Academy of Management Review

2006, Vol. 31, No. 4, 962976.

A PARADOX OF SYNERGY: CONTAGION AND

CAPACITY EFFECTS IN MERGERS AND
ACQUISITIONS
J. MYLES SHAVER
University of Minnesota
Integrating merged businesses to realize synergies can adversely affect the distribution of potential outcomes through two mechanisms: the contagion effect and the
capacity effect. I describe these effects, highlight when they will be pronounced, and
discuss their importance. My arguments demonstrate that an inherent element of
synergy-based mergers and acquisitions is that actions to facilitate synergy capture
can amplify threats and can inhibit firms ability to respond to favorable conditions in
the business environment.

one of the businesses, stemming from changes

in the environment or actions by competitors,
are more likely to have an impact across businesses of the integrated firm, compared to if it
had not been integrated. I refer to this as the
contagion effect. Second, by integrating the previously independent companies to realize synergies, firms often increase the capacity utilization of underlying resourceswhether they are
tangible or intangible. This reduction in slack
resources of the integrated entity decreases the
chances that positive shocks in the business
environment can be realized because of capacity constraints, compared to if the firms had
been left independent. I refer to this opportunity
cost as the capacity effect.
These arguments provide a new perspective
to help understand why mergers and acquisitions can destroy value that does not rely on
agency behavior, incorrect managerial assessment, overpayment for acquired operations, or
inappropriate integration efforts. Moreover, my
arguments highlight that even properly assessed and implemented acquisitions can destroy value. Recognizing these inherent consequences of implementing merger and acquisition
strategies is important to effectively assess, value,
and manage such strategies.

An often-argued motivation for mergers and

acquisitions is that the profit of the merged entity can exceed the profits of the independent
entities through the reduction of average costs
or the enhancement of revenues. This outcome,
which is often referred to as synergy, is driven
by factors such as using production capacity
more effectively (e.g., Seth, 1990; Singh & Montgomery, 1987), sharing knowledge among operating units (e.g., Morck & Yeung, 2002), and umbrella branding products (e.g., Wernerfelt, 1988).
In order to realize these benefits, production has
to be rationalized and possibly relocated, systems have to be developed to share information
or move people, and brand strategies and marketing efforts have to be coordinated within the
merged entity. For this reason, many have argued that integration activities are a vital element of acquisition success (e.g., Jemison & Sitkin, 1986; Mitchell & Shaver, 2003; Pablo, 1994;
Zollo & Singh, 2004).
Less well recognized is that the element that
leads to the realization of synergy (i.e., the integration of the previously independent companies) adversely affects the distribution of potential outcomes through two mechanisms. First,
integration of the two businesses, in a way to
effectively capture synergies, makes them more
interdependent. Therefore, negative shocks to

THEORY DEVELOPMENT
I appreciate helpful comments from the anonymous reviewers, former associate editor Anand Swaminathan, Juan
Alcacer, Xavier Castaner, Wilbur Chung, Gary Dushnitsky,
Isaac Fox, Andrew King, Michael Lennox, Xavier Martin,
David Souder, Mary Zellmer-Bruhn, and seminar participants at the University of Minnesota.

Definitions and Assumptions

I use the term merged entity or merged businesses to describe the firm that results from combining two previously independent firms through
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merger or acquisition. I distinguish this from integration, which is the processes focused on extracting the gains associated with the combination of the two organizations (Zollo & Singh, 2004:
1235), because it is possible to merge previously
independent firms yet fail to integrate them.
The definition of merger or acquisition value
that I use is the discounted value of future profits of the merged entity minus the discounted
future profits of the firms had they not been
merged (i.e., had they continued to operate independently).1 This definition explicitly recognizes that the appropriate counterfactual by
which to assess strategy performance is to assess what would have happened had the strategy not been undertaken (e.g., Masten, 1993;
Seth, 1990; Shaver, 1998). This recognition is necessary to isolate changes in value that stem
from strategy choice versus other factors. For
example, if the merged entity realizes operational efficiencies that the companies operating independently would not have realized, and this is
greater than the costs of implementing the
merger or acquisition, then value is generated.
However, changes in the operating environment
that equally affect profitability, whether or not
the firms are merged, do not affect the value of a
merger or acquisition strategy. Although profit
streams change under this scenario, this change
is not attributable to the merger or acquisition,
because the change in profits is equal regardless of whether or not the firms are merged.2
To present my arguments, I initially focus only
on well-formulated and well-implemented synergy-based mergers and acquisitions, which I
define below. This provides the cleanest context
in which to describe my arguments, because it
differentiates my arguments from other factors
that reduce value in mergers or acquisitions.
Moreover, I do not initially consider the situation
where mergers and acquisitions create value by
rationing output and increasing price (i.e., in-

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creasing market power; Weston, Siu, & Johnson,

