Cross-Border Merger & Acquisition Waves

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Cross-Border Merger & Acquisition Waves

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An empirical investigation of the

GOLE model

Groningen, 29 January 2009

Master’s Thesis International Economics and Business

Author: Matthijs M. Terpstra Student number: 1323571

E-mail: m.m.terpstra.1@student.rug.nl

Supervisor: Prof. Dr. S. Brakman Faculty of Economics and Business

E-mail: S.Brakman@rug.nl

Co-assessor: Dr. P. Rao Sahib Faculty of Economics and Business

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Abstract

This thesis investigates the relationships between Cross-Border Mergers & Acquisitions and sector wages. From the literature we know that mergers come in waves and these waves strongly cluster by industry. From the literature on FDI we know that several spillover effects might arise from multinational presence. The GOLE model, as constructed by Neary, tries to combine those and several other aspects into a general equilibrium model. By the use of this model I try to explain my research question that aims at comparing how Cross-Border Mergers & Acquisitions and sector wages are related over the period that comprises a wave. I derived two hypotheses from the model, the first one concerning the upward phase of the wave, while the latter aims at deriving a relationship for the downward phase of the wave. My data shows nice wave patterns of Cross-Border Merger & Acquisition activity for four out of the five industries. I find strong evidence for a positive relationship between Cross-Border Mergers and Acquisitions and sector wages during the upward sloping phase of the wave for four out of the five industries. Furthermore I find evidence for a positive relationship between Cross-Border Mergers & Acquisitions and sector wages during the downward phase of the wave for two out of the five industries. Finally, evidence can be derived that suggests that Cross-Border Mergers & Acquisitions in previous periods are related to sector wages in later periods.

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1. Introduction

Foreign Direct Investment (FDI hereafter) is seen as one of the driving forces behind economic development. Theory and empirics suggest that FDI may bring along capital, technology, management know-how, jobs and access to new markets. FDI is defined as an investment made to acquire a lasting interest by an entity resident in one economy in an enterprise resident in another economy. The investment should allow the investing entity to exert direct control over the management of assets in the invested firm1.

Attracting FDI as a host country is very important since it can boost a country’s economy. A firm’s decision to invest in a foreign country can have multiple reasons but are mainly driven by a wish to reduce trade costs. When production is moved to a location that is close to the market transport costs, as well as tariff costs, are reduced. The higher the trade costs the more interesting it is for firms to invest. In the literature this trade-off is embedded in a framework constructed by Dunning (1977c, 1981) which provides a classification suggesting that firms should engage in FDI if they have an Ownership advantage, Location advantage or an Internalization advantage (OLI framework).

The importance of FDI has increased rapidly during recent decades. The global stock of inward FDI as a percentage of global GDP has increased from less than 5% in 1980 to 25% in 2006.2 The increase in FDI is largely driven by the ongoing liberalization of trade and investment, and the technological developments in information and communication technologies. FDI is realized through “Greenfield Investments” or “Cross-Border Mergers & Acquisitions”(CB M&As hereafter). Greenfield Investments are investments made in a factory or business unit in order to build it up from scratch while CB M&As lead to a merging or the acquisition of an existing business unit in the host country3. A merger4 is the combination of two or more firms or business units, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock. An acquisition on the other hand is a corporate action in which a company buys most, if not

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Definition of FDI derived from the OECD.

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Source: OECD conference paper “the impact of FDI on wages and working conditions”.

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Most of the literature concerning FDI focuses on Greenfield Investments while in the real world the majority of FDI is the result of CB M&As.

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5 all, of the target company's ownership stakes in order to assume control of the target firm. Acquisitions are often made as part of a company's growth strategy whereby it is more beneficial to take over an existing firm's operations and hence market position instead of expanding its own. A merger aims at sharing strategies and knowledge with another firm in order to achieve synergies.

In order to explain CB M&A activity models have been constructed. Modeling this phenomenon is not easy since CB M&As are characterized by the fact that they come in waves and furthermore cluster by industry. From the existing models one can distinguish partial- and general equilibrium models where the first tries to explain a specific, or partial, sector of the economy hereby assuming that the rest remains constant, while the latter seeks to explain behavior in the economy as a whole with several or many different markets. Although partial equilibrium models did yield interesting insights it fails to explain the economy wide issues caused by CB M&As. Since my thesis is about CB M&A waves that are the result of external shocks to an industry’s economic, technological or regulatory environment, a general equilibrium model is needed since the entire economy is under consideration here. The general international trade models like the Stolper-Samuelson model or one of the extended versions are not able to explain CB M&As since the facts reject the theory time after time. Perfect competition and monopolistic competition models trying to explain international trade fail as well in their attempt to explain CB M&A activity since symmetric firms are assumed hereby leaving no argument for the existence of M&As because this is mainly the result of strategic interactions between firms.

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6 predicts that CB M&A waves tend to reduce factor demands hereby putting downward pressure on the returns to factors.

From the final prediction one can easily question how CB M&A wave patterns hold with factor returns, which are wages in this case. This brings us to my research question:

How do wage patterns hold with the pattern of CB M&A waves?

Neary predicts that merger waves induced by trade liberalization would shift the distribution of income in favor of profits at the expense of wages. The increase in profits for all firms makes subsequent takeovers more expensive and finally ends the M&A wave.

In order to understand the consequences of M&A behavior one needs to discuss the history and motives behind them first. So in the second section I will outline the merger waves throughout history and describe what characterizes them. Then I will present the different literature streams that try to explain the motives behind M&As. An important characteristic of M&As is that they occur in waves. There is a reason for that and I will outline the theory behind it. In the third section I will present a more technical and in-dept description of the GOLE model and derive my hypotheses from it. The fourth section deals with the choice of data sources, cross–sections, and the time period. In the results analysis, which is the sixth section of my thesis, I will present the outcome of the panel data analysis. Results will be discussed for the different industries under consideration. Finally I will conclude my paper by placing the results in the right perspective, list some shortcomings and provide directions for future research. Results, tables, and graphs that were not primarily relevant but might add additional insights to the subject of my thesis are included in the appendix at the end of the thesis.

