EF4312 Mergers and Acquisitions Chapter 7 Sources and Limits of Value Creation in Vertical Mergers

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EF4312 Mergers and Acquisitions Chapter 7
Sources and Limits of Value Creation in Vertical
Mergers

• Prof. Stephen Cheung
• Department of Economics and Finance
• City University of Hong Kong

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Learning Objectives

• At the end of this chapter, you should be able to
  understand
• The economic rationale for vertical integration
• The alternatives to vertical integration
• The costs and benefits associated with vertical
  integration and the alternatives
• Characteristics of industry-blurring mergers and
  the drivers of such mergers and
• The limits to value creation in vertical and
  industry-blurring mergers.

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Key Concepts and Points

• Vertical mergers are mergers of firms that
  produce goods or services representing the output
  of the successive stages of a value chain.
• A vertical chain represents the various stages
  from raw material inputs to the final product
  sold to the consumer.
• At any stage of the value chain activities that
  precede are upstream and activities that follow
  are downstream.

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Key Concepts and Points

• Vertical integration is the combination of
  successive activities in a vertical chain under
  the common coordination and control of a single
  firm.
• A vertical merger replaces two or more
  independent firms with a single firm and
  internalises previously arms length relations
  among them.

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Key Concepts and Points

• The decision to vertically merger is like the
  decision to make rather than buy from an
  independent supplier.
• Alternatives to vertical merger are
• Buying in markets
• Long term contracts with suppliers
• Vertical merger decision made on the comparative
  merits of buying in markets, long term supply
  contracts and vertical integration.

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Key Concepts and Points

• Buying from markets benefits from the competitive
  pressures on suppliers, their scale, scope and
  learning economies, specialisation and the
  suppliers incentive to keep up with new
  technology.
• Buying under supplier contracts benefits from the
  incentive to supplier to make transaction
  specific investments and keep up with technology,
  close coordination with the supplier in
  innovation and product development and avoidance
  of risk in disposing of the residual assets when
  the contract expires.

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Key Concepts and Points

• Vertical integration offers technical efficiency
  benefits, better control over quality, delivery
  and coordination of production flow through the
  vertical chain and avoidance of leakage of
  competition-sensitive information to suppliers
  and rivals.
• Vertical integration also offers coordination
  efficiencies.
• Economic rationale for vertical mergers rests on
  comparative efficiency of vertical integration in
  terms of technical and coordination efficiency.

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Key Concepts and Points

• Vertical merger to create value should also lead
  to revenue enhancement and new growth
  opportunities
• Revenue enhancement arises from ability to offer
  a package of products and services rather than
  products alone. Such a strategy is not inimitable
• Vertical merger can also confer market power
  because of pre-emptive control over inputs or
  distribution channels but evidence of market
  power scarce.

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Key Concepts and Points

• Efficiency of vertical mergers efficiency in
  resolving internal coordination, information
  asymmetry between divisions, performance
  measurement and incentive structure and how well
  the acquired firms resources and capabilities
  are integrated into those of the acquirer
• Downscoping, disintegration and outsourcing by
  firms in recent years point to limited value
  creation potential of vertical merger.

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Key Concepts and Points

• A recent vertical merger type is the industry
  blurring merger.
• Industry blurring merger combines firms operating
  at different stages of different vertical chains
• Examples of industry blurring mergers are bank
  and insurance company mergers and mergers of
  telecommunication, cable transmission, media and
  Internet companies.

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Key Concepts and Points

• Industry blurring mergers designed to create
  value from revenue enhancement through access to
  new markets and the opportunity to cross-sell
  each industrys products
• Recent industry-blurring mergers such as AOL Time
  Warner that combined an Internet firm with a
  cable and media firm failed to create value
• Industry blurring mergers pose challenges that
  destroy rather than create value.

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Value Chain of Production
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Transaction Modes for Sourcing Inputs
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Benefits and Costs of Buying in Markets
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Benefits and Costs of Supply Contracts
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Benefits and Costs of Vertical Integration