How will the recent wave of mergers affect the nation?
June 2, 1998
in this forum:
What is the correlation between mergers and the strength of the economy overall? How will the recent wave of mergers affect the consumer? Does the recent wave of mergers mean fewer rights for labor? In this emerging global economy, how do mergers affect third world countries? Is bigger better? Aaron Gaudio of Corvallis, OR, asks: I've heard that we typically see large numbers of massive mergers, like the ones we are seeing now, at the end of an economic boon cycle. Is this accurate? What is the correlation between mergers and the strength of the economy overall? Could it mean that a downturn in the economy is approaching?
Professor Adams responds:
As Jim Grant noted during our program on the NewsHour, merger fever seems to develop momentum during the boom phase of the business cycle. That was certainly true during the rambunctious 1920's. It was also true during the speculative phase of the late 1980's. It seems to be repeated again in the current bull market, as companies seem willing to pay exorbitant prices for the assets acquired through mergers and acquisitions.
Barron's (the Dow Jones Business and Financial Weekly) provides an apt illustration of this phenomenon. In its April 20,1998, issue, Leslie P. Norton writes: "To get control of Citicorp, Travelers will fork over shares valued at something like $72 billion. Based on Citi's earnings of $3.6 billion last year, Travelers would be getting a 5% return on its investment. Even using Citi's expected earnings for this year of $4.28 billion, Traveler's return amounts to only 5.95%. That's about equal to the return on a 30-year Treasury bond. And let's face it, the risk involved in trying to get a consistent return out of Citicorp over the past decades has proven far greater than the risk that the U.S. government will fail to meet its bond payments."
One can only wonder whether such acquisitions make any sense from the private point of view of the acquiring company. They certainly don't make any sense from the point of view of the economy as a whole.
Professor Weston responds:
With respect to the correlation between mergers and the strength of the economy overall, the relationship is positive and significant. The rate of merger activity is highly correlated with the level of the stock market and the strength of the economy. Merger activity is also highly correlated with plant and equipment expenditures, which is a driving force in the strength of the economy. The correlation between plant and equipment expenditures, the growth rate in the economy, and the rate of merger activity (measured by numbers or dollar values), is very high. The conclusion drawn by economists is that mergers are stimulated by economic growth just as internal plant and equipment expenditures are.
But in addition to these cyclical factors, there are other strong underlying forces at work. The main forces behind the current merger movement are the globalization of markets, which means international competition. There are pressures on companies throughout the world to be lean and efficient to meet the pressures of international competition. Another massive force is technological changes that bring in competition with new products and with new firms and new ideas. A third force is developments in information systems, which require large investments in computer networks, and other technologies. These are basic continuing forces. In any recent year, more than 50% of merger activity takes place in five or six industries. These industries are driven by the continuing forces. In banking, it is well documented that there are big savings from using the large investments in information systems over a larger number of banking units. Also, large corporate customers are looking for a full range of financial services, which helps explain the Travelers/CitiCorp merger.
In the pharmaceutical industry, the big new development is gene mapping. Big investments are being made to do gene napping and other research in pharmaceuticals. It now costs about $400 million to bring a new significant drug to the market. Only about one out of 10 new drug investigations turns out to be a successful drug with FDA approval. It is too risky for a drug company to have all their research effort in one area. By merging, drug companies can have strong research programs going in a number of areas. Similar explanations could be given for tires, automobiles, steel, media and telecommunications. These forces are enduring and are not just cyclical.
Massive mergers do not signal the end of an economic boom cycle. The merger wave of the 1960s, for example, ended without a severe economic downturn. The slight recession in 1990-91 was related to uncertainties around the Desert Storm warfare. It demonstrates that the causality is the reverse. The slight economic downturn was enough to dampen the merger activity of the 1980s. But it was only a slight pause. Some view the mergers of the 1990s as a continuation of some of the long-term basic forces that had already begun to operate in the 1980s. These were facilitated during the 80s with financial innovations, and those innovations are still being used in the 90s.
If an economic downturn takes place, it will not be caused by merger-related factors. If an economic downturn does take place, merger activity like plant and equipment expenditures and other forms of investment will turn down also.