2001), because the mechanism through which
market power increases profits is somewhat different. At the end of this section, I relax the
assumptions of well-formulated and wellimplemented synergy-based mergers and acquisitions and show how my arguments are
generally valid. In most situations, the contagion and capacity effects are more pronounced
when I relax these assumptions.3
By focusing only on well-formulated synergybased mergers and acquisitions, I examine a
scenario where, at the time the decision is
made, there is an expected increase in profit in
the merged entity owing to the reduction of average costs or the enhancement of revenues that
offset the cost of merging the previously separate firms. I do not consider mergers and acquisitions that are motivated by managerial rather
than firm interests (i.e., agency behavior; Amihud & Lev, 1981; Morck, Schleifer, & Vishny,
1990), that are motivated by managers overzealous assessment of their capabilities (i.e., hubris;
Roll, 1986), or that are driven by misassessing
the level of synergies required to offset integration and transaction costs (e.g., Sirower, 1997). In
these cases, the expected value of the merger or
acquisition is negative. Likewise, I assume that
some other transactional form, such as contracting, cannot realize these synergies, thereby
making merger or acquisition the optimal organization form to realize the underlying synergies
(e.g., Williamson, 1985). If this assumption does
not hold, then there is greater profitability in
operating the firms independently, and the expected value of the merger or acquisition is negative.
The set of mergers and acquisitions that fit the
criteria listed above has the potential to create
value. However, such value is only realized if

Integration costs and transaction costs (e.g., advisor

fees) negatively affect the profits of the merged entity and,
therefore, enter into this assessment.
2

My focus on combined profitability does not address the

issue of wealth transfer that might occur during an acquisition (e.g., Bradley, Desai, & Kim, 1988). For example, the
acquiring firm might offer a premium so large that, even if
synergies are realized, its shareholders are worse off and
the target firms shareholders capture the benefits (e.g., Barney, 1988; Capron & Pistre, 2002; Sirower, 1997).

It is important to assess the sensitivity of relaxing these

assumptions, because there appear to be a significant number of acquisitions where the market expects that synergies
will not be realized. Analyzing a sample of 464 U.S. public
firms acquisitions of U.S. public firms from the SDC Platinum Database over the period 1990 to 1999, I found that just
over 40 percent of the acquisitions had negative total abnormal
returns (i.e., the total value change of the acquirer and target
was negative). Negative total abnormal returns indicated that
the market did not expect synergies to result from the acquisition (Bradley et al., 1988). Consistent with this, Moeller,
Schlingemann, and Stulz (2003) found that market losses to
acquiring firms offset gains to targets from 1998 to 2001.

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management effectively integrates the previously independent operations in such a way to

realize these potential benefits (e.g., Capron,
1999; Capron, Dussauge, & Mitchell, 1998; Zollo &
Singh, 2004). I use the expression effectively
integrates to reflect two issues. First, the precise nature and extent of integration must be
appropriately contingent on the specifics of
each acquisition or merger (e.g., Haspeslagh &
Jemison, 1991; Pablo, 1994). Second, the execution of the integration process must be effective
and not dysfunctional. I assume that integration
efforts satisfy these two conditionsthat is, integration is well-implemented. In fact, it is the
integration of previously separate businesses
that gives rise to the mechanisms that are the
focus of this paper.
The Underlying Mechanisms
The contagion effect. Integrating previously
independent entities after a merger or acquisition provides a means through which the resources that form the basis for synergy can be
combined or shared. Therefore, integrating businesses to capture synergies provides a conduit
among previously unconnected businesses or
strengthens the conduit among already connected businesses. This conduit is intended for
the planned positive spillovers across businesses, which provide the basis for synergy.
Creating or strengthening a conduit between
the previously independent businesses also
opens a channel for negative spillovers (i.e.,
contagion). Therefore, negative events that
would have affected only one of the entities had
they not been integrated now have the potential
to affect both entities. Because the negative
events would have affected only one entity had
the merger or acquisition not occurred, and because contagion causes the negative events to
affect the merged entity, contagion reduces the
value of a merger or acquisition.4
Three common examples of synergy sources
in mergers and acquisitions highlight the contagion effect. These include allocating production to one facility from two facilities that are
running with excess capacity, implementing

Given the presentational assumptions that I initially

make, the expected value of merging two firms will be positive. Therefore, contagion will not be the expected outcome.

October

managerial systems or deploying managerial

talent to an acquired company that lacks such
resources, and cross-selling or umbrella branding products to increase consumer acceptance
and sales. In the first case, the merger or acquisition creates value by increasing the utilization
of fixed assets in production and by potentially
selling idle assets. In the second case, the
merger or acquisition creates value by applying
better managers or systems to the acquired enterprise. When merged with the other operations, these resources enhance the previously
independent operations effectiveness. In the
third case, the combination and coordination of
brands, product attributes, or marketing programs increase revenues, compared to having
the products sold independently. Therefore, in
all cases, the merged entity has the potential to
realize better performance than had the firms
continued to operate independently.
Consider first the case of allocating production from two facilities to one facility. An exogenous shock, such as the sole plant burning
down, will have a greater negative impact than
it would had the firms not merged. This is because, under the alternative scenario, where the
two plants operated less efficiently, albeit independently, only partial production capacity
would be lost when one plant burned down.
Moreover, a plant burning down would negatively affect one firm but positively affect the
other, since its demand would likely increase
and it would operate more efficiently because of
increased capacity utilization. Therefore, under
this scenario, the realized profits of the merged
entity will be less than the profits of the independent entities, and the acquisition will reduce
value.
Second, consider the sharing of managerial
systems and expertise. Assume that some event,
such as managerial turnover or a political
power play resulting from the merger or acquisition, allows the less effective managers to take
charge and apply their skills and systems
across the merged businesses. Again, the overall effect of merging the entities will be negative
compared to if the acquisition or merger did not
occur. Had the acquisition or merger not occurred, then the more effective managers and
systems would have stayed in place, and the
less effective managers would be managing

