A New Case for Acquisitions: Target Firms that Benefit from Financial Synergy
Rethinking acquisitions as the Fed tapers off its bond-buying stimulus and target firms face higher capital costs.
Middle market interest in mergers and acquisitions is stronger than in recent years, with close to 40% of mid-sized companies at least open to - if not actively seeking - suitors. But, which target to go after? Frequently, the recommendation is to pair up with a target such that the combination will produce operational synergies, whether it is the elimination of redundant costs or new growth through the pooling of their joint capabilities. But, what about financial synergy? Could not a well-endowed acquirer benefit a resource-constrained target, which might otherwise pass on profitable investments? Helping the target to fund these profitable investments could create value for the mutual benefit of the acquirer and target. Therein lies a new recommendation for seeking a target, particularly in the days ahead when surely the Fedâ€™s stimulus will end and capital will be harder to obtain.
The notion that good investments can fail to attract necessary funding assumes that markets are not working well. While the markets may be working well for large firms that can issue their own bonds and have multiple banks competing for their business, it would not be a stretch to think that middle market targets do not have equally easy access to capital. But, are middle market targets indeed financially constrained? Do mergers relax those constraints, and importantly lead to more investment? Up until now, we have not had the evidence to answer these questions. Examining target financial data, pre- and post-acquisitions, should provide the answers. But, the majority of middle market firms are private, rendering the necessary evidence elusive in the United States.
Professors Erel, Jang, and Weisbach, Fellows of the National Center for the Middle Market (NCMM) offer up the right evidence.  These researchers have now answered these questions by studying European companies, which must disclose financial data for subsidiaries. Thus, targets do not disappear after the acquisition in their study. The NCMM Fellows looked at a sample of over 5,000 European acquisitions occurring between 2001 and 2008. The targets were mostly private firms (97.4%). Some 72% were independent firms and the rest were subsidiaries of other firms prior to acquisition. To assess whether financial constraints are mitigated by acquisitions they examine what happens to the financial constraints of a particular target both before and after being acquired.
But, how should one measure the extent to which a target is financially constrained? The NCMM Fellows consider three measures, which are ultimately useful in assessing targets for whom a strategy of pursuing financial synergy is viable. Interestingly, all three measures are based on observing managers - own actions to address their financial needs, and are also well-grounded in prior finance literature:
- Cash Holdings: The idea is that managers of firms that face difficulties in raising necessary capital will typically hold more cash as a precaution against coming up short in the future.
- Cash Flow Sensitivity of Cash: Firms will withhold more of their incremental cash flow as cash if they fear that they may not be able to raises funds easily.
- Cash Flow Sensitivity of Investment: While a financially unconstrained firm should be able to undertake all desirable investments, for a financially constrained firm the amount of investments will be more driven by the cash flow it generates.
And, now to the findings of the NCMM Fellows regarding relaxation of financial constraints of target firms:
- Cash Holdings, normalized by assets, declined by approximately 1.5% for an average target firm after being acquired.
- The Sensitivity of Cash to Cash Flow declined significantly from a positive 10.4% to close to zero, which implies that the target firm goes from being constrained to unconstrained.
- The Sensitivity of Investment to Cash Flow dropped to less than half of what it was before the acquisition.
As for investments, target firms raised their investment levels by 1.5% to 2% as a fraction of their total assets, which is impressive if you note that prior to the acquisition their mean (median) investments were 6.4% (3.4%) of their total assets.
The Erel, Jang, and Weisbach study offers several useful takeaways for a resource-rich bidder looking for a desirable target: One, as demonstrated, the acquirer can play a positive role in mitigating financial constraints of the target. Two, consequently the target can increase its investment levels. Three, thus following measures of financial constraints from finance literature, a bidder can assess and identify targets, in order to pursue financial synergy as a viable acquisition strategy.
 Erel, Isil, Yeejin Jang, and Michael S. Weisbcah, "Do Acquisitions Relieve Target Firms' Financial Constraints," Published Paper National Center for the Middle Market, Journal of Finance, February 2015.