Mergers and Acquisitions (M&A) as a Fundamental Element of Corporate Strategy

Introduction

Mergers and acquisitions (M&As) are progressively being applied by organizations to reach the corporate growth and maintain their stand and status in the marketplace. The total value of global M&A increased from US $807 billion in 1995 to the highest peak of US $4.580 billion in 2007, with a significant decrease in 2002 to US $1.340 billion (Thomson Reuters 2012). Even though M&A activities experienced a phase of stagnation in the crisis period (US $2.300 billion), the worldwide value remains at a very high level, with a return to the previous peak of US $4.500 billion in 2015 (JPMorgan Chase and Co. 2016). Cross-border M&A set a record in 2015, with a deal value exceeding US $1.380, comprising more than 31 percent of the year’s total M&A deal value (Deloitte 2016). The prevalence of M&A determines that acquisitions are a fundamental element of corporate strategy, as they may contribute to the cost reductions and higher profitability considerably. The expansion and synergy realization, being the most frequently claimed motives for acquisitions, play a significant role in a successful M&A deal (Galpin & Herndon 2007, Gaughan 2007, Picot 2008). Product or knowledge sourcing and organizational learnings are also considered as the reasons for a merger (Bannert-Thurner 2005, Grant 2008, Ichijo & Nonaka 2007, Leonard & Swap 2005, Goulet & Schweiger 2006). By various entities, M&As are perceived as an effective way for development and expansion into new markets, incorporation of new technologies and creation of new knowledge. Even though this trend is likely to remain, numerous studies demonstrate that two-thirds of all M&A deliver surprisingly low success rates and fail to create the intended value (Cartwright & Schoenberg 2006, Gomes et al. 2011, Haleblian et al. 2009).

According to Haspeslagh &; Jemison (1991) and Jemison &; Sitkin (1986), the inefficient integration process in the post-merger phase is one of the primary causes of the disability to generate the value. Recent studies state that high failure rate of M&A transactions, especially for cross-border deals (Grotenhuis 2009), is due to the poor post-merger performance, namely the planning and implementation of integration activities (Galpin & Herndon 2007, Weber & Tarba 2012). The underestimation of the importance of these processes may entail negative consequences concerning the synergy realization. Thus careful and accurate planning and implementation processes along with the adequate time and resource allocation are the fundamental elements of M&As’ success (Galpin & Herndon 2007, Galpin & Whittington 2010, Gomes et al. 2011). Notwithstanding, the executives still underestimate the complexity of M&A transactions. The process involves various dimensions; therefore careful attention is needed throughout the whole process: from the pre-merger phase to the completed integration of the organizations.

As was previously mentioned, the global economic crisis had its adverse effect on the cross-border M&As from 2007 onwards. However, the record-breaking 2015 indicated that the upward trend for this type of corporate activities is not coming to an end (Baker & McKenzie, 2016).

The growing M&A market, especially in the developing countries, determines the relevance of the Master Thesis. With the fast increasing popularity of cross-border acquisitions, various studies were conducted regarding the determinants of the success of such deals, while very few scholars analyzed the risk and its causal factors the acquirer is exposed to by executing before-mentioned transactions. Even though the cross-border acquisition entails the portfolio diversification, the acquirer is also incorporating the internal risk of the target company. In particular, this relates to the target from developing countries with high political uncertainty.

The purpose of this master thesis is to investigate the changes of the default risk of the acquirer in cross-border M&A transactions, where the acquiree is from the emerging markets (BRICS countries); to examine the significance of these changes and their determinants. The proposed research questions are following: Does the inbound mergers and acquisitions with the target company from the developing country impact the probability of default of the acquirer? Is the influence positive or negative? What are the determinants and causal factors of this impact, if it exists?

The theoretical framework for this work will be based on existing scientific literature that studies the phenomenon of M&As. Worth to mention, that the scholars analyzed this issue in two scientific journals of the Q1 category (First Quartile – Based on Impact Factor data in the Journal Citation Reports by Thompson Reuters). The papers mentioned above are focused only on the transactions with American acquirer. Thus, the comparison with these research will be conducted.

Consequently, it is necessary to apply the multiple linear regression analysis to investigate the fundamental causal factors of the changes in the default probability. Additionally, the modified Merton Model will be employed to assess the default probability of the acquirer.

The structure of this thesis is threefold. Part I of this study aims to provide an explicit overview of the BRICS countries’ M&A market as well as of the global one. Moreover, the literature review will be included in this section to elaborate on the following topics: M&As impact on the performance of the companies; Models for the Default Probability assessment of the organizations; The intersection of the former and the later – M&As influence on the default probability of the acquirer.

Part II aims to review various approaches for the Default Probability assessment. Despite the classical methods which are no longer among the most used ones, like inferring default probability from credit spread, this section will cover the cornerstone of this topic – The Merton Model for Structural Credit Risk (1974). Furthermore, the most relevant and conventional models will be discussed – modified Merton Models (Bharat and Shumway (2008); Simple Naive Model). Moreover, Down-and-Out (barrier) option model will be described. Part III is dedicated to the data sample description and summary statistics, multiple linear regression and its assumptions, followed by the results presentation and the conclusion.