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smaller operations. Once again, under this scenario, the realized profits of the merged entity
will be less than the profits of the independent
entities, and the acquisition will reduce value.
Finally, take the case where firms umbrella
brand or cross-sell their products. Assume that
one of the products has a bad batch that significantly impairs the performance of the product. If the products of the merged entity share
the same brand name, then the overall brand
and all affiliated products will suffer. Therefore,
a negative event for any one product will migrate to the other products. Even if the products
do not share the same brand name, bundling
them together to cross-sell can have the same
effect. Therefore, the merger or acquisition will
facilitate the transfer of a negative event across
previously independent products. Under this
scenario, the realized profits of the merged entity will be less than the profits of the independent entities, and the acquisition will reduce
value. Under the scenario where the firms were
not merged and the products not umbrella
branded or cross-sold, there would be no contagion to the other products.
Moreover, in the process of integration, the
action of putting two firms under common legal
ownership can provide larger pools of resources
for claimants to pursue should things go wrong

965

with either of the previously independent firms.

For example, cash from one business is often
difficult to protect from creditors of another business under common legal ownership. Likewise,
claimants against one business might target assets of all businesses under a common legal
structure. Namely, firms with more assets (i.e.,
deeper pockets) might be targeted for legal action.5
These examples show how the contagion effect is relevant, whether the basis of synergy is
reducing average costs (the production rationalization and spread of managerial systems examples) or enhancing revenues (the crossselling and umbrella branding example).
Therefore, I expect this effect to be relevant for
both average costreducing and revenueenhancing mergers and acquisitions.
Figure 1 graphically presents the contagion
effect. The dotted curve represents the distribution of profits from both firms if they had not
merged. Identifying potential outcomes as a dis-

5
Although corporate structures with legally separate subsidiaries might mitigate this effect, courts do not indiscriminantly allow firms to isolate their legal liabilities in such a
manner. For a discussion of some of the issues that Philip
Morris faced when contemplating such actions, see Eaton
(1994).

FIGURE 1
Contagion Effect When the Expected Value of the Merger and Acquisition Is Positive

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tribution reflects that many positive and negative shocks can occur and that managers must
form expectations based on a distribution of potential outcomes. The solid curve represents the
distribution of profits from the merged businesses when the synergies exist. Because these
firms are integrated to realize potential synergies, the curve is both to the right and flatter
than the other curve. The curve is to the right to
indicate that the expected value of this strategy
is greater than that if the firms were left independent (given the assumption of well-formulated and well-integrated acquisitions); the
curve is flatter (i.e., the variance is greater) because of the efforts to capture synergies.
By integrating the merged businesses, positive realizations of the environment have the
potential to spill across both businesses, magnifying their effect. Likewise, negative realizations of the environment can spill across both
businesses and magnify their effect. The increased variance in the expected profits of
merged businesses results in the tails of these
two curves crossing at point some point on the
left-hand side of the figure, which I label i. All
profit levels to the left of point i are more likely
to occur when the firms are merged. This is the
contagion effect. The exact point of i depends on
the shape and relative positioning of the two
curves. Later in this section I describe when the
contagion effect is more or less pronounced.
One can consider the contagion effect the inverse of the coinsurance effect, where firms
reduce the variance of their cash flows by acquiring unrelated businesses (Lewellen, 1971).
This is because integrating businesses for anticipated synergies makes them more interdependent and increases the variance of the profit
stream of the merged businesses.
The capacity effect. Another way in which
opening or strengthening a conduit between
previously independent businesses affects the
distribution of potential outcomes is through a
capacity constraint in that conduit. In particular,
positive outcomes might not be realized owing
to capacity constraints in an underlying resource associated with the desired source of
synergy. Depending on the nature of how the
synergy is generated, there might not exist a
capacity constraint in the underlying resource.
Nevertheless, under such conditions, there are
often organization capacity constraints that become bindingfor example, workload increases

October

to more than what the current set of managers or

employees can effectively handle (Penrose, 1959:
45). The capacity effect is not necessarily binding in the long term because of the firms ability
to increase capacity, but, under certain conditions, increasing capacity is virtually impossible, even in the long term.
The capacity effect can be illustrated by returning to the previous three examples of synergy-based mergers and acquisitions. The first example is the most straightforward. If the
production of two facilities is merged to eliminate excess capacity, then there will be less
slack in production to accommodate increased
demand. Should there be positive shocks in demand, the one plant with limited excess capacity would be less likely to be able to service the
increased demand, compared to the two plants
with greater excess capacity. Although extra capacity might be added over time, for a period of
time, the merged businesses will perform less
well than had the operations been left separate
with excess capacity. Because the merged businesses earn less profit than the two firms operating independently in this scenario, the value
created by the acquisition is negative.
Second, consider the case where effective
managers or management systems are applied
from one business to the other business. If both
businesses realize positive outcomes and high
growth, it is possible that managerial capacity
constraints will become binding (Penrose, 1959:
45). For example, if managers have limited processing capacity, they might not be able to manage the heightened burden of the merged businesses and the growth of the merged businesses
as effectively. Once again, the firm will lose
potential profit because of a capacity constraint.
Therefore, the merged businesses earn less
profit than the two firms operating independently, and the value created by the acquisition
is negative.
Third, consider the case where firms umbrella
brand or cross-sell their products. To the extent
that the new firm encounters unexpected success and this rapidly increases demand for the
products, it might not have the production capacity to realize the full payoff of the merger or
acquisition. However, if production capacity
was not rationalized because of the acquisition,
the capacity constraint should become binding
at the same point for the merged businesses as
if would have had the two entities remained

