Methods of growth - Business Environment

Through takeover and merger firms grow in size internally as part of normal business operation or externally.

Internal growth
Growth is a natural process for many firms that start small, capture a segment of the market and then continue to expand either by producing more of the same goods or by extending their product lines. The advantage of internal growth over external growth is that the company grows within the existing structure of management; there are none of the problems of bringing together two different management systems. There might also be economies of scale from building a bigger plant that might not be available when companies merge and plant size does not change. Set against these, internal growth has certain disadvantages and this is why most of the growth in the size of organisations has occurred through external growth.

External growth
Growth by acquisition is called external growth and occurs through takeover ormerger. A merger involves the mutual decision of two companies to combine and become one entity; it can be seen as a decision made by two "equals". A takeover, or acquisition, on the other hand, is characterized by the purchase of a smaller company by a much larger one. If the management of the threatened company resist it is called a hostile takeover, but if the price offered to shareholders is high enough they will accept. Takeover bids can be and have been successfully fought off by the management of the second firm. A holding company is a new company that is formed to acquire assets in other companies. The acquired companies retain their independent identities but are directed by the holding company.

External growth can be seen to have a number of advantages:

  1. It is fast, so that productive capacity can be increased very quickly.
  2. The acquiring firm has access to an established management team and system.
  3. If the shares of the acquiring company have sufficiently high values relative to the acquired firm, there might be no need for additional cash to be raised.
  4. The purchase of existing assets could be cheaper than building new productive capacity.

But set against these is the fact that the process might not be an easy one; it is a difficult job to merge two companies smoothly and successfully and there are likely to be many teething problems. Research by Coopers& Lybrand (now Price Waterhouse Coopers) found that top executives regarded half of the takeovers in which they had been involved as failures. The main reasons for failure were lack of planning and managerial problems.

Although the definitions of merger and takeover are clear enough, it is often difficult to tell them apart in practice and they are usually put together in official publications under the heading of acquisitions. In order to understand fully the motivation for mergers and takeovers it is important to recognize that there are different types of mergers.

Horizontal mergers
A horizontal merger is when two companies competing in the same market merge or join together. This type of merger can either have a very large effect or little to no effect on the market. When two extremely small companies combine, or horizontally merge, the results of the merger are less noticeable. These smaller horizontal mergers are very common. If a small local drug store were to horizontally merge with another local drugstore, the effect of this merger on the drugstore market would be minimal. In a large horizontal merger, however, the resulting ripple effects can be felt throughout the market sector and sometimes throughout the whole economy.

Large horizontal mergers are often perceived as anticompetitive. If one company holding twenty percent of the market share combines with another company also holding twenty percent of the market share, their combined share holding will then increase to forty percent. This large horizontal merger has now given the new company an unfair market advantage over its competitors.

The motives for this type of merger are:

  • To benefit from economies of scale. Horizontal mergers allow the merged firms a greater level of specialization and the benefits of other economies of scale.
  • Greater market share. When firms come together there will be a reduction in competition in the market and the resulting firm will have a much larger share of the market.
  • Rationalization of output. If the level of demand for a good is shrinking, merger between the producers could be necessary in order to rationalize output.
  • Reaction to competitors. In markets where mergers are taking place, companies may feel that they have to do the same in order to maintain their market position.

Vertical mergers
A vertical merger is one in which a firm or company combines with a supplier or distributor. This type of merger can be viewed as anticompetitive because it can often rob supply business from its competition. If a contractor has been receiving a material from two separate firms, and then decides to acquire the two supplying firms, the vertical merger could cause the contractor’s competitors to go out of business. Antitrust concerns are a focal point of investigation if competition is hurt. The Federal Trade Commission can rule to prevent mergers if they feel they violate antitrust laws.Vertical integration can take place ‘backwards’ towards the beginning of the production process or ‘forwards’ towards the end of it and it can occur for several reasons:

  1. In the case of backwards integration, to control the supplies of raw materials with respect to their quantity and quality. This brings greater security to the acquiring firm.
  2. To restrict supplies of the raw materials to competitors.
  3. In the case of forwards integration, to control the quality of the outlets for the finished product. Manufacturers finance the majority of advertising and they might well feel that a forwards merger would enable them to ensure that the good was being sold in the most appropriate setting.
  4. In both cases, economies of scale are possible if different parts of the production process are brought together.
  5. Again, vertical mergers can be carried out as a reaction to the activities of competitors.

Conglomerate mergers
A conglomeration is the merger of two companies that have no related products or markets. In short, they have no common business ties. These mergers are neither vertical nor horizontal. An example would be the failed merger proposal between Kingfisher (general retailing) and Asda (grocery retailing) in 1999. The main motivation for this type of merger is diversification. It reduces the risk involved in producing for only one market and allows the firm to spread risk further. It can also provide the firm with another option if the original market declines in size.

As far as the economy is concerned, the main gains of mergers are in increased efficiency resulting from economies of scale and also the increased scope for research and development. A common view is that merger and takeover activity serves the purpose of rationalizing business. The weak businesses go and the strong survive. Even when a takeover is carried out for the purpose of asset stripping this will be the case.

Growth by merger and takeover
Growth through merger and takeover first appeared in the USA over a hundred years ago and merger activity tends to come in waves. Five periods of heightened merger activity have been identified in the USA:

  • The period 1880 to 1905 this coincided with the proliferation of the joint stock company and the international establishment of stock exchanges. This period was characterized by mergers of a horizontal nature.
  • The 1920s at this time the mergers were largely vertical in nature, as manufacturers took control of both suppliers and distributors.
  • The 1960s mergers in this period were mainly about diversification and the establishment of conglomerates.
  • The post-1980 period this wave of activity took place in a period of recession and was largely about cost-cutting and rationalization.
  • The late 1990s as companies in mature industries attempted to become global operators. The pace of this surge of activity slowed for a period after September11th 2001, but by 2004 the boom in activity had restarted.

The first two periods of heightened merger activity in the USA had little effect inEurope; however, there were waves of activity in Europe which coincided with the last two. The first wave of merger activity in Europe came in the 1960s after obstacles to trade were removed by the establishment of the EEC in 1957. The second wave of mergers came in the 1980s in the run-up to the establishment of the Single European Market in 1992. As yet there is little evidence of an increase in merger activity as a result of EMU in Europe.

The most recent surge of activity in the USA did not reach the EU until 2005 the value of mergers and acquisitions in Europe in the first quarter of 2005 was three times higher than the same period in 2004 and there are several pending large deals. The motivation for this activity seems to be the synergies achieved through mergers with similar companies it seems that national companies are trying to become European companies.

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