2. Literature Review

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7 proven, but why this is the case and what triggers those waves is something in which there is no consensus yet. This will be outlined as well. Afterwards I will describe the five different merger waves that have been derived throughout history. And finally I will explain the spillover effects that MNE presence has on the host country with a special focus on wages since this deals with my main research question.

2.1 Motives for Mergers

Economic theory has provided many possible reasons for why mergers might occur5. In a paper on mergers Andrade, Mitchell, and Stafford (2001) sum up the possible explanations. First of all a merger might take place based on efficiency-related reasons. Hereby economies of scale or scope might be brought up as the reason. Another argument is that by merging with or acquiring a firm that is active in the same industry, competition is decreased. When many more M&As take place this can eventually lead to oligopoly or monopoly situations in the market, and places the acquiring firm in a position from which it can reap more benefits from its production due to this power position.

Another stream of literature suggests that a motive for a merger might be that the acquiring firm’s management sees the target firm’s management as incompetent and thinks that it can do better by making the target firm “healthier”. Possible synergies between the two business units is used as an argument. The idea is based on the Hubris hypothesis (Roll, 1986) in which financial markets are rational, but corporate managers are not. The phenomenon depends on the presumption of bidders that their valuations of target firms are correct and the market undervalues the target. The target is mainly valued above market value because a premium has to be paid above the existing market price otherwise the current owners won’t sell. Incapable bidders’ market valuations might explain why mergers are almost never profitable. On the other hand, it can also be because managers might become obsessed by expansion and therefore force a merger or an acquisition for its self-interest. Over-expanded firms might be the result. This type of firm is characterized by a lack of transparency in the organizational structure and furthermore the firm is a collection of unrelated diversified businesses without established synergies between the different business units.

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8 Finally, M&As might be searching for diversification opportunities to spread risk across different businesses. The reasoning behind this is that as managers extend their portfolio of different business activities they spread the risk of being a target to external shocks. Furthermore they can allocate capital in a more efficient way and risk is spread over different unrelated business activities. This argument can be linked to the phenomenon of conglomerates that came into existence during the third merger wave on which later more. The disadvantage that is related to this argument for M&A activity is the same as for the over-expanded firms. Examples from the real world tell us that unrelated diversification lead to a lack of transparency and economies of scope, and in more general terms, the absence of synergies between the different established business activities.

Mergers & acquisitions that reach across the boarders can have slightly different motives. Motivations for CB M&A activity can be broadly categorized according to the OLI framework constructed by Dunning (1977c, 1981) which states that a firm will engage in FDI if they have market power given by the ownership of products or production processes (Ownership), if they have a location advantage in locating their plant in a foreign country rather than at home (Location), and, finally, if the firm has an advantage from internalizing their foreign activities in fully owned subsidiaries (Internalizing). Although this framework is a nice categorization of FDI arguments it has the disadvantage that it is not a model that predicts or captures behavior in order to derive interactions with other factors.

This thesis focuses on horizontal CB M&As that falls under the categorization of horizontal FDI. Specific reasons for why firms engage in this activity deal with the fact that taking over another foreign firm give them the advantage that they incorporate a certain market position, and furthermore, a business unit that has knowledge about the market. Building up a firm from scratch comes with a lot of start-up difficulties and costs. Improvement of the current quality and market position of the target can therefore be one of the goals of the acquirer. Economies of scale and scope in relation to making use of product knowledge, share headquarter activities and market knowledge seems to be the main reason for expanding abroad. These factors can boost company sales and hence increase profits.6

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2.2 Merger Waves

Mergers occur in waves and within a wave, mergers strongly cluster by industry. These two statements are the result of empirical research and are facts. These features suggest that mergers might occur as a reaction to unexpected shocks to industry structure. It also seems that industries tend to restructure and consolidate in concentrated periods of time, that these changes occur suddenly, and that they are hard to predict. However, identifying industry shocks and documenting their effect is rather difficult.

If mergers come in waves, but each wave is different in terms of industry composition, than a significant portion of merger activity might be due to industry-level shocks. Industries react to shocks by restructuring the industry via mergers. Since shocks are unexpected, industry-level takeover activity is concentrated in time, and is different over time, which accounts for the variation in industry composition for each wave. Examples of such shocks are technological innovations (the ICT revolution during the 1990s), supply shocks (oil prices for example), and government regulation (deregulation policies).

Mitchell & Mulherin (1996) are one of the first to question the literature on M&A waves. In their work on the fourth merger wave they conclude that most literature only describes and characterizes merger waves ad-hoc, hereby avoiding the dynamics of takeover activity. The authors suggest that there are fundamental factors that drive takeover activities hereby influencing stock price spillover effects of takeover announcement, corporate performance following takeovers and the timing of takeover waves. More specifically, Mitchell & Mulherin suggest that there is a link between industry shocks and takeover and restructuring activity. This can explain why within a wave, mergers strongly cluster by industry and why takeover activity intensity differs between industries. It is important to notice that the authors study M&As at an industry level and not firm-specific. This makes sense since within an industry firms face more or less the same external shocks, deregulations, or structural alterations from which they can gain or lose. These fundamental factors could be used to construct a dynamic model explaining M&A activity, but I will come back to that later.

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10 and the second motive is that merger waves result from managerial timing of market overvaluations of their firms. I will briefly discuss both streams.

2.2.1 Merger waves result from shocks to an industry’s economic, technological, or regulatory environment.

The neoclassical view suggest that merger waves result from shocks to an industry’s economic, technological, or regulatory environment. The influence of shocks on the economy goes al the way back to Coase (1937) as he was one of the first to investigate the influence of technology on the economy. The idea behind the neoclassical hypothesis is that when a shock occurs the reaction of all firms dealing with the specific industry will reallocate the assets through mergers and partial-firm acquisitions. The fact that this activity clusters in time is because a shock occurs suddenly and therefore managers of all firms have to react simultaneously to compete for the best combination of assets. When this is presented over a time period this means that M&A activity intensifies during the upward phase of the wave and dampens after the peak of the activity has been reached.

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11 2.2.2 Merger waves result from managerial timing of market overvaluations of their firms.