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independent. In this situation the merger or acquisition does not reduce value, because the
profits from merging the two firms are not less
than the profits of the firms operating independently.
This last example demonstrates an important qualification with respect to the capacity
effect. The capacity effect will only reduce
value if the basis of synergy stems from more
intensively using a firm resource subject to
capacity constraints. Therefore, the capacity
effect is most relevant when the source of synergy is from reducing average costs rather
than enhancing revenues. Under the scenario
where synergy is driven by the enhancement
of revenues, the merged businesses are
equally likely to realize positive outcomes,
compared to the two independent firms,
should there exist organizational capacity
constraints. In this case, the merger or acquisition does not decrease value, even though it
does not increase it.
Overall, the capacity effect represents an opportunity cost to the merged businesses because
it mitigates the realization of positive outcomes.
Namely, the merged businesses end up realizing positive performance, but not as positive as

967

it could have been had the capacity effect not

been binding.6
Figure 2 graphically illustrates the capacity
effect. Again, the dotted curve represents the
distribution of profits from both firms if they had
not merged. The solid curve represents the distribution of profits from the merged businesses
when synergies exist. The right tail of each
curve is truncated at the point where capacity
becomes binding. This is because more profitable realizations of the environment are not possible owing to capacity constraint. Because the
merged businesses use some resource more intensively, capacity becomes binding closer to
the middle of the unconstrained distribution.
Therefore, there exists a set of positive outcomes
that can be realized if the firms are not merged
but that cannot be realized if the firms are
merged. This is the capacity effect. Note that
6
The increased use of a resource that drives average cost
reduction is tantamount to the reduction of slack in the firm.
Because this reduction of slack is often driven by organizational growth rather than organizational decline, I do not
explicitly consider such factors as violation of employee
trust or reduced innovation that can occur when slack is
reduced from organizational decline and downsizing (e.g.,
see McKinley, 1993).

FIGURE 2
Capacity Effect When the Expected Value of the Merger and Acquisition Is Positive

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Figure 2 also illustrates that, when the right

tails of these distributions are truncated owing
to capacity constraints, the expected values of
both curves will be less than if the capacity
constraints did not exist.

Propositions
Having introduced the contagion and capacity
effects, I introduce the following propositions
predicting when the contagion and capacity effects will be more pronounced.
Extent of integration. The potential sources of
synergy from which a merger or acquisition
might create value are manifold. For instance,
in the preceding discussion I presented such
sources as production rationalization, knowledge sharing, and umbrella branding. Therefore, a particular merger or acquisition might be
able to tap multiple synergy sources. Tapping
multiple sources requires that the merged entity
open or strengthen multiple conduits between
the previously independent firms.
Each channel that is opened or strengthened
between the previously independent firms enhances the contagion and capacity effects (provided that the source is average cost reducing in
the case of the capacity effect). Therefore, the
greater the extent of integration, as indicated by
the number channels opened or strengthened
between the previously separate firms, the
greater the contagion and capacity effects.
Consider the contagion effect. As discussed
previously, the act of putting two businesses
under common legal ownership opens a channel where improprieties by one business can
lead to claims against all assets. If, in addition
to this, the firm cobrands its products and consolidates production (i.e., it seeks multiple
sources of synergy), there will be multiple channels that can lead to negative realized outcomes, compared to if the businesses had not
been merged. Likewise, consider the capacity
effect. If capacity constraints become binding in
any activity a firm undertakes, these constraints
limit the output of the firm. Therefore, the more
activities in which a firm seeks to reduce average cost, the more likely capacity constraints for
the merged businesses will become binding
when the environment is munificent. These arguments lead to the following propositions.

October

Proposition 1a: The more activities

that are integrated, the greater the
contagion effect.
Proposition 1b: The more activities
that are integrated to reduce average
costs, the greater the capacity effect.
Nature of the underlying profit streams. Another two factors that affect whether the contagion and capacity effects will be pronounced
are the underlying variance and covariance in
expected profit streams. These factors are important because, as suggested in Figures 1 and
2, the shapes of the profit distributions influence
how meaningful the contagion and capacity effects are. Increased variance or covariance in
the expected profit streams flattens the distribution of expected profits. This magnifies the contagion effect, because a greater portion of the
expected profit distribution lies to the left of
where the curves cross. It also indicates that a
greater portion of the expected profit distribution is truncated owing to capacity constraints.
Moreover, increased variance of the expected
profit distribution indicates greater risk associated with the merged businesses.
To demonstrate these points, consider first the
variance in the expected profit streams of the
firms that are merged. Under the extreme case
where the future profits of the two firms are
known with certainty, the variance in the expected profit streams is zero. There is no contagion or capacity effect because there is no distribution of outcomes (i.e., there is only one
point). Therefore, as the profit stream of either
firm becomes more certain, the contagion and
capacity effects become less pronounced.
Contrast this with the situation where firms in
a nascent industry merge. In a nascent industry
it is likely that technological standards are not
determined, customer demand is not well established, and the competitive landscape is just
forming. Here, little certainty can be attributed
to expected profit streams. Therefore, the expected profit distributions will have fat tails
reflecting the variance in potential outcomes
and the risk of operating in such an environment. Under these conditions, the contagion and
capacity effects are magnified. For example,
consider two firms in such an industry that
merge and organize to cross-promote their technologies. If an industry technological standard
develops that conflicts with the technology that

