Mergers, Acquisitions, and Corporate Restructurings. Gaughan Patrick А.

strategy. Many small and medium-sized firms also followed this fad and moved into areas outside their core business.

      As firms with the necessary financial resources sought to expand, they faced tougher antitrust enforcement. The heightened antitrust atmosphere of the 1960s was an outgrowth of the Celler-Kefauver Act of 1950, which had strengthened the antimerger provisions of the Clayton Act of 1914. The Clayton Act made the acquisition of other firms' stock illegal when the acquisition resulted in a merger that significantly reduced the degree of competition within an industry. However, the law had an important loophole: It did not preclude the anticompetitive acquisition of a firm's assets. The Celler-Kefauver Act closed this loophole. Armed with tougher laws, the federal government adopted a stronger antitrust stance, coming down hard on both horizontal and vertical mergers. Expansion-minded firms found that their only available alternative was to form conglomerates.

      The more intense antitrust enforcement of horizontal mergers was partially motivated by the political environment of the 1960s. During this decade, Washington policymakers, emphasizing the potential for abuses of monopoly power, worked through the FTC and the Justice Department to curb corporate expansion, which created the potential for monopolistic abuses. Prime advocates of this tougher antitrust enforcement were Attorney General John Mitchell and Assistant Attorney General Richard McLaren, the main architect of the federal government's antitrust efforts during the 1960s. In his book Managing, Harold Geneen, then chief executive officer of ITT, has described the difficulty his company had in acquiring companies when McLaren was in office.31 McLaren opposed conglomerate acquisitions based on his fears of “potential reciprocity.” This would occur, for example, if ITT and its other subsidiaries gave Hartford Insurance, a company ITT acquired, a competitive edge over other insurance companies. ITT was forced to compromise its plans to add Hartford to its conglomerate empire. It was able to proceed with the acquisition only after agreeing to divest itself of other divisions with the same combined size of Hartford Insurance and to not acquire another large insurance company for 10 years without prior Justice Department approval. Years later the European Commission would voice similar arguments for opposing takeovers in the 2000s.

      With the election of Richard M. Nixon toward the end of the decade, Washington policymakers advocated a freer market orientation. Nixon supported this policy through his four appointees to the U.S. Supreme Court, who espoused a broader interpretation of concepts such as market share. The tough antitrust enforcement of the Justice Department came to an end in 1972, as the Supreme Court failed to accept the Justice Department's interpretation of antitrust laws. For example, in some cases the Supreme Court began to use a broad international market view as opposed to a more narrow domestic or even regional market definition. Consequently, if as a result of a merger, a firm had a large percentage of the U.S. market or a region of the nation but a small percentage of the international market, it could be judged to lack significant monopolistic characteristics. By this time, however, the third merger wave had already come to an end.

Management Science and Conglomerates

      The rapid growth of management science accelerated the conglomerate movement. Schools of management began to attain widespread acceptability among prominent schools of higher education, and the master of business administration degree became a valued credential for the corporate executive. Management science developed methodologies that facilitated organizational management and theoretically could be applied to a wide variety of organizations, including corporations, government, educational institutions, and even the military. As these management principles gained wider acceptance, graduates of this movement believed they possessed the broad-based skills necessary to manage a wide variety of organizational structures. Such managers reasonably believed that they could manage a corporate organization that spanned several industry categories. The belief that the conglomerate could become a manageable and successful corporate entity started to become a reality.

Industry Concentration and the Conglomerate Wave

      Because most of the mergers in the third wave involved the formation of conglomerates rather than vertical or horizontal mergers, they did not appreciably increase industrial concentration. For this reason, the degree of competition in different industries did not significantly change despite the large number of mergers. Some 6,000 mergers, entailing the disappearance of 25,000 firms, took place; nonetheless, competition, or market concentration, in the U.S. economy was not greatly reduced. This clearly contrasts with the first merger wave, which resulted in a dramatic increase in industry concentration in many industries.

Shareholder Wealth Effects of Diversification during the Conglomerate Wave

      In Chapter 4 we critically examine diversification strategies and their impact on shareholder wealth. However, while we are discussing the conglomerate wave, it is useful to briefly address some research that has attempted to assess the impact of these types of deals on shareholder wealth. Henri Servaes analyzed a large sample of firms over the years 1961–1976.32 He showed that over this time period, the average number of business segments in which firms operated increased from 1.74 in 1961 to 2.7 in 1976. He then examined the Q ratios (ratios of the market value of securities divided by the replacement value of assets) of the companies in his sample and found that diversified firms were valued at a discount – even during the third merger wave when such diversifying deals were so popular. He found, however, that this diversification discount declined over time. Servaes analyzed the assertion that insiders derive private benefits from managing a diversified firm, which may subject the firm to less risk although at a cost that may not be in shareholders' interests. If managers derive private benefits that come at a cost to shareholders (the discount), then this may explain why companies with higher insider ownership were focused when the discount was high but began to diversify when the discount declined. At least they did not pursue their private benefits when it was imposing a cost on shareholders.

      Some research shows that the stock market response to diversifying acquisitions in the conglomerate was positive.33 Matsusaka found that not only did the market respond positively, but also the response was clearly positive when bidders agreed to keep target management in place and negative when management was replaced as in disciplinary takeovers. While this may have been the case, this does not mean that the market's response in this time period to these diversifying deals was correct. When one considers the track record of many of these deals, it is easy to conclude that they were flawed. Later research covering more recent time periods shows that the market may have learned this lesson, and such deals do not meet with a favorable response.

Price-Earnings Game and the Incentive to Merge

      As mentioned previously, investment bankers did not finance most of the mergers in the 1960s, as they had in the two previous merger waves. Tight credit markets and high interest rates were the concomitants of the higher credit demands of an expanding economy. As the demand for loanable funds rose, both the price of these funds and interest rates increased. In addition, the booming stock market prices provided equity financing for many of the conglomerate takeovers.

      The bull market of the 1960s bid stock prices higher and higher. The Dow Jones Industrial Average, which was 618 in 1960, rose to 906 in 1968. As their stock prices skyrocketed, investors were especially interested in growth stocks. Potential bidders soon learned that acquisitions, financed by stocks, could be an excellent “pain-free” way to raise earnings per share without incurring higher tax liabilities. Mergers financed through stock transactions may not be taxable. For this reason, stock-financed acquisitions had an advantage over cash transactions, which were subject to taxation.

      Companies played the price-earnings ratio game to justify their expansionist activities. The price-earnings ratio (P/E ratio) is the ratio of the market price of a firm's stock divided by the earnings available to common stockholders on a per-share basis. The higher the P/E ratio, the more investors are willing to pay for a firm's stock given their expectations about the firm's future earnings. High P/E ratios for the majority of stocks in the market indicate widespread investor optimism; such was the case in the bull market of the 1960s. These high stock values helped finance the third merger wave. Mergers inspired by P/E ratio effects can be illustrated as follows.

      Let us assume that the acquiring firm is larger

31

Harold Geneen, Managing (New York: Avon, 1989), 228–229.

33

John G. Matsusaka, “Takeover Motives during the Conglomerate Merger Wave,” RAND Journal of Economics 24, no. 3 (Autumn 1993): 357–379.