Synergistic Mergers in an Agency Context: An Illustration of the Interaction of the Observability Problem and Synergistic Merger

Abstract

This paper formulates a simple agency problem in a single division firm and has that firm merge with another firm having the same agency problem. The merger creates synergy, but it also causes the principal to lose information in observing the agent’s performance. We call the latter problem the observability problem associated with merger. We focus on the interaction of these two by-products of merger and study their effects on the firm’s agency contract, and profit. A key point is that many of the beneficial effects that we would associate with the presence of synergy can be undone by the observability problem, so that the synergistic benefits of merger can be misgauged, if the observability problem is ignored. Two empirically testable implications arise. First, if the post merger contract is less sensitive, then the observability problem is essentially nonexistent and the merger is profitable. Second, if the post merger contract is very sensitive, then synergy is swamping the observability problem and the merger is profitable.

The authors benefited from discussions with Tom Gilligan, Tracy Lewis, John Matsusaka, and Jan Zabojnik. An anonymous referee gave beneficial comments. This research was supported by the Marshall General Research Fund.