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one firm possesses, then the other firm will suffer from contagion because it organized to crosspromote the nonstandard standard technology.
Likewise, if demand in the industry grows at
rates much beyond expectation, then it is likely
that the capacity effect will become binding
but only if the merger and acquisition is organized for average cost reduction. These arguments lead to the second proposition.
Proposition 2: The greater the variance in the expected profit streams of
the independent businesses, the
greater the contagion and capacity effects.
In addition to the variance of the expected
profit streams, the covariance of the expected
profit streams also affects the magnitude of the
contagion and capacity effects. Consider the situation where negative shocks to one business
always coincide with positive shocks to the
other business. In this scenario, the expected
profit streams have negative covariance. If the
expected covariance of the two profit streams is
very negative, then the tails of the merged profit
distributions will be very small. This is because
negative shocks in one business are always offset by positive shocks in the other. At the extreme, the expected merged profit stream becomes certain if negative shocks in one
business are always completely offset by positive shocks in the other. As I described in formulating the previous proposition, the more certain
the expected profit of the merged entity, the less
pronounced the contagion and capacity effects.
This leads to the following proposition.
Proposition 3: The more positive the
covariance of the expected profit
streams of the independent businesses, the greater the contagion and
capacity effects.
I recognize that the existence of synergies is
often predicated on firms sharing production
processes or customers. Under these conditions,
it is likely that the profit streams from two businesses with potential synergies will positively
covary. This observation highlights why the contagion and capacity effects will often have a
substantial impact and why they are an inherent element of synergy-based mergers and acquisitions. Nevertheless, some cross-branding
efforts can create synergies in businesses that

969

appear very unrelated (e.g., The Virgin Group). I

do not suggest that firms should acquire or
merge with firms whose profits streams have
negative covariance per se. I propose that,
should this occur, the contagion and capacity
effects would be mitigated. I discuss the implication of this proposition in the following section.
Sensitivity to Relaxing the Assumptions
My first assumption was that the merger or
acquisition was well-formulated, which I defined as the expected value of the merger or
acquisition being positive. Let me relax that assumption and assume that the expected profit of
merging the two firms is less than if the firms
continued to operate independently. This could
occur if a merger or acquisition were motivated
by managerial rather than firm interests, motivated by managers overzealous assessment of
their capabilities, or driven by misassessment of
the level of synergies required to offset integration and transaction costs.
In this situation, I expect that the firm will
integrate the merged businesses because managers believe that synergies exist or they wish
not to reveal their agency behavior. Therefore,
integration opens or strengthens conduits
across the previously independent firms. Given
that this is what gives rise to contagion and
capacity effects, these effects exist when the
assumption that the merger or acquisition is
well-formulated is relaxed. As a result, the contagion and capacity effects remain strategically
relevant.
To assess the impact of the contagion and
capacity effects when the expected value of the
merger or acquisition is negative, examine Figure 3. As in the previous figures, the dashed
curve is the distribution of expected profits of
the firms operating independently. The solid
curve is the distribution of profits of the merged
entity. Because the drivers of the contagion and
capacity effects still exist, the solid curve is flatter than the dashed curve. Moreover, because
the expected value of merger or acquisition is
now assumed to be negative, the solid curve lies
to the left of the dashed curve.
In Figure 3 the contagion effect makes negative outcomes for the merged entity more likely
for a very large portion of the distribution. In
addition, the capacity effect makes it less likely

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FIGURE 3
Contagion and Capacity Effects When the Expected Value of the Merger and Acquisition Is
Negative

that positive outcomes will be realized by the

merged entity. That is, it is unlikely that there
exists any point where the solid curve crosses
the dashed curve in the right tail of this distribution.
For these reasons, I expect the contagion and
capacity effects to be more pronounced if a
merger or acquisition is not well-formulated.
The intuition is that if negative outcomes are
more likely (i.e., the expected value of the
merger or acquisition is negative), then magnification of these negative effects through the
contagion effect compounds the negative outcome on the merged entity compared to if the
firms had remained independent. In addition,
positive realizations in the environment, which
have the potential to make mergers and acquisitions with negative expected values more successful than the merged entity, are less likely to
occur because of the capacity effect.
The second assumption I made was that the
merger or acquisition was well-implemented. I
will now relax this assumption in three ways.
First, I will assume that the merged entity overintegratesnamely, it integrates more activities
than required, given the sources of potential

synergy. Second, I will assume that the merged

entity underintegratesthat is, it does not integrate all of the activities required to capture the
sources of synergy that would exist by merging
the two businesses. Third, I will assume that all
activities that should have been integrated are
integrated and those that should not have been
are not; however, the execution of the integration efforts is dysfunctional and creates more
problems than desired results.7
If a firm overintegrates, I expect the following
to occur. Because the firm integrates activities
that are the source of the expected benefits, the
firm has the potential to reap the rewards of
merging the two firms. Nevertheless, it also expends effort and resources to integrate activities
that do not render any benefits. This reduces the
return of merging the two firms. In addition, by
integrating additional activities, the firm opens
or strengthens additional conduits across the
businesses that, given Proposition 1, magnify

Combinations of this latter effect with the former two is

possible and is a combination of the effects that I present
below.