Mergers & Acquisitions

Definition

Usually, the expression “Mergers and Acquisitions” refers to a wide range of practices through which a firm can restructure its assets, by incorporating those of another company. M&As relate to the aspect of corporate finance strategy and management dealing with the merging and acquiring of different corporations and other assets by another company.

Mergers and acquisitions, whether being domestic or cross-border are considerably important for companies in the continuously increasing competitive environment. Moreover, the successful completion or, in contrast, failure of the M&A transaction may entail tremendous consequences for the entities as well as for the other constituencies in them (Sudarsanam, 2010).

Mergers and acquisitions are often referred to being synonyms, however there are slight differences between the two processes. The Merger relates to the process of combining the assets as well as the operations of the companies, sharing the resources to establish a new legal entity and achieving the collective objectives. Consequently, two individual companies cease to exist and a new combined entity is created. On the other hand, when the acquisition takes place, the acquirer purchases the share or assets of the target firm. In other words, an Acquisition is a transaction where one company takeovers the operations of another company. The acquirer posses the control over the assets with the operations being transferred to it. (Ross, Westerfield & Jaffe 2013).

Mergers & Acquisitions Wave Effect

Mergers and Acquisitions tend to occur in cyclical waves. Usually, the M&A activity fluctuates in conjunction with business cycles. For instance, when the economy is prospering, the volume of M&A deals increases dramatically. In contrast, in the period of the recession, the volume experience a significant decline. Nevertheless, taking into consideration recent years statistics of Mergers and Acquisitions, it can be seen that M&As may also be a source of growth even when the overall economy is stagnant. Usually, the takeover waves are driven by the technological and industrial shocks and frequently fueled by the changes of the legislation. The patterns depict that the takeovers increase in the periods of economic recovery, while their disruption is usually explained by a steep decline on the stock market. According to Martynova & Renneboog (2008), all the M&A waves are unique and have the peculiar characteristics which differentiate them from each other.

At the time of the first wave, multiple giant companies were formed as a result of the increased M&A activity. Public concern grew because of the monopolization attempts which marked restructuring activity. Consequently, the Antitrust Law was inducted in both Europe and the US (Gregoriou & Renneboog, 2007). The objective of the anti-trust policy was to break up dominant firms. As a result, companies expanded through vertical integration, where the firms in a supply chain are united through a joint owner. From that period onward, the Industries were dominated by several corporations, instead of one giant entity. The effort of the corporations to achieve economies of scale was the characteristics of the second wave, in comparison to the first one where the market power was the primary goal. The second wave was a movement towards oligopolies since after the wave many industries were dominated by two or more companies as opposed to just one (Martynova & Renneboog, 2005). The second wave collapsed in 1929 with the stock market crash and The Great Depression (Martynova & Renneboog, 2005). The third M&A wave started in the 1950s and lasted for almost two decades (Martynova & Renneboog, 2005). Similarly to the second wave, the third one also collapsed because of the economic recession. The third wave was different in the UK and the US. While the previous wave emphasized vertical integration, the third wave focused on diversification and development of large conglomerates since the anti-trust legislation left the acquiring firms in the US with the only option of buying companies outside their industries. However, countries without a strict antitrust policy, such as France, Germany, and Australia, did also pursue conglomerate strategies in hopes of enhancing company value and reducing earnings volatility (Andrade, Mitchell & Stafford, 2001).

According to Martynova & Renneboog (2008), due to the inefficient conglomerate structures the need to reorganize the business models appeared. It was a causal factor of the fourth wave in the 1980s. The fifth wave occurred during the 1990s as a result of economic globalization and technological innovations. Similarly to the previous waves, the fifth one ended as a consequence of the equity market collapse in 2000. A distinctive feature of the fifth wave was a substantial number of the cross-border transactions. The sixth wave started in 2003, when the economy began to recover after another stock market crash, the dot-com bubble. A striking characteristic of the recent merger wave is that market returns were considerably lower than market returns before deals in the fifth merger wave. At the time of the sixth wave investors and corporate managers started to show real signs of skepticism about the state of credit markets and its potential destroying effect on the financial system and the economy as a whole (Alexandridis et al., 2012). Start from the period of 2011 and onwards, the last identifiable wave takes place. In comparison to the previous wave, the optimist returns to the market. In 2014, M&A activity experienced the most significant transactions volume since 2007. It is observed that the today’s business environment which is characterized by the risk aversion of the investors and organic growth is dissipating. Nowadays, managers believe that purchasing the growth is significantly less complicated process than building it.

An interesting characteristic of the M&A waves is that they are differentiated from each other, despite the fact that they occur in readily identifiable waves over time. Consequently, the M&A activity in each particular industry tends to vary over time. Thus, sectors with the high merger activity level in one period are no more likely to exhibit the same level of merger activity in the subsequent one. This may indicate that a significant portion of merger activity may be due to industry-level shocks like technological innovations, supply shocks and deregulation (Andrade et al., 2001).

