Why Do Firms Merge and then Divest: A Theory of Financial Synergy

Abstract

This paper develops a theory of mergers and divestitures wherein the motivation for mergers stems from the inability to finance marginally profitable, possibly short-horizon projects as stand-alone entities due to agency problems between managers and potential claimholders. A conglomerate merger can be viewed as a technology that allows a marginally profitable project, which could not obtain financing as a stand-alone, to obtain financing and survive a period of distress. If profitability improves, the financing synergy ends and the acquirer divests assets to avoid coordination costs. Since it is the project's ability to survive as a stand-alone that causes the divestiture, divestiture decisions are interpreted as good news by the market in our model. Further, our theory is able to reconcile two important but seemingly contradictory empirical findings: 1) mergers increase the combined value of the acquirer and target (Jensen and Ruback (1983), Bradley et al. (1988) and Kaplan Weisbach (1992)): and, 2) diversified firms are less valuable than more focused stand-alone entities (Berger and Ofek (1995), Lang and Stulz (1994), and Servaes (1996)). Diversification adds value in our model by facilitating the financing of positive net present value projects that cannot be financed as stand-alones. At the same time, because these same projects are only marginally profitable, diversified firms are less valuable than stand-alones.