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the contagion and capacity effects. Therefore,

relaxing the assumption in this manner
strengthens the contagion and capacity effects,
compared to the scenario where the merger or
acquisition is well-implemented.
If a firm underintegrates, it does not build or
strengthen the conduits that it should across the
merged businesses. Under this condition, synergies cannot be captured. Moreover, because integrating previously separate businesses is
what drives the contagion and capacity effects,
these effects will be dampened under this scenario. At the extreme, if the merged entity does
not undertake any integration activities, it will
not realize any benefits and it will not be subject
to contagion or capacity effects. However, it will
have incurred transactions costs with no corresponding benefits, making the merger or acquisition destroy value.
Now consider the case where the merged entity integrates the appropriate activities yet
does so in a dysfunctional way. Another way to
view this scenario is that the proper actions are
undertaken yet are poorly executed. Under this
condition, success of the merger or acquisition is
unlikely, because integration does not have the
desired results. However, to the extent that even
dysfunctional activities open or strengthen
channels among the previously independent
businesses, they give rise to contagion and capacity effects. Therefore, I expect the contagion
and capacity effects to be as important when I
relax this assumption.
Finally, I assumed that the merger or acquisition was not driven to exploit market power.
Relaxing this assumption does not deny the existence of the contagion or capacity effects, because some coordination and integration are required to rationalize output and realize any
market power benefits (Mitchell & Shaver, 2003).
Therefore, channels are opened or strengthened
across the previously independent businesses,
allowing for the possibility of contagion. Moreover, if the merged entity is effectively managing the rationalization of output, it will reduce
unneeded capacity. As a result, the merged
businesses will have less capacity than the
businesses operating independently, and munificent environmental outcomes will less likely
be realized by the merged versus independent
businesses.
The assumptions that I introduced at the beginning of this section were intended to aid in

971

clearly and cleanly presenting my arguments.

Relaxing these assumptions only mitigates the
existence of the contagion and capacity effects
if the firm underintegrates, yet this makes it
unlikely that a merger or acquisition will be
successful. Otherwise, the contagion and capacity effects remain important considerations. In
fact, I expect these effects to be more pronounced when a merger or acquisition is not
well-formulated or if a merger or acquisition is
overintegrated.

DISCUSSION AND IMPLICATIONS

Assessing the Realized Performance of
Mergers and Acquisitions
The existence of the contagion effect has important implications for assessing the realized
performance of mergers and acquisitions. First,
it suggests that even well-formulated and wellimplemented mergers and acquisitions can destroy value through contagion across the
merged businesses. Because these effects are
inherent in most mergers and acquisitions,
some level of value destruction is expected in
aggregate. Therefore, it is important that such a
benchmark be recognized when assessing
merger and acquisition strategies.
Second, because the contagion and capacity
effects increase with the variance of the previously independent firms profit streams, it is important to recognize that the benchmark level of
value destruction will vary from firm to firm. In
particular, mergers and acquisitions with firms
in nascent industries, which have greater levels
of uncertainty, will predictably lead to higher
levels of value destruction even when mergers
and acquisitions are well-formulated and wellimplemented.
Third, the existence of the capacity effect suggests that careful assessment of well-performing mergers and acquisitions is necessary before concluding that the acquisition or merger
per se is successful. This is because positive
realizations of performance might have been
equally or even more favorable had the firms
not merged. Should this be the case, then attributing positive outcomes to strategic choices or
implementation actions can lead to misinformed learning. This, in turn, might prove disastrous when managing future mergers and
acquisitions. Indicators of this outcome would

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be when a merged entity performs well, but not

as well as similar competitors who did not
merge.
The existence of the capacity effect can also
provide an explanation of why recently merged
businesses are not able to quickly take advantage of fortuitous changes in the business environment compared to other firms, the reason
being that a newly merged entity is potentially
closer to its capacity constraint. Therefore, it has
to expand its organization in order to benefit
from fortuitous changes in the environment. Notice that this interpretation of why recently
merged businesses do not react to potential
profit opportunities differs from asserting that
there exist ineffective merger integration, inertia, or poor decision-making processes.
Fourth, the existence of the contagion effect
can lend insight when forensically examining
failed mergers and acquisitions. In particular,
the contagion effect highlights that failed acquisitions can occur for reasons that are not due to
poor target choice or poor implementation. This
provides one explanation of why firms would
decide to undertake a merger or acquisition,
why the market would positively value it, why
we would observe expected integration efforts,
and yet why the merger or acquisition would
subsequently destroy value.
When assessing whether the contagion effect
is the mechanism that destroys value, the following should be observed. Some a priori unexpected or low-likelihood negative event occurs
and is magnified as it reverberates throughout
the firm because the businesses are tied together. The magnified negative effect offsets the
benefits of merging the two companies. The following is an example that is consistent with this
interpretation.
On November 10, 1999, PSC Inc., a manufacturer of bar code scanning and automatic identification solutions, announced that it would acquire Percon, a manufacturer of wireless and
batch portable data terminals, decoders, input
devices, and data management application software. In the press release, Robert Stranberg,
PSCs president, said:
This acquisition provides significant benefits for
PSC shareholders and customers, primarily because it immediately expands our product line
beyond bar code scanning into complementary
and fast-growing segments of the automatic
identification and data capture industry. We will

October

have broader distribution for both companies

product sets and the opportunity to reduce costs,
as we capitalize on the strengths of each company.

