Synergies and Internal Agency Conflicts: The Double-Edged Sword of Mergers

Abstract

This paper investigates the interaction between synergies and internal agency conflicts that emerges endogenously in multi-division firms. We model internal agency activities as entrenchment: to avoid personal costs, a divisional manager can reduce the likelihood of her division being divested by reducing its attractiveness in an alternative use. As in Williamson (1975, 1985), we characterize asset specificity as the difference between the value of assets in their current use and in alternative uses. We show how the presence of synergies, by modifying this difference, can alter the divisional manager's incentive to entrench herself. While merging divisions is always worthwhile for sufficiently positive synergies, merging firms with mis-deployed assets might actually be detrimental for smaller synergies due to entrenchment incentives spawned by the merger. In mergers of firms with low asset specificity, negative synergies might actually motivate mergers followed by divestiture to improve entrenchment incentives. We emphasize that when the synergy and internal agency effects are of opposite sign, a circumstance we term the double-edged sword of mergers, the gains from merging may not even be increasing in the expected synergies. Finally, in mergers of firms with high asset specificity, synergies alone dictate the choice of organizational form. We characterize when divisions should optimally be stand-alone firms and when they should instead be part of a merged firm. Our model predicts an absence of diversifying mergers in industries plagued by mis-deployed assets and offers a novel explanation for the cross-sectional variation in post-merger valuation. Our model can explain why mergers may be valuable ex ante while leading to successful divestitures ex post, as observed in the 1980s.