Mergers and Acquisitions: Why Companies Buy Each Other

The reasons companies combine, why many acquisitions disappoint, and how competition authorities review big deals.

When two companies combine, it is called a merger if they join as rough equals, or an acquisition if one buys the other. Together, these deals are known as M&A. They can reshape entire industries.

Why companies combine

Companies give several reasons for deals:

Synergies: the combined company might cut duplicated costs, like two head offices, or sell more by combining products and customers.
Growth: buying a company can be faster than building a new business from scratch.
New technology or talent: large firms often buy start-ups to acquire their products or engineers.
Market power: a deal may reduce competition, allowing higher prices. This is the reason regulators watch closely.

The takeover premium

To persuade shareholders to sell, a buyer usually offers a takeover premium: a price above the target company’s current share price. Premiums of 20 to 40 percent are common. The buyer is betting that the synergies will be worth more than the premium it pays.

Do deals work?

A large body of research finds that many acquisitions fail to create value for the buyer’s shareholders. Target shareholders usually gain from the premium, but the buyer often overpays. Reasons include overconfident managers, difficulty combining different company cultures and systems, and synergies that prove smaller than promised.

A merger that disappointed

In 2000, the internet company AOL and the media company Time Warner combined in a deal valued at well over 100 billion dollars, promising to unite online services with films, magazines and cable networks. The expected benefits largely failed to appear as the dot-com bubble burst, and in 2002 the combined company reported a loss of nearly 99 billion dollars, mostly from writing down the value of the deal. The companies later separated. It is often cited as one of the least successful mergers in history.

Competition review

Large deals are usually reviewed by competition authorities, such as the U.S. Federal Trade Commission and Department of Justice, the European Commission, and the Competition Commission of India. They can block deals or require the companies to sell parts of the business if the combination would substantially reduce competition and harm consumers.

Assuming bigger is always more efficient

Merged companies do not automatically become more efficient. Many struggle to integrate, and some deals mainly reduce competition. Whether a merger benefits the economy depends on whether real cost savings or better products outweigh any loss of competition.

Key takeaways

Mergers combine equals; acquisitions involve one company buying another.
Companies seek synergies, growth, technology and sometimes market power.
Buyers usually pay a takeover premium, and many acquisitions disappoint the buyer.
Competition authorities review large deals and can block or change them.