Differential Efficiency & Financial
Synergy: Theory of Mergers
Differential Efficiency
According to the differential efficiency theory
of mergers, if the management of firm A is more efficient
than the management of firm B and if after firm A acquires
firm B, the efficiency of firm B is brought up to the level
of firm A, then this increase in efficiency is attributed
to the merger.
According to this theory, some firms operate
below their potential and consequently have low efficiency.
Such firms are likely to be acquired by other, more efficient
firms in the same industry. This is because, firms with
greater efficiency would be able to identify firms with
good potential operating at lower efficiency. They would
also have the managerial ability to improve the latter’s
performance.
However, a difficulty would arise when the
acquiring firm overestimates its impact on improving the
performance of the acquired firm. This may result in the
acquirer paying too much for the acquired firm. Alternatively,
the acquirer may not be able to improve the acquired firm’s
performance up to the level of the acquisition value given
to it.
The managerial synergy hypothesis is an extension
of the differential efficiency theory. It states that a
firm, whose management team has greater competency than
is required by the current tasks in the firm, may seek to
employ the surplus resources by acquiring and improving
the efficiency of a firm, which is less efficient due to
lack of adequate managerial resources. Thus, the merger
will create a synergy, since the surplus managerial resources
of the acquirer combine with the non-managerial organizational
capital of the firm.
When these surplus resources are indivisible
and cannot be released, a merger enables them to be optimally
utilized. Even if the firm has no opportunity to expand
within its industry, it can diversify and enter into new
areas. However, since it does not possess the relevant skills
related to that business, it will attempt to gain a ‘toehold
entry’ by acquiring a firm in that industry, which
has organizational capital alongwith inadequate managerial
capabilities.
Financial Synergy
The managerial synergy hypothesis is not relevant
to the conglomerate type of mergers. This is because, a
conglomerate merger implies several, often successive acquisitions
in diversified areas. In such a case, the managerial capacity
of the firm will not develop rapidly enough to be able to
transfer its efficiency to several newly acquired firms
in a short time. Further, managerial synergy is applicable
only in cases where the firm acquires other firms in the
same industry.
Financial synergy occurs as a result of the
lower costs of internal financing versus external financing.
A combination of firms with different cash flow positions
and investment opportunities may produce a financial synergy
effect and achieve lower cost of capital. Tax saving is
another considerations. When the two firms merge, their
combined debt capacity may be greater than the sum of their
individual capacities before the merger.
The financial synergy theory also states that
when the cash flow rate of the acquirer is greater than
that of the acquired firm, capital is relocated to the acquired
firm and its investment opportunities improve.
