MAKING AN ACQUISITION - A THREE PART SERIES
PART ONE - THE FACTS OF LIFE.
The prospect of a big takeover causes more excitement in the financial markets and press than any other kind of event. A whole industry of bankers, lawyers, accountants, PR and communications consultants and many others swings into action to support the deal. Investors, Hedge Funds and arbitrageurs will circle around a big deal, wondering how to maximise their gains and those left outside will seek ways of getting in on the act - perhaps a 'White Knight' might be induced to start a bidding war and get the price up, as well as generate more advisers' fees!
Before any definite news of an impending bid reaches the public domain bankers, brokers and possibly lawyers will have put in weeks of work to test the feasibility of the deal and the likely market response. Even before this preliminary work, bankers will almost certainly have eyed up the possible deal and promoted it to clients and anybody else who might listen - it is estimated that at least 50% of deals are originally conceived by investment bankers as 'ideas' and touted around potentially interested parties.
It is certain that recent rumours that Total Elf might bid for Shell did not originate from either company. Behind the scenes, many a banker had pored over 'ideas' for dealing with what they saw to be a troublesome company - and then quietly briefed some journalists to place the rumour in the public domain, until at last Total was forced to issue a denial. Behind the scenes, this sort of stuff is happening continuously, as hungry bankers try to stoke up lucrative deals.
Part of the fascination of acquisitions is the psychological dynamics of deals. For certain types of people, acquisitions are almost compulsive. Deal-making is a way of avoiding the boredom engendered by tedious operating detail.
An executive search consultant once described a well-known business figure to us as a "deal junkie". There is the thrill of the chase and the kill, the fascination of the deal dynamics and, not least, an excitement that comes from working with enormous intensity with very smart professional advisers. Deals are different from managing. They can be performed by a small group of people, who often come to feel very powerful when they think of the strategic, financial and human outcomes of what they might do. History can be made quickly, simply by taking a few risks and spending other peoples' money
This feeling of power, added to the thrill of planning and executing the conquest can make acquisitions take on a life of their own, rather like planning a military campaign.
Advisers often help to sustain the drama by setting up special places, called 'War Rooms' or something similar, to accommodate generals and their staff to plan and execute their campaigns. In this way, the minds of the 'generals' can become totally focused on one aim - doing the deal.
The rewards for a successful general can be huge. A reputation as a master deal-maker is the key to opportunity and fortune. The aftermath of a big merger leads to all kinds of opportunities for bonuses and share grants.
With all the expensive brainpower and expertise that is devoted to M&A activity, surely it is one of the best ways of creating value?
All the research would seem to indicate that this is quite inaccurate.
For example, KPMG's 1999 study of acquisitions and mergers made by large UK quoted companies indicated that over 80% of the senior executives of acquiring companies declared that their deals had resulted in enhanced value for shareholders, Yet the analysis showed that 83% of mergers had failed to produce any benefits for shareholders, and more alarmingly, over half had destroyed value. Not only that, but less than half of the directors interviewed had conducted a post-deal review, said John Kelly, KPMG's head of M&A integration.
By 2001, the picture had improved, but only marginally. About 30% of M&A deals created value, while 31% destroyed value and the rest made no discernable difference. Once again, managers seemed remarkably incurious about the impact of their deals, as 75% did not intend to conduct a post-project review or measure shareholder value when evaluating the success of a transaction.
So, what about the external, or shareholder, perspective? Surely acquisitions are good for the share price, aren't they? According to the David Hume Institute, it is the shareholders in the target company that benefit. (Peacock and Bannock, 1988)
The Institute conducted exhaustive research into the immediate and wider effects of mergers and acquisitions. They found that in the four months before and up to an acquisition, there was an average increase of 30% in the share price of the vast majority of the sample of target companies, but an increase of less than 1% in the share prices of only half of the bidders. The rest suffered from share price decreases. The researchers concluded that, "All the gain in share price goes to the shareholders of the acquired company".
Furthermore, performance of the acquiring companies tended to deteriorate relative to competitors and their own previous performance for at least two years following the acquisition.
They concluded that, The net effect of mergers on shareholder wealth is uncertain and probably small. There is a balance of evidence that abnormal gains are positive in the very short run, although this is far from conclusive. It is fairly certain that the net gains decline over time, and, in the long run, may actually be negative.
But surely M&A activity keeps management on their toes? Some would argue that the purposes of the Stock Market are to pool society's savings and to allocate them to the most profitable use. The dynamics of the market help to ensure that the assets are most profitably employed. Two mechanisms make sure that this happens - the threat of takeover and the actuality of mergers and acquisitions.
Proponents of this theory maintain that even if two managements are maximising the returns from their companies, putting the two together may well yield a better result because of efficiencies of scale. When bidders pay a premium for the companies they acquire, this represents the 'unrealised efficiency gains' that will be unlocked by the merger.
In 1990 The Institute for Public Policy Research published the results of a study into this theory, challenging whether it worked as postulated.
They state, rather baldly, that the purity of the efficient market theory is distorted by several factors;
- Investing institutions tend to base their decisions on short-term market situations rather than long-term value expectations.
