A unified theory of forward‐ and backward‐looking M&As and divestitures

Date01 June 2018
Published date01 June 2018
DOI: 10.1111/eufm.12131
A unified theory of forward- and backward-looking
M&As and divestitures
Qing Ma
Susheng Wang
School of Economics, Southwestern
University of Finance and Economics,
555 Liutai Avenue, Chengdu, China
Email: qingma@swufe.edu.cn
Department of Economics, Hong Kong
University of Science and Technology,
Clear Water Bay, Hong Kong, China
Email: s.wang@ust.hk
Funding information
Funding support from the Research Grants
Council and the Central Policy Unit of the
Hong Kong SAR Government.
In a unified theory of forward- and backward-looking
mergers and acquisitions(M&As) and divestitures, an M&A
today may be a cause for a divestiture in the future;
conversely a divestiture today may be a consequence of an
M&A in the past. M&As and divestitures are not only two
sides ofthe same coin, they are also causes andconsequences
of each other. In this paper,in a two-period model, two firms
considerintegrating or separating ineach period. We analyze
forward-and backward-looking M&As and divestitures,and
compare them with static M&As and divestitures.
backward looking, divestiture, forward looking, M&A, unified
In the business world, it is common to see a firm acquiring another firm but later divesting it, or a firm
divesting a division but later reacquiring it. Ravenscraft and Scherer (1987) find that 33% of
acquisitions in the 1960s and 1970s were later divested. Porter (1987) finds that more than half of the
acquisitions in new industries were subsequently divested and a startling 74% of the unrelated
acquisitions were later divested. He observed that even a highly respected company like General
Electric divested a very high percentage of its acquisitions, p. 45.Kaplan and Weisbach (1992) also
find that, for a sample of large acquisitions during 19711982, the acquirers divested almost 44% of the
We gratefully acknowledge the helpful comments and suggestions from one referee and the funding support from the
Research Grants Council and the Central Policy Unit of the Hong Kong SAR Government.
© 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2018;24:418450.
acquired divisions by the end of 1989. Empirical evidence indicates that firms that merge and then
divest often perform well in the interim period, indicating that divestitures are not failures of the past
(Allen, Lummer, McConnell, & Reed, 1995).
Most of the literature on mergers and acquisitions (M&As) treats M &As and divestitures as
separate strategic decisio ns (see survey papers by Brauer, 20 06; Hitt et al., 2009; Johnson, 1996;
Moschieri & Mair, 2008; Singh , 1993). The literature has di scussed many possible reaso ns for
M&As and divestitures, inclu ding market power, scale econo mies, risk aversion, operat ional
synergies, and legal and tax bene fits. However, many of these re asons arguably fail to explain
M&As and divestitures, espec ially since most of the acquired divisions are later di vested. Given that
a divested business unit is often one tha t was acquired in the past, it is conceiva ble that when
deciding whether or not to acqu ire a business unit, firms take in to account the possibility o f
divesting that unit in the future . Conversely, a planned dive stiture in the future is likely to be
conditional on what the firm deci des to do today. Hence, M&As and di vestitures are naturally tied
across time in firmsconsiderations.
There are relatively few studies focusing on the tied M&As and divestitures which are actually
causes and consequences of each other. Weston (1989) lists 14 reasons for M&As and divestitures. He
concludes that the data on divestiture/acquisition rates portray a healthy dynamic interplay between
the strategic planning of U.S. companies and continually shifting market forces, p. 76.A popular view
in the literature is that acquirers often buy other firms only to sell them later.Porter (1987) finds that
most divestitures are successful acquisitions of the past. Prior literature further points out that the
option of divesting an acquired division is what makes the value of an acquisition positive (Aron, 1991;
Fulghieri & Hodrick, 2006; Kaplan & Weisbach, 1992; Porter, 1987; Shimizu & Hitt, 2005; Weston,
1989) and that the reacquisition of a divested division is also efficient (Aron, 1991). Fluck and Lynch
(1999) theorize that an acquisition occurs when the acquiree needs funding (e.g., a start-up or distressed
firm) and this acquiree is later divested once its performance has improved sufficiently to allow it to be
standalone again. However, by examining the 1960s conglomerate wave, Hubbard and Pahlia (1999)
find that acquirers neither appear to have higher levels of free cash flows than non-acquirers nor are
they punished by the stock market. We argue that two firms may choose to integrate today simply
because they plan to be integrated or to separate in the future or because they were integrated or
separated in the past. Our theory is consistent with both Fluck and Lynchs (1999) theory and Hubbard
and Pahlias (1999) empirical finding.
We develop a two-period mode l with two firms, a downstream fir m (DF) and an upstream firm
(UF). In this setting, we deal wi th related M&As and divestitu res. Our model is built on the vie w
that mergers and divestitures a re corporate strategies bas ed on internal characteristic s and
capabilities and external m arket conditions. When the f irms decide to integrate or s eparate in the
first period, they will have c onsidered whether to be integ rated or separated in the secon d period.
