Merger &

Acquisition (M&A)
C h 5 : Ve r ti c a l M e r g e r
Vertical Merger
Definition (1/2)
• A vertical chain represents the various stages from raw material inputs to the final
product sold to the customer, e.g. from iron ore to steel products sold to automobile
manufacturers. The different stages of the vertical chain are also referred to as
downstream or upstream activities in the flow of the production process. At any stage in
the vertical chain the activities that precede that stage are upstream to that stage and all
activities that follow are downstream.

• There is another type of vertical merger, which accounted for a substantial number and
value of the M & A deals done in the 1990s, that merits a special focus. These mergers
brought firms whose output was in one industry together with firms that provided the
distribution channels originally designed for another industry. For example the Internet,
initially meant as a high-speed communication channel of information, now carries video
and audio signals and has turned into a channel not only for information but also for
entertainment. I.e Napster and Bank & Insurance
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Vertical Merger
Definition (2/2)
Vertical Chain of Production
• Definition: Vertical integration is the combination of
successive activities in a vertical chain under common
coordination and control of a single firm. Thus vertical
merger replaces two or more independent firms with a
single firm and it internalizes the coordination of the
successive activities rather than rely on arm’s-length
market-based transactions or contractual dealings.
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Transaction modes for sourcing inputs

• The choice between external arrangements and internalization through vertical merger is based on the relative
costs and benefits of external versus internal coordination of the activities in a vertical chain. Choice of a
particular transaction mode depends on a range of factors:
• Current and future availability of spot markets for arm’s-length transactions.
• Cost of sourcing from the spot market.
• Direct and indirect costs of contracts and informal arrangements.
• Uncertainty and information asymmetry between buyer and seller.
• Direct and indirect costs of internalizing production.
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Benefits and costs of buying in markets

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Benefits and costs of long-term contracts

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Benefits and costs of vertical integration

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Vertical mergers and value creation (1/2)
• The economic rationale for vertical mergers is derived from the comparative efficiency of
vertical integration in terms of the technical and coordination efficiency. For vertical merger to
create sustainable competitive advantage, in addition to these cost efficiencies, the merger
must also lead to other sources of value such as revenue enhancement and new growth
opportunities through leveraging existing resources and capabilities of the merging firms and
the creation of new resources and capabilities
• Revenue enhancement may arise from the ability to offer a package of services and products
rather than just products alone. Thus the offer of consumer credit and insurance services or
garaging and repair services through dealership may help automobile manufacturers gain
competitive advantage. This may explain why firms such as Ford and General Motors have in
the past acquired or built up consumer finance or dealership activities. However, this strategy
of bundling car sales with associated services is not an inimitable strategy. Therefore it is
doubtful that it can be a source of sustained competitive advantage.
• Higher profitability may be realized through the increased market power that vertical
integration can confer.
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Vertical mergers and value creation (2/2)
• Vertical mergers may have anti-competitive consequences. They may:
• provide opportunities for indirect price discrimination;
• squeeze non-integrated final product manufacturers by cutting the price of the final product, e.g.
ready-mixed concrete, and not the price of the intermediate product, e.g. cement;
• remove firms such as suppliers or distributors with countervailing power; and
• raise entry barriers by raising the capital requirement for new entrants.
• However, evidence of market power enhancement through vertical integration seems
scarce. Whether it confers market dominance again seems a doubtful proposition
• Whether integration is more efficient than market exchange or long-term contractual
relationship depends on the governance structure within the integrated firm

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Downscoping and disintegration
• A further indication of the limited potential for value creation in vertical mergers and vertical
integration is the recent trend towards reversal of vertical integration or de-integration, i.e.
the separation of the successive stages of a vertical chain from common ownership. This
process is variously referred to as downscoping, disintegration or outsourcing9 . Such
separation reduces the vertical scope of the firm and increases its business focus on a
narrower range of activities. Thus downscoping is part of the refocus exercise that caught
the corporate and stock market fancy in the 1980s and 1990s.
• Outsourcing is the shifting of the supply of inputs and support services currently being
produced within the firm to independent outside producers. It unwinds backward
integration. The trend towards outsourcing gathered momentum in the 1980s under
competitive pressures and to improve corporate performance through a clearer focus on
activities that the company could carry out comparatively efficiently and farming out those
for which outside suppliers had a comparative advantage. The outsourcing decision implies
that the technical and coordination efficiencies of market exchange outweigh those of
integrated manufacture
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Is outsourcing a valuable trade-off?
• Surveys in the US indicate that a fifth of the firms that outsourced were dissatisfied with their
outsourcing arrangements, while another fifth were neutral about it. Another survey from Dun &
Bradstreet reported that 20–25% of all outsourcing relationships including manufacturing, finance,
information technology failed within two years and that 50% failed within five years. Nearly 70% of
the respondents to the survey stated that their new suppliers did not understand what they were
supposed to do and were too costly, while providing poor service.
• Thus outsourcing is not a sure-fire way to create additional value. This may be due to overestimation
of the outsourcing gains due to information asymmetry between the outsourcer and the supplier or
an under-estimation of the internalization efficiencies.
• The decision to outsource needs to be based not only on the current tally of comparative benefits
and costs but also on future benefits and costs, taking into account feasible improvements to the
internal operations. These future benefits include the strategic advantages. Ignoring these strategic
aspects and treating outsourcing as a quick fix for operational or financial problems may spell the
kind of disaster that befell Gibson Greetings (GG). GG the US greeting cards maker, having
outsourced manufacturing in order to cope with cash flow problems and to achieve cost saving, soon
ran into supplier management problems and was subsequently taken over by a competitor
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Mergers that blur industry boundaries
• Vertical mergers integrate firms that carry out activities at successive stages of a vertical chain.
Many mergers in the 1990s combined the activities of one vertical chain with those of another.
The merger of a bank with an insurance company or an asset management company is based on
the following premises:
• Banking has become a commodity business and needs to offer value-added products to customers.
• Banks need to offer their customers not just banking products but also other savings and investment products.
• Banks can act as channels for the sale and distribution of savings products developed by insurance companies
and investment products offered by the asset management firms.
• The merger of this type transcends the traditional boundaries of the banking, insurance and
asset management industries. Banks integrated ‘backward’ to source insurance industry’s
products. Insurance companies integrated ‘forward’ to acquire distribution channels. For this
reason the term ‘bancassurance’ has been coined to describe these boundaryblurring mergers.
The combination of traditional commercial banking and investment banking offering investment
products has been facilitated in the US by the repeal of the Glass-Steagall Act enacted in the
1930s following the Great Crash to prohibit such combinations.
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Thank You.
Samuel Sahata
+6282110275326
samuel.sahata@lecturer.pmsbe.ac.id
https://www.prasetiyamulya.ac.id/
Suwandy Wong

Working Experience
• Credit Suisse, Indonesia 2016 - Present
Vice President Investment Banking
• HSBC, Indonesia Dec 2011 – Jun 2016
Senior Vice President – Corporate Banking

Education
• National University of Singapore, Singapore 2010 – 2011
Master of Business Administration (MBA)
• Universitas Pelita Harapan, Indonesia 2003 – 2007
Bachelor Degree, Financial Management