem of surplus investment capital is exacerbated by technological developments that are causing the amounts of capital required for various forms of production to implode, in some cases by two orders of magnitude. Doug Rushkoff, in “How the Tech Boom Terminated California’s Economy,” argued that the desktop revolution meant that for many kinds of information production, the capital required for a startup fell tenfold or more. And we can see similar trends in micromanufacturing today, with $10k worth of garage-scale CNC machine tools doing the kind of production that once required a million-dollar factory.
Great article; although I understand that the emphasis of your article was on the Fed’s role in the M&A surge, tax policy plays a major role as well. Interest on merger debt is tax-deductible so if it’s a leveraged buy-out that’s significant. the relative after-tax cheapness of debt-financed expansion in general is often distortionary. I would suspect that if the corporate income tax were eliminated, we would have a lot fewer mergers, buyouts, and debt-fueled expansions — a lot more small and medium sized firms in the marketplace.
Good article thanks
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