Similarly, when the firms plan to integr ate or separate in the second period, thei r plan is affected by
what they do now. Without the inf luence of the decision in one peri od, the decision in the other
period (called a static solution) can be very different. We emphasize the influence of past and
expected future decisions. W hen considering integratio n or separation now, whether th ey are
already integrated or separa ted will obviously have a majo r influence. When a decision ta kes into
account another decision in the futu re, we call it a forward-looking decisio n. We also consider
backward-looking mergers and divestitures, where a backward-looking de cision takes into account
a decision made in the past. W e identify forward-looking and ba ckward-looking behavior by
comparing a two-period dynami c solution with a one-period st atic solution. If we compare a
two-period solution with a o ne-period solution in the fir st period, we can identify th e forward-
looking effect in the two-perio d solution. If we compare a two- period solution with a one-pe riod
solution in the second period, we ca n identify the backward-loo king effect in the two-period
solution. For example, a b ackward-looking merger is a merger that is condit ional on the fact that the
two firms were merged or separated in th e past. We provide a unified model in w hich both mergers
and divestitures are decisio ns and both decisions can be forwa rd or backward looking.
Our model has a number of interesting fea tures. First,itissafe rto be par t of afi rm than to be an
independent firm in the competi tive market. An upstream divi sion in a firm has the advantage that
there is always a demand for it s product. An independent up stream firm faces the risk o f not being
able to find a buyer for its pr oduct. Second, asset specific ity plays a role when a firms status
changes from separated to integ rated or vice versa. An upstrea m division in an integrated firm ma y
have to produce a specific inter mediate product for the firm . But when it is an independent firm in
the market, it may have to prod uce a general product for the ma rket. This means that the u pstream
firm may incur adjustment co st when it switches from bei ng an integrated divisio n to being an
independent firm, and vice ve rsa. Due to asset specificit y, there is an adjustment cost for an
organizational change. The adju stment cost is a force working agai nst a reversal of an earlier
decision. Hence, the UF chang es its status only if the benefit of doing so is large enough. For more
on such adjustment cost in the literatur e, see theoretical analysis in Riorda n and Williamson (1985)
and empirical evidence in Chang and Si ngh (1999). The use of adjustment cost in our model is
consistent with those studi es in the literature that em phasize organizational in ertia (Amburgey,
Kelly, & Barnett, 1993; Hannan & Fr eeman, 1984; Riordan, 1990; Sh imizu & Hitt, 2005). Third,
market fluctuation is a factor in organizational decisions . Our model takes into account the f act that
the market may expand or contr act over time. The firms may de cide to change their organiz ational
structure in response to ma rket changes. Fourth, our model takes into account synergy wh en the two
firms integrate. Synergy un der integration is captured b y the condition that the margin al output
under integration is larger t han that under separation. Sy nergy in our model is endogenou s in the
sense that, when the two firms merge , their contractual relation ship changes accordingly, w hich
affects incentives and in tu rn the gain from synergy. Nega tive synergy is also allowed. In fact, even
when negative synergy and adj ustment cost exist, the two firms may cho ose to integrate if other
conditions are ripe for integr ation. Fifth, incentives are gover ned by contracts. A contract is a
revenue-sharing arrangeme nt offered by a firms owners to it s manager. We identify the opti mal
contracts for several commo n cases. Incentive encou rages effort,which include s work attitude,
work intensity, time spent , and financial investment. The solution from our mode l offers an optimal
linear contract a contract th at is at least as good as any nonlinea r contract. In the literature, m ost
so-called optimal linear co ntracts are not optimal sinc e they are strictly inferior to many nonlinear
contracts. Sixth,afirms in ternal contractual arrange ment is conditional on its org anizational
structure. This means that, if the two firms chang e their organizational str ucture, their internal
contractual relationship wi ll adjust accordingly. Seve nth, managers in independe nt firms may have
better incentives than div isional managers. A featur e specific to our model is that , the UFs
incentive is better under sepa ration, since the contract under separation is based on the UFs o utput
directly while the contrac t under integration is related to the UFs output ind irectly through the DFs
revenue. Eighth,themood in the marketplace may af fect firmsdecisions. We us e a discount factor
of time preferences to take in to account the market mood. The firms may decide to inte grate early if
they feel optimistic now, and they ma y decide to separate later if they feel pe ssimistic now. This
discount factor may also be due to risk aversion to uncertainty in the marketplace. Ninth,ourmodel
emphasizes forward expecta tions and backward history de pendence in firmsdecisions . Tenth,the
history is exogenous in the dependence on history in the literature. However, it i s endogenous in
our dependence on the past.The cu rrent decision is a planned dec ision in the past when the past
decision was made, and the pas t decision was made condition al on the current decision. I n this

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