The Timing and Returns of Mergers and Acquisitions

This paper studies the interaction between product market competition and takeover activity. We develop a dynamic model in which profit-maximizing production decisions of all firms in an industry as well as the timing and terms of a merger between two firms are jointly determined. We show that there exists an asymmetric equilibrium in production policies with endogenous synergy gains, in which heterogeneous firms have an incentive to merge because restructuring decisions are motivated by operating and strategic benefits. Based on the resulting equilibrium, the model formalizes a number of insights consistent with the available evidence. For example, takeover activities are more likely in more concentrated industries or in industries that are more exposed to industrywide demand shocks. Notably, merger returns are higher for small targets than for large acquirers if merger costs are identical. Furthermore, the model generates a number of novel testable predictions. We find that returns to merging and rival firms arising from restructuring are higher when industry competition is lower. Contrary to some conclusions in recent real options research, increased industry competition delays (rather than accelerates) the timing of takeovers. While industry competition allows us to endogenize the synergy gains in a real options model of mergers, it may also affect an acquisition contest with multiple bidders. It is perhaps surprising, however, that bidder competition does not induce a bid premium in every industry since we demonstrate that it only interacts with industry competition under certain conditions. Moreover, the bid premium declines with product market competition. Finally, the model relates dispersion in firm size (tangible assets) to takeover activity and returns in that mergers are more likely and yield larger returns in industries with more dispersion in firm size. JEL Classification Numbers: G13, G14, G31, G34.