The literature stream that argues that merger waves result from managerial timing of market overvaluations of firms is called the behavioral hypothesis. The relationship between stock valuations and merger activity was theoretically established by Shleifer & Vishny (1986). The authors hypothesized that when increased cash flow leads to rising stock prices, the financial constraint on the acquiring firm is relaxed. As a result the price offered to the target firm goes up as well as the supply of target firms in the M&A market. This is supported by Golbe and White (1988) who find evidence that all five waves of merger activity have occurred during booms in the stock market.

Shleifer and Vishny (2003) agree that the neoclassical hypothesis has some explanatory power but lacks completeness. First of all it focuses on industry-specific shocks and therefore can’t explain aggregate merger waves. Furthermore the neoclassical theory doesn’t say anything about whether cash or stock should be used in order to finance the merger or acquisition. Finally they suggest that the prediction that mergers increase profitability is not proven. There is research available that concludes that there is no evidence supporting the positive relationship between merger activity and profitability7.

The theory behind the behavioral hypothesis is based on the assumption that financial markets are inefficient. This means that some firms are valued incorrectly, or in other words, the stock price doesn’t represent the true company value. On the other hand there are managers which are rational and understand the stock market inefficiencies. By taking advantage of these inefficiencies they can beat the market. Targets of acquisitions are likely to be undervalued firms. If this is the case, Shleifer and Vishny propose three circumstances under which acquisitions take place. First of all, market valuations must be high and there must be a supply of highly overvalued firms as well as relatively less overvalued firms. So the highest overvalued firms will take over the relatively less overvalued firms. Second, there should be a synergetic expectation in the market since this makes the merger more profitable in the short-run. The final circumstance is that target companies’ managers are rewarded for consenting a merger or have a very short-term focus instead. The Hubris hypothesis (Roll, 1986) on the other hand suggest that may think that they are rational and can beat the market, but this

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12 doesn’t necessarily have to be the case. This can serve as an argument for the absence of the positive relationship between M&As and profitability.

But this reasoning itself isn’t a driving force behind a merger wave. To generate a merger wave the model makes several predictions. First of all merger waves will occur following periods of abnormally high stock returns. Second, industries undergoing waves will experience abnormally poor returns following the height of the wave. And finally, as there is no economic driver to the wave, regulatory, economic, technological shocks will not be the driving force behind the wave.

Now let’s go back to Harford (2005) who combined the two views and tried to compare them to see which one has most explanatory power. His findings support the neoclassical view in favor of the behavioral view. One has to acknowledge that Harford used a combination of the capital liquidity argument and the neoclassical view. Harford’s findings suggest that it is the importance of capital liquidity that causes individual industry-level merger waves to cluster in time to create aggregate-level merger waves. The author even suggests that the relationship between asset values and merger activity, which is the basis of the behavioral view, is more a capital liquidity effect than a misevaluation effect.

Harford finalizes his paper by saying that regulatory, economic, or technological shocks cause industry merger waves under the condition that sufficient capital liquidity is present. In other words: not all shocks will end up in a merger wave. It is a combination of the capital liquidity argument and the neoclassical view. The evidence Harford finds in support of the neoclassical view is also in line with the model I use since trade liberalization, which is the result of government deregulation, is assumed to be one of the main triggers of a merger wave.

2.3 Merger Waves throughout History

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13 follow the same time trend. Especially during the last merger wave in the 1990s, the appearance of CB M&As was remarkable. This merger wave is therefore sometimes mentioned in the literature as the first international merger wave (Black, 2000). Historians and M&A specialists have identified five merger waves in the history of the United States. What follows are the dates of each merger wave and some of each wave’s major characteristics.

The first Merger Wave (1897-1907) followed the depression of 1883 and it was concentrated in industries that where booming back then such as petroleum products, mining, and metals. The mergers during this period were mainly horizontal of nature, leading to an increased ratio of concentration in the industries mentioned since fewer companies served the market. This, in turn, led to the existence of monopolies.

The second merger wave (1916-1929) began during World War I and continued until the stock market crash of October 29, 1929. Due to the increased government regulation concerning M&As resulting from the first merger wave, oligopoly market forms instead of monopolies characterized the second wave more. Furthermore the dominant type of merging was vertical suggesting that firms were looking for economies of scope and were aiming at obtaining more control over their supply chain.

The third merger wave (1965-1969) followed from a period of strong economic growth in the US hereby providing firms with enough resources to acquire other companies. Mergers were established between seemingly unrelated firms leading to the term conglomerate mergers. The potential benefits of conglomerates are that they can allocate capital in a more efficient way and risk is spread over different unrelated business activities.

The fourth merger wave occurred during the eighties (1981-1989) and is characterized as a period of hostile takeovers. The amounts of money involved with the mergers were larger then ever before and debt became a more widely used form to finance the mergers.

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short-14 term financial benefits. Mergers during the fifth wave mainly represented longer term business strategies. Furthermore debt was used less as a way of financing the takeover activity.

Old data on merger waves outside the US is scarce and therefore it is sometimes assumed that merger activity within Europe has been limited until the fourth merger wave. Since the time that European markets became more integrated this changed. Nowadays Europe has a single currency and an integrated market, or “Single Market”, and M&As within Europe are normal phenomena.

Black (2000) describes the fifth wave as one that can be characterized as an international wave. He argues that M&As can no longer be seen as national phenomena. The fifth wave included many cross-border transactions of which some even belong to the largest deals ever announced. In his work he shows how US participation in M&A activity worldwide has dropped in the fifth wave compared to the fourth and how, on the other hand, European participation has increased.

When one combines these facts with other factors like the forces of globalization, the search for new markets, and the integration of especially the financial markets, one can only conclude that CB M&A activity is simply part of the process that markets become more integrated and that country borders no longer define the boundaries between which the international economy takes place.

2.4 Effects of Multinationals on the Host Country

To conclude the literature review on CB M&As it is interesting to summarize what is known about the effects that multinationals and their expanding behavior has on host countries. This also creates a bridge with the analysis under focus in this paper.

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15 order to remain competitive. On the other hand it might be that the productivity is higher because multinationals pay higher wages or hire more skilled personnel.

