There are many reasons why companies engage in M&A. For some, the decision is purely financial and intended to increase revenues and profits. But for most, the decision is purely strategic. In short, companies pursue M&A for increase in capabilities, diversification or expansion of market share.
When a company grows to a certain level and requires more than just organic means to grow further, both financially and otherwise, M&A’s are required. In today’s shareholder-centric society where companies are compelled to appease their shareholders each quarter due to the constraint of quarterly reporting formalities, M&A’s is like a cheat code to companies. It helps them to accelerate growth.
Increase in capabilities
Take the case of a pharmaceutical company with the intention to develop a new type of drug. It lacks certain skills and knowledge to develop this drug, and decided to acquire a smaller rival that offers those. This way, the acquirer increases its capabilities and subsequently, its revenues and margins. While one may argue that the expense could have been avoided by the acquirer internally developing the drug, there is also the issue of time and development cost.
Diversification is a strategy used to expand product and client segments. Think of Kellogg’s acquisition of RXBAR, or British American Tobacco’s (BAT) acquisition of Reynolds American. Those are examples of diversification. In the case of BAT, the Reynolds’ acquisition gave them control of the Newport menthol cigarette brand and reach the African-American client segment in the US. Diversification-driven M&A’s are extremely common in the US.
Expansion of market share
This is quite straightforward. When a company acquires a rival or even an overseas firm, it expands market share. They are also called horizontal mergers and result in greater synergies if properly executed. Such synergies enable cost reductions and higher margins. The best, and most recent, example is the acquisition of Starwood hotels by Marriott, that was done to combat the rising threat of Airbnb to the traditional hotel industry.
Economies of scale
Companies also merge to realize economies of scale, which is extremely important to be sustainable. If a company is unable to reach a position where its marginal revenue (MR) is greater than its marginal cost (MC), it has few choices other than to be part of yet another company in its industry.
The rationale behind an M&A deal is crucial and companies have to fully size up the reasons for carrying out this process. It also helps to have such a solid rationale when sourcing for deals.