Analysts and the market appeared to agree, because on news of the acquisition, PSCs shares
rose from $7.38 to $7.88 (6.7 percent). The deal
closed as expected on January 19, 2000. On February 10, 2000, PSC was ruled against in a lawsuit by Symbol Technologies regarding technology licensing fees with respect to an earlier
acquisition. As a result, PSC had to pay Symbol
a higher royalty rate than previously. Moreover,
it had to pay Symbol approximately seven million dollars in back royalties. The magnitude of
the ruling was unexpected and the stock of the
company dropped 19 percent on its announcement. By December of 2000, the company was
struggling financially. Moreover, the company
had been undertaking various restructuring activities since April 2000, including laying off
workers, selling assets, hiring a new management team, and geographically consolidating
its operations. These efforts failed to work. By
January of 2001, the firms was stock was removed from the NASDAQ national stock list, and
the company filed for Chapter 11 bankruptcy
protection on November 22, 2002, with prearranged debtor-in-possession financing.
In this case, the acquisition was a failure ex
post. However, a priori, the expected combination of the two companies was positive, as indicated by the stock price movement and positive
analyst sentiment (the abnormal returns calculation mirrors the simple stock price movements). The unexpected magnitude of the court
ruling in the royalty case made operating the
merged entity unprofitable, because, in addition
to the expected acquisition costs, the company
was required to pay back royalties and increased royalty payments.8 Moreover, because
the previously separate firms were under common legal ownership as a result of integration
efforts due to the acquisition, Percons cash flow
and assets became susceptible to claims stemming from PSCs previous business decisions.
Therefore, the unexpected magnitude of the
award judgment against PSC impacted the
8
If the increased royalties caused per unit profits to become per unit losses, then increasing the volume of sales by
bundling products from the previously independent companies would have an adverse magnifying effect.

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Shaver

former Percon assets because of the acquisition.

Had the companies not been merged, the court
ruling would not have affected the Percon portion of the merged business. Therefore, due to
contagion, there is reason to believe that the
merged entity was worse off, compared to if
these firms had not been merged.
Formulating Merger and Acquisition Strategies
In addition to aiding the assessment of
merger and acquisition outcomes, identifying
and understanding the contagion and capacity
effects have important implications for formulating merger and acquisition strategies.
First, consider the implications of the contagion effect. Integrating companies to capture
synergies increases the potential for positive
outcomes. However, it also increases the possibility that negative outcomes will be realized,
which is the contagion effect. Therefore, risk increases when such strategies are engaged, because the variance of the merged profit stream
increases. Hence, the appropriate managerial
action in response to the contagion effect depends on the risk tolerance of the firm. If the
acquiring or merging firm is risk averse, then
the increased expected value that results from
synergies might be offset by the increased risk.
Merger and acquisition strategies or hurdle
rates of return might have to be reevaluated if
the contagion effect was not considered. If the
firm is indifferent to the increased risk (i.e., it is
risk neutral), then the increased probability of
negative outcomes is not a relevant component
of the strategy assessment because it is offset
by the increased probability of positive outcomes.
It is important that I reconcile my argument
that synergy-based mergers and acquisitions
increase risk with an existing research stream
showing that systematic risk decreases in related mergers and acquisitions (e.g., Chatterjee
& Lubatkin, 1990; Lubatkin & ONeill, 1987). The
key to reconciling this issue is the focus on systematic risk in these studies. Systematic risk
assesses the sensitivity of a firms stock price
movement to the market portfolio. Therefore, it
tends to capture the importance of events to
which all firms are subject. Chatterjee and Lubatkin argue that, in related acquisitions, the
merged entity will be better able to defend its
market position against market fluctuations

973

(1990: 255), thus reducing its systematic risk. This

is consistent with the notion of synergy. However, the observation that systematic risk decreases is also consistent with realizations from
the contagion effect. In this case, some event
specific to one business spills over and negatively affects the other business.9 Here, the
merged entity is less able to defend its market
position against market fluctuations and systematic risk will decrease (i.e., firm-specific factors play a greater role in determining the stock
price).
Second, the implication of the capacity effect
is that mergers and acquisitions aimed at
achieving synergy through reducing average
cost can constrain the merged entity if business
conditions are munificent. This suggests that
acquisitions susceptible to the capacity effect
should be closely monitored if business conditions become favorable, with a focus on increasing capacity in activities that formed the basis
of the expected synergy. Proactively responding
to favorable conditions can mitigate the capacity effect.
Third, the existence of the contagion and capacity effects reaffirms the importance of strategically integrating mergers and acquisitions
for reasons that have not previously been highlighted, however. Most notably, overintegration
not only incurs integration costs with no offsetting benefits but increases the magnitude of the
contagion and capacity effects. Therefore, in addition to the direct loss associated with integrating activities that provide no benefit, such activities leave the merged entity more susceptible to
negative spillovers and potentially less able to
expand when business conditions are favorable.
Fourth, mergers and acquisitions of firms with
more variable profit streams or in more volatile
environments face greater contagion and capacity effects. Therefore, rather than mitigating risk,
many mergers and acquisitions in these environments increase the risk associated with the
merged entity. As a result, well-formulated and
well-implemented mergers and acquisitions in
these situations are more likely to have disappointing results.