There are a number of studies (Lipsey, 2002b) that show that multinationals tend to pay higher wages. It has to be mentioned that this effect is stronger for developing countries than for developed countries. But also for the developed countries research has shown that this wage premium is present. Girma & Görg (2007) find for the UK that foreign takeovers of domestic firms tend to increase wages, but the effects are relatively small. In a new study conducted by the OECD (2008a) new evidence is presented on the impact of inward FDI on wages using data for three developed (Germany, Portugal and the United Kingdom) and two emerging economies (Brazil and Indonesia). The results show that average wages are almost 50% higher in foreign MNEs than in domestic firms. Pay differences are larger in Asia and Latin America, as are the technological and productivity gaps between foreign MNEs and local firms in those regions. In all regions, the productivity gap between foreign and local firms appears to be even larger than the wage gap. Using firm-level data, the report shows that foreign takeovers of domestic firms tend to raise average wages relative to those that would have occurred in the absence of takeovers. However, the impact varies considerably across countries. The effects range from 5% in the United Kingdom to 8% in Portugal, 11% in Brazil, and 19% in Indonesia, while the effect is positive but statistically insignificant in Germany. In general, these results are consistent with previous studies that have shown small and positive foreign wage premiums in developed economies due to the fact that skill premiums are smaller between countries and potentially larger foreign wage premiums in developing countries.

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2.5 Wages

In the previous section I presented an overview concerning the effects of MNE presence for the host country with respect to wages. Furthermore we know that mergers come in waves and cluster by industry. Therefore it makes sense to analyze the relationship between CB M&A activity and wages on the sector level. In this section I will describe the most common sector labor market models. This is important since one needs to derive the different forces that influence the equilibrium outcome of the labor market so that the relationship under consideration in this thesis can be placed in the right context.

In the economic literature the wages are represented by the human capital earnings function which has been developed by Mincer (1974).

( )

y = ₀ + ₁s+ ₂x+ ₃x2 +u

ln β β β β (1.)

s 1

β represents the schooling coefficient times s. It provides an estimate of the rate of return to education. The concavity of the observed earnings profile is captured by the quadratic experience terms x and x which are connected to 2 β₂ and β₃ respectively. This function suggests that if one decides to undertake additional schooling earnings are foregone since the time the person dedicates to schooling could have been used for working. Therefore a worker should be compensated by higher lifetime earnings in order to promote schooling. In order to justify the additional earnings the schooled workers should be more productive then their less schooled colleagues. In the long-run the supply and demand for workers of each schooling level are in equilibrium and no workers wish to change his level. This is the basic idea behind the human capital theory of educational choice. The worker acquires skills through education and on the job training. This is seen as a stock of homogenous human capital which influences the worker’s productivity by the same amount in all lines of work for all employees.

2.5.1 Sector labor market models

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17 models that are present. The author describes 4 alternative models of wages and employment in the formal economy. I will briefly outline the models.

The market-clearing labor market model

The market clearing labor market model is the most basic version of the four and describes the simple mechanics of supply and demand in an open market. The model takes the amount of labor demanded as a decreasing function of wage suggesting that higher wages will result in lower labor demand. The reasoning behind this lies in the idea that labor can be substituted for capital. As labor becomes relatively more expensive, capital becomes more attractive as a substitute.

The opposite side of the mechanism describes the labor supply. Simple logic tells us that the same reasoning is at play here. The supply curve of labor is taken as an increasing function of wage. The outcome is reached when the downward sloping labor demand curve reaches the upward sloping labor supply curve. In this model the wage serves as an intermediary to reach equilibrium since both employers and employees are free to act in self-interest.

The reason why wages fall in the GOLE model is based on this simple mechanism. As demand for labor decreases due to the fact that the remaining companies in the industry are the more efficient ones the price of labor will decrease as well since less work is left for the same amount of workers.

Above-market-Clearing wages set institutionally

The labor market behavior that this type of model tries to capture is that wages are set different from the equilibrium outcome of simple supply and demand forces as under the market-clearing labor market model. A different set of forces leads to wage rigidity and these forces are sometimes referred to as “institutional forces”. In the case of labor market modeling this refers to “forces other than the profit-maximizing behavior of firms and the utility maximizing behavior of workers”. The four different forces Fields (2005) distinguishes are minimum wages, trade unions, public sector pay policies, and multinational corporations.

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18 equilibrium they will hire less personnel than they would have done otherwise. This will lead to unnecessary unemployment. Minimum wage policies are seen as factors that can lead to labor market imperfections since it doesn’t let the market do the work itself

The second institutional force Fields (2005) recognizes is trade unions. By sticking together in a union, employees can form a stronger power block against employers. Research has showed that trade unions have raised the wages of their members in most cases (Aidt & Tzannatos, 2002) although in some countries the opposite is true (Lin, 1989; Park, 1991).

Third, public sector pay policies is distinguished as a force. In some countries these kinds of policies often result in substantially higher wages being paid to government workers than to workers active in the private sector. Therefore it is very popular to work in the public sector in these countries.

Finally, the presence of MNEs in a country is recognized as a force that can lead to higher wages since these corporations tend to pay, on average, higher wages and offer better working conditions than nationals as is explained in the previous section.

Above-Market-clearing wages set by efficiency wage considerations

This model aims at a total different causality than the market-clearing labor market model. Where the latter assumes that all workers are equal and set the minimum wage they want to do the work for by themselves and out of self-interest, this model aims at rising productivity by motivating employees with an above-market-clearing wage. The trade-off firms face is that an employer is willing to pay the higher wage only as long as the benefits of doing so outweigh the costs.

Above-Market-Clearing wages set on the supply side

The main message of this model is that behavior of the unemployed that act strategically and think that wages will go up in the future and are therefore not willing to accept a lower market-clearing wage. Therefore wages are kept unnaturally low.

2.5.2 Other factors determining sector labor market equilibrium

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19 define determinants that can explain the growth rate of sector wages. They present the growth rate of wages as a function of technological change, terms of trade or import changes, interest rate changes and the growth rate of labor supply. By doing this they cover the main fields of factors, namely the influence of international trade or factor movements, technological change or labor market developments, on both sector wages- as well as employment growth rates.

Technological change

Technological change is said to increase the difference between the skilled and less-skilled workers. The basic explanations for this phenomenon is that skill biased technological shocks (the discovery of the computer and its forthcoming ICT hype e.g.) have favored the wages and employment of skilled workers, but have had a negative impact upon the wages of the less skilled employees. In a paper by Desjonqueres, Machin, and van Reenen (1999) the evidence on this topic is reviewed and presented. What they find is that evidence in favor of this theory is rather limited. It is suggested that the theory sounds reasonable but authors that tried to prove it have had difficulties with isolating the effect.

