Risk-return Performance of Related versus Unrelated Acquisitions

This study isolated the effects of acquisitions on the long term risk-return performance of acquiring firms involved in related and unrelated diversifying acquisitions. Confounding effects of multiple acquisitions were controlled by studying only those firms that were involved in a single major acquisition over a ten year period surrounding the acquisition date. Acquisitions did not improve the profitability performance of acquiring firms. Although not statistically significant, firms involved in related acquisitions experienced profitability setbacks. On the risk dimensions, the overall risk of acquiring firms involved in related acquisitions increased in the post-acquisition period. Risk pooling advantages were associated with unrelated mergers as demonstrated by their abiliity to maintain their risk profile. Risk-return relationships were found to be negative for firms involved in both kinds of acquisitions. Firms that succeeded in reducing total or financial risk enjoyed superior returns. Capital structure-return relationships were also significant and negative across both categories of acquisitions implying profitability setbacks for firms that utilize excessive leverage to finance acquisitions. INTRODUCTION Acquisitions continue to play a pivotal role in the implementation of corporate strategy. External growth through acquisitions has become an attractive option for firms pursuing different diversification strategies. Trends in the acquisition behavior of large firms indicate that conglomerate acquisitions are still very popular, while synergy oriented vertical and horizontal mergers are now less popular (Michel and Shaked, 1985). Are these patterns of acquisitions indicative of a superior acquisition strategy? Do acquisitions and mergers succeed in creating value for the shareholders? In the absence of a concrete theory of diversification, the debate on relative superiority of a certain acquisition strategy over others remains unresolved. Increasing value of the acquiring firm has been promoted as the most important motive for acquisitions and mergers. Due to the absence of a good measure of value, a number of studies have evaluated acquisition success by examining the risk-return characteristics of firms employing various acquisition strategies (Silhan and Thomas, 1986; Lubatkin, 1983, 1987; Dundas and Richardson, 1982; Beattie, 1980; Salter and Weinhold, 1978; among others). Within the risk-return framework it has been argued that the motivational framework for all types of acquisitions is the same (Steiner, 1975). This line of thought would lead us to believe that since alternative types of economic activity are a part of the same choice set, one type of acquisition strategy is not likely to have an advantage over other strategies. Contarary to the notions of portfolio theory, several studies have found superior performance associated with strategies involving related businesses implying value creation by synergy oriented acquisitions (Rumelt, 1974; Mason and Goudzwaard, 1976; Leontiades, 1980; Christensen and Montgomery, 1981; Bettis and Hall, 1982; and McDougall and Round, 1984; Chaterjee, 1986; Lubatkin and O'Neil 1987). Lubatkin (1983), in his extensive review of the acquisition literature, developed a framework to identify potential synergies associated with each type of acquisition. Technical economies were possible in related acquisitions, while unrelated acquisitions were associated with financial and diversification synergies. Drucker (1981) outlined five rules for successful acquisitions which strongly advocate related acquisitions. Using a small sample of 26 firms, Power (1982) found that all related acquisitions included in the sample ranked among the top one-third of the perceived effectiveness scale implying that synergy-oriented mergers are perceived to have a higher potential for success. On the other extreme, some studies have found unrelated acquisition strategy to be a superior one in terms of improving firm performance (Elger and Clark, 1980; Kitching, 1967). Unrelated acquisitions may succeed in creating significant economic value through improved cash management, efficient allocation of investment capital, and/or a reduced cost of debt (Salter and Weinhold, 1978, Leontiades, 1982). One possible explanation for superior wealth effects associated with unrelated acquisitions is that when the income stream becomes more stable after the merger, the market value of debt of the combined firms increases due to co-insurance effects. 2 Based on the work of Salter and Weinhold (1978), Dundas and Richardson (1982), and Beattie (1980), Silhan and Thomas (1986) proposed that conglomeration provides opportunities to increase market value when either risk or return can be improved while holding the other constant. Marshall et al. (1982) showed that conglomerate mergers are aimed at diversifying into industries that reduce the acquiring firm's exposure to systematic risk. In a more general study, Song (1983) found that mergers decrease volatality of earnings and sales. Other arguments supporting the risk reduction rationale include those of making debt safer (Lewellen, 1971), and reduction of bankruptcy risk (Higgins and Schall, 1975). Several studies have found that compared to non-conglomerate firms, conglomerates reduce risk (Melicher and Rush, 1974; Holzmann et al. 1975; Beattie, 1980; Beedles, et al. (1982); among others). Risk-reduction is such a popular rationale for diversification that risk-return tradeoffs have to be examined in assessing performance (Bowman, 1980). Inconsistencies and contradictions in the acquisitions and diversification literature may be due to differences in methodological approaches employed by various researchers. One important shortcoming of earlier research may have been the failure to incorporate a host of environmental, industry, and firm-specific factors in assessing post-acquisition performance. Differences in the time frame of various studies may have also contributed to the present confusion regarding performance implications of acquisitions. A more apparent reason is the differences in the employment of performance measures. Another short coming of earlier research is the lack of control for the effects of multiple acquisitions (Lubatkin, 1983). Firms usually embark on acquisition programs that result in the acquisition of several firms over a short period of time. This makes it difficult to study effects of specific acquisitions on long term performance of acquiring firms. This study was designed to address some of these concerns in order to gain a better understanding of performance implications of acquisitions. Confounding effects of multiple acquisitions were controlled by studying only those firms that were involved in a single large acquisition during a ten-year period surrounding the acquisition date. Since divestitures can change profiles of firms only firms that did not make significant divestitures were studied. Data over a long time frame (1966-1984) were used to capture different states of the general economy in order to make results more generalizable. Instead on focusing only on post acquisition performance, this study examined long term changes in risk-return performance to capture performance effects of acquisitions and to control for effects of contextual variables. Since each firm operates in a unique environment described by its contextual variables, one would expect different firms to have different levels of performance due to differences in contexts. These effects would be constant over different time periods. If the acquisition was the only change in a firm's environmental context, its effect could be captured by measuring the change in long term performance. Moreover, this difference in postand pre-acquisition performance would automatically control differences in contexts of acquiring firms since effects of context variables are assumed to be constant over different time periods. By incorporating such methodological issues, and by addressing limitations of earlier studies, it is hoped that results of this study will provide us with a better understanding of performance implications of corporate acquisitions. The following hypotheses (stated in null form) were tested to accomplish objectives of this study. H1 : Acquisitions do not improve the long term risk-return performance of acquiring firms in general, and of firms pursuing either related or unrelated acquisition strategies. H2 : Risk and Return have no significant relationship for acquiring firms in general, and for firms pursuing related and unrelated acquisition strategies. METHODOLOGY THE SAMPLE: The Federal Trade Commission's Statistical Report on Acquisitions & Mergers was used to obtain a list of large acquisitions that were completed. A large acquisition was defined as one that resulted in a ten percent increase in the acquiring firm's assets.