Mergers & Acquisition Typology

According to the theoretical framework of Mergers and Acquisitions, there are three types of merger or acquisition deals, namely horizontal, vertical and conglomerate. A horizontal transaction involves merging with or acquiring a competing entity from the corresponding industry. With this kind of acquisitions, companies typically endeavor to achieve the economies of scale, economies of scope and strengthen their market power. (Ross et al. 2013; Singh & Montgomery, 1987).

A vertical deal refers to merging with or acquiring a company with whom the entity has a supplier or customer relationship. In a given type of transactions, the two companies operate “vertically” in different levels of the production process. Organizations usually seek to exclude or limit the possible hold-up obstacles and enhance the efficiency of the production process with vertical acquisitions. (Ross et al., 2013)

A conglomerate transaction involves merging with or acquiring a company that is not a competitor, purchaser or seller and that is product-unrelated (Gaughan, 2007). The concept behind the conglomerate acquisitions is diversification and the ability to penetrate the new markets and product lines. Conglomerate acquisitions may frequently be considered as less risky and cheaper way of developing a company’s product portfolio or entering new markets. Nevertheless, when neither the acquirer or the target operates in the same industry, economic benefits of the deal can easily be exaggerated (Gaughan, 2007).

Furthermore, Mergers and Acquisitions can be characterized as friendly or hostile, depending on the position of the target company’s management or board of directors. A friendly takeover involves a merger between two corporations or the acquisition of the shares or assets of one corporation by an entity or an individual, with the approval of the directors and the shareholders of both corporations (Gaughan, 2007). In contrast, a hostile takeover occurs when an acquirer endeavors to obtain the control of the firm without the consent or cooperation of the target company’s board of directors. Thus, the fundamental aspect of a hostile takeover is that the target company’s management does not want the deal to fall through. Sometimes a company’s management will defend against unwanted hostile takeovers by using several controversial strategies, such as the poison pill, the crown-jewel defense, a golden parachute or the Pac-Man defense.

A hostile takeover is accomplished by proceeding directly to the company’s shareholders to get the acquisition approved. A hostile takeover can be executed through either a tender offer or a proxy fight. The acquisition type can be defined by various factors employed by the companies for deciding on a potential alliance partner (Galpin & Herndon 2007, Zollo & Singh 2004). Moreover, Mergers and Acquisition can also be classified depending on how the companies physically combine themselves in the transaction to form one entity. The conventional finance paradigm implies that the behavior of economic agents is entirely rational. Consequently, M&A activity is genuinely driven by the economic reasons, and should, therefore, lead to measurable improvements in the post-M&A performance. However, the empirical evidence explicates that numerous M&As destroy shareholder value in the post-merger period.

Behavioral explanations of the Acquisitions

Behavioral explanations of the Acquisitions replace the belief that stakeholders in the M&A process act rationally in a frictionless environment with more relaxed behavioral assumptions (Baker & Kiymaz, 2011). Behavioral corporate finance theories are based on psychology and the assumptions that there are additional motivations, besides value maximization, which explain why firms engage in mergers and acquisitions. From the opposite point of view, neoclassical theories are founded on value maximization and rational human behavior. Neoclassical theories imply that markets are efficient and that stock prices always entirely reflect all available information (Fama 1972). Additionally, these theories are also known as synergistic, and they perceive M&As as an efficiency-improving response to different industry and economic shocks (Shleifer & Vishny 2003).

Neoclassical Theories

The most common incentive for the companies to initiate M&A is the synergy argument claiming that the value of the post-merger firm is greater than the sum of the individual companies’ value before the merger. Generally, synergies are considered as the primary objectives of Mergers and Acquisitions. The concept of synergy is ubiquitous in the context of mergers and acquisitions. The realization of synergies is one of the most crucial drivers for M&A transaction. Moreover, synergy is the fundamental concept that lies behind value creation through M&A. Synergy can be very clearly defined as the concept that 2 + 2 = 5, or creating something that is more valuable than the sum of its components. In other words, the merging of two firms will generate a more valuable entity than the value of the two firms if they were to stay independent (Dermirbag, Ng and Tatoglu 2007). According to Lubatkin, synergy occurs when two operating units can be run more efficiently and more effectively together than apart” (Lubatkin, 1983).

There are two primary kinds of synergies: revenue-based synergies and cost-based synergies. Revenue-based synergies emerge from top-line growth through revenue enhancement while maintaining the same cost base. Whereas, the cost-based synergies occur from the bottom-line improvement due to cost savings while maintaining the same revenue level. According to Capron, horizontal acquisitions create value by utilizing cost-based and revenue-based synergies (Capron,1999). These synergies need not necessarily be mutually exclusive. Beyond these two primary sources of synergies, a value can also be created by generating new resources and capabilities that lead to revenue growth or cost reduction (Sudarsanam, 2003).

Revenue augmentation can arise from a variety of sources. A consolidated firm may increase the market share, enabling it to have extra market power. As was previously mentioned, when two entities consolidate in a horizontal merger, they are usually similar or related regarding products and markets, although not identical. Therefore, after the merger, the companies can leverage marketing resources and exploit each other’s geographic and product platforms to improve their offering (Sudarsanam, 2003). Other sources of revenue enhancement involve the incorporation of each organization’s best practices as well as scientific and technical gains (Ravenscraft and Long, 2000). While the development though revenue augmentation can comprise a genuine source of value creation, it is considered “fairly elusive” and is frequently disdained in favor of its more substantial synergy counterpart: bottom-line enhancement through cost savings (Sudarsanam, 2003). Cost saving strategies are considered as less challenging than the revenue-enhancing ones, as the former usually involves simply the elimination of duplicate costs. (Dermirbag, Ng and Tatoglu, 2007).