9
Given how it is defined, there would be no contagion
effect if all companies were affected by a random event.
Namely, the merged entity would be equally worse off compared to the two firms operating independently.

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Academy of Management Review

An example of this would be Guidant Corporations foray into the drug-eluding stent market.
Guidant was the world market leader in
stents devices that prop open blood vessels.
Its competitors began experimenting with adding a pharmaceutical coating to stents in order
to minimize restenosis, which is the narrowing
of the blood vessels after they have been
opened. This innovation was predicted to substantially change the industrys competitive
landscape.
Slow to internally develop an effective product, Guidant initially entered into an alliance
with the privately held Cook Group, in August of
2001, to sell a stent that used a paclitacelcoating technology that Cook had developed
and a delivery system that Guidant had developed. This would allow Guidant to defend its
market leadership position and to leverage its
extensive sales force. However, this alliance
was ruled to violate licensing agreements underlying Cooks technology. In response to this
setback, Guidant announced that it would acquire Cook for $3 billion in July of 2002.
Guidants stock price rose 7 percent on announcement, as the market applauded its efforts.
But in January of 2003, the deal was scrapped,
because the stents did not meet clinical trial
performance targets set in the acquisition
agreement. Guidants stock fell 5 percent on this
announcement. Because Guidants development
of drug-eluding stents focused on this technology, the adverse clinical trial results left the
company three years behind competitors according to market analysts. By the beginning of
2005, Guidant had lost the market leadership
position in stents and did not expect to launch a
drug-eluding stent in the United States until
2007.
Fifth, the existence of a diversification effect
within synergy-based acquisitions suggests
that if firms are considering two acquisition targets and they cannot acquire both, then some
consideration should be given to the covariance
of profit streams between the firm and the two
target companies. In particular, profit streams
with lower covariance can reduce the variance
of the merged profit stream.
The following example highlights this last
point. I expect that a North American firm that
produces motorcycles will be adversely affected
by long, snowy winters because these shorten

October

the season during which motorcycles can be

used safely. Assume that by sharing brand
name or production technology, this firm can
generate synergies by acquiring a firm that produces snowmobiles or a firm that produces
boats. However, the motorcycle firm does not
have the ability to acquire both firms. Outcomes
in the weather differently affect the performance, depending on whether the snowmobile
or boat firm is acquired. For example, long
snowy winters negatively affect both the demand for motorcycles and boats (because of a
shortened recreation season), whereas they increase the demand for snowmobiles. Short dry
winters positively affect both the demand for
motorcycles and boats (because of a lengthened
recreation season), whereas they decrease the
demand for snowmobiles. As a result, the
merged motorcycle-snowmobile businesses will
have more stable sales than the merged motorcycle-boat businesses. All else being equal (especially expected profitability), the motorcycle
firm will be better off acquiring the snowmobile
firm.
Sixth, the contagion and capacity effects will
often be more pronounced if mergers and acquisitions are not well-formulated and not wellimplemented. This provides additional reinforcement for due diligence when strategically
managing mergers and acquisitions. It suggests
that many chance events will have less impact
when mergers and acquisitions are wellformulated and well-implemented even if the
possibility of such events cannot be eliminated.
In summary, the contagion and capacity effects have important implications for assessing
merger and acquisition success and in formulating merger and acquisition strategies. In particular, by assessing the distribution of potential
outcomes, these two effects provide a more complete and nuanced understanding of the determinants of merger and acquisition performance.
CONCLUSION
In implementing synergy-based merger or acquisition strategies, firms open a conduit to
share resources across previously separate entities. However, opening up such a conduit also
increases the possibility that negative outcomes
can reverberate across it, which is the contagion
effect. Moreover, synergy-based mergers and
acquisitions often result in the more intensive

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Shaver

use of firm resources with limited capacity. This

increases the possibility a firm will not be able
to realize fortuitous outcomes from the merged
businesses because of capacity constraints,
which is the capacity effect.
Because of the nature of how synergies are
realized, these effects are an inherent part of the
merger and acquisition process. Namely, the integration of previously separate companies is
essential to realize success in synergy-based
mergers and acquisitions. However, the integration of previously separate companies can amplify threats and can inhibit firms ability to
respond to favorable conditions in the business
environment.
The existence of the contagion and capacity
effects challenges conventional wisdom that
when mergers and acquisitions are wellformulated and well-implemented, all outcomes
will be superior to those had the two firms remained independent. Moreover, the contagion
and capacity effects will often be even more
pronounced should merger and acquisitions not
be well-formulated or well-implemented.
In conclusion, this paper highlights that integrating merged businesses to realize synergies
adversely alters the distribution of possible outcomes, regardless of whether it increases or decreases expected performance. Although such
effects will be of greatest magnitude when strategy choices are not appropriate, even appropriate strategy choices and implementation can
harm performance in certain circumstances.

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J. Myles Shaver (mshaver@csom.umn.edu) is the Carlson School Professor of Strategic

Management and Organization at the Carlson School of Business, University of
Minnesota. He received his Ph.D. from the University of Michigan. His current research
interests revolve around corporate strategy choices and their impact on performance.