Another paper by Haskel & Slaugther (2001) investigates both the impact of technological change and international trade on changes in the UK skill premium. The skill premium represents the average wage ratio between college and high school graduates and therefore can be seen as the premium that higher educated people receive over the lower educated ones. The authors measure trade as changes in product prices and technical change as TFP growth. The authors find less support for the influence of technology on intersectoral wage differences. Although the aim of this paper is not to explore the intersectoral differences, saying whether or not there is influence does matter since countries or industries that have become more skill-intensive might face a higher growth of wages. Therefore part of the growth in wages can be attributed to technological change.

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20 Interest rate

In my search for determinants that influence the equilibrium outcome of sector wages I analyzed a CPB8 document that describes a multi-sector model of the Dutch economy and hereby illustrates the mechanisms of the model by using several applications. Although it is a country-specific model it still is useful for me since the reasoning behind the mechanisms is also applicable to the other countries in my sample especially the section which describes how equilibrium on the labor market is established. The authors suggest that the level of equilibrium unemployment depends, among other variables, on the real cost of capital. The idea is as follows. An increase in the costs of capital (higher interest rate) means that the cost of labor (wages) as a substitute becomes more interesting since it induces firms to produce in a less capital-intensive way. The result is that the demand for labor will rise.

In support of this statement Arestis, Baddeley, and Sawyer (2007) investigates the relationship between the capital stock, unemployment and wages for nine EMU countries. Their findings suggest robust and significant evidence for a positive association between wages and capital stock. Since the return on the capital stock is the interest rate it suggests a positive relationship between the interest rate and the wage rate. Again this sounds reasonable since a higher interest rate makes substitution of capital-intensive production into labor-intensive production profitable.

Terms of trade

Terms of trade measure sector imports relative to sector exports. This means that an increase in exports means an increase in the demand for products of a country. Simple supply and demand rules tell us that more production means more demand for labor and therefore an increase in the wage rate. The opposite can happen as well. This means that a country faces a deterioration of the terms of trade meaning that more is imported than exported. This will have a negative influence on wages. Supporting this statement with empirical evidence Lawrence and Slaughter (1993) and Krugman (1994) tried to do this for the US economy. Both papers found that the terms of trade remained unchanged over the time period investigated and therefore changes in wages must be due to other factors. It could be that this is a country-specific case and that results are different for other countries.

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21 In the next section I will present a model that tries to link the theory of FDI in general and CB M&A activity specifically to the theory of merger waves. The model combines the different topics of the literature review in order to model CB M&A activity.

3. The Model

Until now this paper has addressed several issues regarding M&As. I explained what the motives are for M&As, why they seem to come in waves, and what the driving forces are behind the phenomenon of merger waves. But there is more to explain. For example, what are the implications of M&A waves? What other factors are influenced by the existence of these waves? Or how do economies or sectors respond to these waves? These questions and many more will be discussed in this section in which I will outline a general equilibrium model that tries to capture the dynamics of CB M&A activity. The main advantage of a model is that it can predict behavior and can give a full overview of all the factors that are influenced.

In the next section I will present the model that explains merger waves in a general equilibrium setting. Furthermore the interactions with other factors are described. After having presented the model I will discuss whether or not it holds with reality. Neary’s theory hasn’t been tested extensively but there are some papers that tried to do so. Then I will discuss some of the pitfalls that the Neary model embodies and which can lead to biased parallels when comparing it with reality. Finally I will present some stylized facts about CB M&As and I will discuss whether or not these facts are in line with the model.

3.1 The GOLE Model

Neary (2003) tries to model globalization and market structure in an oligopolistic general equilibrium model. The author criticizes the perfectly competitive, and monopolistic general equilibrium models in that they lack explanatory power since evidence has repeatedly shown that these theories should be rejected. In short, the idea behind the perfectly competitive general equilibrium models is that due to free trade unskilled-labor-intensive imports into developed countries should lower the wages of unskilled labor within the developed countries hereby increasing the wage inequality between skilled and unskilled labor. This prediction is in line with the Stolper-Samuelson theorem9. Neary suggests that since the evidence points to

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22 rejecting the theory, it might be other factors that are at play here. Feenstra and Hanson (1996) for example allowed for multistage production. This means that production could be fragmented and reallocated where the unskilled-labor-intensive parts will be outsourced to the developing countries, while the skilled-intensive part is kept at the home country which is the developed country in this case. Although this added explanatory power to the modeling of international trade, there was still a lot of unexplained left. What Neary more or less suggests is that it might be the perfectly competitive paradigm and its simplifying assumptions that do not represent the perfect view of reality.

The key conceptual step in Neary’s approach is to view firms as large in their own sector but small in the economy as a whole. This means that in the economy as a whole the companies face monopolistic competition while in its own sector it has an oligopoly position. In the GOLE model described by Neary a two-country world is assumed, with a “home” and a “foreign” country. Furthermore, it is assumed that there are no transport costs or other barriers to international trade, and the world market is fully integrated. All home firms

( )

n face the same marginal costs c

( )

z and equilibrium output y

( )

z . The same goes for the foreign firms

( )

*

n with marginal costs of c*

( )

z and output y*

( )

z . Finally total sales equal the sum of total production by home and foreign firms:

( )

z ny

( )

z n y

( )

z

x = + * * (2.)

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23 Figure 1: equilibrium production patterns for arbitrary home and foreign marginal costs

(From: Neary, J.P., 2003, Globalization and market structure)

Figure 1 displays the different combinations of marginal costs that determine the different equilibria. If both home and foreign marginal costs exceed

( )

a , equilibrium lies within the O region. This means that none of the firms will actually serve the market. Otherwise the market is served by either home, foreign, or both firms. The lines that determine the boarder of whether or not a market is served by home, foreign, or companies from both countries depends on the number of home firms

( )

n and the number of foreign firms

( )

n in * combination with the maximum of the marginal costs a both firms face. In this case, home firms are unprofitable unless c

( )

z is below:

( )

[

]

(

* 1

)

* * + + n z c n a (3.)