According to leading M&A theorists and practitioners, cost savings are considered as a less daunting challenge compared to revenue growth. In economic terms, there are two primary paths which may lead to the cost savings, namely the economies of scale and scope and elimination of inefficiencies (Ravenscraft and Long, 2000). As the name implies, economies of scale emerge from a size factor. Economies of scale occur when the physical process inside the firm is restructured in the way that the same amounts of inputs, or factors of production, yield a greater quantity of outputs. By more efficient allocation of the resources, the firm can reduce its average cost curve and thus enjoy a competitive advantage (Lubatkin, 1983).

Apparently, there are natural boundaries to cost savings imposed by the minimum efficient scale required for operations. If the cost-cutting strategy imposes the negative consequences on company's revenues, this could ultimately lead to value disruption. Thus, the existence of synergies is not enough to justify that an acquisition will create value. There are two crucial factors, which may potentially offset the above-mentioned synergy effect.

First of all, the synergies realization does not come free. The costs associated with the post-merger integration stage like firing employees or shutting down plants may be enormous (Ravenscraft and Long, 2000). Indeed, post-merger integration is considered as one of the most notable challenges of M&A and is frequently cited as the main reason for merger failure. One can not neglect these costs must undoubtedly keep in mind when touting the value creation potential of the synergies.

Second of all, the present value of the synergies should exceed the premium paid in order to create value. Since the acquirer pays the premium up front and purchases an option on uncertain future synergies, it could be stated that the premium is an advance payment on a speculative synergy bet (Rappaport, 1998). When the buyer pays a premium to the target, the latter’s shareholders attain an immediate benefit. The acquirer relies on synergies to capture the value, however in case of an overpayment, the entity diminishes the upside potential and its chances to create value.

Behavioral Finance Theories

Behavioral economics and behavioral finance are the disciplines of economics that combine psychological theories with economics and finance and seek to develop the explanatory power of economics by psychology (Camerer & Loewenstein, 2002). In contrast to traditional finance, behavioral finance implies that markets are not entirely efficient and the agents do not possess unbounded rationality (Mullainathan & Thaler, 2000). As was previously mentioned, neoclassical theories imply that M&As are undertaken only when both the acquirer and the target benefit from the transaction. Various acquiring firms claimed about the potential synergies obtained through mergers and acquisitions. However, it is not always the case. A notable number of M&As never realized the expected synergies.

The Agency Theory

'The relationship of agency, where one party (the agent) acts on behalf of another party (the principal) on a particular decision problem, is one of the oldest forms of social interaction.' (Ross, 1973). As was mentioned previously, Neoclassical theories on corporate finance imply that corporate agents are rational and always attempt to act in the best interest of the shareholders. Ultimately, managers are shareholders' agents, and they strive to maximize the firm value. Although in reality, managers should make adverse decisions where the personal interest does not necessarily correspond to the shareholders' one (Ross, 1973). According to Jensen & Meckling if both parties of the agency relationship, namely, the manager and the shareholder, expect to maximize their utility, then there is a strong reason to assume that the manager will not always act in the best interest of the shareholder (Jensen & Meckling, 1976). Moreover, the authors stated that the conflict of interest between the giving parties might arise when the company generates significant free cash flows. With accordance to value maximization, the excess cash flows should be distributed to the shareholders. However, it entails the reduction of the resources under the management and thus the agents' power. Besides, managers may prefer to maximize corporate growth rather than corporate value since the managers’ profits such as salary, bonuses, promotions or status tend to grow in line with corporate size (Cheng et al., 2007). Nevertheless, according to Datta, Iskandar-Datta & Raman, equity-based compensation is a useful approach to align managements interest with those of shareholders efficiently (Datta, Iskandar-Datta & Raman, 2001). The authors explained that there is a strong positive correlation between equity-based compensation and stock price reaction on M&A announcements. Consequently, the managers with high equity-based compensation pay lower premiums and acquire more top growth targets.

The Hubris Theory

According to the theory of managerial hubris, presented by Richard Roll, managers may have good intentions in increasing their firm’s value. (Roll, 1986). However, by being over-confident, they over-estimate their capabilities to create synergies. Over-confidence increases the likelihood of overcompensating and may leave the winning bidder in a winner's-curse circumstances, which considerably increases the chances of failure (Malmendier and Tate, 2008; Dong et al., 2006). Berkovitch and Narayanan provided empirical evidence of hubris in US takeovers, and Goergen and Renneboog (2004) find the same in a European context. According to the latter about one-third of the large takeovers in the 1990s suffered from some form of hubris. Overconfident managers, who voluntarily keep in-the-money stock options in their own firms, more frequently engage in less profitable diversifying mergers (Malmendier and Tate, 2005). Rau and Vermaelen stated that hubris is more likely to be observed amongst low book-to-market ratio firms – that is, amongst the so-called ‘glamour firms’ – than amongst high book-to-market ratio 'value firms'.