- Fund managers will nearly always accept immediate gain rather than long term possible gain, therefore making takeovers easier than the balanced value argument might indicate.
- That it is just not true that share prices always reflect true long term expected earnings, as, "Myopia, herd behaviour, fads, fashions and short term-ism all get in the way".
The researchers conclude, "If takeover bids were always a success and led to an improvement in the productivity of the companies involved in the business combination, then British industry should be significantly outperforming foreign competitors". (Our italics).
Finally, it is worth considering the findings of a joint study by McKinsey and Southern Methodist University, called 'Mastering revenue growth in M&A'. (McKinsey Quarterly, Summer 2001)
This study examined 193 acquisitions made between 1997 and 1999. All were worth more than $100 million. A further study was made of 160 acquisitions by 157 quoted companies.
The researchers examined the importance of maintaining growth through and after an acquisition. They found that achieving growth synergies is much more important than cost reduction, and maintain that:
- To counteract a 1% shortfall in growth after an acquisition, the acquirer must achieve additional cost savings of 25%.
- Revenue growth of 2% to 3% can offset a shortfall of 50% in cost savings.
These facts have very serious implications, as the two studies found that growth is seldom maintained. In the first, only 9% of companies were showing any growth at all nine months after the acquisition. The other study reached a similar conclusion. Only 12% of companies had managed to accelerate growth after the acquisition and the rest trailed the industry average growth rates by an average of 4%.
The last words of warning should come from Larry Seldon and Geoffrey Colvin in the Harvard Business review of June 2003.
Deal volume during the historic (US) M&A wave of 1995 to 2000 totaled more than $12 trillion. By an extremely conservative estimate, these deals annihilated at least $1 trillion of shareholder wealth. For perspective, consider that the whole dot-com bubble cost investors $1trillion at most. That's right: stupid takeovers did more damage to investors than did all the dot-coms combined.
So, why do so many acquisitions and mergers fail?
Briefly, there are three main causes of failure.
- Inappropriate reason for the Acquisition or Merger
A surprisingly large number of acquisitions and mergers are made as a result of superficial analyses of the strategic reasons and realistic benefits that may be derived.
Headlines like 'industry consolidation', 'convergence of technologies' and 'synergy' are bandied about freely - but often when the results of a deal are examined, the expected benefits have failed to materialize. Beware 'synergy' the most - beyond one-off cost reductions, the potential benefits of a merger can only be understood by examining the benefits of combination at the operating level and in great detail. How will each main customer benefit, how do the skills and cultures of the two companies match or clash, what about operating systems, processes and procedures? None of these questions can be satisfactorily answered by the people who normally make deals - corporate managers and external advisers. By the time the real facts emerge, it will usually be after the deal and too late.
- By Paying Too Much
It all starts at the valuation stage. Valuing a company is a tricky subject at the best of times. Valuing for acquisition is even trickier.
The first step is to look at what the company is worth. Then you need to look at what it's worth to you by valuing the improvements to business or cost savings that will be achieved by combining the two entities. Almost inevitably you will need to pay a premium to acquire a company. If you bid for a quoted company you will need to pay over the current share price to persuade investors to vote in your favour. Thus synergies, the benefits of bringing two entities together, are needed to finance the premium.
As soon as you start to calculate value, you need to make assumptions. These assumptions drive the numbers in the financial model.
One retired senior financial executive from a FTSE 100 company expressed concerns about the valuation process: "There is a real danger implicit in the valuation models used to justify the prices paid for acquisitions.
Firstly, they depend upon the assumptions, which can be flexed to favour the deal.
Secondly, they tend to consider one model only rather than a range of probable outcomes.
Thirdly, they are heavily dependent on the least scientifically calculated number, the terminal value. Many acquisitions are justified on the basis of the terminal value, which is essentially a guess about what the business will be worth after ten years."
Problem is, so many factors can distort valuations - but two stand out in stark relief: a lack of good information and the momentum generated by the 'psycho-drama' of deals.
- Failure to integrate and deliver the benefits.
As we have seen, the price paid for almost all acquisitions can only be justified by the realisation of 'synergy' benefits - the business improvements and cost reductions that will flow from combining two operations. These benefits are realised by a process known as integration - the bringing together of the old and new organisations to create the new entity with a different new culture, market approach and cost base.
In their 1999 report, "Unlocking Shareholder Value, The Keys to Success in M&A" KPMG identified selecting the management team, resolving cultural issues and integration project planning as three of the six critical keys to successful mergers and acquisitions. Yet a 2002 survey by the same company found that two thirds of the companies bought between 1996 and 1998 still needed to be properly integrated.
By now, we hope that you have developed a healthy and rational scepticism about M&A deals as a sure-fire way of assuring business success.
But, despite the pitfalls, many deals have worked out well.
In Part Two, to come shortly, we will examine the practicalities of making acquisitions work through the experience of Bill Yearsley, a top American manager, who evolved a detailed body of philosophy and practice that stood him and his company well.