“How did one of the largest mergers and acquisitions (M&A) deals of recent years go wrong?” asks Mark Scott in BusinessWeek, referring to the collapse of mining giant BHP Billiton’s $150bn bid for rival Rio Tinto. But perhaps BHP’s shareholders should breathe a sigh of relief. As Société Générale’s James Montier points out, although 93% of managers think M&As add value, only about 30% ever do. The predator usually ends up suffering what consultantancy McKinsey calls “the winner’s curse”: stumping up a huge “purchase premium” and overpaying by 10%-35%. So why are deals done at all, and how should an investor react?
M isn’t the same as A
Mergers and acquisitions are different. But both can end in tears. Mergers are usually friendly. Two groups of shareholders in separate firms, typically of a similar size, agree (or at least a majority do) that the firms should combine. This is usually achieved via a share swap – existing shareholders give up their shares in exchange for new ones in the merged firm. An example was the 1998 merger of US carmaker Chrysler Corporation with German firm Daimler Benz to form Daimler Chrysler. In that case, the chairmen of both firms became joint-leaders of the new monster car maker, which has struggled ever since.
Takeovers usually involve a large firm buying a majority (50% + 1 as a minimum) of the voting shares in a smaller one to take control. The target’s shareholders may agree to the predator’s terms, in which case the bid is said to be ‘friendly’. Or the bidder may have to fight for control, revising the initial bid higher several times to get enough ‘acceptances’, which of course increases the risk of overpaying. That’s called a ‘hostile’ bid. Examples include Sir Philip Green’s failed attempt to buy Marks & Spencer in 2004.
Deals often don’t deliver
In the good times, boards are keen on M&A. Deal volumes have plunged this year, but at the 2007 peak, says PricewaterhouseCoopers, there were 1,732 deals in the mining sector alone, with a value of $158.9bn. Yet M&A often ends up creating behemoths that don’t deliver, says Montier. For example, a 2008 report by Ben-David and Roulstone reveals that, on average, acquiring firms underperform by 13% in their first year and 25% over the next three. Flipping M&A on its head, a 2003 study by Kirchmaier of 48 European demergers between 1989 and 1999 found that the combined “abnormal return” of the parent and spin off was 4.2% after three years. In short, they were better off apart. So given the poor returns, what really drives M&A?
Why predators buy
The obvious reason for buying anything is because it’s cheap. But that doesn’t feature in most decisions to buy another company. In fact, a study by Mukherjee, Kiymaz and Baker found that only 8% of corporate managers gave it as the reason for a deal.
The reality is that bull markets reward CEOs for growth – at almost any price. The faster it happens the better. And most CEOs know that spending someone else’s (shareholders’) capital on buying another business is quicker than growing your own, more exciting than running day-to-day operations, and may conveniently eliminate a promising competitor. Big deals also get picked up in the papers – great for a big ego. And if everyone else is doing deals, every CEO wants to make sure they are among the predators, not the targets. None of these reasons would go down well with shareholders. So CEOs need an excuse – and Montier reckons that waffle about ‘synergies’ and ‘diversification’ comes up most often. Don’t be fooled by either.
There are two types of synergies. ‘Revenue synergies’ refers to sales growth that is supposed to flow from benefits such as sharing customer lists, combining sales forces, beefing up product development and aligning marketing strategies. ‘Cost synergies’ are about saving money by firing duplicate staff and cutting back on overlapping premises, systems and so on. But a KPMG study found that only 30% of firms ever conduct a robust analysis of either. Worse, most fail to deliver.
Cost cutting comes naturally to tycoons, so around 60% of mergers do manage to deliver 90% or more of planned cost savings, according to a 2004 study by McKinsey’s Christofferson, McNish and Sias. But that still leaves around 40% of deals where expected cost savings vanish. And 70% of expected revenue synergies never materialise. Plus the scale of any savings is overestimated by at least 25% in more than a quarter of all deals. Next we have ‘diversification’ – a word that means big fees for M&A advisers. Consultants at Bain & Co have shown that 75% of moves into ‘adjacent’ markets fail badly. So-called ‘focus-decreasing’ mergers between 1977 and 1996 on average destroyed around 20% of a company’s value over three years.
So, should you steer clear of M&A?
Not necessarily. M&A activity is down as banks pull lending and cash is conserved to fend off a downturn. But the scene is being set for what Montier calls “good M&A”. Takeovers tend to pay off when a target’s shares are cheap and deals are smaller, adds the FT’s Graham Bowley. So falling stockmarkets are creating “a lorry-load of opportunities”, says The Independent’s Jeremy Warner. It also helps if deals are done in cash rather than shares, and when the firms involved are in similar industries and the motivation is pure cost cutting. So keep an eye on those capable of funding deals in solid, long-term sectors, such as oil and gas, pharma, agriculture, and infrastructure – what Bedlam Asset Management’s Jonathan Compton calls “consolidators”. They might just get the chance to pick up some bargains in the coming months.