The Hubris hypothesis implies that takeovers reflect individual decisions. Managers may convince themselves that their valuation is correct and that the market does not reflect the full economic value of the combined firm. Although the gains do exist for some M&As, a part of the takeover premium could still be induced by the valuation error (Roll, 1986). The hubris hypothesis is consistent with strong-form of market efficiency, which implies that prices at any given time incorporate all information, whether public or private (Frankfurter & McGoun, 2002), and financial markets are thereby assumed to be efficient in that asset prices reflect all information about individual firms (Roll, 1986).

Obstacles to cross-border Mergers and Acquisitions

In order to successfully execute a cross-border M&A transaction a spectrum of complicated and bewildering issues must be navigated. The most successful deals are based on thorough and detailed 'homework,' well-thought-out plans, and deal structures that assume likely and concerns. Most of the issues associated with the transaction should be appropriately addressed beforehand for successful completion of the deal. The cross-border M&A obstacles, tend to be more challenging to overcome than those of domestic M&A due to the risks concerning the different national cultures and institutional settings (Shimizu et al., 2004). The investigation of a target firm initiated by the acquirer before the takeover and the process of realizing the actual value and risks associated with the deal is called the due diligence process. The process usually involves the precise and comprehensive analysis of political, legal and economic environments as well as the target's tax and accounting systems.

The cross-border transactions usually include the approaching of a considerable number of legal entities which are governed by local legislation. In this case, a foreign bidder may experience some disturbances due to the potential lack of information. Moreover, some legal incompatibilities might arise in the acquisition process resulting in a deadlock, even in a 'friendly' merger. Furthermore, depending on the national legislation of different countries, some kinds of offers might be restricted (i.e., cash only vs. exchange of shares). Additionally, some countries may support a “national industrial policy”, which intends to create the so-called “national champions”. One may argue that such a policy may secure adequate financing of the national economy. However, this political intervention may block a cross-border acquisition, even though such transaction is compatible with the existing rules. Also, the cross-border M&As are confronting the hurdles associated with the differences in social and cultural norms, language barriers and history (Shimizu et al., 2004).

In cross-border transactions the parties usually come from divergent cultural backgrounds, speak different languages, have different business approaches, and are located in far-flung territories. Overlooking these concerns may entail an unsuccessful business integration or a failed deal. Organizational differences might also be considered as a barrier for firms to realize integration benefits. Since the organizational culture is extremely influenced by the national culture, the risk of failure associated with cross-border M&A rises with growing cultural differences between the target and the acquirer (Harzing & Van Ruysseveldt, 2004). According to Martynova and Renneboog differences in the quality of corporate governance standards between the bidder and the target countries may explain part of the expected value creation in cross-border M&As (Martynova and Renneboog, 2008).

Summary

To conclude, the companies usually engage in mergers and acquisitions to maximize value through synergies and resource sourcing. However, for various reasons, mergers also can destroy value. The primary theoretical justification for such destruction concentrates on the agency-cost idea that the interests of managers and shareholders may not be aligned. Thus, managers may pursue M&As because of motivations other than the ones in the best interest of shareholders. The motives which are not associated with value-maximization constitute approximately a quarter of all M&A activity (Seth et al.,2000). Both value-increasing and value-destroying motives may coexist during the same merger or acquisition, and considerably impact the outcome of a merger (cf. Seth et al. 2000, Haleblian et al. 2009, Peng 2006). Taking into consideration the fact that anticipated synergies at the time of a deal announcement are frequently exaggerated or inflated, keeping these caveats in mind is particularly important. In fact, most mergers do not achieve the entire synergies that were expected, and actual post-merger integration costs can sometimes exceed the forecasted expenditures. This is precisely what makes mergers so challenging from the bidder’s perspective (Ravenscraft and Long, 2000). Generally, if mergers do generate value, they do so by changing tax liabilities, changing contracting costs, or changing investment incentives. If the size, timing, and riskiness of the consolidated future cash flows of the merged entities exceed the cash flows of the separate firms, the merger is deemed to be successful.  The cross-border mergers and acquisitions activity developed tremendously over the last decade. Meanwhile, the research on the area failed to keep pace with this trend. Even though the literature on the subject is extensive, there are still multiple hiatuses to be addressed (Shimizu et al., 2004). Nevertheless, M&A related studies have been made in various aspects including tendencies in M&A activity, characteristics of the transactions and corresponding gains or losses to shareholders (Dutta & Yog 2009). Worth to mention that most of the studies concentrate exclusively on the US and UK markets. Mergers and acquisitions are considered as the essential mechanisms through which the companies implement their domestic and cross-border growth strategies (Goergen & Renneboog, 2004).

