Financial vs. Strategic Buyers
Executive Summary — What drives either financial or strategic buyers to have a more dominant position in mergers and acquisitions activity at different points in time? The question of competition matters not only because the economic magnitude of this activity is so large, but also because the balance of power between financial vs. strategic acquirers changes the ownership structure of assets and alters the incentives and governance mechanisms that surround the economic engine of our economy. This paper explores how the possibility of misvalued debt markets can both fuel merger activity and alter the balance between PE and strategic buyers. The authors use an approach based on a model of private equity (PE) and strategic merger activity in which all players in the model make value-maximizing decisions conditional on their information. Findings suggest that the possibility of misvalued debt may have important impacts on both firms and investors, on who buys whom, and for default levels in the economy. Key concepts include:
- Misvaluation can stem from asymmetric information between PE firms, managers, and investors.
- The possibility of misvalued debt not only changes the likelihood of an acquisition, it also changes the type of buyer and the way the assets are owned. This matters because although the knowledge that the debt market is under or overvalued may be impossible to possess in real time, looking backward the times when credit was particularly misvalued correspond to increased M&A activity and increased PE activity relative to strategic buyers.
- The level of activity of financial buyers in aggregate in the economy will correlate with default probabilities. Financial buyers will be more active and take on more debt than strategic buyers when debt is overvalued. Thus a surprisingly large number should end up in financial distress.
- Even though both strategic and financial buyers would like to take advantage of interest rates that are "too low" and avoid borrowing when interest rates are "too high," they are differentially impacted by the errors and are willing to pay relatively more or less depending on the sign of the error made on interest rates.
Within the great oscillations of overall merger activity there is a shifting pattern of activity between strategic (operating firms) and financial (private equity) acquirers. What are the economic factors that drive either financial or strategic buyers to dominant positions in M&A activity? We introduce debt market misvaluation in M&A activity. Debt misvaluation might seem limited since both types of acquirer (and the target) can access misvalued debt markets. However, moral hazard and insurance effect differences between types of buyers interact with potential debt misvaluation debt, leading to a dominance of financial versus strategic buyers that depends on debt market conditions.