The PSU merger trap

In recent weeks, several merger ideas have been floating around in the public sector. Among them: oil, telecom and banks. The big ones that have been bandied about are the merger of Oil and Natural Gas Corp with Bharat Petroleum Corp and Hindustan Petroleum Corp, Indian Oil with Oil India, and Mahanagar Telephone Nigam with Bharat Sanchar Nigam.

In the case of banks, the general presumption is that we need lots of mega-buck mergers to make the system stronger. Once the IDBI and IFCI bailouts are out of the way, the focus will shift to the rest of the public sector banking industry.

The objective is to create super banks by merging the weak with the strong, and even the strong with the stronger -- an idea that had the endorsement of the Narasimham committee of the early 1990s.

Ideas of a decade ago need to be re-examined closely in the light of developments since then. Not because there are no benefits in it -- size and scale are important -- but because the global experience with mergers hasn't been a very happy one.

Mergers are planned to make two and two add up to five; they end up with three. The successful ones barely manage to make two plus two equal four. Going forward, mergers will make even less sense in a world in which value keeps shifting from one part of the supply chain to another, and consumer demand for any product is evanescent.

In the case of forced public sector marriages, one needs to be even more cautious because we might end up losing even the small-cost advantages that normal mergers and acquisitions deliver by reducing overheads and cutting staff.

Can you imagine any public sector manager advocating a staff reduction plan through merger? At best, this will be achieved only surreptitiously through costly, long-term VRS plans, which means no benefits will flow in the initial years.

Most mergers fail precisely because of people and culture issues. The cost cuts and "synergies" that look good on paper usually end up being much less because people from two different organisations cannot overnight start trusting one another and accept cuts or ideas proposed by the other.

Mark Sirower, a consultant with Boston Consulting Group and an international authority on M&As, discovered that two-thirds of the mergers that happened between 1978 and 1990 destroyed shareholder value. The results are similar, no matter which period one looks at.

In India, most mergers and takeovers have happened for reasons of tax advantage (setting off losses against profits), tactical advantage (to avoid paying the sales tax at multiple stages in a production process), or outright distress (like Oriental Bank's takeover of GTB).

And looking out into the future, one can say that there will be even less reason to merge. Starting April 2005, most states will shift over to the value-added tax, which means there will be no inherent advantage in vertical integration -- which is what the oil sector mergers are meant to achieve.

While it is true that internationally the oil sector is vertically integrated from oil prospecting to petro-products retailing and petrochemicals, the fact remains that this is still an inefficient way to run different parts of the value chain.

The reason why managements like vertical integration is that it allows a conglomerate to even out the effects of business cycles on earnings. Thus, if oil prices are high, they can capture value from there; if prices are falling, they can try and make bigger money from marketing or petrochemicals.

In other words, price trends and market demand may shift value from one end of the chain to another, but the net effect on corporate profitability is cushioned. The downside: Profit cushions reduce the overall efficiency of a business by making various strategic business units more "comfortable" than they would have been as standalone ventures fighting to survive in a competitive scenario.

While companies have found ways to create internal balance sheets for various SBUs, in a real-life situation managements seldom pull the plug on SBUs as fast as the markets would have if they were operating as standalone units.

The point is: mergers defocus SBUs from survival issues since they are now part of a larger family. They may be good corporate citizens, but they also get less competitive in the process.

If all this means that the odds are stacked against mergers, why even consider them in oil or banking or telecom? The obvious answer is Indian companies still lack scale; they need size to be able to compete with the global giants in their sectors.

The best option, then, is not to force any mergers, but to let the managements themselves come up with a mutually acceptable idea. If it's merger they want, fine. If it's a joint venture, so be it. If they are happy with cross-holdings and a coordination committee, that too should be okay.

If it's done in stages, and the partnership works on the ground, a merger can always follow some years down the line. The thing to avoid is shotgun weddings that neither bride nor groom is happy with.

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