The most cited work in the context of mergers and acquisitions is 'Managing acquisitions: Creating value through corporate renewal' by Haspeslagh and Jemison. The study focuses on the fundamental problem of mergers and acquisitions - the added value that the companies contribute to the transaction and the potential financial benefit achieved through the combining of the entities (synergy). One of the most fundamental aspects covered in the book was the post-merger integration phase of a transaction, as it is considered as the period where the value is created or lost (Haspeslagh & Jemison, 1991). Furthermore, the authors disclosed various obstacles which may arise before the deal closure.

According to the paper by Ferreira et al. (2014), the history of studying the M&A transactions is divided into three periods. The first period (1981-1990) is characterized by the employment of classical financial and economic theories to explain M&A transactions and their attributes (Paine & Power, 1984; Jensen, 1976; Lubatkin, 1983; Rumelt, 1974; Williamson, 1975). The second period (1991-2000) concentrates on the post-merger performance applying financial theory and the theory of transaction costs (Lubatkin, 1987; Chatterjee, 1986). The third period is dedicated to the organizational learning and cultural differences (Gammelgaard, 2004; Haleblian & Finkelstein, 1999).

Numerous scholars devoted their papers to topics which study the impact of mergers and acquisitions on various financial indicators of an acquirer and a target company, on the share price in particular. For instance, one of the latest studies dedicated to this topic, Tao et al. (2017), concluded that Chinese companies performing international acquisitions demonstrate a positive abnormal return. Additionally, the positive abnormal return is significantly higher when buying target companies from countries with a low level of political risk. Moreover, the companies with government involvement tend to receive a lower return than those which are private.

In general, the papers which are dedicated to the cross-border mergers and acquisitions carried out by the companies from emerging markets, show the evidence of a positive return (Bhagat et al., 2011; Boateng et al., 2008; Wang & Boateng, 2007; Zhou et al., 2015). However, there are a few studies which illustrate a negative return Aybar & Ficici (2009) and Chen & Young (2010).

The range of research on the impact of mergers and acquisitions deals on the financial performance of companies is quite extensive. For instance, Stiebale (2013) examines the influence of cross-border M&A on the acquirers' Research and Development costs. In particular, the authors analyzed a sample of international acquisitions carried out by German companies and concluded that the R&D cost to Revenue ratio experiences an increase of 1.5 percent on average. At the same time, the effects are most pronounced for high-tech industries and product innovators.

Default Probability Models

Default Probability Models may be divided into three main categories, namely Structural models, Traditional models, and Hybrid models. Structural models employ various equations to estimate the value of the securities, in particular, options, which are used to assess the default probability afterwards. The examples of this type of models are the Merton model and all its modifications, as well as the Down-and-Out option model, which will be discussed in the following chapter.

The classical regression analysis, in which the specific statistical data and regressors may explain the default probability, is considered as a traditional model. The most notable example of the traditional model is the Altman model (Z-score).

Recently, financial academics started to utilize the so-called Hybrid models. In essence, hybrid models are a mixture of traditional and structural models. Frequently, the combination of these two types of models occurs when calculating the distance to default applying one of the structural models and the further adoption of the retrieved values ​​to regression analysis. Moreover, the hybrid model may be developed as a combination of Logit model and Neural Network to benefit from the advantages of both linear and non-linear models. Multiple scientific studies are proving that the hybrid models for default risk probability assessment outperform the structural and classical models.

Structural Models

In structural models, the default time is determined by an underlying process describing the firm value. This approach was first introduced by Black and Scholes (1973), and Merton (1974). In this setup, a default event may occur only at the debt’s maturity. If the total value of the firm’s asset is less than the face value of its debt, firm defaults and debt holders receive the total value of the firm at maturity. Otherwise, a firm does not default, and its liability is repaid completely. This approach allows for the application of the Black-Scholes-Merton option pricing methods. The firm’s equity is deemed as a European call option on the firm’s asset value with a strike price equal to the face value of the debt at maturity. On the other hand, the payoff to the liability holders can be viewed as the face value of the loan less a put option with strike equal to the face value of the debt.

The first-hitting-time approach extends the original Merton model by allowing the default to occur not only at the debt’s maturity but also prior to this date. In this settings, default happens if the firm value crosses a (constant or random) barrier. These models were first proposed by Black and Cox (1976). The asset level which triggers default can be imposed exogenously (Black and Cox , 1976; Longstaff and Schwartz, 1995) or endogenously by having the shareholders optimally liquidate the firm (Leland and Toft, 1996) among others. The firm’s equity is modeled as European down and out call option instead of a standard call option. In these models, the threshold is an absorbing state, and default leads to bankruptcy right after the firm’s asset value crosses the barrier. However, Gilson et al. (1990) indicate that approximately half of the companies in financial distress avoid liquidation through out-of-court debt restructuring. Under the structural models, when the firm's assets reach a sufficiently low level compared to its liabilities, a default event is deemed to occur. These models require strong assumptions on the dynamics of the firm’s asset, its debt and how its capital is structured. The main advantage of structural models is that they provide an intuitive picture, as well as an endogenous explanation for default.

