Following the Great Recession, low interest rates coupled with high levels of cash reserves propelled companies to grow through mergers and acquisitions rather than organically through capital investments. The year 2015 saw a record number of M&A deals totaling $4.9 trillion.
Firms merge for a variety of sound reasons, such as to create synergies, to consolidate in response to industry shocks like deregulation, to deal with increased competition, or to take advantage of developments in how acquisitions are financed. But companies also merge for more questionable reasons: because an overconfident chief executive overestimates a target firm’s value or seeks to build a business empire, or because the bidder wants to take advantage of its overvalued share price. In a recent paper, I study the acquisitions that firms make in response to increased competition.
I measure increased competition through decreases in ad valorem import tariffs on Most Favored Nations (MFN). The Trump administration has been a big proponent of protectionist trade policies. It argues that higher trade barriers will lead to more U.S. jobs, strengthen the manufacturing base, and promote economic growth. Many economists, however, disagree. Trade barriers give domestic companies an edge by making it costlier for foreign firms to compete with them. But that competitive edge also eliminates incentives for domestic companies to manage costs efficiently. Further, tariffs increase the cost of production for domestic firms, which in turn leads to higher prices for consumers and ultimately loss of jobs and slower economic growth.
Ultimately, a decrease in import tariffs increases imports and competition from foreign firms. One way firms respond to increased competition is through making acquisitions. M&A experts believe that, following the economic recovery and improved investor confidence in about 2015, companies made acquisitions that year largely to strengthen their competitive positions. Testing this idea empirically, I find that firms are more likely to make acquisitions in response to tariff cuts.
I further examine the type of deals driving the increased acquisition activity following tariff cuts. One possibility is that firms consolidate within the industry when competition increases. On the other hand, firms could respond to increased competition by diversifying into other industries when their primary industry gets highly competitive. I find that acquisitions in response to tariff cuts are concentrated within the same industry, and firms are not more likely to make diversifying acquisitions when their industry faces a tariff cut.
As for the types of firms making these acquisitions, the evidence suggests that firms operating in a single industry segment make acquisitions when faced with a tariff cut, but multi-segment firms do not. This is consistent with the idea that single segment firms are affected more by the increased competition, whereas multi-segment firms might be able to offset increased competition in one industry by shifting their focus to other less competitive segments.
As one would expect, these acquisitions in response to increased foreign competition are driven by firms with substantial resources. Compared with industry medians, companies that had more cash and better operating margins in the prior year are more likely to make acquisitions. Further, literature on product market competition shows that firms with low debt can aggressively price their products low enough to push out rival firms with high debt. Consistent with this idea, I find that firms with less than industry median book leverage in the prior year are driving these acquisitions when the industry faces a tariff cut. Moreover, these acquisitions in response to increased foreign competition are driven by firms that have higher bond ratings, and better than median z-scores, in the year before the tariff cuts, implying that firms with lower default risk are the primary acquirers when competition in an industry increases.
Typically, mergers are clustered by industry and time. External shocks to the industry in general are known to start merger waves. Similarly, acquisitions tend to be clustered in periods of low financing costs. Thus, one would expect to find a greater effect of tariff cuts on acquisitions when interest rates are lower. I find that when competition intensifies, firms are more likely to acquire in the years when the commercial and industrial loan (C&I) spreads are lower.
The next logical step would be to see if, following a tariff cut, firms that make acquisitions perform differently in the long run than other firms. I find some evidence suggesting that acquiring firms have better returns on assets. However, more work needs to be done in this area.
The evidence suggests that firms use M&A in response to shocks to industry competition caused by tariff cuts. Taking a closer look at these acquisitions, it turns out that firms that are more affected by such changes in competition, and firms that have ample resources, are driving these acquisitions. One implication of these findings is that the U.S. government’s foreign trade policies will affect domestic M&A. If the Trump administration increases import tariffs on oil and gas and auto industries as promised, and the Fed raises interest rates in its December meeting, we might see a slump or even an end to what many believe is the seventh] merger wave.
This post comes to us from Professor Shweta Srinivasan at the School of Management of Binghamton University at the State University of New York. It is based on her recent article, “Acquisitions and Foreign Competition,” available here.