Good acquisitions

By Paul André

Some say they start with a good strategy and rely on sharing activities and transferring skills

While recent merger and acquisition activity does not match the record-breaking levels of the late 1990s, M&As continue to be a privileged strategy for growth, as illustrated by recent transactions such as Pechiney-Alcan, Manulife-John Hancock, Maple Leaf-Schneiders and GE-Vivendi Universal. The most recent wave of M&As, as well as previous ones, is fuelled by many factors: low interest rates, a bull market, deregulation, global expansion and industry restructuring. But are these large transactions creating value or are they just good stories?

What do we know
The latest wave was by far the most important of all times. Global transactions grew at close to 20% a year from 1990 to 2000 (about 2,000 transactions in 1990 to almost 10,000 in 2000). The value of total deals toppled US$1,000 billion in 1998, 1999 and 2000. Crosbie and Co. reports the Canadian M&A market experienced a record-breaking year in 2000 with almost 1,300 announcements worth more than $200 billion.

In many ways, M&As are unique business transactions. For most firms, M&As are relatively rare and infrequent events, thus implying they have little experience and must rely heavily on outside help. More importantly, M&As usually put into play a large amount of resources that must be paid upfront. And contrary to other investment projects, there are no test runs, no milestones at which point a firm may choose a different path (modify, abandonment). Considering their scale, one would think M&As are well planned so that they create added value for the organization. Unfortunately, and quite surprisingly, one of the most important investment decisions by firms appears to destroy value more often than not, time and time again. While a 2002 Business Week cover story shows that 61% of acquirers destroyed shareholder value, a previous 1995 cover article in the same magazine detailed how half the largest M&As destroyed value and another third only added marginal value. Recent large writeoffs of goodwill (e.g., Nortel for $13 billion and JDS Uniphase for $55 billion) are another indication of the problems that acquiring companies must face. Notwithstanding the secrecy surrounding many transactions, finance, accounting and other management researchers have attempted to understand the value creation outcome of M&As from many perspectives. Let us examine what we know.¹

Assuming stock market efficiency in incorporating relevant information, one of the most reliable measures of value creation is the unexpected short-term stock market reaction at the time of announcements. In that respect, shareholders of target firms are always the big winners with unexpected returns between 10% and 40% over various windows around the announcement date. However, the fate of acquiring firms' shareholders is murkier with many studies showing negative returns, i.e., shareholders of the acquiring firm subsidize the gains enjoyed by target firm's shareholders. What is clear is that the type of transaction makes a difference. While cash-financed transactions appear to create value for both shareholder groups, stock-financed transactions often destroy value for acquiring shareholders and barely end up being overall value-creating projects. These results, while not as extreme, also hold for the Canadian market.

More recent studies examining long-term value creation lead to similar conclusions even if there are many difficulties in setting up proper measures, windows and benchmarks. Furthermore, short-term reactions appear to be good indicators of subsequent stock market and operational results. Hence, on average, M&A transactions appear to destroy value. Again, Canadian firms do not appear to be better than their counterparts around the world.²

Why M&As don't work
Understanding why these transactions destroy value leads us to focus on the large premiums that are paid for targets. On average, acquiring firms pay 25% to 35% more than the current market value for targets. If one assumes the market is relatively efficient at measuring the value of firms, we soon realize the magnitude of implied gains that have to be achieved to make M&A breakeven projects. Unfortunately, many firms fall into what Mark Sirower has rightly called the "synergy trap." Let's look at a simple example. Let's assume the pre-acquisition market value of the target is $10 million. Given that, on average, acquisition premiums range from 25% to 35%, let's say the acquirer pays a $3-million premium. The chart on page 45 measures the level of cash flow needed for such an M&A to be a zero net present value project, assuming a five-year recovery period and a required rate of return of 10%. The new entity has to generate almost $1.1 million of before-tax cash flow ($800,000 after tax assuming a 30% tax rate) over five years to ensure no value destruction, net of all integration costs. The required before-tax cash flow jumps to $1.4 million if we experience a delay of only one year before benefiting from the synergies. Delays create a vicious circle that reduces the probability of ever making such a project profitable. As can be imagined, the higher the expected rate of return, the higher the hurdle. How difficult will achieving these synergies be? True, it does depend on the relative size of the players.

The preceding question begs the following question: why do firms pay too much? It is easy to say bad planning, bad fit, bad communication or bad timing. But let's look more closely at a number of factors that can help explain the puzzle. A major reason so many M&As lead to value destruction is the misconception that it is easy to achieve synergies in very competitive settings. Sirower states the challenge very well: "Acquirers must be able to further limit competitor's ability to contest their or the targets' current input markets, processes, or output markets and/or acquirers must be able to open new markets and/or encroach on their competitors' markets where these competitors cannot respond." However, it is an incredibly difficult task to create new opportunities, to decrease threats or to generate significant improvements in the most dynamic industries. Moreover, competitors will not lie down and wait to be surpassed.

Second, companies do not properly measure the various integration costs, which are undervalued because they are so difficult to estimate. Most firms have trouble managing their own system changes, so it is easy to imagine the challenge faced by an acquirer in integrating different business cultures, in different geographic locations and in different legal environments. Moreover, integration costs depend on the type of integration (e.g., target left as a standalone vs. target becomes part of the acquirer).

