Why do companies merge and are they good?
A guide to mergers and their consequences.
The HDFC twins merger is perhaps one of the most powerful synergies in the finance space ever witnessed in India. Not only did it give intraday traders a hefty return, but it is also believed to revolutionize banking and lending in the country, yet again.
Firstly, what does the merger mean and what are its consequences?
Let’s find out.
What are mergers?
A merger, just like what it sounds, is an agreement that sets to unite two companies into one entity. There are a few ways to do this:
Conglomerate: A conglomerate is created when 2 unrelated companies merge. They operate in different product lines, but the combination gives rise to such synergies that enable them to improve cost savings, and performance, ultimately adding value to shareholders. The Walt Disney and American Broadcasting Company (ABC) merger in 1995 is a merger falling in this category.
Congeneric: Such a merger takes place when 2 companies operate in the same product line or have overlapping markets. The HDFC twins merger was one such merger. It helps in cross-selling and also provides a good price value to customers.
Vertical: When 2 companies selling complementary products combine, it is called a vertical merger. Here, both enterprises are just at different levels of the same supply chain. Such a merger helps achieve market dominance and reduce costs dramatically.
The Mannsesmann AG and Vodafone was one of the biggest mergers.
An acquisition, on the other hand, is when one company acquires another. The acquiring company buys out the assets of the other company to eliminate competition and cost reduction. It’s like a big fish eating a small one, with the aiming to increase and consolidate its market share.
Why do companies merge?
Synergy and market share
Gaining more market share and improving profitability using synergies are the major reasons for mergers. Mergers are a way to grow in size, customers, and scale. They bring more revenue and profitability to the newly formed legal entity.
Typically seen in oligopoly markets, companies merge to consolidate their market position. This also acts as a measure to reduce price wars or even as a method to unite against a common competitor refusing to step down.
Look how Idea and Vodafone combined to form VI, essentially to be able to compete against Reliance’s telecom vertical Jio.
One of the top reasons companies merge is the potential benefit to cross-sell their products.
The recent HDFC merger is a classic example. HDFC Bank is a private banking sector leader in India. And HDFC is so popular that home loans are synonymous with their name. But still, a customer had to open a separate account in HDFC to apply for a loan, despite having a deposit account in its subsidiary bank.
The merger will not only fasten the process of loan applications and approvals but will also allow the bank to sell its products like insurance and wealth management to clients of the housing vertical. The cost of selling and distributing products reduces dramatically for both companies.
A strong balance sheet is another big advantage a merger brings to both enterprises.
A business needs to raise money now and then. Having access to an asset base larger than before enables it to extract more capital since it appears stronger on the balance sheet.
A strong balance sheet achieves a good credit rating. A good rating gives access to funds at lower interest rates. Financial mergers can thus offer attractive rates to customers in the lending process.
But just like assets are combined, liabilities come together too. Managing liabilities in a smooth way is crucial to making substantial gains in business.
Data is gold. Collect as much of it as possible since governments haven’t realized yet that it should be taxed as an asset.
One important and often overlooked reason two companies come together is the availability and access to each other’s databases. Data gives you the power to reach new people to sell, track their behaviors to identify buying patterns, and most importantly, understand where they live on the internet.
Data is what artificial intelligence relies on. Giants like Google and Facebook rely heavily (if not 100%) on the data they collect.
Access to different kinds of consumer data can help companies predict sales, manage inventory and create new products, ultimately offering great value in exchange for great profits.
The upsides of a merger are great, they can conquer markets. But they have certain risks too.
Managing capital: Every company has an optimal capital structure. And it’s a constant battle to maintain the ideal proportion of debt and equity. Merging adds a new layer of complexity to this issue. If a smooth transition is not achieved, it can suck up a lot of time and resources, affecting efficiency negatively.
Integration problems: No two companies work the same way. Each one has its procedures and methods of dealing with things. When two kinds of workforces are combined, there is potential for friction. There can also be culture shocks. An ideal situation would be to reach an equilibrium that honors the effort and obligations of both the management teams.
For an investor, mergers and acquisitions offer good opportunities for profit-making in the short run and significant gains in the long run provided synergies work out well.