This defines a threshold locus, the upward-sloping line separating the F and HF regions.

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24 Home country firm’s marginal cost:

( )

z wa

( )

z

c = (4.)

Foreign country firm’s marginal cost:

( )

z w a

( )

z

c * = * * (5.)

Figure 2: equilibrium production patterns for a given cost distribution

As one can see in figure 2 a downward-sloping line has been entered into the graph. The trick Neary executes is that he assumes that sectors can be ranked unambiguously so that for low values of c

( )

z (and high values of c*

( )

z ) only home firm production can be profitable while for high values of c

( )

z (and low values of c*

( )

z ) the foreign firms are the winners. In the figure we can derive two threshold sectors namely ~z and z~ . In between these sectors, for the * given wage rate and, hence, distribution of costs, both foreign and home production can be profitable. All sectors for which z is less than z~ are competitive in the home country, while all sectors for which z is greater than ~z are competitive in the foreign country. Hence, home * and foreign firms coexist in sectors between ~*

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25 Neary concludes the explanation by claiming that if one had used a competitive model there can be only one sector in which both home and foreign country firms could coexist namely when c

( )

z equals c*

( )

z . By using the market form oligopoly high-cost firms are not necessarily driven out of the market. So if countries are opening up their markets and trade liberalization takes place it is not necessary the case that higher-cost sectors will be competed out of the market. Although in some sectors this will still be the case. The range of countries that can coexist is therefore broadened. This idea supports the evidence that perfect competition models of general equilibrium lack explanatory power.

3.1.1 Cross-Border Mergers & Acquisitions

One of the important features of Neary’s model is that he has achieved to incorporate cross border mergers and acquisitions into a model of oligopoly. Firms that engage in Cournot competition10 do not have a reason to merge since there are no cost savings to achieve. This term is called “the Cournot merger paradox”11. Neary’s oligopoly model allows not only for cost differences (remember that low-cost and higher-cost firms could coexist in equilibrium) but for international differences in the exploitation of technology as well. According to Neary these facts itself are a natural reason for CB M&As. The idea behind M&As are that the incentives for a foreign firm to take over a home firm is equal to the following formula:

0 * 0 * 1 π π π − − ≡ fh G (6.)

Where π₁* is the profit of the combined firms after the takeover minus the profit of the foreign firm in the pre-merger situation, *

0

π , minus the cost of acquiring the home firm, which is assumed to equal its initial profits, π0. In Neary’s model outputs are strategic substitutes in

Cournot competition. Therefore, Neary reasons, a takeover of one firm by another raises profits for all firms. So if the cost differential is large enough the profit of, for example, a foreign firm that has acquired a home firm can be larger than the combined profits of the two firms in the pre-merger stage due to the fact that outputs are strategic substitutes.

10

The classic Cournot model is static in nature, with each (single-product) firm’s strategy being the quantity of output it will produce in the market for a specific homogeneous good.

11

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26 In figure 3 the incentives for takeovers are represented. What we see is that in the region called “incentives for foreign firms to take over home firms” high-cost home firms can be profitable but face the danger of being taken over by a foreign firm that produces at lower costs (remember that the distribution of technology differs across countries). At the opposite side of the figure the same interaction is at play. Here low-cost home firms have incentives to take over high-cost, though still profitable, foreign firms. So what Neary does with his model is relaxing the space of the strict borders defining the region in which home, foreign, or both can exist. Hereby he is also able to explain the merger paradox. It is in this region where my interest of work lies.

Figure 3: takeover incentives

Until now I have only discussed incentives for M&As from a rather static point of view. Since the aim of this paper is to see CB M&As in a time frame and investigate how factors are influenced by merger waves we have to determine what Neary says about merger waves. The question that raises here is how the incentives for CB M&As described above can initiate a merger wave?

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27 comprises a sample of firms ranging from lower-cost to higher-cost firms. As a merger takes place profits for all firms increases relatively by the same amount. Since lower-cost firms have more output due to their cost advantage, they also face higher profits in absolute terms. Therefore another takeover will, again, increase profits of the remaining firms. Profits are divided proportionally equal in relative terms while in absolute terms the lower-cost firms will gain more. Stated theoretically a fall in the number of firms n therefore raises the incentives

fh

G for further takeovers. The result is a sort of “reaction effect” when once a merger takes place it becomes more likely that more mergers will take place. As Neary states it:

“A profitable takeover of one home firm by a foreign firm increases the gain to a takeover of one of the remaining home firms by a foreign firm in the same sector.”

Although this theory may sound reasonable in order to explain why the amount of mergers may increase at a certain time it still doesn’t explain why the amount of mergers contracts at a certain time or even decreases. In order to explain that part I have to discuss how wages react to CB M&As in Neary’s model.

3.1.2 Wage adjustments

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28 result in a fall in wages in order to restore equilibrium. Although we have to assume here that the labor market is perfectly flexible.

3.1.3 How does the merger wave come to an end?

The implication that wages will fall can be seen as the turning point of the cyclical pattern of the merger wave. At the point that wages will fall the merger wave will be at the peak of its cycle. Because what happens is that if wages are falling the profit of the potential target firm, which still faces higher costs than the acquiring firm, increases and therefore the probability of being taken over decreases. So the further wages fall the more firms can remain in business due to an increase in profitability.

When represented graphically as in figure 4 you see that at the upward phase the wages move towards the dashed line until the peak of the wave is reached. From that point on the wage line will move to the left and finally becomes the solid line. The part of the solid line covering the HF area is larger than the dashed line covering the HF area. What this means is that more firms can be profitable, both high- and low-cost, both home and foreign. So the risks of being taken over those high-cost firms are exposed to declines due to the decline in wages. When this risk declines this means that the merger wave dampens.

Figure 4: Wage adjustments dampen cross-border merger waves

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29 3.1.4 Pitfalls of the Neary Model

As in every economic model assumptions about real world behavior have to be made in order to be able to capture this behavior in a model. The Neary model does this as well. Although those simplifying assumptions are necessary they can also create problems that can lead to biases in the output of the model.

