M&As spell value for shareholders*

New research shows that M&As in the current cycle are outperforming the market

*This is an expanded version of a summary that originally appeared in the August 2006 issue of CAmagazine.

By Éric D’Amours

Conventional wisdom has it that mergers and acquisitions destroy value – and in the past this has often been the case. But based on new research conducted by Towers Perrin with The Cass Business School in Europe, the opposite could now be true. Companies involved in deals in the current M&A cycle are generally outperforming the market and creating more value for shareholders. In fact, looking beyond the share price, an examination of broad financial metrics such as return on assets and earnings per share shows companies going through M&As in the current cycle have surpassed the MSCI World Index.

The research analysed the outcomes of deals within the current M&A cycle, which started in 2003, as well as the past two major M&A cycles (those whose peaks arose in 1989 and 1999). The study was complemented by qualitative data from interviews with senior management of companies involved in deals in all three cycles. Results of the analysis show that in the current merger wave, companies involved in M&A deals on average outperformed the market by 7%. In 1988 and 1998, the share price of the companies involved in M&A deals on average underperformed the index by 6.4% and 2.5% respectively.

The purpose of the Cass-Towers Perrin research was to understand the financial outcomes of mergers over three recent M&A cycles. In assuming that 2005 would represent the peak of the current merger wave, we chose the years preceding the peak in the last three waves to provide comparison periods. The study examined a total of 218 global deals with an inflation-adjusted value of between US$400 million and US$1.5 billion, and that were concluded in 1988, 1998 or 2004. (Full criteria and additional details are available at www.towersperrin.com.)

Why has there been such a change in the outcome of M&As? It seems companies have become more disciplined and focused in their acquisitions, choosing their deals with greater care, performing more comprehensive due diligence and paying attention to deal integration and governance. In the past, companies concentrated mainly on financial due diligence, including adverse balance sheet impacts and contingent liabilities. Now, they are placing greater emphasis on integration, as well as on longer-term concerns such as cost volatility, the consequences of workforce demographic evolution and potential hurdles in culture compatibility. It appears that companies – and their shareholders and advisors have learned valuable lessons from past M&A cycles, and are incorporating their experiences into how they approach acquisitions today. In the study, for instance, the financial services sector showed the most deals, followed by the industrial, technology, healthcare and commodities sectors. We don’t think it’s a coincidence that these financial services companies – which have accumulated the most M&A experience – also created more value for shareholders than deals in any other industry.

FACTORS BEHIND THE CHANGE

Deal management and governance

Senior managers today are much more attuned to shareholder opinions, and are more accountable for demonstrating shareholder value than was necessarily the case in the previous two merger waves. This may in part be a by-product of some of the changes in executive compensation programs, where pay is more directly linked to shareholder value creation.

Corporate governance has also become more disciplined, in part as a result of the introduction of Sarbanes-Oxley, and management is recognizing that all stakeholders need to be taken into account when considering any possible deal.

Deals in prior M&A waves were subject to a certain amount of “irrational exuberance”; the market has adapted so that today’s deals are approached from a more rational perspective, with a clear focus on the financial objectives.

Better due diligence

Acquiring companies have learned from mistakes that were made in the last two merger waves and are conducting more rigorous due diligence before making a final decision. This is helping to ensure deals are priced more accurately, but it can also make the differences and synergies between the two companies more clear, which helps inform the integration plan and the deal decision itself.

In the recent wave, the quantification of potential synergies is more about what is likely to happen as opposed to what the buyer hopes will happen. This is especially evident from an HR perspective where the synergy targets are much more realistic, reflecting the expected efforts needed to integrate two cultures and the complexity of employee total rewards systems, especially pension, benefits and compensation programs.

Financial synergies and people integration

Acquirers are no longer focused only on financial synergies. Cultural synergies are rightly taken much more seriously than they were in the previous two merger waves. As a result of this focus on integration, companies are allocating significant resources to post-closing activities, for periods from six months to two years, depending on the nature of the deal.

What does the future hold?

Although the survey results are good news for companies and shareholders, there are still too many cases where the deal price does not reflect the true cost of the acquisition -- especially when it comes to workforce-related costs and liabilities. The main areas where companies typically fall short are in assessing future risk, identifying hidden liabilities and/or estimating pension under-financing. Canadian acquirers are somewhat behind the global curve in adopting today’s more sophisticated approaches to managing the so-called “soft” issues, such as differences in organizational culture.

There is much data from academic and other sources on the reasons for past M&A failures – the most frequently cited issue is failure to address workforce and culture issues in integrating the two organizations. Since integration can be key to the success of any deal, engaging HR earlier in the process might be just what is needed to cure some of these deficiencies – and add even more shareholder value in future cycles.

Éric D’Amours (eric.d’amours@towersperrin.com is principal and national M&A leader at Towers Perrin