Another particularly successful practical implementation of structural credit modeling is called KMV model. This model was developed in 1989 as a commercial modification of the Merton model using market data. In 2002, the rating agency Moody's acquired the rights to this model, since then the model is called Moody's KMV. The main difficulty, as in all structural models, is in assigning dynamics to the firm value, which is an unobserved process. Worth to mention, that KMV slightly diverges from a strict structural model. By a strict structural interpretation, EDF, the expected default frequency, meaning the probability of observing the firm to default within one year, ought to equal the normal probability of the distance to default . KMV, however, breaks the model at this point and instead relies on the extensive database of historical defaults to map DD to EDF by a proprietary function (Grasselli and Hurd, 2010). is designed to give the actual fraction of all firms with the given DD that have been observed to default within one year.

Studies such as Duffie et al. indicate that the distance to default is a reasonable firm-specific dynamic (defined by current observations of the firm) quantity that correlates strongly with credit spreads and observed historical default frequency. There are many articles that shed light on the KMV model fundamentals (Crosbie and Bohn, 2003; Keenan and Sobehart, 1999; Sobehart et al., 2000). Additionally, various authors created their own models based on the KMV framework (Vassalou and Xing, 2004; Campbell et al., 2008; Aretz and Pope, 2013). The authors of Brockman and Turtle (2002) apply barrier options concept to estimate the probability of companies defaulting. Some authors also employ the MLE, maximum likelihood estimation method, to solve the system of equations from the Merton and KMV models. KMV models is also considered as a hybrid model, as it combines the Merton approach with additional financial information (Sobehart and Keenan, 2001b).

Traditional Models

Traditional models utilize fundamental analysis and seek to predetermine which factors such as cash flow adequacy, asset quality, earning performance, or capital adequacy, are crucial in explaining the credit risk of a company. They assess the vital importance of these determinants, mapping a reduced set of accounting variables, financial ratios, and other information into a quantitative score. In some cases, this score can be interpreted as a probability of default while in other circumstances can be used as a classification system.

As was previously mentioned, the philosophy of these models is to determine which factors are relevant in estimating the credit risk of a firm. Beaver (1966), was one of the trailblazers in the field of traditional models. Further, Altman (1968) expanded the model from the Beaver's article and developed a Z-Score model that weighs various independent variables and applies a quantitative score. Further, the Z-Score model was modified by Altman et al. (1977). This article explained the ZETA model, which was imperceptibly effective than the previous model - the classic Z-Score model.

Subsequently, binary regressions became actively employed by the theoreticians to determine the probability of bankruptcy. For instance, Ohlson (1980) adopts a methodology that produces a specific credit rating indicator - O-Score. The O-score is the result of a linear combination of coefficient-weighted business ratios. These ratios may be derived from the standard periodic financial disclosure statements provided by publicly traded companies. The probit and logit models weigh the adopted explanatory variables and assign the probability of failure to each of them using the cumulative distribution function. Application scoring models are used by loan institutions to evaluate creditworthiness of potential clients applying for credit product.

The aim of these models is to classify applicants into two groups: the ones who will not default and the ones who will default. The major advantage of the traditional models is that they can provide significant, incremental information. Nevertheless, such models are rigid and inflexible, as the data from the financial statements is required for the modeling. The main characteristic that differentiates traditional models is the econometric method they apply on their estimation procedure. Apparently, one of the most important aspects of traditional models is the selection of the appropriate financial ratios and accounting-based measures that will be used as explanatory variables.

Generally, mergers and acquisitions are believed to reduce the risk of an acquiring company (Amihud & Lev, 1981; Galai & Masulis, 1976). This result might be considered legitimate for the cases when the buyer and the target companies boast approximately the corresponding level of cash flows risk, with the transaction allowing for diversification. Meanwhile, Furfine and Rosen (2011) present the results, explaining that inbound transactions lead to an increase of the default risk.

Various articles are devoted to studying the effect of mergers and acquisitions on the default risk in the banking sector. According to these papers, the M&A transactions in the banking industry diminish the risk of default due to portfolio diversification (Emmons, Gilbert & Yeager, 2004), geographical diversification (Hughes, Lang, Mester & Moon, 1999), and diversification of the activities (Van Lelyveld & Knot, 2009). However, the articles only involve particular sample based on the US market. The European market results are slightly different: Vallascas and Hagendorff (2011) indicate that, on average, these transactions are risk-neutral.

The main prerequisite for a possible increase of the default risk of the acquiring company is the anticipated transfer of risk from the target company to the bidder (Furfine & Rosen, 2011; Vallascas & Hagendorff, 2011). Further, the default risk might increase due to the association of the target company with a higher risk industry than that for the buyer (Furfine & Rosen, 2011; Maqueira, Megginson & Nail, 1997) . Finally, the method an M&A transaction can be financed might have a significant impact on the default risk company: for the transactions financed by the cash, the level of financial leverage usually rises, which entails an increase of the default risk (Furfine & Rosen, 2011; Vallascas & Hagendorff, 2011).