First of all the Neary model suffers from the “after-you problem”. A wave of mergers has to be initiated since that is one of the driving forces behind the model. Since all outputs in a sector are strategic substitutes the profits of all remaining firms, both home and foreign, increase after the takeover. As a merger takes place profits for all firms increases relatively by the same amount. Since lower-cost firms have more output due to their cost advantage, they also face higher profits in absolute terms. Therefore another takeover will, again, increase profits of the remaining firms. This explanation embeds the “after-you problem”. Since it can be of strategic interest to wait for other companies to merge since profits increase afterwards the merger wave might not be initiated in the first place. If this happens one of the most important carriers of the model is removed. In his work, Neary (2003) ignores this problem by assuming that all profitable bilateral mergers will take place while in reality strategic behavior by companies might result in other outcomes not captured by the model.

Furthermore Neary assumes that labor markets are perfectly flexible. This is needed since wage adjustments make it possible for higher-cost firms to become profitable again. In the literature section I derived several forces from the literature on sector labor markets that are known to disturb the outcome of labor market equilibria. Furthermore strategic behavior of labor market participants might cause wage rigidities. In line with these predictions my results later on will show that wages do not always adjust perfectly hereby following the theory that wages are sticky and might take time to adapt. This is supported by the fact that previous CB M&As might influence wages later on. Although the flexible labor markets assumption is a necessary one it is rejected by real-world evidence and therefore can be considered as a pitfall of the model.

3.1.5 Testing Neary’s predictions

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30 in their CESifo working papers. I will describe their main findings. Their papers are of particular interest for me since I want to follow the same approach as they did. I do understand that there are some disadvantages concerning this approach and I do agree with the critics on the papers that in order to test a general equilibrium model one should test the model in all its facets to truly explore the general equilibrium characteristics of the model. The problem is that this is very difficult and I consider it as beyond the scope of this thesis. Since the Neary model is rather young there is nothing wrong with deriving some specific hypotheses from the model, hereby more or less moving into partial equilibrium, test whether or not there exist some support for it, and design some stylized facts regarding CB M&As. This is helpful in showing in whether or not the model has any significant empirical meaning in the first place. Once this seems to be the case one can explore the characteristics of a general equilibrium model which has without a doubt much more to offer than partial equilibrium models.

Brakman, Garretsen, & van Marrewijk (2005) derived two hypotheses from Neary’s model. The first one is that acquiring firms tend to be efficient and therefore operate in sectors that have a revealed comparative advantage. The authors measure the comparative advantage by making use of the Balassa index12. The index represents a measure of the export of country A’s industry i as part of the total export of country A compared to the export of a number of reference countries’ industry i as part of the total export of the reference countries. If the outcome is larger than 1 the industry is said to have a revealed comparative advantage in that specific sector. If it is lower it represents a weaker sector of the specific country. Combining the Balassa index with the Thomson data set on mergers and acquisitions from which they derive a set of European countries that are very active in CB M&As during the fifth merger wave they can investigate whether or not this is true. Their findings suggest that for their sample M&As are undertaken by “strong” firms that are active in sectors in which revealed comparative advantage as measured by the Balassa index. So this supports Neary’s hypothesis.

The second hypothesis that the authors derive from Neary is that CB M&As come in waves. It is indeed shown that waves are a characteristic of CB M&As. A distinction has to be made between a sector-wave effect and a total-wave effect whereby the sector-wave describes the

12

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31 wave effect within a specific sector while the total-wave aggregates the effect over all sectors. The authors conclude that when looking at sector waves there is positive evidence suggesting that M&As come in waves over a two-year time horizon. For total waves they found positive evidence for a one-year horizon while it was negative for a two-year horizon. This is in line with Neary’s prediction that the positive effect of increased profitability of takeovers lasts about one year and decreases in two years time.

3.2 Stylized Facts about Cross-Border Mergers & Acquisitions

Brakman, Garretsen, and van Marrewijk (2006) in their working paper sum up empirically proven facts that exist about CB M&As. These empirical facts are important in order to determine where theory meets reality. For the analysis of CB M&As the authors use Thomson’s global Mergers and Acquisitions database which is an extensive data source related to this topic. For the exact conditions of what exactly falls under the definition of a completed CB M&A I want to refer to their paper. In this section I just want to discuss their main findings.

In this paper they move away from Neary’s model in that they describe some stylized facts about CB M&As and then discuss how this holds with theory instead of the other way around. The first fact the authors mention is that most FDI comes in the form of CB M&As. This can be called surprising as one looks at the amount of literature on FDI in the form of a “Greenfield investment” relative to that of CB M&As. This again highlights how undiscovered this subject is. When one looks at the distribution of FDI from a large data set one can see that only 22% of FDI comes in the form of Greenfield Investments while the remaining 78% embodies M&As.

The second fact discusses the directions of CB M&As. As discussed in the previous section of this paper, M&As can be horizontal or vertical. Horizontal mergers are mainly based on the idea that taking over one of your competitors (so an M&A within the same sector) reduces competition and increases profits. The authors find that for the fifth merger wave the mergers where mainly horizontal of nature. This is the same way of reasoning Neary follows as his model tries to explain horizontal mergers.

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32 decision to engage in a vertical merger. The main part of CB M&As are horizontal of nature. This is not surprising since both the literature as well as the real world has shown that in general unrelated diversified or over diversified firms are not profitable.

Their third fact has already been discussed widely in this paper namely that M&As come in waves. The authors discuss the different streams of literature describing the nature of the cause of waves. They mention the positive correlation between merger waves and increases in share prices and P/E ratios on the one hand and the overall business cycle in general on the other hand. What is interesting is that they doubt the causality of the relationship so that the question is: What causes what? An upward movement in the business cycle can cause higher share prices hereby making it easier to finance a M&A. On the other hand the increase can also increase profits and share prices of the target hereby making it more expensive and less exposed to the risk of being taken over. It almost seems like a triangular scenario where the three different phenomena namely, the business cycle, the share price and the merger wave influence each other and are all interrelated. This again gives raise to the idea that general equilibrium models are needed in order to explain M&A activity since relations are complex.

Neary also incorporated the fact that mergers come in waves. After the low-cost firm takes over the high-cost firm, the profits are divided amongst the remaining competitors. This makes the next merger more interesting since there is the prospect of increasing profits. This is how Neary tries to embed the beginning of a wave into theory.