Further, an often forgotten cost is management's time and focus. If a large number of a firm's top players are assigned to post-merger integration, they are not addressing other issues in the organization. Also, an over-emphasis on numbers often means not enough attention is given to the complex human issues involved in integrating two large organizations. And as shown in Figure 1, delays are the group's worst enemy. Beyond the time value of money issue, any project manager will tell you delays are a leading cost driver in themselves as organizations attempt to catch up or fight fires; and M&As are very large and complex projects. These problems can also lead to all sorts of games on the numbers themselves.³

Another important issue is "bad governance." There are many circumstances where it may be in management's best interests, but not in other stakeholders', to proceed with a M&A. One is simply power and prestige. Another is over-confidence in one's ability to better manage than others. Yet another is reward. The single most significant factor explaining executive compensation is firm size and not necessarily firm performance.⁴ Well-protected executives of target firms also have little to worry about takeovers, given their golden parachutes and outstanding options that vest with the acquisition. In fact, executives on both sides of the deal have much to gain, often at the expense of other stakeholders.⁵ When we also take into account the large fees that consultants and investment bankers get from the deal, be it good or bad for other stakeholders, left unchecked many players have personal incentives for the deal to go through even if it ends up destroying value. Even after the deal, many have incentives to protect their terrain rather than work for the benefit of the new entity. Only good incentives schemes and rewards with good monitoring by board members, blockholders and other market players can steer the firm in the right direction.

How to make them work
Management's well-known thinkers have attempted to give us formulas for successful M&As. Michael Porter rightly states that good acquisitions start with good strategy and that successful acquisitions rely on sharing activities and on transferring skills. Peter Drucker also offers his five commandments of successful acquisitions: acquirers must contribute something to the acquired firm; a common core of unity is required; acquirers must respect the business of the target firm; the acquiring firm must be able to provide top management to the target firm in a reasonable time frame; and managements in both firms should receive promotions across entities in a reasonable time frame.⁶

Patricia Anskinger and Thomas Copeland show that successful acquirers have a track record of innovative operating strategies; have a team of experienced and successful deal makers; have the ability to identify and put into place capable managerial talent; make use of strong incentive systems linked to the success of the new entity, more precisely to the future changes in cash flows; make sure that turnaround happens very quickly within the first two years; and develop good information and feedback systems. Smaller deals, paid in cash and in the same or a very similar business, are also more likely to be successful.

In the end, successful M&As require good management and good governance. Organizations launch numerous projects and many won't necessarily achieve the desired outcomes but on average they must create value to ensure future success. M&As are somewhat different because of their sheer size and upfront nature. Further, M&As get more outside scrutiny, therefore increasing the pressure to succeed. However, defining and measuring success in the context of M&A projects is not obvious and we will never be sure of the what-if scenario had there not been a merger.

But one would hope that managers and stakeholders understand the important risks of failure and therefore ensure they have all the tools to properly analyse and execute these transactions. Bad transactions not only wastes management time and effort while generating limited improvements, they can destroy the values of both the acquiring and target firms.

References

1.  André, Ben Amar and L'Her (2000): "Regroupements d'entreprises et création de valeur," Revue internationale de gestion, vol. 25, no 3, automne 2000, 158-174. Andrad, Mitchell, and Stafford (2001): "New evidence and perspectives on mergers," Journal of Economic Perspectives 15(2), 103-120.
2. André, Kooli and L'Her (2003): "The Long-Run Performance of Mergers and Acquisitions: Evidence from the Canadian Stock Market." Working paper.
3. André, Ben Amar and Laurin (2000): "Regroupements d'entreprises et gestion des bénéfices," La Revue du Financier, 139, 2003, 26-36
4. Magnan, St-Onge, Craighead and Thorne (1998): "La rémunération des dirigeants: un enjeu économique, politique, symbolique pour le conseil d'administration," Revue internationale de gestion, vol. 23, no.3, 127-134.
5. André, Magnan, St-Onge and Houle (2003): "La rémunération des dirigeants des firmes absorbées : caractéristiques et incidences." Working paper.
6. Weston, Siu and Johnson (2001): chapter 21 for a detailed discussion of these articles and strategies for creating value.

Other References

• André P., Magnan M. and St-Onge S.: "A clinical exploration of stakeholder value creation or destruction in large acquisitions: the case of the pulp and paper merger between Abitibi-Consolidated and Donohue." Working paper (2003).
• Anslinger P. L. and Copeland T. E.: "Growth through acquisitions: A Fresh look," Harvard Business Review, 74 (January-February 1996), 126-135.
• Drucker P. F.: "Five rules for successful mergers," The Wall Street Journal (October 15, 1981), 28.
• Henry D.: "Mergers: Why most big deals don't pay off," Business Week (October 14 2003).
• L'Her J. F. and Magnan M.: " Les vagues de fusions et acquisitions en Amérique du Nord : modes ou rationalités économiques," Revue internationale de gestion, vol. 25, no 3 (automne 2000), 158-174.
• Porter M. E.: "From Competitive Advantage to Corporate Strategy," Harvard Business Review (May-June 1987).
• Sirower, M. L., "The Synergy Trap," The Free Press (1997).
• Weston J. Fred, Juan A. Siu and Brian A. Johnson: Takeovers, Restructurings and Corporate Governance, Prentice Hall, 3rd edition (2001).
• Zweig, P., "The Case Against Mergers", Business Week (October 30, 1995).

Paul André, PhD, CA, is an associate professor at HEC Montréal and senior lecturer at the University of Edinburgh. He is a member of the SSHRC Research Alliance in Corporate Governance and Forensic Accounting

Technical Editor: Michel Magnan, PhD, FCA, associate dean, John Molson School of Business, Concordia, and Lawrence Bloomberg chair in accountancy