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UI Researcher Finds That Risk Management Is Goal of Many Merger Waves

Jon GarfinkelA University of Iowa finance researcher has discovered that while corporations often use mergers and acquisitions (M&A) to increase revenue or market share, they also use them as a risk management tool to cope with volatility in their own industry.

Jon Garfinkel, a finance professor in the Tippie College of Business and the Waugh Business Faculty Research Fellow, reached these findings after studying so-called M&A “waves,” two-year periods when industries see more merger activity than usual. Garfinkel studied these waves between 1980 and 2006, a period marked by frequent consolidation in numerous industries. For instance, telecommunications went through a significant merger wave starting in 1999, highlighted by the 2000 merger of Time Warner and AOL.

Other examples are the waves in the banking industry in 1985 and 1996, and the deregulation-inspired waves in the entertainment and broadcast industry in 1987 and 1996. Garfinkel’s research showed that wave years saw an average of 14.55 acquisitions per year in an industry, while nonwave years saw only 5.83 acquisitions.

In studying these waves, Garfinkel noted that many firms within certain industries experienced cash flow volatility as a result of some kind of economic shock. In other words, he said that perhaps they weren’t selling enough product or service, were paying too much to create that product or service, or both. Some companies also experienced spikes in revenues or significant declines in costs. Garfinkel tracked the firms’ cash flow by measuring their annual operating income and cost of goods sold and found that when those measures became more volatile in an industry, a vertical integration-driven merger wave began shortly afterward.

“Economic shocks like deregulation, new discoveries or a sudden scarcity of a resource tend to cause spikes in firm cash flow volatility, and that makes it difficult for them to raise capital because investors don’t like volatility,” Garfinkel said.

To reduce the volatility, firms responded with a wave of vertical integration, acquiring suppliers, distributors, or other firms in their supply chain in order to better control their costs and reduce their risk. For instance, he said a soft drink maker may acquire a large bottling and distributing company to reduce its volatility by giving it more control over its bottling and distribution costs.

Recently, he said the growth of China’s economy has led to shocks in many industries because explosive growth in its construction sector required large amounts of iron ore, leading to a global scarcity and driving up prices. That price increase and the potential scarcity have led to vertical integration as firms around the world combine to have more control over their prices and availability.

“When you have that added control, you can smooth cash flows and reduce volatility,” he said. He found that on average, 7.96 mergers a year were vertical during wave years; during nonwave years, that number was less than half, at 3.18.

“This shows us that vertical integration activity appears to be a more important component of merger activity during waves,” he said.

Garfinkel said that researchers have known for years that firms engage in M&A activity to grow, to expand geographically, or to increase market share. This is the first study to show that risk management might also be a catalyst.

Garfinkel’s paper, “The Role of Risk Management in Mergers and Merger Waves,” was co-written by Kristine Watson Hankins of the University of Kentucky. It will be published in a forthcoming issue of the Journal of Financial Economics.


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