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33 opportunity that countries can serve as a target country for M&As as well as an acquiring country. The model incorporates the possibility of north-north directions of CB M&A activity.

The final stylized fact that Brakman, Garretsen, and van Marrewijk come up with is that the size of and inequality between M&As has grown over time. They list the largest deals over a time period of 20 years and one can see from this list that the value of the deals are becoming larger over time. This means that the size distribution of M&As has become more unequal over time. The GOLE model doesn’t mention anything about the size and inequality of mergers and therefore this finding is not necessarily in competition with Neary.

3.3 Estimation Equation

So from the story above we can conclude that Neary’s model predicts that CB M&As interacts and influences several other factors. One of the mechanisms of the model is that wage adjustments are the driving force behind the cyclical shape of the merger wave. Furthermore we know that mergers cluster by industry. So in order to be able to analyze how these predictions holds with reality I have derived the following general equation that will be estimated throughout my analysis.

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34

3.4 Hypotheses

From the theoretical framework I can derive two general hypotheses regarding wages that will be tested in different settings throughout this thesis. First of all I will discuss the upward phase of the wave. During the upward phase of the merger wave, wages will probably be positively related to CB M&A activity since higher wages, as a result of increased multinational presence, increase the probability that higher-cost firms are taken over by the lower-cost firms. Actually Neary doesn’t say much about the increase of wages during the upward phase of the wave. But from the literature on MNE presence we can derive that MNE’s pay higher wage than local firms whether or not this is due to the fact that they are multinational or that they hire more skilled personnel doesn’t really matter here since in Neary’s model the distribution of technology across countries differs and is a reason itself for CB M&A behavior. Therefore it is very well possible that there is a positive relationship between sector wages (remember that mergers cluster by industry) and CB M&A activity during the upward phase of the merger wave. From this I derive my first general hypothesis:

H1: As the wave is in the upward phase, which will range from the year the upward phase is initiated until the wave contracts at the peak, there will be a positive relationship between CB M&A activity in industry x and sector wages of industry x.

The second statement that I derive stems directly from the GOLE model and states that during the dampening of the wave, that ranges from the peak of the wave till the lowest level of the wave, higher-cost firms become profitable again due to the fact that wages decrease, therefore profitability increases, and the probability of being taken over decreases. Finally this will end in a situation that is comparable to the start of the wave. Therefore I predict that when the amount of CB M&As decreases, wages will relatively decrease as well. Therefore there will also be a positive relationship between CB M&As and sector wages during the downward phase of the wave. From this I derive my second general hypothesis:

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35

4. Data Sources and Sample Description

In this section I will describe my choice of data. I will discuss over which time period my data is analyzed and why. Afterwards I will explain the choice of countries and industries that I selected for the sample. Furthermore I will discuss which CB M&A and wage data I obtained for my dependent and independent variable. The wage data is linked to a set of control variables that is also discussed in this section. The controls are supported by empirical evidence.

4.1 Time Period

In order to determine how powerful Neary’s model holds with reality I have to analyze a specific M&A wave. I will pick the wave that is known as the “fifth merger and acquisition wave” in history and it took place during the late nineties. I have several reasons for picking this fifth wave. Due to the fact that Neary’s model aims at explaining the importance of cross-border M&A waves this wave suits the model best since it is characterized in the literature as an international wave hereby suggesting that the phenomenon of cross-border mergers and acquisitions is apparent. Furthermore the wave took place recently which makes data availability more likely.

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36 Reasons for this change in the composition of players participating in CB M&A activity is that due to the fact that markets are more integrated (the fact that within Europe financial markets have converged and a single currency unit has been established can be seen as an argument for the rise of other countries besides the UK and the US participating in CB M&A activity) and therefore more transparent, CB M&As became a more profitable option.

I want to investigate whether or not CB M&As influence sector wages. Therefore wave patterns have to be present in the industries under consideration since this is one of the main characteristics of CB M&A activity. The start and the length of the fifth wave have been identified in the literature. In order to capture the run-up period, the peak, and the period that shows the dampening of the wave my data will cover the years 1992-2002. From this I derive figures that show the presence of wave patterns for the different industries when aggregated over countries. The figures are included in the results section.

4.2 Countries

In order to investigate the effect of CB M&As it makes sense to include countries into the data set that have served as target countries throughout the selected time-period. Therefore I will follow Brakman, Garretsen, and Van Marrewijk (2006). From the Thomson data set covering CB M&As they derived the following table:

Table 1: ten largest target M&A countries 1986-2005. (Constant 2005 $ billion) annual average target flows

country 1986-1990 1991-1995 1996-2000 2001-2005 1986-2005 1. United States 86.5 44.6 238.4 99.6 117.3 2. United Kingdom 29.6 22.7 119.7 92.7 66.2 3. Germany 4.1 7.9 83.3 40.3 33.9 4. Canada 11.3 6.9 37.6 22.2 19.5 5. France 5.8 12.9 28.9 26.1 18.4 6. Netherlands 3.0 5.7 29.4 20.6 14.7 7. Australia 4.1 8.4 18.0 13.5 11.0 8. Italy 3.8 5.8 10.4 21.8 10.5 9. Sweden 1.7 4.9 23.7 10.3 10.2 10. Spain 3.1 5.0 11.1 11.8 7.8

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37 Following this table, I selected the following countries13:

1. United States 2. United Kingdom 3. Canada 4. Netherlands 5. Australia 6. Italy 7. Sweden 8. Spain

4.3 Industries

Simple logic suggests that the effects of CB M&A activity is stronger in sectors that are characterized by a high intensity score on CB M&As since M&As come in waves and cluster by industry as explained in the literature review. From a paper by Andrade, Mitchell, and Stafford (2001) I derived a table that represents a top five of sectors in which CB M&A activity has been intensive14.

Table 2: Top five sectors for intensive CB M&A activity 1990 wave

Metal Mining

Media & Telecommunications Banking

Real Estate Hotels

(From: Andrade, Mitchell, and Stafford, 2001, new evidence and perspectives on mergers.)

13

The reason for excluding some countries from this list has to do with the fact that sector wages for the specific countries over the specific time period suffered from limited data availability. Therefore I excluded France and Germany from my sample.

14

Cross-Border Merger & Acquisition Waves