In accordance with the theories of behavioral finance and economics, various researchers identified the possible increase of the default risk prompted by the top-management actions. Consequently, it is common for managers to increase leverage post-merger (Ghosh & Jain, 2000; Morellec & Zhdanov, 2008). Furthermore, the managers' compensation in the form of securities, namely, shares or stock options, motivates them to take more risky and perilous decisions (Chena, Steinerb, & Whytec, 2006). Thus, such compensation method leads to a higher probability of the default risk increase after the transaction (Grinstein & Hribar, 2004; Hagendorff & Vallascas, 2011). For instance, Furfine and Rosen (2011) present statistical evidence that managers with the compensation based on the stock options tend to conduct precarious transactions that consequently increase the default risk. The aggressive managerial actions are affecting risk enough to outweigh the strong risk-reducing asset diversification expected from a typical merger.

Another area of research dedicated to the influence the managers' decisions might have on the default risk is concerning the information asymmetry (Moeller, Schlingemann and Stulz, 2007). Additionally, managers tend to capitalize on the mistakes made in the valuation of the companies, especially in case of high variance between the market stock price and its fair value (Dong, Hirshleifer, Richardson & Teoh, 2006; Erel et al., 2012). Overvalued companies usually tend to execute precarious transactions (Dong, Hirshleifer, Richardson & Teoh, 2006; Erel et al., 2012). That being said, it is believed that overvaluation and undervaluation have a considerable effect on the type of financing of the transactions. Frequently, in case of overestimation, the payment in shares takes place. In contrast, cash payment is prevailing if the company is undervalued (Myers & Majluf, 1984; Travlos, 1987). The scientific literature on this topic is closely connected with the signaling theory.

In the case of cross-border transactions, there are a few main causal factors which might prompt the increase of default risk of the acquiring company, namely: geographical location (distance), cultural differences, and the difference in the government system between the bidder's country and the country of the target company (Kedia, and Panchapagesan, 2008). Traditionally, the shorter the distance between the two countries, the higher the probablity of successful integration. For instance, Kedia and Panchapagesan (2008) investigate the impact geographical distance has on the decision for a takeover by American companies. Additionally, they indicate that the return on inbound deals is twice as large as the one for cross-border transactions. Erel et al. (2012) examine a related problem and conclude that the probability of completing the domestic M&A transaction is much higher than the one for the cross-border deal.

Furthermore, there is a direct relationship between cultural norms and the M&A activity: the countries with a high level of the uncertainty avoidance index tend to participate less in M&A transactions (Frijns, Gilbert, Lehnert, and Tourani-Rad, 2013). Similar results were presented by Ahern, Daminelli, and Fracassi (2015). The authors conclude that there is a negative correlation between the cultural distance and M&A activity. Nevertheless, Erel et al. (2012) claim that cultural peculiarities have a modest effect on cross-border mergers and acquisitions. Moreover, there are numerous papers proving that the corporate governance, accounting standards, laws and regulation, the development of the financial and capital markets have a substantial influence on the activities of the acquiring company (Rossi & Volpin, 2004; Martynova & Rennebog, 2008a, 2008b; Burns, Francis & Hasan, 2007; Bris & Cabolis, 2008; Francis, Hasan & Sun, 2008). For instance, when the bidder is from a country with a strong shareholder orientation, part of the total synergy value of the takeover may result from the improvement in the governance of the target assets. In contrast, when the bidder is from a country with poorer shareholder protection, the expected takeover earnings will be lower as the poorer corporate governance regime of the bidder will be imposed on the target.

Taking into consideration the existing literature concerning the mergers and acquisitions, one can assume what factors might influence the default risk of the acquiring company. The first group of factors is associated with the parameters of the acquirer, the target company, and the transaction itself. The second group includes indicators that reflect the motives of managers for executing a merger. The third group corresponds to the factors regarding the differences between the countries involved in an acquisition, for example, the difference between the level of development of the capital markets in the countries, cultural distance.

Conclusion

In conclusion, the impact of mergers and acquisitions (M&A) on default risk in the banking sector is a complex issue that involves various factors. Empirical studies have shown that M&A transactions in the banking industry tend to diminish the risk of default due to portfolio diversification, geographical diversification, and diversification of activities. However, the European market results indicate that these transactions are, on average, risk-neutral. Moreover, the anticipated transfer of risk from the target company to the bidder, association with a higher risk industry, and method of financing the M&A transaction can also affect the default risk of the acquiring company.

Behavioral finance and economics theories suggest that top-management actions, including an increase in leverage and compensation in the form of securities, can lead to a higher probability of default risk increase after the M&A transaction. Managers tend to capitalize on mistakes made in the valuation of the companies, especially in case of high variance between the market stock price and its fair value. The scientific literature on this topic is closely connected with the signaling theory.

In the case of cross-border transactions, geographical location, cultural differences, and the difference in government systems between the bidder's country and the target company's country are key factors that can prompt an increase in the default risk of the acquiring company. Cultural norms and uncertainty avoidance index can also affect M&A activity. Corporate governance, accounting standards, laws and regulation, and the development of financial and capital markets also play a significant role in the activities of the acquiring company.

In summary, the effect of M&A on default risk in the banking sector is a complex issue that involves various factors. The results of empirical studies are mixed, and it is essential to consider the specific context of each transaction. It is important to evaluate the potential risks associated with the method of financing the transaction, the industry, and the countries involved. Finally, effective corporate governance, accounting standards, laws and regulation, and the development of financial and capital markets can mitigate the potential default risk of the acquiring company.